In our continued conversation around professionalizing your defense startup as you grow, we talk about some of the things to consider as you mature your Accounting/Finance functions. As discussed in prior articles, I won’t be addressing a detailed step-by-step how-to. The topic is too complicated and tailored to you. Instead, you will find a discussion of things to consider and highlight as “need to understand” in your strategic professionalization plan. Put that together early. Evolve it. Use it.
Now on to the conversation ….
In many cases, these functions have had some early attention since even the smallest companies have reporting responsibilities to the IRS and other regulatory agencies. Still, a couple of types of companies should pay particular attention to certain maturity steps when working in the defense industry.
The first type is that small company that has never had any interaction with DCAA or DCMA. If they plan to continue growth in this segment of their business, this won’t last long. These agencies do have oversight over many of your efforts with your defense partners. They have many different charters and areas of interest than the IRS. As a result, smaller companies, optimized only for internal controls and the IRS, will usually fall short when it comes to these two groups. Often, material interaction with these two defense agencies won’t come right away so you have some time to understand what is important to them and prepare. It will change as you grow and as your contract types change over time.
While this first type is fairly obvious, the second one might not be so clear. This type refers to the small defense company that HAS had some nominal interactions with one or both of these agencies. Often, they may even have a stamp of approval from them on their early accounting systems. These small exchanges may lead to a false sense of security about your maturity level. I have often heard “yeah I’m good. DCAA has approved our systems”. Ok well, good. But … and there’s a lot of Buts. These early interactions don’t really represent a true acceptance of your systems and practices. DCAA doesn’t have the bandwidth to do that for micro-companies. So, they take a very surface look and hit a couple of points and may give you that checkmark. So many companies get caught off guard as they grow and the microscope goes deeper. They thought they were golden. If your early communications have been short and sweet, you are likely in this category. Don’t rest on those laurels as you start winning bigger contracts.
Some of the things you should keep on your radar and professionalization schedule for your defense business are:
- Accounting System
- Budgets
- Rates (direct and indirect)
- Time and expense
- Tax (multiple states and locales)
- Indirect Rate development (greater cost reimbursement emphasis, DCAA, Forward pricing)
- Banking
- Line of credit,
- Positive Pay
- Capital financing
- CAS (Cost Accounting Standards)
- CAS DS-1 (CAS Disclosure Statement)- if you’re unsure how to even start this, you should reach out to a CPA firm to assist you with your first draft.
Your accounting system is the backbone and workhorse of your regulatory infrastructure. One cautionary point, before we get into a brief set of thoughts on this maturation. I often see a misunderstanding in the word “System” when talking about DCAA and DCMA system reviews. Your accounting system, for example, doesn’t mean the software system you use for accounting. Unfortunately, that is also referred to as a “system”. When the defense department refers to your “Accounting System” they are referring to your ecosystem of tools, policies, and procedures. Not your software. Your software tool is just a piece of the overall system. In theory, any piece of software could be used to execute parts of your process. DCAA doesn’t care what software you use, and they don’t approve pieces of software. This is another common misperception. They don’t pass judgment or give compliance approval for ANY piece of software. They analyze and determine the adequacy of your processes and your ability to properly track and report the required data to execute your contracts compliantly in the defense ecosystem. The various tools you use to do that are up to you.
That said, your actual tools to manage your finances including government accounting elements, do need to evolve. Many defense companies start with inexpensive but robust tools like QuickBooks or something similar. This is not a bad place to start. Tools like this tend to be pretty easy to use. For this type of setup to be compliant you need to build several processes and additional reporting tools on top to help you properly segregate the various types of cost. At a high level, these costs are direct costs and indirect costs. Typically, indirect cost structures are comprised of Fringe, Overhead, and G&A pools.
On that foundation, many policies and procedures must be shown to be applied consistently. These are:
- Definition for costs. When is a direct cost, an indirect cost, or an unallowable cost?
- Indirect cost pools and how they are allocated appropriately
- Timekeeping and labor tracking
- Travel and another similar expense tracking
- Project reporting, especially with respect to any Limitation of Funds clauses in your contracts
- Invoicing procedures. This is especially important for any cost reimbursable contracts you may have
- Procedures for identifying and properly segregating all costs appropriately, but especially costs deemed unallowable by the FAR (Federal Acquisition Regulations) and DFARS (Defense Federal Acquisition Regulations)
On top of these, depending on your company, you are likely to also need policy support for:
- Subcontract and purchasing
- Government Property
- Fixed asset capitalization, depreciation
- Many other possibilities are based on your type of company.
DCAA wants to know that you are managing your company around a set of policies, procedures, and tools to appropriately segregate and allocate costs, not just across contracts but across different business models and parts of the company. Keep in mind that the agency’s goal is simply compliance and part of that is ensuring costs are accounted for fairly and accurately. It’s very easy to see how larger portions of costs could end up getting allocated, incorrectly, to your government business. They exist to review whether that is happening. They do not exist to train you how to do that, so get educated and be prepared. Every once in a while, you will get an auditor who might give you some advice but recognize they are not supposed to.
Hopefully, you will achieve a size and complexity in your company where you someday outgrow QuickBooks or that initial system. You will find that the complexity you must manage on top of that tool is just too much and perhaps not even dependable. That will be a time to consider maturing your tools beyond that beginning software system. Some useful tools in the market that specialize in defense companies today are Unanet, Deltek, Procas, and JAMIS. These tools are much more expensive, complex and in my experience not as user-friendly. They do, however, specialize in helping you manage those items in the list above and more. Migrations from one accounting system to another are very difficult and not cheap. Don’t rush to do it before it’s necessary. Don’t wait too long or it will be harder and costlier. There is no exact answer for when, but in most cases, very small companies should stick with the smaller tools and build procedures that can grow around them, while building a plan around change if they start growing quickly. That plan should be part of your strategic professionalization roadmap.
One adjacent function with your accounting procedures is your budget and rate development. Every defense company should have a budget plan for the coming year and perhaps beyond. As you evolve, though, there is much more emphasis on this externally. Not only do you need to have strong company-wide budgets for your standard components such as revenue and expenses, but you will also need to have an understandable, auditable derivation for your various indirect rates. As mentioned above, some example indirect rate pools are: Fringe, Overhead and G&A. Others examples are Field or customer site overhead, subcontractor handling, material handling, etc. As you get bigger and your company’s complexity expands, you very possibly could have multiple versions of some of these. As your revenue and customer strategy evolves, this should be a part of that plan. These rates should be the basis for your annual budgeting process. The derivation of these rates must be understandable to an outside auditor from DCAA or similar organizations. They will want to see how you develop and manage against these pools. Also, how do you handle deviations from the plan, from a process and policy perspective?
In addition to your indirect rates, you will need more mature direct rates. As you grow, more attention will be paid to how you set your T&M ( Time & Material ) and the basis for your bidding categories in cost reimbursable labor efforts. How do you define the job grades, credentials, special cases, etc.? Do your P&Ps account for setting these up and maintaining them over time? How do you handle pay increases, i.e. annual merit increases? How do you handle the cost-of-living adjustments and a whole host of other considerations? Not only will government organizations increasingly want to see this buildup, but your prime contractors will be delegated that responsibility to ensure you are compliant.
When do you need to ratchet this maturity up? If you are primarily fixed-price jobs, not yet. The real turning points happen when your size of flexibly priced contracts start growing. Your most likely encounters with flexible pricing will be T&M and graduating to cost reimbursable. Each of those two steps requires more maturations than most anticipate. Plan for it.
Extra Credit
Many other related items can hit your radar as you begin that growth curve. A couple of other items that I will only touch the surface on are advanced banking, multiple state tax planning, and preparing for your first CAS Disclosure Statement. These are all big topics, that you may not have to worry about for a while. Keep them on your radar and your longer strategy plan. Put flags in your plan that would indicate when you should start preparing.
- Advanced banking.
- Positive Pay for fraud prevention,
- Line of Credit for unknown hiccups in your cash flow process,
- Capital financing such as fixed assets financing.
- Working in multiple states and the impact on your company tax filing. What defines working in multiple states? Paying employees that hold residency in another state defines ‘working in multiple states’
- What is CAS and should I care? Cost Accounting Standards are a set of 19 standards and rules promulgated by the United States Government for use in determining costs on negotiated procurements. CAS differs from the Federal Acquisition Regulation in that FAR applies to substantially all contractors, whereas CAS applies primarily to the larger ones.
Remember, these are each deep topic. If they look important do some research or contact us for more information.
As with each of the professionalization tasks, it’s best to have a plan early (well before needed) with an idea of what gates will cause you to make a change. You don’t want to do these things too early or all at once. Conversely, getting caught off guard with an unexpected new set of expenses and a realization that you have to rush to get in place is also not optimal. Your growth should allow you to invest in your infrastructure. It’s not a luxury. At some point, it will be critical to mature beyond a startup mentality. The best strategy is to be aware of what is coming as you continue to understand your future growth trajectory. Have that rough plan on a shelf. Dust it off every once in a while, and refresh it. Invest in over time.
I deliberately stayed away from too many specifics on these tools. As always, I’m happy to share more of those in a one-on-one conversation.
Contact us with any thoughts or questions regarding accounting and financing for defense businesses. High Stakes Partners is eager to have those individual conversations with defense startups to help overall growth!