A Governmental Audit Quality Center Web Event September 25, 2012 Understanding Indirect Cost Rates: A Primer for Auditors Performing Single Audits A Governmental Audit Quality Center Web Event September 25, 2012

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Presenters Kim McCormick, CPA Partner Grant Thornton LLP & Alex Weekes, CPA Principal ML Weekes & Co., PC

What we will cover Single Audit Objectives Overview of Regulations Rate Proposals and Indirect Rate Example Factors Affecting Allowable Costs Types of Rates General Risk Areas for Indirect Costs Rate Agreements

Single Audit Objectives

Single Audit Objectives Part 3 of OMB A-133 Compliance Supplement (Allowable Costs/Cost Principles) Compliance Internal Controls over Compliance State, Local and Indian Tribal Governments Educational Institutions Non-Profit Organizations

Single Audit Objectives Compliance: Indirect rates are applied consistent with rate agreement AND agency/program limitations Need to understand current agreement and program-specific cost limitations Indirect rates are applied consistent with appropriate base (e.g., MTDC) Actual billings reflect approved rate Indirect costs pools reflect allowable costs Verify against billings and cost reporting forms Was most current applicable rate used Could lead to over recovery or duplicate recovery

Single Audit Objectives Internal Controls over Compliance: Look to Part 6 of Compliance Supplement Control Objectives- To provide reasonable assurance that Federal awards are expended only for allowable activities and that the costs of goods and services charged to Federal awards are allowable and in accordance with the applicable cost principles. 5 COSO buckets Control activity examples Accountability provided for charges and costs between Federal and non-Federal activities. • Process in place for timely updating of procedures for changes in activities allowed and cost principles. • Computations checked for accuracy. • Supporting documentation compared to list of allowable and unallowable expenditures. • Adjustments to unallowable costs made where appropriate and follow-up action taken to determine the cause. • Adequate segregation of duties in review and authorization of costs. • Accountability for authorization is fixed in an individual who is knowledgeable of the requirements

Overview of Regulations

Cost Principles Federal Rules & Cost Principles Not-For-Profits (OMB A-122 now 2 CFR Part 230) Hospitals (OASC-3) Colleges and Universities (OMB A-21 now 2 CFR Part 220) State and Local Governments (OMB A-87 now 2 CFR Part 225) Commercial Entities (Federal Acquisition Regulations – FAR Part 31)

Administrative and Audit Federal Rules & Cost Principles Administrative Requirement (OMB Circular A-110 now 2 CFR Part 215) Applies to All Entities OMB Circular A-133 – Audit Requirements

OMB Circular A-87 “…establishes Principles and standards for determining costs for federal awards carried out through grants, cost reimbursement contracts, and other agreements with state and local governments and federally-recognized Indian tribal governments”

OMB Circular A-122 “This circular establishes Principles for determining cost of grants, contracts, and other agreements with non-profit organizations ……the principles are designed to provide that the federal government bear its fair share of costs except where restricted or prohibited by law”

Applicability “Shall be used by all federal agencies in determining costs of work performed …. under grants, cooperative agreements, cost reimbursement contracts, and other contracts in which costs are used in pricing, administration, or settlement.”

Rate Proposals and Indirect Rate Example

What is Cost Allocation? Accomplished through an annual cost allocation plan Concept recognizing operating programs should pay for the general fund support received – Causal and beneficial relationship between cost incurred and benefits received Document identifying and distributing State and Local indirect (administrative, support, overhead) costs to benefiting departments/divisions/programs/final cost objectives

Types of Cost Allocation Plans Used to recover costs from federal grants and programs Prepared in accordance with OMB Circular A-87 Full Cost Used to allocate indirect costs to enterprise operations, departments and final cost objectives Can be used to recover indirect costs in non-federally funded programs and departments Unallowable costs per A-87 are not considered

OMB Circular A-122 Section C – “Indirect Costs” Direct Allocation Method: “Joint Costs, such as depreciation, rental costs, operation & maintenance of facilities, telephone expenses, and the like are pro-rated individually as direct costs to each category and to each award or other activity using a base most appropriate to the particular cost being pro-rated.”

Directly Allocated Costs Common Allocation Bases Cost Allocation Plans Directly Allocated Costs Common Allocation Bases Occupancy Sq. ft. of programs Cost of programs Property Insurance Cost of property per dept. Professional Liability Ins. # of staff with prof. degrees Information Technology # computers # personnel Hours spent per dept.

Cost Allocation Plans (cont’d) Directly Allocated Costs Common Allocation Bases Human Resources # of employees Payroll dollars Internal Audit Hours worked per dept. Maintenance Services Sq. ft. of programs Actual charges Grant & Contract Adm. Revenue of grants & K’s Cost of programs % of salary charged direct

Cost Allocation Goals Try to keep it as simple as possible Measurements should be based on relative benefits received Be able to replicate the process Your accounting system structure and capabilities should be considered

Direct Costs Costs that can be specifically identified with a particular cost objective Program Salaries Materials specific to award Travel Equipment Other minor direct items

Indirect Costs Terms Indirect Costs Overhead, Administrative and Facilities Overhead Costs (are directly associated with programs) Facilities, Program Supervision, Equipment Administrative Costs (benefit the entire organization) Accounting, Finance, IT, Facilities for Administration Facilities and Administrative Costs (F&A) All of the above

Indirect Costs Terms Cost Objective “A function, organizational subdivision, contract, grant, or other activity for which cost data are needed and for which costs are incurred” Indirect costs are allocated to “Final Cost Objectives” and Final Cost Objectives will incur direct costs and be allocated indirect costs (i.e. grants and contracts)

Indirect Costs “Indirect Costs are costs that are incurred for common or joint objectives, and therefore cannot be readily and specifically identified with a particular project or activity.” Indirect costs generally include: Operations and Maintenance Depreciation and Use Allowance Administration Costs Legal, Accounting, Finance, HR, IT - Administrative

Simplified Method – Indirect Cost Rate Expressed as a percentage Ratio between indirect and direct costs Simply stated if the indirect cost rate is 40%: For every $1.00 spent on sponsored activities (direct) 40 cents of indirect costs are incurred Establishes a fair and equitable way to allocate costs to projects, grants, contracts, etc.

How Do We Get a Rate? Indirect Cost Rate Proposal is submitted to Cognizant Federal Agency (generally agency with most funding) Proposal & documentation are reviewed Negotiated Indirect Cost Rate Agreement (NICRA) is executed Outlined in Appendix E of OMB Circular A-87

Allocation Methods Simple Method – Used when major functions benefit from indirect costs in the same degree Multiple Allocation Base Method – When organization has several major functions which benefit from its indirect costs in varying degrees (e.g. clinical vs. research, instruction, other sponsored activity) Direct Allocation Method – When programs are charged for all costs directly

Simplified Method Modified Total Direct Cost Salary & Wage Pro’s & Con’s to both S&W (higher rate, but not recovery) MTDC (most organizations use this base)

Indirect Cost Rate Example

Modified Total Direct Cost Includes S&W, Benefits, Materials, Supplies, Services, Travel Excludes (typically) Subcontract Costs (usually over $25k) Capital Equipment Purchases Other Distorting Items

MTDC Example Simple example of one project’s MTDC: Total Direct Costs in our budget: $ 210,000 Salaries/benefits: $ 95,000 Supplies: $ 5,000 Subcontract: $ 100,000 Capital Equipment: $ 10,000 Modified Total Direct Costs: = $210,000 - $10,000 - $75,000 (subcontract) = $125,000 MTDC (apply IDC)

Factors Affecting Allowable Costs Allowable, Allocable and Reasonable

Determining Chargeable Costs Ordinary and necessary Support operation Contribute to performance Tied to cost objective, contract, service Proportional to benefits Allowability determined by OMB guidelines & grant provisions REASONABLE ALLOCABLE ALLOWABLE

Factors Affecting Allowability General Criteria: Be reasonable for the performance of the award and be allocable thereto under these principles; Conform to any limitations or exclusions set forth in these principles or in the award as to the types or amount of cost items; Be consistent with policies and procedures that apply uniformly to both federally financed and other activities of the organization; Be accorded consistent treatment; Be determined in accordance with generally accepted accounting principles (GAAP); Not be included as a cost or used to meet cost sharing or matching requirements of any other federally financed program in either the current or a prior period; and Be adequately documented.

Unallowable Costs Entertainment Contributions to Reserve Funds Cost of Elected Officials Donations & Contributions Investment Management Fees Lobbying Bad Debt Expense

Types of Rates

Types of Indirect Rates Types of Rates Provisional Fixed Rates with Carry-Forward Predetermined

Rate Types Provisional Rate “A provisional indirect cost rate is a temporary rate established for a given period of time to permit funding and reporting of indirect costs pending establishment of a final rate for that period.”

Provisional Rate The following rules apply when a provisional indirect cost rate or a rate applicable to an earlier period is used to calculate the reimbursement of indirect costs on a financial status report. Such indirect costs must be adjusted downward, if appropriate, when a new lower permanent rate (i.e., final or predetermined) is established. They may also be adjusted upward (based on a higher rate) at the grantee's request, but not to exceed the unobligated balance of the grant. If the grantee fails to establish a permanent rate, any indirect costs previously reimbursed based on the provisional or earlier permanent rate shall be disallowed.”

Rate Types Predetermined Rate “A predetermined indirect cost rate is a permanent rate established for a specific future period based on an estimate of the costs for that period. Except under very unusual circumstances, this type of rate is not subject to adjustment…”

Predetermined Rates - Continued Rate Types Predetermined Rates - Continued “Predetermined rates are established when there is a reasonable assurance, based on experience and a reliable estimate of the organizations costs, that the predetermined rate will approximate the organization’s actual rate.”

Predetermined Rates - Continued Rate Types Predetermined Rates - Continued “Predetermined rates can be used only when an organization conducts activities solely under grants. It cannot be used if an organization performs work only on contracts or performs under both grants and contracts.” This applies to direct federal contracts only.

Rate Types Fixed Rates “an indirect cost rate which has the same characteristics as a predetermined rate, except that the difference between the estimated costs and the actual costs of the period covered by the rate is carried forward as an adjustment to the rate computation of a subsequent period.”

Carry-forward Carry-forward provision Negotiated Fixed Rate - 2012 40% Direct Cost Base – 2012 $10,000,000 Actual indirect Costs - 2012 $ 4,200,000 Indirect Cost Recovery – 2012 $ 4,000,000 Actual Rate - 2012 42% Under-recovery $ 200,000* *Carry-forward is 2 years forward (2014 in this scenario).

Carry-forward Carry-forward Actual Indirect Costs - 2014 $ 4,500,000 Carry-Forward from - 2012 $ 200,000 Indirect Costs - 2014 $ 4,700,000 Direct Cost Base - 2014 $10,000,000 Rate with Carry-forward 47% Rate without Carry-forward 45%

General Risk Areas

General Risk Areas Key areas of Risk include: Predetermined and fixed rates carry lowest compliance risk Rates cannot change; therefore program costs for prior years not subject to adjustment For fixed rates must determine if current year indirect costs and carry-forward are correctly identified Provisional rates carry risk that changes in base or pool may have material impact on programmatic costs

General Risk Areas Key areas of Audit Risk include (cont’d): Consistency in applying rate to correct base Consistent treatment of costs (no “double dipping”) Inadequate documentation / Unsupported costs Timeliness of preparing and submitting rate proposals (6 months after year end) Expired Rate Agreements

Rate Agreement

Rate Agreement - Predetermined

Rate Agreement - Provisional

Rate Agreement – Fixed CF Provision

Questions ????? 56

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