News & Events

Sluggish Audit Environment Can Threaten the Sale of a Company

Government contractors continue to operate in an environment of heightened oversight.  Economic and budgetary pressures have increased the level of “audit scrutiny” for companies that contract with the federal government.  This increased scrutiny has vastly inflated the mean-time of audits performed by the Defense Contract Audit Agency (“DCAA”).

This sluggish audit environment has resulted in an overwhelming backlog of contracts awaiting an audit.  The backlog stretches back over six years and amounts to almost $600 billion in contract value – over five times the backlog amount six years ago.  The main result of these delays is 1) companies working from provisional rates with a potential “true-up” liability and; 2) that the rules and guidelines for allowable costs have actually changed during the period the costs were incurred and the actual audit – costs that were allowable five – six years ago may no longer be allowable.  Collectively, this can result in large potential payments owed to government.

This operational liability can be problematic when a contractor pursues a sale.  Buyers’ diligence these potential liabilities with sharpened focus, assuming that backlogged audits may pose a potential problem.   If there are concerns over the potential exposure to audit-related liabilities, buyers are likely to 1) reduce the overall purchase price given concerns around general compliance; 2) require protection through special indemnification; or 3) request additional funds withheld in escrow until the audits are completed.

Prior to considering a transaction, it is important for contractors to understand that exposure to potential audit-related liabilities aren’t limited to active contracts prior to closeout.   Additionally, contractors must realize that financial accounting / systems audits rarely cover the liabilities that materialize from a DCAA audit.  This recognition will allow sellers to preemptively address buyer concerns and mitigate audit-related transaction risks.