Understanding Indirect Cost Rates: A Primer for Auditors Performing Single Audits

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

6. 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

7. Single Audit Objectives

8. 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

9. 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

10. 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

11. Overview of Regulations

12. 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) Cost Principles

13. 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 Administrative and Audit

14. “…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-87

15. 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”

16. 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.”

17. Rate Proposals and Indirect Rate Example

18. 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 What is Cost Allocation?

19. A-87 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 Types of Cost Allocation Plans

20. OMB Circular A-122Section 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.”

21. Cost Allocation Plans

22. Cost Allocation Plans (cont’d)

23. 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

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

25. 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

26. 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)

27. “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 Indirect Costs

28. 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.

29. 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

30. 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 Allocation Methods

31. 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) Simplified Method

32. Indirect Cost Rate Example

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

34. 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)

35. Factors Affecting Allowable CostsAllowable, Allocable and Reasonable

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

37. 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. Factors Affecting Allowability

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

39. Types of Rates

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

41. 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.” Rate Types

42. 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.” Provisional Rate

43. 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…” Rate Types

44. 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.” Rate Types

45. 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

46. 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.” Rate Types

47. 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).

48. 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%

49. General Risk Areas

50. 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