U.S. DEPARTMENT OF EDUCATION Office of Inspector General Office of Audit Services-Region IX MEMORANDUM DATE: March 31, 1998 TO: Ricky Takai Acting Assistant Secretary Office of Educational Research and Improvement FROM: Area Manager Western Area SUBJECT: FINAL AUDIT REPORT WestEd’s Administration of the Regional Educational Laboratory Contracts Audit Control No. A0960009 Attached is our subject report presenting our findings and recommendations resulting from our audit of WestEd’s Administration of the Regional Educational Laboratory Contracts. In accordance with the Department’s Audit Resolution Directive, you have been designated as the primary action official responsible for the resolution of the findings and recommendations in this report. The Chief Financial and Chief Information Officer of the Office of the Chief Financial & Chief Information Officer is a collateral action official. Please coordinate with this official on actions in connection with all of the recommendations. If you have any questions or wish to discuss the contents of this report, please contact me at (916) 498-6609. Please refer to the above audit control number in all correspondence relating to this report. GLORIA PILOTTI Attachment 801 I Street ! Suite 219 ! Sacramento ! California ! 95814 TABLE OF CONTENTS Page No. Executive Summary ........................................................ 1 Audit Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Finding No. 1 - WestEd Leased Space to a Radio Station and a Computer Facility in Buildings Purchased with Federal Funds for Educational Research Purposes and Retained Profits from the Leases. . . . . . . . . . . . . . . . . . . . . . . . 2 Finding No. 2 - WestEd Used Lease-Purchase Agreements that Resulted in Excessive Charges for Furniture, Equipment and Building Improvements. . . . . . . . . . . . . . . . . . . . . . 7 Finding No. 3 - WestEd Over Recovered Indirect Costs by Improperly Applying Its Indirect Cost Rate to Subcontracts. . . . . . . . . . . . . . 11 Finding No. 4 - WestEd Charged Contracts Unallowable Indirect Expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Finding No. 5 - WestEd’s Indirect Cost Rate Does Not Reflect All Indirect Costs Charged to Its Contracts. . . . . . . . . . . . . . . . . . 14 Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Other Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Purpose, Scope and Audit Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Statement on Management Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Appendix A - WestEd Indirect Cost Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Attachment 1 - WestEd Response to the Report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 WestEd’s Administration of the Regional Educational Laboratory Contracts Executive Summary WestEd, a new entity that combined the operations of Far West and Southwest Regional Educational Laboratories, did not comply with certain Federal laws and regulations in managing its Office of Educational Research and Improvement (OERI) contract. Also, WestEd’s indirect cost rates negotiated by the U.S. Department of Education do not reflect all of its indirect costs. WestEd: # Leased space to a radio station and a computer facility in buildings purchased with Federal funds for educational research purposes and retained profits from the leases. WestEd’s fund balance included about $627,000 of lease profits earned over the two-year period from December 1994 to November 1996. # Used lease-purchase agreements that resulted in excessive charges for furniture, equipment and building improvements. The interest portion of the lease-purchase payments was excessive since WestEd had funds available in its reserve to make cash purchases. Also, it accelerated charges to the contract for the purchases and charged interest to the contract during periods when interest was an unallowable cost. # Improperly billed the contract for indirect costs on work performed by subcontractors. # Charged the contract for indirect costs that were not necessary for the performance of Federal contracts. # Gave the impression that indirect costs remained fairly constant when in fact the indirect cost rate increased 29 percent over the past three years. For fiscal year 1996, WestEd’s actual indirect cost rate was 45 percent rather than its stated rate of 12.8 percent. The report presents recommended actions for the Offices of OERI and the Chief Financial and Chief Information Officer (OCF & CIO). The actions are necessary to ensure that WestEd uses Federally-purchased property and Federal funds for their intended purposes and that Federal funds are used in an efficient manner. The report also recommends that WestEd be required to return about $131,000 in Federal funds that were used for unallowable interest, improperly computed indirect costs, and other unallowable direct costs in Recommendations No. 5, 7 and 8. OERI should coordinate resolution actions with OCF & CIO on all of the recommendations. We further conclude that as much as $2.6 million of accumulated rental profits could be better used to reduce program expenditures or further program objectives. In the future years, about $300,000 of rental profits would be available for these purposes annually. Except for indirect expenses paid for airfare upgrades and DJ entertainment, WestEd did not concur with our conclusions and recommendations. The entire text of WestEd’s response is included in Attachment 1 of this report. 1 Audit Results We concluded that WestEd, in its administration of the OERI contract, did not comply with certain Federal laws, regulations, and contract terms as discussed in our findings. During the audit, nothing came to our attention that would lead us to believe that WestEd did not comply with other laws, regulations and contract terms. Finding No. 1 - WestEd Leased Space to a Radio Station and a Computer Facility in Buildings Purchased with Federal Funds for Educational Research Purposes and Retained Profits from the Leases. WestEd leased excess space to entities with no educational research functions and retained the profits in its reserve fund. These actions did not comply with the provisions of the original Federal grants given to the regional educational laboratories (RELs) for construction or purchase of their buildings. Also, WestEd did not comply with Federal regulations regarding the use of the buildings’lease income. As a result, Federally-funded assets and income generated from those assets have not been used for their intended purposes. Further, because WestEd does not separately identify lease profits in its fund balance, the retained profits are at risk of being used for inappropriate purposes. WestEd Leased Excess Space in Its Facilities for Non-educational Research Purposes. The Cooperative Research Act (Title 20, United States Code, Section 332a) authorized Federal grant funds to construct facilities for research and related purposes. In the 1970s, the Federal Government (Department of Health, Education and Welfare) gave grants to the two RELs now comprising WestEd for the purchase or construction of buildings to conduct educational research. In 1989, the Department specified that the REL could rent excess space only to compatible tenants, for example, tenants whose business is appropriate in light of WestEd’s educational research. This restriction on the use of the building will expire in the year 2019. WestEd has no outstanding debt on the purchase or construction costs of its buildings. WestEd violated the grant provision by leasing excess space to entities with no related educational research functions. In its San Francisco building, about 34 percent of the building is leased to tenants with no relationship to educational research. One of the tenants is a rock music radio station. In Los Alamitos, about 70 percent of its building is rented to 2 the California State University System, which operates a computer center for the University system and houses staff in other non-research functions. Thus, the Federally-funded buildings have not been fully used for their intended purposes. WestEd Retained Building Rental Profits Rather Than Using Them to Further Program Objectives. Besides leasing excess space in its facilities for non-educational research purposes, WestEd did not use its building rental income to offset program costs, further program objectives or finance building improvements. Instead, WestEd retained the rental income in its reserve fund. Federal provisions require WestEd to use rental profits for program purposes. The Office of Management and Budget (OMB) Circular A-110 provides standards for Federal agencies in administering grants and agreements with nonprofit organizations. Section 2 (x) of the Circular defines program income to include the rental of real property acquired under Federally-funded projects. Section 24 of the Circular further requires that program income earned from Federal awards must be retained by the recipient and used to: (1) further eligible project or program objectives, (2) finance the non-Federal share of the project or program, or (3) deducted from the total project or program allowable cost in determining the net allowable costs. The U.S. Department of Education (Department) reemphasized the requirements for the use of rental income from Federally-funded buildings. In a letter1 to Southwest Regional Laboratory (Southwest), it authorized the use of the rental income to carry out the broad objectives of the Cooperative Research Act “. . . including, but not limited to, any purpose which furthers the support or maintenance of the building, equipping the facility or educational research.” Far West Laboratory (Far West) also received a letter2 from the Department granting similar approval for the use of rental revenue. WestEd contends it can retain rental profits. WestEd officials contend that the Departmental letters provided them approval to retain the rental profits. They stated that the reserve fund is needed for future major 1 The letter to Southwest, dated August 19, 1992, was from the Department’s Federal Real Property Assistance Program. Southwest’s building is located in Los Alamitos, California. 2 The letter to Far West, dated November 30, 1989, was from the Department’s Deputy Under Secretary for Management. Far West’s building is located in San Francisco, California. 3 building improvements and repairs because such costs are not covered under the building grant agreements with the Federal government. From a review of the letters, we found no provision allowing the retention of rental profits. Also, the minutes for WestEd’s Board of Directors’meetings show the Board approved recovery of major building improvements3 by charging the costs to its contracts. In the minutes of the meeting held on December 1, 1995, the Board approved plans to remodel the fourth floor of WestEd’s San Francisco building. The minutes indicated that the project’s estimated cost was $400,000 and that funds were available to cover this cost. However, the minutes also stated that WestEd would recover the costs by billing the contracts that use these remodeled facilities. At another board meeting held on March 29, 1996, the Board decided to remodel the Los Alamitos building at a cost of about $375,000. Similarly, the Board decided to recover the costs by charging contracts over a ten-year period. These actions contradicted the claims by WestEd officials that rental profits retained in its reserve fund will be used to finance building costs. Instead, WestEd financed building improvements with capital leases and charged depreciation and interest expenses to the contracts. In addition, our review of WestEd’s expenses confirmed that reserve funds were not used to pay for building related expenses. Financial reports for fiscal years (FY) 1995 and 1996 show that WestEd used about $300,000 of its reserve funds. WestEd expended these funds for costs, such as travel, salaries, membership dues, and bank fees, which were ineligible for reimbursement under its various contracts. The financial reports and records showed no outflow of reserve funds for building related costs or program expenditures. The funds accumulated in WestEd’s reserve balance are substantial. For FYs 1995 and 1996, the rental income collected from WestEd’s tenants and contracts exceeded the maintenance costs of the buildings resulting in a profit. WestEd allocated space costs based on the square footage occupied by the tenants and WestEd. The net rental profits earned in these two years totaled about $627,000. Table 1 shows WestEd’s rental income, expenses and profits for FYs 1995 and 1996. Table 1. WestEd’s 1995 & 1996 Rental Income, Expenses and Profits Location San Francisco Los Alamitos Year 1995 & 1996 1995 & 1996 Total Rental Income $2,326,439 $1,931,119 $4,257,558 (Tenants and Contracts) Building Expenses 1,963,189 1,667,585 3,630,774 Net Profit $363,250 $263,534 $626,784 3 Improvements relate to existing building space. 4 As of FY 1996, WestEd’s financial statements show a reserve fund balance of about $6.4 million.4 We estimated that the fund balance included about $2.6 million of accumulated rental profits, which is about 40 percent of the fund balance.5 This estimate does not include interest earned on the rental profits. Also, WestEd’s financial records do not separately identify accumulated lease profits and related interest earnings or disclose the restricted use of those funds. This places lease profits at risk of being used for inappropriate purposes. We estimated that based on current earnings of rental profits as shown in Table 1 above, WestEd could accumulate an additional $6.9 million of rental profits in its reserve fund balance by the expiration of the grant restrictions in the year 2019. This amount does not include a provision for rental increases or interest that WestEd would earn on those funds. WestEd Should Lease Excess Space to Tenants with Educational Research Purposes and Limit the Amount of Lease Profits Retained in Its Reserve Fund. We recommend that OERI and OCF & CIO require WestEd to seek tenants that are compatible with the mission or objectives for educational research purposes when lease agreements with its current tenants expire. We also recommend that OERI limit the rental profits and the related interest earnings accumulated in WestEd’s reserve fund balance. The amount to be retained should be limited to a reasonable estimate to cover necessary building expenditures, including capital improvements, that are not recovered through WestEd’s operations. The rental profits and related interest earnings exceeding the limit should then be used to reduce program expenditures and/or further program objectives as required by Federal regulations. WestEd uses reserve funds for expenditures that are ineligible for reimbursement under its contracts. Thus, the accumulated rental profits may be at risk of being used for inappropriate purposes. We recommend that OERI, in coordination with OCF & CIO, require WestEd to separately identify the accumulated lease profits, including related interest earnings, in its financial records and disclose the restricted use of those funds. 4 WestEd’s reserve fund balance of $6.4 million consists of $4.6 million from Far West and $1.8 million from Southwest Regional Laboratories. 5 The estimated percentage of rental profits in WestEd’s fund balance is the ratio of total rental profit shown in Table 1 to the increase in the fund balance accounts for FYs 1995 and 1996. The fund balance increase for WestEd was $1.5 million. 5 Auditee’s Response WestEd officials did not concur with our finding and recommendations. They asserted that WestEd leases space in its facilities in a manner permitted by the Department and the grants under which the facilities were constructed. They further asserted that personnel in the Department have never objected to the types of tenants leasing space at the Far West and Southwest facilities. WestEd officials contended that the explicit written agreements in the letters from the Department gave Far West and Southwest discretion over the use of funds derived from leasing space. They stated that the limitations in OMB Circular A-122 relate to program income under contracts. Whereas, WestEd’s facility rental income is governed by the grants under which the facilities were constructed and were not subject to OMB Circular A-122. WestEd officials asserted that WestEd is authorized to retain accumulated rental income because neither WestEd’s grants nor any communication from the Department prohibits the practice. The most critical concern to WestEd is being able to accumulate the necessary capital funds for catastrophic events such as earthquakes. Officials stated that the reserve will continue to provide WestEd the financial security necessary to prevent insolvency or the need to repair and maintain the facilities. Recovery from earthquakes alone could require expenditures of up to $5.5 million from the reserve. WestEd officials stated that its financial records currently contain information regarding all details on lease revenues. Also, a separate accounting would be redundant. Auditor’s Comments The grant terms and conditions specifically stated that the RELs will use the facilities for research or related purposes. Far West sold the original building acquired under the Federal grant and purchased a replacement facility. The Department set forth additional conditions for the replacement facility. One of the conditions specified that Far West apply all terms under the grant to the replacement facility. Therefore, according to the grant terms, Far West should seek tenants who will use the space for research or related purposes. Also, since WestEd contended that Southwest obtained a similar arrangement with the Department on the use of the REL building, the grant terms and additional conditions also apply to Southwest. OMB Circular A-122 establishes cost principles not only for contracts, but also for grants and other agreements with nonprofit organizations. In addition, Paragraph A.5.c. of the Circular refers to Section 24 of OMB Circular A-110 for rules governing program income under grants. We have cited the Circular A- 110 criteria in the finding. 6 Federal funds reserved for catastrophic events such as earthquakes are unallowable. Under OMB Circular A-122, Attachment B, Paragraph 7, contingent reserves are not allowable for events that cannot be foretold with certainty as to time, intensity, or with an assurance of their happening. An earthquake meets the definition of events provided in this criteria. Further, WestEd’s financial statements do not separately identify accumulated lease profits and related interest earnings or disclose the restricted use of those funds. Our recommendations remain unchanged. Finding No. 2 - WestEd Used Lease-Purchase Agreements that Resulted in Excessive Charges for Furniture, Equipment and Building Improvements. WestEd acquired assets through lease-purchase agreements rather than outright purchases. Under this purchasing method, contract costs for assets were excessive due to the additional interest expense. Also, WestEd accelerated the charges of asset costs to contracts by using the lease period rather than the useful economic lives of the assets. In addition, it charged contracts for interest costs during the period when interest was an unallowable cost. WestEd’s Asset Costs Were Greater Due to Use of Lease-Purchase Agreements. WestEd charged the contracts excessive costs by acquiring assets using lease- purchase agreements. The monthly payments of the leases included interest expense. With this added interest component, the leasing costs exceeded the assets’ outright purchase costs. We compared WestEd’s leasing costs with the property’s outright purchase costs in three leases for furniture and computer equipment. Table 2 shows how WestEd’s leased assets cost more than outright purchases. Table 2. WestEd’s Leased Assets Cost More Than Outright Purchases. Type of Asset: Furniture Furniture Computers Total Dates of Lease: Aug. 27, 1992 June 22, 1993 Sept. 30, 1992 Total Lease Costs $ 74,215 $ 86,806 $ 140,679 $301,700 Outright Purchase $ 57,777 $ 67,783 $ 115,319 $240,879 Cost Cost Difference $ 16,438 $ 19,023 $ 25,360 $60,821 Percent Increase 28.45% 28.06% 22.00% 25.25% 7 For the three leases, the outright purchase costs of the leased assets amounted to $240,879, while the total leasing costs that WestEd charged to contracts were $301,700 or a 25 percent increase in contract costs. This 25 percent cost increase represented the interest component in the lease purchase agreements. WestEd Expedited Charges to Contracts by Accelerating the Cost Recovery Periods of Asset Acquisitions. For the three leases we reviewed, WestEd recovered leased asset costs using the lease payment periods rather than over the useful lives of the assets. The leasing terms for WestEd’s assets were often less than the estimated useful lives specified in its depreciation policy and the Internal Revenue Service (IRS) guidelines for asset recovery periods.6 WestEd charged the entire monthly lease payments to its contracts. These charges exceeded the assets’ depreciation allowances specified in WestEd’s policy. For example, WestEd leased furniture over a four-year period, its depreciation policy specifies five years, and IRS guidelines provide for seven years. Table 3 compares WestEd’s leasing terms with its asset recovery policy for the three selected leases. Table 3. Most of WestEd’s Leasing Terms Are Accelerated. Type of Asset: Furniture Furniture Computers Dates of Lease: Aug. 27, June 22, Sept. 30, 1992 1993 1992 Lease Period: (Period WestEd Used to 4 years 4 years 3.17 years Recover Asset Costs) WestEd’s Asset 5 years 5 years 3 years Recovery Policy IRS Guideline 7 years 7 years 5 years Recently, WestEd entered into capital leasing agreements to finance building improvements. The lease terms are seven years, its depreciation policy is ten years, while IRS guidelines state 31.5 years. 6 As WestEd is a nonprofit, tax exempt organization, it is not subject to Internal Revenue Service (IRS) guidelines for asset recovery periods. However, the IRS guidelines provide the reader of this report a basis for assessing the reasonableness of WestEd’s asset recovery periods. WestEd did not provide any data or studies to support its own asset recovery policy. 8 WestEd Charged the Contract Unallowable Interest Costs. WestEd charged the contract for interest costs during the period when interest was an unallowable cost. Prior to September 29, 1995, interest was an unallowable cost under applicable contract regulations. After that date, interest costs were allowable provided that the interest was not incurred under agreements for financed or refinanced assets acquired before that date.7 WestEd charged the entire monthly lease payments, which included interest costs, to its contracts during the period when interest was an unallowable expense. Also, WestEd continues to charge its contracts for the entire monthly lease payments for assets acquired before September 29, 1995. We estimated that WestEd charged the OERI contract about $20,000 of unallowable interest in FY 1996.8 WestEd Should Be More Cost Effective in Its Asset Acquisitions. We recommend that OERI, in coordination with OCF & CIO, require WestEd to select methods for acquiring assets that are most cost effective for the REL and other Federal contracts. WestEd should even consider using its reserve funds for furniture, computer equipment and building improvements. We also recommend that OCF & CIO review WestEd’s practices for recovering asset costs. Furthermore, WestEd should discontinue charging the REL and other Federal contracts any interest costs associated with assets refinanced after September 29, 1995. Also, WestEd should compute the amount of unallowable interest expense charged to the REL contracts prior to FY 1996 and return those funds to the Department. Auditee’s Response WestEd did not concur with our finding and recommendations. Officials stated that WestEd has in the past selected, and continues to select, methods for acquiring assets that are cost effective under the circumstances. Also, Far West’s decision to lease assets was prudent in matching cash outlays with projected cash inflows. WestEd officials stated that the purchase amount, including the associated 7 Attachment B, Paragraph 19.a. of OMB Circular A-122, Cost Principles for Non-Profit Organizations, states that interest on debt incurred to finance or refinance assets acquired before or reacquired after September 29, 1995, is not allowable. 8 Computation of the estimated $20,000 of unallowable interest costs: Lease payments paid by WestEd in FY 1996 $343,462 OERI contract’s share of lease payments (23.35% of $342.462) $80,186 Unallowable interest costs (interest component is 25% of $80,186) $20,000 9 time value of that amount, exceeded the lease cost for the base period. The leases had a base period and an option for a 12-month extension. At the time of entering into the leases, Far West anticipated that it would need the items only for the base period. The total costs would equal the lease costs of the base period only. Officials stated that Far West ultimately extending the leases for another year is irrelevant to whether the decision to lease was reasonable at the time that decision was made. WestEd officials stated that Far West did not charge the contract for interest costs during the period when interest was an unallowable cost. They reasoned that the lease costs represented allowable rental cost from operating leases, not interest costs under a capital lease. As for assets refinanced after September 29, 1995, officials stated that Far West never charged interest expenses, only rental costs, to any of its contracts. Officials construed that the auditor has assumed the monthly rental payment represented depreciation expense and interest. They also stated that the auditor apparently assumed the lease period was the same as the depreciation period. Further, officials stated that WestEd’s methods for recovering asset costs are consistent with all Federal regulations and sound accounting practices. Auditor’s Comments When entering leases, Far West should have carefully considered the need to extend the leases. At the end of the base period, Far West extended all three leases cited in the report. Consequently, Far West incurred an additional $40,7899 in lease payments over the purchase costs even when factoring in the time value of money. When we compared the lease costs of the base period with the total lease costs, Far West incurred an additional $74,49310 (or about 33 percent) in lease costs by extending the leases for another year. Further, WestEd retained the assets at the end of the lease terms. Accordingly, we do not consider WestEd’s action to lease the assets a prudent decision. We recognize that lease payments under operating leases are recorded as rental costs for accounting purposes. However, whether WestEd called its lease agreements an operating or a capital lease, it is irrelevant when applying the interest provisions of OMB Circular A-122. The lease payments were based on an interest rate factor at the inception of the leases. Therefore, 9 Total lease costs for base period plus 12-month extension $301,700 — Purchase costs plus time value of money = - $260,911 Lease costs over purchase costs $ 40,789 10 Total lease costs for base period plus 12-month extension $301,700 — Total base period lease payments = - $227,207 Additional lease payments by extending the leases for a year, $ 74,493 an increase of 33 percent ($74,493 divided by $227,207) 10 interest costs were part of the lease payments. WestEd’s practice was to charge the entire monthly lease payment to its contracts. Thus, WestEd ultimately charged interest costs to contracts. Further, the Education Department General Administrative Regulations under Section 74.44 requires organizations to do a lease and purchase analysis to ensure that assets are procured effectively and economically. WestEd had sufficient cash reserves accumulated during the periods when it executed the leases. Therefore, WestEd’s decision to match its cash outflows with inflows was irrelevant and did not result in the economical use of Federal funds. WestEd officials misinterpreted the essence of the finding regarding the assets’ accelerated cost recovery periods. We did not assume that the monthly lease payment represented the depreciation expense and interest cost. For the three leases in our review, WestEd accelerated the charges of asset costs to contracts using the lease period. Whereas, if WestEd had acquired the assets with outright purchases, it would have allocated asset costs using the useful economic lives of the assets. We also did not assume that the capital lease period was the same as the depreciation period. We presented WestEd’s depreciation policy and IRS guidelines on the capital lease for building improvements for comparison purposes. Finding No. 3 - WestEd Over Recovered Indirect Costs by Improperly Applying Its Indirect Cost Rate to Subcontracts. WestEd properly excluded subcontract costs from the denominator of the formula for calculating indirect cost rates for periods prior to FY 1996 and its provisional rate for FY 1996. However, when WestEd used the rates to determine the amount of indirect costs to be charged to contracts, WestEd applied the rate to direct costs that included subcontract costs. By applying the rate to direct costs not included in the formula’s denominator, WestEd overcharged contracts for indirect costs. In FY 1996, WestEd overcharged indirect costs to the OERI contract by $108,061. In its response to the draft report, WestEd provided us its computations for the final FY 1996 indirect cost rate that it submitted to the Department. WestEd submitted the computations to the Department after our fieldwork. We confirmed that the computations for this rate included total subcontract costs in the formula’s denominator. Including total subcontract costs in the denominator is not appropriate. OMB Circular A-122, Attachment A, Paragraph D.2.c., instructs organizations to exclude major subcontract costs from the denominator when computing the indirect cost rate. WestEd has not obtained approval from the Department to include 11 total subcontract costs in the denominator. While the Circular instructs organizations to exclude subcontract costs, it is common practice to include a limited amount of subcontract costs in the denominator, for example, up to $25,000. Then the entity can apply the indirect cost rate to this limited amount to recover indirect costs allocable to subcontracts, such as processing payments to the subcontractors. We recommend that OCF & CIO determine the appropriate amount of subcontract costs that WestEd may include in the denominator of the indirect cost rate formula. This will enable WestEd to recover indirect costs related to processing subcontracts. Also, WestEd should apply the indirect cost rates to only those direct costs included in the formula denominator. Further, WestEd should return $108,061 of indirect costs overcharged to the OERI contract in FY 1996. Auditee’s Response WestEd did not concur with our finding and recommendations. WestEd officials stated that Far West included all subcontractor costs in the FY 1996 direct cost base (formula’s denominator) and properly applied its indirect cost rate to subcontract costs. Officials stated that Far West’s indirect cost agreement, which both Far West and the Department approved, specified the method for calculating indirect costs. WestEd contended that if Far West had done as recommended in the report, the agency would have violated its explicit agreement with the Department. Auditor’s Comments Prior to WestEd’s submission of the FY 1996 final indirect cost rate, WestEd did not include subcontract costs in the denominator. Therefore, WestEd should not apply those rates to subcontract costs. We confirmed WestEd’s change in the denominator with the Department’s Indirect Cost Group. Further, the Department has not approved WestEd’s FY 1995 and 1996 indirect cost rates. Thus, WestEd did violate its agreement with the Department by applying the rate to subcontract costs. Finding No. 4 - WestEd Charged Contracts Unallowable Indirect Expenses. WestEd charged its contracts indirect expenses in FY 1996 that were unallowable and unnecessary in the performance of Federal contracts. Our review of selected transactions identified the following questionable costs: 12 Description Amount • Lease of a Jeep Grand Cherokee for the Lab’s Director $5,179 • DJ for dinner entertainment at two-day board and one-day staff/board meetings at a resort $450 • Airfare for foreign travel $532 • Airfare upgrades (includes $124 direct charged to the OERI contract) $560 • Reorganization costs without prior approval $12,608 (Includes $2,804 direct charged to the OERI contract) OMB Circular A-122, Attachment A, Paragraph A states that for a cost to be allowable, it must be reasonable for the performance of the award. In determining reasonableness, the cost should be ordinary and necessary for the performance of the award. WestEd officials agreed that the DJ expenses for dinner entertainment and airfare upgrades are unallowable. They plan to exclude those expenses in the calculation of the final indirect cost rate. Also, WestEd should return $124 of unallowable costs charged directly to the OERI contract for airfare upgrades. WestEd incurred legal costs related to its merger of Far West and Southwest to form WestEd. According to the OMB cost principles for nonprofit organizations, such costs are disallowed, except with prior approval from the awarding agency. WestEd did not obtain prior approval from the Department nor did the Department request the merger. WestEd should return $2,804 of these costs that were charged directly to the OERI contract. OMB Circular A-122 does not specifically list foreign travel and executive automobiles as unallowable indirect costs. However, WestEd did not demonstrate that these costs were necessary for the performance of Federal contracts. Therefore, such costs should be excluded in the calculation of the final indirect cost rate. We recommend that OCF & CIO ensure that WestEd make the proper adjustments for the unallowable indirect costs in the final indirect cost rate. Auditee’s Response WestEd officials stated that except for $560 for airfare upgrade and $450 for DJ expense, all other costs are allowable under OMB Circular A-122. WestEd disagreed that the legal costs associated with the merger of Far West and Southwest are unallowable. Officials asserted that only $4,569 of legal costs were related to the finding and such expenditures were not considered organization costs. Officials stated that WestEd leased the Jeep Cherokee for the Chief Executive Officer (CEO). The cost is in the CEO’s compensation package and reported as income to the Internal Revenue Service. As for the foreign travel airfare that 13 WestEd charged to the indirect cost pool, officials asserted that OMB Circular A-122 requires only direct charges for foreign travel need prior approval to be allowable. Auditor’s Comments Our position has not changed for the unallowable indirect expenses for the reorganization costs, auto lease and foreign travel. The legal costs associated with the merger of Far West and Southwest is an expenditure meeting the criteria for organization costs in Paragraph 26 of OMB Circular A-122, Attachment B. Under this criteria, fees to attorneys in connection with the reorganization of an entity are unallowable, except with prior approval of the awarding agency. The legal fees were incurred in connection with the reorganization of Far West and Southwest to form WestEd. Also, WestEd did not submit sufficient documentation to justify that only $4,569 of legal costs were related to the merger. For the auto lease, WestEd has not submitted documentation to demonstrate that the costs were included in the CEO’s compensation package and reported as income to the Internal Revenue Service. As for the foreign travel, WestEd did not provide justification for the necessity of the trip and the allocability of the travel costs. Finding No. 5 - WestEd’s Indirect Cost Rate Does Not Reflect All Indirect Costs Charged to Its Contracts. WestEd’s stated indirect cost rate11 gave the impression that indirect costs remained fairly constant when in fact the rate increased 29 percent over the past three years. For FY 1996, the indirect cost rate was 34.8 percent rather than the stated 12.8 percent. It should be noted that WestEd has other indirect costs, for example, buildings and facilities costs that WestEd excludes from its indirect cost rates and would not be applicable for the discussion in this finding. If we took into account these additional costs, the actual indirect cost rate would be about 45 percent for FY 1996. WestEd shifted most of its indirect costs to its contracts as direct costs. Beginning in FY 1994, WestEd charged most of its indirect costs as direct costs by establishing cost centers for data processing, program support, contract management, and general services. WestEd directly charged cost 11 Indirect costs are expenses incurred for common or joint objectives and cannot be readily identified with a particular program. An indirect cost rate is a device for allocating the proportion of indirect costs to each program. It is the ratio (a percentage) of the indirect costs to a direct cost base. 14 center expenses to its contracts using direct labor hours as a basis for allocating costs. Under the new methodology, the indirect cost rate included only expenses for the accounting department, the office of the executive director, bid and proposal effort, and the Board members. Appendix A provides a graphic comparison of the former and new methodology. As part of our analysis, we recalculated the indirect cost rates using WestEd’s former methodology. Table 4 shows the indirect cost rates under the former and new methodology for FYs 1994 to 1996. Table 4. WestEd’s Indirect Cost Rate Does Not Reflect All Indirect Costs. Indirect Cost Rates Fiscal Year Former Methodology New Methodology 1993 27.0% 1994 26.4% 12.4% 1995 29.0% 12.8% 1996 34.8% 12.8% Indirect costs have increased over the years. In FY 1993, WestEd’s final indirect cost rate was 27 percent. Since FY 1994, it directly charged most of its indirect costs that resulted in reduced indirect cost rates of 12.4 percent in FY 1994 and 12.8 percent in FYs 1995 and 1996. These stated low rates could give the appearance that WestEd is more efficient than other organizations. To gain marketing advantage in its contract bids, WestEd has an incentive to keep the stated indirect cost rate low. However, former indirect costs, such as contract services, actually increased from $1 million to $1.3 million between FYs 1994 and 1996 and would not be reflected in its stated low rate. Under the new methodology, WestEd’s stated indirect cost rate also gave the impression that the rate remained fairly constant. However, using the former approach, the indirect cost rate actually increased by 29 percent from FY 1993 to 1996. Further, the indirect costs increased by 20 percent between FY 1995 and 1996. During this period, WestEd’s business base grew from $16.9 million to $24.6 million, or a 45 percent increase in its operating revenues. In a period of substantial expansion, we would expect the indirect cost rate to decrease as more contracts are available to absorb the increased indirect costs. We recommend that OCF & CIO, in coordination with OERI, assess the reasonableness of WestEd’s indirect costs in relation to other nonprofit entities. To ensure that all indirect cost rates are fully disclosed, the Department should include WestEd’s rates for each cost center, including buildings and facilities, in WestEd’s indirect cost rate agreement. 15 Auditee’s Response WestEd did not concur with our finding and recommendations. WestEd officials interpreted our finding to mean that WestEd must have a single indirect cost pool that includes all costs incurred. They stated that the relevant question is whether WestEd is allocating costs in a manner that ensures the Federal share of costs is not disproportionate. They contended that the indirect cost rate, under the old methodology, was 32.5% in FY 1996. Auditor’s Comments WestEd misinterpreted the essence of the finding. Our intent was to show that WestEd’s new methodology for computing the indirect cost rate did not reflect the increase of indirect costs during a period of substantial expansion. We did not express that WestEd must have a single indirect cost pool. Also, WestEd has not provided documentation to support the 32.5 percent rate that it computed for FY 1996 using the former methodology. Recommendations We recommend that OERI, in coordination with OCF & CIO: 1. Require WestEd to seek future tenants that are compatible with the mission or objectives for educational research purposes. [Finding No.1] 2. Limit the rental profits and related interest earnings accumulated in WestEd’s reserve fund. The amount to be retained should be limited to a reasonable estimate to cover necessary building expenditures, including capital improvements that are not recovered through WestEd’s operations. The amount exceeding the limit should be used to reduce program expenditures and/or further program objectives. [Finding No.1] 3. Require WestEd to separately identify the accumulated lease profits and related interest earnings in its financial records and disclose the restricted use of those funds. [Finding No.1] 4. Require WestEd to select methods for acquiring assets that are most cost effective for the REL and other Federal contracts. WestEd should even consider using its reserve funds for furniture, computer equipment and building improvements. [Finding No.2] 16 We also recommend that OCF & CIO: 5. Recover $20,000 of FY 1996 costs that represent the interest component in WestEd’s payments for asset leases. WestEd should also be required to compute the amount of unallowable interest expense charged to the REL contracts prior to FY 1996 and return those funds to the Department. Further, WestEd should discontinue charging the REL and other Federal contracts any interest costs associated with assets refinanced after September 29, 1995. [Finding No.2] 6. Review WestEd’s practices for recovering asset costs. [Finding No.2] 7. Recover excess indirect costs amounting to $108,061 associated with subcontracts. Also, OCF & CIO should determine the appropriate amount of subcontract costs that WestEd may include in the denominator of the indirect cost rate formula. Then, OCF & CIO should require that WestEd apply the indirect cost rates to only those direct costs included in the formula denominator. [Finding No.3] 8. Ensure that WestEd makes the proper adjustments for unallowable costs in the FY 1996 final indirect cost rate. Also, OCF & CIO should recover $2,928 of other direct costs ($2,804 for reorganization costs and $124 for airfare upgrades). [Finding No.4]. 9. Assess the reasonableness of WestEd’s indirect costs in relation to other nonprofit entities. [Finding No.5] 10. Ensure that WestEd’s rates for each cost center, including buildings and facilities, are fully disclosed in WestEd’s indirect cost rate agreement. [Finding No.5] 17 Other Matters WestEd Purchased Furnishings Exceeding the Quality Necessary for Federal Contracts. WestEd remodeled the Los Alamitos building at a cost of about $240,000 and financed this project through a building improvement capital lease with seven-year payout terms. From our observation, the furnishings purchased exceeded the quality that is necessary for the performance of Federal contracts. WestEd purchased about $31,000 of furniture for the executive offices of this building between January and April 1997. These costs were originally allocated among WestEd’s contracts. After we inquired as to how these costs are recovered, WestEd reclassified these costs to a general fund account. In its response to the draft report, WestEd officials stated that they furnished the offices in a manner comparable to the office suites provided for senior staff in the nonprofit and government sectors. WestEd Included CEDaR Dues in Its Contract Charges. In FY 1996, WestEd paid $60,000 in dues to the Council for Educational Development and Research (CEDaR), a trade organization for the regional educational laboratories. The dues were based on WestEd’s full-time staff count. Of the $60,000, a total of $4,200 was charged to the general fund, and $55,800 was placed in the general services cost pool and allocated to WestEd’s programs based on direct labor hours. OMB Circular A-122, Attachment A, Paragraph A provides that for costs to be allowable, such costs must be reasonable, allocable and necessary for the performance of the contract. OCF & CIO developed a guideline on the amount of CEDaR dues that could be charged as indirect costs. The Department limits allowable CEDaR dues to 0.2 percent of WestEd’s revenue.12 Under this guideline, $51,500 in CEDaR dues could be included as indirect costs. Thus, OCF & CIO may consider $4,300 ($55,800 minus $51,500) of CEDaR dues as unallowable. In its response to the draft report, WestEd officials stated that the CEDaR dues are allowable costs in their entirety. They asserted the guideline referred to in the report limiting the recovery of the costs on government contracts has no standing in either law or regulation. The officials also stated that the guideline was never published in the Federal register, disseminated in any official Federal publication, or transmitted by letter prior to, or during the period relevant in this instance. Further, they contended that the guideline is completely arbitrary because any standard of reasonableness requires an assessment of benefits received in relation to their costs. 12 WestEd’s revenue sources and amounts are listed in the Background Section of this report. 18 Background Congress originally authorized the regional educational laboratories (REL) to improve education through research and development under Title IV of the Elementary and Secondary Education Act of 1965. The Educational Research, Development, Dissemination and Improvement Act of 1994, Public Law 103-227, provides funding for the ten current RELs. The RELs, in partnership with state and local educators, carry out educational research and development projects. In fiscal year 1996, the ten RELs received a combined total of about $51 million in Federal funds. The RELs also received funds from other Federal, state and private sources. On December 1, 1995, WestEd was created to unite the operations of Far West Laboratory for Educational Research and Development (Far West) and Southwest Regional Laboratory (Southwest). WestEd’s main facilities are in San Francisco and Los Alamitos, California. Under the REL contract, WestEd serves the states of Arizona, California, Nevada and Utah. On December 1, 1990, Far West was awarded a five-year OERI contract for $17.7 million. During that time, Southwest was a subcontractor for Far West. On December 11, 1995, Far West was awarded a new five-year OERI contract for $22.0 million. During 1995 to 1996, Southwest continued as a subcontractor for Far West. As of December 1, 1996, through an agreement submitted to the Department, WestEd became the prime contractor on the current OERI contract. Since Southwest is now part of WestEd, the prime and subcontractor relationship between Far West and Southwest does not exist. Currently, WestEd is a nonprofit research, development, and service agency organized under the Joint Powers Act of the State of California. With a staff of 250, its business base and related revenues for FY 1996 consisted of: Contracts Revenue: OERI $ 4.1 million Other Federal 11.4 million State 3.4 million Other13 5.7 million $ 24.6 million Other Revenue: Building 0.9 million Other Income 0.3 million 1.2 million Total Revenue $ 25.8 million 13 This amount includes fiscal agent contracts for which WestEd’s responsibilities are limited to providing accounting services, including preparing the billings and paying contract expenditures. No programmatic functions are performed on these contracts. 19 Purpose, Scope and Audit Methodology The purpose of the audit was to determine whether costs incurred by WestEd and its subcontractors under the REL contract with OERI complied with applicable Federal laws and regulations and the terms of the contract. The audit covered the period from December 1, 1995 to November 30, 1996. We conducted our fieldwork from January 6, 1997 to May 5, 1997, at WestEd’s business office in Los Alamitos, California. We also performed data analyses as appropriate to our audit at our field audit office in Long Beach, California. To accomplish the audit purpose, we reviewed and analyzed Federal Regulations, contract terms, procedures manuals, accounting records and financial reports. We interviewed Department staff and WestEd personnel. We also reviewed records, reports and transactions from other award years that we considered relevant to our review. We conducted our audit in accordance with generally accepted government auditing standards appropriate to the scope of the audit described above. 20 Statement on Management Controls As part of our review, we assessed the system of management controls, policies, procedures, and practices applicable to WestEd’s administration of material aspects of the OERI contracts in accordance with Federal requirements. Our assessment was performed to determine the level of control risk for determining the nature, extent and timing of our substantive tests to accomplish our audit objective. For the purpose of this report, we assessed and classified the significant controls into the following categories: # Management of Federally-funded buildings # Asset acquisitions # Contract billings # Cash management for drawdowns # Contract expenditures # Subcontract costs # Indirect costs # Financial and administrative reporting Because of inherent limitations, a study and evaluation made for the limited purposes described above would not necessarily disclose all material weaknesses in the management controls. However, our assessment disclosed control weaknesses which affected WestEd’s ability to administer the OERI contracts. These weaknesses included WestEd not complying with all Federal laws and regulations and the terms of the contract. Also, WestEd’s indirect cost rates negotiated by the Department do not reflect all of its indirect costs. The control weaknesses and their effects are fully discussed in the Audit Results section of this report. The findings of this report that relate to the control categories listed above are WestEd’s: improper use and retention of rental profits from its Federally-funded buildings, excessive and unallowable costs for asset acquisitions, improper application of indirect cost rate to subcontracts, and unnecessary indirect and other direct costs for the performance of Federal contracts. 21 Appendix A 22 Attachment 1 WestEd Response to the Report 23 U.S. Department of Education Office of Inspector General Note The exhibits of WestEd’s response are available in our office and will be provided upon request 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53
WestEd's Administration of the Regional Educational Laboratory Contracts.
Published by the Department of Education, Office of Inspector General on 1998-03-31.
Below is a raw (and likely hideous) rendition of the original report. (PDF)