oversight

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)

                        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




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