Government Contract Cost Accounting System - Adequacy and DCAA Compliance

A critical pre-requisite to government contracting and particularly to negotiated contracts is an adequate cost accounting system. The need for a compliant accounting system depends on the contractor's circumstances and contract types.  For instance negotiated fixed price contracts do not require an adequate accounting system, only that the cost or pricing data submitted meets the cost or pricing data requirements of FAR Subpart 15.4.   The accounting system should report certain financial data to support the cost or pricing data requirements under fixed prixed contracts such as indirect cost rate data. An adequate accounting system subject to DCAA preferences is most relevant to cost reimbursable contracts.  Under cost reimbursable contracts the accounting system must be adequate and approved by the government under FAR Subpart 16.3.  Securing approval is a significant accomplishment in this industry.  A common service I provide is to help contractors with their government contract cost accounting systems by converting them to DCAA compliant systems as may be needed given the contractors circumstances.   This is a crucial pre-requisite to winning certain types of government contracts such as cost reimbursable contracts as mentioned.

I provide assessments of cost accounting systems to convert the system, procedures and internal controls compliant with DCAA and FAR requirements.  This usually takes a few days.  I provide the contractor an exact and specific road map to secure DCAA compliance.  I also help the contractor make the corrections needed to be compliant.  If the client follows my road map its system will pass any objective DCAA audit and will secure approval of its government contract cost accounting system. This is because I was a DCAA auditor once and have over 28 years experience with DCAA, FAR and CAS matters.   I know what it takes.

What does it take to get an Approved Government Contract Accounting System?

For non-major contractors there are twelve (12) key elements that you must pass.  These are must haves, no exceptions, to secure approval for cost reimbursable contracts.  Below not only have I listed the 12 key elements, but I have also elaborated on what these 12 items mean to prepare you for your approved DCAA cost accounting system.   In order for an accounting system to be approved it must demonstrate the ability to:

  •  Segregate direct costs from indirect costs. 

This means the contractor must have a policy defining the characteristics of a direct cost and an indirect cost.  It must also define the consistency requirements of FAR 31.202 and FAR 31.203.  It must define the circumstances when certain cost elements may be charged direct and indirect.  The accounting system must have separate accounts for each cost element in significant detail for audit and finally the direct costs must be separated from indirect costs in the accounting system.  This is normally accomplished by pooling the costs into separate cost pools, one for direct costs and one or more cost pools for indirect costs.

  • Accumulate contract costs by cost element by contract, project, task or cost objective for each cost element.

This means the contractor must maintain an adequate job costing system that is integrated with the accounting system.  It means that costs must be accumulated by cost element and by project.  Cost elements normally include direct labor, direct materials, subcontracts, consultants, direct travel and other direct costs.  It means that for every direct cost transaction a job or project number must be assigned.  It means that a job cost ledger by project must be maintained.  Finally the contractor must be able to provide a report showing direct costs by cost element by project, job and/or contract. Normally policies or procedures are needed that describe the above.

  • Maintain an adequate timekeeping system.

In order to the pass the audit an adequate timekeeping system is crucial.  The timekeeping system can be manual (paper) or electronic.  First a policy must be in place defining the timekeeping procedures and rules that meet DCAA preferences.  The time sheet itself must permit hours be accumulated by day and by project numbers/indirect labor accounts.  The systems must address all the DCAA preferences.  Some of these include:

           - Each employee must record all hours worked and complete their time daily.

           - Provisions for identity and control of time keeping documents.

           - Employee must sign the timesheet and it must be approved by the employee's supervisor at the end of the timekeeping period.

           - The system must require correction procedures that meet DCAA preferences.

           - Time must be recorded based on actual time worked not funding or any other criteria.

           - Periodic training of employees regarding timekeeping rules.

           - Electronic systems require additional requirements for security and change control/visibility.

  • Maintain adequate labor and accounts payable distribution systems.

Contractors must be able to provide labor distribution systems of labor allocated to projects and jobs based on the timekeeping system.  This means the labor distribution system must provide labor hours and labor dollars by employee by job and indirect labor accounts.  The source of this distribution must be the timekeeping system.  Accordingly the labor distribution must reconcile to the timekeeping hours, payroll system, job cost and general ledger.  All these reports must be compared or reconciled each accounting period.

  • Accounting for unallowable costs and exclude such costs from billings, claims and proposals

Contractors must comply with the unallowable accounting requirements of FAR 31.201-6.  This means it must maintain a policy outlining how it meets this requirement.  It means that it must maintain unallowable cost accounts in its accounting system.  These accounts are separately pooled in its own unallowable cost pool typically.  Unallowable costs that are Direct costs, Fringe, Overhead or G&A are separately accounted for, usually by separate unallowable cost pools.  Accounting personnel must be knowledgeable in the unallowable cost definitions and requirements so it may properly code unallowable costs to the unallowable cost accounts.

  • Make certain direct costs and indirect costs are controlled by the general ledger

Most accounting system software packages provide for general ledger control as a standard feature.  That is as transactions are added to direct and indirect cost accounts the general ledger is updated automatically.  This also includes job cost control as well.  As transactions are added to job cost or projects the direct cost accounts and general ledger must be updated simultaneously.  To make certain general ledger control is operating effectively, a comparison needs to be made between the job cost system and the general ledger each accounting period.  Policies or procedures should be included defining how the contractor maintains general ledger control. 

  • Meet Generally Accepted Accounting Principles

Accounting systems must be in accord with Generally Accepted Accounting Principles (GAAP).  For this purpose, this usually means that the direct costs and indirect costs must be on an accrual basis.  A cash basis accounting system will not meet these requirements.  To be on an accrual basis this means that costs need to be recorded as incurred not necessarily when paid.  For most small businesses the focus is on recording labor consistent with timekeeping, match payroll with the timekeeping hours for a given period.  Depending on when Payroll is paid this may require adjusting journal entries to record payroll in the same period that the hours recorded in the timekeeping system represent.  In other words recording payroll in February for hours incurred in January for example would violate this standard. Other accrual possibilities include costs paid in advance such as rent and insurance or costs that are based on the elapse of time such as depreciation and insurance.  Lately some DCAA auditors have requested that revenue also be accrued based on when the revenue was earned. 

  • Capture pre-contract costs separately

The contractor must also demonstrate the ability to capture pre-contract costs separately.  Pre-contract contract costs are costs incurred before the effective date of a contract that were required to be incurred to meet schedule for some other contract requirement.  Usually to be allowable the cost must be subject to an advanced agreement with the government.  To demonstrate capability, the contractor typically needs to maintain a policy on how these costs will be controlled and segregated.  The contractor must show the ability to set up separate project numbers to segregate and accumulate these costs from the costs of contract performance.  This is normally accomplished by using separate sub-project numbers similar to task numbers.

  • Maintain homogeneous indirect cost pools and allocate indirect costs to contracts, projects, tasks or cost objectives based on a beneficial, causal and equitable basis.

To be considered compliant the contractor must first define indirect cost accounting practices, indirect cost pools and allocation bases in a policy that is consistently followed.   This policy must also demonstrate that it monitors indirect cost rates against provisional or budgeted rates periodically. 

The contractor must maintain homogenous indirect cost pools to be compliant.  This means that the pools need to be grouped in such a manner that the components of the pool have a similar relationship to the cost objectives that these indirect costs are to be allocated to.  In simpler terms, this means that the contractor can pool similar functions but not disparate functions unless the allocation does not result in a material difference from any other combination or allocation.  In extreme terms, the requirement prevents the grouping of services and manufacturing together for example.    The typical indirect cost pool structure is Fringe, Overhead and G&A.

To be compliant the indirect cost pools must be allocated using allocation bases that are equitable.  This means the indirect cost pools must be allocated using allocation bases that allocate the costs on a causal and beneficial basis.  This can be subjective.  However, the typical allocation bases used and acceptable to DCAA in most circumstances include:

Fringe: Total Company Labor

Overhead: Direct Labor and Fringe associated with direct labor.

G&A: Total Cost Input Base (direct costs and allocable fringe, overhead). In cases where the total cost input base is not equitable a value added base may be used.  The value added base excludes subcontracts and materials.  Generally this base can be used once the contractor demonstrates the total cost input base is not equitable.

  • Comply with financial clauses like the Limitations of Costs/Funds and Progress Payments clauses

First the contractor must establish policies that demonstrate compliance with the Limitation of Funds clause, invoicing clauses and any other relevant financial clauses.  This will vary depending on the specifics of the contracts under execution by the contractor.  However, in assuming a cost reimbursable environment, the contractor must demonstrate the ability to accumulate direct costs by project, allocation of indirect costs to projects and show current period, year to date and inception to date cost reports with comparisons to funding.  In regards to invoicing compliance, must maintain policies that meet the Allowable Cost and Payment clause and accounting procedures that meet those requirements.  Depending on the types of contracts compliance with other invoicing clauses may be required as well, such as time and material contracts.

  •  Make interim accumulation of costs in the books of account, at least monthly

The contractor must record and accumulate costs at least monthly. This is a common practice for most businesses and should not be an issue.  Further, contractors must accumulate costs on a full cost absorption basis to show not only direct costs but indirect cost allocations as well.  To meet this requirement, contractors must be able to present projects on a monthly basis showing full absorption costing, showing total costs incurred on a given project including indirect cost allocations.  This can be shown manually however not recommended.  The Deltek report, Job Summary Report meets this requirement.  For Quick Books users there are applications that work with Quick Books that can meet this requirement quite well, such as ICAT providing reporting options similar to the Deltek report mentioned above.  There are other applications that meet this requirement as well.  Quick Books standard reports generally will not meet this requirement without significant modification.

  • Track costs by contract line item

Contractors must track costs by contract line item treating contract line items as projects.  This includes charging direct costs to line items and allocating indirect costs to contract line items.  Contract line items are commonly referred to as CLIN's and are tasks or segments within a contract.  They can also be deliverables.   The contract line items are delineated in the contract.  Policies should outline the accounting procedures for contract line item accounting.  This can be accomplished by setting up tasks under a contract as sub-project numbers and charging costs accordingly. Contract line items should be accounted for in the same manner as any project.

  • Provide reliable historical accounting data for follow-on procurements

Meeting this last requirement is dependent on compliance with the requirements discussed above.  Provided the above requirements are met, the contractor should be able to meet the reliability of historical cost data for follow-on procurements requirement.  Of course the scopes of work would need to be similar to make the historical data even relevant.  Compliance with the above requirements will render the labor rate and indirect cost rates reliable in all cases.

I know to some this may be overwhelming.  But I make it simple for the contractor.  My assessment will highlight exactly what you need to do. Implementation of the corrective actions will render a favorable outcome.  I have conducted many of these assessments and helped contractors secure compliance.  I have also developed the corrective actions for contractors and have secured DCAA compliance and government approval in all cases.

As a small business going at this alone is not a good idea, with all the underlying complexities.  Given the small cost of an assessment or corrective action project, my advice is to seek a few days time of an expert to lead you in the right direction so you may secure an approved accounting system.