An important milestone for government contractors and particularly to negotiated contracts is an adequate cost accounting system. Further, in today’s contracting environment having an adequate accounting system can be a pre-requisite for contracts. Today many Requests For Proposals (RFP) require it.

The need for a compliant accounting system depends on the contractor’s circumstances and contract types. For instance negotiated fixed price contracts do not normally require an adequate accounting system (except when progress payments are requested), only that the cost or pricing data submitted meets the cost or pricing data requirements. These requirements are defined by FAR 15.4. The accounting system should report certain financial data to support the cost or pricing data requirements under fixed price 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. In some cases the government requires adequate accounting systems under time and material contracts as well. DFARS 252.242-7006 now requires it for DoD contracts.

To gain approval normally an audit is conducted by DCAA. Now, DCAA will not conduct this audit simply because the contractor wants an approved system. DCAA conducts audits on behalf of procurement agencies at their request. Contracting officers request DCAA perform these audits when there is a government need. So the first thing to do is get government sponsorship. This government agency can request the audit. This request is normally associated with an open RFP or contract.

What Does It Take to Get Approval?

For non-major contractors, I refer to 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 the contractor for its approved DCAA cost accounting system. In order for an accounting system to be approved, it must demonstrate the ability to meet these 12 key elements. Each of these elements is described below.

Key Element No. 1: Segregate direct costs from indirect costs.

This means the contractor must demonstrate its system adequately segregates direct costs from indirect costs. First, the accounting system must pool the direct costs and indirect costs separately by account. Second, it should maintain a policy that describes the criteria for charging costs direct to contracts and indirect to indirect cost pool accounts. Third, it must demonstrate that the personnel responsible for coding costs fully understand the criteria for costing transactions direct and indirect. Finally, the contractor’s cost history must show that it adequately and consistently charges costs direct and indirect.

Key Element No. 2: Accumulate contract costs by cost element and by cost objective or contract

This means the contractor must maintain an adequate job costing system that is integrated with the accounting system. The contractor might need to have proper business bank accounts (similar to those listed on the blogpost: Best Business Checking Account – Our Top 6 Picks for 2022) so that they can demonstrate the costs that are accumulated by the cost element and by the project accurately. This is typically accomplished by setting up a job number system and charging transactions to jobs by cost element account. The summary of all these jobs should equal the direct costs of each direct cost account in the company’s general ledger. Typically a summary report must be generated by a job or project demonstrating the above. These reports can be created by a business accountant that a company may hire (probably, by searching online for keyphrase such as a small business accountant near me) to manage the corporate finances and taxes. Often DCAA will request a job cost subsidiary ledger that agrees with the general ledger. A job cost subsidiary ledger lists each transaction charged to a job or project. The summary of all project subsidiary ledgers must add up to the direct cost balances in the general ledger.

Key Element No. 3: Homogenous indirect cost pools and allocation bases

Contractors are required to maintain homogenous indirect cost pools. This means the indirect costs must be accumulated into separate indirect cost pools combining functions that are not disparate. This means the functions must be similar and have a similar relationship to the cost objectives being managed. A violation would be combining manufacturing functions with engineering or services functions. These are disparate functions and are not homogenous. The most common indirect cost pool structure includes fringe, overhead and G&A.

The allocation bases used must be equitable. This means the allocation base selected must allocate indirect costs in an equitable manner avoiding skewing the allocation to one or a group of contracts. Allocation bases should be selected that best represent the activity being managed. This is normally an input base, an output base or some surrogate of both. The most commonly accepted allocation bases are:

Fringe – Total employee labor
Overhead – Direct labor, B&P/IR&D labor and allocable fringe
G&A – Total cost input or a value added base when the total cost input base proves to be inequitable.

These are not the only acceptable allocation bases but are the most common. Any base that would be considered equitable are acceptable.
Under cost reimbursable contracts, indirect cost rates should be calculated periodically on a year to date basis and compared to the budget or provisional indirect cost billing rates.

To demonstrate compliance, contractors are first expected to maintain a policy on indirect costs and allocation bases outlining the components of the indirect cost pools and their allocation bases. In addition, DCAA commonly will inspect and evaluate the indirect cost pools and composition to determine compliance with this requirement. Allocation bases are also evaluated to determine whether the allocation bases are equitable.

Key Element No. 4: Contract costs must be controlled by the general ledger

Most accounting system packages address this concern automatically. That is the job cost subsidiary ledger is controlled by the general ledger. As transactions are added or deleted or changed in the job cost subsidiary ledger, the general ledger for these direct cost accounts is updated automatically. A common DCAA test is to compare the summary of job costs by job or project to the direct cost account balances in the general ledger. Failure to demonstrate this test is a formula for failure for sure.
Key Element No.5: Demonstrate compliance with Generally Accepted Accounting Principles.

Compliance requires that the accounting procedures and processes be in accord with generally accepted accounting principles. This means that direct costs and indirect costs must be accounted for on an accrual basis. Cash basis accounting systems are not acceptable. Accrual means that costs are recorded in the proper period as incurred not necessarily when paid. Costs should be accrued or recorded when the contractor is liable for the cost and in some cases the cost should be allocated over periods that the cost represents.

To demonstrate compliance contractors normally show accrual entries and accrual liability accounts. Often DCAA will inspect and evaluate accrual entries and test their validity. The most significant accrual item is labor to match payroll with the timing of timesheets or the timekeeping system. Other common accrual items include, payroll taxes, insurance, rent, depreciation and accrual of material and subcontract transactions. Recently DCAA has also requested in certain cases evidence that revenue is accrued when required by generally accepted accounting principles.

Key Element No. 6: Pre-contract cost accounting

The contractor must record pre-contract costs separately. This is normally accomplished by setting up a pre-contract job or project number to separate pre-contract costs from costs incurred after the award of the contract. Pre-contract costs are incurred prior to the effective date of a contract to meet contract schedule or other significant contract requirements. If the costs incurred as pre-contract costs before the award or effective date of the contract would be allowable if incurred after the award of the contract, the pre-contract costs are generally speaking considered allowable subject to the need to meet contract schedule. Pre-contract costs are generally subject to an advanced agreement, FAR 31.205-32.

Normally to demonstrate compliance with this requirement the contractor should demonstrate the ability of the accounting system to segregate these costs from contract costs including procedures to consistently segregate these costs.

Key Element No. 7: Maintain an adequate timekeeping system.

A crucial item in securing an adequate accounting system is to maintain an adequate timekeeping system. Given that labor is a large component of contract cost and the government focus on timekeeping, it is a must have to be successful. Honestly there really are not any FAR or legal authoritative regulations that define what an adequate timekeeping system requires. It is limited to having a system that accurately records time to accurately charge labor to cost objectives. The timekeeping system requirements or preferences have been developed over time by regulators such as DCAA outlining preferences required. First, the contractor must maintain a written policy on timekeeping describing timekeeping practices. This document should be provided to all employees and periodic training should be provided. Both manual and electronic systems are acceptable. The government typically is indifferent as long as the system used is consistently applied in a compliant manner.

Some of these preferences include:

– Each employee must record all hours worked and complete their time daily. Projects, indirect accounts or cost objectives must be charged by daily tally.
– 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. In manual systems this means changes are made by the employee by single line cross out and employee initials and date. The reason for changes are often required. Essentially the ability to track changes to the time record is the concern. Any approach to tracking should be acceptable.
– 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. Under these systems, the most significant difference is all entries, changes, signature and approvals must be tracked by time stamp. In other words, it must answer the question who did what to who and when in regard to timekeeping entries.

It should also be noted that any training session requires a substantial amount of time for the employees to thoroughly understand things. So, whether the training is for timekeeping rules or new responsibilities that you want your employees to take on, you may want to implement microlearning strategies to strengthen your workplace environment by optimizing your training program and delivering learning concepts in a way that aligns more strongly and is better acquired. That can also lead to improved outcomes across the board, from productivity to retention.

Key Element No. 8: Adequate labor distribution systems.

To be considered compliant, contractors must be able to provide a labor distribution report based on the timekeeping system. This report typically includes hours and labor dollars by employee by cost objective (projects) and indirect labor accounts. This report should tie to both the timekeeping system and the payroll system. Typically a reconciliation between the labor distribution report, the timekeeping system and the payroll are required.

Key Element No. 9: Accounting for unallowable costs

The contractor must demonstrate its ability to meet the requirements of FAR 31.201-6. This means that contractors must segregate costs determined to be unallowable based on FAR 31.2 separately from direct and indirect cost pools. These costs are typically accumulated and segregated in an unallowable cost pool. Unallowable costs must be excluded from the indirect cost pools when developing indirect cost rates. Such costs cannot be included in any billing, claim or proposal.

To demonstrate this capability, contractors must show the unallowable cost pool by account. Also, it should maintain a policy defining the procedures it uses to meet this requirement. It should demonstrate that personnel responsible for coding transactions are adequately trained and knowledgable in FAR 31.2. Generally speaking contractors should make the provisions of FAR 31.2 readily available for employees as a reference document. On a separate note, indirect cost rates must be developed in a manner that allocates indirect costs to unallowable allocation base costs. If a cost is normally included in an allocation base it must be included whether allowable or not. For example any direct, fringe, or overhead cost that is determined to be unallowable per FAR 31.2 must be included in the appropriate allocation base if allowable direct, fringe and overhead costs are included in the allocation base.

Key Element No. 10: Interim Accumulation of Costs

The accounting system needs to be updated or post transactions at least monthly. In addition, the accounting system must be able to present the costs on a current, year to date and cumulative basis at least monthly inclusive of indirect costs to provide a full absorption costing view of a project or contract.

This can be demonstrated with job cost reports on a current period, year to date and inception to date basis. The balances need to be traceable to the job cost subsidiary ledger. Most project accounting systems can handle the accumulation of direct costs by project as described above. Indirect cost allocation tools may be necessary to present indirect cost allocations. The indirect cost allocation can be handled manually as well. Indirect cost allocations must be consistent with the contractors disclosed practices.

Key Element No. 11: Track costs by contract line item

Under certain types of contracts, the tracking of costs by Contract Line Item (CLIN) may be required. This means the project must be segregated by CLIN. The accounting system must treat each CLIN as a project or cost objective and charge costs to the CLIN in the same manner as it charges costs to projects. These CLIN accumulations should be reported or rolled up to the contract level.

Compliance with this requirement can be demonstrated by showing CLIN level project numbers within a contract and reporting costs to each contract line item.

Key Element No 12: Limitation of Cost and Funds/Invoicing Clauses

Many contracts include the Limitation of Costs and Funds clauses. These clauses require the contractor to track funding and contract cost. Contractors are required to notify the contracting officer when the contract costs reach 85% of funding.

Under an accounting system evaluation the government requires costs be tracked and reported on a cumulative basis and be compared to funding. This will permit the contractor to evaluate the cost position as compared to funding.

To demonstrate compliance or capability, reports should be generated showing costs by project on a current, year to date and cumulative to date basis inclusive of indirect cost allocations. This cost presentation is then compared to funding.

There are many different invoicing clauses. The contractor must demonstrate its capabilities to meet the applicable invoicing clause. Under cost reimbursable contracts compliance with the Allowable Cost and Payment clause is required. The major provisions include:

• Demonstrating that costs can be reported by project by cost element on current, year to date and cumulative to date basis.
• Accumulating and invoicing costs by CLIN or other contract funding requirements.
• Use of provisional indirect cost billing rates. This includes providing provisional indirect cost rate proposals on a timely basis
• Timely payment of direct costs that are accrued and billed. This would include labor, materials and subcontract accruals among others. In this case, payment must be made in the normal course of business in accordance vendor or subcontract terms or within 30 days of invoice.
• Procedures to make adequate and timely incurred cost submissions
• Maintenance of records in accordance with government contract record retention requirements
• Invoicing of project costs based on the accounting system. That is, invoice direct costs recorded for the period. This prohibits the invoicing of estimated costs. Invoiced direct costs must agree to the direct costs recorded by the accounting system.

If the contractor can meet these cost reimbursable contract invoicing requirements, it will likely be able to meet progress payment and time materials invoicing terms.

I hope this discussion has been helpful in understanding the government contract accounting system requirements. Should you need help with any of these items please contact me.

Edward D. Moore
Principal
T: 336-880-9040
E: emoore@dcaaconsulting.com
W: www.dcaaconsulting.com

dcaaConsulting LLC is a professional consulting company specializing in Defense Contract Audit Agency audits and related matters, government contract proposals and pricing, the Federal Acquisition Regulation and the Cost Accounting Standards.
dcaaConsulting LLC

A common service I provide for government contractors is mock audits. Mock audits are especially valuable when a contractor is expecting an upcomming audit by DCAA. My mock audit morrors what DCAA will do. The mock audit will identify any issues that would arise in the DCAA audit. In my review I outline in detail any corrective action that is needed to pass the DCAA audit. This provides the contractor the opportunity to correct any deficiencies before the DCAA audit. My clients find the mock audit valuable no surpises approach to DCAA.

Having an upcomming audit? Please contact me about audit preparation and the mock audit service.

An important concept in DCAA audits is the authority of DCAA Audits. That is DCAA has very little authority, not any different than a CPA firm in a commercial setting. That is their findings and recommendations are advisory only. It is the authority of the contracting officer only to act or not act on the DCAA findings. The process in these audits is that the contractor must be given the opportunity to respond to findings before the audit report is issued. This response should be written with the contracting officers authority in mind. Your audience is the contracting officer not DCAA. It is imperative that you be given the opportunity to respond to any findings. Granted unless you have a compelling argument, Contracting Officers tend to side with DCAA. In my experience I have swayed many a contracting officer to either ignore or discount DCAA findings. Very important stuff

If a contractor performs cost reimbursable contracts subject to the Allowable Cost and Payment clause, the contractor is required to submit an incurred cost submission annually. The due date is 6 months after the close of the contractor’s accounting year. Most small businesses’ accounting year is December 31. In this case the due date is June 30. DCAA usually requires the incurred cost submission be submitted using their ICE model. It is complex. Contractors should provide for adequate time to meet this dead line. If you need an extension of time it is important to request an extension in advance with the contracting officer.

If you have questions about this subject please contact me.

Unallowable costs are defined by FAR 31.2. Costs can also be deemed unallowable by the contracting officer’s decision. This regulation, FAR 31.2, defines costs as unallowable in two broad categories. One is expressly unallowable costs. This one is manageable it includes those costs that are unallowable 100% under all circumstances. This is a relatively short list. The second is what is called circumstantial unallowable costs. In other words, it depends on the specific circumstances. It depends on a number of criteria.

As they say, for every rule there are exceptions and limitations. This is definitely the case in government contracting. The circumstantial unallowable costs fit this criterion quite well. Those keen on knowing the ins and outs of it better can seek advice from a financial advisor, potentially from the likes of Lincoln Frost. Apparently, the majority of FAR 31.2 focuses on this latter category defining rules, exceptions, and criteria for allowability.

Most small businesses do not incur costs often falling into this latter category. However, there are circumstances where the contractor incurs an indirect unallowable cost, which could affect the business fund. In order for a business to function properly, these unallowable costs may need to be reduced. If not, there is a risk that the business could incur heavy financial losses, thereby hampering its expansion plans. Aside from this, their poor financial records might make it impossible for them to obtain business loans (similar to a bpi loan). Nevertheless, if these unallowable costs are controlled, it might be possible for a business to get a loan and flourish.

The typical expressly unallowable costs for small businesses in most situations include the following:

Promotional Advertising (FAR 31.205-1)

Promotional activities of any kind (FAR 31.205-1)

Bad debt expense (FAR 31.205-3)

Federal income tax (FAR 31.205-41)

Contingencies (FAR 31.205-7)

Interest expense, other financing costs and professional services related to financial costs. (FAR 31.205-20)

Recreation, entertainment, and amusement (FAR 31.205-14)

Fines and penalties (FAR 31.205-15)

Organizational and re-organizational costs (FAR 31.205-27)

Charitable contributions and political contributions (FAR 31.205-8)

Certain types of travel costs such as first class air fare, hotels and meals over the Federal Per Diem Rates. There are exceptions to this rule of course. (FAR 31.205-46)

Expenses representing a distribution of profits (FAR 31.205-6 and others)

Alcoholic beverages (FAR 31.205-51)

Good will (FAR 31.205-49)

Losses on contracts (FAR 31.205-48)

Personal use of anything, as compared to allowable documented business use (FAR 31.205-46/31.205-6)

Asset write-ups from business combinations, contractors are prohibited from charging depreciation for the write-up. This item rarely effects small businesses (FAR 31.205-52).

There are certain circumstantial unallowable costs that small business contractors commonly incur that DCAA likes to target and question. Some of these include:

Compensation, if considered unreasonable it will be questioned. This is especially a focus area of DCAA for the compensation paid to owners and executives of closely held small contractors. (FAR 31.205-6)

Bonuses and incentive compensation. Bonuses and incentive compensation must be based on a written plan or policy implying an agreement with the employee. These plans should be performance based to the extent possible. DCAA frowns upon profit sharing. (FAR 31.205-6)

Legal costs: Certain legal costs are unallowable. Some of these include legal costs associated with organization and re-organizations, costs associated with patents not required by a government contract, patent infringement, legal costs to defend against allegations of fraud or noncompliance, etc. (FAR 31.025-47)

Consultant costs: This is a DCAA cherry picking target. The substantiation now required for allowable consultant costs is significant. DCAA is very much focused on this item in audits of small contractors. Need a well-documented agreement that spells out scope of work, contractor need, rates, period of performance, detailed accounting on invoices, work product, etc. Failure to provide this documentation will put the allowability of these costs in jeopardy. (FAR 31.205-33)

Related Party Rental Costs: This is another cherry pick target for DCAA. If the contactor and its landlord or lessor are under common management, ownership or control in most cases the allowable rent costs are limited to ownership costs. Ownership costs include depreciation, property taxes, insurance, other facility costs and cost of money. Small business owners that purchase a building with the intent to lease it back to the owner’s government contracting business is not a good idea if the owner has more than 50% ownership of both the lessor and lease or executes common control. The costs will be limited to ownership costs in most cases. (FAR 31.205-36). Businesses, however, whether governmental or non-governmental, are now required to follow ASC 842, a lease accounting standard published by the Financial Accounting Standards Board (FASB). Almost all leases must be represented on the balance sheet with liability and an ROU asset under ASC 842. That is why small businesses could be seen much more interested in including lease accounting software that can assist them in stripping away some burden from their shoulders.

Travel Costs: Allowable costs limited to lowest available coach air fare. In some situations business class is appropriate and provided for in the regulation. Hotel and meals are limited to the Federal Travel Regulation Per Diem Rates. The lodging rate is a not to exceed, receipt required, the meals/incidental per diem is a fixed rate. (FAR 31.205-46)

Auto Expense: If the contractor does not keep a mileage log it is likely DCAA will question the cost on lack of business purpose grounds. Need to document business mileage to win on this one. (FAR 31.205-46 and FAR 31.205-6).

Of course the government can make a case for unallowable cost for any cost that it perceives to be unreasonable. Burden of proof for reasonableness rests with the contractor (FAR 31.201-3).

This document is not intended as a complete discussion on the subject. The subject of unallowable costs is a large and complex one. The intent of this document is to identify those costs that a small business contractor is likely to incur and to point out the DCAA cost challenges a small business contractor is likely to encounter.

An adequate or approved accounting system is not required for all government contractors. Although it is a good idea to maintain an accounting system that properly charges costs to contracts by cost element, an adequate government contract accounting system is only required for contractors that perform cost type contracts (see FAR Subpart 16 on cost type contracts). Contracting officers are only supposed to award cost type contracts to contractors that maintain an adequate accounting system. Adequate accounting systems are validated by DCAA through their accounting system audits. These audits are typically requested by the contracting office when there is a government need. Contractors that perform fixed priced contracts are not subject to this requirement. Contractors that base fixed priced contracts on pricing subject to cost or pricing data requirements (FAR 15.4) are required to provide adequate cost or pricing data. This usually involves the ability to properly pool indirect costs, segregate direct costs from indirect costs and exclude unallowable costs. This is necessary to calculate indirect cost rates for cost proposals. Competitive fixed priced contracts based on adequate price competition and other contracts exempt from cost or pricing data such as commercial items contracts are exempt from cost or pricing data requirements. In these two cases an adequate accounting system is not normally required.

Edward D. Moore

Principal

E: emoore@dcaaconsulting.com

W: www.dcaaconsulting.com

dcaaConsulting is a professional consulting company specializing in Defense Contract Audit Agency audits and related matters, government contract proposals and pricing, the Federal Acquisition Regulation and the Cost Accounting Standards.