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.

DCAA attacking compensation rates. DCAA is using their own generalized survey and mis-labeling personnel into wrong categories. In addition their survey does not take into account technical expertise or clearances very well. Contractors should do their homework find a survey that fits their business and employee skill sets and bench mark their compensation. These surveys can be used to offset any DCAA attacks on compensation.

I am often asked about compensation in a private small business environment. Often DCAA raises this issue in its audit reports questioning the costs as unreasonable or unallowable. It is a focus area for DCAA for sure. The FAR itself also focuses on it suggesting it requires special treatment. It is a crucial item requiring special attention.

The allowability of compensation is governed by FAR 31.205-6. To be allowable the cost must be reasonable. It must be for services provided. It cannot be for services provided in a prior year. Labor costs paid in the current year for a prior year are unallowable. The burden of proof for reasonableness is on the contractor not the government. That is DCAA can question the cost without substantiating their position. It is the responsibility of the contractor to demonstrate that the cost is reasonable.

Reasonableness is defined as what a prudent business person would do. In other words what is reasonable in light of industry established practices. The government usually assesses reasonableness of compensation by using salary surveys. DCAA uses a selected survey and varies from agency to agency. Often the government will judge the reasonableness of compensation without any survey at all. It will make a subjective determination from their own personal vantage point. The burden is on the contractor to demonstrate reasonableness.

Another important point for privately or closely held contractors is that owner compensation cannot exceed the amount that is deductible as compensation under the Internal Revenue Code. Any excess would be unallowable.

Bonuses

An even more common DCAA questioned cost is bonuses or incentive compensation. Practically every privately owned closely held contractor maintains some form of a bonus program. These programs are usually informal and subjective. In this form, the cost is unallowable. For this reason it is a hunting ground for DCAA auditors, a gold mine for DCAA to cherry pick questioned costs.

Bonuses and incentive programs are allowable costs if certain criteria are met. These include:

1. The bonuses must be based on a written agreement, plan or policy implying an agreement.
2. The criteria should avoid subjective evaluations. The more objective the evaluation criteria the better.
3. The basis for the award is supported. This means the criteria for award must be supported and documented.

Recommendations:

1. Maintain support for owner and executive compensation. This can be industry statistical comparisons, salary surveys, etc. The challenge is to secure relevant data that resembles the personnel in question. Often these surveys are to general. Remember burden of proof for reasonableness is the responsibility of the contractor. DCAA may question the costs without this support. DCAA very well may question the cost any way if it exceeds what they consider reasonable. In any event you will have a basis to refute whatever the DCAA position is.

2. Develop agreements, plans or policies to address bonuses. This must be written. It is best to base the bonus compensation on objective criteria versus a subjective year end evaluation. Profit distribution concepts should be avoided as DCAA may conclude the bonus is a profit distribution. Profit distributions are unallowable.Please contact me if you have questions about the FAR position on compensation of bonuses.

DCAA is seeking provisional indirect cost rate proposals for 2013. Some offices have set a due date of mid January 2013. Getting provisional indirect rate agreements in place as soon as possible for 2013 is important. In many cases DCAA will not approve billings under cost reimbursable contracts without it. Provisisional indirect cost rate agreements establish the billing rates throughout the year subject to change as may be required. I normally include the following in provisional indirect rate proposals.
1. Provide 2013 budgetary data showing the proposed pool and base by cost element for each indirect rate. I normally provide a narrative explaining any significant variances from prior years and any accounting or organizational changes impacting the rates.
2. Final 2012 actual indirect cost rates showing pools and bases by cost element.
3. Financial statements if available, unaudited statements are ok.

4. A break down of sales estimated for 2013 and a comparison to 2012.
5. DCAA often prefers executive compensation, aged accounts payable and government sales data supplemental schedules as well. I normally provide this data if requested.

If you have cost reimbursable contracts I suggest you pursue this proactively to avoid any delays in government payments for 2013.

In regards to accounting systems for government contractors please note the following. Deltek GCS or Essentials is no. 1 in my opinion, provided the contractor can afford it and can handle the back office support required. At a minimum an experienced Controller is required. JAMIS is a close second. Both are excellent integrated solutions for government contractors.

A very viable alternative for small business is Procas. I tested it and like it for small business with some accounting resources. Procas is a very good intermediate step for those that cannot afford Deltek. It offers remote capabilities that are lacking in most Quick Books options. It also offers integration that is lacking in Quickbooks . Procas offers the ability to meet government contract accounting system requirements.

For very small business, Quick Books Premier or Enterprise is a common approach. To be compliant, at a minimum, a compliant timekeeping system or approach is needed on the front end. Compliant timekeeping systems include GHG, Spring Ahead, EFAACT, Replicon, Unanet, etc. QuickBooks is a decent accounting system processor. To be compliant and to pass DCAA accounting system audits, an application will need to be added on the back end. Preferable applications include ICAT, Govcon, EFAACT and GovCalc. Manual options for DCAA cost reporting are a last resort and time intensive. I don’t recommend this option as DCAA acceptance is not guaranteed. This acceptance varies from auditor to auditor.

I have reviewed or used all the systems mentioned.

No matter what system is used, adequate policies and procedures is a must. Second, employees must be properly trained on government accounting requirements to succeed. It goes without saying, that success requires proper system set up, policies and procedures and training.

If you have questions about accounting system selection for government contractors please contact me.

To emphasize the importance of documenting costs incurred please consider the following.

I was retained by a new client to help them resolve a nasty DCAA audit report of a small business. The report questioned $200,000 in costs mainly due to a lack of cost support such as receipts, invoices, consulting agreements and mileage logs. The company relied mainly on credit card statements. This simply will not answer the mail. Additionally DCAA is attempting to apply Level 1 Unallowable cost penalties equal to the $200,000. So as you might imagine this is a huge issue for the small business. I expect I will be able to at least cut that number in half and hopefully negotiate something reasonable with the ACO.

This is a classic example why it is so important to maintain adequate records and fully document the costs incurred as well as business purpose. Credit card statements simply will not fly in an audit. Must have receipts, must document consultants and legal charges with agreements and require your consultants to detail the charges on their invoices. If you are involved with automobile expense must document the business usage with mileage logs or similar documentation. Need written plans or policies for any bonuses, etc.

Yes this is very bureaucratic and an nuisance to everyone involved, but better to be safe today than sorry later.

I have noticed that DCAA is placing more emphasis on budgeting and forecasting in its audits of contractor accounting systems. This is not a direct requirement of accounting systems but is at least implied in a number of contract clauses related to pricing and invoicing and limitations of funds and similar clauses. To get DCAA buy-in need to adequately cover the budgeting, forecasting and cost reporting processes. Particular attention should be placed on monitoring actual indirect cost rates each month, comparing to provisional and updating budgets/forecasts on a timely basis. I have noticed an increased interest by DCAA on forecasting of costs on a given project. This is all driven by cost reimbursable projects. Suggest processes and policies be updated accordingly.

As I have mentioned on my website, Deltek is the leader in government contract accounting systems. However, for the most part Deltek has not been very attainable for most small businesses. As a result most small businesses have been limited to Quick Books. As I mention on this website, Quick Books can be made DCAA and FAR compliant. This involves some add-ons and other work arounds. I do this rather often for small business clients. Deltek apparently has now developed an alternative that may be reachable by some small businesses. I feel the need to let the small business community know about this capability. It is called Deltek Essentials. I have not experienced this new Deltek product so I cannot comment on how well it will work for small business. The price tag is greater than any Quick Books solution; however, it is within reach of some small businesses. My first reaction to Essentials is whether the typical small business would have the adequate resources to run it and manage it. Or is this a tail wagging the dog thing. That would be my number one question. There is no doubt it will exceed the FAR and DCAA accounting system requirements as the Deltek technology has always been a leader. Deltek has always been an excellent technology for government contract accounting systems; actually it is no. 1 in the industry. JAMIS is right there as well. It has a lot of advantages over Quick Books. Assuming government contract accounting expertise is not required to run and manage it, and additional accounting resources are not required either, then I believe it will be a good solution for small businesses. This new Deltek product is certainly worth investigating. If I get the chance to see Essentials in action I will certainly comment on its viability for small business. At this point, it sounds like an alternative worth investigating.

I hear DCAA is going to re-focus on marketing costs for allowability. I understand they are going to start increasing its scrutiny on reviewing sales and marketing expense reports for allowability. This should make one emphasize the segregation of promotional marketing from Bid and Proposal efforts and direct selling efforts. The latter two are allowable in most cases. Contractors should review its expense reporting practices to make certain unallowable costs are properly segregated.