Government Contractor Accounting: DCAA Compliance Basics

If your business holds or pursues federal government contracts, your accounting system must comply with the Defense Contract Audit Agency (DCAA) standards and the Federal Acquisition Regulation (FAR). Non-compliance can result in disallowed costs, withheld payments, contract termination, and even suspension or debarment from future government work. This guide covers the foundational elements every government contractor must have in place.

What Is DCAA and Why Does It Matter?

The DCAA is the audit arm of the Department of Defense, but its standards apply to contracts across all federal agencies. DCAA auditors review contractor accounting systems, cost proposals, incurred cost submissions, and billing practices to ensure that taxpayer dollars are spent appropriately. Even if you have never been audited, your accounting system must be DCAA-compliant from day one of your first government contract.

The FAR, specifically Part 31 (Contract Cost Principles), defines which costs are allowable (can be charged to government contracts) and which are unallowable (cannot be charged). Getting this wrong means you could be billing the government for costs that will later be disallowed and required to be repaid.

Setting Up a DCAA-Compliant Accounting System

A DCAA-compliant accounting system must meet the criteria outlined in SF 1408 (Pre-Award Accounting System Survey). The key requirements include the ability to accumulate costs by contract, separate direct costs from indirect costs, exclude unallowable costs from billing, maintain a consistent method of allocating indirect costs, and produce timely and accurate financial reports.

Your accounting software must be able to track costs at the individual contract or project level. QuickBooks Online with the Projects feature can work for smaller contractors, but many growing government contractors migrate to Unanet, Deltek Costpoint, or PROCAS as their contract portfolio expands.

Understanding Direct vs Indirect Costs

Direct costs are expenses that can be specifically identified with a particular contract. Examples include labor hours charged directly to a contract, materials purchased for a specific project, travel required for a specific contract, and subcontractor costs.

Indirect costs are expenses that benefit multiple contracts or the business as a whole and cannot be directly attributed to a single contract. These are allocated to contracts through indirect cost rates. Common indirect cost pools include fringe benefits (employer payroll taxes, health insurance, PTO, retirement contributions), overhead (rent, utilities, office supplies, IT costs, depreciation), and general and administrative (G&A) expenses (executive salaries, accounting, legal, business development, corporate insurance).

Indirect Cost Rate Structure

Most government contractors use a three-pool indirect cost rate structure. The fringe rate is applied to direct labor costs and covers employee benefits. It is calculated as total fringe costs divided by total direct labor costs. The overhead rate covers operational expenses and is also typically applied to direct labor. The G&A rate covers company-wide administrative costs and is usually applied to total cost input (the sum of all direct costs plus applied fringe and overhead).

For example, if your fringe rate is 35%, your overhead rate is 45%, and your G&A rate is 12%, a direct labor hour costing $50 would be billed as: $50 (direct labor) + $17.50 (fringe at 35%) + $22.50 (overhead at 45%) = $90.00, then $90.00 multiplied by 1.12 (G&A at 12%) = $100.80 total cost per labor hour, plus any applicable fee or profit.

Unallowable Costs Under FAR Part 31

Several categories of costs are expressly unallowable and must be excluded from all indirect cost pools and direct charges to government contracts. Key unallowable costs include entertainment expenses, alcoholic beverages, donations and contributions, lobbying costs, fines and penalties, bad debt expense, interest expense (in most cases), advertising (with limited exceptions for recruitment), and executive compensation above certain thresholds set annually by OFPP.

Your accounting system must flag and segregate these costs so they are never included in your indirect rate calculations or billed to the government. Setting up separate "unallowable" accounts in your chart of accounts is the standard approach.

Timekeeping Requirements

DCAA places enormous emphasis on accurate timekeeping. Every employee must record time daily, showing hours worked on each contract or indirect cost category. Timesheets must be signed by the employee and approved by a supervisor. Corrections must be made through documented amendments, not by simply overwriting original entries.

Manual timesheets are acceptable but increasingly risky. Automated timekeeping systems like Unanet, TSheets (now QuickBooks Time), or Deltek provide audit trails and reduce the risk of errors. DCAA auditors frequently test timekeeping records and interview employees to verify that recorded hours match actual work performed.

Incurred Cost Submissions

After each fiscal year, government contractors with cost-type or time-and-materials contracts must submit an Incurred Cost Submission (ICS) to DCAA. This detailed report reconciles your claimed indirect rates with your actual costs for the year. It includes your indirect cost rate calculations, a schedule of direct costs by contract, a reconciliation to your financial statements, and certification by a responsible official.

The ICS is due six months after the end of your fiscal year. Failure to submit on time can result in suspended payments and negative audit findings. The DCAA may take several years to audit your ICS, but having it prepared accurately and on time is critical.

Preparing for a DCAA Audit

DCAA audits can be triggered by a pre-award survey (before you receive a contract), an incurred cost audit (after your ICS is submitted), a floor check (unannounced visit to verify timekeeping), or a system audit (evaluating your accounting, estimating, or purchasing systems).

The best preparation is maintaining compliant systems year-round rather than scrambling before an audit. Work with a CPA firm experienced in government contractor accounting to set up your systems, train your staff, and perform internal reviews before DCAA arrives.