FAR Part 31 Allowable Cost Audit for Government Contractors — DC, Maryland & Virginia

FAR Part 31 (Cost Principles and Procedures) establishes the cost principles that govern cost reimbursement and time-and-materials government contracts. It applies to all cost-reimbursement contracts, flexibly-priced contracts, modifications to fixed-price contracts where cost analysis is performed, and subcontracts under those prime contracts. FAR Part 31.205 identifies specific cost items and whether they are allowable or unallowable when claimed as contract costs. Contractors on firm-fixed-price contracts are not subject to FAR Part 31 for that contract's pricing, but may be if they also hold cost-type awards.

Under FAR 31.205-6(p), the allowable compensation for each contractor senior executive is capped annually. For contractor fiscal years 2024, the benchmark compensation cap is $653,152. Compensation above this benchmark is unallowable on government contracts. The cap applies to the five most highly compensated employees in management positions at each contractor home office and segment. Many contractors discover this limitation only during a DCAA audit, resulting in significant cost disallowances.

FAR Part 31.205 identifies several costs that are always unallowable regardless of reasonableness: entertainment costs (FAR 31.205-14), lobbying and political activity costs (FAR 31.205-22), fines and penalties (FAR 31.205-15), bad debts (FAR 31.205-4), interest and financing costs (FAR 31.205-20), goodwill amortization (FAR 31.205-49), and executive compensation above the statutory benchmark (FAR 31.205-6(p)). Contractors must maintain an unallowable cost account to segregate these costs from their government contract cost pools.

Under FAR 31.201-2, a cost is allowable only if it is: (1) allowable — not specifically prohibited by FAR 31.205 or contract terms; (2) allocable — assignable or chargeable to the final cost objective (the contract) based on relative benefits received; and (3) reasonable — does not exceed what a prudent person would incur in a competitive marketplace under similar circumstances. All three tests must be met. A cost can be allowable and reasonable but unallocable if it does not relate to the contract being charged.

The Defense Contract Audit Agency (DCAA) tests for unallowable costs primarily during incurred cost audits of the contractor's annual Incurred Cost Proposal (ICP). DCAA auditors review the contractor's general ledger, expense accounts, and supporting documentation to identify costs that are specifically unallowable under FAR 31.205. DCAA also looks for expressly unallowable costs that were not segregated — which can result in penalties equal to the amount of the unallowable cost under 10 U.S.C. § 3743. DCAA may also conduct real-time billing system audits.

Bid and proposal (B&P) costs under FAR 31.205-18 are the costs incurred in preparing, submitting, and supporting bids and proposals for potential government contracts. B&P costs are generally allowable as indirect costs and may be allocated across government contracts through an indirect cost pool. However, they are subject to a ceiling based on the contractor's prior year's B&P cost history when total B&P plus IR&D costs exceed negotiated ceilings. B&P costs must be tracked in a separate cost account and must not include unallowable costs such as entertainment associated with proposal activities.

Billing unallowable costs to the government can trigger multiple penalty regimes. Under FAR 42.709, contractors may be assessed penalties equal to 2x the amount of the expressly unallowable costs included in a final indirect cost rate proposal — or the amount of the disallowed cost if the clause applies. More seriously, knowingly billing unallowable costs constitutes a False Claims Act violation, exposing contractors to treble damages (3x the amount billed) plus civil penalties of approximately $13,000–$26,000 per false claim. Criminal penalties are also possible for intentional fraud.

An unallowable cost account is a separate general ledger account (or set of accounts) where contractors record costs that are specifically unallowable under FAR 31.205. Maintaining this segregation is required under FAR 31.201-6 and is tested during every DCAA incurred cost audit. Setting up unallowable cost accounts involves: (1) identifying all FAR 31.205 specifically unallowable categories, (2) creating dedicated GL accounts or subaccounts, (3) training AP and expense report reviewers to code unallowable costs correctly at point of entry, and (4) establishing a year-end review process. Our firm helps contractors build this system from the ground up.