The Federal Acquisition Regulation (FAR) cost principles serve as the guiding standards that contractors must comply with to lay the foundation for success in government work.
Contractors must demonstrate that costs charged to the government are allowable, properly allocated, and well-documented. FAR Subpart 31.2 provides the framework, and contracting officers and auditors rely on these standards when reviewing records.
Strong financial systems, clear documentation practices, and disciplined internal controls help organizations pass audits and avoid costly disputes. Organizations that adopt proactive methods for handling costs gain greater stability in government contracting and build confidence with oversight agencies.
Applying the Five Tests for Allowability
Every cost charged to the government must meet five standards: reasonableness, allocability, compliance with applicable accounting rules, adherence to contract terms, and consistency with FAR Subpart 31.2. Each standard carries its own expectations, and failing any of them may result in disallowance.
Reasonableness is judged against what a prudent business would pay in a competitive market, and contractors hold the burden of proof when questioned. Allocability requires that expenses clearly benefit the contract or the business in proportion to the charge.
Documentation plays a decisive role here, as contracting officers and auditors must be able to trace records and verify the treatment of costs. Maintaining evidence demonstrating how each test is satisfied reduces the likelihood of disputes and strengthens credibility during reviews.
Building an Acceptable Accounting System
For cost-type contracts and many flexibly priced awards, an accounting system must meet pre-award adequacy requirements and, in some cases, additional defense contracting criteria.
The Standard Form 1408 checklist from the General Services Administration provides guidance, focusing on the segregation of direct and indirect costs, timekeeping practices, contract cost accumulation, monthly postings, and the exclusion of unallowable costs.
The Defense Contract Audit Agency (DCAA) further interprets these requirements and provides practical checklists that translate the criteria into day-to-day internal controls.
Department of Defense contracts may also incorporate DFARS 252.242-7006, which requires strong internal controls and compliance with timekeeping, indirect allocation, and billing procedures. Deficiencies under this clause can trigger payment withholds of up to 5%, making compliance a financial and operational necessity.
Organizations that outsource accounting functions can benefit from asking providers to map every requirement to documented policies, system controls, and supporting evidence.
Accounting For Unallowable Costs
Segregating unallowable expenses is fundamental to compliance. Dedicated accounts in the general ledger allow clear identification, segregation, and exclusion of items that may not be charged to the government.
FAR and Cost Accounting Standards specify that unallowables include entertainment, alcohol, lobbying, and political activity, among others. Certain travel costs are limited by per diem caps and strict documentation requirements. CAS 405 requires that unallowable costs remain in the allocation base when that is normal practice, and directly associated costs must often follow the same treatment.
To reduce risk, many firms establish a disallowance log that reconciles to billing files and reflects the monthly ledger. Training staff to code these expenses accurately and consistently prevents mistakes that could otherwise result in penalties or disallowed claims.
Strengthening Labor Charging and Timekeeping
Labor often represents the largest expense in government contracting, and auditors pay close attention to how hours are recorded and billed.
Systems must support daily entry of all hours worked, proper assignment to charge numbers, supervisory approvals, and reconciliation to payroll records. Accuracy in labor distribution links directly to job cost reports and ultimately to the general ledger, forming a trail auditors can follow without gaps.
Unannounced timesheet checks and reconciliation of labor costs for one pay period provide strong evidence of compliance. Service providers handling timekeeping should be prepared to demonstrate the integrity of their processes through documented tests and reconciliations.
Designing Logical Indirect Rate Structures
Indirect rate structures influence billing, cost recovery, and audit results. Allocation bases must reflect a fair and consistent relationship between indirect expenses and benefiting activities, and the rationale should be documented in a clear rate book.
During the year, contractors bill at provisional rates, which must be updated periodically to prevent significant variances. At fiscal year-end, an adequate incurred cost submission must be filed within six months, and DCAA’s ICE model provides the structure and schedules that auditors expect to see.
Maintaining a live draft of the required schedules throughout the year simplifies preparation and minimizes year-end surprises. Some organizations take it a step further by producing quarterly variance analyses that compare actuals to provisional rates, providing an early opportunity to adjust billing rates.
Controlling High-Risk Cost Areas
Certain categories require special attention because they frequently trigger audit scrutiny. Travel must follow per diem limitations and include records of purpose, traveler, dates, and locations, supported by both pre-trip approvals and post-trip audits.
Compensation requires evidence of reasonableness and compliance with the statutory benchmark cap, often demonstrated through salary surveys, board minutes, and written bonus plans. Subcontracts demand careful oversight, particularly where contract terms require flow-down clauses and evidence that subcontractors maintain acceptable systems.
Clear policies and consistent documentation in these areas help contractors avoid disputes while demonstrating disciplined control over sensitive costs.
Using Advance Agreements for Gray Areas
When the treatment of a cost could be subject to debate, contractors can request an advance agreement with the contracting officer. These agreements clarify how certain expenses will be handled, reducing the chance of disputes later.
Keeping executed agreements alongside contract briefs and rate documentation secures that guidance is readily accessible during reviews or audits.
Developing Confidence Through Proven Compliance
FAR cost principles demand structure, discipline, and strong financial systems. Organizations that adopt clear policies, reliable documentation, and well-designed accounting practices gain contract stability and credibility with auditors.
At Diener & Associates, decades of experience supporting government contractors, nonprofits, and service businesses have shown that a proactive approach to compliance strengthens long-term success. Schedule a consultation online or contact us at 1-(703)-386-7864 to speak with our professional CPA team.