Understanding and managing unallowable costs is an essential aspect of maintaining compliance in government contracting. Missteps in this area can lead to audit findings, penalties, and reputational risks.
For organizations engaged in federal contracts, effectively identifying, documenting, and segregating their unallowable costs is a foundational practice that can help them maintain compliance.
What Are Unallowable Costs?
Unallowable costs, as defined in FAR 31, are expenses that cannot be included in government contract pricing, reimbursements, or settlements. These costs fall into several distinct categories.
Expressly unallowable costs are explicitly prohibited by federal regulations, leaving no room for interpretation. Contractually unallowable costs, on the other hand, may generally be allowable but are excluded under the specific terms of a contract.
Additionally, costs that fail to meet the five allowability criteria, such as reasonableness, allocability, or proper documentation, are also treated as unallowable. Also, directly associated costs, those incurred alongside unallowable expenses, can also be disallowed.
Improperly managing unallowable costs carries several significant risks. For example, audits may uncover inaccuracies, leading to financial penalties, interest charges, or increased scrutiny of future contracts. That’s why maintaining clear records and understanding these distinctions are essential to avoiding costly consequences.
The Primary Criteria for Allowability
Determining whether a cost is allowable under FAR 31 hinges on five main criteria: reasonableness, allocability, applicable accounting standards, contract terms, and regulatory limitations. Each plays an essential role in assessing whether a cost is acceptable:
- Reasonableness examines whether an expense aligns with what a prudent person would consider ordinary and necessary for contract performance. For instance, renting a compact car for a single traveler might be reasonable, while opting for a luxury vehicle could raise questions from regulators.
- Allocability focuses on whether a cost directly benefits a specific contract, benefits multiple contracts proportionally, or supports overall business operations, such as administrative expenses.
- The applicable accounting standards, often CAS or GAAP, guide the appropriate treatment of costs.
- Along with this, contract-specific terms may impose stricter requirements, explicitly disallowing certain costs.
- Finally, FAR limitations outline the broader restrictions that contractors must follow. Ignoring these criteria can lead to reclassified costs and compliance issues.
Maintaining Consistency in Cost Treatment
Treating costs consistently as direct or indirect across similar circumstances is a fundamental requirement in government contracting.
FAR 31.201-2(d) emphasizes that consistent treatment confirms costs are classified appropriately and supported with adequate documentation. Without this consistency, discrepancies can arise, potentially leading to audit findings or penalties.
One common pitfall involves a contractor’s administrative expenses. For instance, categorizing an administrative salary as an indirect cost in one case and as a direct cost in another creates inconsistencies that auditors are likely to flag. Avoiding such issues requires clear policies and well-defined procedures for cost classification.
Consistent treatment also simplifies record-keeping and strengthens compliance. Any costs incurred for the same purpose under similar conditions should always be treated uniformly to maintain accuracy.
Regular reviews, along with established internal guidelines, allow for early detection and correction of potential inconsistencies.
The Segregation of Unallowable Costs
Segregating unallowable costs within the accounting system is an important practice for maintaining compliance with government contracting regulations. Proper segregation prevents these expenses from being inadvertently included in claims, proposals, or invoices submitted to the government.
Best practices for segregation include creating dedicated accounts or cost centers specifically for unallowable expenses. These accounts can be labeled with clear identifiers, such as account codes that include “unallowable” or a unique numbering system, which simplifies tracking and makes it easier to exclude these costs during audits or reporting.
Some contractors opt for alternative methods like statistical sampling to estimate unallowable costs. While permissible under FAR 31.201-6(2), this method carries risks, including heightened scrutiny during audits. Establishing an advanced agreement with the Administrative Contracting Officer can mitigate these risks.
Integrating cost segregation into daily accounting workflows is also essential here. Routine monitoring and periodic reviews help reduce errors and align accounting practices with regulatory expectations, ultimately supporting long-term compliance efforts.
Potential Penalties for Unallowable Costs
Including unallowable costs in claims or proposals can lead to significant consequences, as outlined in FAR 42.709. Organizations may face financial penalties, including interest charges and reimbursement of disallowed costs.
In cases where unallowable costs were identified before the submission of an incurred cost proposal, penalties can double the disallowed amount, adding further strain to contract performance.
Beyond financial impacts, non-compliance carries reputational risks. A history of unallowable costs can lead to increased scrutiny in future audits, damaging relationships with government agencies. Severe violations may also result in civil or criminal penalties, particularly if the unallowable costs reflect intentional misrepresentation or gross negligence.
Best Practices for Long-Term Compliance
Maintaining long-term compliance with government contracting regulations requires consistent attention to detail and proactive management.
Implementing the following practices strengthens internal controls and reduces the risks associated with unallowable costs. Over time, they contribute to more efficient and reliable compliance management.
- Conduct regular audits of cost records and policies to identify any potential discrepancies, misclassifications, or gaps in documentation.
- Periodically review FAR updates and contract terms to remain aligned with shifting rules and regulations.
- Take advantage of DCAA-compliant accounting systems and software to help streamline core processes like cost segregation, tracking, and reporting.
- Strengthen transparency and accountability within your organization by encouraging candid communication and clear, organized documentation practices. Remember: informed teams make better decisions, reducing the likelihood of non-compliance.
Accounting and Consulting Services Designed to Deliver Results
Effectively managing unallowable costs is an essential part of staying compliant and maintaining strong relationships with government agencies. From understanding the criteria for allowability to implementing best practices like cost segregation and employee training, proactive steps can make all the difference in avoiding costly penalties and audit findings. Maintaining consistency, transparency, and conducting regular process evaluations are all essential to success in this area.
To help with this, the professional team of CPAs at Diener & Associates specializes in consulting and accounting services tailored to government contractors. With expertise in staying on top of complex regulations, we provide the essential tools, systems, and guidance needed to prevent missteps and pitfalls.
To get started, book a consultation online or call 1-(703)-386-7864 to discuss potential solutions for effectively managing your firm’s unallowable costs.