It is the responsibility of the government to optimize the use of taxpayers’ money. For this reason, accounting for government contractors is subject to strict regulations and guidelines.
The rules aim to eliminate the inclusion of unallowable costs in government contract pricing as they result in overcharging and ultimately harm the public’s interest.
For greater success, it is necessary to first understand what unallowable costs are and what the best practices are to avoid the risks of unallowable costs in government contract accounting.
Understanding Unallowable Costs
Unallowable costs are deemed unreasonable and unnecessary and therefore unallowable to a government contract. These costs encompass both direct and indirect costs and include advertising, donations, entertainment, fines and penalties, and lobbying.
How to Identify Unallowable Costs
Federal Acquisition Regulation (FAR) 31.2 is the principal guide for determining cost allowability. According to FAR 31.201-2, a cost is considered allowable if it meets the following criteria:
- Compliant with standards promulgated by the CAS Board, if applicable
- Compliant with generally accepted accounting principles (GAAP) if CAS is not applicable
- Conforms with the terms and conditions of the contract
Costs arising from accounting practices inconsistent with these regulations are deemed unallowable. This implies that if the contractor’s accounting procedures result in costs exceeding those that would have been incurred under practices consistent with these regulations, such excess costs are unallowable.
Under FAR 31.201-3, a cost is deemed reasonable if its nature and amount reflect the actions that a prudent person would have taken while conducting a competitive business.
The reasonableness of costs is usually examined with extra care in connection with contractors not subjected to effective competitive constraints. If the contracting officer challenges a certain cost upon review, the contractor must prove that the cost is reasonable.
According to FAR 31.201-4, allocability of a cost is determined based on the benefits received or expected to be received from incurring such cost. A cost is considered allocable to a government contract if it is:
- Explicitly incurred for the contract
- Beneficial to both the contract and other related work and can be distributed to them in a reasonable proportion
- Necessary to the operation of the business, even though a direct relationship to any particular cost objective cannot be shown
In accounting for government contractors, any income, rebate, allowance, or other credit related to any allowable cost received by the contractor is essentially an unallowable cost.
These must be credited to the government through cost reduction or cash refund. For example, if the contractor receives a rebate for costs covered by the contract, they must credit that amount to the government.
Costs That Are Expressly Unallowable
Contract costs may become expressly unallowable if they are connected to a contractor’s violation of any agreement made with the government. For instance, if a contractor violates a “most favored customer” clause, the costs associated with that breach may be deemed unallowable.
Some costs are expressly unallowable by mutual agreement between the parties. Such costs may be expressed during contract signing or through negotiations. If a cost is deemed unallowable, any direct cost associated with it must also be considered unallowable. For instance, any direct costs related to advertising, such as salaries and wages, are also considered unallowable.
Contractor Responsibility for Cost Accounting
Government contractors bear full responsibility for their cost accounting. Part of this responsibility is maintaining records of supporting documentation. The documents must validate that the costs claimed are allocable. The contracting agency reserves the right to disallow all or part of a claimed cost that is not adequately supported.
Risks Associated With Unallowable Costs
Failure to correctly identify and exclude unallowable costs from government contract pricing can lead to significant risk for contractors. These include:
- Penalties and fines
- Tarnished reputation following repeated instances of including unallowable costs in contract pricing
- Additional scrutiny
- Loss of contracts and disqualification from future government contracts
- Legal consequences under the False Claims Act
- Wrongful identification of unallowable costs means reduced cost recovery
Best Practices for Avoiding Unallowable Costs
Below are some practices government contractors can adopt to avoid the risks associated with unallowable costs:
- Adopt an efficient cost accounting system
- Conduct frequent internal audits to test the cost accounting system
- Develop formally written policies and procedures differentiating contract costs
- Train key personnel on the policies and regulations
- Revise the policies and procedures periodically
- Maintain detailed documentation of all allowable costs
Work With Government Contract Accounting Experts
Government contracts involve sizable investments the costs of which are usually complicated and may be challenging to identify, track, and allocate. Experienced accountants in government contracting can assist in these tasks.
Diener & Associates is a leading accounting firm that has been helping government contractors for over three decades. The team of CPAs at Diener & Associates has commendable expertise in accounting for government contractors.
We provide and implement first-rate cost accounting systems and policies, provide training, and conduct internal audits to ensure full compliance with FAR regulations. Contact Diener & Associates today for expert assistance in government contract accounting.