Entering into a contract with the federal government means forming a business relationship with the world’s largest and most sophisticated buyer of goods and services. With strict written and unwritten rules, as well as significant consequences for non-compliance, it is essential to maintain Federal Acquisition Regulation (FAR) compliant accounting to meet the demands of government contracts and grants.
This article provides an overview of cost-reimbursable government contracts and the various types of Defense Contract Audit Agency (DCAA) audits they may undergo. By understanding these audits and the associated rules and regulations, you will be better equipped to make informed decisions and ensure proper oversight of your accounting system.
Fixed-price, Time and Materials, and Cost-reimbursable Contract Methods
Below are examples of the three primary contracting methods generally used by the federal government to procure goods and services.
Fixed-price Basis
A fixed-price contract sets a firm price for a clearly defined scope of work. The contractor assumes most of the risk because payment remains the same regardless of actual costs. This type of contract works best when requirements are well understood and unlikely to change.
Time and Materials Basis
In contrast to fixed-price contracts, a time and materials (T&M) contract offers flexibility. The government pays for the actual hours worked at agreed-upon rates, plus the cost of materials. This approach is ideal when the scope is uncertain or evolving, but it places more cost risk on the government since expenses depend on time and resources used.
Cost-reimbursable Basis
A cost-reimbursable contract reimburses the contractor for allowable costs incurred during the project, along with a fee that may be fixed or incentive-based. These contracts are common for complex or high-risk projects where the scope cannot be precisely defined. Here, the government bears most of the financial risk because costs can vary significantly.
If you have a federal contract containing FAR clause 52.216-7 Allowable Cost and Payment, the award is a cost-reimbursable type funding vehicle. These awards require the recipient to carefully account for actual project costs, including the proportional indirect costs, according to the accounting and administrative requirements contained in the FAR, Cost Accounting Standards (CAS) and the Defense Federal Acquisition Regulation Supplement (DFARS).
The following types of Department of Defense (DoD) funding vehicles usually have FAR 52.216-7 embedded in the terms and conditions of their award:
- Small Business Innovation Research (SBIR)/Small Business Technology Transfer (STTR) Phase II
- Indefinite Delivery, Indefinite Quantity (IDIQ)
- Broad Agency Announcement (BAA)
If you receive one of these awards, you must establish an acceptable accounting system and maintain continuous audit readiness.
The Role of the DCAA
The DoD maintains thousands of DCAA auditors in more than 300 branch locations to ensure you can demonstrate your ongoing compliance with the FAR, DFARS and CAS, as well as any contract-specific requirements.
DCAA has the responsibility to protect the public interest by scrutinizing the use of taxpayer dollars used to fund DoD awards. To monitor the proper spending on these awards over the life of the project, DCAA conducts different types of audits spanning the entire procurement cycle. These audits begin before the award is funded and conclude with a final audit to document cumulative costs and close out the contract.
Types of DCAA Audits
Below, we discuss several of the more common types of DCAA audits, their purpose, and provide some perspectives. A "how hard is it to pass" score has been introduced using a scale of one to 10, where 10 indicates the greatest level of difficulty. This assessment is based on over 25+ years of experience and thousands of DCAA audits we’ve helped our clients pass.
- Pre-award Survey, aka SF1408 (3/10): Before you receive your funding, the government wants to make sure you are aware of the FAR Part 31 rules and show a willingness to abide by them.
- Post-award Accounting System Audit (10/10): You’ve delivered on your government contract and now DCAA wants to perform a deep dive into your accounting records to make sure you’ve done everything properly and haven’t overcharged them.
- Provisional Billing Rate Review (2/10): This involves sharing the budgetary data and assumptions you used to develop the indirect cost rate you used in your funding proposal with a DCAA auditor.
- Forward Pricing Audit (6/10): Conducted before contract award, this audit evaluates proposed costs for future work, including Forward Pricing Rate Proposals. Auditors assess estimating methods, assumptions, and supporting data to ensure proposed prices are fair and reasonable.
- Progress Payment Audit (4/10): Provided your accounting is accurate and compliant, this audit requires you to demonstrate that you can tie back every number in a randomly chosen bill you’ve charged to your government contract to source documentation.
- Surprise Time Sheet Audit (7/10): This real time labor floor check audit can occur when a whistle blower makes an accusation under the False Claims Act (10/10). Otherwise, this is a routine exercise a DCAA auditor performs to document your ongoing compliance when your volume of business with the federal government increases (1/10).
- Financial Capability Review (6/10): DCAA usually performs this review when you are set to receive a larger than usual government contract. The purpose is to make sure you have the financial ability to float cash flow and successfully perform on the potential funding award. The review focuses on your balance sheet, current ratio, debt ratios, etc.
- Annual Incurred Cost Audit (7-9/10): FAR 52.216-7 requires you to submit an annual Incurred Cost Submission. It’s hard to rank the difficulty of passing this type of audit as it all depends on the “risks” inside the report and how aggressive you are in trying to recover costs. However, DCAA will sample and test multiple areas of costs (both direct and indirect) back to source documents to determine compliance with FAR Part 31.
- Contract Closeout (2/10): This is generally a formality, unless you’ve overbilled the government or made an error.
Pre-award Survey
Before your company receives its first cost-reimbursable award, you will meet your first DCAA auditor. The Procuring Contracting Officer (PCO) will direct DCAA to perform a preliminary review of your accounting system to make sure you are ready to do business with the federal government.
DCAA’s goal in a pre-award survey is to review the prospective contractor’s accounting system and related internal controls to provide reasonable assurance that:
- Applicable laws and regulations are complied with
- Accounting system and cost data are reliable
- Risk of misallocations and mischarges are minimized
- Contract allocations and charges are billed the same way they are accounted for
More specifically, DCAA will focus on your system’s ability to:
- Allocate costs among contracts in a logical manner
- Exclude unallowable costs
- Record employee labor hours and dollars by contract
- Segregate direct and indirect costs
- Provide timely, accurate cost accounting data to support billings
- Provide accurate data to support incurred costs claimed by contract
What’s at Stake?
We frequently hear stories of companies who fail a pre-award survey and lose out on a $1.5 million Phase II SBIR award.
In fact, we recently started working with a client who hired us after failing their pre-award survey and initial accounting system review. They had $3 million in contracts delayed for nine months until we were able to install a proper accounting system, which was then re-audited under heavy scrutiny. This delay forced the client to lay off key personnel and seriously set back the timeline for development of their technology.
Post-award Accounting System Audit
This audit is similar to the pre-award survey, except that the post-award accounting system audit is typically a multi-day, on-site audit of virtually every aspect of the accounting system. The intensity of the systems reviewed is determined by the total value and types of awards you have with the federal government.
The main purpose of the post-award accounting system audit is to ensure your accounting system remains compliant with federal requirements after a contract has been awarded. The government will make sure you have internal controls in place to properly monitor project costs and invoice the government, and can demonstrate that the controls work. Some commonly tested controls include:
- Displaying segregation of duties, as prudent, including:
- The person reconciling the operating cash account is also not in charge of invoicing and disbursing funds
- Vouching and coding of expenses, including approvals, are designed and working properly
- Proving that the labor distributed in the general ledger (an accrual basis document) reconciles to the outside payroll tax returns (a cash basis document)
- Demonstrating that the job cost reports reconcile to the general ledger for a certain time frame and can be reconciled to current and cumulative amounts billed to the government
- Allowing the auditor to verify that you accumulate costs as either direct, indirect or unallowable expenses, and can provide a monthly calculation of your actual indirect cost rates
- Demonstrating contract billings can be reconciled to cost accounts and comply with contract terms and conditions
Provisional Billing Rate Review
*Two out of 10 for a lower indirect rate, but more difficult for a higher rate
Now that you have passed your pre-award accounting system survey and received your contract, your provisional billing rates (a.k.a. indirect cost rates) must be approved before you submit your first invoice.
The procedures for establishing provisional billing rates are governed by FAR 42.704. The purpose of a provisional billing rate is to establish a method to reimburse the contractor for interim (monthly) payments. Monthly vouchers and progress payments can be returned as unpaid if submitted without properly establishing provisional billing rates.
It’s important to understand that provisional billing rates must be monitored against actual indirect cost rates monthly. They may be adjusted by either party at any time to prevent potential substantial overbilling or underbilling.
IMPORTANT NOTE:
The settlement, or true up, of final indirect rates is established during the audit of the annual incurred cost submission.
The government asks contractors to voluntarily submit a billing rate proposal to assist DCAA and the Administrative Contracting Officer (ACO) in establishing indirect cost rates annually in the month preceding the beginning of your fiscal year — December for most companies. DCAA prefers your projections to be prepared electronically (in Excel) and sent to them in an email. This allows them to run the following tests from their office (which is known as a desk audit):
- Perform a fluctuation analysis where they compare proposed pool (numerator) and base (denominator) expenses to prior year, and year-to-date amounts
- Review trends of questioned costs in relevant incurred cost audits
Some of the more common deficiencies include:
- Failure to remove unallowable costs from the numerator
- Failure to adjust provisional billing rates based on actual experience
Be prepared to provide an explanation of any significant differences.
Businesses who bid incredibly low indirect cost rates on their initial government contract proposals often find it difficult to grow their business over time. This is because the funds necessary to help build the infrastructure for the business were not requested.
In one case, we had a client who realized as time passed that his competitors were building more sophisticated solutions than he was because their higher indirect cost rates allowed them that freedom. However, as he began to systematically attempt to increase his indirect rates over time, he ran into more and more resistance from DCAA, who ultimately prepared regression analyses as a way to substantiate their position against his higher indirect cost rate request.
Later, the client acknowledged the short-sightedness of his initial decision to bid such a low indirect cost rate and realized that DCAA made it harder for his business to compete because of his indirect rate history.
Forward Pricing Audit
A forward pricing audit is conducted by DCAA to evaluate the reasonableness of a contractor’s proposed costs for future work, typically before a contract is awarded or modified. These audits are critical because they directly influence the government’s negotiation position to ensure that taxpayer dollars are spent wisely. Contracting officers will consistently use DCAA findings and recommendations as a baseline position for contract negotiations.
The primary purpose of a forward pricing audit is to determine whether the contractor’s cost estimates are current, accurate and complete, and whether they reflect realistic assumptions about future performance. This includes reviewing proposed direct labor, materials, overhead and other indirect costs to confirm they align with historical trends and expected conditions.
DCAA Auditors will typically examine:
- Estimating System Adequacy: Does the contractor have documented policies and procedures for developing cost estimates?
- Basis of Estimates: Are labor hours, material quantities and rates supported by historical data or credible forecasts?
- Indirect Rate Projections: Are overhead and G&A rates reasonable and consistent with trends?
- Compliance with FAR and CAS: Are unallowable costs excluded? Are cost accounting practices consistent?
- Fluctuation Analysis: Comparing proposed costs to prior year actuals and year-to-date figures.
- Trend Analysis: Reviewing historical indirect rates and questioning significant variances.
- Verification of Data Sources: Ensuring estimates are based on reliable data, not unsupported assumptions.
- Evaluation of Risk Factors: Identifying areas where estimates may be overly optimistic or conservative.
Passing a forward pricing audit requires a robust estimating system and thorough documentation. Contractors with weak internal controls or inadequate historical data often face significant challenges. Auditors may recommend adjustments that reduce proposed costs, impacting profitability.
Forward pricing audits protect the government from overpaying and ensure fair and reasonable pricing. For contractors, a successful audit builds credibility and can speed up negotiations. Conversely, deficiencies can delay awards or lead to unfavorable pricing adjustments.
Progress Payment Audit
*Four assumes you’re maintaining job costs and billing properly
To ensure visibility into contract costs as work progresses, DCAA performs progress payment audits on individual invoices.
After you submit an invoice, you may receive a call from a DCAA auditor to let you know that the invoice submitted has been selected for audit. You are then tasked with providing substantiation for each individual line item on the invoice — working backwards all the way to the supporting document for the initial creation of cost from government invoice back to job cost report, then from job cost report back to source documents:
- Labor Costs Distributed: Traced back to payroll reports, and approved, properly coded timesheets.
- Consultant and Subcontractor Costs: Traced back to approved, properly coded invoices and agreements.
- Travel Costs: Traced back to expense reports, coding, approvals and analyses of per diem limitations.
- Indirect Costs Applied: Traced back to the indirect cost rate agreement.
Surprise Time Sheet Audit
*Could be 10 out of 10 if you have a disgruntled employee!
DCAA understands that payroll is usually the largest cost for most small businesses, and that labor charges are relatively easy to manipulate. As a result, timekeeping policies merit special scrutiny by DCAA, and timekeeping irregularities have led to more criminal investigations than any other accounting system anomaly.
The False Claims Act allows private citizens who allege government programs are being defrauded to file actions on behalf of the government and receive a portion of the recovered damages, usually 15% to 30%.
The goal of this surprise time sheet audit (also known as a floor check) is to ensure that you and your employees are following both the government’s strict timekeeping rules and any internal timekeeping policies and procedures.
The DCAA will visit your facility unannounced and randomly select employees for timekeeping interviews. These employees must be ready to properly answer questions on timekeeping procedures and demonstrate that their timesheets reflect those procedures.
For our clients with labor charging concerns, we offer mock time sheet audits. Of greater importance, we work with management to develop more effective policies, and how to properly coach employees on their work plans, work ethic issues, time charging and time sheet correction disciplines.
Financial Capability Review
In this review, DCAA performs extensive balance sheet analysis of your organization to determine its underlying financial solvency. The government wants to avoid doing business with companies who won’t be able to deliver on a contract due to inadequate financial resources.
During this analysis, DCAA will calculate many common financial ratios to determine the level of your financial viability, with your current ratio and debt-to-equity ratio being of critical importance. If you are struggling, make as many disclosures about your financial condition as possible during this process, such as an infusion of capital or significant cost cuts planned.
Failure of a financial capability review may lead to your company being overlooked for upcoming awards, as you are seen as a financial risk. The appeal process for failing this type of review can be extremely time-consuming and expensive.
Annual Incurred Cost Audit
*Depending on DCAA’s risk analysis
Every cost-reimbursable type contract contains FAR 52.216-7, The Allowable Cost and Payment Clause. This clause requires you to submit an annual “true up” report, also known as an incurred cost submission, within 180 days after your fiscal year end.
This document represents your final cost accounting for all the activity from your business for the prior year, in accordance with the FAR, DFAR, CAS and any contract-specific stipulations.
Once this document is filed and final indirect rates have been settled, you are required to “true up” your cumulative provisional billings to the government for each project settled within 60 days of settlement. One important condition for an adequate accounting system is that it provides for progress billings to be reconciled to the final cost accounts for both current and cumulative amounts claimed.
The annual incurred cost submission has a 100% chance of being reviewed by DCAA. Fortunately, DCAA will perform a risk analysis and may cycle your audits between full-blown live audits and desk reviews.
Bear in mind, most cost-reimbursable contracts are for a significant amount of funding. As such, they will also contain FAR clause 52.242-3, which is referred to as the penalty clause. With the penalty clause in place, if DCAA audits the incurred cost submission and finds a specifically unallowable expense, or a questioned cost that has been disallowed in a prior year, they will not only disallow the expense but may also impose penalties of up to 100% of the assessed amount.
One prospective client contacted us to see if we could help them when their controller (who they thought understood government contracting) claimed several hundred thousand dollars of a specifically unallowable expense in their incurred cost submission. Several years later, after the incurred cost audit was complete and DCAA disallowed the expense, the company was forced to lay off several employees, including the controller. Upon appeal, the government ruled that not knowing the rules or relying on someone who doesn’t know the rules is not an acceptable excuse and enforced the large penalty.
Contract Close Out
The government contracting closeout process is the final step in completing a contract and officially wrapping up all obligations between your business and the government. Once all work is finished, payments are made, any property or equipment is returned, and the contracting officer reviews the contract to confirm everything is complete and accurate. This includes verifying that all deliverables were provided, invoices are settled, and any required reports are submitted. After these steps, the contract is formally closed in the government’s system.
DCAA plays a critical role in this process by validating contract actuals for all years to support the contracting officer during closeout. Their review ensures that costs billed are accurate, allowable and properly documented, which helps the government confirm compliance before final closure.
For small businesses, closeout is especially important because it clears the way for future opportunities without lingering administrative issues. While not technically an audit, it’s essential to understand that until the contracting officer formally closes your contract, your organization remains subject to the award’s terms and conditions — and you may still have financial exposure.
DCAA Audit Compliance Checklist
Below is a DCAA compliance checklist to help you meet the requirements to pass a DCAA audit.
- Make sure your accounting systems, policies, and procedures are current and accurate
- Maintain clear segregation of duties across different departments in your organization
- Keep all necessary documentation and information easily accessible upon request
- Ensure that subcontractors and vendors comply with all contract regulations
- Establish a straightforward plan to respond to DCAA audit processes
- Educate staff on government contracting regulations so they can effectively respond to questions during audits
- Reach out to a government contracting accounting advisor for guidance on common areas of scrutiny
- Review all requirements in FAR, DFARS and CAS to confirm your business's compliance
Avoid Potential Audit Issues
The interrelatedness of all the reports and documents that DCAA receives and audits cumulatively over time is important to consider. At Cherry Bekaert, we’ve created proprietary internal procedures for all our clients’ reporting requirements to anticipate potential issues that may be scrutinized.
Then, we take steps to proactively educate and prepare our clients before any filing so that they’re taking steps to mitigate any potentially significant risks. Our 25+ years of experience in this area of accounting empowers our professionals to anticipate an auditor’s concern and respond as succinctly as possible.
Your Guide Forward
Cherry Bekaert’s experienced government contracting advisors have deep knowledge and experience in government award accounting. We know the DoD, DCAA and the regulations and can help you avoid the pitfalls. We also know how to help you manage risk in accordance with your business goals.
If you need support or have questions about DCAA audits, Cherry Bekaert is here to help you move forward.
Related Insights
- Article | Best Practices for Preparing Your Annual Incurred Cost Submission
- Article | Contractor Business Systems Series: Part 1 — DCAA Government Contractor Accounting System Requirements
- Webinar Recording | Annual Financial Executive Forum Weekly Webinar Series: Anchoring Your Foothold in Government Contracting & Today’s Hot Topics on the Mind of DCAA
