What Contractors Should Know About Accounting For Government Contracts

Founder and CEO of CPA Department, I share tips about growing and leading small businesses.

In a prior article, I wrote about the appeal of counting the Federal Government as a customer, because of the size of the government’s budget, as well as its creditworthiness. In that article, I discussed Federal Acquisition Regulations and contract types. Building upon that base, this article begins a discussion of accounting for government contracts for those new to these concepts.

Generally Accepted Accounting Principles

Government contractors are required to follow generally accepted accounting principles (GAAP
GAA
) issued by the Financial Accounting Standards Board (FASB). This means contractors are not permitted to apply cash basis accounting which is often used for tax preparation by small businesses not required to obtain financial statement audits. Rather, contractors must apply fully GAAP compliant, accrual-based, accounting principles when accounting for government contracts.

Cost Accounting

In addition to following GAAP, most government contractors are required to apply cost accounting principles to account for contract costs. For this reason, accounting for government contracts requires a greater level of complexity and sophistication than accounting required of commercial entities. 48 CFR Chapter 99 of the Federal Acquisition Regulations (FAR
AR
) delineates formal cost standards issued by the Cost Accounting Standards Board (CASB).

These standards were established to achieve uniformity and consistency in the cost accounting principles followed by contractors to estimate, accumulate and report costs and to require contractors to disclose in writing their cost accounting practices. Large government contractors are required to comply with these cost accounting standards. While small contractors are typically exempt from the rigorous requirements of 48 CFR Part 99, most small contractors will be required to implement cost accounting procedures to properly account for government contracts.

Direct And Indirect Costs

FAR part 31.202 requires contractors to segregate direct costs from indirect costs and requires direct costs to be charged directly to a contract. Direct costs are those specifically identified with a final cost objective, or contract. Typical examples of direct costs include employee labor expended in meeting contract objectives or materials used in performing on a contract.

Indirect costs are those costs that cannot be specifically identified with a final cost objective or those identified with two or more contracts, or an intermediate cost objective. Indirect costs are required by FAR 31.203 to be accumulated in logical groupings, or cost pools, and allocated to final cost objectives, or contracts, based on the benefits accruing to the contract.

The cost accounting system must identify what costs are considered direct and what costs are considered indirect. Once these criteria are defined, they must be consistently applied. Fundamentally, this means that a cost may not be allocated as an indirect cost to a final cost objective if other costs incurred for the same purpose have been included as direct costs of that or any other cost objective. Indirect costs are normally placed in fringe, overhead or general and administrative (G&A) expense pools and allocated to contracts on an equitable basis.

Labor Costs And Timekeeping Requirements

Employees of government contractors are required to comply with rigorous timekeeping requirements to ensure labor is appropriately charged to contracts and indirect pools. Unlike other costs, labor is not supported by external documentation or physical evidence to provide an independent check or balance. The key link in any sound labor time charging system is the individual employee.

All hours worked by all employees must be recorded in timesheets, including time spent performing all direct and indirect work objectives and including uncompensated overtime. Recording all hours worked is called “Total Time Accounting,” and impacts the calculation of labor cost per hour and the subsequent cost charged to each cost objective or contract.

Unallowable Costs

Contractors are required to exclude certain costs considered “unallowable” from being charged to the government. Costs that are not allowable are defined in FAR Part 31, Contract Cost Principles and Procedures, and may also be defined by contract provisions. The FAR identifies some costs as expressly unallowable, meaning they are always unallowable under all circumstances. Examples of these costs include bad debts (FAR 31.205-3); contingencies (FAR 31.205-7); contributions or donations (FAR 31-205-8); and entertainment (FAR 31.205-14). These costs must always be excluded from proposals and billings to the government. Additionally, costs mutually agreed to be unallowable between the contractor and the Contracting Officer also may not be proposed or billed.

Accounting systems of government contractors must have a method of identifying these unallowable costs and segregating them in the books and records. While these costs may be legitimate business expenses and deductible for tax purposes, they will not be accepted by the U.S. Government as allowable contract costs. In fact, FAR 42.709 authorizes Contracting Officers to assess a penalty if a contractor bills an expressly unallowable cost to the government.

Prospective contractors will be much better prepared to profitably do business with the federal government, armed with basic information about the government as a customer, which is vast and complex. It’s important to have an understanding of the regulations governing accounting for government contracts, as contractors are subject to audit once a contract award is won. There are significant responsibilities placed on contractors through FAR and financial risks associated with failing to account properly for costs on government contracts. Understanding the FAR and regulations governing accounting for government contracts sets contractors up for success.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. Do I qualify?