Federal Contract Audit Readiness: How Small Businesses Can Avoid FAR Compliance Pitfalls

October 3, 2024

For many small businesses looking to grow, federal contracts, including Department of Defense (DOD), provide one of the most significant expansion opportunities. Every year, the government sets aside at least 23% of federal contracting dollars specifically for small businesses.  As a CEO, if you see this as a growth platform, you had better be prepared to change your accounting practices.

Why do I need to be concerned about accounting practices?

You should feel a sense of accomplishment winning a government contract. Those contracts can be very lucrative and fill your pipeline for years.  However, without knowledge of Federal Acquisition Regulations (FAR), you will start to complete that contract under systems and processes that don’t comply with government regulations.  A bookkeeper, office manager, or controller who is new to government contracts won’t know the rules or anticipate the pain that comes with a lack of compliance.

The Defense Contract Audit Agency (DCAA) serves as an auditing arm for the Department of Defense (DOD) and other federal government agencies. The agency’s core responsibility is to conduct audits to ensure that government contracts are equitable and that contractors abide by guidelines set forth in the FAR. This covers everything from proper timekeeping to adherence to Cost Accounting Standards (CAS).

While the DCAA primarily works for the DOD, its auditing services also extend to other federal entities, such as NASA, the Department of Energy (DOE), the Environmental Protection Agency (EPA), the Department of Homeland Security (DHS), and the Veterans Affairs (VA).

Talk to any CEO who has bid on Federal contracts, and they will tell you that the DCAA audits are the bane of their existence because they are seen as nitpicking and slow. It takes years for some audits to be closed.

Below are just a few FAR regulations to consider:

Segregate Direct and Indirect Costs

One of the most important aspects of DCAA compliance is the segregation of direct and indirect costs. Direct Costs can be traced directly to a specific contract (e.g., labor, raw materials), while Indirect Costs support multiple contracts (e.g., overhead, general administrative expenses).  The average accounting system of a small manufacturer does not necessarily consider direct costs, which ensures that all labor and material costs directly related to a specific government contract are accurately recorded and tracked. Failure to segregate these costs could lead to overcharging the government, resulting in non-compliance.

Establish a Timekeeping System

Accurate time tracking is crucial for labor-intensive manufacturing contracts. The DCAA requires that employees’ time be tracked in real time and that it be tied directly to specific contracts. FAR requires employees to record their time daily and should:

  • Include clear documentation on how time is spent on each project.
  • Implement electronic timekeeping systems that provide an audit trail for DCAA inspections.

Maintain an Adequate Billing System

A DCAA-compliant billing system must accurately reflect costs incurred on government contracts. Billing inaccuracies, such as charging for unallowable costs or incorrect amounts, can lead to penalties or a rejection of claims.  To bill in compliance, companies must:

  • Regularly reconcile accounting and billing records.
  • Ensure that all charges are consistent with contract terms.
  • Segregate billable and non-billable expenses.
  • Perform internal reviews before submitting claims.

Labor Distribution

Labor distribution is the process of assigning labor costs to various projects or contracts. This is essential for accurate direct labor cost charging, especially in manufacturing.  Some companies don’t need to capture labor in the appropriate buckets before securing a federal government contract and should consider the following:

  • Ensure that labor costs are distributed based on actual time spent on projects.
  • Regularly audit labor charges for accuracy.
  • Keep documentation of labor costs and allocation methods for auditors.

Prepare for Audits with Robust Documentation

DCAA auditors will review a company’s financial processes and records to ensure compliance. Having organized, accessible documentation is key to passing these audits.

  • Keep detailed records of all transactions, including receipts, contracts, and supporting documentation.
  • Store all accounting records securely for easy retrieval.
  • Train employees on the importance of accurate documentation and timekeeping.

Next Steps

Maintaining DCAA-compliant accounting in the manufacturing sector requires robust systems, diligent record-keeping, and continuous oversight. Staying proactive and prepared for DCAA audits will safeguard your business from penalties and enhance its reputation as a reliable government contractor.

We welcome the opportunity to speak with you for a complimentary assessment to see if your business is audit-ready. Please reach out to us.


Mike Benjamin - Stambaugh Ness