By Jim Wesloh
Navigating the challenging landscape of cost accounting within the framework of federal contracting requires an understanding of both the Federal Acquisition Regulation (FAR) and Generally Accepted Accounting Principles (GAAP). Below we explore these topics with particular focus on the categorization and management of costs.
As businesses engaged in federal contracting strive to maintain compliance and optimize their financial operations, understanding the delineation between direct and different types of indirect costs, as well as the specific requirements for unallowable costs, is paramount. We attempt to clarify these classifications and provide actionable insights for structuring an accounting system that aligns with both GAAP and FAR guidelines.
By examining the components of GAAP financial statements and the FAR’s directives on cost allocation, we aim to furnish contractors with the knowledge and examples to develop a chart of accounts.
The accounting systems should be operated in accordance with GAAP applicable to the circumstances, according to the SF 1408, Pre-Award Survey of Prospective Contractor (Accounting System), prescribed by FAR 53.209-1(f). GAAP financial statements will include the following sections:
Assets
Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
Liabilities
Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
Owners’ equity
Residual interest in the assets of an entity that remains after deducting its liabilities.
Revenue
Inflows or other enhancements of assets of an entity or settlement of its liabilities (or combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.
Expense
Outflows or other using up of assets or incidences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.
Federal procurement and federal government contracting are subject to the FAR, which requires expenses to be divided into the following categories:
- Direct costs (FAR 31.202): A direct cost is any cost that can be identified specifically with a particular final cost objective (project).
- Indirect costs (FAR 31.203 (a)): An indirect cost is any cost not directly identified with a single, final cost objective, but identified with two or more final cost objectives or an intermediate cost objective. In other words, if an expense is not a direct cost associated with a project, it is an indirect cost. The FAR goes on to specify that indirect costs should be further segregated.
- Indirect costs (FAR 31.203 (b)): Indirect costs shall be accumulated by logical cost groupings with due consideration of the reasons for incurring such costs. Each grouping should be determined so as to permit distribution of the grouping on the basis of the benefits accruing to the several cost objectives.
The following cost groupings are established to be consistent with the FAR and government contracting conventions:
- Overhead (FAR 31.201-4 (b)): Benefits two or more final cost objects (projects) and can be distributed in reasonable proportion to the benefits received.
- General and administrative: (FAR 31.201-4 (c)): Necessary to the overall operation of the organization, although a direct relationship to any particular cost objective cannot be shown.
- Fringe benefits (FAR 31.205-6 (m)(1)): Fringe benefits are allowances and services provided by the contractor to its employees as compensation in addition to regular wages and salaries.
- Facilities: Costs associated with office space. (Costs that would not be incurred if work was performed at a customer’s work site.)
- Bid and proposal (FAR 31.205-18 (a)): The costs incurred in preparing, submitting, and supporting bids and proposals (whether or not solicited) on potential government or non-government contracts.
- Internal research and development (FAR 31.205-18 (a)): Projects falling within the four following areas: basic research, applied research, development, and system and other concept formulation studies.
A minority of government contractors (approximately 25%) separately track material handling and/or subcontract administration costs:
- Material handling: Costs associated with purchasing, receiving, and storage of materials.
- Subcontract administration: Costs associated with the management and administration of subcontracts.
Chart of accounts structure
No specific coding for a chart of accounts is required by either GAAP or the FAR, but with the information above, we can begin to organize a chart of accounts. We recommend following the convention outlined below for the first character for a government contractor’s chart of accounts.
1. Assets
2. Liabilities
3. Owners’ equity
4. Revenue
5. Direct costs
6. Fringe benefits
7. Facilities
8. Overhead
9. General and administrative (G&A)
M. Material handling
P. Bid and proposal (B&P)
R. Internal research and development (IR&D)
S. Subcontract administration
Assets, liabilities, and owners’ equity are presented on a balance sheet in accordance with GAAP. Assets and liabilities that would be consumed or paid sooner are generally presented before items that would be consumed or paid later and are listed with the following sub-sections:
Assets
- Current assets: Cash and other assets that are expected to be converted into cash, sold, or consumed in one year.
- Long-term investments: Securities, tangible fixed assets not currently used in operations, special funds, subsidiaries.
- Property, plant, and equipment: Properties of a durable nature used in the regular operations of the business.
- Intangible assets: Lack physical substance. (For example, patents, copyrights, trademarks, and organization costs).
- Other assets: Items sufficiently different from assets included in the categories above.
Liabilities and owners’ equity
- Current liabilities: Obligations that are expected to be liquidated within one year.
- Long-term debt: Obligations that are not reasonably expected to be liquidated within one year.
- Owners’ equity: Residual interest in the assets of an entity that remains after deducting its liabilities (assets – liabilities = owners’ equity).
An income statement includes revenue and expenses. Depending on your organization’s contracts and classification as a business, revenue may need to be presented by category such as:
Operating revenue
- 8-A revenue
- General Services Administration (GSA) revenue
- Non-8-A or GSA government revenue
- Commercial revenue
Other income
- Interest
- Investments
- Other
Federal contracts often require that direct costs are proposed, recorded, and reported by element of cost. The elements of cost usual include:
Direct costs
- Direct labor: Employee (W-2) labor performed for a project.
- Consultants: Non-employee (1099) labor performed for a project.
- Subcontractors: Work performed for a project by other organizations under contract.
- Materials: Materials purchased and used for a project.
- Travel: Travel for a project.
- Other direct costs: Costs for a project that do not fall into one of the elements of cost above.
We also recommend recording revenue and expense transactions with a division, location, and worksite to allow for the ability to calculate and apply indirect rates at that level. We recommend a one-character division (allowing for up to 36 alphanumeric codes for divisions), a two-character location (allowing for revenue and/or expenses to be recorded by state if appropriate) and a one-character worksite (allowing for up to 36 worksites).
Worksites are often categorized by company site and client site to designate when the company is paying for facilities and when the customer is paying for facilities. Companies with a sensitive compartmented information facility (SCIF) may choose to record transactions related to the SCIF with a separate worksite.
Unallowable costs
The final topic before presenting a complete chart of accounts for a government contractor is unallowable or unbillable costs. Contracts and other agreements with the government may preclude specific types of costs from being reimbursed by the government. The FAR lists the following costs that explicitly cannot be reimbursed by the government and need to be segregated from allowable costs in a contractor’s chart of accounts:
- FAR 31.205-1: Public relations and advertising costs
- FAR 31.205-3: Bad debts
- FAR 31.205-6: Compensation for personal services (unreasonable)
- FAR 31.205-7: Contingencies
- FAR 31.205-8: Contributions or donations
- FAR 31.205-13: Employee morale (gifts, recreations)
- FAR 31.205-14: Entertainment costs
- FAR 31.205-15: Fines, penalties, and mischarging costs
- FAR 31.205-17: Idel facilities and idle capacity costs
- FAR 31.205-20: Interest and other financial costs
- FAR 31.205-22: Lobbying and political activity costs
- FAR 31.205-23: Losses on other contracts
- FAR 31.205-27: Organization costs
- FAR 31.205-31: Plant reconversion costs
- FAR 31.205-41: Taxes (federal corporate income taxes)
- FAR 31.205-49: Goodwill
- FAR 31.205-51: Costs of alcoholic beverages
Purchases that would be allowable in some circumstances may be unallowable in other circumstances. For example, computer supplies can be a legitimate and allowable business expense, but if the same computer supplies are purchased for an individual’s personal use, the purchase would be unallowable (and should not have been charged to the company in the first place). We recommend adding the letter “U” at the end of an unallowable expense account code in the chart of accounts to designate that expenses accumulated to that account are unallowable.
(A sample chart of accounts for government contractors is available to download below.)
Sample chart of accounts
In the complex and regulatory-intensive environment of federal contracting, understanding the intricacies of cost accounting, and the proper handling of unallowable costs, is critical for ensuring compliance and optimizing financial performance. The stringent guidelines of the FAR and the principles of GAAP provide a strategic blueprint for financial management. Also, the critical differentiation and segregation of unallowable costs underscore the importance of meticulous accounting practices in upholding the integrity of financial reporting and contract compliance.
Armed with these insights, government contractors are better positioned to make informed decisions that enhance their financial operations while adhering to the legal and regulatory frameworks that govern federal contracting.
Download a sample chart of accounts
A white paper on developing a chart of accounts can be found here.
ABOUT THE AUTHOR:
Jim Wesloh is the founder of PROCAS, a leading provider of financial solutions for government contractors. Wesloh is a University of Cincinnati alumnus.
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