What makes a contractor's accounting and recordkeeping system compliant and ready for a government-contract audit?

What is actually being evaluated?

DFARS clause 252.242-7006, from the Defense Federal Acquisition Regulation Supplement, defines an accounting system as a contractor's system or systems for accounting methods, procedures, and controls, which may include subsystems for indirect and other direct costs, compensation, billing and labor. Where the clause is in your contract, it requires you to establish and maintain an acceptable one, meaning a system that complies with its eighteen criteria.

Documents are the system's outputs. FAR clause 52.215-2, Audit and Records, defines records to include accounting procedures and practices and computer data, and on cost-reimbursement, incentive, time-and-materials, labor-hour and price-redeterminable contracts gives the contracting officer or an authorized representative the right to examine all records and other evidence sufficient to reflect properly all costs claimed. A folder your ledger cannot reproduce proves nothing.

Use the eighteen criteria as your self-assessment sheet, recording the evidence that shows each one working:

Which requirements apply to you, and when is the system evaluated?

DFARS 242.7502 requires contractors receiving cost-reimbursement, incentive type, time-and-materials or labor-hour contracts, or contracts with progress payments based on costs or on a percentage or stage of completion, to maintain an accounting system, and DFARS 242.7503 prescribes clause 252.242-7006 for those contracts. On another agency's contract, the solicitation and contract clauses show which terms apply. In a preaward survey, FAR 9.106-4 has the surveying activity complete the applicable parts of SF 1408, Preaward Survey of Prospective Contractor-Accounting System, whose evaluation checklist covers criteria 2 to 5, 9 to 14 and 17 of the table above and adds financial information to support progress payment requests; walk it alongside the table. Read the clause versions your solicitation and contract cite.

Before award, the question is whether the design can produce the cost data the contract type needs, and how much of it already operates. FAR 16.104 says that before agreeing on any contract type other than firm-fixed-price, the contracting officer shall ensure your accounting system will permit timely development of all necessary cost data in the form that type requires. FAR 16.301-3 allows a cost-reimbursement contract only when, among other conditions, your accounting system is adequate for determining costs applicable to the contract or order. SF 1408 also asks whether the system is currently in full operation and, if not, which portions are set up but not yet in operation, anticipated or nonexistent. The surveyor may recommend award with a follow-on accounting system review after award.

After award, the operating system is judged. Under DFARS 242.7502, the cognizant contracting officer, in consultation with the auditor or functional specialist, determines whether the system is acceptable and approves or disapproves it. FAR 42.101 names the Defense Contract Audit Agency (DCAA) as normally the responsible Government audit agency for contractors other than educational institutions and nonprofit organizations. On contracts with FAR 52.216-7, the contracting officer may have your vouchers and statements of cost audited at any time before final payment, and any payment may be reduced by amounts found not to be allowable costs or adjusted for prior overpayments or underpayments. Keep the system ready continuously, not for a date.

What if you hold only firm-fixed-price work?

FAR 9.104-1 requires every prospective contractor, to be found responsible, to have the necessary organization, experience, accounting and operational controls, and technical skills, or the ability to obtain them. DFARS 242.7503 does not prescribe clause 252.242-7006 for a firm-fixed-price contract without cost-based or completion-based progress payments, so read the audit clauses your contract does contain. If a fixed-price contract is an incentive type or has cost-based or completion-based progress payments, DFARS 242.7503 prescribes the clause for it. FAR 16.104 says the accounting-system factor may be critical when a contract type requires price revision while performance is in progress, or when a cost-reimbursement contract is being considered and all current or past experience with the contractor has been fixed-price. Build the structure below before bidding such work, because a preaward survey asks whether it already operates.

What if you are a subcontractor?

FAR 52.215-2 requires the prime to insert its audit clause, altered only to identify the parties and the Contracting Officer under the Government prime contract, in each subcontract that exceeds the simplified acquisition threshold and is cost-reimbursement, incentive, time-and-materials, labor-hour or price-redeterminable, requires certified cost or pricing data, or requires the reports the clause describes. Because the flowed-down FAR 52.215-2 clause includes paragraph (g), you must insert it in your own subcontracts that meet the same tests, applying the threshold as defined in FAR 2.101 on the date of subcontract award. FAR 9.104-4 makes primes generally responsible for determining their prospective subcontractors' responsibility, and a prime may be required to provide written evidence of it, so the prime may assess your system before a Government auditor does. Find the audit, payment and accounting-system clauses in your subcontract: a flowed-down clause binds you as a term of your own contract.

How must direct and indirect costs be separated, pooled and allocated?

Criteria 2, 4 and 15 cover this, and FAR part 31 sets the rules behind them:

• Direct costs. FAR 31.202 requires direct costs of the contract to be charged directly to it; costs specifically identified with your other final cost objectives, such as commercial jobs, are not charged to the contract directly or indirectly. FAR 31.202(b) lets you treat a direct cost of a minor dollar amount as indirect if the treatment is consistently applied to all final cost objectives and produces substantially the same results as charging it direct; define "minor" in your written classification policy.
• Consistency. FAR 31.202 bars charging a cost as direct when other costs incurred for the same purpose in like circumstances are in an indirect pool allocated to that or any other final cost objective, and FAR 31.203 bars the reverse.
• Pools and bases. FAR 31.203 requires indirect costs to be accumulated in logical cost groupings, with due consideration of the reasons for incurring them, each permitting an allocation base common to all cost objectives it is allocated to. FAR 31.203 also requires the base selected to allocate each grouping by the benefits accruing to intermediate and final cost objectives; document why each base reflects those benefits. An accepted base may not be fragmented by removing individual elements, and every item properly includable in it bears a pro rata share of indirect costs irrespective of its acceptance as a Government contract cost.

In an invented year, an overhead pool of 90,000.00 over a direct-labor base of 200,000.00 (120,000.00 government, 80,000.00 commercial) gives 45%, so contract G-1, with 60,000.00 of direct labor, carries 27,000.00. Dropping commercial labor from the base would give 75% and put 45,000.00 on G-1, the fragmentation FAR 31.203 bars. Your books should reproduce each figure.

How are costs that cannot be charged kept out?

FAR 31.201-6 requires costs that are expressly unallowable or mutually agreed to be unallowable, including mutually agreed unallowable directly associated costs, to be identified and excluded from any billing, claim or proposal applicable to a Government contract. A directly associated cost is one generated solely as a result of incurring another cost, and is unallowable when that cost is; it stays in a pool allocated over a base that includes its unallowable cost, and otherwise, if material, is purged from the pool. FAR 31.201-6 applies the practices of 48 CFR 9904.405, and criterion 12 makes the exclusion a system requirement.

Build the exclusion into the ledger: separate accounts for unallowable costs, coded as each transaction is entered. FAR 31.201-6 also accepts statistical sampling for unallowable costs if the sample is unbiased and representative, large-dollar and high-risk transactions are reviewed separately outside the sample, and the sampling permits audit verification; it says the method should be covered by an advance agreement with the cognizant administrative contracting officer or Federal official. Either way the identification sits in your records, not in the billing. A screen applied only when bills are prepared leaves the costs inside pools, rates and proposals, with no record of how they were identified. Segregation does not remove unallowable items from an allocation base they properly belong in: under FAR 31.203 they still bear their pro rata share of indirect costs. Whether a particular cost is allowable is a separate question under FAR part 31's cost principles and your contract.

How must costs accumulate by contract and line item?

Criteria 3, 5, 13 and 14 require costs to be accumulated by contract under general ledger control, and by line item, unit and production stage where they apply. That takes structure set up before the first transaction:

• Chart of accounts. Cost-element accounts cover direct labor, materials, subcontracts, other direct costs, each indirect pool and unallowable costs, and work the same way on every contract.
• Job structure. Each contract has a job, with a level for each line item, task or work breakdown element the contract reports on; commercial work and indirect activities have their own jobs.
• Coding at entry. Every timesheet line, purchase order, supplier invoice and expense report carries its job, line and cost element when recorded, and the system refuses entries without them.

Recoding months of uncoded transactions is reconstruction, which these criteria exist to prevent. Setting up job costing is its own question; an existing job-cost setup can be extended to the contract's lines and fed from the general ledger.

How must labor be recorded, approved, corrected and distributed?

Criteria 9 and 10 require timekeeping by cost objective and distribution of direct and indirect labor to the appropriate cost objectives. On time-and-materials and labor-hour contracts, FAR 52.232-7 requires vouchers to be substantiated by evidence of actual payment and by individual daily job timekeeping records, records verifying that employees meet the contract's labor-category qualifications, or other substantiation the contracting officer approves. Under FAR 52.216-7, the final indirect cost rate proposal includes, unless the cognizant Federal agency official specifies otherwise, a reconciliation of total payroll per IRS Form 941 to total labor costs distributed.

The rules set outcomes, not a procedure; the sequence below is one way to produce them, and the evaluator judges how your system actually operates:

1. Each employee records their own hours daily against the charge codes for the work actually done, including commercial work, indirect activity, leave and hours beyond the normal schedule.
2. A supervisor who knows the work approves each timesheet at period end; nobody approves their own time.
3. A correction is entered or acknowledged by the employee, with the reason on the entry and a fresh approval, and the system keeps the original.
4. Labor distribution runs only from approved timesheets.
5. Each pay period, distributed labor is reconciled to gross pay on the payroll register, and differences are explained before the period closes.

Hours filled in from memory at month end, or spread by percentage, cannot show where the time went, and no later correction can.

When employees split time between government and commercial work, only the timesheet evidences the split: FAR 31.202 keeps commercial costs off the contract and FAR 31.203 keeps commercial labor in the base, so record both. Certified payroll on public-works jobs is a separate obligation.

How do the cost records tie to the ledger and to billings?

Criteria 5, 6, 7, 11 and 16 of clause 252.242-7006 make these ties system requirements, and criterion 16 also requires billings that comply with contract terms. Books that are right only after a year-end reconstruction fail the monthly criterion even if the annual totals are correct.

On contracts containing FAR 52.216-7, you must submit an adequate final indirect cost rate proposal to the contracting officer (or cognizant Federal agency official) and auditor within the 6-month period following the end of each fiscal year. Unless that official specifies otherwise, it summarizes claimed indirect rates by pool, base and calculated rate, schedules direct costs by contract with indirect expense applied, reconciles the general ledger to claimed direct costs by major cost element, and schedules cumulative costs claimed and billed by contract.

Here is one employee's day and one supplier invoice on invented contract G-1, with overhead at a 45% billing rate (under FAR 52.216-7, a rate established by the contracting officer or an authorized representative, the cognizant auditor, as the anticipated final rate, subject to adjustment when final rates are established) and reconciliation points marked RP:

Distribution reclassifies the gross pay payroll already posted, so labor is in the ledger once:

RP1 would still balance if all 8.0 hours had gone to G-1: totals cannot catch a wrong code, so the approved timesheet carries that control.

Which controls must be written down?

Criteria 1 and 8 require a sound internal control environment and management reviews or internal audits of the system against your established policies, procedures and accounting practices; a review against policies needs written ones. FAR 4.703 requires retention and transfer procedures for computer data that maintain its integrity, reliability and security, and an audit trail describing any transfer. Write down at least these, a recommended minimum for criteria 1, 7 and 8 rather than a regulatory list, each saying who acts and what evidence it leaves:

• Authorization. The procedure names who approves purchases, timesheets, adjusting entries, rate changes and each billing before it goes out.
• Separation of duties. Whoever enters a transaction neither approves it nor reconciles the account it lands in. New or changed supplier or employee payment details are confirmed by calling a phone number you already held before the change arrived, or in person, never by email or any other message; until then, payment goes only to the details confirmed before the change.
• System access. Each user has a named account with rights limited to their role, reviewed periodically.
• Change control. Changes to accounts, charge codes, allocation bases, rates and system settings follow a written approval step.
• Audit trail. The system records who entered, changed and approved each entry and when, and no user can delete that history.

In a one- or two-person office, have someone who did not make the entries, such as an outside accountant, review and sign each month's reconciliations, adjusting entries and billings.

How long must records be kept, and how must they be produced?

FAR 52.215-2 requires you to make records available at your office at all reasonable times for examination, audit or reproduction until 3 years after final payment, or for any shorter period specified in FAR subpart 4.7 or any longer period required by statute or other clauses of the contract. Records of terminated work stay available until 3 years after any resulting final termination settlement, and records relating to Disputes clause appeals, litigation or settlement of claims until those are finally resolved. FAR 4.703 adds that the FAR 4.705 periods extend one day for each day a final indirect cost rate proposal is late. Check the record class in FAR 4.705 before discarding anything sooner than 3 years after final payment.

FAR 4.703 allows electronic storage unless the originals contain significant information not shown on the record copy, and lets imaged copies replace originals in an audit only if your procedures ensure the imaging preserves accurate images, including signatures, and is reliable and secure; you maintain an effective indexing system for timely and convenient access; and you keep the originals at least one year after imaging. Computer data must be kept on a reliable medium and not destroyed, discarded, deleted or written over during the retention period.

What happens after an adverse determination?

Before award, an inadequate system rules out a cost-reimbursement contract under FAR 16.301-3. After award, clause 252.242-7006 sets this sequence for material weaknesses, meaning internal-control deficiencies that make it reasonably possible a material misstatement will not be prevented, or detected and corrected, on a timely basis:

1. The contracting officer gives a written initial determination of any material weaknesses, describing the underlying deficiency in enough detail for you to understand it.
2. You respond within 30 days, stating your rationale in writing if you disagree.
3. The contracting officer notifies you in writing of a final determination on remaining material weaknesses, the adequacy of any proposed or completed corrective action, and disapproval of the system if one or more material weaknesses remain.
4. Within 45 days of receiving it, you either correct the weaknesses or submit an acceptable corrective action plan showing milestones and actions to eliminate them.

If the system is disapproved and the contract also contains DFARS clause 252.242-7005, Contractor Business Systems, payments are withheld under that clause, which applies only to covered contracts subject to the Cost Accounting Standards; check whether yours includes it. The contracting officer then withholds 5 percent of amounts due from progress payments and performance-based payments and directs you to withhold 5 percent from interim cost vouchers on cost-reimbursement, labor-hour and time-and-materials contracts, until the contracting officer determines all material weaknesses are corrected. If you submit an acceptable corrective action plan within 45 days of receiving notice of intent to withhold, and the contracting officer, consulting the auditor or functional specialist, determines you are effectively implementing it, withholding tied to the weaknesses it covers falls to 2 percent, returning to the initial percentage if you fail to follow the plan. The total withheld from any payment or voucher cannot exceed five percent for weaknesses in one business system or ten percent across several, and none applies to payments on fixed-price line items where performance is complete and the Government has accepted the items. You notify the contracting officer in writing when the weaknesses are corrected.

How do you assess your own system and close the gaps?

Criterion 8 makes management reviews or internal audits part of the system, so a documented self-assessment is itself evidence. Run it in this order:

1. List the clauses. For each contract, subcontract and live solicitation, record the contract type, payment clause and every audit, accounting-system and business-system clause, including flowed-down ones.
2. Walk every criterion. Fill in the evidence column of the table above, then trace one recent voucher back through the contract ledger and general ledger to timesheets and supplier invoices.
3. Classify each gap. A design gap, such as no contract-level jobs or timesheets without charge codes, means the system cannot meet the criterion and must be restructured. An operating gap, such as late timesheets or unreconciled months, means an adequate design is not followed; fix the practice and keep evidence of several correct closes.
4. Assign and schedule. Give each gap an owner and a date, fixing design gaps in cost structure, timekeeping and unallowable-cost segregation first, because hours and costs recorded without contract and charge codes cannot be repaired afterwards.
5. Keep the record. Date and sign the assessment, keep the samples and results, and repeat it on a set cycle and after any system change.

In an ordinary accounting system, most ledger criteria are a matter of configuration: jobs or classes for contracts and lines, separate accounts for unallowable costs and indirect pools, and a monthly close. Test timekeeping approval and correction history, rate calculation and billing from the contract ledger first; where the software cannot enforce them, add a contract accounting module or system, or cover the gap with written procedure and retained evidence.