Accounting systems, policies and procedures make up a critical component of government contract management. To win and keep profitable federal contracts, businesses must show compliance with federal accounting regulations.
Effective government contract accounting rests on a foundation of Generally Accepted Accounting Principles used by almost every business. Starting with a solid GAAP framework makes compliance with specific government requirements that much easier.
Federal contractors also must meet a unique set of accounting requirements under the Federal Acquisition Regulations (FAR) and Cost Accounting Standards (CAS). These standards apply to contractors of all sizes – including small businesses.
This article explores basic GAAP, FAR and CAS principles as they apply to government contracting.
The Ten Principles of Accounting Under GAAP
The ten principles of accounting under Generally Accepted Accounting Principles provide basic guidance for accounting transactions in organizations of all sizes.
In the U.S., GAAP was established by the Financial Accounting Standards Board and the American Institute of Certified Public Accountants.
The following accounting principles are used in both government and private-sector accounting.
1. Economic Entity Principle: The activities of a business must be kept separate from the financial activities of its business owners.
2. Monetary Unit Principle: Only transactions in U.S. dollar amounts can be included in accounting The effects of inflation are ignored on previously recorded dollar amounts.
3. Time Period Principle: Principal business activities may be reported in short, distinctive time intervals. These may be weeks, months, quarters, a calendar year or fiscal year.
Some contractors elect to follow the federal fiscal year, October 1 to September 30. Others follow state fiscal years, often July 1 to June 30.
The interval must be identified in the headings of the financial statement.
4. Cost Principle: Assets must be recorded at the cash amount (or the equivalent) at the time an asset is acquired.
5. Full Disclosure Principle: Requires information pertinent to an investing or lending decision to be included in the content of the financial statements or in the notes to the statement.
6. Going Concern Principle: Refers to the intent of a business to carry on its operations and commitments into the foreseeable future and not to liquidate the business.
7. Matching Principle: Requires that businesses use the accrual basis of accounting and match business income to business expenses in a given time.
8. Revenue Recognition Principle: Under the accrual basis of accounting, revenue must be reported on the income statement in the period in which it is earned – regardless of whether the money is received or not.
With a fixed priced contract, a contractor might not bill the government until they have fulfilled the contract, yet incur significant costs before they can present an invoice. They must still record income as it is earned and expenses as they are incurred. Failure to do so can create large swings in profitability.
9. Materiality Principle: Refers to the miss-statement in accounting records when the amount is insignificant or immaterial. As a result, financial statements usually show amounts rounded to the nearest dollar.
10. Conservatism Principle: Company accounts must be prepared with caution and a high degree of verification. An accountant facing an accounting challenge with two solutions should choose the one that yields lesser net income and or a lesser asset
Federal Acquisition Regulations
The Federal Acquisition Regulations are a unique set of rules that set consistent, uniform policies and procedures for purchase of goods and services by federal government agencies.
FAR applies to contracts with most executive-branch agencies. Codified at Codified at CFR 48, the regulations ensure that government agencies award and administer contracts in a fair and impartial manner.
Some key sections that apply to accounting policies, and cost and pricing procedures:
- Part 15 Contracting by Negotiation – addresses contract pricing and related data requirements.
- Part 16 Types of Contracts – defines types of contracts and certain cost and pricing information.
- Part 31 Contract Cost Principles – governs allowability – which costs can be charged to a government contract. It sets standards for allowable and unallowable costs. It also determines how to allocate direct costs and indirect costs.
- Part 52 governs all contract provisions referenced in individual contracts.
There are also agency-specific FAR regulations. For example, the Defense Federal Acquisition Regulation, or DFARs supplement, applies to defense contractors. Because the Department of Defense consumes the largest portion of the federal budget, it issues more federal contracts than any other agency.
Cost Accounting Standards
Cost Accounting Standards promote uniformity and consistency in cost accounting. CAS consists of 19 different standards set by the federal Cost Accounting Standards Board. These dictate how contractors measure, accumulate, allocate and assign costs.
CAS was designed to level the playing field for all government contractors by defining how certain kinds of costs must be treated.
Contracts may be considered full CAS or modified CAS. Even though a contractor may not have a CAS-covered contract, CAS is still used as a best-practice guideline. Government auditors often reference CAS in their evaluations and recommendations.
Segregating Costs in Government Contracts
Segregating costs is a big issue for government contractors. The government pays only for direct costs of contracted goods or services and what it deems a fair portion of indirect costs in fulfilling the contract.
To avoid issues with contract reimbursement, contractors must put costs into the correct cost pools and treat them consistently.
Direct Costs and Indirect Costs
Many private-sector businesses have only two categories of cost: cost of goods sold and general administrative/overhead expenses.
In government contracting, costs of goods sold are called direct costs. These can be attributed to an end cost objective such as a contract, job/project or product/service.
General administrative/overhead costs are considered Indirect costs. They must be segregated into relevant cost pools.
For example, many companies categorize buying of components, supplies and raw materials as an indirect function, part of overhead. After winning a large government contract, they may desire to start treating the cost of an assigned buyer as a direct cost. But, if the nature of the work is still the same, the cost must still be categorized as indirect.
The only exception is that companies are free to make changes to their accounting structure. Perhaps a company made an incorrect decision about cost allocation in the past. It can change it going forward.
Note that companies cannot make changes retroactively and cannot flip costs back and forth between direct and indirect from year to year.
Indirect Cost Pools
After defining direct and indirect costs, contractors must develop and maintain cost pools of related indirect costs.
These are placed into logical groupings of accounts that have a similar relationship to the function being managed, such as:
1. Fringe – Costs to support W-2 employees:
- Employer taxes
- Paid absences
- Health insurance
2. Overhead – Costs to support customers and products or services. These are not directly attributable to an end-cost objective, such as a project or contract:
- Product support
- Idle time
3. General and Administrative – Costs to run the business regardless of number of customers:
- Business development
- Human Resources
- Information Technology
4. Unallowable – Costs not necessary to deliver products or services to the federal government, as outlined in FAR 31. Examples include:
- Interest and finance charges
- Charitable contributions
This article covers the basics of cost pools from a high level. Other cost pools will be addressed in our next article and webinar: Fundamentals of Indirect Rates.
General Ledger Chart of Accounts: The Backbone of Your Accounting System
General ledger accounts are the backbone of any accounting system. All transactions, reports and policies and procedures revolve around the location of accounts in a company’s books.
Well-written accounting policies and procedures reference specific accounts and account groups and describe how certain costs are treated.
Individual accounts must be homogenous (containing only one kind of expense). Each cost pool must also be homogenous.
Categorizing labor creates issues for many contractors. Some companies lump all their direct labor costs – for W-2 employees, contract labor and temporary labor – into a single account. Since the nature of the labor differs, each type needs a separate account.
Training also can create confusion. A contractor might create an account called training and put it under overhead. This may work if tuition or fees are the only training expenses involved.
If an employee wants to take a training class in another city, however, travel costs should not go in the base training account. The best practice is to create individual accounts for different training expenses, such as tuition, travel and labor while training.
If you combine different expenses into a single account, it becomes difficult to perform proper analysis on those accounts. This creates issues with setting indirect rate structures in the future.
Pools should be homogenous. For example, the Fringe cost pool should only include costs related to fringe benefits for W-2 employees.
Industry Best Practice for Numbering Accounts
Following industry-accepted best practice for numbering accounts allows apples-to-apples comparisons and analysis of a company’s books.
Avoid numbering accounts sequentially without any correlation to how the rest of the accounts are structured.
A DCAA or DCMA auditor won’t fail a company if its accounts are not set up in this sequence. But, following industry standards helps assure auditors that the books are structured correctly.
- 1xxx Asset
- 2xxx Liabilities
- 3xxx Capital/Equity
- 4xxx Revenue
- 5xxx Direct/Cost of Goods Sold (COGS)
- 6xxx Fringe
- 7xxx Overhead
- 8xxx G&A
- 9xxx Unallowable & Other
This basic structure makes it easy to grow and add new accounts.
Building on the Foundation to Master Government Contract Accounting
Mastering government contract accounting requires navigating a complex and changing array of federal regulations.
Left Brain Professionals knows government contracting – and we’re happy to share our expertise. Our experienced professionals can help you succeed.
We know how to craft compliant proposals and accounting systems that help you get paid faster, breeze through audits and grow your company’s government business.
This article is the first in a series of 12, each with an accompanying Encoursa webinar offering Continuing Professional Education credits.
Brick by brick, each course and article will build your understanding of government contract accounting. If you commit to taking the webinars and reading the articles, you should have a solid foundation of government contracts expertise by December 2020.
Robert E. Jones will present the next series webinar, Fundamentals of Indirect Rates, on Tuesday, February 11 from 1 p.m. to 2 p.m. Look for the accompanying article soon after the webinar.
Questions about government contracts and your business? LeftBrainPro can help! We’ll show you how to manage your government contracts more profitably, with fewer headaches. Give us a call at (614) 556-4415 or email Support@LeftBrainPro.com to schedule an initial consultation.