DCAA Compliant Accounting System: Requirements, Setup, and Common Deficiencies

If you want to perform work for the federal government under a cost-reimbursement, time-and-materials, or incentive-type contract, your accounting system has to pass muster with the Defense Contract Audit Agency (DCAA). “DCAA compliant” is the shorthand contractors use, but the real standard is “adequate” under DFARS 252.242-7006, the clause that lists the criteria your system must satisfy. An adequate system tracks costs by contract, segregates direct from indirect costs, isolates unallowable costs, supports interim billing, and follows generally accepted accounting principles (GAAP). The system does not need to run on a specific piece of software. DCAA does not certify QuickBooks or Deltek or anything else. What the agency audits is whether your system, whatever it runs on, can do what the clause requires. If DCAA finds the system inadequate, the contracting officer can withhold up to 10% of every interim payment until the deficiencies are corrected. That withhold, combined with the reputational damage and the practical barrier to winning new cost-type awards, makes system adequacy one of the highest-stakes accounting questions a government contractor faces.

What does DCAA compliant actually mean?

“DCAA compliant” is not a formal designation. DCAA does not issue certificates or stamp software as approved. The phrase is contractor shorthand for an accounting system that satisfies the adequacy criteria in DFARS 252.242-7006. That clause, which is incorporated by reference into most DoD contracts above the simplified acquisition threshold, requires the contractor’s accounting system to do specific things: accumulate costs by contract, segregate direct costs from indirect costs, exclude unallowable costs from billings to the government, generate interim cost reports that support progress payments, identify unit costs for production contracts, and reconcile back to the general ledger. The system must also be consistent with GAAP, internally consistent across contracts, and capable of producing the data the contracting officer needs for price negotiation on future awards.

When DCAA audits the system (either as a pre-award survey or as a post-award audit), the auditor walks through each criterion in the clause and evaluates whether the contractor’s actual practice, not just its written policy, satisfies the requirement. A “significant deficiency” in any criterion can lead to an overall finding of inadequacy, which goes to the contracting officer (the administrative contracting officer, or ACO, for post-award) for a formal determination.

What are the DFARS 252.242-7006 criteria?

The clause lists the criteria that define an adequate accounting system. The contractor’s system must be able to do all of the following:

• Accumulate costs under general ledger control and reconcile subsidiary cost ledgers and cost objectives to the general ledger
• Segregate direct costs from indirect costs
• Identify and accumulate direct costs by contract
• Accumulate and report costs consistently across contracts and accounting periods, and comply with the contractor’s disclosed practices and Cost Accounting Standards (CAS), if applicable
• Provide a basis for billing costs under cost-reimbursement contracts (i.e., generate interim vouchers)
• Exclude unallowable costs from billings, proposals, and claims (unallowable costs are defined in FAR 31.205)
• Identify unit costs by contract line item (for production contracts)
• Provide cost data for pricing future proposals and for contract modifications
• Account for costs in a manner consistent with GAAP and the Cost Accounting Standards (CAS), if the contractor is CAS-covered

Each criterion generates its own audit steps. The auditor does not check a box and move on; the auditor tests transactions, reviews account classifications, traces costs from timesheet to invoice, and interviews staff. A system that looks correct on paper but cannot survive a transaction test is not adequate.

What happens during a pre-award survey?

Before a contracting officer awards a cost-reimbursement, time-and-materials, or incentive-type contract, the government typically asks DCAA to evaluate the prospective contractor’s accounting system. This is the pre-award accounting system survey. The primary tool is the SF 1408, Pre-Award Survey of Prospective Contractor Accounting System, a questionnaire that covers the DFARS 252.242-7006 criteria in a structured format.

The SF 1408 asks the contractor to describe its accounting system, chart of accounts, timekeeping procedures, indirect cost allocation methodology, job cost system, billing procedures, and cost estimating practices. It also asks about written policies and procedures, segregation of duties, and the treatment of unallowable costs. DCAA reviews the responses, visits the contractor’s facility (or conducts a virtual review, which has become more common since 2020), interviews accounting staff, and tests a sample of transactions.

The survey produces one of three outcomes: the system is adequate, the system is inadequate with identified deficiencies, or the contractor is too new to have enough transaction history for a meaningful evaluation (in which case DCAA may issue a conditional approval or recommend a post-award audit). If the system is found inadequate, the contracting officer will generally not award the contract until the deficiencies are corrected. For a contractor pursuing its first cost-type award, failing the pre-award survey can kill the deal entirely.

The timeline for an SF 1408 survey varies. DCAA’s stated goal is to complete pre-award surveys within a reasonable period after receiving the request, but audit backlogs and contractor responsiveness both affect the schedule. A well-prepared contractor with clean records and written policies can expect the survey to take a few weeks from request to report. A contractor with gaps in documentation or informal practices will take longer, because the auditor will ask follow-up questions and request additional evidence.

What chart of accounts structure does DCAA expect?

DCAA does not prescribe a chart of accounts. The clause requires that the system segregate direct from indirect costs, accumulate costs by contract, and exclude unallowable costs. How the chart of accounts accomplishes those things is up to the contractor. That said, certain structural features are effectively mandatory for a system that will pass audit.

Direct cost accounts must be organized by contract or task order. Each contract gets its own cost center, job, or project code (the label depends on the software), and every direct cost, whether labor, materials, travel, subcontractor costs, or other direct costs, posts to that contract’s cost center. The auditor needs to pull a report showing all costs charged to Contract X and reconcile that report to the invoices submitted to the government for Contract X.

Indirect cost accounts are organized by pool. The typical structure for a government contractor includes fringe benefits (payroll taxes, health insurance, retirement contributions, PTO), overhead (facilities, IT, depreciation on equipment used in contract performance), and general and administrative (G&A) costs (executive compensation, corporate insurance, accounting, legal, business development not classified as bid and proposal). Contractors that perform independent research and development (IR&D) or bid-and-proposal (B&P) work may have a separate pool for those costs or include them in G&A, depending on their disclosed practices.

Unallowable costs under FAR 31.205 must be identified and excluded from billings. The cleanest approach is to set up specific accounts for each category of unallowable cost (entertainment, alcoholic beverages, bad debts, contributions, fines, lobbying, and so on) so they are flagged in the chart of accounts itself. Some contractors use a “contra” or “suspense” approach where unallowable costs post to a regular expense account and are then reclassified. DCAA auditors generally prefer the direct-account approach because it creates a cleaner audit trail and reduces the risk that an unallowable cost slips through to a billing.

What timekeeping rules does DCAA enforce?

Timekeeping is one of the most heavily audited areas of a contractor’s accounting system, because labor is typically the largest direct cost on a government contract and labor mischarging is one of the most common findings in DCAA audits. The core requirements are straightforward in principle but demanding in practice.

Employees must record their time daily. Not weekly, not at the end of the pay period. Daily. The record must show the hours worked on each contract, the hours charged to indirect activities, and any leave taken. The employee signs (physically or electronically) the timesheet to certify its accuracy.

A supervisor must review and approve the timesheet before it feeds into payroll and cost accumulation. The supervisor’s approval is a control against mischarging (intentional or accidental), and the auditor will check that approvals are documented and timely.

Corrections to timesheets must follow a documented procedure. The original entry must be preserved (no “whiting out” an entry), the reason for the correction must be recorded, and both the employee and supervisor must approve the correction. DCAA treats an undocumented timesheet correction as a red flag for labor mischarging.

DCAA conducts “floor checks,” which are unannounced visits to the contractor’s work site to verify that employees are working on the contract they are charging. An auditor might walk through a facility at 2 p.m. on a Tuesday, note who is present and what they are working on, and compare that observation to the timesheets submitted for that day. If an employee’s timesheet says they worked eight hours on Contract A, but the floor check at 2 p.m. found them working on a commercial project, the auditor has a finding. Floor checks can also be conducted virtually for remote workers, through screen-sharing, communication logs, or other evidence of activity.

The timekeeping system must also enforce the total-time-accounting principle: employees must account for all hours worked, not just the hours charged to government contracts. If an employee works 45 hours in a week, all 45 hours must be accounted for, even if only 40 are charged to government contracts. The remaining 5 hours go to an indirect or overhead account. This prevents a contractor from “eating” unbilled time by not recording it, which would distort the indirect rates.

What written policies does DCAA require?

DCAA expects the contractor to maintain a written accounting policies and procedures manual that covers the key areas of cost accumulation, timekeeping, indirect rate computation, purchasing, travel, compensation, and billing. The manual does not need to be a 500-page document, and for small contractors a clear, focused set of policies that covers the required areas is sufficient. What matters is that the policies exist in writing, that they are followed in practice, and that they are consistent with the contractor’s disclosed practices and CAS board disclosure statement (if the contractor is CAS-covered).

The policies should cover at a minimum: the basis for distinguishing direct costs from indirect costs, the indirect cost pools and their allocation bases (typically direct labor dollars, total cost input, or value-added cost input for G&A), the timekeeping requirements (daily recording, supervisor approval, correction procedures), travel policies (per diem rates, advance approval requirements, documentation), compensation policies (how salaries are set, bonus criteria, reasonableness testing against survey data), purchasing procedures (competitive bidding thresholds, sole-source justification), and billing procedures (how interim vouchers are prepared, what supporting documentation is retained). A section on unallowable costs is also important: the manual should list the FAR 31.205 categories and describe how the contractor identifies and excludes them from government billings.

DCAA auditors compare the written policies to actual practice. A policy that says travel requires advance approval is worthless if the auditor finds that employees routinely travel without approval and the costs are still billed. Consistency between written policy and actual practice is the standard, and a gap between the two is itself a deficiency.

What software does a DCAA-compliant system need?

No specific software is required. DCAA audits the system’s outputs, not its brand name. That said, the system must be capable of producing the required reports, maintaining an adequate audit trail, and supporting the segregation of costs by contract and by direct/indirect classification.

For small contractors (under $50 million in government revenue, and often well under that), properly configured QuickBooks (Desktop or Online, with the projects/classes feature used to track contracts) can work. The contractor uses classes or projects for each contract, sets up indirect cost pools as separate classes, maintains a chart of accounts that flags unallowable costs, and integrates a timekeeping system (QuickBooks Time, formerly TSheets, or a standalone system) that enforces daily entry and supervisor approval. The key limitation of QuickBooks is that it does not natively enforce government-contracting-specific controls (like preventing an unallowable cost from being billed), so the contractor’s procedures and manual controls must fill those gaps.

For mid-size and larger contractors, dedicated government contractor accounting software is more common. Deltek Costpoint is the most widely used system in the federal contracting space and is designed from the ground up for DCAA compliance. Unanet, Jamis Prime, and PROCAS are other systems built for government contractors, each with job costing, timekeeping, indirect rate management, and billing capabilities that align with the DFARS criteria. These systems enforce controls at the software level (blocking unallowable cost codes from appearing on government invoices, requiring timesheet approval before payroll processing, generating SF 1034/1035 vouchers) that QuickBooks requires manual procedures to replicate.

The choice between QuickBooks and a dedicated system is primarily a function of contract volume, contract complexity, and the contractor’s growth trajectory. A contractor with one or two cost-type contracts under $5 million can operate on QuickBooks with good procedures. A contractor managing ten contracts across multiple agencies, with CAS-covered contracts and forward-pricing rate proposals, will find a dedicated system much easier to audit and operate.

What are the most common DCAA deficiencies?

DCAA publishes summary data on audit findings, and the recurring themes are consistent year after year. The most frequent deficiencies fall into a handful of categories.

Failure to segregate unallowable costs is near the top of every list. The contractor either does not have accounts for unallowable costs (so entertainment, alcohol, lobbying, and fines are buried in general expense accounts and get swept into indirect pools), or has the accounts but does not use them consistently. The auditor tests a sample of transactions in the indirect pools and finds costs that should have been excluded. This is one of the easiest deficiencies to fix (set up the accounts, train the bookkeeper, review before billing) and one of the most common to find.

Inadequate timekeeping is the second major category. The specific findings vary: employees do not record time daily (they fill in timesheets at the end of the week from memory), supervisors do not review or approve timesheets, corrections are made without documentation, the system does not enforce total-time accounting, or the system does not link timesheets to payroll and cost accumulation in a way the auditor can trace. Labor is usually 50% or more of contract cost, so timekeeping deficiencies affect the reliability of the entire cost accumulation system.

No written policies and procedures manual is a common finding for first-time contractors. The contractor may have informal practices that work well in daily operations, but without written documentation the auditor cannot evaluate whether the practices are consistent and adequate. The auditor also cannot verify that employees are following a standard, because there is no standard to follow.

Comingling of direct and indirect costs happens when the contractor does not maintain a clear distinction between costs charged directly to a contract and costs included in indirect pools. If direct labor for Contract A is posted to an overhead account, or if overhead costs are charged directly to a contract, the cost accumulation is unreliable and the indirect rates are distorted.

No job cost accounting by contract is a fundamental deficiency. If the contractor cannot produce a report showing all costs (labor, materials, subcontractors, travel, other direct costs) accumulated for a specific contract, the system cannot support interim billing or contract closeout. This finding typically indicates that the contractor is using a system designed for commercial operations (where job costing may not be needed) and has not configured it for government contract work.

Inconsistent indirect rate computation arises when the contractor changes its allocation bases, pool composition, or rate methodology from period to period without a documented change in practice. CAS-covered contractors must follow CAS 401 (consistency) and CAS 402 (cost allocability), but even non-CAS-covered contractors must demonstrate that their cost allocation is consistent and produces equitable results.

What happens when DCAA finds the system inadequate?

When a DCAA audit identifies significant deficiencies in the contractor’s accounting system, the process follows a defined path under DFARS 252.242-7006.

The auditor issues a report identifying the deficiencies and recommending a determination of inadequacy. The report goes to the administrative contracting officer (ACO), who has the authority to make the formal determination. The ACO is not required to accept DCAA’s recommendation, and the contractor has the opportunity to respond to the audit findings before the ACO makes a decision. In practice, most ACOs follow DCAA’s recommendation when the deficiencies are clearly documented.

If the ACO determines the system is inadequate, the ACO issues a formal determination letter identifying the specific deficiencies. The contractor must submit a corrective action plan (CAP) to the ACO within a specified period (usually 30 to 45 days, though the ACO sets the timeline). The CAP must describe the specific actions the contractor will take to correct each deficiency, the timeline for completion, and the evidence the contractor will provide to demonstrate that the corrections are in place.

While the system is in an inadequate status, the ACO may withhold up to 10% of each interim payment (progress payment, performance-based payment, or interim voucher payment) under DFARS 252.242-7006(d). This withhold is not a penalty; it is a reserve against the risk that billings based on an inadequate system may overstate costs. The withhold continues until the ACO determines that the deficiencies have been corrected and the system is adequate. The withheld amounts are paid to the contractor once the system is restored to adequate status.

An inadequate system determination also affects the contractor’s ability to win new cost-type awards. Contracting officers evaluating proposals for new contracts will see the inadequacy determination in the contractor’s record (it is reportable in the Contractor Performance Assessment Reporting System, or CPARS, and in pre-award surveys), and many contracting officers will not award a cost-type contract to a contractor with an unresolved system inadequacy. The reputational and competitive effect can be more damaging than the 10% withhold.

Do small businesses face the same requirements?

The short answer is yes, with some relief on the compliance overhead but not on the core requirements. If a small business holds a cost-reimbursement, time-and-materials, or incentive-type contract, the DFARS 252.242-7006 criteria apply regardless of the contractor’s size. The clause does not have a small business exemption.

Where small businesses get relief is in Cost Accounting Standards (CAS) coverage. Under 48 CFR 9903.201-1, small businesses as defined by the Small Business Administration are exempt from CAS. This means they do not need to file a CAS Disclosure Statement (CASB DS-1), do not need to comply with the individual cost accounting standards (CAS 401 through 420), and are not subject to CAS administration. They still need to comply with FAR Part 31 cost principles and the DFARS 252.242-7006 system adequacy criteria, but the incremental CAS compliance burden (which is significant for larger contractors) does not apply.

Small businesses performing only firm-fixed-price (FFP) contracts do not need a DCAA-adequate accounting system, because the government pays a fixed price regardless of actual costs. The system adequacy clause applies to cost-type contracts, and a contractor that works exclusively on FFP contracts may never encounter a DCAA audit of its accounting system. However, if that contractor bids on its first cost-type contract, the system will be evaluated at that point, and the contractor will need to be prepared.

The practical implication for small businesses is that the system can be simpler (QuickBooks instead of Deltek, a 20-page policy manual instead of a 200-page manual, a single overhead pool instead of multiple pools), but it still must satisfy the clause. Direct and indirect costs must be segregated. Costs must be tracked by contract. Unallowable costs must be identified and excluded. Timekeeping must be daily with supervisor approval. Written policies must exist and be followed. DCAA does not lower the bar for small businesses on these fundamentals.

How do indirect rates work in government contracting?

Indirect rates are the mechanism by which a contractor allocates shared costs (costs that benefit multiple contracts or the business as a whole) to individual contracts. Every cost-type government contract includes indirect costs in its billings, and DCAA audits the computation and application of those rates closely.

The typical structure has three or four pools. Fringe benefits cover payroll taxes (Social Security, Medicare, FUTA, SUTA), health insurance, retirement plan contributions, paid time off, and other employee benefits. The allocation base is usually direct labor dollars or total labor dollars (direct plus indirect labor). Overhead covers facility costs (rent, utilities, maintenance), IT infrastructure, depreciation on production equipment, and other costs related to the performance of contracts. The allocation base is typically direct labor dollars. General and administrative (G&A) costs cover executive compensation, corporate accounting and legal, business development (other than B&P), corporate insurance, and other costs of running the business. The allocation base for G&A is usually total cost input (all direct costs plus all applied overhead and fringe) or value-added cost input (total cost input minus material and subcontractor costs that pass through without significant contractor value added).

Contractors establish provisional (estimated) rates at the beginning of each fiscal year, usually as part of a forward-pricing rate proposal submitted to the ACO. These provisional rates are used for billing throughout the year. At year-end, the contractor computes actual rates based on actual costs and actual base amounts, and prepares an incurred cost submission (the “ICE” or incurred cost electronically submission, due within six months of the contractor’s fiscal year-end under FAR 52.216-7(d)(2)(i)). DCAA audits the incurred cost submission, compares actual rates to provisional rates, and settles the difference. If actual rates were lower than provisional rates, the contractor owes money back; if higher, the government owes the contractor additional reimbursement (subject to any contract ceiling).

Getting the indirect rate structure right at the outset is critical. A contractor that commingles fringe costs with overhead, or allocates G&A on an inappropriate base, will face findings in every incurred cost audit. The initial setup, establishing the pools, choosing the allocation bases, and documenting the methodology, is one of the most important steps in building a DCAA-adequate system.

What costs are unallowable under FAR Part 31?

FAR 31.205 lists specific cost categories that are unallowable, meaning they cannot be included in billings to the government, in cost proposals, or in claims. The contractor must identify these costs in its accounting system and ensure they are excluded from all government cost submissions. The list is long, but the categories that most frequently generate audit findings include:

• Entertainment costs, including amusement, social activities, and related costs (FAR 31.205-14)
• Alcoholic beverages (FAR 31.205-51)
• Bad debts (FAR 31.205-3)
• Contributions and donations (FAR 31.205-8)
• Fines, penalties, and mischarging costs (FAR 31.205-15)
• Goodwill (FAR 31.205-49)
• Interest and other financial costs, with limited exceptions for facilities capital cost of money (FAR 31.205-20)
• Lobbying and political activity costs (FAR 31.205-22)
• Organization costs, such as incorporation fees and costs of forming partnerships (FAR 31.205-27)
• Certain selling costs, to the extent they are excessive or unrelated to government work (FAR 31.205-38)

Some costs are partially allowable, partially unallowable. Travel meals, for example, are allowable up to the federal per diem rate but unallowable for the excess. First-class airfare is generally unallowable; coach is allowable. Executive compensation is allowable up to a cap set annually by OFPP (the Office of Federal Procurement Policy publishes the benchmark compensation amount, which for 2025 was $668,525 for the top five management positions); the portion above the cap is unallowable.

The contractor’s accounting system must be able to identify unallowable costs at the point of entry (when the cost is recorded) rather than after the fact. DCAA auditors test this by reviewing a sample of expenses in indirect pools and checking whether unallowable costs have been properly flagged or segregated. A system that relies on a year-end scrub to remove unallowable costs is much more likely to miss items than a system that captures them at the time of posting.

How do I prepare for a DCAA audit?

Preparation for a DCAA audit, whether it is a pre-award survey, an incurred cost audit, or a system audit, starts with having the fundamentals in place before the auditor arrives. Retrofitting a system during an audit is far more expensive and disruptive than setting it up correctly from the start.

First, make sure the chart of accounts is structured to segregate direct costs by contract, indirect costs by pool, and unallowable costs by category. Every account should have a clear purpose, and the account descriptions should make the classification obvious. An auditor reviewing a trial balance should be able to identify at a glance which costs are direct, which are indirect (and which pool), and which are unallowable.

Second, implement a compliant timekeeping system before you need one. If employees are recording time on spreadsheets, switch to a system that enforces daily entry, requires supervisor approval, maintains an audit trail for corrections, and links to payroll. The cost of a timekeeping application ($5 to $15 per employee per month for cloud-based systems) is trivial compared to the cost of a labor-mischarging finding.

Third, write the accounting policies and procedures manual. It does not need to be exhaustive for a small contractor, but it needs to exist and it needs to cover the required areas. DCAA provides guidance on what the manual should include, and there are templates available through industry associations (the National Contract Management Association, NCMA, and professional accounting firms that specialize in government contracting publish guides and templates).

Fourth, run a mock audit. Trace a sample of labor transactions from timesheet to payroll to job cost report to invoice. Trace a sample of material costs from purchase order to receipt to job cost report. Compute your indirect rates for a test period and reconcile the pools and bases to the general ledger. If you can do all of that without finding errors, you are in good shape. If you find gaps, fix them before DCAA does.

Fifth, maintain your records. DCAA expects to see supporting documentation for every cost charged to a government contract: timesheets, receipts, purchase orders, subcontractor invoices, travel authorizations, and expense reports. The retention requirement under FAR 4.703 is three years after final payment on the contract, but for incurred cost records the clock does not start until the costs are settled, which can extend the retention period significantly for contracts under audit.

What should I do next?

If you already hold cost-type government contracts, the priority is an honest assessment of your current system against the DFARS 252.242-7006 criteria. If you are pursuing your first cost-type award, the priority is getting the system in place before the pre-award survey request arrives. Either way, the work is the same: structure the chart of accounts, implement compliant timekeeping, write the policies, and test the system with a mock audit before DCAA tests it for real.

The following guides cover related accounting and compliance disciplines:

• Construction job costing and tax compliance, the parallel job-cost-by-contract discipline for construction contractors, with progress billing and WIP reporting
• Construction worker classification: 1099 vs. W-2, the labor classification rules that parallel DCAA’s focus on proper labor charging and timekeeping
• Law firm bookkeeping and billing, the time-based billing parallel for professional services firms that track billable hours by client matter
• Nonprofit grant management and restricted funds, restricted fund accounting and the Uniform Guidance/Single Audit requirements that parallel DCAA cost segregation by funding source
• Nonprofit Form 990 filing guide, compliance reporting requirements that parallel the government contractor’s obligation to produce auditable cost reports
• DCAA audit process, the types of DCAA audits (pre-award survey, incurred cost, floor check, forward pricing, CAS compliance) and how to prepare for each one
• Small business government contracting, set-aside programs (8(a), HUBZone, SDVOSB, WOSB) and the accounting system requirements that apply when a small business wins its first cost-type contract
• Cost Accounting Standards (CAS), the 19 CAS Board standards that add methodology requirements beyond the DFARS 252.242-7006 system adequacy criteria, with coverage thresholds at $7.5M (modified) and $50M (full)

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.