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 requires the system to accumulate costs by contract, segregate direct from indirect costs, exclude unallowable costs from billings, generate interim cost reports, identify unit costs, and reconcile to the general ledger.

• When DCAA audits the system (pre-award survey or post-award audit), the auditor evaluates actual practice, not just written policy, against each criterion
• A “significant deficiency” in any criterion can lead to an inadequacy finding, which goes to the contracting officer (the 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, along with written policies, segregation of duties, and treatment of unallowable costs
• DCAA reviews the responses, visits the contractor’s facility (or conducts a virtual review), interviews accounting staff, and tests a sample of transactions
• Three possible outcomes: the system is adequate, the system is inadequate with identified deficiencies, or the contractor is too new for a meaningful evaluation (conditional approval or post-award audit recommended)
• If found inadequate, the contracting officer will generally not award the contract until deficiencies are corrected; for a contractor pursuing its first cost-type award, failing the survey can kill the deal
• Timeline varies from a few weeks for a well-prepared contractor to significantly longer when documentation gaps or informal practices require follow-up

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, but 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, and every direct cost (labor, materials, travel, subcontractors, ODCs) posts to that contract’s cost center so the auditor can pull a report of all costs charged to Contract X and reconcile it to invoices
• Indirect cost accounts are organized by pool: fringe benefits (payroll taxes, health insurance, retirement, PTO), overhead (facilities, IT, depreciation), and G&A (executive compensation, corporate insurance, accounting, legal, business development). IR&D and B&P may get a separate pool or fold into G&A
• Unallowable costs under FAR 31.205 must be identified and excluded from billings. The cleanest approach is a specific account for each unallowable category (entertainment, alcohol, bad debts, contributions, fines, lobbying) so they are flagged in the chart of accounts itself. DCAA auditors prefer this over a reclassification approach

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 time daily, showing hours by contract, indirect activities, and leave, and sign each timesheet.

• A supervisor must review and approve the timesheet before it feeds into payroll and cost accumulation; the auditor checks that approvals are documented and timely
• Corrections must follow a documented procedure: original entry preserved, reason recorded, employee and supervisor both approve. Undocumented corrections are a red flag for labor mischarging
• DCAA conducts “floor checks” (unannounced site visits, or virtual checks for remote workers) to verify employees are working on the contract they are charging
• The system must enforce total-time accounting: all hours worked must be recorded, not just government-contract hours. Unrecorded time distorts indirect rates

What written policies does DCAA require?

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

• Minimum coverage: basis for distinguishing direct from indirect costs, indirect cost pools and allocation bases, timekeeping requirements, travel policies, compensation policies, purchasing procedures, billing procedures, and a section listing the FAR 31.205 unallowable cost categories with the exclusion process
• DCAA auditors compare written policies to actual practice; a gap between the two is itself a deficiency, regardless of how good the policy reads on paper

What software does a DCAA-compliant system need?

No specific software is required. DCAA audits the system’s outputs, not its brand name. 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.

• QuickBooks (Desktop or Online) can work for small contractors when properly configured: classes or projects for each contract, indirect cost pools as separate classes, a chart of accounts that flags unallowable costs, and an integrated timekeeping system (QuickBooks Time or standalone) enforcing daily entry and supervisor approval. The key limitation is that QuickBooks does not natively enforce government-contracting-specific controls, so procedures and manual controls must fill the gaps
• Dedicated GovCon software (Deltek Costpoint, Unanet, Jamis Prime, PROCAS) is more common for mid-size and larger contractors. These systems enforce controls at the software level: blocking unallowable cost codes on government invoices, requiring timesheet approval before payroll, and generating SF 1034/1035 vouchers
• The choice is a function of contract volume, complexity, and growth trajectory. One or two cost-type contracts under $5 million can run on QuickBooks with good procedures; ten contracts across multiple agencies with CAS coverage will need a dedicated system

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, each capable of triggering an inadequacy determination on its own.

• Failure to segregate unallowable costs. The contractor either lacks accounts for unallowable costs or has them but does not use them consistently; unallowable expenses get swept into indirect pools and onto government billings
• Inadequate timekeeping. Employees do not record time daily, supervisors do not approve timesheets, corrections lack documentation, total-time accounting is not enforced, or timesheets do not link to payroll and cost accumulation in a traceable way
• No written policies manual. Informal practices may work daily but give the auditor nothing to evaluate for consistency and adequacy
• Comingling of direct and indirect costs. Direct labor posted to an overhead account, or overhead charged directly to a contract, distorts both the cost accumulation and the indirect rates
• No job cost accounting by contract. The system cannot produce a report of all costs accumulated for a specific contract, so it cannot support billing or closeout
• Inconsistent indirect rate computation. Allocation bases, pool composition, or methodology change period to period without documented justification. CAS-covered contractors must follow CAS 401 and CAS 402, but even non-CAS contractors must show consistency

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 deficiencies and recommending inadequacy. The report goes to the administrative contracting officer (ACO), who makes the formal determination. The ACO is not required to accept DCAA’s recommendation, and the contractor can respond before a decision is made.

• If the ACO determines inadequacy, the contractor must submit a corrective action plan (CAP) within 30 to 45 days, describing the fix for each deficiency, the timeline, and the evidence of completion
• The ACO may withhold up to 10% of each interim payment under DFARS 252.242-7006(d) until the deficiencies are corrected. This is a reserve against overstatement risk, not a penalty, and withheld amounts are released once adequacy is restored
• An inadequacy determination appears in CPARS and pre-award surveys, and many contracting officers will not award a cost-type contract to a contractor with an unresolved finding. The reputational damage often exceeds 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 size. The clause has no small business exemption. Where small businesses get relief is in CAS coverage: under 48 CFR 9903.201-1, SBA-defined small businesses are exempt from CAS, so no Disclosure Statement, no CAS 401-420 compliance, and no CAS administration.

• Small businesses on only firm-fixed-price contracts do not need a DCAA-adequate system, because FFP contracts do not include the system adequacy clause. But a first cost-type bid triggers the evaluation
• The system can be simpler (QuickBooks, a 20-page policy manual, a single overhead pool), but it still must satisfy the clause: direct/indirect segregation, cost tracking by contract, unallowable cost exclusion, daily timekeeping with supervisor approval, and written policies that are followed in practice

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: payroll taxes, health insurance, retirement contributions, PTO. Allocation base is usually direct labor dollars or total labor dollars
• Overhead: facility costs, IT infrastructure, depreciation on production equipment. Allocation base is typically direct labor dollars
• G&A: executive compensation, accounting and legal, business development, corporate insurance. Allocation base is usually total cost input or value-added cost input (total cost input minus pass-through subcontractor and material costs)
• Contractors bill at provisional (estimated) rates during the year, then submit an incurred cost submission within six months of fiscal year-end under FAR 52.216-7(d)(2)(i) proposing final rates. DCAA audits the submission and settles the difference
• Getting the structure right at the outset is critical. A contractor that commingles fringe with overhead or allocates G&A on an inappropriate base will face findings in every incurred cost audit

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 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.

• Chart of accounts: segregate direct costs by contract, indirect costs by pool, and unallowable costs by category. An auditor reviewing the trial balance should identify each classification at a glance
• Timekeeping: implement a compliant system before you need one. The cost ($5 to $15 per employee per month) is trivial compared to a labor-mischarging finding
• Written policies: the accounting policies and procedures manual needs to exist and cover the required areas. Templates are available through NCMA and GovCon-specialized CPA firms
• Mock audit: trace labor from timesheet to payroll to job cost report to invoice; trace materials from PO to receipt to job cost report; compute indirect rates and reconcile pools to the general ledger. Fix gaps before DCAA finds them
• Records retention: DCAA expects supporting documentation for every cost charged to a government contract. Under FAR 4.703, retain records three years after final payment, but for incurred cost records the clock starts at rate settlement, which can extend retention significantly

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.