Unallowable Costs Under FAR 31.205: What Government Contractors Cannot Charge

Government contractors operate under a cost framework that does not exist in the commercial world. When you bill the federal government for costs incurred on a contract, the government does not pay for everything. FAR Part 31 establishes the cost principles that determine whether a given expense is “allowable” (the government will reimburse it or include it in indirect rate computations) or “unallowable” (the government will not). The bulk of the unallowable cost rules live in FAR 31.205, a series of 52 subsections that address specific cost categories and spell out what is and is not chargeable.

Failing to identify and exclude unallowable costs is one of the most common DCAA audit findings. It is also one of the most expensive. If the Defense Contract Audit Agency finds unallowable costs in your billings, you do not simply remove them and move on. You refund the questioned amount plus interest, and if the costs were “expressly unallowable” (specifically named in FAR 31.205), you may also owe a penalty equal to the amount allocated to covered contracts, with that penalty doubling for repeat or willful violations. The mechanics of identifying unallowable costs, coding them correctly in your accounting system, and excluding them from every billing, claim, and proposal are not optional refinements. They are threshold requirements for a DCAA compliant accounting system.

What is an unallowable cost and why does it matter?

An unallowable cost is any cost that the government will not reimburse or accept as a component of a contractor’s indirect rates. The concept applies to cost-reimbursement contracts (where the government pays actual costs), time-and-materials contracts, and fixed-price contracts that are subject to cost-based price negotiations or cost accounting standards. Even on a firm-fixed-price contract, unallowable costs can matter if the price was negotiated using cost data that included unallowable items, or if the contractor is subject to CAS and must compute compliant indirect rates.

The unallowable cost rules serve a straightforward policy objective: the government should not pay for costs that do not benefit contract performance or that public policy says the government should not subsidize. Entertainment, lobbying, and alcohol fall into the public-policy bucket. Executive compensation above the statutory cap reflects a judgment that taxpayers should not fund pay packages above a defined ceiling. Fines and penalties represent costs caused by the contractor’s own misconduct, not by contract performance.

The operative standard comes from CAS 405 (Accounting for Unallowable Costs). CAS 405 requires contractors subject to Cost Accounting Standards to identify unallowable costs, exclude them from billings and proposals, and maintain records that demonstrate the exclusions. Contractors not formally subject to CAS still must comply with the FAR 31.205 rules, and DCAA audits those contractors against the same substantive requirements. In practice, the obligation is universal for any contractor billing costs to the federal government.

The distinction between “expressly unallowable” and other unallowable costs matters for penalty purposes. Expressly unallowable costs are those specifically identified by name in the cost principles (entertainment, alcohol, lobbying, contributions, bad debts, and others listed in FAR 31.205). If you include an expressly unallowable cost in a billing, claim, or proposal, you face the penalty provisions of FAR 42.709 in addition to the basic refund and interest. Costs that are unallowable because they fail the reasonableness or allocability tests (but are not expressly named) still must be excluded, but the penalty provisions may not apply in the same way.

What are the major unallowable cost categories under FAR 31.205?

FAR 31.205 contains 52 subsections, each addressing a specific type of cost. Not all of them declare costs unallowable; many establish conditions under which costs are allowable, with limits or exceptions. The following are the categories that generate the most DCAA findings and the most financial exposure.

Entertainment costs (31.205-14)

Entertainment costs are expressly unallowable, with no exceptions. This includes tickets to sporting events, concerts, theater, amusement parks, and any social activity or event that has an entertainment purpose. Meals are allowable as a business expense when they have a clear business purpose (a working meal during a contract negotiation, for example), but meals that are primarily social or have no documented business purpose fall into the entertainment category. The line between an allowable working meal and unallowable entertainment is one of the most litigated areas in government contracting, and the safest practice is to document the business purpose of every meal contemporaneously.

Alcoholic beverages (31.205-51)

Alcoholic beverages are expressly unallowable. Period. There is no business-purpose exception, no de minimis threshold, and no distinction between a glass of wine at a client dinner and a case of champagne at a holiday party. If the receipt shows alcohol, the cost is unallowable. Contractors must ensure that alcohol charges are separated from meal receipts and coded to the unallowable account. When a restaurant bill includes both food and alcohol, the alcohol portion must be identified and excluded. This seems simple, but it generates findings year after year because the accounts payable process does not consistently split receipts.

Lobbying and political activity costs (31.205-22)

Costs associated with lobbying or political activity are expressly unallowable. This includes direct lobbying (attempting to influence legislation or executive action), grassroots lobbying (attempting to influence the public on legislative matters), political contributions, and the costs of attending fundraisers or political events. It also includes the salary and overhead costs of any employee who spends time on lobbying activities, prorated for the time spent. Contractors that maintain a government relations function must carefully track how much time those employees spend on allowable activities (monitoring legislation that affects contract performance, for example) versus unallowable lobbying.

Contributions and donations (31.205-8)

Contributions and donations are expressly unallowable. This includes charitable donations, gifts to nonprofit organizations, and sponsorships that are donations in substance (paying $5,000 to sponsor a charity golf tournament, for example). There is a narrow exception for contributions that are in fact payment for a specific service received (sponsoring a booth at a trade show where the sponsorship fee covers the booth rental and is priced at market), but the burden of demonstrating that a “sponsorship” is really a purchase of services falls on the contractor.

Bad debts (31.205-3)

Bad debts are expressly unallowable. This includes any losses from uncollectible receivables or claims, regardless of the reason. If a subcontractor fails to deliver and the contractor writes off the advance payment, that write-off is an unallowable bad debt.

Fines, penalties, and mischarging costs (31.205-15)

Fines and penalties imposed by any governmental body (federal, state, or local) are expressly unallowable, whether they result from contract violations, regulatory noncompliance, or criminal conduct. This includes late-filing penalties, OSHA fines, environmental penalties, and any other governmental sanction. The costs of legal defense in proceedings that result in a fine or penalty may also be unallowable depending on the nature of the proceeding (see 31.205-33 on professional and consultant service costs). Costs incurred as a result of contractor mischarging (charging government contracts for costs that should have been charged elsewhere) are also unallowable.

Compensation for personal services (31.205-6)

Compensation is not categorically unallowable, but there is a hard ceiling. Executive compensation above the senior executive compensation benchmark is unallowable. The benchmark is set annually through the National Defense Authorization Act and published by the Office of Federal Procurement Policy. It applies to the five most highly compensated employees in management positions at each home office and each segment of the contractor. The benchmark has historically been in the range of approximately $212,000 to $232,000 per year, depending on the fiscal year and contractor type (there are separate caps for defense and non-defense contractors, though recent legislation has been narrowing the gap). Any compensation paid to a covered executive above the applicable cap is unallowable. “Compensation” for this purpose includes salary, bonuses, deferred compensation, and stock-based compensation. It does not include employer contributions to defined-benefit pension plans (which have their own cost principles under 31.205-6(j)) or to defined-contribution plans (up to limits).

This is one of the largest single categories of unallowable costs for many contractors, because the caps apply per executive, per year, and the excess can easily reach six figures per individual for contractors with market-competitive pay packages.

Public relations and advertising (31.205-1)

Not all public relations and advertising costs are unallowable. Recruitment advertising (help-wanted ads) is allowable. Advertising for the sale or disposal of surplus materials is allowable. Advertising required by contract is allowable. But institutional advertising (promoting the company’s image or capabilities without a direct tie to contract requirements or recruitment) is unallowable. Public relations costs that go beyond normal communication with stakeholders and into image-building or lobbying-adjacent activity are also unallowable. The dividing line requires case-by-case analysis, and contractors with significant marketing budgets need clear coding policies to separate allowable from unallowable advertising.

Interest and other financial costs (31.205-20)

Interest expense is generally unallowable, with a limited exception. Ordinary borrowing costs (interest on lines of credit, term loans, and bonds) are unallowable. The rationale is that the government provides contract financing through progress payments and performance-based payments, so the contractor should not also charge the government for interest on private borrowing.

The exception involves facilities capital employed in contract performance. Under CAS 414, a contractor may claim an imputed cost of money (not actual interest) on facilities capital. This is an “allowable” cost, but it is not a cash cost; it is a computed amount based on the net book value of tangible capital assets and the Treasury Department’s semi-annual cost-of-money rate. This imputed cost of money under CAS 414 should not be confused with the unallowable actual interest expense under 31.205-20. The two are separate concepts with different accounting treatments, and mixing them up is a finding waiting to happen.

Travel costs (31.205-46)

Travel costs are generally allowable, but with specific constraints. The contractor’s travel policy must be consistent with the Federal Travel Regulation (FTR) or the Joint Travel Regulations (JTR), or the contractor must have a written travel policy that the contracting officer accepts as reasonable. Per diem rates (lodging and meals) in excess of the FTR/JTR rates for the travel destination are unallowable unless the contractor documents why the higher rate was necessary (a conference hotel with no alternatives within the per diem rate, for instance). First-class airfare is unallowable; business-class airfare is unallowable unless the flight meets specific duration or medical-necessity criteria. The allowable standard is coach/economy class. Airfare that is unreasonably high (last-minute bookings at premium prices when advance booking was feasible) can also be questioned as unreasonable even if it falls within the coach category.

Taxes (31.205-41)

Not all taxes are treated the same way. Federal income taxes and state/local income taxes are unallowable. The government’s position is that income taxes are a distribution of profit, not a cost of contract performance. Payroll taxes (the employer’s share of FICA, FUTA, state unemployment taxes) are allowable as part of fringe benefit costs. Property taxes, sales taxes, and excise taxes incurred in the normal course of business are also allowable. Penalties and interest on tax underpayments are unallowable under the fines-and-penalties rule.

Employee morale, health, and welfare costs (31.205-13)

These costs are generally allowable. Company picnics, holiday parties, coffee service, fitness facilities, and employee assistance programs are all recognized as legitimate costs of maintaining workforce morale and are typically included in the fringe or overhead pools. However, the costs become unallowable when they cross into entertainment territory. An annual company picnic with food, games, and team activities is allowable. A company party at a high-end restaurant with open bar and a DJ starts to look like entertainment. The alcohol component is unallowable regardless, per 31.205-51.

Contingencies (31.205-7)

Contingency reserves, meaning accruals for events that may or may not occur, are generally unallowable. A contractor cannot build a “contingency” line into a cost proposal or include a general contingency reserve in its indirect rate pools. Self-insurance accruals, however, can be allowable under specific conditions. If the contractor maintains a formal self-insurance program with actuarial or statistical support for the reserve, and the self-insurance covers risks that would otherwise be insured commercially (workers’ compensation, general liability), the accrual can be treated as an allowable cost. The distinction is between a measured, documented self-insurance reserve and a general “just in case” contingency.

Professional and consultant service costs (31.205-33)

Professional and consultant fees are generally allowable if reasonable in amount and necessary for contract performance or general business operations. However, contingent fee arrangements tied to the outcome of government contract awards are unallowable. Legal costs for defense in proceedings where the contractor is found liable for fraud or similar misconduct can also be unallowable. The key test is reasonableness: are the fees consistent with market rates for the services provided, and do the services benefit the contractor’s business or contract performance?

Recruitment costs (31.205-34)

Recruitment costs are generally allowable. Job postings, recruiter fees, interview travel, and background checks are all recognized as legitimate costs of building and maintaining the workforce. Relocation costs for new hires are also allowable, but with specific rules: the costs must be reasonable, they must be consistent with the contractor’s established policy, and certain items (like loss-on-sale-of-home payments) have dollar limits. The key is to have a written relocation policy and to apply it consistently.

What are directly associated costs?

One of the most important and frequently missed concepts in unallowable cost accounting is the “directly associated cost” rule. Under FAR 31.201-6(a), a cost that would not have been incurred but for an unallowable activity is itself unallowable, even if the cost category is normally allowable.

Travel is the clearest example. Travel costs under 31.205-46 are generally allowable. But if an employee flies to Washington, D.C. to attend a lobbying meeting (lobbying costs are unallowable under 31.205-22), the airfare, hotel, and per diem for that trip are also unallowable, because they would not have been incurred but for the unallowable lobbying activity. The same logic applies to the employee’s salary for the time spent on the lobbying trip.

This rule extends to any cost that supports or enables an unallowable activity. If the contractor hosts a dinner with alcohol (alcohol is expressly unallowable), the full cost of the dinner, including the food, the service, and the venue rental, may be unallowable if the dinner would not have occurred but for the social/entertainment purpose. If the food was incidental to an otherwise legitimate business meeting, only the alcohol is unallowable. The distinction depends on the facts, and contractors need to document the business purpose of mixed-purpose events carefully.

The directly associated cost rule also creates an obligation to track the time employees spend on unallowable activities. If a government relations employee spends 30% of their time on lobbying (unallowable) and 70% on monitoring legislation that directly affects contract performance (allowable), 30% of their salary, benefits, and office costs must be classified as unallowable. This requires a timekeeping or activity-tracking system that captures the split, which is why the timekeeping requirements in a DCAA-compliant system are so important.

How must the accounting system handle unallowable costs?

CAS 405 and DCAA audit practice require that unallowable costs be identified at the point of entry, meaning when the cost is first recorded in the accounting system, not at year-end or when preparing an incurred cost submission. The contractor’s accounts payable process must include a step where each expense is reviewed for allowability before it is posted. Unallowable costs must be coded to designated unallowable accounts or flagged with an unallowable indicator in the chart of accounts. They must then be excluded from every indirect rate computation and from every billing, claim, or proposal submitted to the government.

The cleanest approach is to maintain a separate general ledger account (or sub-account) for each major category of unallowable cost. A contractor’s chart of accounts should include, at minimum, dedicated accounts for entertainment, alcoholic beverages, bad debts, contributions and donations, lobbying and political activities, fines and penalties, excess executive compensation, unallowable interest, unallowable advertising, and unallowable taxes (federal and state income tax). When the AP clerk or bookkeeper codes an invoice, any cost that falls into one of these categories goes directly to the unallowable account. It never touches the indirect cost pools. It never appears on a voucher. It is visible in the trial balance, clearly labeled, and excluded by design.

The alternative approach, where unallowable costs are posted to regular expense accounts and then reclassified at period-end, is weaker. DCAA auditors have repeatedly found that contractors using a reclassification approach miss items, particularly small-dollar expenses (a $45 bottle of wine on a dinner receipt, a $200 charitable contribution) that escape notice during the scrub. The point-of-entry approach, reinforced by AP process controls and training, produces a cleaner result.

When computing indirect rates, the contractor must exclude all unallowable cost accounts from every indirect cost pool. The fringe pool should not contain unallowable compensation. The overhead pool should not contain entertainment. The G&A pool should not contain lobbying, contributions, or unallowable interest. The exclusions must be documented in the rate computation workpapers and must be consistent with the accounts flagged as unallowable in the chart of accounts. DCAA tests this by reconciling the indirect rate computation to the trial balance and checking whether any unallowable accounts were included in a pool.

What happens if I include unallowable costs in a billing?

The consequences operate on three levels: refund, penalty, and interest.

The baseline consequence is straightforward. If DCAA identifies unallowable costs that were included in a billing, you must refund the government for the overpayment. The refund amount equals the unallowable costs that flowed through the indirect rate computation (or were billed directly) and were included in vouchers submitted to the government. Because indirect costs are allocated across all contracts, a single unallowable cost in an overhead pool can affect billings on every cost-type contract the contractor performed during that period.

The penalty layer applies specifically to expressly unallowable costs. Under FAR 42.709, if the contractor includes expressly unallowable costs (those specifically named in FAR 31.205 as unallowable) in a proposal, billing, or claim, the contractor owes a penalty equal to the amount of the expressly unallowable costs allocated to covered contracts. For a first occurrence, the penalty equals the disallowed amount. For a repeat or willful violation, the penalty doubles to two times the disallowed amount. These penalties are in addition to the refund and the interest.

Interest accrues on the overpayment from the date the government paid the voucher to the date of refund. The interest rate is the rate established by the Secretary of the Treasury under 26 U.S.C. 6621(a)(2), which is the rate used for tax underpayments.

Hypothetical example: DCAA audit finding with penalty computation. Suppose a contractor included $28,000 in expressly unallowable costs in its overhead pool for Fiscal Year 2025: $16,000 in entertainment expenses (meals coded to overhead without documented business purpose, tickets to client appreciation events) and $12,000 in first-class airfare upgrades. The overhead rate was applied to all cost-type contracts. DCAA identifies the $28,000 in its incurred cost audit, questions the costs, and determines the allocation to covered contracts. Assume the full $28,000 allocated to government contracts (common when government work is 80% or more of the contractor’s revenue). The contractor must refund $28,000 plus interest from the dates the vouchers were paid. Because both entertainment and first-class travel are expressly unallowable, the contractor also owes a penalty of $28,000 (first offense). Total financial impact: the $28,000 refund, the $28,000 penalty, plus interest. On a first offense, the contractor has turned $28,000 in overbillings into roughly $58,000 to $60,000 in total exposure. A repeat offense would carry a $56,000 penalty, pushing total exposure above $85,000.

How do I perform an annual unallowable cost scrub?

Even with point-of-entry controls, a year-end review of the general ledger for unallowable costs is an essential validation step before preparing the incurred cost submission. The scrub walks through every expense account and tests whether costs that should be unallowable were inadvertently coded to an allowable account.

Hypothetical example: annual unallowable cost review. Suppose a contractor reviews its general ledger for Fiscal Year 2025 and identifies $85,000 in unallowable costs spread across eight categories. The breakdown:

• Entertainment (meals without documented business purpose, client event tickets): $12,000
• Alcoholic beverages (bar tabs at company events, wine at client dinners): $3,000
• Contributions and donations (charity sponsorships, nonprofit gifts): $5,000
• Lobbying and political activity (government relations consultant, political event attendance): $8,000
• First-class and business-class airfare upgrades: $4,000
• Executive compensation above the statutory cap (excess above the $230,000 benchmark for two executives): $35,000
• Fines and penalties (late filing penalty, OSHA citation): $2,000
• Interest expense (line of credit interest, loan interest): $16,000

Each of these amounts is coded to its respective unallowable account in the chart of accounts and excluded from the indirect rate pools. The rate computation workpapers show the unallowable accounts and their balances, with a clear reconciliation to the trial balance. When the contractor prepares Schedule H (the unallowable cost schedule) of the incurred cost submission, these amounts appear as identified exclusions.

If any of these costs had been coded to an overhead or G&A account instead, they would have inflated the indirect rates, increased billings on every cost-type contract, and created exposure for both a refund and a penalty. The scrub catches what the AP process missed.

The scrub should also test for directly associated costs. If the lobbying consultant’s invoices include travel reimbursements, those travel costs are also unallowable. If the entertainment expenses include venue rentals and catering that would not have occurred but for the entertainment event, those are also unallowable. A thorough scrub traces the directly associated costs back to their root activity.

How does the executive compensation cap work?

The compensation cap under FAR 31.205-6(p) is one of the most financially significant unallowable cost rules for mid-size and larger contractors. The cap applies to the five most highly compensated employees in management positions at each home office and each segment of the contractor. “Segment” is a CAS term that generally corresponds to a profit center or division that accumulates costs and reports them separately.

The cap amount is set annually. It is established through the National Defense Authorization Act and published by the Office of Federal Procurement Policy in the Federal Register. The cap has increased over time but remains well below the market rate for senior executives at government contractors of any significant size. Recent caps have been in the range of approximately $212,000 to $232,000, with some variation between defense contractors (subject to the DFARS cap) and civilian agency contractors.

Compensation for this purpose is broadly defined. It includes base salary, bonuses (including performance bonuses and signing bonuses), deferred compensation, severance, and stock-based compensation (valued at grant or vesting, depending on the plan). It does not include employer contributions to qualified defined-benefit pension plans (which have separate cost principles) or employer matching contributions to defined-contribution plans (up to a statutory limit).

To compute the unallowable amount, the contractor compares total allowable compensation (the sum of all compensation elements included in the cap) for each covered executive to the applicable annual cap. The excess is unallowable. For a CEO earning $400,000 in total compensation against a $230,000 cap, $170,000 is unallowable per year, for that one executive alone. Across five covered executives, the unallowable amounts can easily total $500,000 or more per year.

The excess must be removed from whatever cost pool it is in (usually G&A, where executive salaries typically reside) and reclassified to the unallowable accounts. The contractor must perform this computation annually and document the benchmark comparison. DCAA tests the computation in every incurred cost audit.

Are any costs only partially allowable?

Yes, and this is where the rules get nuanced. Several FAR 31.205 categories are not simply “allowable” or “unallowable” but “allowable with conditions” or “allowable up to a limit.”

Compensation is the most prominent example: it is allowable up to the benchmark, unallowable above it. Travel is another: coach airfare is allowable, first-class is not; per diem within the FTR/JTR rates is allowable, per diem above those rates requires justification. Insurance is generally allowable, but insurance costs for risks that are “remote” or for coverage that exceeds what a reasonable business would carry may not be. IR&D (independent research and development) and B&P (bid and proposal) costs are allowable under FAR 31.205-18, but only if they are reasonable in amount and properly accounted for.

For partially allowable costs, the contractor must establish a consistent method for splitting the allowable and unallowable portions and apply it each period. The split method should be documented in the accounting policies manual and should produce results that are verifiable by an auditor. For compensation, the split is mechanical (compare to the cap). For travel, the split requires receipt-level analysis (separate the first-class upgrade charge from the base fare). For advertising, the split requires a judgment about each campaign or expenditure (is this recruitment advertising or institutional advertising?).

What is the difference between unallowable and unallocable costs?

These are related but distinct concepts, and confusing them leads to errors in rate computations. An unallowable cost is one that the FAR cost principles say the government will not reimburse, regardless of how it is allocated. An unallocable cost is one that cannot be assigned to a particular cost objective (contract, pool, or final cost objective) under a reasonable allocation method.

Allocability is defined in FAR 31.201-4. A cost is allocable to a contract if it is incurred specifically for that contract, if it benefits the contract and can be distributed to it in reasonable proportion to the benefit received, or if it is necessary for the overall operation of the business (even if a direct relationship to a specific contract cannot be shown). The third prong is what justifies G&A allocations: G&A costs benefit the business as a whole and are allocated to all final cost objectives.

A cost can be allocable but unallowable. Entertainment costs benefit the business (arguably), and they could be allocated to contracts using a reasonable method, but the FAR says the government will not pay for them. The cost is allocable in theory but must be excluded as unallowable. Conversely, a cost that is allowable in type (say, office supplies) could be questioned as unallocable if the contractor charges it to a contract that received no benefit from it.

In practice, most DCAA findings involve allowability rather than allocability, because the FAR 31.205 categories are clearly defined. Allocability disputes tend to arise in indirect rate audits where the auditor questions whether a particular cost pool is being allocated on a base that reflects the causal/beneficial relationship between the pool and the contracts.

How should I handle mixed-purpose costs?

Mixed-purpose costs are expenses that have both an allowable and an unallowable component, or that serve both a government-contract purpose and a commercial purpose. The most common examples are meals (part business, part social), travel (part contract-related, part personal), conferences (part professional development, part entertainment), and compensation (part allowable salary, part excess above the cap).

The general rule is that the contractor must identify and separately account for the unallowable component. If a conference registration fee includes admission to a technical session (allowable) and a gala dinner with entertainment (unallowable), the contractor should split the cost based on the portions attributable to each component. If a business trip includes two personal vacation days, the lodging and per diem for those days is unallowable.

Documentation is critical for mixed-purpose costs. The contractor should maintain contemporaneous records showing the business purpose, the allocation between allowable and unallowable portions, and the basis for the split. “Contemporaneous” matters because reconstructing the split months or years later, during a DCAA audit, is far less reliable and far more likely to be challenged.

For recurring mixed-purpose costs (like the salary of an employee who splits time between allowable and unallowable activities), the contractor should establish an allocation method in its accounting policies, apply it consistently, and document it with timekeeping or activity records. The auditor will test whether the method is reasonable and whether the actual records support the reported split.

What are the most common mistakes contractors make with unallowable costs?

The most frequent mistake is simply not having a system to identify and exclude unallowable costs. A contractor that posts all expenses to a standard commercial chart of accounts without unallowable-cost accounts will inevitably include unallowable costs in its indirect pools. The costs flow through the rate computation, inflate the rates, and end up in billings, where DCAA finds them.

The second most common mistake is classifying unallowable costs at year-end rather than at the point of entry. The year-end reclassification approach misses items, particularly small-dollar costs that do not draw attention during a bulk review. A $50 bottle of wine on a $400 dinner receipt, a $150 donation to a charity 5K race, a $75 late-payment fee from a vendor: each is unallowable, and each is easy to overlook in a pile of thousands of transactions.

The third mistake is failing to capture directly associated costs. The contractor properly excludes the lobbying consultant’s fee but codes the consultant’s travel reimbursement to the allowable travel account. The contractor excludes the cost of a client entertainment event but misses the venue rental and catering that supported it. The directly associated cost rule requires a cause-and-effect analysis at the transaction level, which AP clerks are rarely trained to perform without specific guidance.

The fourth mistake is ignoring the executive compensation cap. Smaller contractors sometimes assume the cap applies only to large defense contractors. It does not. The cap applies to any contractor that is subject to FAR 31.205-6(p), which includes contractors performing cost-reimbursement, time-and-materials, or incentive contracts for any federal agency, not just the Department of Defense.

The fifth mistake is treating unallowable costs as a compliance formality rather than a financial risk. A contractor that views unallowable cost exclusions as a box-checking exercise misses the penalty exposure. The penalties under FAR 42.709 are real, they are applied, and they can turn a modest overbilling into a significant financial hit, as the hypothetical example above illustrates.

How does the unallowable cost analysis connect to the incurred cost submission?

The annual incurred cost submission (ICS) is the vehicle through which the contractor reports its actual indirect rates to the government for final settlement. The ICS includes a schedule (Schedule H in the ICE model) that specifically lists the contractor’s unallowable costs and demonstrates that they were excluded from the indirect rate computations.

Schedule H must tie to the general ledger. Each unallowable cost account appears as a line item on the schedule, with the balance matching the trial balance for the fiscal year. The indirect rate computations on other ICS schedules (Schedules A through G and Schedule I) must exclude the Schedule H amounts. DCAA cross-references these schedules during the incurred cost audit, and any unallowable cost that appears in a rate pool but not on Schedule H is a finding.

The connection between the unallowable cost analysis and the ICS underscores why the accounting system must get it right during the year. If unallowable costs are coded to the wrong accounts, the ICS will either understate the unallowable amounts (leading to a DCAA finding and potential penalty) or overstate them (which is conservative and avoids penalties but reduces the contractor’s reimbursement by excluding costs that were actually allowable). Getting the classification right at the point of entry is the only way to produce an ICS that is both accurate and defensible.

What about costs that are allowable but subject to conditions?

Several cost categories in FAR 31.205 are allowable only if specific conditions are met. If the conditions are not satisfied, the costs become unallowable. Understanding these conditional categories is important because contractors sometimes treat them as fully allowable without verifying that the conditions are met.

Self-insurance costs (31.205-19) are allowable if the contractor has a formal self-insurance program, the reserves are supported by actuarial or historical data, and the coverage replaces insurance that would otherwise be commercially obtained. Without these conditions, self-insurance reserves are treated as unallowable contingencies under 31.205-7.

Professional and consultant service costs (31.205-33) are allowable if reasonable and not contingent on the outcome of a government contract award. A consultant hired to improve manufacturing processes is allowable. A consultant hired on a success fee tied to winning a contract award is not. Legal fees are generally allowable, but legal costs related to proceedings arising from fraud, willful misconduct, or violation of law may not be, depending on the outcome.

Independent research and development and bid-and-proposal costs (31.205-18) are allowable if the contractor maintains adequate records, the costs are reasonable, and the work is consistent with the contractor’s established pattern of research or business development. DCAA tests the reasonableness of IR&D/B&P costs by comparing them to industry norms and by reviewing whether the costs are properly accounted for in a separate pool or allocated through G&A.

Restructuring costs (31.205-52) are allowable only with advance agreement from the contracting officer. A contractor that restructures its operations (closing a facility, terminating a product line) cannot simply include the restructuring costs in its indirect pools. The costs require an advance agreement (essentially a pre-approval from the government) that establishes which costs will be allowed and the method of allocation.

What should I do next?

If you hold cost-type government contracts and have not conducted a systematic review of your chart of accounts for unallowable cost categories, that review is overdue. Every account in the indirect cost pools should be tested against the FAR 31.205 categories. Every expense that falls into an unallowable category should be coded to a designated unallowable account. The AP process should include a gate that catches unallowable costs at the point of entry, with training for the staff who code invoices. The year-end scrub should validate that the point-of-entry controls are working.

The related guides below cover the accounting system requirements that DCAA audits, the indirect rate structure that unallowable costs must be excluded from, the direct vs. indirect cost classification that determines which pool a cost enters before allowability is tested, the incurred cost submission where unallowable exclusions are formally reported, the DCAA audit process that tests all of it, and the proposal pricing guide where forward pricing rates must exclude unallowable costs before they reach the cost proposal.

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