Government contracting 101 starts with one fact most new contractors miss: the federal government requires an entirely different accounting system than commercial business. The firms that set up correctly from day one protect their billing rates. The firms that wait lose money to questioned costs, disallowed expenses, and audit findings.
Government contract accounting classifies every cost as direct, indirect, or unallowable under FAR Part 31. Your books must segregate cost pools, track expenses by contract, and run a timekeeping system that identifies each employee’s labor by cost objective, which is the criterion written into the Defense Federal Acquisition Regulation Supplement (DFARS) 252.242-7006. Daily entry is not in that clause; it is what DCAA auditors look for when they test the system. Get that structure wrong and the penalties hit your cash flow directly.
Picture this. A 30-person security company in Virginia wins its first $2.5M contract with the Department of War, which statutes and contract documents still call the Department of Defense. The owner has run commercial contracts for a decade. Payroll works. QuickBooks works. Invoicing works. Then the contracting officer asks for an indirect rate schedule, a compliant timekeeping system, and written cost accounting policies. None of those things exist.
The clock is ticking on the first invoice, and every dollar billed without the right structure behind it becomes a liability. The gap between commercial bookkeeping and government contract accounting catches new contractors off guard because it touches everything: how you categorize expenses, how you track time, how you bill, and how you prove it all to an auditor who shows up unannounced.
The Fundamental Accounting Shift: Commercial vs. Government Work
Commercial accounting tracks revenue and expenses. Government contract accounting tracks costs by type, by contract, and by allowability under federal law. This distinction drives every requirement that follows, and ignoring it is the most expensive mistake a new contractor makes.
In commercial work, your books answer one question: did we make money? In government contracting for beginners, your books answer three different questions. Did you charge only costs the government allows [FAR Part 31]? Did you charge each cost to the right contract? Did you allocate shared costs using a consistent, documented method?
A $5M construction contractor billing the Army Corps of Engineers needs a system capable of tracking every dollar to a specific contract or cost pool. The same $5M contractor doing commercial tenant buildouts needs nothing close to this. The volume of transactions might be identical. The accounting infrastructure is not.
What are the three cost types every new government contractor must know?
Every cost in your business falls into one of three categories under federal contracting rules: direct, indirect, or unallowable. Getting this classification wrong on a single expense creates a ripple effect across your billing, your indirect rates, and your audit exposure. FAR Part 31 governs all three [FAR 31.201].
Direct costs tie to a specific contract. Labor hours for an electrician working on Contract #1234. Materials purchased for that contract. Travel to the contract site. Each direct cost must trace to one contract, and your accounting system must prove the connection.
Indirect costs benefit multiple contracts or your business as a whole. Rent, utilities, your office manager’s salary, health insurance for employees working across several projects. These costs accumulate in pools (fringe, overhead, G&A) and get allocated to contracts using a rate. Our indirect rate guide breaks down exactly how these pools work.
Unallowable costs are expenses the government refuses to reimburse, period. Entertainment expenses [FAR 31.205-14]. Alcoholic beverages [FAR 31.205-51]. Lobbying [FAR 31.205-22]. Fines and penalties. Bad debt. Your books must flag these costs at the point of entry, not at year-end. Including an unallowable cost in your indirect rate calculation inflates every invoice you send, and DCAA will find it.
What DCAA Is and Why New Contractors Need to Care
The Defense Contract Audit Agency (DCAA) is the federal government’s accounting watchdog for defense contracts. DCAA auditors review your books, your timekeeping, your policies, and your indirect rates to confirm you are charging the government only for costs that are allowable, allocable, and reasonable. In FY2025 the agency issued 2,480 audit reports and 7,047 memos while examining $788.4 billion in contract costs, figures it publishes in its FY2025 Management Discussion and Analysis.
New contractors often assume DCAA only matters for large defense primes. Wrong. A $1.2M janitorial contract with a military base falls under DCAA jurisdiction if it is a flexibly-priced contract. A $3M information technology task order under a General Services Administration (GSA) schedule carries the same exposure. The threshold is not size. The threshold is contract type and funding source.
DCAA conducts three audits that matter most for new contractors. Pre-award audits review your proposed rates before the government signs the contract. Accounting system audits evaluate whether your books meet the criteria in DFARS 252.242-7006. Incurred cost audits verify the actual costs you claimed on flexibly-priced contracts. Each one examines your system from a different angle, but all three demand the same underlying infrastructure.
FAR Part 31: The Cost Rules That Govern Your Books
The Federal Acquisition Regulation (FAR) is the rulebook for all federal contracting. FAR Part 31 specifically governs cost principles: which costs are allowable, how to allocate them, and what documentation you need. Every new government contractor accounting system must align with FAR 31 before the first invoice goes out.
FAR 31.201-2 sets five requirements a cost must satisfy before it counts as allowable: reasonableness (a prudent business person in similar circumstances would incur it), allocability (it benefits the contract being charged), compliance with the Cost Accounting Standards (CAS) where they apply and otherwise with generally accepted accounting principles, the terms of the contract, and any limitation set out in FAR subpart 31.2. Allowability is the conclusion you reach after all five, not a sixth test alongside them. Fail one requirement and the cost gets questioned or disallowed.
FAR 31.205 lists roughly 50 specific cost categories with individual rules. Some are always unallowable (entertainment, alcohol, lobbying). Some require specific conditions (bonuses must be reasonable and based on an existing policy). Your bookkeeper or CPA needs a working knowledge of the categories that appear most often in your cost structure: labor [FAR 31.205-6], travel [FAR 31.205-46], materials, subcontractors, and rented facilities [FAR 31.205-36, Rental costs].
How do different government contract types affect your accounting requirements?
The type of government contract you hold determines how much accounting rigor the government demands. A firm-fixed-price (FFP) contract requires the least cost accounting infrastructure. A cost-reimbursable contract requires the most. Knowing where your first government contract falls on this spectrum shapes every accounting decision you make.
| Contract Type | How You Get Paid | Accounting Requirements | DCAA Audit Risk |
|---|---|---|---|
| Firm-Fixed-Price (FFP) | Set price for deliverables. You keep profit or absorb loss. | Basic job costing. Track costs by contract for internal management. | Lowest. DCAA rarely audits FFP contracts unless CAS-covered. |
| Cost-Reimbursable (CR) | Government reimburses allowable costs plus a fee. | Full DCAA-compliant system. Segregated cost pools, documented indirect rates, daily timekeeping, written policies. Annual Incurred Cost Submission required. | Highest. DCAA audits incurred costs, indirect rates, and the accounting system. |
| Time & Materials (T&M) | Fixed hourly rate for labor plus materials at cost. | DCAA-compliant timekeeping. Materials tracking by contract. Hourly rate must include defensible indirect cost structure. | Moderate. DCAA reviews labor hours, hourly rates, and material costs. |
One critical detail for new contractors: a first award is often firm-fixed-price, and it is tempting to build only the accounting system that award needs. Then a T&M or cost-reimbursable award arrives, and the accounting gap becomes a costly problem overnight. Build the system for your most demanding contract type, not your current one.
The 5 Mistakes New Government Contractors Make with Their Books
After working with dozens of first-time government contractors, Amerifusion Bookkeeping sees the same five accounting failures repeatedly. Each one starts small. Each one compounds into a problem that costs real money to fix.
1. Running government contracts through a commercial QuickBooks setup. A default QuickBooks file does not separate direct and indirect costs, does not track costs by contract, and does not flag unallowable expenses. Your chart of accounts needs a GovCon-specific structure from day one. Our QuickBooks setup guide covers exactly how to configure this.
2. No compliant timekeeping system. Employees filling out timesheets weekly from memory, or worse, a supervisor filling them out on behalf of the team. DCAA auditors expect daily time recording by the employee, supervisor approval, and an unalterable audit trail. A single timekeeping deficiency flags your entire labor billing for review.
3. Ignoring unallowable costs until year-end. Client dinners, conference cocktails, political donations: all unallowable under FAR. When these costs sit in your indirect pools for months, they inflate every invoice. Flag them at booking, not at audit prep.
4. No written accounting policies. DCAA expects documented policies for compensation, travel, purchasing, and timekeeping. “We do it the same way every time” is not a policy. A written policy signed by management is.
5. Treating indirect rates as someone else’s problem. New contractors often focus on direct costs and ignore their indirect rate structure entirely. Then proposal season arrives, and they guess at fringe, overhead, and G&A rates. Guessed rates lose competitions (too high) or lose money (too low). Use our indirect rate calculator to model your actual numbers.
Frequently Asked Questions
What accounting system do I need for government contracting as a beginner?
New government contractors need an accounting system that separates direct and indirect costs, tracks expenses by individual contract, flags unallowable costs at the point of entry, and supports job cost reporting. QuickBooks works if configured correctly for GovCon accounting with the right chart of accounts and cost tracking structure.
Does DCAA audit small government contractors?
Yes. DCAA audits contractors of all sizes when they hold flexibly-priced contracts (cost-reimbursable or time-and-materials). Contract dollar value does not determine audit exposure. Contract type and funding source do. A $1M cost-reimbursable contract faces the same audit standards as a $100M one.
What is the difference between direct and indirect costs in government contracting?
Direct costs tie to one specific contract: labor hours, materials, travel for that project. Indirect costs benefit multiple contracts or the whole business: rent, insurance, administrative staff. FAR Part 31 requires contractors to classify every expense as direct, indirect, or unallowable, and track each type separately in their accounting system.
Do I need a CPA for my first government contract?
A CPA is not legally required, but the accounting requirements for government contracts are significantly different from commercial bookkeeping. Firms that set up their financial systems under CPA guidance avoid the costly corrections from audit findings. The setup cost is a fraction of the cost of fixing problems after DCAA identifies them.
What happens if my accounting system fails a DCAA audit?
A failed DCAA accounting system audit (under DFARS 252.242-7006) results in a “material weakness” finding. The contracting officer receives the finding and withholds 5% of your billings under DFARS 252.242-7005 until the deficiency is corrected. That drops to 2% once you submit a corrective action plan the contracting officer accepts, which you have 45 days to do. The 10% ceiling applies only when material weaknesses sit in more than one business system. Repeated failures risk suspension of billing privileges entirely, stopping your contract cash flow.
DFARS 252.242-7005 applies only to contracts subject to the Cost Accounting Standards, and small businesses are exempt from CAS at any contract value [48 CFR 9903.201-1(b)(3)]. If you qualify as a small business, this withholding does not reach you. An inadequate accounting system still matters: a cost-reimbursement contract is awarded only when your accounting system is adequate [FAR 16.301-3(a)(3)].
Key Takeaways
- Set up your chart of accounts for GovCon before your first invoice, not after. Retrofitting a commercial QuickBooks file into a DCAA-compliant system costs far more than building it correctly at the start, because the cleanup reaches back through every month you have already billed.
- Learn the three cost types (direct, indirect, unallowable) and classify every expense correctly from day one. Misclassification in month one compounds into questioned costs across your entire contract.
- Build your accounting infrastructure for your most demanding future contract type. An FFP-only system fails the moment you win a cost-reimbursable or T&M award.
- Timekeeping compliance is not optional and not fixable retroactively. Implement daily employee time entry, supervisor approval, and an audit trail before DCAA asks for it.
- Take the Compliance Readiness Check to identify gaps in your current system before they become audit findings.
Your First Contract Deserves the Right Financial Foundation
The accounting transition from commercial to government work trips up experienced business owners every year. The requirements are specific, the auditors are thorough, and the penalties for getting it wrong hit your cash flow directly. None of this needs to be overwhelming. It needs to be set up correctly once.
Amerifusion Bookkeeping is a CPA-managed firm built for this exact transition. We configure your QuickBooks for GovCon compliance, establish your indirect rate structure, and keep your books audit-ready from the first invoice forward. Start with our Compliance Readiness Check to see where you stand, or review our GovCon accounting services to learn how the CPA-managed model works.
