Unallowable costs under FAR 31.205 are specific expense categories that government contractors cannot charge to federal contracts, either directly or through indirect rate pools. FAR 31.205 covers 52 cost subsections, and missing even one category during your incurred cost submission exposes the firm to questioned costs, penalty assessments up to double the disallowed amount, and indirect rate adjustments across every open contract.
A janitorial contractor in Maryland submitted an incurred cost proposal with $14,000 in entertainment expenses buried inside the G&A pool. The transactions were coded to “Business Development” in QuickBooks. No one flagged them.
DCAA’s auditor pulled the general ledger detail, matched the vendor names to restaurants and event venues, and questioned the full amount. The penalty: $14,000 on top of the disallowance. The real cost: a rate adjustment clawing back overbillings on three active contracts.
Most contractors know alcohol and entertainment are off-limits. Few realize how far the unallowable net extends, or how “directly associated costs” double the damage when an auditor traces the full chain of a single unallowable expense.
What Makes a Cost Unallowable Under FAR Part 31
FAR Part 31 establishes three tests for cost allowability: reasonableness, allocability, and conformance with the specific cost principles in FAR 31.205. A cost fails if it flunks any one of these tests [FAR 31.201-2 through 31.201-5]. The 52 subsections under FAR 31.205 add a fourth filter: specific cost categories named and restricted by the regulation, regardless of whether they pass the other three tests.
Three categories of unallowability exist. Expressly unallowable costs are named and stated to be unallowable in the regulation, the contract, or applicable law. No judgment required. Alcoholic beverages [FAR 31.205-51], entertainment [FAR 31.205-14], and lobbying [FAR 31.205-22] fall here.
Mutually agreed unallowable costs result from a written agreement between the contractor and the contracting officer designating specific costs as unallowable for a particular contract. Conditionally allowable costs qualify only when they meet stated criteria. Travel [FAR 31.205-46] is allowable if it complies with the Federal Travel Regulation or the Joint Travel Regulations. Exceed those limits, and the excess becomes unallowable.
The Most Common Unallowable Costs Under FAR 31.205
FAR 31.205 spans 52 subsections covering everything from advertising to goodwill. Nine categories generate the majority of DCAA findings during incurred cost audits. Every contractor’s accounting system must flag these at the transaction level, not at year-end during the incurred cost submission.
| FAR Reference | Cost Category | Allowability | Key Detail |
|---|---|---|---|
| 31.205-14 | Entertainment | Expressly unallowable | All costs of amusement, diversion, social activities, and related costs. Includes tickets, hosted meals with no business purpose, and sporting events. |
| 31.205-51 | Alcoholic beverages | Expressly unallowable | All costs of alcoholic beverages. No exceptions. The sales tax on the alcohol is also unallowable as a directly associated cost. |
| 31.205-22 | Lobbying and political activity | Expressly unallowable | Costs to influence legislation, executive orders, or elections. Includes lobbyist fees, PAC contributions, and employee time spent on lobbying. |
| 31.205-15 | Fines, penalties, and mischarging costs | Expressly unallowable | Fines and penalties from federal, state, or local government violations. Includes costs of investigating and defending against fraud charges. |
| 31.205-3 | Bad debts | Expressly unallowable | Losses from uncollectible accounts and related collection costs. Write-offs for unpaid invoices cannot flow into indirect pools. |
| 31.205-8 | Contributions or donations | Expressly unallowable | Cash, property, or service donations to any entity. Includes charitable contributions, even if tax-deductible under IRS rules. |
| 31.205-20 | Interest and financial costs | Expressly unallowable | Interest on borrowings, bond discounts, finance charges. One exception: facilities capital cost of money (FCCM) under CAS 414 is an imputed cost the government allows separately. |
| 31.205-27 | Organization costs | Expressly unallowable | Costs of incorporating, merging, reorganizing, or recapitalizing. Legal fees for entity formation, stock issuance costs, and SEC registration fees. |
| 31.205-1 | Advertising (promotional) | Split: promotional is unallowable, recruitment is allowable | Advertising to promote the company’s image or sell products is unallowable. Advertising to recruit employees or attract subcontractors is allowable. |
Two categories deserve extra attention. Compensation for personal services [FAR 31.205-6] is conditionally allowable, but excess compensation above what the IRS Benchmarks of Compensation survey supports becomes unallowable. DCAA regularly questions executive salaries above $212,000 (the current statutory cap under Section 702 of the Bipartisan Budget Act for contracts awarded before June 24, 2014, with higher thresholds for more recent awards).
Travel costs [FAR 31.205-46] are allowable when they comply with federal per diem rates, but the amount above per diem is unallowable. A $350/night hotel in a city with a $189 federal rate produces $161/night in unallowable lodging cost.
Directly Associated Costs: The Hidden Multiplier
FAR 31.201-6 defines a directly associated cost as any cost incurred solely because the unallowable cost was incurred. When an unallowable cost exists, every cost that exists solely because of it is also unallowable. This rule doubles and sometimes triples the financial impact of a single disallowance.
A security contractor sponsors a $5,000 table at a charity gala. The sponsorship is unallowable under FAR 31.205-8 (donations). The damage does not stop at $5,000.
Two employees attend the gala. Their combined salary for the four hours: $480. Fringe benefits on the salary: $168. Travel to the venue: $94. Every one of those costs exists only because the firm purchased the sponsorship. Total unallowable amount: $5,742, not $5,000.
DCAA auditors are trained to trace directly associated costs. The DCAA Contract Audit Manual instructs auditors to identify not only the unallowable cost itself but all related labor, fringe, travel, and material costs. A contractor who flags the sponsorship as unallowable but leaves the employee time in the overhead pool has an incomplete exclusion. The auditor will find it.
What Happens When DCAA Finds Unallowable Costs in Your Indirect Rates
DCAA discovers unallowable costs primarily during incurred cost audits, the annual examination of your indirect rate proposal. The consequences unfold in three stages, each more expensive than the last.
Stage 1: Questioned costs. The auditor identifies expenses in your indirect pools that fail the allowability tests. These appear in the audit report as questioned costs. A $40,000 finding in your G&A pool does not mean you owe $40,000; the auditor recommends the contracting officer disallow it.
Stage 2: Rate adjustment. The contracting officer reviews the audit findings, considers the contractor’s response, and issues a final determination. Disallowed costs are removed from the indirect pool, which changes the indirect rate for the entire fiscal year.
A $40,000 disallowance in a G&A pool with a $2M total cost input base changes the G&A rate by 2 percentage points. Every contract billed at the original rate now reflects an overbilling. The contractor refunds the difference across all affected contracts.
Stage 3: Penalties. For expressly unallowable costs, FAR 42.709 and contract clause FAR 52.242-3 authorize penalty assessments on contracts exceeding $800,000 (excluding firm-fixed-price without cost incentives). First occurrence: a penalty equal to the disallowed cost allocated to the contract. Repeat occurrence of the same cost type: double the allocated amount, plus interest at the six-month Treasury rate.
A $40,000 expressly unallowable cost allocated 25% to a single cost-reimbursable contract generates a $10,000 penalty on top of the $10,000 refund. On a repeat finding, the penalty doubles to $20,000.
How to Identify and Segregate Unallowable Costs in Your Books
The accounting system, not the annual incurred cost submission, is where unallowable cost segregation must happen. FAR 31.201-6 requires contractors to identify and exclude unallowable costs from any billing, claim, or proposal applicable to a government contract. Waiting until year-end to scrub the general ledger is the most common and most dangerous approach.
CAS 405 (Accounting for Unallowable Costs) reinforces this requirement for CAS-covered contractors. The standard mandates unallowable costs be identified at the time they are defined or become unallowable, not at the time of proposal submission. For contractors below the CAS threshold, the same discipline applies under FAR 31.201-6.
Segregation means the unallowable cost never enters an allowable indirect pool. It sits in a separate account, clearly labeled, excluded from the allocation base before any rate calculations run.
A contractor with $500,000 in overhead costs and $12,000 in entertainment coded to the overhead account is computing rates on $500,000 when the correct base is $488,000. The resulting rate is inflated. Every contract billed at the inflated rate absorbs a share of the entertainment cost. The error compounds monthly.
Setting Up Your Accounting System to Flag Unallowable Costs
A properly configured accounting system catches unallowable costs at entry, not during audit preparation. The goal: no unallowable transaction reaches an allowable cost pool without a deliberate reclassification and a documented reason. Here is the setup process for QuickBooks or any comparable system.
- Create dedicated unallowable accounts in your chart of accounts. Add accounts under each indirect cost pool for unallowable expenses: “6900 – G&A Unallowable,” “7900 – Overhead Unallowable,” or more granular sub-accounts like “6910 – Unallowable Entertainment,” “6920 – Unallowable Donations,” “6930 – Unallowable Interest.” These accounts must be excluded from your indirect rate calculations.
- Build a vendor-level flag system. Tag vendors who frequently provide unallowable goods or services. A caterer who provides alcohol at events, a lobbyist, a country club, a political action committee. When a bill arrives from a flagged vendor, the bookkeeper routes it to the unallowable account by default.
- Code at the point of entry. Every transaction gets coded when it enters the system. The bookkeeper or accounts payable clerk determines allowability at the time of entry, not at month-end or year-end. Train your staff with a one-page reference sheet listing the nine most common unallowable categories and their FAR references.
- Run a monthly unallowable cost reconciliation. Pull a report of all transactions in unallowable accounts. Verify completeness: did any unallowable costs get coded to allowable accounts by mistake? Cross-reference credit card statements against entertainment, alcohol, and donation accounts. Flag discrepancies.
- Exclude unallowable accounts from rate calculations before running monthly allocations. Your indirect rate computation must pull only from allowable accounts. If you use a spreadsheet for rate calculations, the formula must reference only allowable account ranges. If your software auto-calculates rates, confirm the unallowable accounts are excluded from the pool definition.
DFARS 252.242-7006 defines the criteria for an adequate accounting system. Criterion (c)(5) requires the system to “exclude from costs charged to Government contracts those costs which are not allowable.” Failing this criterion triggers a deficiency finding, a corrective action request, and payment withholds of 5-10% on all cost-type invoices.
Conditionally Allowable Costs: The Gray Areas That Trip Contractors Up
Not every cost under FAR 31.205 falls neatly into “allowable” or “unallowable.” Several categories split based on purpose, amount, or compliance with secondary regulations. These conditionally allowable costs produce more audit disputes than the expressly unallowable ones because both the contractor and the auditor have room to interpret.
Meals and business meetings. A working lunch with a subcontractor to discuss contract performance is an allowable business expense under FAR 31.205-13 (employee morale and welfare). The same lunch at a prospective-client restaurant, no active contract discussed, slides toward entertainment under FAR 31.205-14.
Document the business purpose, the attendees, and the contract or proposal number for every meal. Without documentation, the auditor defaults to unallowable.
Professional development. Training and education costs [FAR 31.205-44] are allowable when the training maintains or improves skills needed for the employee’s current role. An MBA program for a mid-level project manager with no clear connection to current duties becomes questionable. A PMP certification for a program manager running a $10M task order is defensible.
Selling costs. FAR 31.205-38 allows costs of selling when they relate to securing government contracts through the normal proposal process. Costs of entertainment, gifts, or gratuities provided to government personnel are expressly unallowable under this section. The line between allowable “selling” and unallowable “entertainment” runs through documentation and business purpose.
Frequently Asked Questions
What are unallowable costs under FAR 31.205?
Unallowable costs under FAR 31.205 are specific expense categories that contractors cannot charge to government contracts. The regulation covers 52 cost subsections. Expressly unallowable categories include entertainment, alcoholic beverages, lobbying, fines and penalties, bad debts, charitable donations, and certain interest costs. These must be identified and excluded from all billings and indirect rate proposals.
What happens if DCAA finds unallowable costs in my indirect rates?
DCAA issues questioned costs in the audit report. The contracting officer then determines the final disallowance. For expressly unallowable costs, FAR 42.709 authorizes penalties equal to the disallowed amount allocated to the contract on first occurrence, and double that amount on repeat findings. The contractor must also adjust indirect rates and refund overbillings across all affected contracts.
What is a directly associated cost under FAR 31.201-6?
A directly associated cost is any expense that exists only because an unallowable cost was incurred. If the unallowable cost disappears, the directly associated cost disappears with it. Example: labor hours spent planning an unallowable entertainment event are themselves unallowable. The tax paid on unallowable alcoholic beverages is also unallowable.
How do I segregate unallowable costs in QuickBooks?
Create a dedicated unallowable cost account (or sub-accounts by category) in your chart of accounts. Code every unallowable transaction to these accounts at the time of entry, not at year-end. Use class tracking to flag unallowable items within indirect cost pools. Run a monthly report to confirm no unallowable costs leaked into allowable accounts.
Are all costs listed under FAR 31.205 unallowable?
No. FAR 31.205 covers 52 cost subsections. Some are expressly unallowable (entertainment, alcohol, lobbying). Others are conditionally allowable, meaning they qualify under specific rules. Travel costs under FAR 31.205-46 are allowable when they follow federal travel regulations. Advertising is split: recruitment advertising is allowable, but promotional advertising is not.
Can penalties for unallowable costs be waived?
FAR 42.709-5 allows waiver when the contractor withdraws the incurred cost submission before the audit entrance conference, when total unallowable costs subject to penalty fall below $10,000, or when the contractor demonstrates policies, personnel training, and internal controls designed to prevent inclusion. Waiver is not automatic. The contracting officer decides.
Key Takeaways
- Segregate at the point of entry, not at year-end. Every unallowable transaction must hit a dedicated unallowable account when the bookkeeper enters it. Scrubbing the ledger during incurred cost preparation guarantees missed items and audit findings.
- Directly associated costs multiply every disallowance. A $5,000 unallowable sponsorship becomes $5,700+ once you add the employee time, fringe, and travel that existed only because of the sponsorship. DCAA auditors trace the full chain.
- Penalties for expressly unallowable costs hit twice: the disallowance plus an equal penalty amount on the first occurrence, and double on the second. FAR 42.709 applies to cost-type contracts over $800,000. This is real money, not a theoretical risk.
- Conditionally allowable costs produce more disputes than expressly unallowable ones. Document the business purpose, attendees, and contract relevance for every meal, training expense, and selling cost. Documentation is your defense.
- Run a monthly unallowable cost reconciliation. Cross-check credit card statements against your unallowable accounts. One missed entertainment charge in a $300,000 overhead pool changes the rate by a fraction, but that fraction applies to every contract for the entire year.
Get Your Unallowable Costs Under Control
Unallowable cost findings are the most preventable DCAA audit deficiency. The fix is structural: dedicated accounts, point-of-entry coding, monthly reconciliation, and staff training on the nine categories that generate 90% of findings.
Start with our Compliance Readiness Check to see whether your current system properly segregates unallowable costs. Then use the indirect rate calculator to verify your rates exclude every unallowable account.
Amerifusion is a CPA-managed bookkeeping firm built for government contractors. We set up the unallowable cost accounts, train your staff on the FAR 31.205 categories, and run the monthly reconciliations keeping questioned costs out of your indirect rate proposals.
