You won the contract. The funding is flowing. Then an email arrives from DCAA requesting access to your accounting records, timekeeping system, and indirect rate calculations.
For small government contractors without the right financial infrastructure, that moment is when months of revenue become months of risk.
DCAA compliance is not optional for government contractors. It is the baseline expectation for any firm that bills the federal government for costs incurred. Yet most small contractors, particularly those in the $1M to $20M revenue range, run accounting systems, timekeeping practices, and cost allocation methods that would not survive a DCAA audit.
The gap between “good enough for commercial work” and “adequate for federal contracting” is where contracts get questioned, costs get disallowed, and firms get sidelined from future awards. What follows are the core requirements, in practical terms you can act on this quarter.
What DCAA Actually Audits (and Why It Matters)
The Defense Contract Audit Agency exists to protect the government’s financial interests. DCAA auditors verify that contractors are charging the government only for costs that are allowable, allocable, and reasonable: the three pillars defined under FAR Part 31. Every audit circles back to these three questions:
- Allowable: Is this cost permitted under FAR 31.205? Certain costs are expressly unallowable, including entertainment, alcohol, lobbying, bad debts, and fines. If your books do not segregate unallowable costs, DCAA will question your entire cost pool.
- Allocable: Can you demonstrate a clear, beneficial relationship between the cost and the contract being charged? A cost that benefits multiple contracts must be allocated proportionally using a consistent methodology.
- Reasonable: Would a prudent business person have incurred this cost at this amount? DCAA applies the “prudent person” standard, and it is more subjective than contractors expect.
DCAA conducts several types of audits, but the ones most relevant to small contractors are accounting system audits (evaluating whether your system meets the standards in DFARS 252.242-7006), incurred cost audits (verifying actual costs claimed on flexibly-priced contracts), and pre-award audits (assessing your proposed rates and cost estimates before contract award). Each one examines the same underlying data from a different angle.
The Five Pillars of a DCAA-Compliant Accounting System
DCAA evaluates your accounting system against specific adequacy criteria. If you are using QuickBooks or any commercial accounting package, the software itself is not the issue. The configuration and the processes surrounding it are.
Here is what your system must demonstrate:
1. Segregation of Direct and Indirect Costs
Your chart of accounts must cleanly separate direct costs (labor, materials, subcontractor costs, and travel charged to specific contracts) from indirect costs (overhead, fringe benefits, and general and administrative expenses). Commingling direct and indirect costs in the same accounts is the most common deficiency DCAA finds in small contractor systems.
2. Proper Indirect Cost Pooling and Allocation
Indirect costs must be accumulated in logical, homogeneous cost pools, typically fringe, overhead, and G&A, and allocated to final cost objectives using appropriate bases. Fringe is typically allocated over direct labor dollars. Overhead is allocated over a direct labor or total direct cost base.
G&A is allocated over total cost input or value-added. The allocation base must be consistent and must reflect the beneficial or causal relationship between the pool and the contracts it supports. Inconsistent or arbitrary allocation is a finding waiting to happen.
If you need to understand how your current rates compare, our indirect rate calculator provides a useful starting point.
3. DCAA-Compliant Timekeeping
Timekeeping is the area where DCAA applies the most scrutiny, because labor is usually the largest direct cost on a government contract. Your timekeeping system must meet these non-negotiable requirements:
- Employees record their own time daily (not weekly, not retroactively)
- Time is recorded by specific project, contract, or indirect account
- Supervisors review and approve timesheets
- Corrections follow a documented audit trail. No erasures, no overwritten entries.
- Total hours recorded equal total hours compensated
A spreadsheet-based timekeeping system can technically satisfy these requirements, but it creates significant audit risk. Any system where an employee can alter a prior entry without a visible correction trail is a liability.
4. Job Cost Accounting by Contract
Every dollar of direct cost must be traceable to the specific contract it benefits. Where applicable, costs must also trace to the specific Contract Line Item Number (CLIN). Your accounting system must support job costing at the contract level, with the ability to generate reports showing costs incurred by contract, by cost element (labor, materials, travel, subcontracts, other direct costs), by period.
5. Unallowable Cost Identification
FAR 31.205 lists specific cost categories that are unallowable when charging the government. Your accounting system must identify and exclude these costs from any billing, indirect rate calculation, or cost claim.
This is not a year-end exercise. Unallowable costs must be flagged at the point of entry, when the expense is recorded, not discovered later during audit preparation. Common unallowable costs include entertainment [FAR 31.205-14], alcoholic beverages [FAR 31.205-51], and lobbying costs [FAR 31.205-22].
FAR Compliance Beyond the Accounting System
A compliant accounting system is necessary but not sufficient. FAR compliance extends into your policies, procedures, and business practices. DCAA expects to see written policies governing:
- Compensation: A compensation policy that documents how you determine employee pay and demonstrates it is reasonable for your labor market [FAR 31.205-6]
- Travel: A travel policy that establishes reimbursement limits, approval requirements, and documentation standards, typically tied to the Federal Travel Regulation or Joint Travel Regulations
- Purchasing: A procurement/purchasing policy that demonstrates a consistent method for obtaining competitive pricing on materials and subcontracts
- Timekeeping: A written timekeeping policy covering all the requirements noted above
For contractors subject to Cost Accounting Standards (CAS), there is an additional layer. CAS 401 requires consistency in estimating, accumulating, and reporting costs. CAS 402 requires consistency in allocating costs for similar purposes.
Most small contractors fall under modified CAS coverage rather than full CAS (the thresholds are periodically updated by Congress, so verify the current figures with your CPA or contracting officer). Regardless of coverage level, the consistency requirements of CAS 401 and 402 still apply and are actively audited.
Preparing for a DCAA Audit: What to Do Before They Call
The best time to prepare for a DCAA audit is before you need to. Contractors who treat compliance as a year-end cleanup exercise consistently fare worse than those who build it into their monthly operations. Here is a practical audit-readiness checklist:
- Monthly close discipline: Reconcile all accounts monthly. Review indirect cost pool balances. Confirm that job cost reports tie to the general ledger. A monthly close that takes three weeks is a symptom of a system that will not survive audit scrutiny.
- Incurred Cost Submission readiness: If you have flexibly-priced contracts (cost-reimbursement, time-and-materials, or cost-plus), you are required to submit an adequate Incurred Cost Submission (ICS) within six months of your fiscal year end. The ICS is the document DCAA uses to audit your actual costs and final indirect rates. Build the schedules as you go. Do not wait until month five to start.
- Document everything: DCAA operates on a “if it isn’t documented, it didn’t happen” standard. Every cost allocation methodology, every rate calculation, every policy decision should be in writing and accessible.
- Test your own system: Run internal audits using DCAA’s own SF 1408 checklist (the Pre-Award Survey of Prospective Contractor Accounting System). If your system would not pass your own review, it will not pass theirs.
Key Takeaways
- Segregate direct and indirect costs from day one. Retrofitting a chart of accounts after a DCAA finding is exponentially harder than building it correctly upfront.
- Timekeeping is the highest-risk area. Daily recording, supervisor approval, and an unalterable audit trail are non-negotiable. Fix this first.
- Written policies are not optional. DCAA expects documented policies for compensation, travel, purchasing, and timekeeping, and expects you to follow them consistently.
- Build compliance into your monthly operations. Monthly closes, ongoing unallowable cost segregation, and real-time job costing prevent the year-end scramble that leads to findings.
- Get CPA-level oversight on your government contractor bookkeeping. Bookkeepers record transactions. A CPA-managed engagement means your entire system, from structure to policies to reporting, is built to withstand federal scrutiny.
Frequently Asked Questions
What does DCAA compliance mean for small contractors?
DCAA compliance means your accounting system, timekeeping practices, and cost allocation methods meet the standards the Defense Contract Audit Agency uses to evaluate government contractors. For small contractors, this typically means configuring your accounting software to segregate direct and indirect costs, maintaining daily timekeeping records, and having written policies for compensation, travel, and purchasing. The requirements apply regardless of company size if you hold cost-reimbursement or time-and-materials contracts.
How long does a DCAA audit take?
The duration depends on the audit type and your level of preparation. A pre-award accounting system audit typically takes 2 to 4 weeks of active fieldwork. An incurred cost audit can stretch over several months, particularly if DCAA identifies issues that require additional documentation. Contractors with clean books, organized records, and current Incurred Cost Submissions generally experience shorter, less disruptive audits.
Can I use QuickBooks and still be DCAA compliant?
Yes. DCAA does not mandate a specific accounting software. QuickBooks Desktop Premier, Enterprise, and QuickBooks Online Plus or Advanced can all support DCAA compliance when properly configured. The key requirements are a chart of accounts that segregates cost pools, enforced class tracking for indirect rate categories, job costing by contract, and integration with a compliant timekeeping system. See our QuickBooks setup guide for the specific configuration steps.
What happens if DCAA finds my accounting system inadequate?
An inadequate system determination can result in several consequences: the contracting officer may withhold a percentage of your billings (typically 5% to 10%), you may be ineligible for new cost-type contract awards, and the government can require you to correct the deficiencies at your own expense. In serious cases, costs already billed may be questioned or disallowed. The most practical response is to address the specific deficiencies documented in the audit report and request a follow-up review.
Do I need a CPA to handle DCAA compliance?
There is no regulatory requirement to use a CPA. However, DCAA compliance involves applying FAR cost principles, CAS requirements, and audit preparation practices that go beyond standard bookkeeping. A CPA-managed engagement provides the professional oversight needed to build a defensible accounting system and respond appropriately to audit inquiries. For small contractors who cannot justify a full-time controller, outsourced CPA-managed bookkeeping is the most cost-effective approach to maintaining compliance.
Is Your Accounting System Audit-Ready?
Most small government contractors have gaps they do not know about until DCAA points them out. Our Compliance Readiness Check takes 30 seconds and identifies where your system stands today. No obligation, no sales pitch.
If you already know you need help, book a discovery call and we will walk through your specific situation with CPA-level guidance.
