Accounting Practices for Government Contractors (Part 1)
In this two part blog series we review the accounting principles and practices of government contracting, as well as the handling of costs and revenue recognition.
Accounting Basics for Non-Accountants
Whether or not you’re in government contracting, accounting boils down to some basic functions:
- Classifying and recording business transactions
- Invoicing customers and processing payments received
- Paying employees and suppliers
- Reporting the financial results and condition of the firm
And just in case you didn’t take an accounting class, we review a few other key accounting terms. An asset is something of value your company owns such as computers, inventory and intellectual property. A liability is basically the opposite: something that the firm owes to someone else, such as employees (payroll), creditors (loan payments), and suppliers (payments for products or services provided to the firm). Equity is the value of claims of the owners of the firm.
Just a few more key terms. Revenue is the value of goods and/or services sold to customers, while expenses are the costs your firm incurs.
The financial reporting function is one of the most important jobs in accounting. Primary financial reports include:
- The Balance sheet: This shows the financial condition of the firm at a particular point in time, listing the assets, liabilities, and equity.
- The Income statement: This shows the results of operations for a specific time period by listing revenue (sales), expenses, and the difference between the two (that’s the profit or loss).
Government Contracting Accounting Specifics
In government contracting, the primary accounting concern is cost. There’s a big difference between accounting conducted by a commercial firm and a government contractor in terms of how costs are classified, segregated, and reported.
Okay, so what does this all mean? FAR answers that a direct cost is “any cost that is identified specifically with a particular final cost objective.” Final cost objective refers to a contract or an element of a contract, such as a specific task or delivery order. In layman’s terms, a direct cost is any cost that can be identified as benefiting one, but only one, contract or element of a contract. More specifically, direct costs can include direct labor, materials, and travel expenses.
FAR further explains that an indirect cost is “any cost not directly identified with a single, final cost objective, but identified with two or more final cost objectives.” It may make more sense to think of an indirect cost as any cost not classified as a direct cost related to a specific contract. Indirect costs include overhead, general and administrative (G&A) costs, and materials and subcontracting burdens.
With that determination made, next comes classifying a cost as either allowable or unallowable. An allowable cost in government contracting speak means billable — it’s allowable if the rules permit it to be included in an invoice to the government. An unallowable cost is just the opposite; it’s the kind of cost you can’t bill the government for.
It’s Important to Note: Under FAR 31.201-2, a cost is allowable only when it meets all of these requirements:
- Terms of the contract: The contract might specify that a certain cost is unallowable, even though under normal circumstances it would be allowable. By the way, you’ll never see a contract that says the opposite; that a normally unallowable expense is allowable this time.
- Limitations set forth in FAR 31.201: FAR spells out a lot of things that are allowable, and things that are not. Find this with a search engine and print it out, because you’ll really want to know what’s allowable.
- Reasonable and allocable: Everyone’s read the horror stories of the government paying thousands of dollars for a toilet seat. For the record, FAR doesn’t allow that. A cost is considered reasonable if its cost and nature are what a prudent person dealing with a competitive business would pay. As contractor, the burden of proof is on you in this case.
An Important Tip: It all sounds pretty complicated, but when all else fails, just apply the newspaper test: If you would not be embarrassed by having the Washington Post or New York Times report that you billed the government for a particular cost, it’s probably allowable.
So, if you’ve been taking careful notes, you have now put two and two together to find that there’s a simple cost matrix for government contractors. Any cost will be classified as direct allowable, direct unallowable, indirect allowable, or indirect unallowable.
How to Handle Indirect Costs
It’s easy enough to figure out how to assign a direct allowable cost. If it’s a direct cost, it ties into one specific contract, so you charge it to that contract. But what about indirect costs? Here’s the basic plan:
- Indirect costs are collected in various pools, the totals of which are allocated or spread, ultimately, to contracts.
- Indirect cost pools may be allocated to other indirect cost pools, or directly to contracts.
- The number and composition of pools isn’t dictated by regulation but is left to the contractor.
A major component of managing indirect costs is the indirect cost allocation rate, or the rate at which indirect costs are allocated (charged) to contracts. There are three key concepts:
- Final cost objective: A government contract.
- Indirect pool: A logical grouping of indirect costs with a similar relationship to the cost objective (the numerator).
- Base: Some measure of direct effort that can be used to allocate pool costs based on benefits received by the several cost objectives/contracts (the denominator).
A good example of a cost pool is a fringe benefit. Items to include in the numerator of the cost pool are statutory expenses (FICA, FUTA, SUTA, and worker’s compensation); paid absence (vacations, sick days, military or jury duty); and other benefits such as 401(k) contributions, bonuses, and health insurance. Notice how similar in nature these items are.
Base options are typically total labor dollars or hours. As total labor dollars or hours increase, the expenses in the cost pool will likely increase as well. Note that fringe doesn’t have to be a separate pool; instead you might opt to include it in an overhead pool or a General and Administrative (G&A) pool.
On the other hand, you may need more than one fringe pool. Separate fringe benefit pools may be necessary if various groups of employees — such as full-time versus part-time workers — receive materially different benefits packages.
An Important Tip: Make sure you have an accounting system that enables you to identify and segregate labor by employee type. Otherwise, you’ll be spending a lot of time doing workarounds on paper.
Overhead Cost Pools
Overhead costs are those incurred in support of specific operations. Overhead cost pools are necessary when the indirect costs incurred benefit more than one contract and can be distributed to them in a reasonable proportion to benefits received. Options for the overhead bases include:
- Direct labor dollars: This is the norm when labor rates are relatively uniform and when labor costs are significant in relation to total costs.
- Direct labor hours: This is accepted when the employees are interchangeable, as in manufacturing operations.
- Machine hours: This is appropriate when machinery is heavily used.
- Material cost: Material handling costs may be allocated on the physical quantity of direct materials as opposed to the dollar value of the material.
- Units of production: One of the simplest methods. It may not be your best option if products vary in size or require different amounts of material or time to produce.
Overhead pools can be “onsite” or “offsite.” Separate overhead pools are ideal to segregate where the work is performed. This reflects the fact that it may be less costly from an overhead standpoint to support workers at a government facility than at a company workspace.
An Important Tip: Your accounting system should be capable of identifying and segregating offsite from onsite labor.
General and Administrative Cost Pools
General and Administrative (G&A) cost pools collect those costs that are necessary to the overall operation of the business, even though a direct relationship to any particular cost objective can’t be shown. It’s the cost of operating a business — rent, phone services, and so on — but nothing that can be directly allocated to the performance of a particular government contract. Options for your G&A base include:
- Total cost input
- Value-added cost input, which is total cost input minus direct materials and subcontractors
- Single element of cost (for example, direct labor)
It’s Important to Note: Sales, cost of goods sold, or cost of sales can’t be used by government contractors as an allocation base for any pool.
G&A pools are the only pools necessary; deciding the remaining number and composition of pools is left to the convenience of the contractor. If you maintain fewer cost pools, you’ll find it easier to monitor rates, administrative costs will be lower, and there will be less impact by a volatile business base. On the other hand, consider more cost pools when you need a higher degree of accuracy, want more visibility into costs, and need more rates to choose when bidding on future government contracts.
Service centers are a lot like cost pools, with a big exception. The service center allocation base relates to some measureable element other than cost, based on the use of the service. Examples include square feet, head count, number of copies, and time. A big advantage of service centers is that they provide management with data on the cost of providing a particular service. Their costs may be allocated directly to contracts, to indirect cost pools, or to other service centers.
Warning: If you operate a mix of government and commercial business, you should be aware of the potential for audits of your cost allowability. Many companies segregate their government contracting operations to mitigate such risks. Look for expert guidance on how to ideally structure your organization and indirect pools.
- This blog is an excerpt from Deltek’s special edition “Government Contracting for Dummies”. Download your free copy of “Government Contracting for Dummies” to learn strategies to keep ahead of the competition and win more government business.
Deltek ERP for Government Contractors has a strong heritage of understanding the intricacies of government contracts and the way government contractors work. Learn more about Deltek Costpoint, the industry’s leading ERP system for Government Contractors.
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