Contractors that hold cost-reimbursement contracts with the federal government bill at provisional indirect rates and settle at final rates after year end. The final rates come from a proposal the contractor must prepare from its general ledger, and the government audits it. Small and mid-size contractors often lack the schedules, and CPA firms are asked to help. The rules sit in FAR 52.216-7 and Part 31.
What the clause requires
Under FAR 52.216-7(d), final annual indirect cost rates and the appropriate bases are established under FAR subpart 42.7. The contractor must submit an adequate final indirect cost rate proposal to the contracting officer or cognizant federal agency official, and the auditor, within the 6-month period following the expiration of each of its fiscal years. Extensions are for exceptional circumstances only and must be requested in writing and granted in writing. The proposed rates must be based on the contractor's actual cost experience for the period, supported by adequate data.
An adequate proposal includes, unless the agency specifies otherwise:
- a summary of all claimed indirect expense rates, including pool, base and calculated rate;
- schedules of claimed expenses by element of cost for general and administrative, overhead and occupancy pools, from the chart of accounts;
- claimed allocation bases by element of cost;
- a facilities capital cost of money computation;
- a reconciliation of books of account (the general ledger) and claimed direct costs by major cost element;
- a schedule of direct costs by contract and subcontract with indirect expense applied at claimed rates, and the government participation percentage in each base; and
- a schedule of cumulative direct and indirect costs claimed and billed by contract and subcontract, and subcontract information;
- a summary of each time-and-materials and labor-hour contract, including labor categories, rates, hours and amounts;
- a reconciliation of total payroll per IRS Form 941 to total labor costs distribution;
- a listing of decisions, agreements and approvals and a description of accounting or organizational changes;
- the certificate of final indirect costs; and
- contract closing information for contracts physically completed in the fiscal year.
The test for an allowable cost
FAR 31.201-2(a) provides that a cost is allowable only when it complies with all of the following:
- Reasonableness.
- Allocability.
- Standards promulgated by the Cost Accounting Standards Board, if applicable, otherwise generally accepted accounting principles and practices appropriate to the circumstances.
- The terms of the contract.
- Any limitations in FAR subpart 31.2.
Under FAR 31.201-4, a cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship, for example if it is incurred specifically for the contract, benefits both the contract and other work and can be distributed in reasonable proportion, or is necessary to the overall operation of the business. FAR 31.201-2(d) places the burden on the contractor to account for costs appropriately and to keep records that demonstrate costs claimed have been incurred, are allocable and comply with the rules.
Paragraph (c) adds that costs resulting from accounting practices inconsistent with subpart 31.2 are unallowable to the extent they exceed the amount a consistent practice would produce, and paragraph (d) lets the contracting officer disallow all or part of a claimed cost that is inadequately supported.
Specific costs are unallowable regardless of how they are recorded. Entertainment costs, including amusement, social activities and directly associated tickets, meals and gratuities, and membership in social, dining or country clubs, are unallowable under FAR 31.205-14. Costs of alcoholic beverages are unallowable under FAR 31.205-51. Costs related to certain legal proceedings are limited by FAR 31.205-47.
Worked example
A contractor's overhead pool for the year shows $1,200,000 of expense. The direct labor base is $2,000,000. A review of the pool finds $48,000 of client entertainment, $12,000 of alcohol included in meals, and $30,000 of country club dues.
- Unallowable amounts: $48,000 plus $12,000 plus $30,000, or $90,000.
- Allowable overhead pool: $1,200,000 minus $90,000, or $1,110,000.
- Claimed rate: $1,110,000 divided by $2,000,000, or 55.5 percent.
- Rate without the adjustment: $1,200,000 divided by $2,000,000, or 60.0 percent.
If the contractor billed provisional rates at 60 percent on $1,500,000 of direct labor charged to cost-type contracts, the overbilling is the difference of 4.5 percentage points: $1,500,000 times 4.5 percent, or $67,500, which would be owed back on settlement. The point of the review is to find unallowables before the government does.
The certificate and the penalty
Under FAR 52.242-4, the contractor certifies any proposal to establish or modify final indirect cost rates, and the certificate must be signed by an official at a level no lower than a vice president or chief financial officer of the business segment that submits the proposal. The certificate states that all costs in the proposal are allowable under the FAR cost principles and that the proposal includes no expressly unallowable costs. Failure to submit a signed certificate may result in final indirect costs at rates unilaterally established by the contracting officer.
FAR 31.201-6(a) requires costs that are expressly unallowable, and their directly associated costs, to be identified and excluded from any billing, claim or proposal. Under the clause at FAR 52.242-3, a contracting officer who finds an expressly unallowable cost in a proposal assesses a penalty equal to the disallowed cost allocated to the contract plus simple interest on the excess payment. If the cost had previously been determined unallowable for that contractor, the penalty is two times the disallowed cost allocated to the contract. The contracting officer may waive the penalty under the criteria in FAR 42.709-6.
Second example: the penalty
A proposal includes $10,000 of club dues allocated to a cost-type contract.
- First time found: the penalty is $10,000 (the disallowed cost) plus simple interest on the amount paid in excess of entitlement, in addition to removing the cost.
- Cost already determined unallowable for this contractor in an earlier year: the penalty is 2 times $10,000, or $20,000.
This is why the unallowable cost analysis precedes the certificate, and why a prior-year disallowance schedule belongs in the file.
Common errors
- Leaving unallowable amounts inside the pool because they sit in an account such as meals or dues.
- Missing the six-month deadline without a written extension from the contracting officer.
- Submitting a certificate signed below the required level.
- A general ledger that does not reconcile to claimed direct costs by major cost element.
- Payroll that does not reconcile from Form 941 totals to labor distribution.
- Billing at provisional rates that stay well above the actual rate for the year.
Readiness checklist
- General ledger mapped to direct and indirect pools, with the allocation bases reconciled to payroll and time records.
- Labor distribution tested against timesheets.
- Unallowable cost analysis by account, with a clear identification in the ledger.
- Subcontract, consultant and travel support for the largest items.
- A calendar tied to fiscal year end plus six months.
For general readiness practices, see month-end close and chart of accounts design.
Sources
- Code of Federal Regulations, 48 CFR 52.216-7, Allowable cost and payment (eCFR): https://www.ecfr.gov/current/title-48/section-52.216-7
- Code of Federal Regulations, 48 CFR 31.201-2, Determining allowability (eCFR): https://www.ecfr.gov/current/title-48/section-31.201-2
- Code of Federal Regulations, 48 CFR 31.201-4, Determining allocability (eCFR): https://www.ecfr.gov/current/title-48/section-31.201-4
- Code of Federal Regulations, 48 CFR 31.205-14, Entertainment costs, and 48 CFR 31.205-51, Costs of alcoholic beverages (eCFR): https://www.ecfr.gov/current/title-48/section-31.205-14
- Code of Federal Regulations, 48 CFR 31.201-6, Accounting for unallowable costs (eCFR): https://www.ecfr.gov/current/title-48/section-31.201-6
- Code of Federal Regulations, 48 CFR 52.242-4, Certification of Final Indirect Costs, and 48 CFR 52.242-3, Penalties for Unallowable Costs (eCFR): https://www.ecfr.gov/current/title-48/section-52.242-4
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