What Is DCAA Compliance for Government Contractors?

DCAA compliance means running your accounting, timekeeping, and cost-allocation systems in a way that meets the standards the Defense Contract Audit Agency enforces on companies billing the federal government under cost-reimbursement, time-and-materials, or similar contracts. In practice, that translates to a specific set of duties: an accounting system that can separate direct from indirect costs and track them by contract, a timekeeping process that records labor as it happens, a clear line between allowable and unallowable expenses, and annual submissions that reconcile what you billed to what your books actually show. Fall short in any of these areas and the government can withhold payments, disallow costs, assess penalties, or in the worst case pursue False Claims Act liability with per-violation penalties currently set at $14,308 to $28,619.¹

Which Contracts Bring You Under DCAA Oversight

The trigger is contract type. Cost-reimbursement contracts always require an adequate accounting system and are subject to DCAA audit, because the government is paying your actual costs rather than a fixed price.² Contracts with progress payments based on costs incurred, or on percentage of completion, bring DCAA in as well.³ Time-and-materials contracts carry similar exposure, since the government reimburses labor hours at agreed rates plus material costs.

Firm-fixed-price contracts are generally the safest, because the government pays a set amount regardless of your costs. Even so, fixed-price contractors can face DCAA reviews when their contracts include audit-access clauses or when they provide certified cost or pricing data during negotiations. The moment the government has a right to look at your books, DCAA is often the one doing the looking.

What Your Accounting System Must Do

Before a cost-reimbursement contract can be awarded, the government must determine that your accounting system is adequate for tracking costs at the level federal oversight demands.² The evaluation tool is Standard Form 1408, the Preaward Survey of Prospective Contractor Accounting System.⁴

SF 1408 sets pass/fail criteria your system must demonstrate:

Separate direct costs from indirect costs, so every expense is classified as either tied to a specific contract or shared across projects.
Accumulate direct costs by contract, tracking each dollar to the project that generated it.
Group indirect costs into pools with clearly defined allocation bases for distributing them to the contracts they benefit.
Report costs by contract line item where the contract requires that level of granularity.
Flag and exclude unallowable costs from anything billed to the government.⁵

Failing SF 1408 means no cost-type contract award. For contractors already holding these contracts, a later determination that the accounting system has become inadequate under DFARS 252.242-7006 lets the contracting officer withhold payments until the deficiencies are fixed.³

Allowable and Unallowable Costs

Federal Acquisition Regulation Part 31 is the rulebook for which costs the government will reimburse.⁶ To be allowable, a cost must be reasonable in amount, allocable to the contract, consistent with generally accepted accounting principles, and compliant with the terms of the agreement.

Some categories are flatly unallowable regardless of circumstance. Entertainment, alcoholic beverages, and fines or penalties from legal violations are the most commonly cited. Others trip contractors up less obviously: donations, lobbying expenses, first-class airfare, and certain advertising costs are also off-limits.

Executive compensation carries its own cap. Employee compensation charged to government contracts cannot exceed a benchmark set annually by the Office of Federal Procurement Policy, with the statutory baseline for defense contracts established under 10 USC 3744 and adjusted using the Bureau of Labor Statistics Employment Cost Index.⁷ You can pay executives whatever your board approves, but any amount above the benchmark is unallowable.⁸ The Secretary of Defense can grant narrow exceptions for science, technology, engineering, cybersecurity, and medical positions.

Identifying unallowable costs on paper is not enough. You have to segregate them in the general ledger with dedicated accounts, so those costs never feed into a government invoice. Auditors test this by pulling invoices and tracing line items back to your ledger. If an unallowable cost sits in an account that flows into government billing, you have a finding whether or not it reached a claim.

Timekeeping

Labor is the most scrutinized cost category in government contract auditing, for a simple reason. Material purchases and subcontractor invoices leave external receipts. Labor hours don’t. The only evidence that an employee worked eight hours on Contract A rather than Contract B is the timesheet, which makes your timekeeping system the foundation of everything else.

DCAA expects employees to record time contemporaneously, as work happens, not reconstructed later from memory or project schedules. Each entry should specify the contract, project number, or cost objective. Supervisors must review and approve timesheets. Any correction needs a documented audit trail showing who changed what and when.⁹ The DCAA manual is emphatic that management’s most important responsibility is making employees understand they are personally accountable for accurate charges.

Uncompensated Overtime

When salaried employees exempt from overtime laws work more than 40 hours in a week, the extra hours create an accounting adjustment many contractors miss. You calculate an adjusted hourly rate by dividing the weekly salary by total hours actually worked, uncompensated hours included, and use that lower effective rate for all proposed hours.¹⁰ Proposals must separately identify regular and uncompensated overtime hours by labor category, and the practices used to estimate those hours must match the practices used to record them.

Floor Checks

DCAA auditors conduct unannounced floor checks. They show up at your work site to verify that employees are physically present and working on the projects their timesheets say they’re working on. Auditors compare observations against timekeeping records, interview employees about labor charging procedures, and check whether the system is used daily rather than backfilled at the end of a pay period. For remote arrangements, virtual floor checks require that employees be reachable for interviews and supervisors be able to verify time records on demand.

Indirect Cost Pools and Allocation

Most government contractors carry substantial indirect costs: rent, utilities, management salaries, IT infrastructure. Federal rules require these to be grouped into pools and allocated to contracts using a method that reflects the relative benefit each contract receives.

A common structure has three pools. Fringe benefits (health insurance, payroll taxes, paid leave) typically allocates based on direct labor dollars. Overhead (facility costs, equipment, direct supervision) often uses direct labor hours or dollars. General and administrative expense (executive management, accounting, legal, human resources) usually allocates across total cost input or value-added cost input. Which method you pick matters less than applying it consistently. Switching allocation bases between periods or contracts without a disclosed change is exactly the inconsistency that produces audit findings.

The Annual Incurred Cost Submission

Every contractor holding a cost-reimbursement contract must submit a final indirect cost rate proposal within six months after the end of each fiscal year. For calendar-year contractors, that deadline is June 30.¹¹ Extensions are available only under exceptional circumstances and require a written request to the contracting officer before the deadline passes.

DCAA provides an Incurred Cost Electronically model with standardized schedules for the submission. Which schedules apply depends on your size, accounting complexity, and contract types. At minimum, the submission must include enough supporting data for the auditor to evaluate your proposed final indirect rates, reconcile them to your financial statements, and verify that unallowable costs were excluded. DCAA publishes an adequacy checklist auditors use to decide whether the submission is complete enough to accept.¹² Submissions that fail adequacy get returned, and you lose time in the queue.

Once DCAA accepts a submission as adequate, federal law requires the agency to complete its audit and issue findings within one year.¹³ If DCAA misses that window, the audit is deemed complete and no further audit work can be performed unless the Under Secretary of Defense (Comptroller) grants a case-by-case waiver.

The Audits You Will Face

DCAA conducts several distinct audits, each tied to a different phase of the contract lifecycle:

Pre-award survey, which evaluates whether your accounting system meets the SF 1408 criteria before a cost-type contract is awarded.
Forward pricing audit, which tests whether the labor rates, overhead rates, and material estimates in your proposal are supported by historical data and reasonable assumptions.
Incurred cost audit, which reviews the actual costs you billed against what your records support after the work is performed. This is the audit tied to the annual submission and the one-year completion clock.
Accounting system audit, a deeper review of your internal controls, triggered by a new contract requirement or by deficiencies flagged in other audits. A negative finding here can lead to system disapproval and payment withholding under DFARS 252.242-7006.³
Floor checks, the unannounced timekeeping verifications described above.

The audit report doesn’t decide your fate on its own. It goes to the contracting officer, who makes the final call on questioned costs, system adequacy, and corrective actions. Contracting officers lean heavily on DCAA’s findings, though, so a report full of questioned costs puts you in a difficult negotiating position.

What Non-Compliance Costs You

The penalty structure runs on a sliding scale.

An inadequate incurred cost submission gets returned, delaying final rate settlement and keeping your billing rates provisional for years. Provisional rates mean the government holds back a portion of each payment as a buffer against future adjustments, tying up cash you have already earned.

A formal determination that your accounting system is inadequate triggers payment withholding under the Contractor Business Systems clause until the deficiencies are corrected.³ For smaller contractors, this cash flow disruption alone can threaten the business.

Including expressly unallowable costs in an incurred cost proposal triggers a penalty equal to the disallowed amount allocated to the contract, plus interest at rates set by the Secretary of the Treasury. If the cost was previously determined unallowable for your company in an earlier audit, the penalty doubles.¹⁴ Paying the penalty does not erase the underlying obligation to reimburse the government for the overpayment.

Knowingly submitting a false claim invokes the False Claims Act. The statute imposes civil penalties of not less than $5,000 and not more than $10,000 per violation as written, but inflation adjustments have pushed the current range to $14,308 through $28,619 per false claim as of 2025.¹ On top of the per-violation penalty, the government can recover three times the damages it sustained.¹⁵ Each invoice counts as a separate violation. A contractor with 50 invoices containing unallowable costs is looking at 50 penalties, not one. Contractors facing False Claims Act liability also risk suspension or debarment from future government work.

Cost Accounting Standards for Larger Contractors

Beyond the baseline rules, larger contractors face an additional layer called Cost Accounting Standards. CAS governs how you measure costs, assign them to time periods, and allocate them to government contracts. The two foundational standards are CAS 401, requiring consistency between how you estimate costs in proposals and how you record them, and CAS 402, requiring that costs incurred for the same purpose are always allocated the same way.

Whether CAS applies depends on the size of your contracts. Contracts below the CAS applicability threshold are exempt. Contracts above approximately $2.5 million but below $50 million generally fall under modified CAS coverage, which requires CAS 401 and CAS 402 plus disclosure of your accounting practices.¹⁶ Once a contractor receives $50 million or more in CAS-covered contracts, full CAS coverage brings all 19 standards into play. Consistency is the theme across every standard: whatever practices you set up, apply them the same way across all contracts, every time.

1
Federal Register. Civil Monetary Penalties Inflation Adjustments for 2025
2
Acquisition.GOV. 48 CFR 16.301-3 – Limitations
3
Acquisition.GOV. DFARS 252.242-7006 Accounting System Administration
4
U.S. General Services Administration. Pre-Award Survey of Prospective Contractor (Accounting System)
5
U.S. General Services Administration. Standard Form 1408 – Preaward Survey of Prospective Contractor (Accounting System)
6
Acquisition.GOV. FAR Part 31 – Contract Cost Principles and Procedures
7
Office of the Law Revision Counsel. 10 USC 3744
8
Acquisition.GOV. FAR 31.205-6 – Compensation for Personal Services
9
Defense Contract Audit Agency. DCAAM 7641.90 – Information for Contractors
10
Acquisition.GOV. FAR 52.237-10 – Identification of Uncompensated Overtime
11
Acquisition.GOV. FAR 52.216-7 – Allowable Cost and Payment
12
Defense Contract Audit Agency. Incurred Cost Submission Adequacy Checklist
13
Office of the Law Revision Counsel. 10 USC 3842
14
Acquisition.GOV. FAR 52.242-3 – Penalties for Unallowable Costs
15
Office of the Law Revision Counsel. 31 USC 3729 – False Claims
16
Acquisition.GOV. FAR Part 30 – Cost Accounting Standards Administration