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So, you won a government contract! Congratulations! However, you may find yourself wondering what comes next? After winning the contract, it is highly likely that a torrent of thoughts will flood your mind. Hopefully, while preparing your proposal, you did some pre-planning so you could act quickly upon hearing the government agency’s decision. Perhaps you arranged project teams, put together lists of possible subcontractors, or even prepared bids for materials necessary for the contract. However, there are several concerns that warrant careful attention, particularly related to the internal controls of your business. Considering that Defense Contract Audit Agency (DCAA) compliance is critical, it is worthwhile to take a moment and examine this in detail.

A primary concern of a new government contractor is, “will my current accounting system be adequate?” If you pose this question to software vendors who sell packaged accounting systems that claim to be all inclusive, odds are that you will hear that your system is broken, unusable, or not allowed under the rules of DCAA. The truth is – most of the time, these claims are simply not true.

If you are a small to mid-size business, you don’t have to spend thousands of dollars implementing a new accounting system to be DCAA compliant. Most of the time, you can configure your existing system. If you are using QuickBooks, which is one of the most common accounting systems, there are predefined steps that will allow you to maintain your current system and records. The truth is, compliance has more to do with the way you configure a system than with the system itself.

Let’s take a look at some of the basic government requirements so you can understand more about accounting systems and DCAA compliance:

Who is the DCAA?

When you work for the federal government, you are subject to the overview of the DCAA. This agency’s job is to evaluate contractors’ financial policies, procedures, and internal controls. Ultimately, they are responsible for performing audits that can identify opportunities for contractors to minimize, eliminate, or avoid costs.

Contract Types

The extent of the DCAA’s involvement is determined by the type of contract that will be awarded. The three types of contract are Fixed Price, Cost Reimbursable, and Time and Materials. The basic characteristics of the contracts are as follows:

  • Fixed Price: As the name suggests, these contracts provide a fixed price that will be paid to the contractor regardless of the costs associated with the completion of the project. In very specific, appropriate cases, this price may be adjusted, but in general, what you see is what you get.
  • Cost Reimbursable: In cost reimbursable contracts, the government agency will provide for the payment of allowable costs, up to a prescribed amount specified in the initial contract. An initial estimate is provided to the government so that they can obligate and appropriate quantity of funds.
  • Time and Materials: Time and materials contracts provide for the payment of direct labor paid at specified rates and materials paid at cost. These contracts will always include a ceiling price for expenditures.

Direct Versus Indirect Costs

A significant portion of accounting for government contracts is the classification of costs, commercial and government, as either direct or indirect. In addition, all costs need to be assigned to a “final cost objective.” Generally, a final cost objective is a contract. Accordingly, costs of a contract are comprised of direct costs and the contract’s allocable share of indirect costs. Costs that are identified specifically with a contract are direct costs of the contract and need to be charged directly to the contract. Contractors need to spend some time and effort identifying exactly which costs are direct, because what remains is, by default, indirect.

Certain costs are unallowable and must be separated in an accounting system. These costs include such things as alcohol, entertainment, interest expense, bad debts, advertising, lobbying costs, patent expenses, and more. Obviously, it is important to check to see if any of your costs fall under this category.


The government has no desire to pay for other commercial contract costs in addition to their own costs. To that end, no final cost objective can have a direct cost allocated to it if other costs were incurred for the same purpose in like circumstances. No direct costs can be included in any indirect cost pool or be allocated to that or any other final cost objective. For example, if a commercial contract has overrun costs, they cannot be charged to the indirect pool because the government would then pay for a portion of what should have been a direct cost of the commercial contract.

You may not have two sets of books and/or accounting practices for your government business and your commercial business. If you have a government contract, then your entire system across your company must use the same processes. If, for instance, you have a single government contract then your entire business must use an approved timekeeping system that every employee uses consistently, even if the majority of employees do not work on the contract. This regulation is in place because every business has overhead expenses, and because the government will pick up its share of the overhead, the entire organization must be compliant.

Indirect Rates

Indirect costs must be classified and grouped together into indirect cost pools: either an overhead cost pool or the general and administrative (G&A) cost pool. The pools are then allocated to final cost objectives using an indirect cost allocation base that best links the cost pool to the cost objectives.

To allocate means to distribute overhead pool costs to contracts. In order to distribute indirect costs, the contractor must select an allocation base. There must be a relationship between the selected allocation base and the pool of costs to be allocated to contracts. For example, an engineering overhead pool would logically be allocated over total engineering direct labor dollars or engineering direct labor hours.

Accounting Systems Requirements

Now that you know some of the criteria and terminology for government contracting accountability, let’s take a look at how to configure your existing QuickBooks accounting system for compliance. Numerous other companies have used QuickBooks to pass DCAA audits and continue to use it even as they have grown.

Project Accounting

You must set up your system for Project Accounting, which QuickBooks provides for. All final cost objectives, or contracts, must be tracked on a per-project basis. Any direct cost transactions will require entering a general ledger account (separating direct costs from indirect) plus a customer job. QuickBooks will be able to track customer jobs, tasks, sub-tasks, etc. to whatever level is necessary.

Chart of Accounts

You will need to revamp your Chart of Accounts. There will be two major expense components: Direct and Indirect. Direct Costs are generally further broken down for Direct Labor, Direct Subcontracts, Direct Travel, Direct Materials, and Other Direct Costs. Indirect Costs are broken into logical categories that will support your indirect rate calculations. It is imperative that you have a separate series of accounts for all Unallowable Costs. Each type of unallowable cost should have its own general ledger account.

The indirect cost accounts must then be broken into pools, such as Fringe Benefit Pool, Overhead Pool, and G&A Pool. Under each pool, there are separate accounts that further logically group expenses into categories like Facility Costs, Equipment Costs, etc. Within each of those categories, specific accounts should be set up for things like Rent, Utilities, Property Taxes, etc.

Timekeeping and Labor Distribution

Here is where specific DCAA approval is extremely important. While the DCAA doesn’t require any particular software, it does have certain criteria that a timekeeping system must meet in order to be DCAA compliant. Because QuickBooks doesn’t offer a built-in, compliant time-tracking system, it is necessary to use an external system that integrates well with QuickBooks and has all controls required for DCAA approval.

Following are the requirements for a DCAA-compliant timekeeping system. Keep in mind, the employee must input his or her own time. Managers cannot fill out or change an employee timesheet. Employees must:

  • Record time on a daily basis
  • Provide, in writing, an explanation for any change to a prior day’s time records and approve those changes
  • Enter the correct distribution of time by project numbers, contract number or name, or other identifiers for a particular assignment. To ensure accuracy, a listing of project numbers and their descriptions should be made in writing to the employee
  • Record all hours worked, paid or unpaid
  • Sign the timecard at the end of each work period and have the supervisor approve the time

It is important, particularly when evaluating third-party timekeeping solutions, to make sure that all of these systems are in place, and preferably automated. Usually it is best to give the vendor a call and have them talk you through each of these steps personally. The best vendors will be happy to give you a live demo and answer any questions you may have.

Accounting Manual

One of the initial audits that the DCAA performs is the Accounting Systems Review. The pre-award accounting system survey is an audit to determine the acceptability of a contractor’s accounting system for accumulating costs under a prospective government contract. An accounting manual that documents the policies and procedures of the contractor is also required.

Purchasing Systems

The DCAA may audit your Purchasing System. QuickBooks has a good purchasing module that can handle any purchases, not just inventory. Each approved vendor or subcontract purchase should be entered as a Purchase Order against specific contracts. The accounting department would then process vendor invoices against approved purchase orders.

Government Property

You must track all government property separately. Government property is defined as any piece of equipment that is charged as a direct cost on a government contract. The QuickBooks fixed asset module is recommended to separately track all assets purchased under a government contract, as all as indirect assets to automate the depreciation calculations for book and tax purposes.

Changes to the Chart of Accounts

You should take your existing QuickBooks file and simply add a new profit and loss account structure. You can then inactivate your old structure while retaining historical data. As soon as you have won the government contract, you will need to start accumulating costs under the new structure. It is much easier to have the system reconfigured and in use before you win the contract.

Customers/Projects/Work Breakdown Structure

For companies that don’t already use Project Accounting, typically the customer master file only track billings to customers. To support project accounting, the master file will now be a list of billable contracts. We recommend that you use the customer for the billing level of the contract. For example, you may have 10 contracts with the Air Force, and each contract will be a customer record.

Revenues, billings, and costs will be tracked by these project/contract master file records going forward. Accounts payable transactions, timesheet transactions, revenue entries, and customer invoices will all have a general ledger account and a customer/job. Only indirect accounts don’t require project numbers (except for bid and proposal, and independent research and development). However, many companies track indirect costs by projects (especially labor costs) to allow greater visibility and management of indirect activities.

Payroll Classes and Service Items

Payroll items are an important link between the timesheet system and the QuickBooks system. The payroll item determines what general ledger account the timesheets and labor distribution will be posted to.

Payroll classes are often used for Labor Classifications, such as Engineer, Research Analyst, etc. They can also be used to assign employees to internal departments.

Service items are used to automate billing and to determine what revenue general ledger account the invoices are posted to. You can set up unique service items that assign billing rates to individuals and jobs.

Separate Timekeeping from Payroll

Because in QuickBooks the payroll process is what distributes labor dollars to projects, based on timesheet hours, the payroll function should be separate from your main QuickBooks file. The payroll file will house all your payroll deductions and direct deposit information. The main QuickBooks file will handle labor distribution, project accounting, and general ledger accounting.

Job Cost Reports

QuickBooks has an extensive collection of project reports. You can download reports into Microsoft Excel and email them to project managers on a weekly basis.

Billing in QuickBooks

QuickBooks can easily automate Time and Material, and Fixed Price invoices. By properly setting up service items, you can import timesheet hours directly to your customer invoice along with the “billing rates” category. You can also create custom templates and email invoices to customers.

Upgrade to Enterprise

If you have non-accounting staff entering information into QuickBooks, it is a wise decision to upgrade to their enterprise level of software. QuickBooks Enterprise supports 25 concurrent users, as opposed to the Premiere version which only accommodates five users. There are also more user security options in Enterprise. Even if you are a small company, the upgrade can be worth it for the increase in performance and security.

Closing Thoughts

There are numerous add-ons for QuickBooks, and an equal number of software solutions that claim to surpass it in ability. However, QuickBooks will usually prove flexible enough to meet the task at hand, especially when integrated with strategic timekeeping software that will unlock the full potential of QuickBooks as a DCAA-compliant system. It is possible to waste a good deal of money and time trying to refine a system that is perfectly good. Avoid “shelfware” and spend your energy on the right things, such as completing the contract and maintaining compliance. As the old adage goes, if it ain’t broke, don’t fix it.

By Sarah Glass, President, AimSourcing and Curt Finch, CEO, Journyx

About the Authors:

Sarah Glass is the President and CEO of AimSourcing, a group of highly skilled accounting, finance, and information systems professionals, with over 25 years experience implementing business systems and managing large-scale administrative operations for international companies. Sarah has a BBA and Masters Degree in Accounting from the University of Texas at Austin and is a licensed CPA in Texas.

Curt Finch is the CEO of Journyx. Journyx helps customers automate payroll, billing and cost accounting for compliance with DCAA and other government regulations. Founded in 1996, Journyx has been providing time management solutions to government contractors for nearly 15 years.