The Audit That Comes Years Later: DCAA, Incurred Costs, and the Unallowable-Cost Trap

Published 2026 | TIKC NewsWire

On a firm-fixed-price contract, your price is your price. But the moment you take cost-reimbursement or time-and-materials work, you invite the government to look inside your books, and it can do so years after you invoiced. The reviewer is the Defense Contract Audit Agency (DCAA), and the concept that trips up more small contractors than any other is the unallowable cost. Charge one and the government wants its money back. Charge one you knew was off limits and penalties, or worse, can follow.

What DCAA actually reviews

Contractors performing cost-type work generally submit an annual incurred cost proposal (often called the incurred cost submission) that reconciles what they billed to what they actually spent. DCAA tests those costs for three things: are they allowable under FAR Part 31, are they allocable to the contract, and are they reasonable. It also examines your accounting system, your indirect rates, and your compliance with contract terms. If billed costs exceed what the rules allow, you owe the difference back.

The unallowable-cost trap (FAR Part 31)

FAR Part 31 lists categories of cost the government simply will not pay for, even if they are legitimate business expenses. Common examples include entertainment, alcohol, most advertising and public relations, lobbying, bad debts, interest on borrowing, certain travel above federal per diem, contributions and donations, and fines and penalties. The point that surprises people: a cost can be perfectly normal for your business and still be unallowable to charge to the government. Your job is to identify those costs and keep them out of your billings and your indirect rate pools.

Expressly unallowable costs carry penalties

There is a sharper edge here. Certain costs are expressly unallowable, meaning a specific rule names them as unallowable. If you include an expressly unallowable cost in a proposal or billing, the government can assess a penalty on top of recovering the cost, and if you did it knowingly, you drift toward False Claims Act exposure. This is why a clean process for screening and segregating unallowable costs is not bookkeeping hygiene. It is legal protection.

What to do now

• Build an unallowable-cost screen into your accounting. Flag and segregate entertainment, alcohol, lobbying, penalties, and the rest so they never touch a government billing or an indirect pool.
• Keep your timekeeping and indirect rates clean. DCAA reviews how you allocate overhead and G&A, so your rate structure needs to be documented and consistent.
• File your incurred cost submission on time and keep the supporting records. Late or unsupported submissions invite scrutiny.
• Get help before your first cost-type award, not after. An accounting system that passes DCAA review is a prerequisite, not an afterthought.

Cost-type work can be a growth engine, but it comes with an open-book promise the government can call in years later. Keep the books clean the whole time and the audit is a formality instead of a crisis. Brick by brick.

FAQ

Does DCAA audit fixed-price contracts?

Generally the deep cost review applies to cost-reimbursement and time-and-materials work, where you bill actual costs. Firm-fixed-price contracts are far less exposed to incurred-cost auditing, though other reviews can still apply.

What is the difference between unallowable and expressly unallowable?

An unallowable cost is one the government will not reimburse. An expressly unallowable cost is one a specific rule names as unallowable, and including it can trigger a penalty in addition to repayment.

How far back can DCAA look?

Incurred cost reviews often happen well after the year in question, so records from several years back can be examined. Keep your cost documentation for the full retention period.

Do I need a special accounting system?

For cost-type work you generally need an accounting system that can segregate direct and indirect costs, exclude unallowable costs, and track costs by contract. Confirm adequacy before you take on cost-reimbursement awards.

Sources

Defense Contract Audit Agency. (2026). Information for contractors and incurred cost audit guidance.

Federal Acquisition Regulation. (2026). Part 31, Contract cost principles and procedures; 42.709, Penalties for unallowable costs.

This article is general information, not legal advice.