Last reviewed on May 12, 2026.
What DCAA does and why it matters
The Defense Contract Audit Agency (DCAA) provides audit and financial advisory services to DoD components and other federal agencies on negotiated contracts. DCAA reviews contractor accounting systems, audits incurred costs, evaluates forward pricing proposals, and assesses business systems. "DCAA-compliant accounting" is shorthand for an accounting system that DCAA has reviewed (or could review) and found adequate to support government contract billing and pricing.
An accounting system review matters most for contracts that are not firm-fixed-price. Cost-reimbursement contracts, time-and-materials contracts, and most progress payments on fixed-price work all depend on the contractor's accounting system to determine what gets paid and when. Solicitations for these contract types frequently require — or strongly prefer — bidders with an approved accounting system. For the broader system framework that includes the accounting system plus five others, see DFARS business systems. For the underlying contract types this work supports, see federal contract types.
The SF1408: what reviewers check
The standard accounting system review uses SF Form 1408, "Preaward Survey of Prospective Contractor Accounting System." The form asks whether the system meets specific criteria. The criteria can be grouped into seven capabilities:
- Proper segregation of direct from indirect costs. The system must separately accumulate direct contract costs and indirect costs. A small business that books everything to a single "expenses" account does not meet this requirement.
- Direct cost identification by contract. Each direct cost must be attributed to the specific contract it supports — through cost center codes, project codes, or equivalent.
- Indirect cost pools and allocation bases. The system must accumulate indirect costs in homogeneous pools and allocate them to contracts using a logical, consistent base.
- Accumulation of costs under general ledger control. Costs charged to contracts must reconcile to the general ledger. Spreadsheet-based job costing that doesn't tie to the books fails this test.
- Timekeeping that identifies labor by intermediate or final cost objective. Time must be recorded by employee by day by project. Weekly summary timesheets without daily detail are inadequate.
- Labor distribution charging actual costs to cost objectives. Hours recorded must flow through payroll and into the cost ledger at actual labor rates.
- Interim determination of costs charged to contracts. The contractor must be able to determine, at month-end or more frequently, how much has been incurred on each contract.
SF1408 also asks about exclusion of unallowable costs (FAR Part 31), pre-contract cost identification, and management approvals for cost transfers. Each of these criteria is binary in the review — adequate or not — but the cumulative judgment is a holistic "system is adequate" or "not adequate" determination.
Direct versus indirect: the conceptual core
The hardest part of building a compliant system for new contractors is internalizing the direct/indirect distinction. A few rules of thumb:
- Direct costs are costs identified specifically with one contract or final cost objective. The labor hours an engineer spent on a specific deliverable, the equipment purchased specifically for a project, the travel that supported one customer visit.
- Indirect costs are costs that benefit more than one cost objective and cannot be specifically identified with one. Office rent, the CFO's salary, general liability insurance, software licenses used across all projects.
- Unallowable costs are costs the government will not pay for under FAR Part 31. Examples: bad debts, certain types of advertising, lobbying, alcohol, entertainment, fines and penalties. These must be tracked and excluded from anything billed to or used to price a government contract.
The mistake most new contractors make is being inconsistent. A cost that is treated as direct on one contract should not be treated as indirect on another unless there is a specific, documented reason. Inconsistency is the single most common audit finding.
Indirect rate structure: the standard pools
Most government contractors organize indirect costs into three pools:
- Fringe pool. Costs that vary with labor — payroll taxes, health insurance, paid time off, retirement contributions. The base is usually total labor dollars (direct plus indirect). The resulting fringe rate is applied on top of every labor dollar in the system.
- Overhead pool. Costs that support production but cannot be tied to a single contract — supervision, production tools, facilities used for direct work, project management overhead. The base is usually direct labor plus fringe.
- G&A (general and administrative) pool. Costs that support the company as a whole — executive salaries, finance and HR, legal, general office. The base is usually total cost input (direct costs plus overhead-burdened labor) or, occasionally, value-added cost input.
Larger contractors sometimes split overhead into multiple pools (engineering overhead, manufacturing overhead, site overhead) or add a material handling rate when material is a significant cost element. The structure should match how the business actually operates — not a generic template.
For the math on how rates stack into a fully burdened labor rate, see the wrap rate calculator and pricing strategies. For the structural design choices behind rate pools — including when to split overhead into multiple pools and how allocation base choice affects competitiveness — see indirect rate structures.
Timekeeping: where most small contractors fail
Timekeeping is the area where DCAA reviewers find the most deficiencies during pre-award reviews and floor checks. The expectations:
- Daily entry. Employees record time at least daily, not at week's end from memory.
- Specific charge codes. Every hour is charged to a specific project code or indirect activity code. "General work" or "miscellaneous" charge codes are not acceptable.
- Employee responsibility. Each employee enters their own time. Supervisors do not record subordinates' hours. Time entered by anyone other than the employee must be specifically reviewed and approved.
- Supervisor approval. Timesheets are approved by a supervisor who has visibility into the work being performed.
- Audit trail. Changes to time entries are logged with the original entry, the change, who made the change, and when.
- Floor checks. DCAA may conduct unannounced floor checks comparing employees actually present to time being charged for that day. Phantom employees and ghost charges surface here.
Off-the-shelf time systems (Deltek, Unanet, JAMIS, QuickBooks Time with proper configuration) handle most of these requirements out of the box. Paper or spreadsheet-based timekeeping can be made compliant but takes more administrative discipline.
Worked example: how a labor hour becomes a billed dollar
Consider a $50/hour direct labor employee who spends 8 hours on Contract A on a particular Tuesday. The cost flow:
- Time entered. Employee charges 8 hours to Contract A's project code.
- Direct labor cost. $50/hr × 8 hours = $400 in direct labor charged to Contract A.
- Fringe applied. If the fringe rate is 30%, fringe of $120 is applied. Contract A now carries $520 in direct labor and fringe.
- Overhead applied. If the overhead rate is 50% on labor + fringe, overhead of $260 is applied. Contract A now carries $780.
- G&A applied. If the G&A rate is 10% on total cost input, G&A of $78 is applied. Contract A now carries $858 in fully burdened cost for that day's work.
- Fee or profit added. On a fixed-price contract, the profit is built into the price; on a cost-plus contract, the fee is calculated under the contract's fee structure.
For this flow to work without an audit finding: the $50/hr must come from payroll, not an estimated rate; the 8 hours must be recorded by the employee on the day worked; the project code must map to Contract A in the general ledger; and the rates applied must be the rates approved (or the rates the contractor proposes to use, subject to year-end true-up).
Provisional rates, billing rates, and final rates
Contractors with cost-reimbursement work negotiate indirect rates with the government on three different bases:
- Forward pricing rates — projected rates used to price future proposals.
- Provisional billing rates — rates used to invoice during the current year. These are usually based on the current budget; the contracting officer or DCAA can challenge them if they look unrealistic.
- Final rates — actual rates calculated from year-end actuals once the books are closed. The contractor submits an incurred cost proposal (often called an "ICE submission" after the Incurred Cost Electronically template) reconciling actual rates to billed rates.
The reconciliation matters: if actual rates were lower than billing rates, the contractor owes the government a refund. If actual rates were higher (and within negotiated ceilings), the contractor may bill the difference. Either way, the calculation depends on the accounting system producing defensible numbers.
Audit types and what triggers them
- Pre-award accounting system review. Triggered by a cost-reimbursement or T&M solicitation. Uses SF1408. Output is an adequate/inadequate determination that informs the contracting officer's source selection decision.
- Incurred cost audit. Annual review of submitted incurred cost proposals. May be selective sampling for small contractors and detailed for larger ones.
- Forward pricing rate audit. Review of the contractor's projected rates for use in proposal pricing. Common for contractors with significant negotiated work.
- Floor check. Unannounced timekeeping verification at the contractor's site.
- Business system audit. For contractors with DFARS business system clauses (DFARS 252.242-7006 and related), a broader review of the accounting system as one of six required business systems.
- Proposal audit. Cost or pricing data review on specific proposals over certain thresholds.
- Defective pricing audit. Post-award review of whether the certified cost or pricing data submitted at award was current, accurate, and complete.
Common audit findings and how to avoid them
- Unallowable costs in indirect pools. Bad debts, lobbying, alcohol, and certain advertising not screened out before pool allocation. Add an "unallowable" cost classification in the chart of accounts and screen at month-end.
- Inconsistent direct/indirect treatment. The same type of cost treated as direct on one contract and indirect on another. Document the policy and apply it across the portfolio.
- Personal use of company resources buried in overhead. Personal travel, executive perks, family member salaries without justification — all common findings. Maintain clear policies and document business purpose.
- Inadequate timekeeping documentation. Missing daily entries, supervisor approvals, or audit trails on time changes.
- Cost transfers without documentation. Moving costs from one project to another at month-end without written justification and approval.
- Allocation base manipulation. Choosing a base that makes a particular contract carry more or less indirect cost than its actual benefit warrants.
- Late incurred cost proposals. ICE submissions are due six months after fiscal year end. Repeated late submissions trigger compliance scrutiny.
Decision framework: do you need DCAA-compliant accounting now?
- Are you bidding cost-reimbursement, T&M, or labor-hour work? If yes, you almost certainly need it.
- Are you bidding firm-fixed-price work below $2 million? Probably not yet — basic books with clean direct/indirect segregation may be enough.
- Are you a sub on a cost-type prime contract? You will need to support the prime's audit requirements, which means your system has to produce auditable data.
- Do you anticipate growth into negotiated work in the next 12–24 months? Build the system now — retroactive cleanup is more expensive than starting compliant.
- Is a specific contract opportunity gated on an "adequate" accounting system finding? Engage a consultant or your accounting software vendor early; the SF1408 review process takes weeks at minimum.