Any audit can be cause for anxiety. Being familiar with the various types of audits that may be conducted, however, will help a contractor be prepared. When an audit is to occur, a contractor should: (1) be aware of why the audit is a requirement, (2) understand what the auditor will be looking for, and (3) request an entrance and exit conference with the auditor to avoid any misunderstandings.


An accounting system review typically occurs when the government contract auditor makes his or her first review of an accounting system to determine whether that sys­tem is adequate for accumulating costs under cost-type contracts, for determining progress payments under fixed-price contracts, and for estimating future costs on new contracts. Tin's review tends to be quite difficult for smaller companies that are facing it for the first time.

It is essential to the success of the accounting system review that the contractor have an accounting policy and procedures manual. The disadvantages of not having written policies are twofold. First, when the auditor begins an accounting system review, he or she wants to see what the contractor's ground rules are for cost accounting. The auditor will test the accounting system to determine whether the company's practices are what the written procedures require. If the company does not have these procedures clearly documented, the auditor will have to review a myriad of detailed accounting records to determine what the procedures actually are. The second disadvantage of not having clearly written procedures is that a company runs the risk of not having consistent practices for booking costs. If an accounting practice is in writing, it will provide more consistency to the company's internal operations for charging costs.

The accounting for unallowable costs should also be explained clearly in the accounting procedures because when auditors make their review, they want to see such segregations. If the written procedures do not have separate classifications for what are clearly unallowable costs, government auditors might perform an account-by-account analysis and remove any unallowable costs that might have inadvertently been included in another type of account.

The internal controls of an accounting system are also quite important. The government auditor looks for different internal controls than do most external auditors. For example, the government auditor will look for an assurance that the accounting system has detailed written procedures and works effectively in practice; that is, that the costs (both direct and indirect) charged against the individual contracts are valid as charges against those contracts. The government is concerned that the direct costs by contract are proper because different government agencies buy under different contracts, us­ing many different contract types. Similarly, contracts can share differently in indirect costs from the various pools. As a result, if the indirect costs are not charged to the proper pool, the charges against the contracts may be distorted.

An adequate accounting system for tracking costs and providing vital financial information to management is not only important, but is required for the performance of government contracts. An accounting system represents a combination of records, internal controls, and written policies and procedures that function together in the process of accumulating and reporting financial data. During the performance of government contracts, the contractor is required to develop its accounting systems in a manner consistent with generally accepted accounting principles (GAAP). However, government regulations, particularly FAR Part 31 and the CAS, play a significant role in the tailoring of a contractor's accounting system.

Typically, an adequate accounting system for the accumulation of costs under government contracts has to include; (1) segregation of costs by contract and by contract line Item; (2) data at Interim periods to allow for contract repricing or negotiating revised contract targets; (3) accounting for specific unallowable costs as established in FAR Subpart 31.2; (4) separation of preproduction costs from production costs; and (5) reliable data for purposes of pricing follow-on procurements.


The types of books and records used in an accounting system are based on what is most suitable for a contractor's business. The objective is to provide accounting and financial data that are adequate for government contract costing purposes. At the very least, the basic record keeping system must provide visibility of contract costs at a sufficiently detailed level so that costs can be determined at interim levels for purposes of repricing, negotiating revised targets, and determining billings. The use and design of certain specific accounting records will vary from contractor to contractor; however, a standard requirement for essentially all companies involved in government contracts is that their books and records include a general ledger, job cost ledger, labor distribution, time records, subsidiary journals, chart of accounts, and financial statements.

Several key factors are essential to the adequacy of any basic record keeping system: (1) segregation of direct costs by contract or job, and indirect costs by account and title; (2) accumulation of costs on a current and cumulative basis; (3) periodic reconciliation of time sheets to labor costs included in job cost ledgers and basic cost records to the general books of account; (4) posting of costs to the books on a current basis; and (5) separation of unallowable costs in the regular books of account or by means of any less formal cost accounting technique that establishes and maintains adequate cost Identification.


Good internal controls—established in written policies and procedures and followed by management—are the backbone of any accounting system. The government regulations do not prescribe specific internal control procedures; however, the CAS require the establishment and use of written procedures for several areas of cost accumulation and allocation, including depreciation, capitalization of tangible assets, accounting for acquisition of material costs, and allocation of direct and indirect costs. In addition, government auditors will be evalu­ating the strengths and weaknesses of contractor internal control systems in determining the overall adequacy of the contractor's accounting system. If they find significant deficiencies, the auditors will qualify their audit reports submitted to government procurement officials by citing the inadequacy of the contractor's record keeping system for government contract costing purposes.

Every good accounting system requires adequate internal controls if it is to operate in an efficient and effective manner. The following are some of the more significant positive internal control features, identified in generic form, of an acceptable accounting system for government contract costing purposes:

  1. Separation of authority between key accounting functions (e.g., payroll vs. timekeeping, requisitioning of materials and services vs. purchasing vs. accounts payable)
  2. Policies and procedures establishing the purposes and requirements of the accounting system (e.g., timekeeping, payroll, purchased services and materi­als, direct and indirect cost control, asset capitalization and utilization)
  3. Internal reviews by management to ascertain employee compliance with policies and procedures
  4. Periodic reconciliation of cost control records from the point of original entry through the cost accumulation summaries to the billing records
  5. Management authorizations of critical accounting functions and events (e.g., issuance of payroll checks, signing of timesheets, purchasing of materials and services)
  6. Budget control procedures established for comparison of actual costs to budgets and contract financial status
  7. Productivity measurement techniques used to allow management to focus on problem areas and improve overall economy and efficiency (e.g., application of work measurement techniques)
  8. Organizational charts created to define lines of authority and responsibility and to provide for division of responsibility In operating, recording, and custodial functions
  9. ln-house "hotlines" established to encourage employees to inform management of possible areas of fraud, waste, or abuse.

Excerpted from Pricing and Cost Accounting by
Darrell Oyer