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Complete Guide to FAR Audits

Complete Guide to FAR Audits

 

 

INTRODUCTION

What a FAR Audit is and why it matters?

A FAR audit refers to a financial audit performed in accordance with the Federal Acquisition Regulation (FAR). The FAR is the primary set of rules governing the acquisition process by which federal agencies purchase goods and services. When companies contract with the federal government, especially under cost-reimbursement contracts, they may be required to undergo a FAR audit to ensure compliance with federal regulations and proper use of government funds.

The main goal of a FAR audit is to determine whether a contractor’s financial systems, cost records, and internal controls are accurate and reliable for reporting contract costs. They must also be compliant with FAR cost principles and adequately documented to support billings, incurred costs, and indirect cost allocations. A FAR audit provides federal agencies with confidence that contractors are billing only for allowable and allocable costs while ensuring  taxpayer money is spent appropriately.

Who Needs a FAR Audit?

A FAR audit is generally required for:

  • Federal Government Contractors – Especially those working under cost-reimbursable contracts, time-and-material contracts, or other agreements where payment is based on actual costs incurred.
  • Large Federal Contractors – Organizations with significant government contract activity often undergo regular Defense Contract Audit Agency (DCAA) oversight.
  • Small Businesses with Cost-Type Contracts – Even new or smaller contractors may be subject to FAR audits if their agreements involve reimbursement of costs.
  • Grant and Cooperative Agreement Recipients (in some cases) – While grants often fall under the Uniform Guidance audit requirements (2 CFR Part 200), certain agreements may still require FAR compliance depending on the funding agency and contract terms.

What Contract Types trigger FAR Audits?

The types of government contracts under the Federal Acquisition Regulation (FAR) that are most likely to trigger audits by agencies like the Defense Contract Audit Agency (DCAA) are generally those where the contractor’s costs determine the final price or payment. The contracts with the highest audit risk include:

  • Cost-Reimbursement Contracts – These are designed to pay a government contractor for allowable, allocable and reasonable incurred costs, plus a profit. They trigger audits when the government is paying for the actual costs, to ensure the costs are legitimate, properly accounted for, and comply with FAR Part 31 Cost Principles and Cost Accounting Standards (CAS). Note that the audits also include incurred cost audits and provisional billing rate audits.
  • Time and Materials and Labor-Hour Contracts – This type of contract pays for direct labor hours at fixed hourly rates and the actual costs of materials. They trigger audits because these contracts require close oversight to verify the claimed labor hours, calculation of loaded hourly rates, and cost of materials. This places the burden of oversight on the government.
  • Incentive Contracts – These can either be fixed price or cost-reimbursement, offering incentives based on performance, costs, or schedule targets. Audits are often needed to verify the cost data used to determine the final incentives or price adjustments.

In contrast, the contract types least likely to trigger an audit include Firm Fixed Price Contracts because the price is set up front, and the contractor assumes all cost risk. Although there are certain exemptions to this rule.

What federal agencies oversee FAR Audits?

FAR audits are overseen by agencies responsible for ensuring that federal contracting dollars are spent appropriately and in compliance with the Federal Acquisition Regulation. The primary authority is the Defense Contract Audit Agency (DCAA), which is the agency responsible for conducting cost and compliance audits for defense contractors. The Defense Contract Management Agency (DCMA) also plays a key role by monitoring contract performance, administering contract terms, and coordinating with DCAA when financial or cost compliance concerns are identified.

Oversight extends beyond the Department of Defense when other federal agencies are involved. Offices of Inspector General (OIGs) may review contractor activities when fraud, waste, or abuse is suspected in agency-specific procurement programs. The U.S. Government Accountability Office (GAO) also provides high-level oversight of federal procurement processes and reports on systemic risks and policy compliance. Together, these agencies ensure contractors maintain accurate cost records, follow required accounting standards, and protect taxpayer funds throughout the life of a government contract.

 

KEY FAR AUDIT PRINCIPLES

Allowable vs. unallowable costs

When a company prepares its department of transportation (DOT) overhead rate submission, every dollar of allowable cost matters. An overhead rate increase of even 1% can have a significant positive impact on profitability when multiplied over an entire portfolio of DOT contracts. Performing a detailed analysis of overhead costs is, therefore, a worthwhile investment because it enables firms to identify nuanced instances of allowability. Certain allowable costs can easily be dismissed as unallowable if only a cursory overview is performed. The following are a few such examples.

Bonuses

When analyzing bonuses for allowability, the key distinguishing factor to consider is whether the payment is directly tied to the individual’s performance. Performance-based bonuses are generally allowable under the regulations, while profit-sharing bonuses must be disallowed. Establishing and documenting performance-based criteria for bonus distributions (even if the amounts being distributed are ultimately discretionary rather than strictly formula driven) can provide A/E firms with sufficient standing to include those expenses as allowable costs within their overhead rate calculations.

Bid and Proposal Costs

While most marketing expenses are disallowed under the regulations, the costs associated with bid and proposal (B&P) activities are generally permissible for inclusion in the overhead rate calculation, if they are reasonable and allocable to specific contracts. Maintaining consistent timekeeping records that clearly and specifically connect employee time to the underlying B&P activities is critical to establishing the allowability of these costs.

Legal Costs

The costs of fines and penalties are expressly disallowed under the regulations. However, there are many types of legal costs that are allowable, as well. Generally, A/E firms may treat legal expenses as allowable if the costs arose in the normal course of business and do not involve:

  1. Claims or appeals involving the government, including bid protests.
  2. Matters in which the firm was found criminally liable.
  3. Matters in which the firm was found liable for fraud or similar misconduct.

The determination of legal cost allowability is an especially nuanced topic. The key takeaway here is that legal costs should not be immediately dismissed as unallowable, as there are plenty of opportunities for allowability depending on the nature of the underlying litigation. The list above should serve as a starting point for a more thorough analysis from the firm.

Gifts to Employees

Most employee gifts are unallowable. However, there are some notable exceptions to this rule. One such exception is a gift to an employee in recognition of an achievement made pursuant to an established plan or policy. Thus, if an A/E firm has an established practice of awarding employees for achievements, such as years of service or professional licensure, it is worthwhile tracking these costs, as they will likely meet the allowability standards.

Direct vs. Indirect Costs in FAR Audits

A key focus of FAR audits is to ensure that contractors properly classify and allocate the costs charged to federal contracts. FAR regulations mandate that costs be allowable, allocable, and reasonable. In addition, they must be properly classified, which plays a major role in determining compliance.

Directs costs are those that can be directly identified with a single contract of cost objective. This may include labor hours spent on the contract, materials purchased only for the project, or travel/subcontractor costs that directly support contract deliverables. Since these are charged to the government, a FAR audit will closely review timekeeping, purchasing and labor allocating to determine accuracy and prevent overcharging.

Indirect costs are those that support multiple contracts or the overall business, rather than on a specific project. Examples include administration, salaries, rent, utilities, accounting, IT, depreciation or insurance. Since these costs are allocated through indirect cost pools (i.e. general and administrative), a FAR audit determines whether the allocation methodology is consistent and in compliance with established standards.

It is important to note that cost misclassification is one of the most common audit findings. An indirect expense improperly classified as a direct expense can inflate project costs, while the opposite can distort the contractor’s indirect rate structure. For this reason, audits do not only focus on the costs, but the policies, procedures, and internal controls used to classify and allocate costs across the organization.

 

The FAR Audit Process

The FAR audit process examines whether a contractor’s accounting system, cost structures, internal controls, and billing practices comply with Federal Acquisition Regulation (FAR) Part 31, Cost Accounting Standards (CAS) (when applicable), and any agency-specific requirements. Although audits vary slightly depending on the contract type and the requesting agency (often DCAA or DCMA), the process generally follows a structured sequence of phases supported by extensive documentation.

Planning and Risk Assessment

The audit process begins with a review of information about the contractor and assessing risks that could lead to unallowable, unreasonable, or misallocated costs. This sets the scope and objectives of the audit.

The typical documentation requested in this phase includes the organizational chart, chart of accounting, accounting policies and procedures, list of major cost pools, indirect rate structure descriptions, prior audit report, contract list with contract types, internal control documentation including segregation of duties, timekeeping and labor charging. During this phase, the audit firm evaluates whether the accounting system is capable of segregating direct/indirect costs, excluding unallowable costs, and producing reliable reporting.

Fieldwork

This is the core of a FAR audit. Auditors perform testing to determine whether the contractor’s financial systems and cost practices comply with FAR and CAS. The testing focuses on allocability, allowability, reasonableness, and consistency. Auditors will typically collect documentation in several areas including indirect costs and pools, direct costs, unallowable cost controls, billing and incurred cost reporting and internal control evidence. During this time classification accuracy will be verified, misallocation tested sample expenses collected for allowability, and confirmation that indirect rates have been applied consistently.

Analysis and Findings

After fieldwork, auditors evaluate variances, identify questioned costs, and determine whether any business systems are deficient. During this stage, the documentation reviewed usually includes corrective actions taken for system weaknesses, responses to inquiries, revised cost pool schedules or indirect rate calculations, and additional information on unsupported transactions.

The auditors will also reconcile costs to financial statements, check rate calculations, and ensure the contractor has followed proper CAS/FAR guidelines. High-risk areas—such as labor charging, subcontract management, and executive compensation—often receive deeper review.

Reporting

The auditors issue a formal audit report summarizing findings, questioned costs, system deficiencies, and recommendations. This report is often sent to the contracting officer, who uses it to negotiate final indirect rates or determine further actions.

 

Types of FAR-Related Audits

The Federal Acquisition Regulation (FAR) governs how the U.S. government acquires goods and services, and compliance often involves various types of audits, particularly for contractors seeking cost reimbursement. A list of the most common types of FAR audits are listed below.

  • Overhead Rate Audits – This is commonly referred to as a FAR audit, and it is designed to determine if a contractor’s indirect cost rate is calculated properly according to FAR Part 31. The focus of this audit is reviewing the contractor’s accounting system and internal controls, test indirect expenses for unallowable costs, test payroll and timesheets to verify the proper allocation of costs through the job cost system. The key framework used for this audit is the American Association of State Highway and Transportation Officials (AASHTO) audit guide. A FAR audit is typically required for architectural and engineering firms working on federal or state funded projects.
  • Accounting System Audit – This is a pre-award or post-award review to ensure the contractor’s financial system is suitable to support government contracts, specifically cost reimbursement contracts. The requirements are outlined in FAR 52.232-20 and the DCAA’s Audit Manual. The key areas reviewed include cost segregation, timekeeping, job costing, invoicing, unallowable costs, and systems interface. Any contractor that has an accounting system that is deemed inadequate can face contract withholding or be prohibited from bidding on certain contract types.
  • Estimating Systems Audit – This audit is triggered when a contractor submits a proposal that required Certified Cost or Pricing Data (CCPD). It ensures the methods used to forecast contract costs are reliable, accurate, and properly applied. The requirements are outlined in FAR 15.407.-5. The key areas reviewed include data reliability, consistency, documentation, reasonableness, system control, and Truth in Negotiations Act (TINA) An approved estimating system allows contractors to submit proposals with more confidence and often speeds up the government’s proposal review process.
  • Compliance Audits – These audits are designed to review adherence to the specific terms and conditions in the contracts. The key areas evaluated include contract clauses, billing/invoicing, and system integrity. A key part of these audits is determining compliance with Cost Accounting Standards which appear in 48 CFR Chapter 99. These are detailed rules that contractors must follow for measuring, assigning, and allocating costs. There are two requirements for CAS covered contractors, including consistency with the rules and completing of disclosure statement (DS-1).
  • Provisional Billing Rate Audits – This audit is designed to determine and approve a reasonable set of indirect rates which can be used to bill the government until the actual annual rates are finalized. This ensures the government is not over or underpaying during the contract. The auditor examines the reasonableness of the forecasted direct labor base and indirect cost pools, identifies whether the estimates properly exclude unallowable costs, and compares the proposed and historical ensuring estimates are realistic. These audits establish interim rates while the Overhead Rate Audit establishes the final rates.
  • Forward Pricing Audits – This audit is generally conducted by the DCAA to evaluate cost estimates used by a contract is a specific, single proposal, for a future contract or contract modification. The focus is on the reasonableness and support for the proposed costs which will be incurred in the future. The areas examined include labor, materials, indirect, and subcontractor costs. Attention is also paid to the use of systems including the estimating system. A successful Forward Pricing Audit provides the contractor with confidence in the proposed cost elements which means a faster negotiation and award process.
  • Business System Audits – The audit focuses on the contractor’s internal control environment and management systems to ensure reliability and effectiveness. They also ensure compliance with government requirements for properly tracking costs, materials, and compliance data. It is triggered by DFARS clauses 252.242.-7005 which permits payment to be withheld if a system is deemed significantly deficient. The key business systems reviewed include accounting, estimating, earned value management, material management and accounting, property management and the purchasing system. There is high risk in these audits because if the DCAA finds a significant deficiency they can not only withhold payments they can also disallow contract costs.

FAR Audit Findings: Common Issues

The most common findings uncovered during a FAR audit are related to compliance and generally center on a contractor’s accounting practices and internal controls.

Cost Related Deficiencies

These are related to how contractors classify, record, and claim costs on government contracts. The most common are charging unallowable costs, improper cost allocation, and inadequate documentation.

  • Charging Unallowable Costs – This happens when expenses not allowed by FAR Part 31 (including entertainment, lobbying, or advertising costs) are included in billings or indirect rate submissions.
  • Improper Cost Allocation – This happens when the contractor fails to correctly allocate certain costs as direct versus indirect to all contracts. This finding may also be used when there is inconsistent charging of the same type of cost.
  • Insufficient Documentation – This happens when a contractor has insufficient supporting records to verify the allowability, allocability, and reasonableness of claimed costs.

Labor and Timekeeping Issues

  • Inconsistent Timekeeping – This happens when employees fail to accurately record time worked or supervisors do not properly review submitted timesheets. This practice undermines the accuracy of labor costs charged to the government.
  • Lack of Total Time Reporting – This happens when there is a failure to record all hours worked by employees even those not charged to a specific contract.
  • Inaccurate Timesheet Updates – This happens when a supervisor or administration corrects or alters an employee’s timesheet without the worker’s knowledge or signature/approval.

Documentation & Policy Deficiencies

  • Inadequate Documentation – This happens when missing or incomplete documentation (invoices, approval forms) to substantiate the necessity and amount of a cost is found.
  • Missing/Outdated Policies – This finding occurs when an auditor discovers that policies and procedures are not documented in writing or updated leaving them out of compliance with DFARS requirements.
  • Failure to Follow Policies – Even when written policies do exist, occasionally employees fail to consistently follow required internal controls leading to compliance issues.

Incurred Cost Submission (ICS) and Rates

  • Late or Incomplete ICS – This finding occurs when the contractor fails to submit the annual Incurred Cost Submission with the required six-month period after the contractor’s fiscal year-end.
  • Inaccurate Provisional Billing Rates – Using estimated indirect billing rates that are very different from the actual costs can lead to over or under billing.
  • Lack of Reconciliation – This finding occurs when there is a failure to reconcile the costs claimed in the ICS and final billings back to the general ledger and related records.

 

Preparing for a Successful FAR Audit

Preparation is an ongoing, proactive process that ensures the contractor’s accounting system and internal controls are robust and compliant.

Understand FAR and AASHTO Guidelines

Become familiar with FAR Part 31, which outlines the criteria for allowable costs, and the , which provides detailed guidance for calculating overhead rates. The AASHTO Audit Guide should be a “go-to” tool that contains nearly anything and everything related to overhead rate calculations and audit.

Internal Readiness Assessments

Contractors should consider conducting a comprehensive internal or hiring an external consultant specializing in DCAA to conduct a mock audit. The focus should be high risk areas like Incurred Cost Submissions (ICS), timekeeping, and travel expenses. Time should also be spent comparing current policies and practices against the requirements of FAR Part 31 and SF 1408 (Pre-Award Survey) checklist. Finally, run reports and trace transactions through the accounting system to final billings to ensure there is a clean audit trail.

Accounting System Requirements

Contractors must use an accounting system that meets minimum standards based on DCAA and other requirements. It is essential to review systems to ensure they can properly segregate costs. This means it should be able to distinguish between direct, indirect, and unallowable costs. Job costing functionality should permit accumulated costs to be tracked by contract, task, or Contract Line-Item Number (CLIN). There should also be the ability to reconcile job cost ledgers to the general ledger.

While the DCAA does not approve or certify a specific accounting product it is ideal to use accounting software specifically designed for government contractors such as Deltek, Unanet, etc.. Many of these programs have built-in functionality including indirect cost pool calculations, labor distribution based on timesheets, and unallowable cost tracking.

Policies, Procedures and Internal Controls

It is important to have written documentation because auditors rely on this information when evaluating whether what is documented is actually followed. For this reason, it is important to have formal manuals that include a set of written policies and procedures that govern all financial activities. This should include timekeeping, purchasing, expense reporting and subcontracts. There should also be documented internal controls designed to prevent and detect misstatements and errors. Be sure there is appropriate segregation of duties and various levels of authorization. Finally ensure every policy specifically refers to and aligns with relevant FAR or DFAR clauses.

Timesheet and Labor Charging Best Practices

Since labor is the number one audit risk, contractors should maintain strict controls and ensure they are consistently applied. This includes daily time entry, total time accounting, supervisory review, and training and certification. For daily time entry the contractors must enforce a strict policy requiring daily recording of hours worked by all employees. The system must also capture all hours worked by each employee to avoid distortion of labor rates. Supervisors must knowingly approve all worked performed and not just rubber stamp time sheets. Finally, the contractors should provide regular training to all employees on the proper coding and certification of timesheets.

Record Retention and Compliance Documentation

Ensuring that records are organized and documentation complete is essential to a quick and successful audit. For this reason, it is important for contractors to have an established record retention policy. This should contain information on how long specific records (invoices, timesheets, etc.) must be retained in accordance with FAR 4.703 which often requires three years after final contract payment. Files should be organized and easy to access. Separate files should be maintained for the Disclosure Statement (DS-1), all indirect cost rate proposals and DCAA audit reports, and internal audit reports and Corrective Action Plans.

 

FAR Audit Outcomes

A FAR audit can have various outcomes which impact a contractor’s financial situation and future ability to win new government work. The audit findings are included in the final audit report delivered to the government’s contracting officer (CO) who makes a final determination. The most common outcomes are listed below and include favorable, unfavorable, and disputed.

Favorable Outcomes

  • Unmodified Opinion – For reviews of an entire system, such as an Accounting System or Estimating System, this is the optimal result. In essence, an unmodified opinion means the system is considered adequate and in compliance with FAR criteria.
  • No Significant Findings – This outcome means there may have been minor issues the contractor can address easily, most times without a formal Corrective Action Plan (CAP) as mandated by the CO.
  • Final Indirect Rate Settlement – For incurred cost audits, a successful outcome is the final negotiation and agreement of the contractor’s actual indirect cost rates for the audited fiscal year, formally closing out the costs for that period.

Unfavorable Outcomes

  • Questioned Costs –In this case, the auditor identifies specific costs that are deemed unallowable and recommended they be disallowed. Examples may include entertainment, lobbying, or other inadequately supported costs. The CO will review the contractor’s response to questioned costs and make a final decision about whether repayment is required.
  • Defective Pricing – For audits subjected to Truth in Negotiations Act (TINA) requirements, the auditor can find the contractor submitted inaccurate, incomplete, or non-current data. In this case, the government may implement a price reduction on the contract, and the contractor could be subject to penalties in addition to the overcharged amount.
  • 100% Penalty – For certain specifically unallowable costs (like costs for alcoholic beverages or corporate advertising) included in an incurred cost proposal, the contractor may be subject to a 100% penalty on top of the cost disallowance.

Disputed Outcomes

The outcome of an audit may result in follow-up and negotiation. The final outcome is determined by the Contracting Officer’s Final Decision (COFD) which formalizes the government’s position on findings and any adjustments. This can result in an agreement on all issues and a determination of a final rate settlement. There may also be a binding decision on costs or system adequacy that the contractor must satisfy to make an appeal.

In the event of appeal, the outcome is elevated into the formal dispute resolution process, which generally means appealing to the Board of Contract Appeals or the US Court of Federal Claims. It is important to note; repeated audit failures can have an adverse impact on a contractor’s reputation and lead to the loss of future contracts or a lower competitive standing.

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