The notification arrived on a Tuesday. A Defense Contract Audit Agency (DCAA) auditor was on-site, reviewing overhead pool charges for the prior fiscal year. By Wednesday afternoon, the auditor had flagged $47,000 in entertainment expenses that had been pooled into overhead and billed across every government contract. The contractor’s controller explained the charges as client relationship costs. The auditor pulled Federal Acquisition Regulation (FAR) 31.205-14 and read it aloud: entertainment costs are expressly unallowable. Every contract that absorbed any portion of that overhead pool now carried a questioned cost finding.
The cost was not the $47,000. The cost was the audit finding that traveled with every contract renewal, every new proposal, every follow-on award for the next three years. DCAA findings do not stay in the audit room. They follow the contractor into every subsequent pricing negotiation and forward pricing rate agreement discussion.
FAR Part 31 governs which costs the federal government will reimburse under cost-type contracts and cost-reimbursement arrangements. The regulation is not ambiguous on entertainment. It is not ambiguous on most of the 51 cost categories it addresses. Most DCAA findings on allowable costs trace to contractors who never read the regulation, or who read it and assumed exceptions applied to their situation.
Determine whether a cost is allowable under FAR Part 31 by applying four tests in sequence: Is it reasonable for the work performed per FAR 31.201-3? Is it allocable to a specific contract per FAR 31.201-4? Is it consistent with Cost Accounting Standards (CAS) or Generally Accepted Accounting Principles (GAAP) per FAR 31.201-2(a)(3)? Does the contract prohibit it per FAR 31.201-2(a)(4)? A cost that fails any single test is unallowable. FAR 31.205 lists 51 named cost categories. Common unallowable categories include entertainment per 31.205-14, alcoholic beverages per 31.205-51, and lobbying per 31.205-22.
What Are the Four Allowability Tests Under FAR 31.201-2?
Every cost submitted for government reimbursement passes four tests before it reaches the invoice. FAR 31.201-2 states the tests, and DCAA applies all four during incurred cost audits. A cost that fails any single test is unallowable, regardless of how it performs on the other three.
Test 1: Reasonableness
A cost is reasonable if, in its nature and amount, it does not exceed what a prudent person would incur under comparable circumstances, as defined in FAR 31.201-3. Reasonableness has two dimensions. The first is whether incurring the cost at all was prudent. The second is whether the amount paid was appropriate. A contractor who books a $900-per-night hotel for a program manager traveling to a customer site has a reasonableness problem on amount even if the travel itself was legitimate.
DCAA tests compensation reasonableness by comparing salaries and total compensation against Bureau of Labor Statistics data for comparable positions in the same geographic region and industry sector. When a small contractor pays its CEO $650,000 in a market where the BLS median for the role is $285,000, the auditor will question the excess as unreasonable under FAR 31.205-6. The contractor must document compensation surveys and approval processes before audit, not after.
Test 2: Allocability
A cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship, as defined in FAR 31.201-4. Three sub-conditions establish allocability: the cost is incurred specifically for the contract, benefits both the contract and other work and can be distributed proportionately, or is necessary to the overall operation of the business even if a direct relationship cannot be shown.
Allocability is where overhead pool contamination originates. A cost that has no reasonable connection to the work being performed fails this test. Entertainment expenses, country club dues, and personal expenses buried in the overhead pool fail allocability because the government receives no benefit from them proportionate to what it is being charged.
Test 3: CAS and GAAP Consistency
Costs must be consistent with Generally Accepted Accounting Principles (GAAP) and, where applicable, CAS per FAR 31.201-2(a)(3). CAS applies to contractors and subcontractors awarded contracts of $2 million or more under 48 CFR 9903.201-1. Large contractors subject to full CAS coverage must follow all 19 standards. Modified CAS coverage applies to contracts between $2 million and $50 million and requires compliance with CAS 401, 402, 405, and 406.
The consistency requirement bites contractors who treat identical costs differently across contracts. Charging a cost as direct on one contract and indirect on another, without documented justification, violates CAS 402. DCAA auditors look for inconsistent treatment as a marker of potential cost shifting, where unallowable costs are migrated toward government contracts through reclassification.
Test 4: Contract Terms Compliance
A cost is unallowable if the contract specifically prohibits it or limits its allowability per FAR 31.201-2(a)(4). Contract-specific exclusions appear in special contract requirements, performance work statements, and negotiated contract modifications. A contractor must read the contract’s cost provisions before establishing its accounting treatment, not after the invoice is questioned.
The audit fix. Build a four-column checklist for every significant cost category in your overhead pool. Column one: is the cost reasonable in nature and amount (document the comparable market rate)? Column two: does the cost benefit the work being performed in proportion to the charge allocated? Column three: is the treatment consistent with how you treat this cost across all contracts? Column four: does any contract clause specifically prohibit or limit this cost? Run this checklist quarterly, not at audit time. DCAA finds what you have not yet found yourself.
What Costs Are Expressly Unallowable Under FAR 31.205?
FAR 31.205 contains 51 cost categories. Several are expressly unallowable, meaning no circumstances, justifications, or contract clauses can make them reimbursable by the government. Expressly unallowable costs carry an additional consequence: if a contractor includes them in a final indirect cost rate proposal and DCAA finds them, the penalty is two times the disallowed amount under FAR 42.709.
Entertainment and Alcoholic Beverages
Entertainment costs are expressly unallowable under FAR 31.205-14. The regulation defines entertainment broadly: amusement, diversion, social activities, and costs directly associated with those activities including meals, lodging, rentals, transportation, and gratuities. The intent of the expenditure governs the classification, not the format. A dinner that would otherwise qualify as a business meal becomes entertainment if its primary purpose is social rather than substantive business discussion.
Alcoholic beverages are separately and expressly unallowable under their own provision, FAR 31.205-51. A dinner with alcohol charges requires the contractor to segregate the alcohol costs before billing. Mixing alcohol charges into a meal or entertainment line item and billing the aggregate to the government is a compliance failure even if the meal itself is otherwise allowable.
Bad Debts, Fines, and Penalties
Bad debts, including losses arising from uncollectible accounts and related collection costs, are unallowable under FAR 31.205-3. The rationale is straightforward: the government does not subsidize a contractor’s credit decisions on commercial work. Fines and penalties resulting from violations of laws and regulations are similarly unallowable under FAR 31.205-15. A contractor who incurs an OSHA penalty, a tax penalty, or a contract-related fine absorbs that cost entirely without government participation.
Advertising and Lobbying
Most advertising costs are unallowable under FAR 31.205-1. The exception covers advertising with a direct, demonstrable connection to government contract performance: help-wanted ads for positions required under a specific contract, or advertising required by the contract itself. Brand advertising, general marketing campaigns, and promotional materials without a direct contract connection are unallowable. Contractors who pool marketing department costs into overhead must segregate the unallowable advertising component before billing rates are established.
Lobbying and political activity costs are unallowable under FAR 31.205-22. This covers attempts to influence federal, state, or local legislation; attempts to influence the election of public officials; and contributions to political parties or candidates. The prohibition extends to indirect costs: if a trade association dues payment funds lobbying activity, the lobbying portion of those dues is unallowable and must be broken out.
Expressly unallowable costs are not a DCAA finding that gets negotiated down. They are a mathematical penalty: two times the disallowed amount if included in a final indirect cost rate proposal. A $47,000 entertainment pool contamination does not become a $47,000 adjustment. It becomes a $94,000 penalty under FAR 42.709. Segregation before billing is not compliance housekeeping. It is risk management with a defined cost if skipped.
The audit fix. Pull your last three years of overhead pool charges and run a keyword search against the unallowable categories in FAR 31.205. Flag any charge containing the words entertainment, hospitality, alcohol, beverage, event, sponsorship, lobbying, dues, or penalty. For each flagged item, determine whether it was identified as unallowable before billing or pooled into the government-bearing overhead. If it was pooled, calculate the amount and assess whether your incurred cost submission requires amendment before DCAA asks the same question.
What Costs Are Allowable Under FAR 31.205?
The same FAR 31.205 that prohibits entertainment and lobbying permits a substantial range of costs essential to business operations. Understanding the allowable categories and their conditions prevents overcorrection: contractors who disallow too aggressively lose the reimbursement they are entitled to.
Compensation for Personal Services
Compensation is allowable subject to a reasonableness test under FAR 31.205-6. Allowable compensation includes salaries, wages, incentive compensation, bonuses, paid time off, and fringe benefits. The reasonableness benchmark is what the contractor would pay for comparable services in the absence of government work, measured against published surveys and BLS data.
Deferred compensation and pension costs carry additional conditions. Pension plan costs are allowable only if the plan is established under a written plan document and the contractor uses an actuarially determined funding method per FAR 31.205-6(j). Golden parachute payments and severance arrangements that exceed what is customary in the private sector face scrutiny under the reasonableness standard. The compensation cost accounting policy must be written, consistent across employees, and available for auditor review.
Travel Costs
Travel costs are allowable when incurred for purposes that benefit the contract and the costs are reasonable under FAR 31.205-46. Allowable travel includes transportation, lodging, meals, and incidental expenses for employees traveling on official business. The regulation sets a specific ceiling: airfare is allowable only at the lowest customary standard, coach, or equivalent class, with first-class or business-class allowed only when coach is not available, when the flight exceeds a defined duration, or when the employee’s medical condition requires it.
Per diem rates for lodging and meals are tested against GSA rates for the destination city. Charges above GSA rates require documentation establishing that lower-cost accommodations were unavailable. Travel costs for the personal benefit of employees, including personal side trips and companion travel, are unallowable regardless of how the expense report is submitted.
Professional and Consultant Services
Professional and consultant service costs are allowable when the services are necessary for contract performance, the fees are reasonable, and the contractor can document the specific services performed per FAR 31.205-33. The documentation requirement is strict: a retainer payment to an attorney or consultant without a description of specific services rendered and deliverables produced will be questioned during audit.
Legal costs require additional sorting. Legal costs incurred in connection with obtaining contracts are allowable. Legal costs for defending against government claims or proceedings are generally unallowable. Legal costs for prosecuting claims against the government under the Contract Disputes Act are allowable if the contractor prevails per FAR 31.205-47. Contractors with active litigation must classify legal costs at the matter level before pooling them into overhead.
Insurance
Insurance costs are allowable when the type of coverage is required or approved by the contracting officer, the premiums are reasonable, and the coverage is maintained under an established insurance program per FAR 31.205-19. Allowable insurance includes workers’ compensation, employer’s liability, general liability, and property insurance. Self-insurance programs are allowable if the contractor maintains adequate reserves and the program is approved.
The audit fix. For each of the four major allowable cost categories (compensation, travel, professional services, insurance), verify that you have a written accounting policy documenting cost treatment. DCAA expects written policies, not verbal practices. A compensation policy must state how bonuses are determined, approved, and allocated. A travel policy must state the standard for airfare class, per diem rates, and approval authority. A consultant services policy must state the documentation required before payment. Missing written policies are a finding before DCAA reviews a single transaction.
What Costs Are Partially Allowable or Conditionally Allowable?
Some FAR 31.205 categories are neither fully allowable nor fully prohibited. They are allowable under specific conditions or up to defined limits. These partial allowability rules generate the most disputes in incurred cost audits because the boundaries require judgment, and DCAA and contractors frequently reach different conclusions.
IR&D and B&P Costs
Independent Research and Development (IR&D) and Bid and Proposal (B&P) costs are allowable subject to annual negotiated ceilings for major contractors under FAR 31.205-18. IR&D covers costs of research not sponsored by a contract but related to the contractor’s general product lines. B&P covers costs of preparing bids, proposals, and quotations. Both categories are allowable only to the extent they represent costs of effort that would have occurred without the government contract.
Major contractors (defined by the Act as contractors whose covered segments had incurred IR&D costs exceeding $11 million in the prior year) negotiate IR&D and B&P cost ceilings with the Defense Contract Management Agency (DCMA). Costs above the negotiated ceiling are unallowable in the year incurred but may carry forward to future periods if the contractor and government agree. Small contractors without negotiated ceilings can claim reasonable IR&D and B&P costs, but must document that the work addressed requirements potentially relevant to a Department of Defense mission.
Depreciation
Depreciation is allowable for tangible capital assets used in contract performance, subject to conditions on method and rate under FAR 31.205-11. The allowable depreciation charge is the lesser of the amount computed using the method adopted for financial accounting or the amount computed using straight-line depreciation over the asset’s estimated service life. Assets fully depreciated for financial accounting purposes are fully depreciated for government contract purposes: a contractor cannot claim ongoing depreciation on assets that have reached the end of their accounting life.
The depreciation method must be consistent. A contractor who switches from straight-line to accelerated depreciation to maximize allowable costs will face a CAS 409 consistency challenge. The method chosen must be applied consistently across all cost objectives, and changes require advance agreement with the cognizant federal agency.
Pre-Contract Costs
Costs incurred before a contract is awarded are allowable if they would have been allowable under the contract had it been in effect when the costs were incurred, and if the contracting officer grants written advance authorization per FAR 31.205-32. Without advance authorization, pre-contract costs are at the contractor’s risk. Contractors who begin contract performance before award, a common practice in urgent programs, must secure contracting officer authorization in writing to protect their pre-award cost investment.
The audit fix. For IR&D and B&P costs, document the connection between each project and a potential government requirement at the time the cost is incurred, not retrospectively. DCAA auditors are skeptical of post-hoc justifications. For depreciation, confirm your depreciation schedule matches your capitalization policy: the same asset lives used for financial reporting must be used for government contract billing. For pre-contract costs, build a standard operating procedure requiring a written contracting officer authorization before incurring any cost that will be claimed under a not-yet-awarded contract.
How Does DCAA Test Allowable Costs During an Audit?
DCAA’s primary tool for testing allowable costs is the incurred cost audit, which examines a contractor’s final indirect cost rate proposal for a given fiscal year. The audit determines whether costs included in the proposal comply with FAR Part 31, CAS where applicable, and contract terms. DCAA auditors follow the Contract Audit Manual (CAM) procedures, and understanding those procedures is the clearest map to what the auditor will examine.
The Final Indirect Cost Rate Proposal
Contractors performing cost-type or time-and-materials contracts submit a final indirect cost rate proposal within six months of fiscal year end, covering all indirect costs incurred in that year per FAR 52.216-7. The proposal reconciles the contractor’s books to the indirect rates used for billing during the year. DCAA audits the proposal to verify that unallowable costs have been identified, segregated, and excluded from the rates billed to the government as required by FAR 31.201-6.
The most common finding in incurred cost audits is unallowable costs included in indirect pools. DCAA does not give credit for good intentions. If entertainment charges, excessive compensation, or advertising costs appear in the overhead pool as submitted, the auditor questions the full amount and assesses whether the contractor’s failure to segregate was knowing, constituting a false claim risk under the False Claims Act (31 U.S.C. § 3729).
Compensation Analysis
DCAA benchmarks executive and employee compensation against published salary surveys and BLS data. The auditor identifies comparable positions in the relevant industry, geographic area, and company size, then compares total compensation (salary plus bonus plus benefits) against the benchmark. Compensation above the benchmark upper quartile triggers a reasonableness question. The contractor must produce compensation surveys and board approval documentation to support compensation levels.
Related-party compensation receives additional scrutiny. Payments to owners, family members of owners, and affiliated entities require documentation that the compensation reflects fair market value for services actually performed. DCAA treats undocumented related-party compensation as a presumptively unreasonable cost that the contractor must affirmatively justify.
Segregation and Identification Requirements
FAR 31.201-6 requires that unallowable costs be identified and excluded from any billing, claim, or proposal. The regulation goes further: costs that are similar to expressly unallowable costs must also be identified and treated consistently. A contractor with a written unallowable cost identification policy that is actually implemented before billing demonstrates good faith. A contractor who discovers unallowable costs only after the auditor arrives is in a materially different position.
Accounting systems must be structured to segregate unallowable costs at the transaction level. This means maintaining separate general ledger accounts or subaccounts for unallowable cost categories. A chart of accounts that pools entertainment, travel, and meals into a single “marketing and entertainment” account without subaccount segregation is an accounting system weakness DCAA will note as a material weakness in its pre-award survey and incurred cost audit.
The audit fix. Conduct a self-audit of your indirect cost pools before the DCAA auditor arrives. Print a trial balance for each pool (overhead, G&A, fringe). For each account over $5,000, determine the allowability classification under FAR 31.205 and verify the account contains only costs of that type. Document your determination in writing. Any account containing mixed allowable and unallowable charges must be split before submitting your final indirect cost rate proposal. The segregation requirement is not satisfied by a spreadsheet adjustment at year end. It must be reflected in the accounting records.
| Cost Category | FAR Reference | Allowability Status | Key Conditions |
|---|---|---|---|
| Compensation | 31.205-6 | Allowable | Must pass reasonableness test; BLS benchmark applies to executives |
| Travel | 31.205-46 | Allowable | Lowest available airfare; lodging at GSA rate or justified exception |
| Professional Services | 31.205-33 | Allowable | Requires documentation of specific services performed |
| Insurance | 31.205-19 | Allowable | Required or approved coverage; reasonable premiums |
| Depreciation | 31.205-11 | Conditionally Allowable | Consistent method; cannot exceed financial accounting charge |
| IR&D / B&P | 31.205-18 | Conditionally Allowable | Negotiated ceiling for major contractors; mission relevance required |
| Pre-Contract Costs | 31.205-32 | Conditionally Allowable | Requires advance written authorization from contracting officer |
| Entertainment | 31.205-14 | Expressly Unallowable | No exceptions; includes meals where primary purpose is social |
| Alcoholic Beverages | 31.205-51 | Expressly Unallowable | Must be segregated even when included in otherwise allowable meals |
| Bad Debts | 31.205-3 | Expressly Unallowable | No exceptions; includes related collection costs |
| Fines and Penalties | 31.205-15 | Expressly Unallowable | No exceptions; includes regulatory penalties and tax penalties |
| Most Advertising | 31.205-1 | Generally Unallowable | Exception for recruitment ads and contract-required advertising only |
| Lobbying | 31.205-22 | Expressly Unallowable | Includes portion of trade association dues funding lobbying activities |
| Legal Costs (Govt Claims) | 31.205-47 | Generally Unallowable | Allowable only if contractor prevails under Contract Disputes Act |
FAR Part 31 is not a gray area regulation. The 51 cost categories in FAR 31.205 provide clear allowability determinations for the overwhelming majority of costs a contractor incurs. The contractors who face DCAA findings are not victims of regulatory ambiguity. They are contractors who either did not read the regulation or did not build an accounting system capable of applying it before billing. Build the written policies, segregate the unallowable costs at the transaction level, and run a self-audit against your indirect pools before submitting any final indirect cost rate proposal. The four allowability tests in FAR 31.201-2 are not a checklist for the auditor. They are a checklist for you. For the full compliance checklist covering accounting systems, timekeeping, indirect rates, and incurred cost submissions, see the DCAA audit readiness checklist.
Frequently Asked Questions
What is the FAR Part 31 allowable costs guide for government contractors?
FAR Part 31 is the Federal Acquisition Regulation cost principles governing which costs a contractor may charge the government under cost-reimbursement, time-and-materials, and cost-type contracts. FAR 31.201-2 establishes four allowability tests (reasonable, allocable, CAS/GAAP compliant, and not prohibited by contract). FAR 31.205 provides allowability determinations for 51 specific cost categories, from compensation and travel to entertainment and lobbying.
What are expressly unallowable costs under FAR Part 31?
Expressly unallowable costs are categories FAR 31.205 prohibits from government reimbursement under any circumstances. The primary categories are entertainment per FAR 31.205-14, alcoholic beverages per FAR 31.205-51, bad debts per FAR 31.205-3, fines and penalties per FAR 31.205-15, lobbying per FAR 31.205-22, and most advertising per FAR 31.205-1. Including expressly unallowable costs in a final indirect cost rate proposal triggers a penalty of two times the disallowed amount under FAR 42.709.
How does DCAA test whether compensation is allowable?
DCAA benchmarks total compensation (salary, bonus, and benefits) against Bureau of Labor Statistics data and published compensation surveys for comparable positions in the same geographic area, industry, and company size. Compensation above the upper quartile benchmark triggers a reasonableness question under FAR 31.205-6. The contractor must produce compensation surveys, board approval documentation, and a written compensation policy to support above-benchmark pay levels.
What is required to segregate unallowable costs?
FAR 31.201-6 requires contractors to identify and segregate unallowable costs from allowable costs before billing, claiming, or proposing rates. Segregation means maintaining separate general ledger accounts or subaccounts for unallowable cost categories, not a year-end spreadsheet adjustment. Contractors must also maintain written accounting policies documenting the cost treatment for each category in their cost pools.
Are travel costs allowable under FAR Part 31?
Travel costs are allowable when incurred for official business purposes at reasonable amounts per FAR 31.205-46. Airfare is allowable at the lowest available standard or coach class. Lodging is tested against GSA per diem rates for the destination city. Personal side trips, companion travel, and first-class airfare without documented justification are unallowable. The contractor must have a written travel policy specifying approval authority and cost limits.
When are IR&D and B&P costs allowable?
Independent Research and Development and Bid and Proposal costs are allowable when they represent costs of effort related to the contractor’s product lines and potentially relevant to government requirements per FAR 31.205-18. Major contractors with prior-year covered IR&D costs exceeding $11 million negotiate annual cost ceilings with DCMA; costs above the ceiling are unallowable. All contractors must document the mission relevance of IR&D efforts at the time of incurrence, not retrospectively during audit.
What happens if DCAA finds unallowable costs in a rate proposal?
DCAA questions the full amount of unallowable costs identified in the final indirect cost rate proposal and issues a Form 1 (Notice of Contract Costs Suspended and/or Disapproved) or an audit report recommending disallowance. If the costs are expressly unallowable and the contractor included them knowingly, DCAA refers the matter for a contracting officer penalty determination under FAR 42.709, which sets the penalty at two times the disallowed amount. Repeated findings can result in a contractor being referred to the Department of Justice under the False Claims Act.
Does FAR Part 31 apply to fixed-price contracts?
FAR Part 31 does not apply to firm-fixed-price contracts where the contractor assumes full cost risk. The cost principles apply to cost-reimbursement contracts, time-and-materials contracts, labor-hour contracts, and fixed-price contracts with economic price adjustment based on actual costs. Contractors performing primarily fixed-price work who also hold cost-type contracts must maintain accounting systems capable of separating the cost environments and applying FAR 31 only to the cost-type work.
Subscribe to The Authority Brief for next week’s analysis.
