The Dangers of Improperly Segregating Direct and Indirect Costs

MISTAKE #7: Improper allocation of costs (aka not coding expenses properly)

When you receive a Phase II SBIR, STTR, RO1, APRA-E, BARDA or BAA grant or contract, you need to comply with the Federal Acquisition Regulation (FAR) Part 31, and specifically FAR 52.216-7. Of course, there are pitfalls along the way. One is not coding your direct, indirect and allowable costs correctly.

After more than 30 years of specializing in government award accounting, we know the mistakes government awardees make, and how to prevent them. Our “Top 10 Accounting Mistakes Government Awardees Make,” blog series is designed to help you avoid trouble and protect your business.

Now that you have received your government award, you may have reached out to a CPA for help. That’s not a bad move, but you need to know that while most CPAs understand the internal revenue code (IRC) and generally accepted accounting principles (GAAP), they can’t offer proper guidance on developing accounting policies and procedures that adhere to Federal Acquisition Regulations (FAR) or the Cost Accounting Standards (CAS).  This can get you in big trouble.

A brief overview of direct, indirect, and unallowable costs.

In a nutshell:

Direct costs benefit one project and only one project.

Indirect costs are costs that you incurred to run a business.  A percentage or these costs need to be applied to all the projects you work on.  This could mean administrative staff, benefits and vacation time, rent, and so on.  Note that your employee’s indirect time (time not spent directly for the benefit of a project) is typically your largest indirect cost.

Unallowable costs are expenses that the government specifically will not reimburse you for.  This includes the cost of first-class travel and 5-star hotels over government per diem allowances, drinks with customers and employees, and so on.

The failure to have a working knowledge of the FAR will frequently lead to improperly coding expense between direct, indirect or unallowable.  Not knowing how to do it correctly does not dismiss your obligation.

Confused about how to allocate costs? – Cost Accounting Standard (CAS) 402 and changing your perspective can provide some clarity.

The Cost Accounting Standards typically apply to larger contracts (>$7.5M) but can be a good source of information and education on subject matter that can be confusing.  The purpose of CAS 402 is to require that each type of cost is allocated only once and on only one basis to any contract or other cost objective.

In other words, you have to come up with a consistent way of thinking about how are you going to treat this cost incurred for the same purpose under like circumstances.

When we speak on this subject, people with only one award frequently looked perplexed, until we ask them to change their perspective a bit – imagine you have 3 or 4 active projects – would this cost benefit just one project or all of them?

CAPTURING COSTS IN A FAR-COMPLIANT ACCOUNTING SYSTEM

To comply with the FAR and to survive an audit, you need a FAR-compliant accounting system. That means it must:

• Segregate direct, indirect and “unallowable” costs
• Accumulate direct costs by contract/grant budget category
• Allocate indirect costs to intermediate and final cost objectives based on a “logical and consistent method”
• Reconcile the job-cost ledger with the general ledger
• Track employee time by job activity
• Charge direct and indirect labor costs to the appropriate accounts
• Produce monthly reports of charges to contracts & grants to support billings/draw downs
• Exclude unallowable costs to avoid billing them to the government

Simply put, your accounting system needs to produce a Job-Cost Report that demonstrates compliance.

QuickBooks as a stand-alone product is not a FAR-compliant accounting system.

Even if you set your QuickBooks up correctly, then run a job cost report, it will only show direct expenses. There are no indirect expenses tracked or allocated to jobs.

Know that there are solutions to this. We have one, JamesonWorx. You can read more about it here.

Problems surface during the audits.

Improper allocation of costs can lead to audit findings, which often occur two to three years after the contract or grant has been completed.

The government auditors have a lot on their plate, and often, the timing for an audit is sporadic. You must always be audit-ready, which means you’re able to produce past job cost reports, explain expenses and coding from years ago, and so on.

In our experience, improper cost allocation problems typically surface in audit findings that can cost tens or hundreds of thousands of dollars.  You want to get this right.  And you won’t know if you’re OK until you get audited.

We’re here to help.

Ready to Learn More? Speak With A Government Funding Award Expert!
Call Now: 781-862-5170 – or – Schedule A Call

To learn more about allocating costs and indirect rates, check out our video: How Do You Project an Indirect Cost Rate for a Phase II Cost Proposal?

Top 10 Mistakes Government Awardees Make:

1. Mistake #1: Taking The NIH Safe Rate
2. Mistake #2: Not Having a Far Part 31 Compliant Accounting System
3. Mistake #3: Overspending on Direct Costs
4. Mistake #4: Overspending on Indirect Cost Rates
5. Mistake #5: Audit Findings
6. Mistake #6: Spending Too Much on Accounting Staff
7. Mistake #7: Improper Allocation of Costs
8. Mistake #8: Not Paying Attention To Agency-Specific Rules
9. Mistake #9: Timekeeping and Uncompensated Overtime Issues
10. Mistake #10: Spending Too Much on Accounting When You’re Not a CPA