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 called them client relationship costs. The auditor pulled the Federal Acquisition Regulation (FAR) and read FAR 31.205-14 aloud: entertainment costs are expressly unallowable. Every contract that absorbed any portion of that overhead pool now carried a questioned cost finding.
The damage was not the $47,000. It was the audit finding that traveled with every contract renewal, every new proposal, and every follow-on award for the next three years. That $47,000 also carried a penalty under FAR 42.709-2: a first-occurrence penalty equal to the disallowed amount plus interest on any paid portion (FAR 42.709-2(a)(1)). If the same contractor had previously been told entertainment costs were unallowable and let them slip into a later indirect cost rate proposal, the penalty would double to two times the disallowed amount under FAR 42.709-2(a)(2). DCAA findings don’t stay in the audit room.
FAR Part 31 allowable costs rules are not ambiguous. Most findings trace to contractors who never read the regulation, or who read it and assumed exceptions applied to their situation. This guide explains who needs to know FAR Part 31, how the four allowability tests work, and which specific cost categories get small contractors in trouble.
What You’ll Learn
- Who FAR Part 31 applies to (and who can skip this article)
- The four tests every cost must pass under FAR 31.201-2
- Which costs are always unallowable and how the FAR 42.709-2 penalty actually works
- Which costs are allowable but come with conditions
- How DCAA actually tests costs during an audit
- A 14-category quick-reference table for your accounting team
Who FAR Part 31 Applies To
FAR Part 31 applies to contracts where the government reimburses your actual costs. That means cost-reimbursement contracts, time-and-materials (T&M) contracts, and labor-hour contracts. If you have a firm-fixed-price (FFP) contract, the government pays the agreed price regardless of what it actually costs you to do the work. On FFP, you carry the cost risk. FAR Part 31 doesn’t apply to you on those contracts.
If your business only holds firm-fixed-price contracts right now, you can bookmark this article for later. When you move into cost-type work, come back and read it carefully.
If you hold any cost-reimbursable, T&M, or labor-hour contract, every dollar you charge to those contracts must comply with FAR Part 31. That includes direct costs charged to the contract and your indirect cost pools. For more on the difference between these contract types, see our guide to cost-plus vs. fixed-price contracts.
For help with how indirect cost rates flow through your billing system, see our guide to indirect cost rates for government contractors. For the full picture of what a DCAA-compliant accounting system looks like, see DCAA compliance for small contractors.
The Four Allowability Tests (FAR 31.201-2)
Before a cost can be charged to a government contract, it must pass four tests. FAR 31.201-2 sets out all four. A cost that fails any single test is unallowable, no matter how it does on the other three. DCAA applies all four during incurred cost audits.
Test 1: Reasonable (FAR 31.201-3)
A cost is reasonable if it doesn’t exceed what a prudent person would pay under similar circumstances. In practice, this test has two parts: was it reasonable to incur the cost at all, and was the amount paid reasonable?
A program manager traveling to a customer site is reasonable. A $900-per-night hotel room for that same trip is not, even if the trip itself was necessary.
FAR 31.205-6 governs compensation allowability and reasonableness. In practice, DCAA typically benchmarks total compensation against Bureau of Labor Statistics (BLS) Occupational Employment and Wage Statistics for the same job title, industry, and geographic area, supplemented by published commercial salary surveys (such as ERI, Mercer, or Radford) for executive and specialized roles. If a small contractor pays its CEO $650,000 when the relevant benchmark for the role in that region is $285,000, expect the auditor to question the excess under FAR 31.205-6.
The DCAA practice of testing total compensation against the upper quartile of comparable surveys (the Bowsher framework) has been challenged in litigation (J.F. Taylor, ATK Thiokol); current DCAA practice still relies on survey benchmarks, but the methodology is contested rather than codified in FAR 31.205-6. You need compensation surveys and a written approval process in place before any audit, not after.
Test 2: Allocable (FAR 31.201-4)
A cost is allocable if it actually benefits the work being charged. FAR 31.201-4 says a cost is allocable if it is incurred specifically for the contract, benefits the contract and other work and can be distributed fairly, or is necessary to the overall operation of the business even when a direct relationship to a specific contract can’t be shown.
Allocability is where overhead pool contamination starts. Entertainment costs, country club dues, and personal expenses buried in overhead fail this test because the government gets no proportionate benefit from them.
Test 3: CAS and GAAP Compliant (FAR 31.201-2(a)(3))
Costs must be consistent with Generally Accepted Accounting Principles (GAAP) and, where applicable, with Cost Accounting Standards (CAS).
CAS are a set of 19 accounting rules specific to government contracting, codified at 48 CFR Chapter 99. Small businesses are categorically exempt from CAS regardless of contract size under 48 CFR 9903.201-1(b)(3). If you qualify as a small business under your NAICS size standard, CAS does not apply to you.
If your business has grown out of small status, the contract-level CAS thresholds matter: the legacy threshold (in effect for contracts entered before June 30, 2026) is $2.5 million per contract for modified coverage, with full CAS coverage triggered at $50 million in net CAS-covered awards in the prior cost accounting period. Section 1806 of the FY2026 NDAA raises those thresholds for contracts entered after June 30, 2026 to $35 million per contract for modified coverage and $100 million for full coverage. Modified coverage requires compliance with four of the 19 standards (CAS 401, 402, 405, 406). If you are unsure whether CAS applies to your contracts, check with your contracting officer or a DCAA-experienced CPA.
The consistency principle still matters even if CAS does not apply to you. FAR 31.201-2 requires consistent treatment of like costs in like circumstances. CAS-covered contractors who treat the same type of cost as direct on one contract and indirect on another without documented justification can violate CAS 402 (which applies to costs incurred for the same purpose in like circumstances); for non-CAS small businesses, the same pattern fails the FAR 31.201-2 consistency test. DCAA auditors look for inconsistent treatment as a sign of cost shifting, where unallowable costs get migrated toward government work through reclassification.
Test 4: Contract Terms Compliant (FAR 31.201-2(a)(4))
A cost is unallowable if your specific contract prohibits it. Contract-specific exclusions can appear in special contract requirements, the statement of work, or negotiated contract modifications.
Read your contract’s cost provisions before you set up your accounting treatment for any new cost category. Discovering a prohibition after the invoice is questioned is an avoidable problem.
Action: Build a four-column worksheet for every major cost category in your overhead pool. Column 1: Is the cost reasonable in nature and amount? Document the market rate. Column 2: Does the cost benefit the work being charged? Column 3: Is the treatment consistent across all contracts? Column 4: Does any contract clause prohibit or limit this cost? Review quarterly, not at audit time.
Costs That Are Always Unallowable (FAR 31.205)
FAR 31.205 covers more than 50 named cost categories (sections 31.205-1 through 31.205-52, with several reserved or deleted entries). Some are expressly unallowable. That means no circumstances, no contract clause, and no contracting officer approval can make them reimbursable by the government.
Expressly unallowable costs included in a final indirect cost rate proposal carry a penalty under FAR 42.709-2. The default penalty for a first occurrence is the disallowed amount plus interest on any paid portion (FAR 42.709-2(a)(1)). The penalty doubles to two times the disallowed amount only if that specific cost was previously determined unallowable for your company in a prior contract or audit (FAR 42.709-2(a)(2)). Repeat offenders pay double; first-time findings still bring the disallowance, interest, an audit finding that follows you into every future proposal, and potential False Claims Act exposure under 31 U.S.C. § 3729. The math is set by regulation, not negotiated at the closeout table.
The False Claims Act (31 U.S.C. § 3729) adds another layer. Knowingly submitting a false bill to the government can result in the government suing you for up to three times the amount in question. That’s why unallowable cost segregation is risk management, not just accounting housekeeping.
Entertainment and Alcohol (FAR 31.205-14, FAR 31.205-51)
Entertainment costs are expressly unallowable under FAR 31.205-14. The definition is broad: amusement, diversion, social activities, and anything directly connected to those activities, including meals, lodging, rentals, transportation, and gratuities. The key word is “primary purpose.” A dinner with a customer qualifies as a business meal if the primary purpose is substantive business discussion. If the primary purpose is social, it’s entertainment and it’s unallowable.
Alcoholic beverages are separately and expressly unallowable under FAR 31.205-51. A dinner that’s otherwise a legitimate business meal still requires you to pull out the alcohol charges before billing. You can’t combine the whole tab and bill the aggregate.
Bad Debts, Fines, and Penalties (FAR 31.205-3, FAR 31.205-15)
Bad debts, meaning losses from uncollectible accounts and related collection costs, are unallowable under FAR 31.205-3. The government doesn’t subsidize your credit decisions on commercial work.
Fines and penalties from violations of laws and regulations are unallowable under FAR 31.205-15. An OSHA penalty, a tax penalty, or a contract-related fine is your cost to absorb. The government has limited carve-outs for certain situations, but for most small business contractors, fines and penalties go to zero in your indirect pools.
Most Advertising and Lobbying (FAR 31.205-1, FAR 31.205-22)
Most advertising is unallowable under FAR 31.205-1. The exceptions are narrow: help-wanted ads for positions required under a specific contract, and advertising the contract itself requires. Brand advertising, general marketing campaigns, and promotional materials without a direct contract connection are unallowable. If your marketing department costs flow into overhead, you must pull out the unallowable advertising component before you set your billing rates.
Lobbying and political activity are unallowable under FAR 31.205-22. This covers attempts to influence legislation at the federal, state, or local level, attempts to influence elections, and contributions to political parties or candidates. Trade association dues that fund lobbying are partially unallowable: you must identify the lobbying portion of the dues and exclude it from your indirect pools.
Action: Pull your last three years of overhead pool charges and search for these words in account descriptions and vendor names: entertainment, hospitality, alcohol, beverage, event, sponsorship, lobbying, dues, penalty. For each flagged item, determine whether it was identified as unallowable before billing or pooled into a government-bearing overhead account. If it was pooled, calculate the amount and assess whether your incurred cost submission needs to be amended.
Costs That Are Allowable With Conditions
FAR 31.205 also identifies costs that are fully allowable when they meet specific conditions. Knowing these conditions prevents a different problem: contractors who disallow costs they’re entitled to claim and leave money on the table.
Compensation (FAR 31.205-6)
Compensation is allowable when it passes the reasonableness test. Allowable compensation includes salaries, wages, bonuses, paid time off, and fringe benefits. The reasonableness benchmark is what you would pay for comparable services if you had no government work, measured against published surveys and BLS data.
Deferred compensation and pension costs carry additional rules under FAR 31.205-6(j), which references CAS 412 and 413 for measurement and assignment of pension costs. Defined benefit pensions must be supported by a written plan document and an actuarially determined funding method. Defined contribution plans (such as a 401(k) employer match) are generally assigned to the period funded. Severance arrangements that go above what’s customary in the private sector face scrutiny under the reasonableness standard.
Your compensation accounting policy must be in writing, applied consistently across employees, and available for auditor review before any audit begins.
Travel (FAR 31.205-46)
Travel costs are allowable when they benefit the contract and the amounts are reasonable. That includes transportation, lodging, meals, and incidental expenses for employees traveling on official business.
The regulation is specific about airfare: allowable only at the lowest available standard or coach class. First-class or business-class airfare is allowable only when coach is unavailable, when the flight exceeds a defined duration, or when a documented medical condition requires it. No exceptions outside those three situations.
Lodging is tested against General Services Administration (GSA) per diem rates for the destination city. Charges above GSA rates require written documentation that lower-cost accommodations were genuinely unavailable. Personal side trips and companion travel are unallowable regardless of how the expense report is submitted.
Professional and Consultant Services (FAR 31.205-33)
Professional and consultant services are allowable when the services are necessary for contract performance, the fees are reasonable, and you can document the specific services performed and deliverables produced.
A retainer payment to an attorney or consultant without a description of specific work done will be questioned during audit. FAR 31.205-33 requires documentation of what was performed, not just what was paid.
Legal costs require sorting. Legal costs for obtaining contracts are allowable. Legal costs for defending against government claims are generally unallowable under FAR 31.205-47, with limited exceptions depending on the nature of the proceeding and the outcome. Contractors with active litigation must classify legal costs at the matter level before pooling them into overhead.
Insurance (FAR 31.205-19)
Insurance costs are allowable when the coverage type is required or approved by the contracting officer (CO), premiums are reasonable, and the coverage is part of an established insurance program. Workers’ compensation, employer’s liability, general liability, and property insurance all qualify. Self-insurance programs are allowable if you maintain adequate reserves and the program is approved.
Action: For each of these four categories, verify you have a written accounting policy in place. DCAA expects written policies, not verbal practices. A compensation policy must explain 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 what documentation is required before payment is released. Missing written policies are a finding before DCAA reviews a single transaction.
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Partially Allowable Costs
Some FAR 31.205 categories are neither fully allowable nor fully prohibited. They’re 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.
IR&D and B&P (FAR 31.205-18)
Independent Research and Development (IR&D) covers costs of research not sponsored by a contract but related to your general product lines. Bid and Proposal (B&P) covers the cost of preparing bids, proposals, and quotations. Both categories are allowable under FAR 31.205-18, but only for effort that would have happened without a government contract driving it.
For most small business contractors, the annual negotiated ceiling that applies to large defense contractors doesn’t affect you directly. IR&D and B&P allowability is governed by FAR 31.205-18. For Department of Defense contracts, DFARS 231.205-18 adds the “major contractor” designation: contractors whose covered segments allocated more than $11 million in IR&D and B&P costs to covered contracts during the prior fiscal year. Below that threshold, the negotiated ceiling does not apply to you.
What does apply: you must document the connection between each IR&D project and a potential government requirement. Write that down at the time the cost is incurred. DCAA is skeptical of justifications written after an audit notice arrives.
Depreciation (FAR 31.205-11)
Depreciation is allowable for tangible assets used in contract performance, subject to conditions on method and rate. The allowable charge is the lesser of the amount computed using your financial accounting method or the amount using straight-line depreciation over the asset’s estimated service life.
An asset that’s fully depreciated for financial accounting is fully depreciated for government contract purposes. You can’t claim ongoing depreciation on an asset that’s reached the end of its accounting life.
The depreciation method must be consistent. Switching from straight-line to accelerated depreciation to increase allowable costs can trigger a CAS 409 consistency challenge for CAS-covered contractors and a FAR 31.201-2 consistency failure for all others (including small businesses, who are exempt from CAS). Any method change should be coordinated through advance agreement under FAR 31.109 with the cognizant federal agency.
Pre-Contract Costs (FAR 31.205-32)
Costs incurred before a contract is awarded are allowable if they would have been allowable had the contract been in place when the costs were incurred. FAR 31.205-32 governs this category.
FAR 31.109 strongly recommends getting a written advance agreement with the contracting officer (CO) before you incur costs you plan to claim under a not-yet-awarded contract. Some agencies require it. If you start work before award on an urgent program, get that authorization in writing first. Without it, pre-contract costs are at your risk, and some agencies will deny them outright.
Action: For IR&D and B&P costs, create a brief project memo for each effort documenting the connection to a potential government requirement. Date it when the cost starts, not when the auditor asks. For pre-contract costs, build a standard procedure: no work begins on an unawarded contract until you have written authorization from the Administrative Contracting Officer (ACO) or CO on record.
How DCAA Tests These Costs During an Audit
DCAA’s primary tool for testing allowable costs is the incurred cost audit. The audit examines your final indirect cost rate proposal for a given fiscal year. Auditors follow the Contract Audit Manual procedures, which are publicly available on dcaa.mil.
Contractors performing cost-type or time-and-materials contracts must submit a final indirect cost rate proposal within six months of fiscal year end under FAR 52.216-7(d)(2). Calendar-year companies have a June 30 deadline. The proposal reconciles your books to the indirect rates used for billing during the year. DCAA audits it to confirm that unallowable costs were identified, segregated, and excluded from the rates billed to the government, as required by FAR 31.201-6.
Unallowable costs charged to government contracts are consistently among the top DCAA audit findings. DCAA doesn’t give credit for good intentions. Entertainment charges, excess compensation, or advertising costs that appear in your overhead pool trigger a questioned cost and an assessment of whether you knowingly included them, which creates False Claims Act exposure under 31 U.S.C. § 3729.
For compensation, DCAA benchmarks total pay (salary plus bonus plus benefits) against BLS data and published salary surveys for comparable positions in your area, industry, and company size. Compensation above the upper quartile triggers a reasonableness question. Related-party compensation, meaning pay to owners, family members, or affiliated entities, receives extra scrutiny. You’ll need compensation surveys, board approval documentation, and a written compensation policy to defend above-benchmark pay.
FAR 31.201-6 requires that unallowable costs be identified and excluded from any billing, claim, or proposal. Costs similar to expressly unallowable costs must be identified and treated consistently too. The accounting system must segregate unallowable costs at the transaction level: separate general ledger accounts or subaccounts for each unallowable category. A chart of accounts that pools entertainment, travel, and meals into a single “marketing and entertainment” account is an accounting system weakness DCAA will note. For more on building a compliant accounting system, see DCAA compliance for small contractors.
Action: Before you submit your final indirect cost rate proposal, print a trial balance for each indirect pool (overhead, G&A, fringe). For every account over $5,000, determine the allowability classification under FAR 31.205 and confirm the account contains only costs of that type. Document your determination in writing. Any account with mixed allowable and unallowable charges must be split in the accounting records before submission. A spreadsheet adjustment at year-end doesn’t satisfy the segregation requirement.
FAR Part 31 Allowable Costs: Quick Reference Table
The table below covers the 14 cost categories that matter most for small business contractors. For the full FAR compliance picture across the FAR 31.205 cost principles (sections 31.205-1 through 31.205-52), see acquisition.gov.
| 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 documented 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 / DFARS 231.205-18 | Conditionally Allowable | DFARS $11M major contractor ceiling for DoD, mission relevance required for all |
| Pre-Contract Costs | 31.205-32 | Conditionally Allowable | Advance written agreement strongly recommended, some agencies require it |
| 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 OSHA, tax, and regulatory penalties |
| Most Advertising | 31.205-1 | Generally Unallowable | Exception for recruitment ads and contract-required advertising only |
| Lobbying | 31.205-22 | Expressly Unallowable | Includes the lobbying portion of trade association dues |
| Legal Costs (Government Claims) | 31.205-47 | Generally Unallowable | Limited exceptions depend on nature of proceeding and outcome |
Do This Monday
- Pull the trial balance for each of your indirect cost pools (fringe, overhead, G&A). Flag any account containing the words entertainment, alcohol, beverage, dues, penalty, lobbying, or advertising. Calculate the total in flagged accounts and determine whether those amounts were excluded from your last indirect cost rate proposal submission.
- Check your chart of accounts for combined accounts that mix allowable and unallowable costs. A single account labeled “meals and entertainment” is a problem. Split it into two separate accounts in your accounting system this week, not at year-end.
- Verify you have written policies covering at least these four areas: how compensation is set and approved, the standard for travel airfare and lodging, what documentation is required before paying a consultant, and how you identify and exclude unallowable costs before billing. If any policy is missing, put a 30-day deadline on creating it.
- For the full DCAA audit readiness picture across accounting systems, timekeeping, indirect rates, and incurred cost submissions, see the DCAA Audit Readiness Checklist.
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