Key Details: Government contractors face increased scrutiny over accounting systems, internal controls, and documentation. As audit practices evolve and agencies modernize, contractors must proactively stay compliant to avoid delays, reduce friction, and safeguard contract opportunities. Understanding requirements for a compliant accounting system and planning ahead helps lower audit risk. For further information regarding our government contracting consulting services, contact us or visit our website today.
The Role of DCAA
The Defense Contract Audit Agency (DCAA) is responsible for performing contract audits and providing financial advisory services to the Department of War (DoW) and other federal agencies, as appropriate. The DCAA helps contracting officials determine whether contractor costs are allowable, allocable, and reasonable under applicable regulations, including the Federal Acquisition Regulation (FAR), the Defense Federal Acquisition Regulation Supplement (DFARS), and Cost Accounting Standards (CAS).
In the DCAA FY 2024 Report to Congress, published in mid 2025, the DCAA emphasized a risk-based audit approach, prioritizing areas with the greatest potential impact on the government, such as the acquisition process when cost data influences pricing and negotiations. For contractors, this means having a sound and compliant accounting system and internal controls in place is of high importance.
DCAA audit activity continues to center on the six contractor business systems identified in DFARS 252.242-7005:
- Accounting System
- Estimating System
- Earned Value Management System
- Material Management and Accounting System
- Property Management System
- Purchasing System
The accounting system remains a key audit area for contractors performing cost-reimbursable, time & materials (T&M), or labor-hour contracts, as these contract types rely heavily on incurred costs, correct billing, indirect rates, and labor charging. As such, deficiencies in the accounting system can have cascading effects across other audit areas, making early system adequacy a critical risk management issue. If you would like a quick guide on accounting systems, you can read our article here.
Elimination of Significant Deficiency as an Audit Outcome
A notable change in DCAA audit practice stems from a memorandum published in August 2025 that requires certain audit findings under covered contracts to be classified as material weaknesses. This shift is more than a terminology update as it raises the stakes for contractors. A material weakness could indicate that the system does not meet applicable regulatory criteria, requires documented remediation, and often triggers additional audit attention. As such, contractors are encouraged to conduct an internal review of their accounting system and ensure the necessary documentation (such as policies and procedures) is in place to support it.
Expanded Use of Data Analytics and Technology in Audits
The DCAA has also been modernizing its audit approach by increasing the use of data analytics, automation, and centralized audit platforms. These tools support risk-based audit selections, more consistent sampling, the identification of anomalies across large datasets, and the reduction of audit backlogs. While these technologies improve efficiency, the DCAA has noted that they do not replace auditor judgment. This development has an important implication for contractors as auditors are increasingly data-driven, and patterns that might once have gone unnoticed may now surface through analytics.
Contractors can also adopt a similar mindset internally by using AI or other analytical tools to identify issues early. Examples include the following:
- Labor charging analysis to highlight unusual patterns such as employees charging significantly more indirect time than others, sudden shifts in charge codes near period-end, or heavy use of miscellaneous charge codes.
- Indirect rate monitoring to identify volatility in indirect cost pools or allocation bases, unexpected reclassifications, or significant differences between provisional billing rates and actual results.
- Expense allowability screening to flag transactions that may contain unallowable costs under FAR Part 31.
Contractors should remember that analytical tools are support tools, not replacements for professional judgment. Assign professionals to review analytical results, ensure sensitive information remains confidential, and clearly define where and how AI tools may operate.
Refresher on Compliance Accounting Systems
Though the term “DCAA compliance” is a buzzword in the government contracting industry, it is important to note that the DCAA does not certify contractors as “compliant.” DCAA compliance essentially means that the contractor can follow the agency's recommendations and guidance to follow various federal regulations and is prepared for audits. For the purposes of this article, we are focusing on accounting system compliance.
The consequences of noncompliance could expose contractors to audits or investigations. There could also be significant legal consequences and financial losses. As such, contractors are encouraged to ensure their accounting system is aligned with DCAA standards. These standards ensure that contractors can, among other things:
- Maintain accurate and complete records of billings and costs.
- Segregate direct, indirect, and unallowable costs accurately and consistently.
- Implement robust timekeeping and labor distribution systems with regular reviews, approvals, and reconciliations.
- Provide audit-ready documentation.
- Follow the regulations set forth in the Federal Acquisition Regulation (FAR) and Cost Accounting Standards (CAS).
The SF 1408’s evaluation checklist specifically tests cost segregation, contract cost accumulation, indirect allocation methodology, general ledger control, timekeeping and labor distribution, and interim (at least monthly) posting of contract costs. Contractors are encouraged to review the items below and to perform an internal review to determine if their accounting system is set up correctly:
- Review your chart of accounts and cost pool configuration. Ensure the chart of accounts adequately segregates direct, indirect, and unallowable costs.
- Ensure your timekeeping system can be integrated with your accounting system, so employees can be tracked by job or contract.
- Ensure policies and procedures outline that employees are required to enter time daily, and that supervisors are required to review and approve employee timesheets.
- Ensure that employee labor is identified by intermediate or final cost objectives through the use of unique project or time codes that are only made available to employees who are authorized to record time to a project.
- Enable the generation of an audit trail to show employee timesheet edits and supervisor approvals, and provide regular employee timekeeping training.
- Ensure project and job costing are set up in the accounting system to track revenues and expenses by contract, job, task order, CLIN, etc.
- Maintain your books in accordance with generally accepted accounting principles (GAAP). This would include reporting on an accrual basis and ensuring you can print basic financial reports.
- Ensure customers have unique codes to easily distinguish between contracts, modifications, task orders, etc., when recording billings and costs.
- Regularly review where indirect costs are being accumulated to ensure they are classified consistently and accurately within each cost pool.
- Ensure employees record total time worked to the correct projects by implementing regular supervisor reviews and providing training.
- Ensure direct costs are recorded by contract, so total costs incurred for a given project can be reported monthly.
- Provide relevant accounting staff with training to understand and identify unallowable costs, so they are not charged to a contract.
- Segregate preproduction costs from production costs through different account numbers.
- Track monthly costs and billings to support progress payment requests.
- Ensure your accounting system is in full operation.
- Perform routine reconciliations of indirect rate calculations with accounting system records to verify accuracy and maintain consistency between computed rates and recorded costs.
- Verify that system configurations, processes, and reporting are aligned with documented accounting policies and procedures.
Conclusion
As the contracting landscape continues to evolve, contractors are encouraged to ensure the fundamentals of their accounting system remain correct and compliant. This includes performing internal reviews against SF 1408 requirements and leveraging AI and other analytics techniques to enhance visibility and control.
For further information and expertise, contact Ryan & Wetmore today.
Today’s Thought Leaders
About Peter Ryan
Partner, Co-founder, & CPA
Peter T. Ryan co-founded Ryan & Wetmore in 1988 with business partner Michael J. Wetmore. Peter provides clients with the best strategies for success. His expertise extends across various industries. Peter obtained a Master of Business Administration in Finance from the University of Baltimore and a Bachelor of Arts in Accounting from the Catholic University of America.
About Rosie Cheng
Senior Finance Consultant
Rosie Cheng is a Senior Finance Consultant at Ryan & Wetmore. She focuses on government contracting services and produces many of the firm’s government contracting newsletters. Rosie earned her Master of Science in Management from Georgetown University and a BBA from William and Mary.
