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Whitepaper: The Audit World's Biggest Myths
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Whitepaper: The Audit World's Biggest Myths
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Insights by: Eric Hayman, Senior Manager

Summary

It is the time of year when many contractors are preparing their annual Incurred Cost Submission (ICS).  As part of these preparations, contractors should be mindful to exclude unallowable costs from their submissions, as required by the Contract Cost Principles and Procedures (FAR Part 31) and the Allowable Cost and Payment Clause (FAR 52.216-7). 

Of particular note, are those indirect costs which are deemed to be “Expressly Unallowable”; as their inclusion in the ICS or claims could result in fines, penalties & interest, and even an inadequate determination of a contractor’s accounting system.

What is an Expressly Unallowable Cost?

As defined by Federal Acquisition Regulation (FAR) 31.001 and Cost Accounting Standards (CAS) 405, expressly unallowable costs are a “particular item or type of cost, which under express provisions of an applicable law, regulation, or contract is specifically named and stated to be unallowable”.  Simply put, expressly unallowable costs are those which are stated as unallowable in direct terms within a contract, FAR Subpart 31.2 or an executive agency supplement to the FAR.

The precise and narrow designation of specific costs as expressly unallowable has existed since the promulgation of CAS 405 in the early 1970s and has been supported by applicable FAR provisions.  Further, legal precedent and several Board decisions have consistently upheld this application and interpretation.  Nevertheless, the government over the last several years has sought expansion of this interpretation to apply in broader and presumptive terms from its initially drafted and intended meaning.  

In recent years, the DCAA has taken the position (with limited support from the Board) that a cost is expressly unallowable if:

  1. The cost principle states in direct terms that the costs are unallowable; or
  2. Leave little room for interpretation or differences of opinion as to whether the particular cost meets the allowability criteria; or
  3. That it was unreasonable, under all the circumstances, for a prudent business-person to conclude that the costs were allowable.

This broader interpretation has resulted in costs being deemed expressly unallowable and subject to penalties, even when the cost is not directly identified as expressly unallowable within a cost principle.

Example List of Expressly Unallowable Costs

In our experience, contractors fail to properly identify and exclude unallowable costs from their annual ICS for the following reasons:

  • Lack of training/employee knowledge of FAR 31.205 and the Cost Principles, and company policies;
  • Inadequate review and approval of expense reports and invoices prior to entry into the general ledger; and
  • Misalignment between company travel policies and applicable laws and regulation (this is generally a concern with non-traditional contractors or those contractors with large commercial segments).

The list of expressly unallowable costs below includes examples commonly found by Capital Edge Consulting when preparing and/or supporting contractors’ annual ICS:

  • Interest Expense;
  • Bad Debt Expense;
  • Re-organization and Merger & Acquisition Costs;
  • Alcohol;
  • Entertainment;
  • Advertising;
  • Compensation in Excess of Limits;
  • Federal Income Tax Expense; and
  • Charitable Contributions.

Expressly Unallowable Cost Penalties?  Interest?  But, these are legitimate expenses!

In many cases, costs which are deemed to be expressly unallowable are indeed legitimate and reasonable business expenses.  However, specific statutory or regulatory requirements have classified them as unallowable in very direct terms. 

Generally,  expressly unallowable costs are viewed by Congress as expenses which, if reimbursed by the Government, would be contrary to public policy and a misuse of taxpayer dollars or are related to activities for which the Government would not receive a benefit. 

Example:  The Government has a strong track record of paying its debts to contractors in a fairly timely manner.  Therefore, bad debt is an expressly unallowable cost, as collection of outstanding payments from the Government is rarely in doubt. 

Put more simply, as the Government routinely pays its bills, it is not a generator of a contractor’s bad debt provision, and therefore should not have bad debt expense allocated to the goods and services purchased under government contracts.

FAR 31 Expressly Unallowable Costs: How Much are We Talking Here?

In accordance with FAR 42.709 and the implementing clause 52.242-3 Penalties for FAR Unallowable Costs, penalties and interest apply to all contracts in excess of $800,000, except fixed-price contracts without cost incentives or any firm-fixed-price contracts for the purchase of commercial items.

However, FAR 42.709-5 requires Contracting Officers to waive penalties for the following scenarios:

  • The contractor withdrawal of an ICS before the audit entrance conference or the Government’s written notice of audit;
  • The amount of unallowable costs subject to penalty is $10,000 or less;
  • The contractor has established policies, internal controls & training to prevent the inclusion of unallowable costs; or
  • The unallowable costs were inadvertently included in error.

Should the Contracting Officer  not waive penalties, penalties and interest are to be assessed in accordance with FAR 52.242-3, as follows:

  • First Occurrence: penalty equal to the amount of disallowed cost allocated to the contract;
  • Second Occurrence (of same type of cost): penalty equal to twice the amount of disallowed cost allocated to the contract;
  • Simple interest: using the 6-month treasury rate.

Contractors should note, it is not uncommon for auditors and/or contracting officer to incorrectly calculate penalties related to expressly unallowable costs. 

The below is a recent example of a client experiencing such a miscalculation:

Example:  During the audit of the annual ICS, the Defense Contract Audit Agency (DCAA) questioned $350,000 in expressly unallowable G&A expenses, and proposed the contractor repay $350,000 in unallowable cost, and recommended the contracting officer assess a penalty of $350,000.  

The contractor is a non-traditional government contractor, with a single cost-type contract, which comprised only two percent (2%) of the G&A basis. The DCAA took no exception to the contractor’s reported G&A basis. 

In the example above, the DCAA correctly questioned the total amount of expressly unallowable costs which should have been excluded from the G&A pool; however, the calculation of the expressly unallowable costs allocable to the contract and the resulting penalties was incorrect.

As the contractor’s contract that is subject to the penalties clause (FAR 52.242-3) accounted for two percent of the overall G&A expense allocation base, the expressly unallowable costs allocable to this government contract was $7,000 ($350,000 x 2% = $7,000).  As the correct penalty amount is $7,000 (amount equal to unallowable cost allocated to the contract), the Contracting Officer shall not seek penalties in accordance with FAR 42.709()(b). 

Pursuant to a January 21, 2021 Memorandum for Regional Directors, the DCAA is no longer to compute and include in their audit reports penalty amounts associated with expressly unallowable costs.

Best Practices for Mitigating Risk Related to Expressly Unallowable Costs

Contractors can reduce the likelihood of including expressly unallowable costs in their annual ICS filings, and therefore the possibility of penalties and interest by implementing the following activities:

  1. Routinely (at least annually) providing unallowable cost training to all contractor staff;
  2. Implementing preventative controls, including the review of transactions by the accounting staff, and approval of all transactions by accounting management;
  3. Reviewing the annual ICS for accounts which should be identified as unallowable; and
  4. Performing unallowable testing of high-risk accounts as part of the ICS process and projecting the results.

What are FAR Allowable Costs?

FAR allowable costs are the costs that are reasonable and allocatable to the contract, per funding statute and agency requirements, Cost Accounting Standards, and the FAR. These allowable costs include salaries, travel expenses, medical expenses, publication fees, and other items deemed necessary to running a business. Far section 31 specifically covers many different types of costs contractors may incur.

Allowable vs Unallowable Costs

In government contracting, not all costs are treated the same. Between allowable and unallowable costs, there are differences.

Allowable costs are those that can be included on your invoice to the government for reimbursement. While unallowable costs are those that you can include on your invoice to the government for reimbursement, and they’re subject to certain criteria.

Have questions regarding Expressly Unallowable Costs or other Federal government contracting concerns?

About Capital Edge Consulting

Capital Edge government contract consultants support Government Contractors and Federal Grant Recipients. Our consultants specialize in the regulatory compliance matters you need.

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Whitepaper: The Audit World's Biggest Myths
Download Now
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