Incurred Cost Audit: What DCAA Reviews and How to Survive Scrutiny

Filing Your Incurred Cost Submission Is Not the Finish Line. It Is the Starting Line.

Most government contractors focus their efforts on filing the incurred cost submission by the June 30 deadline. The schedules are assembled, the package is submitted, and everyone exhales. The assumption is that the hard part is over.

It is not. The incurred cost submission is a filing. The incurred cost audit is where your filing gets tested. DCAA will examine your submission with a level of detail that most contractors do not anticipate, tracing numbers from your schedules back to your general ledger, testing individual transactions for allowability, and verifying that your indirect rates are accurately calculated and properly supported. The quality of the submission you filed determines whether that audit is a manageable process or a prolonged, expensive problem.

This article explains exactly what DCAA reviews during an incurred cost audit, where contractors most commonly fail, and how to build a submission package that withstands scrutiny.

When the Audit Happens and What Triggers It

DCAA does not audit every incurred cost submission in the year it is filed. Some contractors wait years before their submission is selected. Others are audited relatively quickly. The timing depends on DCAA’s risk assessment, their workload priorities, and the dollar value of your contracts.

High-dollar contracts receive more attention. Contractors with a history of audit findings receive more attention. New contractors on their first cost-reimbursable award may be prioritized because DCAA has no baseline for evaluating their cost accounting practices. There is no way to predict exactly when your audit will happen, which is why the submission needs to be audit-ready from the day it is filed.

Once DCAA initiates an audit, it issues an engagement letter outlining the scope, the fiscal year under review, and the documentation it will need. The audit itself can take anywhere from a few months to well over a year, depending on the complexity of your cost structure and the number of issues that surface during the review.

What DCAA Examines: The Core Audit Areas

An incurred cost audit is a comprehensive review of your actual costs for the fiscal year, your indirect rate calculations, and the allocation of those costs to government contracts. DCAA follows a structured audit program, and understanding its focus removes uncertainty about what to expect.

Indirect Rate Verification

This is the central purpose of the incurred cost audit. DCAA verifies that your actual indirect rates, fringe, overhead, and G&A, are accurately calculated based on your real cost data.

The auditor will reconstruct your rate calculations from your general ledger. They will verify that each indirect cost pool contains only the costs that belong there. They will confirm that your allocation bases are appropriate, consistently applied, and correctly computed. They will compare your actual rates to the provisional rates you used for billing and calculate any over- or under-recovery.

If your actual rates are lower than your provisional billing rates, you overbilled the government and owe a refund. If your actual rates are higher, the government owes you the difference. Rate verification determines the final financial settlement for the fiscal year under audit.

Allowable Cost Testing

DCAA selects a sample of costs from your indirect pools and tests them against FAR Part 31 allowability criteria. Each sampled transaction must be allowable (not prohibited by regulation), allocable (it benefits the cost objective to which it is charged), and reasonable (a prudent business person would incur the cost under similar circumstances).

The auditor reviews the documentation supporting each transaction. They look for proper authorization, adequate supporting evidence such as invoices and receipts, and correct classification in your accounting system. Costs that fail any of the three tests are considered questioned costs, which means the DCAA recommends they be disallowed and excluded from your rate calculations.

Common areas where allowability testing produces findings include travel expenses that exceed Federal Travel Regulation limits, entertainment and employee morale costs that were not properly segregated, professional service fees without adequate documentation of business purpose, and compensation costs that exceed reasonableness benchmarks.

Direct Cost Verification

DCAA verifies that the costs you charged directly to government contracts are properly allocable. They select a sample of direct charges and confirm that each cost provides a direct, identifiable benefit to the specific contract it was charged against.

The most common finding in direct cost testing is misclassification. A cost that benefits multiple contracts is charged directly to one contract rather than allocated through an indirect pool. A cost that is clearly indirect, such as general office supplies or company-wide software, is charged as a direct cost. These classification errors distort both your direct contract costs and your indirect rates.

Reconciliation Testing

Everything in your incurred cost submission must reconcile. Your schedule of direct costs by contract must tie to your general ledger. Your indirect cost pool summaries must tie to your financial statements. Your allocation bases must be mathematically consistent across schedules.

DCAA traces numbers across your submission to verify internal consistency. If Schedule A shows total direct labor of $1.2 million and Schedule B shows a different number for the same category, you have a reconciliation problem. If your total claimed costs do not equal your audited financial statements, you have a reconciliation problem. These discrepancies do not necessarily mean fraud. They usually mean the submission was hastily assembled and the quality review was insufficient.

Billing Reconciliation

The auditor compares the amounts you billed to the government during the fiscal year against the costs you claimed in your incurred cost submission. Billing amounts should be traceable to your accounting records and should reflect your provisional billing rates applied to actual costs.

If your cumulative billings exceed your total allowable costs, you have overbilled and owe a refund. DCAA calculates this adjustment as part of the rate settlement process. Contractors who do not track the relationship between provisional billing and actual costs throughout the year are often surprised by the magnitude of the adjustment.

Where Contractors Fail: The Most Common Audit Findings

After reviewing hundreds of audits, the same issues surface repeatedly. Each one is preventable with proper preparation and ongoing attention to your cost accounting practices.

Unallowable costs in indirect pools. This is the single most frequent finding. Costs that should have been segregated as unallowable under FAR Part 31, including entertainment, alcohol, late fees, and certain lobbying costs, remain embedded in indirect cost pools. Every unallowable dollar in your pools inflates your rates and overstates your billing to the government.

Inconsistent cost treatment. A cost that is treated as direct on one contract and indirect on another, or a cost category that is classified differently from one fiscal year to the next without proper justification and disclosure. Consistency is a fundamental requirement, and deviations need documented reasoning.

Inadequate documentation. Transactions selected for testing that lack sufficient supporting evidence. An invoice without a purchase order. A travel expense without documented business purpose. A consulting fee without a contract or scope of work. The absence of documentation does not mean the cost was inappropriate. It means the auditor cannot verify that it was appropriate, resulting in the same outcome.

Timekeeping deficiencies. Labor cost testing often extends to the timekeeping practices underlying labor charges. If employees are not recording time daily, if supervisors are not approving timesheets, if corrections are not properly documented, the labor charges become vulnerable. Labor is typically the largest cost element, and timekeeping problems can affect both direct and indirect cost pools.

Reconciliation failures. Schedules that do not tie to each other, claimed costs that do not match the general ledger, or allocation bases that are mathematically incorrect. These errors undermine the credibility of the entire submission and often lead to expanded audit scope because the auditor cannot rely on the numbers without additional verification.

The Audit Process: What to Expect

Understanding the mechanics of the audit helps you prepare for it and manage it effectively when it happens.

Entrance conference. DCAA holds an initial meeting to explain the scope of the audit, outline the documentation they will need, and establish a timeline. This is your opportunity to understand what the auditor will focus on and to identify any issues you should address proactively.

Document requests. The auditor will request your general ledger, trial balance, financial statements, billing records, timekeeping records, policies and procedures, and supporting documentation for sampled transactions. Having these organized and accessible before the audit starts reduces friction and signals that your systems are well-maintained.

Fieldwork. The auditor conducts their testing, which may include on-site visits, interviews with accounting staff, and detailed review of selected transactions. During fieldwork, respond promptly and completely to information requests. Delays create the impression that you are hiding something, even when you are simply disorganized.

Draft findings. Before issuing the final report, DCAA typically shares preliminary findings and allows you to respond. This is critical. If the auditor has misunderstood a transaction, misapplied a cost principle, or made an error in their analysis, this is your chance to correct it before it becomes an official finding.

Final report. The audit report includes the auditor’s opinion on your incurred cost submission, any questioned costs, and the recommended final indirect rates. The contracting officer uses this report to negotiate the final rate settlement with you.

Building a Defensible Submission

The best time to prepare for an incurred cost audit is before you file the submission. Every decision you make during preparation affects how the submission performs under scrutiny.

Close your books with audit precision. Year-end close should produce financial statements that are reconciled, accurate, and consistent with the data in your ICS schedules. If an auditor finds discrepancies between your financial statements and your submission, the entire package loses credibility.

Segregate unallowable costs throughout the year. Real-time segregation through dedicated general ledger accounts is always more reliable than year-end reclassification. The fewer manual adjustments required during ICS preparation, the lower the risk of errors.

Document everything as it happens. Business purpose memos for travel and meals. Signed timesheets with supervisor approvals. Contracts and scopes of work for professional services. Source documents for every significant transaction. If the documentation does not exist at the time of the audit, it is too late to create it.

Perform internal quality review before filing. Have someone other than the preparer review the completed submission for internal consistency, mathematical accuracy, and reconciliation to source records. This step catches the errors that would otherwise become audit findings.

Maintain your submission workpapers. Keep the supporting calculations, reconciliations, and source documents that you used to build each schedule. When the auditor asks how you arrived at a number, the answer should be immediate and traceable, not a reconstruction from memory.

The Bottom Line

An incurred cost audit is not a random event that happens to unlucky contractors. It is a predictable, structured review that follows a well-defined process. The contractors who treat their incurred cost submissions as audit-ready documents from the start handle the review with minimal disruption and financial exposure. The contractors who rush the filing and hope the audit does not come are the ones who end up with questioned costs, rate adjustments, and repayment obligations that could have been avoided.

Your submission is the story of your fiscal year told in numbers. Make sure the story holds up when someone reads it closely.

Need help building audit-ready incurred cost submissions? Contact Eubanks Accounting & Advisory to ensure your package withstands DCAA scrutiny.

Sources

1. DCAA Incurred Cost Submission Guide – dcaa.mil
2. DCAA ICE Model – dcaa.mil
3. DCAA Contract Audit Manual – dcaa.mil
4. FAR 52.216-7: Allowable Cost and Payment – acquisition.gov
5. FAR Part 31: Contract Cost Principles – acquisition.gov