Thoughts on Segregation... of costs that is.



So, on our last blog, we began unpacking the audit program for DCAA's Accounting System review. Remember, that is the audit program used by DCAA to see if your accounting system is ready to handle a government contract. Well, last time we covered step 1 - verifying the accounting system's compliance with GAAP. In this issue, we continue with audit program Step 2 - Proper Segregation of Costs.


Step 2 - Proper Segregation of Costs.


So, what does "Proper Segregation of Costs" mean?

The easy answer would be to group your expenses by types. The common understanding is that we should not do this with people; however, when it comes to expenses, we do need to segregate them by like-kinds.

So, what are the types then? Good question! We’d have to know the types in order to group them, right? Well, let’s dive into this audit program step together.

Step 2 requires the auditor to review your accounting system and check to see if it can prevent direct charging of indirect expenses and indirect charging of direct costs.

In other words, your accounting system must be able to segregate direct vs indirect costs.

I assume that most of you understand the difference between direct and indirect costs, so rather than explaining that difference, let's dive into an example scenario.


Let's say at ABC company, you have an engineer, Ms. Angelina, who also serves as a manager.


Ms. Angelina spends a portion of her day working with the marketing department, another portion talking to her managers, and a portion of her day doing engineering work on a specific contract for a specific government agency.


You see, in this situation, there is a high risk for Ms. Angelina's time to be charged directly when she's actually working on an indirect function and vice versa. This situation presents a risk to the government, and also other clients of the company. If her indirect hours inadvertently get charged directly to a contract, that one customer ends up paying for indirect work that everyone else benefited from without having the other customers pay their fair share. This situation also presents the risk that the company may purposely charge some indirect costs directly to a contract in an effort to lower the indirect costs on other contracts. The risk here is that costs may be shifted between contracts through the misclassification of direct and indirect costs. Therefore, the audit program directs the auditor to verify that adequate controls, designed to prevent and detect such errors, exist.


The specific type of control that should be in place, and the effectiveness of such control, depend on the type of cost element (i.e. labor, materials, etc.) and business. Popular controls for labor include the use of Work Authorization Forms, restrictive timekeeping systems, and written Policies & Procedures that describe the proper treatment of such costs.


I hope that going over audit step 2 provided some insight into controls for direct vs indirect costs.


In our next issue, we'll unpack step 3 - accumulation of direct costs by contract.


Until then, as always, please feel free to reach out with questions or comments.


Happy Government Contracting!