Unallowable Costs Under FAR 31.205

There is nothing improper about a government contractor incurring an unallowable cost. Companies sponsor charity golf tournaments, hold holiday parties, retain lobbyists, and take clients to dinner. The regulation does not prohibit spending money this way. It says the government will not reimburse it, and it requires the contractor to identify and exclude it. The compliance failure is almost never the spending. It is the accounting.

The Allowability Framework

FAR 31.201-2 establishes that a cost is allowable only if it satisfies several tests together: reasonableness, allocability, compliance with applicable Cost Accounting Standards or generally accepted accounting principles, the terms of the contract, and any limitations in FAR Part 31 itself.

FAR 31.205 then works through selected costs one by one, resolving specific categories. Some are unallowable outright. Some are allowable subject to conditions or ceilings. Some are allowable in one form and not another — the distinction between a business meal and entertainment being the classic example that generates argument every year.

The Categories That Actually Come Up

The selected-costs list at 31.205 is long, and most of it is irrelevant to any given contractor. In mid-market GovCon the recurring items are a short list:

• Entertainment. Unallowable as a category, including amusement, social activities, and the associated costs. This regularly captures spending that a private company would book without a second thought — tickets, outings, club memberships.
• Alcoholic beverages. Unallowable in all circumstances. It is a small number that is almost always found, because it is easy to test for.
• Contributions and donations. Unallowable regardless of the recipient or the business rationale.
• Lobbying and certain political activity. Unallowable, with a defined scope covering attempts to influence legislation and related activity.
• Fines and penalties. Unallowable, including those resulting from violations of law or contract terms.
• Interest. Interest on borrowings is unallowable, which surprises contractors who financed growth with debt and expected the carrying cost to be recoverable.
• Bad debts. Unallowable, including related collection and legal costs.
• Organization costs. The costs of organizing or reorganizing the business, including costs of raising capital and of mergers and acquisitions activity, are unallowable. This one matters enormously in a transaction, because sell-side deal costs land squarely in it.
• Advertising and public relations. Largely unallowable, with narrow exceptions such as recruitment advertising and advertising required by contract.
• Compensation. Allowable but subject to reasonableness, and to the statutory compensation cap for senior executives and certain other employees.
• Travel. Allowable subject to conditions, with costs above federal per diem and lodging ceilings requiring justification. The RFO deviation text edited some of the approval-delegation language here, so this is one to read in current form rather than from memory.
• Legal costs. Allowable in the ordinary course, but costs of defending certain proceedings involving fraud or similar misconduct are unallowable where the proceeding results in specified adverse outcomes.

Directly Associated Costs

This is the provision that catches contractors who thought they had the problem solved.

FAR 31.201-6 requires that when an unallowable cost is incurred, any directly associated cost — a cost that would not have been incurred but for the unallowable cost — is also unallowable. The lobbying invoice is unallowable, and so is the travel to the meeting, and so is the labor of the employee whose time was spent on it.

The labor piece is the one that gets missed. Salaried effort devoted to unallowable activity is itself unallowable, which means it has to come out of the indirect pools and out of the allocation bases. A contractor that excluded the vendor invoices but left the associated executive labor in G&A has not actually complied.

Segregation Beats Reconstruction

There are two ways to handle unallowables, and the difference between them is the difference between a clean audit and an expanded one.

Reconstruction means the company books everything normally during the year, and at submission time someone reviews the general ledger, identifies the unallowables, and backs them out in a spreadsheet adjustment. This is what most contractors do. It is defensible in principle and fragile in practice, because it depends on one person's judgment applied once, under deadline pressure, across twelve months of transactions they mostly did not witness.

Segregation means the chart of accounts contains dedicated unallowable accounts, and costs are coded there at the point of entry by the person closest to the transaction. Year-end exclusion becomes a query rather than an investigation.

FAR 31.201-6 contemplates the use of accounting practices that identify unallowable costs, and an accounting system that cannot segregate them is a system that will draw a finding. More practically: segregation is the only approach that scales. A contractor doing it by reconstruction at $8M of revenue will still be doing it by reconstruction at $40M, and the reconstruction will be worse.

Penalties, and Why Certification Matters

Claiming expressly unallowable costs is not treated as a neutral error to be corrected. FAR 42.709 provides for penalties where expressly unallowable costs are included in a final indirect cost rate proposal, with a higher penalty where the cost was previously determined unallowable for that contractor.

The certification on the incurred cost submission is what makes this bite. An authorized official signs a representation that the proposal excludes expressly unallowable costs. That signature converts a bookkeeping question into a personal representation, and it is the reason the submission should never be certified by someone who has not actually verified the exclusion process rather than trusting that it happened.

The Transaction Dimension

Unallowable cost findings do damage disproportionate to their dollar value in diligence, for a reason worth understanding.

The direct exposure is usually modest. What a buyer takes from the finding is inferential: if the control environment did not catch entertainment coded to G&A, what else did it not catch? The scope of review expands, more is found, and the buyer's confidence in management's representations degrades across the board.

There is also a specific trap in the transaction itself. Sell-side deal costs — banker fees, transaction legal, quality of earnings — fall within the organization costs provision and are unallowable. A contractor running these through the ordinary G&A pool during a sale process is claiming unallowable costs in the very year the buyer is examining most closely. They belong in a segregated unallowable account from the first invoice.