Understanding FAR part 31 and why it matters

FAR Part 31 establishes the cost principles governing federal contracts. To be allowable, a cost must be: Reasonable for the work performed Allocable to the contract Consistent with Cost Accounting Standards, if applicable, otherwise consistent with generally accepted accounting principles and practices appropriate to the circumstances Compliant with FAR Part 31 and contract terms Engineering and design firms are particularly exposed because they often: Perform both commercial and government work Operate labor-intensive cost structures Use complex indirect rate pools Offer incentive-based compensation to attract technical talent Without strong policies and controls, these characteristics significantly increase audit exposure.

Indirect cost pitfalls and allocation errors

Indirect costs are another frequent source of FAR audit findings. FAR 31.203 requires indirect costs to be accumulated in logical cost groupings and allocated on bases that reasonably reflect causal or beneficial relationships. Common issues observed Misclassification of direct and indirect costs Inclusion of unallowable costs in indirect pools Inconsistent allocation bases Poor documentation of rate methodologies Engineering firms that grow quickly or acquire new entities often struggle to maintain consistency, increasing audit risk. Responsible practices Clearly define direct versus indirect costs in accounting policies Segregate unallowable costs at the general ledger level Review indirect rate structures at least annually Perform mock audits prior to rate submissions

The overlooked income tax impact of FAR cost allowability

FAR compliance is commonly viewed through a contract audit lens, even though the same cost allowability decisions often affect income tax positions. Without coordination between FAR compliance and tax planning, firms increase the risk of exposure in IRS examinations and ASC 740 reviews. Permanent and temporary book-tax differences FAR-unallowable costs — such as lobbying, certain meals and entertainment, and some legal or marketing expenses — often create permanent book-tax differences. When these costs are not properly identified and segregated: Tax deductions may be overstated Effective tax rates may be understated ASC 740 provisions may be misstated Embedding unallowable costs in indirect pools is a common root cause.

Why integration matters

Managing FAR compliance and income tax planning in silos increases risk. A coordinated approach supports: Accurate identification of nondeductible costs Stronger ASC 740 positions Reduced exposure in both DCAA and IRS audits

1. What is the most common FAR audit issue for engineering firms?

Labor charging errors remain the most frequent and highest-risk finding.

2. Are FAR-unallowable costs always nondeductible for tax?

Not always, but many create permanent book-tax differences that must be tracked.

3. Can bonuses be allowable under FAR?

Yes, if they are reasonable, documented, and based on pre-established plans.

4. How often should indirect rates be reviewed?

At least annually, or more often during periods of growth or restructuring.

5. Do FAR issues increase IRS audit risk?

Yes. Poor documentation and inconsistent cost treatment often draw IRS scrutiny.

6. Is annual compliance training necessary?

Yes. Regular training reduces errors and demonstrates a strong compliance culture.

Article

Common FAR cost allowability pitfalls for engineering and design firms test

March 2, 2026 · Authored by Rich Weber

Engineering and design firms that perform work for the US federal government operate in a highly regulated environment where technical excellence alone isn’t enough.

One of the most persistent challenges these firms face is navigating cost allowability risks, particularly under Federal Acquisition Regulation (FAR) Part 31. These rules determine whether costs charged to government contracts are allowable, allocable, and reasonable — and they are a frequent focus of DCAA and agency audits.

Common FAR cost allowability pitfalls for engineering and design firms remain a leading source of government agency audit findings, but they are largely preventable.

Cost allowability issues are a leading driver of audit findings, questioned costs, delayed contract payments, and in some cases, penalties or repayments. This is typical at engineering and design firms across the defense, infrastructure, environmental, and professional services sectors.

Labor charging, indirect costs, bonuses, travel, and unallowable expenses continue to be top risk areas, and each carries potential income tax consequences if not properly managed. Importantly, these same issues often carry hidden income tax consequences that firms don’t recognize until much later, but, with the right strategy, can be mitigated before posing risk.

Firms that take a proactive, integrated approach — combining FAR compliance, accounting discipline, and tax planning — are far better positioned to withstand DCAA and IRS scrutiny while supporting sustainable growth in the federal marketplace.

Explore the most frequent FAR Part 31 cost allowability issues and how your firm can reduce both contract compliance and income tax risk.

Rich Weber

Principal

Related sections

Professional Services

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

Common FAR cost allowability pitfalls for engineering and design firms test

Rich Weber

Related sections

Understanding FAR part 31 and why it matters

Labor charging errors: The highest-risk area

Frequent labor issues

Risk mitigation strategies

Indirect cost pitfalls and allocation errors

Common issues observed

Responsible practices

Bonus and incentive compensation challenges

Typical findings

Compliance responsible practices

Travel costs: Small dollars, frequent findings

Common travel pitfalls

Risk reduction tips

The overlooked income tax impact of FAR cost allowability

Permanent and temporary book-tax differences

FAR-unallowable doesn’t always mean nondeductible for tax

Bonus timing and deductibility

Common tax issues

Labor charging and R&D tax credit exposure

Why integration matters

Expressly unallowable costs: A persistent risk

Unallowable costs examples

Unallowable costs prevention strategies

Six common questions on FAR cost allowability and tax considerations