Your company passed its initial DCAA accounting system audit three years ago, but during this year’s incurred cost audit, auditors discovered that supervisors routinely approved timesheets without review, accounting staff processed journal entries without supporting documentation, and unallowable costs accumulated in indirect pools without identification or exclusion. DCAA issued a significant deficiency determination questioning $680,000 in indirect costs, citing inadequate internal controls allowing systematic cost misclassification and management override of accounting procedures. Here’s what contractors miss about internal controls: establishing compliant accounting systems represents only the foundation—maintaining control effectiveness requires ongoing discipline through documented procedures, systematic monitoring, management oversight, and corrective action processes ensuring controls function as designed rather than degrading into informal practices that look compliant on paper but fail in operation. Understanding how to design, implement, and maintain effective internal controls isn’t about creating bureaucracy—it’s about building systematic safeguards preventing the cost accounting errors, timesheet manipulation, unallowable cost charging, and allocation mistakes that transform compliant systems into deficient operations triggering questioned costs and business system disapproval.
The Legal Framework Governing Internal Control Requirements
Federal acquisition regulations establish specific internal control expectations ensuring contractor accounting systems produce reliable cost data supporting government contract billing. FAR 31.201-2(d) requires contractors to maintain adequate internal controls and accounting systems for accumulating and billing costs, with adequacy encompassing both system design and operational effectiveness. This provision makes internal controls a regulatory requirement rather than optional best practice—your accounting system must include controls preventing cost misclassification, detecting errors, and ensuring compliance with cost accounting standards.
The business system criteria under DFARS 252.242-7006 explicitly require contractors to maintain adequate internal control procedures providing reasonable assurance that costs are properly accumulated, segregated, and allocated. These requirements extend beyond basic accounting design to encompass control procedures including: segregation of duties preventing single individuals from controlling entire transaction cycles, management review and approval of significant transactions and adjustments, reconciliation procedures detecting discrepancies, and monitoring mechanisms ensuring ongoing control effectiveness. Understanding DCAA compliance requirements means recognizing that system adequacy depends equally on control design and control operation.
DFARS 252.242-7006(c)(7) specifically mandates that accounting systems exclude unallowable costs from billing, invoicing, and indirect rate calculations. This requirement necessitates internal controls systematically identifying costs FAR prohibits, segregating unallowable amounts in separate accounts, and preventing their inclusion in government contract charges through both direct billing and indirect allocation. Control failures allowing unallowable cost charging represent significant deficiencies regardless of dollar magnitude, as they demonstrate fundamental system inadequacy in distinguishing allowable from prohibited expenses.
The critical consideration involves FAR 42.302(a)(12), assigning DCAA responsibility for examining and evaluating contractor internal control systems as part of accounting system audits. DCAA doesn’t simply verify that control procedures exist—auditors test whether controls operate effectively by examining transactions, interviewing personnel, observing processes, and evaluating whether actual practices align with documented procedures. Control designs failing operational testing trigger deficiency findings even when written procedures appear adequate, because paper controls providing no actual protection fail regulatory adequacy standards.
What Contractors Must Understand About Internal Control Challenges
Here’s what contractors miss about internal controls: establishing procedures in written policies doesn’t ensure those procedures operate effectively in daily practice. DCAA compliance explained emphasizes that DCAA evaluates control effectiveness through operational testing examining whether employees actually follow procedures, whether management actually reviews transactions, and whether monitoring actually detects problems. Your comprehensive accounting manual means nothing when employees bypass procedures, managers rubber-stamp approvals without review, and monitoring consists of cursory year-end reconciliations discovering problems too late for correction.
The timesheet approval breakdown represents the most common internal control failure when supervisors approve timesheets without reviewing time distribution accuracy, validating charge codes, or verifying hours worked. This is where audits go sideways—contractors implement electronic approval workflows requiring supervisor sign-off but supervisors treat approval as administrative formality, clicking “approve all” without examining individual timesheets for accuracy, reasonableness, or compliance. When DCAA interviews supervisors who cannot explain their approval procedures, describe what they review, or identify concerns they’ve raised about timesheet accuracy, auditors conclude that timesheet controls exist only nominally without providing actual oversight preventing labor mischarging. DCAA timekeeping requirements mandate meaningful supervisor review as essential control over labor cost accuracy, not mere electronic workflow completion.
The segregation of duties violation emerges when small contractor size concentrates accounting functions in single individuals controlling entire transaction cycles without independent review. The same person who approves purchases, processes invoices, records costs, and reconciles accounts possesses ability to manipulate transactions, conceal errors, and override controls without detection. While small contractors cannot achieve the segregation possible in large organizations, they must implement compensating controls including enhanced management review, periodic surprise audits, and systematic reconciliation procedures providing oversight that segregation would otherwise offer.
The journal entry control weakness manifests when accounting staff post adjusting entries, reclassifications, or corrections without supporting documentation, management approval, or explanatory notation describing entry purpose and authorization. Unrestricted journal entry capability enables manipulation of contract costs, indirect pools, and allocation bases that audits discover through transaction testing. When DCAA selects random journal entries for examination and discovers entries lacking supporting documentation or approval, auditors question whether accounting system controls prevent cost manipulation or whether management possesses adequate visibility into accounting adjustments affecting government contract charges.
The unallowable cost control failure occurs when contractors lack systematic procedures identifying prohibited costs at transaction recording, resulting in unallowable expenses accumulating in indirect pools and allocating to government contracts through overhead rates. Without proactive identification procedures, contractors discover unallowable costs only during year-end incurred cost preparation or DCAA audits—too late to prevent improper charging through months of billing. Effective controls require front-end identification at accounts payable processing, expense report review, and payroll administration, with automatic segregation into dedicated accounts excluding amounts from indirect pools before rate calculations occur.
The monitoring inadequacy becomes apparent when contractors lack systematic procedures detecting control failures, identifying policy violations, or measuring compliance performance. Controls degrade over time without monitoring—employees develop workarounds, managers become complacent, procedures drift from written policies, and problems accumulate undetected until external audits reveal systematic control breakdowns. Effective monitoring requires periodic management reviews examining transaction samples, compliance metrics tracking control performance, and corrective action processes addressing identified problems before they escalate into significant deficiencies.
The documentation insufficiency affects control effectiveness when contractors cannot demonstrate that controls operated as designed because monitoring records, approval evidence, review documentation, and exception reports don’t exist or aren’t retained. DCAA evaluates controls through evidence examination—if you cannot produce timesheet approval records, reconciliation documentation, unallowable cost reviews, or monitoring reports, auditors conclude controls didn’t operate regardless of verbal assertions about procedures followed.
Five Essential Steps for Effective Internal Control Implementation
Step 1: Design Comprehensive Control Framework Addressing Key Risk Areas
Develop systematic internal control framework identifying key risk areas requiring protection including: labor charging accuracy through timesheet controls, cost classification through chart of account controls, unallowable cost exclusion through identification procedures, indirect rate accuracy through allocation controls, and billing accuracy through invoice review procedures. For each risk area, design specific controls addressing the risk through preventive measures stopping problems before occurrence or detective measures identifying problems requiring correction.
Document control procedures with detailed descriptions explaining what control activity occurs, who performs the control, when control operates, what evidence the control creates, and how exceptions are resolved. This documentation provides the control foundation supporting both employee understanding of required procedures and DCAA verification that controls are properly designed. Generic procedure statements like “supervisors approve timesheets” provide inadequate control documentation compared to detailed descriptions: “Supervisors review each employee’s timesheet weekly, validating time distribution reasonableness against known project assignments, questioning unusual charge codes or hour patterns, and documenting review through electronic approval with comments explaining any concerns identified.”
Implement control stratification applying stronger controls to higher-risk transactions while maintaining reasonable efficiency for routine activities. Require enhanced approval for large-dollar transactions, unusual expenses, or first-time vendors while streamlining routine purchases within established parameters. This risk-based approach focuses control resources where protection provides maximum value rather than treating all transactions identically regardless of risk profile.
Step 2: Establish Clear Segregation of Duties with Compensating Controls
Create responsibility matrix documenting which positions perform transaction authorization, recording, custody, and reconciliation functions, ensuring no single individual controls complete transaction cycles without independent oversight. Separate timesheet approval from payroll processing, purchase authorization from invoice payment, and cost recording from account reconciliation, preventing concentration of incompatible functions enabling fraud or error concealment.
Implement compensating controls addressing segregation limitations that small organization size creates. Deploy enhanced management review examining transaction details when segregation proves impractical, conduct periodic surprise audits testing control effectiveness, engage external resources for independent reconciliations or control assessments, and rotate responsibilities periodically preventing entrenchment of informal workarounds or manipulation schemes. Document compensating controls with same rigor as standard segregation, demonstrating to DCAA that you recognize segregation limitations and implemented alternative protections.
Establish management oversight procedures requiring executive review of significant transactions, unusual adjustments, or policy exceptions even when normal segregation exists. Management oversight provides additional control layer catching problems that transaction-level controls might miss while demonstrating organizational commitment to control effectiveness that DCAA considers when evaluating overall control environment adequacy.
Step 3: Deploy Systematic Monitoring and Exception Reporting Mechanisms
Implement automated exception reporting identifying control violations, policy deviations, or unusual patterns requiring investigation including: late or missing timesheet approvals, charge code usage outside normal patterns, journal entries exceeding thresholds without approval, unallowable cost account activity, and allocation base variances from expected amounts. Configure systems generating exception reports automatically and distributing to responsible managers, forcing proactive attention to potential control problems rather than relying on periodic manual reviews that might miss issues.
Establish periodic management review procedures requiring systematic control assessment including: monthly timesheet control reviews examining approval timeliness and supervisor comments, quarterly unallowable cost assessments verifying identification procedures operated effectively, semi-annual segregation reviews confirming responsibilities remain properly separated, and annual comprehensive control effectiveness evaluations assessing whether controls achieved intended objectives. Document these reviews with formal reports, management responses to identified issues, and corrective action plans addressing deficiencies, creating the monitoring evidence demonstrating ongoing control oversight.
Deploy compliance metrics measuring control performance including: timesheet approval completion rates, average approval turnaround time, exception frequency by type, unallowable cost identification percentage, and reconciliation completion timeliness. Establish performance targets for each metric, monitor actual performance against targets, and implement corrective action when performance falls below acceptable levels. These metrics provide objective control effectiveness measurement supporting both internal management and DCAA assessment of control adequacy.
Step 4: Implement Rigorous Timesheet Review and Approval Procedures
Develop detailed timesheet approval procedures requiring supervisors to validate: hours worked align with known schedules and project assignments, charge codes match authorized contract work, time distribution appears reasonable compared to project status and deliverable progress, unusual patterns receive explanation and justification, and corrections follow established procedures with documentation supporting changes. Train supervisors that approval represents certification of accuracy and reasonableness rather than administrative formality, with supervisors accountable for labor charging accuracy on timesheets they approve.
Configure timekeeping systems requiring explanatory comments when supervisors identify concerns, make corrections, or approve timesheets containing unusual patterns. These comments create the approval documentation demonstrating supervisors actively reviewed timesheets rather than mechanically approving submissions without examination. Implement escalation procedures requiring management review when significant timesheet issues emerge, preventing supervisors from resolving material problems without appropriate oversight.
Establish timesheet approval monitoring including weekly reports showing approval status, turnaround times, and supervisors with chronic approval delays indicating inadequate control operation. Implement quarterly timesheet control assessments where management examines sample timesheets evaluating approval quality, reviewing supervisor comments, and assessing whether approval procedures operate as designed. This monitoring provides ongoing verification that timesheet controls remain effective rather than degrading into pro forma approvals lacking actual review.
Step 5: Create Comprehensive Control Documentation and Evidence Retention
Maintain detailed control documentation including written procedures, approval evidence, reconciliation workpapers, exception reports, monitoring reviews, and corrective action records. Organize documentation logically with clear filing systems enabling efficient retrieval during audits, management reviews, or operational needs. Inadequate documentation undermines otherwise effective controls by preventing verification that controls operated as designed.
Implement document retention policies ensuring control evidence preservation for adequate periods supporting both operational needs and audit requirements. Retain timesheet approvals, purchase authorizations, journal entry support, reconciliations, and monitoring reports for periods matching contract record retention requirements, preventing the control evidence gaps that create DCAA audit challenges when historical records cannot be produced.
Develop control narrative documentation describing your internal control framework, specific control procedures, monitoring mechanisms, and control effectiveness assessment results. This narrative provides comprehensive control environment description supporting both management understanding and DCAA evaluation, demonstrating systematic control approach rather than ad hoc procedures developed reactively to address individual problems.
The Investment in Effective Internal Controls
Implementing comprehensive internal control framework meeting DCAA standards costs between $20,000 and $70,000 for small to mid-sized contractors depending on organization size, system complexity, and current control adequacy. This includes control design, procedure documentation, system configuration, training, and monitoring implementation. Annual maintenance costs typically run $10,000 to $25,000 for ongoing monitoring, control testing, documentation updates, and continuous improvement.
Let me show you the value: contractors with effective internal controls prevent the cost accounting errors, timesheet manipulation, and unallowable cost charging that create questioned costs during DCAA audits. They demonstrate accounting system adequacy through operational control effectiveness supporting efficient audit processes with minimal findings. They maintain positive DCAA relationships through demonstrated fiscal responsibility and control discipline that auditors recognize and respect.
Contractors with inadequate internal controls face substantial questioned costs when control failures allow systematic cost misclassification, labor mischarging, or unallowable cost accumulation. They experience accounting system disapproval requiring corrective action before new contract awards, creating business development barriers and customer relationship problems. They incur crisis remediation costs implementing emergency control improvements under DCAA pressure, exceeding systematic control development investments while still risking inadequate solutions prolonging deficiency status.
Understanding Internal Control Requirements Across Contract Types
Internal control requirements apply uniformly to all government contractors maintaining cost-reimbursement contracts, time-and-materials contracts, or other arrangements requiring cost visibility and verification. Fixed-price contractors face lighter control expectations since government doesn’t reimburse actual costs, but contractors mixing contract types must maintain comprehensive controls supporting cost-reimbursement work regardless of contract portfolio composition.
DFARS accounting system requirements establishing explicit internal control standards apply specifically to DoD contractors, while civilian agency contracts follow FAR provisions with generally similar expectations but potentially different emphasis areas. Your internal controls must satisfy applicable regulatory standards for your customer agencies, with DoD requirements typically representing the most stringent baseline providing adequate foundation for most civilian agency needs.
Your Path to Internal Control Excellence
The internal control landscape rewards contractors who invest in systematic control design, operational implementation, and ongoing monitoring rather than treating controls as compliance checkbox satisfied through policy documentation alone. DCAA evaluates control effectiveness through operational testing examining actual practices, with adequacy depending on demonstrated control operation rather than procedure existence.
For contractors seeking internal control compliance, Hour Timesheet provides control-enabled timekeeping platforms with built-in approval workflows, exception reporting, audit trails, and monitoring capabilities supporting the timesheet controls that represent critical internal control foundation. Our systems create the approval documentation and monitoring evidence demonstrating control operation during DCAA assessments.
Your accounting system deserves internal controls providing actual protection rather than paper procedures lacking operational effectiveness. Build control infrastructure ensuring compliance through systematic operation rather than hoping documentation satisfies audit requirements.
Additional Resources
Related Hour Timesheet Articles:
- DCAA Compliance Requirements for Contractors
- DCAA Compliance Explained
- DCAA Timekeeping Requirements
Official Regulatory References:
