Setting Up Your Accounting System for Your First Cost-Type Government Contract

You've decided to pursue cost-type government work. Whether you're transitioning from firm-fixed-price contracts or entering federal contracting for the first time, your accounting system needs to satisfy the SF-1408 criteria before the contracting officer requests a pre-award survey.

This guide walks through the setup process, regardless of which software you use.

What we've seen in practice "QBO works for DCAA compliance because it's the system most accountants already use, and because business owners — even without accounting experience — can navigate it and make decisions from what they see."

— Jordan Glaze — Business Development Specialist/Accountant, Wendroff & Associates, CPA

Step 1: Structure Your Chart of Accounts

Your chart of accounts needs to clearly separate four categories of costs.

Direct costs — accounts for labor, materials, subcontracts, travel, and other direct costs. You'll use classes, projects, or job codes (depending on your software) to track which contract each direct cost belongs to.

Indirect cost pools — separate account groups for Fringe (payroll taxes, health insurance, retirement, PTO), Overhead (rent, IT, equipment, technical supervision), and G&A (executive salaries, accounting, legal, insurance, HR, business development).

Unallowable costs — their own accounts, segregated from everything else. Entertainment, alcohol, fines, and certain executive compensation above FAR thresholds. These must never flow into indirect rates applied to government contracts.

Revenue — by contract, so you can track revenue against costs for each award.

If your current chart of accounts is a flat list of expenses, restructuring it now — before you have cost-type transactions — is far easier than reclassifying after the fact.

Step 2: Enable Cost Tracking by Contract

Whichever accounting software you use, you need a mechanism to tag every direct cost with a specific contract. In QuickBooks Online, this is class tracking. In Xero, tracking categories. In Deltek or Unanet, project codes.

Create an identifier for each contract. Use the contract number (e.g., "FA8532-24-C-0012") or a readable abbreviation. Consistency matters — everyone on the team should use the same identifiers.

Also create identifiers for your indirect pools: "Fringe," "Overhead," "G&A," and "Unallowable." Employees will use these when recording indirect time.

The structure above gets you a strong starting point. As Sarah Sun, CPA, frames the gap:

"QuickBooks handles the foundational pieces well: chart of accounts setup and classes for project separation. Where it falls short is everything downstream — labor distribution calculation, indirect rate calculation, and profit and loss by contract."

— Sarah Sun, CPA — Wendroff & Associates, CPA

The next phase — timekeeping and labor distribution — is where most contractors trip up.

Step 3: Implement Timekeeping

Your timekeeping system must support daily recording by the employee, supervisor approval, an audit trail for changes, and total time accounting (direct and indirect hours).

The options range from paper timesheets (functional but risky) to spreadsheets (better than paper but no audit trail) to dedicated timekeeping software (best — automated timestamps, approval workflows, immutable logs) to ERP-integrated timekeeping (Deltek, Unanet).

Whatever you choose, document a written timekeeping policy that describes the process, distribute it to all employees, and train everyone before the first pay period.

Step 4: Set Up Labor Distribution

You need a process to convert approved timesheet hours into dollar amounts and record them in the general ledger. This means calculating hourly rates from payroll data, multiplying hours by rates for each cost objective, handling rounding (every penny must be accounted for), and generating journal entries that post to the G/L. For a step-by-step walkthrough of the mechanics, see our Labor Distribution guide.

This can be done manually in a spreadsheet (works for very small teams but is error-prone), through a compliance tool that integrates with your accounting software, or within an ERP's built-in labor distribution module.

Brian Wendroff, CPA, gives a concrete benchmark for when manual stops working:

"Around 20+ employees is where Excel-based allocation breaks down. The accountant simply can't keep up with the volume across pay periods. That's the second migration trigger — independent of contract type."

— Brian Wendroff, CPA — CFO & Co-founder, WiseCost · Founder, Wendroff & Associates, CPA

Whichever method you use, the key requirement is that the total distributed equals total payroll for the period, and the journal entries reconcile to the general ledger.

Step 5: Document Your Policies

Before the pre-award survey, you need written documentation for your timekeeping policy (when/how time is recorded, corrections process, approval chain), your indirect rate methodology (which costs go in which pools, what allocation base each pool uses), and your unallowable cost procedures (how you identify and exclude non-allowable expenses).

These don't need to be elaborate. Two to three pages each, written clearly, describing what you actually do. The auditor will compare these documents to your actual system — inconsistencies are findings.

Step 6: Run at Least One Complete Cycle

Before the pre-award survey, run through at least one full pay period: employees record time, supervisors approve, you run labor distribution, journal entries post to the G/L. Ideally, run 2–3 periods so you can demonstrate the system producing real outputs.

Calculate your interim indirect rates from the posted data. Verify they're reasonable by comparing to industry norms (Fringe: 25–40%, Overhead: 30–80%, G&A: 10–30%, depending on your cost structure and industry).

Step 7: Self-Walkthrough

The pre-award survey is essentially a walkthrough. Practice it yourself. Pick one employee's time entry for one day. Trace it: time entry → approved timesheet → labor distribution calculation → journal entry → general ledger → P&L by contract.

If you can follow that trail without gaps, the auditor can too. If you hit a dead end — fix it before the survey.

Common Mistakes to Avoid

Starting too late — don't wait until the contracting officer requests the survey. Set up your system when you decide to pursue cost-type work.

Over-engineering — your first setup doesn't need to handle every edge case. Get the basics right (accounts, classes, timekeeping, labor distribution) and refine from there.

Neglecting training — the best system fails if employees don't know how to use it. Invest 30 minutes in training each person.

Forgetting documentation — the system can be perfect, but without written policies the auditor can't verify your intent.

For a deeper look at the most common compliance mistakes small contractors keep making, see our companion blog.

Timeline

If you're starting from scratch with an existing accounting system and adding compliance tools, a reasonable timeline is: Week 1, restructure chart of accounts and set up classes. Week 2, implement timekeeping and train employees. Week 3, run first pay period through complete cycle. Week 4, document policies, self-walkthrough, and clean up any gaps.

Four weeks from decision to audit-ready. Faster if your accounts are already structured well.

Ready to find where your setup stands today? Take our free DCAA Readiness Self-Assessment — see your readiness score and the gaps to close before the contracting officer asks.

Reviewed by Brian Wendroff, CPA — CFO & Co-founder, WiseCost · Founder, Wendroff & Associates, CPA; Sarah Sun, CPA — Wendroff & Associates, CPA; and Jordan Glaze — Business Development Specialist/Accountant, Wendroff & Associates, CPA.