Unallowable Costs and FAR 31.205: What You Can't Bill the Government

"Unallowable" does not mean "forbidden"

The word trips people up on first contact, so start here: an unallowable cost is not a cost you are prohibited from incurring. Your business can buy a bottle of wine for a client dinner, sponsor a party, or pay a late fee — nobody is stopping you. Unallowable means you cannot charge it to the government, directly or indirectly. It cannot be billed to a contract, and it cannot be tucked into an overhead or G&A pool where it would quietly inflate the rates the government pays. It is your money to spend; it is just not the government's money to reimburse.

For a small business doing federal work, understanding this distinction — and building your books to enforce it — is one of the highest-leverage things you can do. The cost of getting it wrong is not just paying the disallowed amount back; it is doing so with interest, and sometimes penalties, after a review finds the same kind of cost scattered through years of billings. This article covers what makes a cost unallowable, the categories small contractors meet most, and the one habit that keeps the whole problem contained. It is general educational information, not compliance or legal advice — the governing rules are detailed and the edge cases are exactly where a DCAA-experienced CPA earns their fee.

Where the rules come from

Federal contract costs are governed by a part of the Federal Acquisition Regulation known as FAR Part 31 — specifically the cost-principle section usually cited as FAR 31.205, which walks through category after category of "selected costs" and states whether, and to what extent, each is allowable. You do not need to memorize it. What you need is the mental model: for a cost to be billable it must generally be allowable (not excluded by a cost principle), allocable (it actually benefits the contract), reasonable (a prudent person would have paid it), and consistent with your own accounting practices and the contract terms. Unallowable costs fail the first test — a specific rule says they cannot be recovered.

The "reasonable" test deserves a note because it catches people: even an otherwise allowable cost becomes unallowable to the extent it is unreasonable. Fly your team first-class when coach was available and the premium can be disallowed even though travel itself is fine. Allowability is not always all-or-nothing.

The categories small contractors meet most

You do not need the whole catalog. A handful of categories account for the vast majority of small-contractor problems:

• Alcoholic beverages. Flatly unallowable. The wine at the client dinner comes out even if the meal itself might be defensible.
• Entertainment. Tickets, sporting events, amusement, most social activities — unallowable. This is a common trap because entertainment often rides along with legitimate business meals and travel; the entertainment portion has to be pulled out.
• Lobbying and most political activity. The cost of trying to influence legislation or elections is unallowable.
• Bad debts. Writing off a customer who never paid is ordinary commercial accounting, but the bad-debt expense itself is not recoverable on government work.
• Interest and financing costs. Interest on borrowing is generally unallowable — a meaningful one, since the interest portion of a loan payment is easy to leave bundled. Recording a loan's principal and interest separately is exactly the kind of split that keeps the unallowable piece identifiable.
• Fines and penalties. Costs from violating a law or regulation are unallowable.
• Certain advertising and public relations, contributions and donations, and specific others — each with its own nuances.

Two things about this list. First, notice how ordinary these costs are — this is why segregation, not avoidance, is the strategy. Second, notice that several are partially unallowable or context-dependent, which is why "just don't spend on them" is not a real plan. You will incur some of these; the job is to keep them out of the wrong place.

Directly associated costs: the trap behind the trap

There is a second-order rule that catches careful contractors: when a cost is unallowable, the directly associated costs — costs incurred only because of the unallowable activity — are usually unallowable too. Take a lobbying trip. The lobbying is unallowable; so are the airfare, hotel, and meals incurred for that trip, because they would not have been spent otherwise. You cannot rescue the travel by calling it "just travel" when its whole reason for existing was the unallowable activity.

This is why unallowable costs are treated as a category to identify and quarantine, not a line item to erase. The activity happened; the associated costs happened; your books have to recognize the whole cluster as unallowable so none of it leaks into a rate.

The one habit that contains the whole problem: segregation

Everything above collapses into a single practice: segregate unallowable costs into their own accounts, as they happen. Give unallowable costs dedicated accounts in your chart of accounts so that the moment a cost is coded, it is walled off from every direct charge and every indirect pool. When you build your overhead and G&A rates, the unallowable accounts are simply excluded from the pools — automatically, because they were never in them.

The alternative — booking these costs to general expense accounts and trying to strip them out at year-end or, worse, when a review is announced — is where contractors get hurt. Reconstructing which meals included alcohol, which travel was for lobbying, and which write-offs were bad debts, months or years later, is miserable and error-prone. And an inconsistent or after-the-fact scrub is exactly what makes a reviewer expand the sample. As with the direct/indirect split, the discipline belongs in the chart of accounts, not in a spreadsheet you run once a year.

Concretely, small contractors commonly set up:

• An unallowable expense block of accounts, sometimes mirroring their regular expense categories (e.g., "Meals – unallowable," "Travel – unallowable," "Interest – unallowable").
• A policy note documenting that these accounts are excluded from all indirect cost pools and from direct billing.

Once that structure exists, an employee coding a client-dinner receipt with wine on it just splits the transaction — the meal to its normal account, the alcohol to the unallowable account — and the rate calculations take care of themselves.

Documentation is the other half

Segregation keeps unallowable costs out of billings; documentation proves you did it deliberately and consistently. Two records carry most of the weight:

• A written policy stating which cost categories your business treats as unallowable and confirming they are excluded from pools and billings. This is the companion to the direct/indirect policy from your cost-structure setup — together they describe how your accounting system actually works.
• A clean transaction trail. Every unallowable cost should be traceable: what it was, why it was coded unallowable, and the receipt or record behind it. A tamper-evident audit trail turns "trust us, we excluded those" into "here is every excluded cost and when it was recorded."

If you also reimburse employees for expenses, the same discipline extends there: an accountable plan with real substantiation keeps reimbursed costs documented, and the unallowable ones flagged, at the point of entry.

Why it is worth the trouble

Segregating unallowable costs feels like tracking money you have already decided you cannot recover — why bother accounting for it carefully? Because the payoff is protection:

• Your rates stay defensible. Unallowable costs kept out of your pools mean your overhead and G&A rates reflect only recoverable costs. Rates padded with unallowables are not just wrong — if found, they get recalculated downward across every affected billing.
• A review stays narrow. When a reviewer sees unallowables cleanly segregated and consistently excluded, there is nothing to chase. When they find one unallowable cost buried in a pool, they assume there are more, and the sample — and your exposure — grows.
• You avoid paying it back with interest. The real cost of a missed unallowable is rarely a single dinner's wine. It is the aggregate across years, returned with interest and possibly penalties, long after the money is spent.

The rule to carry: you can spend on almost anything; you just cannot ask the government to pay for the things a cost principle excludes. Set up the accounts to catch them, code them as they happen, document the practice, and the scariest-sounding corner of contract accounting becomes a quiet, automatic part of how your books run.

Hosting Books lets you carve out dedicated unallowable-cost accounts in your chart of accounts, split a single transaction across allowable and unallowable accounts as you record it, and preserve every entry in a signed, hash-chained audit log — so unallowable costs stay out of your rates and billings, and the record of how you handled them is there when someone reviews it.

This article is general educational information about government-contract cost principles and is not compliance, legal, or contracting advice for your specific situation. FAR Part 31 and its cost principles are detailed and fact-specific — consult a qualified contract accountant or CPA before relying on any treatment.