Audit Readiness: Essential Practices to Ensure Your Business is DCAA or IRS Audit-Ready

For government contractors, an audit is not a question of if, but when. Whether it is a DCAA audit tied to your indirect rate proposal or an IRS audit evaluating your tax filings, unpreparedness can lead to questioned costs, disallowed deductions, delayed payments, and even contract terminations.

Audit readiness is not a one-time effort. It is a continuous discipline. Contractors that build systems and habits around documentation, internal controls, and regulatory compliance reduce risk, demonstrate professionalism, and maintain healthy relationships with auditors. 

Here is a breakdown of what it takes to stay audit-ready year-round, and how a Government Contracts CPA can help you get there.

The Importance of Audit Readiness

Government agencies expect your financial house to be in order. If you are awarded federal funds, you must prove those funds were managed and used according to strict rules.

Two major agencies that review your finances are:

• DCAA (Defense Contract Audit Agency) – Oversees contractor compliance with the Federal Acquisition Regulation (FAR), especially indirect rates, timekeeping, and cost allowability.
• IRS (Internal Revenue Service) – Ensures your reported income, deductions, and taxes comply with federal tax law.

Both agencies can trigger audits based on red flags, contract thresholds, or routine evaluations. Each has different objectives, but both require robust documentation and consistent accounting systems.

Essential Documentation to Have on Hand

Being audit-ready starts with having the right documents readily accessible, well-organized, and consistently maintained. Both DCAA and IRS audits demand detailed support for your accounting practices, timekeeping, and cost allocations. Below are the five key categories of documentation that every government contractor should have prepared at all times.

1. Timekeeping Records

Accurate and consistent timekeeping is one of the most scrutinized areas in a DCAA audit. DCAA Timekeeping Guidance requires that contractors must be able to demonstrate that hours worked are properly tracked, documented, and approved according to a clear policy.

Make sure to maintain:

• Employee timesheets either electronic or paper-based, with clear audit trails
• Documented time tracking policies and procedures
• Supervisor approvals with date/time stamps for changes and approvals

2. Indirect Rate Support

Your indirect rate structure, Fringe, Overhead, and G&A must be substantiated with supporting documentation that aligns with both your internal accounting system and DCAA requirements. This is especially critical when submitting provisional billing or incurred cost proposals.

Ensure your records include:

• A complete general ledger
• Detailed breakdowns of indirect cost pools with backup
• Provisional billing rates and final incurred cost proposals

3. Invoicing and Billing Records

Billing accuracy is essential to both compliance and cash flow. DCAA and contracting officers may request full documentation to support every invoice submitted.

Be sure to retain:

• Copies of all invoices sent to the government
• Records of payment receipts
• Detailed documentation backing each line item on your invoices
• Proof of approvals when required under the contract terms

4. Tax Filings and Schedules

The IRS may examine your tax reporting to verify that income and expenses are correctly reported.. This includes coordination between financial statements, payroll reporting, and contract income.

Keep accessible:

• Federal and state tax returns for at least 3–7 years
• Payroll tax filings (e.g., Forms 941, 940)
• Fixed asset depreciation schedules
• Forms 1099 and W-2 for all relevant personnel and contractors

5. Cost Allowability and Contract Files

DCAA will evaluate whether the costs you have charged to contracts are allowable under FAR Part 31. You must maintain clear justification and documentation for all costs, especially those that could be considered questionable.

Your files should include:

• Purchase orders and executed subcontractor agreements
• Memos justifying cost allowability and allocation
• Documentation of compliance with FAR Part 31 cost principles

Common Audit Triggers and How to Address Them

Avoiding an audit may not be possible but avoiding problems during one is. Here are the most common triggers and how to manage them proactively:

Inconsistent or Manual Timekeeping

Trigger: Discrepancies in hours worked, manual edits, or missing approvals.

Prevention: Use electronic systems with audit trails. Enforce a strict timekeeping policy that includes training, manager sign-off, and real-time tracking.

Inadequate Segregation of Costs

Trigger: Commingling of allowable and unallowable costs, vague expense descriptions, or misallocated labor.

Prevention: Maintain a well-structured chart of accounts that segregates direct, indirect, and unallowable expenses in accordance with FAR Part 31.

High or Unusual Indirect Rates

Trigger: Rates that vary widely from industry norms or change dramatically year to year.

Prevention: Have documented rationale for your rate structure. Conduct mid-year reviews and reconcile your provisional and actual rates.

Missed Filing Deadlines

Trigger: Late incurred cost submissions or overdue tax filings.

Prevention: Implement a compliance calendar and assign responsibilities to specific team members or your CPA.

Disallowed or Questioned Costs

Trigger: Charging costs not allowed by FAR (e.g., entertainment, lobbying, or alcohol).

Prevention: Educate your team on unallowable costs and ensure they are flagged and excluded from billings and rate bases.

Best Practices for Year-Round Audit Readiness

Audit preparation is not a task. It is a system. Complying with both the DCAA Guidebook for Small Businesses and IRS Recordkeeping Guidelines is easier if you build these practices into your operations:

• Monthly reconciliations: Ensure your books match your bank statements and general ledger.
• Quarterly indirect rate reviews: Monitor costs and adjust provisional billing rates as needed.
• Document retention policies: Maintain financial and operational records for at least 3–7 years, depending on agency and contract.
• Internal mock audits: Have your CPA perform dry runs of DCAA or IRS audits to identify gaps.
• Training and compliance culture: Ensure your team understands timekeeping, expense reporting, and cost allowability basics.

The Role of a Government Contracts CPA in Audit Readiness

An experienced Government Contracts CPA does not just help with taxes, they build audit-proof systems tailored to government rules. They prepare and review incurred cost submissions (ICS) while aligning accounting and tax strategies across FAR and IRS rules. 

A Government Contracts CPA conducts risk assessments and internal reviews to spot issues early and represents you during DCAA or IRS audits. With the right CPA on your team, an audit becomes a manageable event not a crisis.

Do Not Wait for the Audit Letter

Audit readiness is a competitive advantage. Contractors that prepare in advance gain the trust of contracting officers, reduce billing delays, and protect their profits. A DCAA or IRS audit may be inevitable but penalties, stress, and questioned costs are not.

Are you audit-ready? Working with a specialized CPA ensures your systems, submissions, and strategy are built to withstand audit scrutiny so you can meet auditors with confidence and clarity. We are here to help. Contact us to learn more.