FAR 31.205-1: A Guide to Bad Debts and Unallowable Costs

For government contractors navigating federal cost compliance rules

Table of Contents#

1. What Is FAR 31.205-1?
2. Core Definitions Under the Clause
3. Full List of Unallowable Costs Covered by FAR 31.205-1
4. Policy Rationale: Why Are These Costs Unallowable?
5. Common Contractor Missteps to Avoid
6. Best Practices for FAR 31.205-1 Compliance
7. What to Do If Your Bad Debt Costs Are Disallowed
8. Frequently Asked Questions
9. References

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What Is FAR 31.205-1?#

The Federal Acquisition Regulation (FAR) is the set of mandatory rules governing all executive agency federal contracts. FAR Subpart 31.2 outlines cost principles for commercial organizations, which define which costs can be billed to the federal government.

FAR 31.205-1 is the specific clause governing bad debts. It applies to all cost-reimbursement, time-and-materials, labor-hour, and fixed-price contracts with cost incentives, progress payments, or incurred cost reporting requirements. Compliance is mandatory for all contractors working with federal agencies, including the Department of Defense, GSA, and civilian executive agencies.

Core Definitions Under the Clause#

Before diving into unallowable costs, clarify these key terms:

Full List of Unallowable Costs Covered by FAR 31.205-1#

The clause explicitly prohibits charging the government for the following bad-debt related costs, regardless of the source of the debt:

1. Uncollected accounts receivable
   • Examples: Unpaid invoices from bankrupt commercial clients, uncollected payments from defaulted subcontractors, and even unpaid government invoices that you have not pursued through the formal contract disputes process.
2. Collection costs
   • Examples: Third-party collection agency fees, late payment penalties you incurred because of delayed customer payments, and internal labor hours spent chasing unpaid invoices.
3. Legal and administrative costs for debt recovery
   • Examples: Lawyer fees to sue for unpaid amounts, court filing fees, arbitration costs, and administrative labor to process debt recovery claims.
4. Bad debt write-off costs
   • Examples: Accounting adjustments for writing off uncollectible amounts, and labor spent processing write-off requests in your accounting system.
5. Related indirect costs
   • Examples: A portion of your accounts receivable team’s overhead allocated to bad debt processing, and software costs dedicated to tracking uncollectible accounts.

Policy Rationale: Why Are These Costs Unallowable?#

FAR cost rules are built on the core principle that the government only pays for costs directly tied to delivering contracted goods or services. Bad debts are considered a general business risk, not a cost of contract performance, for three key reasons:

1. Contractors are expected to manage their own credit and collection processes, just as they do for commercial clients.
2. The government will not bear the cost of a contractor’s poor invoicing practices, credit checks, or subcontractor management.
3. The U.S. Comptroller General has repeatedly upheld that bad debt losses are not allocable to government contracts, as they do not benefit the federal government.

Common Contractor Missteps to Avoid#

Most FAR 31.205-1 compliance failures stem from simple oversights, not intentional fraud. The most common missteps include:

1. Including bad debt write-offs from commercial clients in indirect cost pools used to calculate government contract billing rates.
2. Billing the government for losses from subcontractor defaults, assuming these risks are passed through to the federal customer.
3. Writing off disputed government invoices as bad debt instead of pursuing formal resolution through the FAR Disputes clause process.
4. Failing to segregate bad debt costs in general ledger accounts, leading to accidental inclusion in incurred cost submissions.

Best Practices for FAR 31.205-1 Compliance#

Follow these actionable steps to avoid audit findings and penalties:

1. Configure your accounting system to segregate bad debt costs: Create dedicated general ledger accounts for all bad debt write-offs, collection fees, legal recovery costs, and internal labor tied to bad debt management.
2. Explicitly exclude bad debt costs from all billing pools: When calculating indirect rates or submitting incurred cost proposals, add a step to your review process to remove all bad-debt related line items.
3. Optimize your invoicing process to reduce bad debt: For government clients, follow all Prompt Payment Act invoicing requirements, including submitting all required supporting documentation with each invoice to avoid payment delays.
4. Use the formal disputes process for unpaid government invoices: If a federal agency refuses to pay an invoice, submit a formal claim under FAR 52.233-1 (Disputes) instead of writing the amount off as bad debt.
5. Conduct quarterly internal audits: Have your contracts or accounting team review all bad debt accounts to confirm no costs have been incorrectly allocated to government contract cost pools.
6. Train your team on FAR 31.205-1 requirements: Ensure your accounts receivable, accounting, and contracts teams understand which bad debt costs are unallowable to avoid accidental misclassification.

What to Do If Your Bad Debt Costs Are Disallowed#

If a DCAA audit or contracting officer review flags bad debt costs as unallowable:

1. First, verify the classification: Confirm the disallowed costs are actually tied to bad debt, not another allowable activity (e.g., legal fees for a contract performance dispute, not debt collection, are often allowable).
2. Provide supporting documentation if you believe the cost was misclassified: Share receipts, work records, or contract terms to prove the cost is unrelated to bad debt.
3. Adjust your cost submissions immediately to remove confirmed unallowable costs, to avoid interest charges or penalties.
4. If you disagree with the final disallowance, submit a formal claim to your contracting officer, and appeal to the relevant Board of Contract Appeals if the claim is denied.

Frequently Asked Questions#

Q: Can I ever bill the government for bad debt from an unpaid government invoice?#

A: No, unless your contract explicitly includes an exception (which is extremely rare). If the government refuses to pay an invoice, you must pursue payment through the formal disputes process, not write it off as bad debt and attempt to charge it to other government contracts.

Q: Are bad debts from commercial clients also unallowable for my government contract rates?#

A: Yes. All bad debt costs, regardless of the client or source, are unallowable and must be excluded from any cost pools used to calculate billing rates for federal contracts.

Q: What penalties can I face for including unallowable bad debt costs in my billings?#

A: Penalties include repayment of the overbilled amount plus interest, civil penalties of up to 2x the overbilled amount under the False Claims Act if the inclusion was intentional, and suspension or debarment from future federal contracts.

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References#

1. U.S. General Services Administration. (2024). FAR 31.205-1: Bad Debts. Retrieved from https://www.acquisition.gov/far/31.205-1
2. U.S. General Services Administration. (2024). FAR Subpart 31.2: Cost Principles for Commercial Organizations. Retrieved from https://www.acquisition.gov/far/part-31#subpart-31.2
3. Defense Contract Audit Agency. (2023). Contract Audit Manual Chapter 7-1000: Unallowable Cost Guide. Retrieved from https://www.dcaa.mil/CAM/Volume_7/Chapter_7_1000.html
4. Comptroller General of the United States. (1983). Decision B-209365: Allowability of Bad Debts Under Government Contracts. Retrieved from https://www.gao.gov/products/b-209365