CPE for Government Auditors

CHAPTER 2: Tests of Cost Allowability for Federal Grants


  • Judge whether an item of cost is allowable per the cross-cutting principles
  • Detect which allowability principle has been violated

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The cost principles set out the basic guidelines to test the allowability of costs. To be allowable under federal awards, costs must meet every one of the following criteria. Costs must:

  • Be both necessary and reasonable for proper and efficient performance and administration of the award;
  • Conform to all limitations contained in the law, regulations, and grant terms and conditions;
  • Be net of applicable credits[1];
  • Be allocable to the federal award;
  • Be treated consistently regardless of the source of funds;
  • Be accorded consistent treatment as either direct or indirect costs in like circumstances;
  • Be determined in accordance with generally accepted accounting principles (GAAP);
  • Be charged only to the federal award or indirect pool to which they relate, and not be included as a cost or used to meet cost sharing or matching requirements of any other federal award; and
  • Be adequately documented.


§200.403 Factors affecting allowability of costs.

Except where otherwise authorized by statute, costs must meet the following general criteria in order to be allowable under Federal awards:

(a) Be necessary and reasonable for the performance of the Federal award and be allocable thereto under these principles.

(b) Conform to any limitations or exclusions set forth in these principles or in the Federal award as to types or amount of cost items.

(c) Be consistent with policies and procedures that apply uniformly to both federally-financed and other activities of the non-Federal entity.

(d) Be accorded consistent treatment. A cost may not be assigned to a Federal award as a direct cost if any other cost incurred for the same purpose in like circumstances has been allocated to the Federal award as an indirect cost.

(e) Be determined in accordance with generally accepted accounting principles (GAAP), except, for state and local governments and Indian tribes only, as otherwise provided for in this part.

(f) Not be included as a cost or used to meet cost sharing or matching requirements of any other federally-financed program in either the current or a prior period. See also §200.306 Cost sharing or matching paragraph (b).

(g) Be adequately documented. See also §§200.300 Statutory and national policy requirements through 200.309 Period of performance of this part.

The sections in this chapter discuss these criteria in more depth.


2-1 Reasonable and Necessary

Reasonable people may have different concepts of what is a necessary cost. My spouse thinks over 200 DVDs of every Disney movie ever made is necessary to entertain children; I don’t. I think staying in a Motel 6 is unacceptable; my spouse thinks it is more than fine.

While not specifically stated, the cost principles recognize this conundrum and set out some basic criteria related to determining the reasonableness of costs incurred in the performance of federal projects.

Basketball Tickets

Over many years, we conducted numerous audits of the U.S. Department of Education’s Title I program. This program is designed to help children who are functioning below average to perform at their grade level.

During these audits, we found many instances of schools conducting activities, particularly field trips, which did not seem designed to improve educational achievement. Schools had taken kids to Disneyland, Knott’s Berry Farm, and roller rinks under the Title I program. One school district even paid for the junior high prom dinner with Title I funds. Another district took about 30 children to a professional basketball game and charged the tickets to the Title I program. They classified the activity as part of the reading program. I wondered whether they were teaching the children to read defenses.

As a side note, after we reported on a number of these abusive practices, the audit reports became public. The districts were severely criticized in the newspapers (for you younger folks, newspapers were the predecessors to blogs). After the publicity, the number of field trips and conferences charged to Title I reduced significantly.


2-1-1 The Prudent Person Rule

The cost principles make it clear that to be reasonable, a cost may not be more than a “prudent person” would spend in its nature and amount at the time of the decision.

§200.404 Reasonable costs.

A cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person under the circumstances prevailing at the time the decision was made to incur the cost. …

The prudent person rule is also used in the Government Auditing Standards (also known as the Yellow Book) to define abuse. Under GAGAS 5.08[2], “Abuse involves behavior that is deficient or improper when compared with behavior that a prudent person would consider a reasonable and necessary business practice given the facts and circumstances.”

Therefore, to determine whether a cost is reasonable in a given situation, we must consider whether a “prudent person” would have expended it. I am the only prudent person I know. Needless to say, determining what is reasonable is quite subjective. However, the cost principles try to supply some guidance.


2-1-2 Factors Used to Determine Reasonableness

The determination of whether a cost is reasonable requires the application of the following sub‑criteria:

1. The cost generally would be recognized as ordinary and necessary for the operation of the governmental unit or the performance of the federal award.

2. The cost considers market prices for similar goods in the geographical area.

3. The cost conforms to:

  • Sound business practices,
  • Arm’s length bargaining,
  • Laws and regulations, and
  • Terms and conditions of the federal award.

4. The cost was incurred using the organization’s established practices. (Significant deviations from established organizational practices of the governmental unit may unjustifiably increase the federal award’s cost.)

§200.404 Reasonable costs.

… The question of reasonableness is particularly important when the non-Federal entity is predominantly federally-funded. In determining reasonableness of a given cost, consideration must be given to:

(a) Whether the cost is of a type generally recognized as ordinary and necessary for the operation of the non-Federal entity or the proper and efficient performance of the Federal award.

(b) The restraints or requirements imposed by such factors as: sound business practices; arm’s length bargaining; Federal, state and other laws and regulations; and terms and conditions of the Federal award.

(c) Market prices for comparable goods or services for the geographic area.

(d) Whether the individuals concerned acted with prudence in the circumstances considering their responsibilities to the non-Federal entity, its employees, where applicable its students or membership, the public at large, and the Federal government.

(e) Whether the non-Federal entity significantly deviates from its established practices and policies regarding the incurrence of costs, which may unjustifiably increase the Federal award’s cost.

If employees of an organization normally do not travel first class, they do not have permission to fly first class simply because a federal award is paying the tab. In general, the rules do not permit flying first-class. However, suppose that your boss informs you that you need to fly across the continent immediately. The only coach seats available are on a red-eye that makes two stops and arrives around noon the next day. Since such a trip would be considered unreasonable, you may very well justify flying first-class. In addition, some entities have a policy that permits employees to fly business class for particularly long flights (over 10 hours, for example). Such policies would be acceptable if applied uniformly and if reasonable. A policy that permitted business class for flight over two hours would almost certainly be considered unreasonable.

What about charging the costs of an out-of-town meeting for the staff of an organization to a grant? Let us assume, for purposes of this example, that the meeting is necessary for the efficient delivery of grant services. It could be argued that, to assure uninterrupted training, holding the meeting at a location other than the grantee’s place of business is necessary. But, if a federal reviewer finds that the costs or the location selected is inappropriate, then the costs may be disallowed as unreasonable and not necessary to properly administer the federal award. An inappropriate venue for a mainland organization to hold a meeting would be Honolulu or a five-star hotel.

The rules do not expect grantees to suffer the use of poor quality equipment, beg for supplies on the street corner, or work for food. The rules simply require the wise use of federal award funds by grantees. The delivery of grant services should always be paramount but within the constraints of the cost principles.

One guideline that often is used is the “Washington Post” test (or substitute the name of your local newspaper). If the paper got word of what you were doing, would they report it on one of the first three pages? They don’t put the good news on those pages. If the newspaper were to consider it reportable, then it wouldn’t consider the cost to be reasonable. That “prudent person” probably wouldn’t consider it reasonable either.

There are other similar tests. The “red-face” test asks whether you can explain the cost without blushing. The “giggle” test asks whether people start to giggle as they explain why the cost is acceptable.

I often use the giggle test when I am teaching a class. A student will ask about the acceptability of a cost with which he is clearly not comfortable. I sometimes pretend not to have understood the question and ask the student to ask it again. The second time the student starts to smile as he asks the question. I will then point out that he is failing the giggle test. These costs are not allowable.

2-1-3 Context Matters

It is important to consider the context of a cost. A cost may be reasonable in one context but not another.

For example, imagine that a federal grant has been awarded to an established organization that provides laptop computers to all of the employees. It probably would not be reasonable to purchase additional laptops using grant funds. On the other hand, if the federal government made an award to a relatively new organization that owns very few laptops, the purchase of one or more laptops to be used on the grant may be very reasonable.

But Condoms?

Years ago, we conducted an audit at a major university. One auditor believed he had found a small, but sure-fire finding: a research lab had purchased a carton of condoms. It certainly sounded questionable.

However, the purchase turned out to be acceptable. In the research lab, they needed flexible, lightweight, waterproof containers. The condoms met the needs perfectly and were far less expensive than anything else that fit the bill. The costs were allowable after all.


2-2 Allocability

The allocability of costs to a project is among the more technical and, thus, more difficult issues included in the cost principles. In general, a cost will be considered directly allocable to a project if it was incurred specifically for that project. (However, we must always consider the consistency requirement, discussed in the next section.)

To be considered allocable, a cost must benefit, or have been intended to benefit, a project or activity. Complications arise when a cost is intended to benefit more than one project. For example, in operating a Back-to-School Lunch program, the electricity that is needed to run the kitchen and the lunchroom benefits not only the program but other students and faculty as well.

When costs must be distributed among several organizational activities, we must determine and apply an equitable method to allocate the costs to ensure that each activity receives its fair share of the distributed costs[3].

Here are some general concepts to keep in mind regarding allocability:

  • Relative Benefits Received – Activity costs are allocable when associated goods or services can be charged to the cost “in accordance with relative benefits received.”
  • Fair Share of Costs – Indirect costs will be allocated appropriately to activities, even those that are unallowable, when they derive benefit from the entity’s indirect cost.
  • Shifting Costs – It is not allowable to transfer costs related to Grant A to Grant B simply because the costs are not permitted under Grant A. Nor can costs be transferred because Grant A has no remaining fund availability. That is about as simple as we can state it. Yet, inappropriate transfers happen all too often.

§200.405 Allocable costs.

(a) A cost is allocable to a particular Federal award or other cost objective if the goods or services involved are chargeable or assignable to that Federal award or cost objective in accordance with relative benefits received. This standard is met if the cost:

(1) Is incurred specifically for the Federal award;

(2) Benefits both the Federal award and other work of the non-Federal entity and can be distributed in proportions that may be approximated using reasonable methods; and

(3) Is necessary to the overall operation of the non-Federal entity and is assignable in part to the Federal award in accordance with the principles in this subpart.

(b) All activities which benefit from the non-Federal entity’s indirect (F&A) cost, including unallowable activities and donated services by the non‑Federal entity or third parties, will receive an appropriate allocation of indirect costs.

(c) Any cost allocable to a particular Federal award under the principles provided for in this part may not be charged to other Federal awards to overcome fund deficiencies, to avoid restrictions imposed by Federal statutes, regulations, or terms and conditions of the Federal awards, or for other reasons. However, this prohibition would not preclude the non-Federal entity from shifting costs that are allowable under two or more Federal awards in accordance with existing Federal statutes, regulations, or the terms and conditions of the Federal awards.

(d) Direct cost allocation principles. If a cost benefits two or more projects or activities in proportions that can be determined without undue effort or cost, the cost should be allocated to the projects based on the proportional benefit. If a cost benefits two or more projects or activities in proportions that cannot be determined because of the interrelationship of the work involved, then, notwithstanding paragraph (c) of this section, the costs may be allocated or transferred to benefitted projects on any reasonable documented basis. Where the purchase of equipment or other capital asset is specifically authorized under a Federal award, the costs are assignable to the Federal award regardless of the use that may be made of the equipment or other capital asset involved when no longer needed for the purpose for which it was originally required. See also §§200.310 Insurance coverage through 200.316 Property trust relationship and 200.439 Equipment and other capital expenditures.

(e) If the contract is subject to CAS, costs must be allocated to the contract pursuant to the Cost Accounting Standards. To the extent that CAS is applicable, the allocation of costs in accordance with CAS takes precedence over the allocation provisions in this part.

For example, Project A’s costs exceed the approved federal award budget. While there is no question that the costs are related to the project, the organization rationalizes that the excess costs should be charged to another federal project. After all, they are costs for a federal award. In an attempt to recover the costs, the organization charges another federal award for the excessive costs.

This transfer of costs from one federal award budget to another is simply unallowable. The costs are not allocable to a second grant. Of course, the organization made the impermissible transfer because costs that exceed the approved grant budget are unrecoverable. The only solution to this problem would be for the grant budget to be increased.

Don’t let the term “benefit” confuse you. Even though we often find that new computer programs don’t work as well as we hoped, the fact that the computer program did not benefit a project would not render it unallocable. After all, it was expected to benefit the project. (Keep in mind that the cost would be unallowable if a reasonable person would not have assumed that it would succeed.)


2-2-1 Indirect Cost Allocation

This course was not intended to fully explain the development of indirect cost rates. Indirect cost allocation requires a course of its own (actually more than one course because the each type of organizations has distinct requirements regarding the development of indirect cost rates). However, we should discuss cost allocation to some extent.

We stated earlier that a cost is applicable to a federal award in relation to the benefits received. Perhaps the easiest way to explain this concept is with salary costs. If I spend all of my time on a federal project, then all of my salary (and fringe benefits) is directly allocable to that project. If, on the other hand, I spend only a third of my time on a project, then only a third of my salary is directly allocable to the project.

If I work on a general administration function, such as accounting, then I probably cannot charge any of my time directly to the project. Instead, my time will be considered indirect, and some share of my salary costs will be allocated to the project through the use of an indirect cost rate.

As a grantee, you can determine the indirect cost rate by taking all of the indirect costs and dividing that total by an appropriate allocation base. The most common allocation bases are direct salaries and wages (with or without the various fringe benefits) or modified total direct costs. You would then negotiate with a federal of the pass-through entity the percentage that can be claimed on each dollar of the direct cost allocation base. So, if the grantee can show that, for every dollar of the allocation base, it spends 43 cents on indirect costs, the indirect cost rate is 43%.


2-2-2 Advance Agreements

We point out periodically in this text the importance of discussing potentially contentious issues with granting agencies before disagreements develop. If you can negotiate an advance agreement, life will be far more serene as the grant progresses. The new uniform guidance sets out those areas of cost for which advance understandings are particularly valuable to avoid later disputes.

§200.407 Prior written approval (prior approval).

Under any given Federal award, the reasonableness and allocability of certain items of costs may be difficult to determine. In order to avoid subsequent disallowance or dispute based on unreasonableness or nonallocability, the non-Federal entity may seek the prior written approval of the cognizant agency for indirect costs or the Federal awarding agency in advance of the incurrence of special or unusual costs. Prior written approval should include the timeframe or scope of the agreement. The absence of prior written approval on any element of cost will not, in itself, affect the reasonableness or allocability of that element, unless prior approval is specifically required for allowability as described under certain circumstances in the following sections of this part:

(a) §200.201 Use of grant agreements (including fixed amount awards), cooperative agreements, and contracts, paragraph (b)(5);

(b) §200.306 Cost sharing or matching;

(c) §200.307 Program income;

(d) §200.308 Revision of budget and program plans;

(e) §200.332 Fixed amount subawards;

(f) §200.413 Direct costs, paragraph (c);

(g) §200.430 Compensation – personal services, paragraph (h)

(h) §200.431 Compensation – fringe benefits;

(i) §200.438 Entertainment costs;

(j) §200.439 Equipment and other capital expenditures;

(k) §200.440 Exchange rates;

(l) §200.441 Fines, penalties, damages and other settlements;

(m) §200.442 Fund raising and investment management costs;

(n) §200.445 Goods or services for personal use;

(o) §200.447 Insurance and indemnification;

(p) §200.454 Memberships, subscriptions, and professional activity costs, paragraph (c);

(q) §200.455 Organization costs;

(r) §200.456 Participant support costs;

(s) §200.458 Pre-award costs;

(t) §200.462 Rearrangement and reconversion costs;

(u) §200.467 Selling and marketing costs; and

(v) §200.474 Travel costs.


2-3 Consistent Treatment

Typically, total costs applicable to a federal award program consist of both allowable direct costs and allocable indirect costs.

There is no universal rule for classifying costs as either direct or indirect. However, like costs must be treated consistently in like circumstances. A cost may not be allocated to a federal award as an indirect cost if any other cost incurred for the same purpose, in like circumstances, has been assigned to another federal award as a direct cost.

And the consistency principle applies not only to federal projects but also to projects not funded with federal dollars. Like costs in like circumstances may not be treated differently on federal projects as compared to non-Federal projects. Similarly, they must be treated the same whether or not they are included as direct costs in the grant budget.

§200.403 Factors affecting allowability of costs

Except where otherwise authorized by statute, costs must meet the following general criteria in order to be allowable under Federal awards:

(c) Be consistent with policies and procedures that apply uniformly to both federally-financed and other activities of the non-Federal entity.

(d) Be accorded consistent treatment. A cost may not be assigned to a Federal award as a direct cost if any other cost incurred for the same purpose in like circumstances has been allocated to the Federal award as an indirect cost.

(e) Be determined in accordance with generally accepted accounting principles (GAAP), except, for state and local governments and Indian tribes only, as otherwise provided for in this part.


For governmental award recipients, typical examples of indirect costs may include:

Government-wide central service costs,

  • General administration of the grantee department or agency,
  • Accounting and personnel services performed within the grantee department or agency,
  • Depreciation on buildings and equipment, and
  • Costs of operating and maintaining facilities.

For nonprofit organizations, typical examples of indirect cost may include:

  • Depreciation on buildings and equipment,
  • Costs of operating and maintaining facilities, and
  • General administration, such as the salaries and expenses of executive officers, personnel administration, and accounting.


2-3-1 Like Costs in Like Circumstances

Consistency refers to like costs in like circumstances. Let us assume that an entity treats all office supplies as indirect costs to avoid having to identify each post-it note and each pencil with a project. In such a case, all office supplies must be considered as indirect costs.

The fact that a particular award budget lists $500 for office supplies would not make the office supplies allowable as direct costs. The federal awarding officials are not expected to know your system — you are! You are supposed to be sure that any budget submission conforms to your organization’s system. That means that the person who develops budgets for grant proposals must understand the organization’s techniques for separating direct costs from indirect costs.

Office supplies obviously include scratch pads and bond paper. However, suppose an entity received a grant that required printing of brochures on expensive coated paper that costs much more than regular bond paper. Such a purchase would not be considered regular office supplies. This expensive coated paper normally would not be found in the supply cabinet. Therefore, such paper could be charged directly to a grant, as it does not qualify as “like costs.”

Let us now assume that an entity charges all postage as indirect costs. However, it receives a grant to conduct a nationwide survey. Because of all of the mail requirements, the organization expects to spend about $10,000 in mail costs for this grant. Its normal mail costs are only $5,000 in a year. Thus, the entity can charge the mail costs for this grant as direct charges because the circumstances are not alike.

You always need to decide whether you are dealing with like costs in like circumstances or whether you have a valid basis to deviate from normal procedures. However, recognize that another person, particularly a federal auditor or reviewer, may question your treatment of such costs. For this reason, you should have a solid rationale for deviating from your normal procedures. We will discuss documenting your thoughts on allowability in later sections.


2-4 Net of Applicable Credits

Applicable credits refer to financial transactions that reduce costs allocable to federal awards as either direct costs or indirect costs[4]. Examples are:

  • Purchase discounts,
  • Rebates or allowances,
  • Recoveries or indemnities on losses,
  • Insurance refunds or rebates, and
  • Adjustments of overpayments or erroneous charges.

When credits relating to otherwise allowable costs accrue to the grantee, they shall be credited to the federal award either as a cost reduction or cash refund, as appropriate.

For example, when an organization purchases several computers for use on its federal award (an allowable cost for this example), the manufacturer may offer an associated rebate that reduces the total cost of the acquisition. When this occurs, the grantee must reduce the otherwise allowable costs claim by the rebate amount.

Entities cannot charge the federal government for items for which it has already paid. The cost of any buildings or equipment previously reimbursed by the government must be excluded in the calculation of depreciation. The federal government sometimes refers to this exclusion as an applicable credit.

§200.406 Applicable credits.

(a) Applicable credits refer to those receipts or reduction-of-expenditure-type transactions that offset or reduce expense items allocable to the Federal award as direct or indirect (F&A) costs. Examples of such transactions are: purchase discounts, rebates or allowances, recoveries or indemnities on losses, insurance refunds or rebates, and adjustments of overpayments or erroneous charges. To the extent that such credits accruing to or received by the non-Federal entity relate to allowable costs, they must be credited to the Federal award either as a cost reduction or cash refund, as appropriate.

(b) In some instances, the amounts received from the Federal government to finance activities or service operations of the non-Federal entity should be treated as applicable credits. Specifically, the concept of netting such credit items (including any amounts used to meet cost sharing or matching requirements) should be recognized in determining the rates or amounts to be charged to the Federal award. (See §§200.436 Depreciation and 200.468 Specialized service facilities, for areas of potential application in the matter of Federal financing of activities.) ‘‘Depreciation and use allowances,’’ for areas of potential application in the matter of Federal financing of activities.)


2-5 Compliance with GAAP

Generally accepted accounting principles (GAAP) are the foundation of financial accounting and reflect the standards for financial accounting to meet federal award requirements. GAAP, while varied to accommodate different entities and industries, are based on certain basic principles. These principles include:

  • Consistency – All information should be gathered and presented the same across all periods (This sounds a lot like the consistency provision in the general cost principles, doesn’t it?).
  • Relevance – The information presented in financial statements should be appropriate and assist a person evaluating the statements.
  • Reliability – The information presented in financial statements is reliable and verifiable by an independent party.
  • Comparability – An entity’s financial documents can be compared to documents of similar businesses within its industry.

To be allowable under an award, costs must be determined in accordance with GAAP applicable for the entity[5].

§200.403 Factors affecting allowability of costs.

Except where otherwise authorized by statute, costs must meet the following general criteria in order to be allowable under Federal awards:

(e) Be determined in accordance with generally accepted accounting principles (GAAP), except, for state and local governments and Indian tribes only, as otherwise provided for in this part.


State and local governments must adhere to GAAP issued by the Government Accounting Standards Board (GASB). Financial Accounting Standards Board (FASB) is the designated organization in the private sector for establishing standards of financial accounting. FASB issues the GAAP for the private world, including nonprofit organizations. There is even a GAAP for the federal government, set forth by the Federal Accounting Standards Advisory Board, FASAB.


2-6 Conform to the Law

The cost principles provide that costs must be made within the constraints of applicable laws and regulations. For example, within Subpart A Definitions, 2 CFR 200 provides the following:

§200.53 Improper payment.

(a) Improper payment means any payment that should not have been made or that was made in an incorrect amount (including overpayments and underpayments) under statutory, contractual, administrative, or other legally applicable requirements; and [emphasis added]

(b) Improper payment includes any payment to an ineligible party, any payment for an ineligible good or service, any duplicate payment, any payment for a good or service not received (except for such payments where authorized by law), any payment that does not account for credit for applicable discounts, and any payment where insufficient or lack of documentation prevents a reviewer from discerning whether a payment was proper.

Again, 2 CFR 200 provides for complying with state and local laws in procurements:

§200.318 General procurement standards.

(a) The non-Federal entity must use its own documented procurement procedures which reflect applicable State and local laws and regulations, provided that the procurements conform to applicable Federal law and the standards identified in this section.

As an example of a cost that does not comply with applicable law, let us assume that a nonprofit receives a grant to construct a bridge. However, every few days, a building inspector shows up and finds more problems for the nonprofit to fix. After a few weeks of virtually no progress, the CEO finds a solution. On his next visit, the inspector receives an envelope bulging with cash. Lo and behold! The inspector approves the construction and identifies no more problems.

The nonprofit would like to claim the bribe. The costs were reasonable and necessary: the bribe was a reasonable amount. The costs are allocable: it related directly to the bridge. There were no applicable credits: the inspector did not give a rebate. And, the costs were consistent: they always charge bribes as direct costs. The costs are even documented: they required the building inspector to give them a receipt! But, of course, as the costs were against the law, they are unallowable.

Really new?

Among the many audits we conducted of nonprofit entities was a grant program for developing new suicide prevention techniques.

During the audit, the auditor found a newspaper article in the entity’s files that cited the nonprofit’s CEO saying that the nonprofit had implemented a new idea in suicide prevention. That “new idea” happened to be the same technique that the grantee claimed to have developed under the grant. The problem was that the article was dated a year before the grant started. It, therefore, could not have been a new development.

At the exit conference, we told the nonprofit’s CEO that the entire amount claimed under the grant was in question because the technique wasn’t new. He replied, “You can’t rely on that article. I was lying when I gave that interview.”

I told him as nicely as I could that we all understood at this point that he was a liar. I usually believe the first lie. However, if he wished, he could contest the disallowance on the basis that the government should trust that he was lying the first time, not the second time. As you might have guessed, he decided not to dispute the finding.


2-7 Conform to Any Limitations

In addition to conforming to all state and federal laws, entities that receive federal awards must comply with any other limitations that are contained in the program’s laws and regulations, the specific grant provisions and, of course, the federal cost principles.

Some programs specifically prohibit charging any indirect costs to the grant. The grantee may not charge indirect costs even if it has a negotiated indirect cost rate with the federal government.

Similarly, the grant award itself may have some limitations. For example, it may prohibit charging any foreign travel to the grant.

The final limitation is the federal cross-cutting cost principles. For instance, when discussing specific types of costs, the cost principles render costs for alcoholic beverages unallowable.

There is one exception: A clear-cut prior approval will supersede virtually all of the usual limitations. But remember, to be valid, a prior approval must be in writing! Most agencies will accept e-mails to constitute “writing” these days.

If the grant program precludes indirect costs, for example, the grantee cannot charge items normally treated as indirect costs as direct costs (that pesky consistency principle again). However, a prior approval can overturn this prohibition. But the approval must indicate that the awarding agency understands that the direct charge differs from the institution’s normal practices, but is willing to accept it, regardless.

A prior approval will always override the general provisions, so long as it is clear that the approval was granted knowingly. That is, the approving agency was aware that it was approving something that would normally be unacceptable.

§200.403 Factors affecting allowability of costs.

Except where otherwise authorized by statute, costs must meet the following general criteria in order to be allowable under Federal awards:

(b) Conform to any limitations or exclusions set forth in these principles or in the Federal award as to types or amount of cost items.


§200.404 Reasonable costs.

… In determining the reasonableness of a given cost, consideration must be given to:

(b) The restraints or requirements imposed by such factors as: sound business practices; arm’s-length bargaining; Federal, state and other laws and regulations; and terms and conditions of the Federal award.

Seasonal milkers?

The U.S. Department of Education administers the Migrant Education program. This program provides funding for students whose parents or guardians cross school district lines to obtain seasonal or temporary agricultural employment. Under this program, state agencies required that parents and guardians complete forms describing the move and the kind of employment they obtained.

We reviewed these forms in one state with a large Migrant Education program and found many questionable occupations listed. In particular, a large number of the forms showed the occupation as “milker.” Since milking did not seem to be either temporary or seasonal, a condition of the program, we questioned the state representatives about the accuracy of the forms. Shortly thereafter, all of the “milkers” became “seasonal milkers.”

We found this change unpersuasive. I don’t know what the season is for milking. But I do know that the cows will get very uncomfortable during the off-season! After a lengthy dispute process, the state was required to repay over $13 million to the Migrant Education program.


2-8 Claimed Only Once

In quantum theory, electrons can exist in two places at the same time. However, this does not apply to the cost principles. Costs associated with federal awards can be claimed only once. Forbidding the claim of the same cost more than once seems self-evident. Just how creative can accounting become?

The same costs cannot be claimed for reimbursement on:

  • Two grants,
  • One grant and as cost sharing or matching on the same or any other grant, or
  • A direct charge to one grant and as an indirect cost included in the indirect cost pool.

§200.403 Factors affecting allowability of costs.

Except where otherwise authorized by statute, costs must meet the following general criteria in order to be allowable under Federal awards:

(f) Not be included as a cost or used to meet cost sharing or matching requirements of any other federally-financed program in either the current or a prior period. See also §200.306 Cost sharing or matching paragraph (b).

§200.413 Direct costs.

(a) General. Direct costs are those costs that can be identified specifically with a particular final cost objective, such as a Federal award, or other internally or externally funded activity, or that can be directly assigned to such activities relatively easily with a high degree of accuracy. Costs incurred for the same purpose in like circumstances must be treated consistently as either direct or indirect (F&A) costs.

A grantee might mistakenly, rather than intentionally, bill twice for the same cost. A cost, normally treated as an indirect cost, could erroneously be charged directly to a federal award.

For example, an organization charges the costs to purchase equipment as a direct cost to a federal award. The depreciation on the same equipment finds its way into the grantee’s indirect cost calculation, as a simple error and with no devious intention. When the rate is calculated, the organization has effectively billed the federal project for the same costs more than once.

Regardless of the reason, however, a grantee is not allowed to charge the same cost twice, or to charge it to one grant and use if for cost sharing on another grant.


2-9 Adequate Documentation

It would be difficult, at best, to attempt to describe in detail what constitutes adequate documentation. Federal regulations governing the management of award funds do not set forth detailed documentation standards. The documentation must be sufficient to convince a “reasonable person.” That reasonable person often turns out to be the auditor. As an old auditor, I know all auditors are reasonable; though, some may dispute that. Therein lies the problem. We all consider ourselves to be reasonable.

It can really help, therefore, to get other people’s opinions. If a cost involves an important or high-profile issue, you may want to have a brainstorming session regarding the needed documentation. Does everyone agree on the documentation that is needed? Does everyone agree that the transaction is adequately supported? If not, improve the documentation immediately. Do not wait until an auditor or program reviewer raises a question.

We mentioned earlier that the question of reasonableness could result in differences of opinion. If that could happen in a given case, be sure to document the rationale behind your decisions. Why do you consider the cost to be reasonable at the time you expend the funds? Why do you feel that you are adequately documenting this expenditure?

General guidelines to follow when documenting rationale include ensuring that the documentation is:

  • Contemporaneous,
  • Relevant, and
  • Sufficiently detailed to enable a reviewer to follow the transaction.[6]

If you prepare the documentation contemporaneously, it accomplishes a number of objectives:

  • It ensures that the preparer consciously thought about the allowability of the cost.
  • It reassures the reviewer that the organization is not trying to hide anything. After all, the data is there in plain view.
  • It shows that no fraud is intended. If there is a difference of opinion, it is just that. The concern regarding fraud is alleviated.

Contemporaneous records are far more credible than documentation prepared after-the-fact. If documentation is prepared after an auditor has raised a question, she will look at the documentation with a great deal of skepticism. She does not know whether the data correctly states the justification for the expenditure or whether the data was prepared merely to eliminate the finding.


Documentation by Faith

In the 1980s, we were asked to evaluate the proposal submitted by the Jewish Community Center in a southwestern city to run a Meals on Wheels program. Our auditor reviewed the proposal and the center’s records and then spoke to the head of the center, a rabbi. He said, “Rabbi, your proposal clearly sets forth what you plan to do and how you have budgeted your funds. The one question I don’t have answered from your submission is: Where will your matching funds come from?”

The rabbi smiled, patted him on the shoulder, and said, “The Lord will provide, my son.” It’s hard to argue with that one, even though the documentation was lacking.


Chapter 2 Summary

The general cost principles discussed in this chapter are perhaps the most crucial to a clear understanding of the nature of allowable costs under federal awards. Costs associated with any federal award may be permissible costs for reimbursement yet be denied when: not treated consistently by a grantee; improperly allocated to a federal award; erroneously included as both direct and indirect costs (thus claimed twice); or not properly supported.

Disallowances create disruptions in service and reduce the amount of funds available to provide services to future participants. Therefore, it is very important to understand the basic premises regarding the allowability of costs.

To be allowable under Federal awards, costs must:

  • Be necessary and reasonable;
  • Be allocable;
  • Be accorded consistent treatment;
  • Be net of all applicable credits;
  • Be determined in accordance with generally accepted accounting principles;
  • Conform to any limitations or exclusions set forth in the cost principles, federal law, terms and conditions of the federal award or other governing regulations;
  • Be consistent with policies, regulations, and procedures that apply uniformly to both federal awards and other activities of the organization;
  • Not be included as a cost or used to meet cost sharing or matching requirements of any other federal award; and
  • Be adequately documented (supported by verifiable information).

[1] This requirement is set out in §200.406 Applicable credit.

[2] 2011 revision of Government Auditing Standard, dated December 2011

[3] When indirect costs will result in charges to a federal award, a cost allocation plan is necessary.

[4] Credits do not include income items. In some cases, a grantee generates income as a result of grant activities. The rules covering program income are included in the administrative rules contained in 2 CFR 200, Subpart D.

[5] Governmental units may deviate from GAAP to the extent permitted in 2 CFR 200. For example, they may use cash basis accounting for leave, pension fund costs, or other similar costs.

[6] Documentation should not become the end product; it is merely a means to show that the federal award funds were expended appropriately under the terms of the federal award.

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