Bad Debts

The FAR cost principle addressing bad debts (FAR 31.205-3) is very brief. It states that bad debts, including actual or estimated losses arising from uncollectible accounts receivable due from customers and other claims, and any directly associated cost such as collection costs, and legal costs are unallowable.  This basic provision has been around since 1942. Since the Government always pays its bills, bad debts only arise from non-government transactions and therefore are not allocable to Government work (or so the theory goes - some contractors will tell you that the Government doesn't always pay its bills).

The tricky part of this cost principle concerns "directly associated costs". It states that bad debts and directly associated costs (such as collection and legal) are unallowable. Auditors will attempt to question or disallow all collection efforts, even those efforts that ultimately result in collection. But that is not what the cost principle states. It makes cost of collection efforts unallowable only if the underlying debt is ultimately unallowable. The cost of collecting debts that are ultimately paid are allowable.

This distinction between bad debts and debts that are ultimately collected was confirmed in an ASBCA (Armed Services Board of Contract Appeals) case from 1965 where the Board rejected the Government's argument that collection costs were unallowable when there was "not the slightest evidence that the collection expense was incurred with respect to bad debts."