Phase II can feel like the moment an SBIR/STTR company has been waiting for.

 

The project is moving forward. The award may be larger. The company may be preparing to hire, expand technical work, work with consultants or subawards, purchase materials, submit invoices or drawdowns, and manage a more complex federal funding environment.

 

But Phase II can also expose accounting weaknesses quickly.

 

A company that managed Phase I with basic bookkeeping, spreadsheets, or manual reports may not be ready for Phase II expectations.

 

If project costs are not tracked clearly, timekeeping is weak, indirect rates are unsupported, unallowable costs are not separated, documentation is scattered, or reports are prepared manually, the company should address those gaps before Phase II begins.

 

At Peter Witts CPA PC, we help SBIR/STTR companies prepare for Phase II financial review by strengthening accounting system readiness, project costing, timekeeping, labor distribution, indirect rates, documentation, billing support, and reporting.

 

Why Phase II Readiness Is Different

 

Phase I may be smaller, shorter, and simpler.

 

Phase II often brings more funding, more technical work, more labor, more documentation, and more financial review risk.

 

SBIR.gov explains that the federal government usually expects small businesses to have a basic accounting system for Phase I, but many agencies become more stringent in Phase II. It also notes that Phase II review may involve documentation, financial stability, accounting system adequacy, indirect rates, and payroll tax deposits.

 

That means the accounting system should be ready before the company is deep into Phase II performance.

 

Phase II readiness matters because the company may need to support:

• Project cost tracking

• Timekeeping

• Labor distribution

• Payroll support

• Direct and indirect cost separation

• Indirect rates

• Unallowable cost tracking

• Consultant and subaward costs

• Drawdowns or invoices

• Budget-to-actual reports

• Financial capability review

• Agency or DCAA-related questions

• Closeout records

If the system is not ready, the company should not wait for an agency request to start fixing it.

 

Start With a Gap Assessment

 

The first step is to identify what is not ready.

 

A Phase II accounting gap assessment should review:

• Chart of accounts

• Project codes

• Direct cost tracking

• Indirect cost tracking

• Unallowable cost accounts

• Timekeeping

• Labor distribution

• Payroll support

• Indirect rate calculations

• Consultant files

• Subaward files

• Drawdown or invoice process

• Budget-to-actual reporting

• Documentation folders

• Policies and procedures

• Cash flow planning

• Prior approval requirements

The goal is not to create panic.

The goal is to understand what must be fixed before Phase II spending, billing, reporting, or review begins.

 

Gap 1: No Project Costing

 

One of the most urgent gaps is no project costing.

 

This happens when the accounting system cannot clearly separate Phase II costs from:

• Phase I costs

• Other federal awards

• Internal R&D

• Commercial product work

• Customer-funded pilots

• Fundraising

• Sales and marketing

• General operations

• Unallowable activity

2 CFR 200.302 requires financial management systems to identify the amount, source, and expenditure of federal funds and compare expenditures with budget amounts for each federal award.

 

If all activity is recorded under one general R&D category, the company will struggle to show which costs belong to Phase II.

 

What to Fix: Set Up Project Codes

 

Before Phase II begins, set up a separate project code for the award.

 

Depending on the accounting software, this may be called a class, project, job, customer, contract, grant, department, cost center, or tag.

 

The project code should allow the company to produce reports showing:

• Direct labor

• Fringe

• Consultants

• Subawards

• Materials and supplies

• Travel

• Equipment

• Other direct costs

• Indirect costs

• Drawdowns or invoices

• Cost transfers

• Remaining budget

If the company has multiple federal awards or commercial work, each should have its own code.

 

A single “R&D” code is not enough for Phase II readiness.

 

Gap 2: Chart of Accounts Is Too Basic

 

A tax-focused chart of accounts may not support Phase II reporting.

 

For example, the books may have broad categories such as:

• Payroll

• Contractors

• Supplies

• Software

• Travel

• Professional fees

• Miscellaneous

These categories may help with tax preparation, but they may not support award reporting, indirect rate calculations, or cost review.

 

A Phase II-ready chart of accounts should help separate:

• Direct labor

• Indirect labor

• Fringe benefits

• Consultants

• Subawards

• Materials and supplies

• Travel

• Equipment

• Other direct costs

• Indirect costs

• Unallowable costs

• Internal R&D

• Commercial activity

• General and administrative costs

The chart should support the approved budget and the company’s reporting needs.

 

What to Fix: Map Accounts to the Phase II Budget

 

Review the approved or proposed Phase II budget and map each category to the accounting system.

 

Ask:

• Can the accounting system report costs by budget category?

• Are consultants separated from subawards?

• Are labor and fringe separated when needed?

• Are indirect costs visible?

• Are unallowable costs isolated?

• Are travel and equipment tracked clearly?

• Can reports be generated without major spreadsheet cleanup?

If the answer is no, clean up the chart of accounts before spending begins.

 

Gap 3: Weak Timekeeping

 

Timekeeping is one of the most important Phase II readiness issues.

 

SBIR.gov identifies timekeeping as a key accounting system requirement and explains that timesheets help document employee time spent across business activities, proposal work, commercialization planning, and other activities.

 

Weak timekeeping may look like:

• No formal timesheets

• Time recorded after the fact

• Founder time estimated from memory

• Employees only track award hours, not total activity

• Time is not coded by project

• Commercial work is mixed with federal work

• Fundraising time is not separated

• Supervisor approvals are missing

• Corrections are not documented

For Phase II, this can create major labor support problems.

 

What to Fix: Implement Timekeeping Before Work Begins

 

The company should implement timekeeping before Phase II labor starts.

 

Timesheets should capture:

• Employee name

• Date worked

• Hours worked

• Project or award code

• Direct Phase II labor

• Indirect labor

• Non-award labor

• Internal R&D

• Commercialization

• Fundraising

• Sales or customer activity

• Founder time

• Approval

• Corrections

Timekeeping should show actual work performed, not budget assumptions.

 

Gap 4: Payroll Does Not Tie to Timekeeping

 

Payroll records show what employees were paid.

 

They do not automatically show which award or project benefited from the labor.

 

A company is not Phase II-ready if payroll is processed without connecting it to timekeeping and project codes.

 

Warning signs include:

• Payroll is recorded as one monthly expense

• Employee time is not allocated by project

• Founder payroll is not supported by activity records

• Payroll reports do not tie to award labor

• Fringe costs are not tracked clearly

• Payroll journal entries lack project coding

• Labor costs are allocated manually after payroll

Without payroll support, labor charged to Phase II may be difficult to defend.

 

What to Fix: Build Labor Distribution

 

Labor distribution connects timesheets, payroll, and the general ledger.

 

A labor distribution report should show:

• Employee name

• Pay period

• Hours by project

• Direct Phase II labor

• Indirect labor

• Non-award labor

• Salary or wage allocation

• Fringe allocation, if applicable

• Project code

• General ledger account

• Total labor cost charged to Phase II

DCAA’s pre-award accounting system adequacy checklist addresses whether an accountin g system identifies employee labor by cost objective and distributes direct and indirect labor appropriately.

 

If the company cannot produce labor distribution reports, this should be fixed before Phase II starts.

 

Gap 5: Unsupported Indirect Rates

 

Indirect rates often become more important in Phase II.

 

A company may have used a rough rate in Phase I or copied a rate from an old proposal.

 

That may not be enough for Phase II.

 

Unsupported indirect rate issues include:

• No cost pool schedule

• No allocation base support

• No fringe calculation

• No overhead or G&A support

• Unallowable costs included in pools

• Commercial work excluded from the base without support

• Founder management time misclassified

• Actual costs do not support the proposed rate

• Rate exists only in a proposal spreadsheet

SBIR.gov explains that indirect rates should be developed from the company’s own accounting system, annual budget, projected cost categories, or other company-specific cost information.

 

What to Fix: Build an Indirect Rate Support File

 

Before Phase II, prepare an indirect rate support file.

 

Include:

• Profit and loss statement

• General ledger detail

• Payroll records

• Labor distribution reports

• Fringe schedule

• Overhead schedule

• G&A schedule

• Allocation base support

• Unallowable cost exclusions

• Commercial activity treatment

• Internal R&D treatment

• Forecast assumptions

• Rate calculation

• Notes explaining the cost structure

The rate should be tied to the company’s records, not just the proposal budget.

 

Gap 6: No Unallowable Cost Tracking

 

Unallowable costs should be visible in the accounting system.

 

They should not be mixed with direct award costs or hidden in indirect pools.

 

Common examples requiring review include:

• Fundraising

• Investor activity

• Certain lobbying

• Entertainment

• General sales activity

• Non-award commercialization

• Unsupported costs

• Personal or non-business costs

• Costs outside the period of performance

• Costs restricted by award terms

SBIR.gov identifies isolation of unallowable costs as part of a strong accounting system.

 

If the accounting system cannot identify unallowable costs, the company should fix this before Phase II billing, drawdowns, or reporting begin.

 

What to Fix: Create Unallowable Cost Accounts or Codes

 

Set up accounts or project codes for unallowable and restricted activity.

 

At minimum, the company should separate:

• Fundraising

• Investor relations

• Sales and marketing

• Entertainment

• Non-award commercialization

• Personal or non-business costs

• Costs outside the award period

• Other restricted costs

The goal is not to suggest these costs cannot exist as business expenses.

 

The goal is to prevent them from being charged improperly to the award or included incorrectly in indirect rates.

 

Gap 7: Poor Documentation

 

Phase II can require stronger documentation.

 

NSF says prospective Phase II awardees may be asked to provide documentation so NSF can evaluate the organization’s ability to manage a federal award effectively and efficiently. NSF also performs financial capability review on prospective Phase II awardees to assess financial stability, resources, and risk of waste, fraud, or abuse.

 

Poor documentation may look like:

• Award files scattered across email

• No approved budget file

• Missing payroll support

• Missing timesheets

• Consultant agreements not organized

• Subaward documentation incomplete

• Vendor invoices not tied to project purpose

• Indirect rate schedules missing

• Drawdown support not retained

• Cost transfer explanations vague

• Reports not saved with backup

If records are hard to find internally, they will be harder to produce during review.

 

What to Fix: Build Phase II Documentation Folders

 

Create organized folders before Phase II starts.

 

Include folders for:

• Award documents

• Approved budget

• Statement of work

• Payroll

• Timekeeping

• Labor distribution

• Vendor invoices

• Consultant files

• Subaward files

• Travel

• Equipment

• Indirect rates

• Drawdowns or invoices

• Budget-to-actual reports

• Prior approvals

• Cost transfers

• Agency correspondence

• Reports submitted

• Closeout records

Documentation should be organized monthly, not assembled during review.

 

Gap 8: Manual Reporting

 

Manual reporting is common during Phase I.

 

By Phase II, it becomes risky.

 

Manual reporting gaps include:

• Budget-to-actual reports built outside the accounting system

• Costs manually copied from bank statements

• Labor reports built from spreadsheets

• Indirect rates calculated outside the books

• Drawdowns based on estimates

• Invoices prepared without support files

• Award reports not reconciled to the ledger

Manual reports may be necessary in some cases, but they should reconcile to the accounting system.

 

The company should not depend on disconnected spreadsheets as the primary source of truth.

 

What to Fix: Build Reports From the Accounting System

 

Phase II reports should be connected to the accounting records.

 

Set up reports for:

• General ledger by project

• Budget-to-actual by award

• Direct labor

• Labor distribution

• Consultant costs

• Subaward costs

• Travel and equipment

• Indirect costs

• Unallowable costs

• Drawdowns or invoices

• Cost transfers

• Remaining budget

2 CFR 200.302 requires financial systems to support required reporting and track expenditures to establish that funds were used according to federal statutes, regulations, and award terms.

 

Reports should be ready before the agency asks for them.

 

Gap 9: No Billing or Drawdown Support Process

 

Phase II may involve larger drawdowns, reimbursement requests, invoices, vouchers, or milestone payments.

 

The company may not be ready if:

• Payment requests are based on estimates

• Drawdowns do not tie to expenditures

• Invoices lack payroll support

• Indirect rates are not tied to the books

• Vendor support is incomplete

• Consultant invoices lack detail

• Costs are not reviewed before submission

• Cash on hand is not monitored

• Prior payments are not reconciled

Payment support should be built before the first Phase II payment request.

 

What to Fix: Define the Payment Support Workflow

 

Before Phase II begins, define:

• Who prepares drawdowns or invoices

• Who reviews them

• What support is required

• How payroll is included

• How vendor costs are included

• How indirect costs are calculated

• How unallowable costs are excluded

• How payments are reconciled

• Where backup is stored

Each payment request should have a support file.

 

Gap 10: No Written Policies and Procedures

 

A company may have capable people but still lack a repeatable accounting process.

 

That becomes a problem in Phase II.

 

Written procedures should cover:

• Timekeeping

• Labor distribution

• Project coding

• Direct cost classification

• Indirect cost classification

• Unallowable costs

• Purchasing

• Expense approvals

• Consultant invoice review

• Subaward monitoring

• Equipment tracking

• Travel documentation

• Drawdowns or invoicing

• Cost transfers

• Monthly close

• Record retention

DCAA’s checklist focuses on how the accounting system is designed to meet SF 1408 criteria, which means the company should be ready to explain both the tools and procedures behind the system.

 

What to Fix: Document the Process

 

Write practical procedures that the team can actually follow.

 

The procedures do not need to be overly long.

 

They should explain:

• What must be done

• Who is responsible

• When it happens

• What documentation is required

• How exceptions are handled

• Where records are stored

• Who reviews the process

A good policy is useful only if it matches how the company operates.

 

Prioritize the Most Urgent Fixes First

 

If Phase II is approaching, the company may not be able to fix everything at once.

 

Start with the areas that affect award cost support most directly:

• Project codes

• Timekeeping

• Labor distribution

• Payroll support

• Direct and indirect cost separation

• Unallowable cost tracking

• Indirect rate support

• Drawdown or invoice process

• Documentation folders

• Budget-to-actual reporting

These areas form the foundation for Phase II financial review.

 

Do Not Wait for DCAA or Agency Questions

 

Some founders wait until the agency asks for documentation.

 

That is risky.

 

SBIR.gov notes that the largest hurdle for contractors new to cost-reimbursement contracts, such as DoD Phase II SBIR/STTR contractors, is often passing the pre-award accounting system survey.

 

NSF also says Phase II proposals can be subject to administrative and financial review, including significant accounting and administrative documentation and possible follow-up requests to company leadership.

 

The company should prepare before the request arrives.

 

Build a 30-Day Readiness Plan

 

If Phase II is close, create a short readiness plan.

 

In the first 30 days, the company should aim to:

• Review the Phase II budget

• Set up project codes

• Clean up the chart of accounts

• Implement timekeeping

• Connect payroll to labor distribution

• Build indirect rate schedules

• Create unallowable cost accounts

• Organize documentation folders

• Define drawdown or invoice support

• Build budget-to-actual reports

• Draft basic accounting procedures

• Review cash flow

This may not solve every historical issue, but it can create a stronger foundation before Phase II performance begins.

 

Review Historical Costs Carefully

 

If the company already incurred costs or is transitioning from Phase I to Phase II, historical cleanup may be needed.

 

Review:

• Phase I costs

• Pre-award costs, if any

• Proposal costs

• Payroll records

• Founder time

• Consultant invoices

• Vendor expenses

• Internal R&D

• Commercial activity

• Cost transfers

• Drawdowns or reimbursements

• Indirect rate assumptions

The goal is to avoid carrying Phase I or non-award accounting problems into Phase II.

 

Prepare for Cash Flow Pressure

 

Phase II may increase cash flow pressure.

 

Larger awards can require larger payroll, consultant payments, subaward costs, materials, travel, and equipment purchases.

 

Before Phase II begins, review:

• Payroll timing

• Hiring plans

• Consultant payment terms

• Subaward payment terms

• Vendor invoices

• Drawdown timing

• Invoice timing

• Payment delays

• Working capital

• Indirect cost recovery

• Funding ceilings

An accounting system can be technically stronger and still fail to support the business if cash flow planning is ignored.

 

Common Signs Your System Is Not Ready for Phase II

 

Your SBIR/STTR accounting system may not be ready if:

• Costs are tracked mainly in spreadsheets

• There is no separate project code for the award

• Phase I and Phase II costs are mixed

• Timekeeping is informal

• Payroll does not tie to project labor

• Labor distribution reports are missing

• Indirect rates are unsupported

• Unallowable costs are not isolated

• Consultant and subaward files are incomplete

• Drawdowns or invoices are hard to support

• Reports require manual cleanup

• Documentation is scattered

• Policies are not written

• Leadership cannot see award financial status

These signs should be addressed before Phase II pressure begins.

 

Phase II Financial Review Readiness Checklist

 

Before Phase II begins, review:

• Award type

• Approved budget

• Project codes

• Chart of accounts

• Direct cost tracking

• Indirect cost tracking

• Unallowable cost accounts

• Timekeeping process

• Payroll support

• Labor distribution reports

• Founder time coding

• Indirect rate schedules

• Consultant files

• Subaward files

• Vendor documentation

• Travel and equipment support

• Drawdown or invoice workflow

• Budget-to-actual reports

• Cost transfer process

• Documentation folders

• Written policies

• Cash flow forecast

• Monthly close process

This checklist helps the company identify what must be fixed before Phase II spending, billing, or review.

 

Questions to Ask Before Phase II Review

 

Before a Phase II financial review or pre-award accounting system review, ask:

• Can our accounting system track costs by award?

• Can we produce reports by approved budget category?

• Are direct and indirect costs separated?

• Are unallowable costs isolated?

• Is timekeeping active and reliable?

• Does payroll tie to labor distribution?

• Can we support founder compensation?

• Are indirect rates supported by accounting records?

• Can we support drawdowns or invoices?

• Are consultant and subaward files complete?

• Are reports connected to the ledger?

• Are documentation folders organized?

• Are procedures written?

• Can leadership explain the accounting system?

• Are we ready to respond quickly if the agency asks?

If several answers are no, the company should begin remediation immediately.

 

Final Thoughts: Phase II Accounting Gaps Should Be Fixed Before Review

 

Phase II can create real growth for an SBIR/STTR company, but it also raises the expectations for accounting readiness.

 

Companies should not wait until a financial review, pre-award survey, drawdown issue, invoice question, or agency request exposes the gaps.

 

If the company lacks project costing, strong timekeeping, labor distribution, supported indirect rates, unallowable cost tracking, organized documentation, and award-ready reporting, those issues should be addressed before Phase II begins.

 

At Peter Witts CPA PC, we help SBIR/STTR companies prepare for Phase II financial review by identifying accounting system gaps and strengthening the records, reports, and procedures needed for federal award performance.

 

Need Help Preparing for Phase II Financial Review?

 

If your SBIR/STTR accounting system is not ready for Phase II, Peter Witts CPA PC can help review your project costing, timekeeping, payroll support, labor distribution, indirect rates, unallowable cost tracking, documentation, drawdown or invoice process, and budget-to-actual reports.

 

Backed by 35+ years of government contract accounting experience and first-hand DCAA knowledge, our team helps innovators strengthen accounting readiness before Phase II review, award setup, billing, or reporting pressure begins.

 

Schedule a strategic consultation with Peter Witts CPA PC to prepare for Phase II financial review.