Is Your Company At Risk?

Transcription

1 Executive Compensation Disallowances: BY david j. lundsten Is Your Company At Risk? Understanding why portions of a company s executive compensation are disallowed after a DCAA audit can help you avoid it from happening in the first place. 44 Contract Management May 2008

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3 While compensation cost has in the past been subject to review during a Defense Contract Audit Agency (DCAA) audit, the level of that review by DCAA increased significantly in 2006, and a compensation review is now an expected part of the audit. Many companies have discovered that the DCAA was disallowing portions of their executive compensation, and have wondered why they are now subject to this increased scrutiny. This is probably the result of a memorandum from DCAA s assistant director for policy and plans, which was issued on June 30, The memo makes the following points: The third highest amount of questioned costs in FY 2004 related to compensation costs ; This memorandum is to remind all regions of the audit risk associated with claimed compensation costs, and emphasizes the availability of the Mid- Atlantic Region Compensation Team, which has established an expertise and has had success in this area ; and The Mid-Atlantic Compensation Team has a significant investment in purchased compensation surveys that can be used. The Mid-Atlantic Compensation Team The memorandum pointedly refers DCAA auditors to the Mid-Atlantic Compensation Team (MCT). Located in Philadelphia, Pennsylvania, MCT was formed to specialize in compensation auditing. As noted in a November 2007 presentation, MCT describes itself as: Skilled in the resolution of audit issues with contractors and consultants, Highly involved with agency-wide compensation audits, and Having team members trained and certified in the compensation area. These points are worth noting. Contractors must do a significant amount of homework if they plan to challenge MCT s determination of a reasonable amount of compensation. Regulatory Rules Guidance The Federal Acquisition Regulation (FAR) and two particular court cases comprise the regulatory rules and guidance in executive compensation matters. It is also important to note that many of the regulations and court cases are used solely as guidance, and are not requirements. The most important section in the FAR relating to compensation is at This is one of the longest cost principles in the FAR, and government contractors should become very familiar with it. MCT pointedly cites several passages that are important to note: No presumption of allowability exists for major revisions or new plans that have not been reviewed by the government; 1 Compensation must be reasonable for the services delivered; it must not be a distribution of profits; 2 Compensation is reasonable if the aggregate of each measurable and allowable element sums to a reasonable total; 3 and Among the factors that may be relevant are the compensation practices of firms of the same size, industry, geographic area, and engaged in nongovernment work. 4 MCT also emphasizes that FAR places the burden of proof on the contractor to prove that a cost is reasonable. Additionally, two particular court cases are often cited by MCT. These are the ISN and Tech Plan decisions. The ISN case has been interpreted by MCT to support the following: Properly dated compensation survey data should be used when available; No premium or increase in compensation is justified for owners filling several jobs simultaneously since this is typical of smaller, privately held companies; The company s annual financial performance should be reviewed to determine an appropriate percentile in a salary survey; and Offsets of the various components of compensation must be considered. The Tech Plan case is considered by MCT to support the following: Owner-CEOs perform multiple functions, Survey data should be relevant to the size of the company and larger company data should be excluded, Multiple surveys should be used, A 10 percent range of reasonableness is acceptable, and Survey data should be aged to the midpoint of the company s current fiscal year. 46 Contract Management May 2008

4 MCT s Methodology Although the FAR does not lay out any specific method to analyze compensation cost, MCT has developed a standard methodology: 1 MCT selects one or more (usually two to four) salary surveys with data for companies of a similar size and, when possible, the same geographic area with similar products/services. Judgment must be used to select appropriate surveys and how to interpret them. 2 The 50th percentile compensation amount for each of up to the five highest paid executives is determined by MCT. a MCT often must make a judgment as to the appropriate job title. b Many surveys do not have compa- rable company sizes and a regression formula must be interpreted and used to determine a compensation amount. Judgment is also used to determine when and how to use regression analysis. 3 The compensation amount is increased by 10 percent to allow for a range of reasonableness of variation in compensation. This is an arbitrary percentage developed by MCT. 4 The various components of an executive s compensation are summed and compared to the MCT-determined amount. Any excess is disallowed. 5 As illustrated, this methodology is the result of various judgments and is neither dictated by the FAR nor based on empirical data that supports its results. However, MCT treats the methodology as a given, and will rarely agree to any variation. Compensation Surveys MCT spends thousands of dollars each year on salary surveys covering the entire country, which it uses to decide what the allowable amount of compensation will be for the top five executives in a company and, if applicable, the five highest-paid executives in business segments that report directly to the home office. Since MCT picks and chooses the surveys that support their determinations of reasonable compensation, it is not an uncommon occurrence for MCT to disallow a significant amount of compensation. When a contractor disagrees with their findings, MCT s response is almost always Show us a survey that supports your compensation amount. To really understand their position, and attempt to find an error or unreasonable position, is difficult without buying and analyzing the surveys used by DCAA. Most small and midsize companies can t afford to do that. Many are forced to accept DCAA s findings, even though it may cost them Contract Management May

5 2006 Revenues of Five Highlighted Executives Position Average of Services Companies Average of All Companies CEO COO CFO Executive VP CIO (or Top IT) $127 million $654 million $1.7 billion $5.6 billion > $50 billion $135 million $508 million $1.7 billion $1.8 billion > $50 billion 48 Contract Management May 2008

6 thousands, or even hundreds of thousands, of dollars. 6 What is the best way to determine in advance what reasonable compensation will be so that you can either adjust compensation or treat the excess as unallowable? Unfortunately, MCT does not issue any safe harbor guidelines. However, in the November 2007 presentation, it did suggest what revenue level would be reasonable to justify the maximum allowable compensation set annually by the Office of Federal Procurement Policy. This amount is known informally as the compensation cap. In order for your company to be able to pay the 2006 cap amount of $546,689, your 2006 revenues would need to be as displayed in the table on page 48. If your 2006 revenues are less than these amounts, you can be sure that any compensation amount near the compensation cap will be challenged and that a significant amount would be disallowed. However, when attempting to determine what percentage of the compensation cap you should set as your executive compensation, these guidelines do not help very much. For small and midsize companies, the only way to determine and defend your executive compensation as reasonable is to obtain several acceptable compensation surveys as defined by DCAA covering companies like yours, and to determine if your company s performance compared to average performance justifies a higher (or lower) compensation. This is one situation where it might be worthwhile to hire a compensation expert prior to DCAA s next incurred cost audit. In fact, DCAA has stated that it will give more weight to a study performed to support your choice of executive compensation if you perform the study prior to, or during, the fiscal year in question as opposed to preparing a study after DCAA disallows a portion of your executive compensation. CM About the Author DAVID J. LUNDSTEN, MBA, CPA, CVA, is a partner at Cherry Bekaert & Holland LLP and a member of the firm s Government Contractor Services Group. Send comments about this article to cm@ncmahq.org. Endnotes FAR (a)(4). FAR (a)(6). Note that distribution of profits is not an allowable cost. FAR (b)(2). FAR (b)(2). However, the MCT drops the may be relevant and takes the position that these four criteria are essential and complete. The numbered bullet points were generally discussed in a presentation by the MCT to the NDIA on November 14, Remember, DCAA is a few years behind in auditing your records. Even if you change (which means lower) your executive compensation after getting DCAA s report, you will have a tail of two or more unaudited subsequent years which will also result in a DCAA disallowance. Therefore, the amount at stake can be very significant. Contract Management May