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Executive Compensation

(Editor’s Note. Differing interpretations of regulations covering personal compensation cause considerable grief for our clients. Budget cuts at DCAA offices has eliminated highly trained compensation teams, leaving determination of allowability to often-untrained auditors at the local level. In this second part of a three-part article on executive compensation, we will discuss the criteria for allowability and discuss specific elements of compensation.

Our series of articles are based on an excellent article by Karen Manos of the law firm of Hourey & Simon in the December 1997issue of Briefing Papers. Because we want to discuss use of salary surveys in greater depth, we have expanded our original two part series on executive compensation to three. The first article discussed government changing rules on executive compensation caps while the third article will explore how to determine what are reasonable levels of compensation with particular emphasis on what auditors consider appropriate use of salary survey. Though our newsletters are oriented to cost, price and contracting issues, we believe this series will be quite helpful for human resources personnel. We will be happy to provide the previous issue of the DIGEST to all new subscribers at no charge.)

Employee compensation is the single largest element of cost by many contractors. The government is, not surprisingly, quite interested. In addition to the more recent caps on executive compensation, the FAR cost principle 31.205-6, "compensation for personnel services" holds the record for most revisions (over 20) in the last 15 years.

The cost principle defines "compensation broadly:

Compensation for personal services includes "all remuneration paid currently or accrued, in whatever form and whether paid immediately or deferred for services rendered by employees to the contractor during the period of contract performance". It includes, but is not limited to salaries, wages, directors and executive committed members’ fees, bonuses, stock securities, insurance, fringe benefits, contributions to pension, annuity, and management incentive plans, off-site pay, severance and differential pay.

Criteria for Allowability

Five general criteria must be met for costs of personal compensation to be allowable.

With limited exception we will discuss later, compensation must be for work performed in the current year and may not be for retroactive payment for work performed in prior years.

Compensation must be paid in accordance with "an established compensation plan or practice followed so consistently as to imply, in effect, an agreement to make payment". Does this mean it needs to be in writing? Boards of Appeals have ruled that a compensation policy can be held to exist without being in writing when costs were incurred for the "first time" (Boeing, ASBCA 46274). On the other hand, a Board disallowed bonus payments when a survey of employees indicated the major of employees said they did not believe a promise or agreement existed. It certainly is easier to prove an establihsed policy or practice if the compensation program is set forth in writing and communicated to employees.

There is no presumption of allowability where the contractor has failed to notify the contracting officer of a "major revision" to its compensation plan or practices. Conversely, there will be such a presumption if the contractor notifies the ACO and gives them the opportunity to review the change.

Costs unallowable under other cost principles are not considered allowable simply because they are called "compensation". For example, costs of membership in social, dining or country clubs made unallowable under "Entertainment Costs" are still unallowable even if reported as income to employees.

Compensation must be "reasonable" for the work performed. The cost principle has undergone considerable changes in clarifying what is "reasonable". It started out with the prudent person principle – not to exceed what would be incurred by a prudent person in the conduct of competitive business. This principle has been supplemented by more specific guidance that we will discuss next issue.

Specific Elements

Bonuses and Incentive Compensation

Use of bonuses has proliferated in recent years. The principle identifies as allowable bonuses incentive compensation for managers, cash bonuses, suggestion awards, safety awar4ds and incentive compensation based on production, cost reduction or efficient performance provided such costs are accrued under an agreement before the services are rendered. Employees need not have had the right to receive the bonus provided there was a reasonable expectation the bonus would be paid.

Other criteria includes (1) if payment is deferred, criteria of deferred compensation must be met (discussed later) (2) compensation in lieu of salary for partners and sole proprietors cannot be a distribution of profit. (Editor’s Note. This is a major area of dispute we encounter in our consulting engagements. Compensation for owners in excess of reported W-2 earnings are commonly questioned by auditors on the grounds they are a "distribution of profit") and (3) for closely-held corporations, the compensation must be tax deductible.

Corporate Securities

Executive compensation frequently includes payments in the form of contractor’s corporate securities such as stock options and stock appreciation rights. The government has imposed additional restrictions on allowability of this form of compensation:

Securities must be valued at their fair market value on the "measurement date" (the first date the number of shares awarded is known).

Accruals for the cost of the securities before issuance to employees must take into account the possibility some employees’ interests in the accrual will be forfeited.

For stock options, allowable costs are limited to the difference between the option price, if lower and the market price of the stock on the first date both number of shares and option price are known. Since option prices are generally equal or greater than the market price, stock options are generally unallowable.

Compensation calculated or valued on the basis of changes in the price of the securities (e.g. stock appreciation rights, phantom stock plans and junior stock conversions) are unallowable because it is considered not compensation based on actual work performed.

Compensation in the form of dividend payments are unallowable because they are considered "distribution of profits").

For employee stock ownership plans (ESOPs) (a) contributions cannot exceed 15% of participant’s salary and wages (25% when a money purchase plan is included) (b) contribution rates higher than earlier ones must be approved by the CO (c) funding must be made by the time for filling the contractor’s federal income tax (d) payment in the form of corporate securities must be valued at the fair market value of the stock on the date title is effectively transferred.

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