(Editor’s Note. Though our subscriber base primarily includes a wide variety of government contractors, several government audit agencies also subscribe. Occasionally we receive questions from them and we thought the following dialogue we had with the head of a state agency audit group that audits contractors for programs receiving federal funds would be instructive. We hope the following will be of interest because it illuminates (1) the mind-set of a highly competent auditor and (2) addresses several interesting issues such as deferred compensation, senior executive limits and relevance of cost accounting standards to non-CAS covered contractors. The contractor and dollar amounts are disguised.)

The contract being audited is with a state transportation agency financed with federal funds that is cost reimbursable with a downward adjustment only to indirect rates after the contractor’s incurred cost proposal is audited. The contractor is a small business that provides various services and the agency is auditing an incurred cost proposal that includes $175,000 in its overhead pool for "deferred compensation." The auditor is highly skeptical of the cost, believing it is simply a fictional amount inserted to increase the contractor’s overhead rate since otherwise there would be a downward adjustment to its overhead rates since its overhead rate would be significantly lower than that billed during the year. The auditor has said "it would be against public policy" to allow the cost and has put forth various grounds to challenge the cost and has asked us for our feedback.

During our conversations the auditor expressed his intent to disallow the costs and put forth various reasons to base his disallowance:

1. The cost is unlikely to be paid since the company, at this time, seems unable to afford a deferred amount of $175,000.

2. The deferred compensation is not tax deductible and hence is not allowable.

3. There is no distinct plan for the compensation.

4. The amount does not meet the conditions of CAS 415, Deferred compensation, namely (a) the amount to be paid in the future is not a bona fide obligation because payment can be unilaterally avoided by the contractor and (b) the measurement of the future payment is not clearly made. We also discussed whether CAS 415 is relevant to the company since its small business status exempts it from CAS.

5. The deferred amount is really a form of compensation and the owner is in essence saying my time is worth $156 dollars per hour and since the owner bills the government directly for all of its time, the deferral should be considered a direct cost, not indirect. The auditor indicates that charging the deferred compensation as direct labor would have the effect of lowering, not increasing, the overhead rate (e.g. a higher direct labor base would make the denominator higher).

6. Since the owner’s raw labor rate charged on its contracts is approximately $72 dollars per hour, that implies a salary of $150,000. That salary plus the deferred compensation would appear to be excessive even though it is below the senior executive compensation cap set by the Office of Federal Procurement Policy (OFPP).

7. Much smaller amounts of deferred compensation were incurred in prior years making the proposed amount in the current year an unreasonable increase.

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