(Editor’s Note.  As part of our continuing efforts to provide “real life” case studies we encounter in our consulting practice and “Ask the Experts” discussions offered to subscribers, we provide a summary of correspondences we had with one of our subscribers who wanted advice on challenging DCAA’s assertion that the President of their company received excess compensation. We thought it would be interesting to recount our communications here since executive compensation is the number one area of audit scrutiny, specific surveys used by the government are identified, differences of unallowable stock options but allowable stock compensation are addressed and potential methods of challenging assertions of unreasonableness are discussed.  One cautionary word – our responses were not based on authoritative research nor included in position papers we would prepare for a client but were rather quick opinions our subscriber asked us to provide.  We have changed the data to disguise the identity of our subscriber who we will refer to as “Contractor.”)

Audit Opinion

In their audit of Contractor’s incurred cost proposal, DCAA questioned $340,000 of compensation paid to its CEO, consisting of two elements:  (1) $250,000 of stock that DCAA asserted was unallowable stock options and (2) $90,000 of excess salary compensation. Since most of its work consisted of cost type work with the government, the impact of the questioned costs would be huge.

The basis for the stock compensation was Contractor’s decision to establish an Employee Stock Ownership Plan (ESOP) that would be capitalized with 100,000 shares of additional stock the company would issue. In order to ensure the percentages of ownership remained the same, the company gave the CEO an amount of shares worth $250,000.

The basis for questioning the $90,000 was the CEO’s total salary and bonus of $260,000 (the stock compensation was separate since it is not part of “salaries”) while a comparison of salary surveys indicated that the appropriate salary and bonus compensation plus a 10% error factor was $170,000. DCAA used three salary surveys – Watson Wyatt Data Services, Economic Research Institute Executive Compensation Assessor and D. Dietrick Associates – that benchmarked engineering and research services firms, conducted a “sales regression analysis” to compare survey results with Contractor’s size and computed an average compensation figure at the 50% median level plus 10% error factor that equaled $170,000.

Advice

The Contractor asked my opinion on how to proceed. After hearing the nature of the stock compensation, I was convinced it was not an unallowable stock option but was allowable “corporate securities” that FAR 31.205-g(d)(1)(ii) provides are allowable forms of payment.  I suggested Contractor prepare a letter providing the group who conducted the compensation analysis a clear description of the stock compensation and how it met the requirements set forth in the FAR section identified above. One word of caution: though the stock compensation was not compensation from an ESOP, DCAA may assert that it is which limits such compensation to, I believe, 15-25% of salary plus bonus. 

As for excess compensation, I suggested inquiring into how the “sales regression analysis” was conducted. Though DCAA’s specialized compensation team located in the Mid-Atlantic regional office is quite experienced in conducting compensation analyses (one of our associates was a member of the team) other teams or individuals conducting compensation reviews throughout the agency are significantly less experienced. We have encountered very “creative” approaches taken to applying a survey that is by necessity not precisely oriented to a particular company (e.g. industry, size, location, etc.) so there may be some inappropriate analyses conducted for benchmarking Contractor’s business with survey results.  Next, since DCAA has conducted its own survey analysis, the burden falls on Contractor to show why the survey results are not appropriate. Two approaches that come to mind include: (1) provide a better bona fide survey that more closely benchmarks compensation of your particular firm (e.g. more industry specific, size, location, skill levels, etc.) and (2) justify use of a higher percentile on the surveys DCAA used (e.g. demonstrate why your firms’ sales, profit, returns on assets/equity/capital, etc. are superior, etc.) so that, for example, a 75% percentile would be more appropriate than using a 50% level that is the default level used by DCAA.

Current Status

Contractor did prepare a letter addressed to DCAA’s special compensation team describing the nature of the stock compensation and told us that it appeared as if DCAA agreed that the stock was not unallowable stock options.  Contractor also apparently hired a consultant who used a Salary.com compensation survey that provided significantly higher compensation levels, resulting in there being no excess salary if DCAA accepted the results. Examining the survey, it benchmarked companies with 100 employees which was more closely related to Contractor’s size than the three surveys used by DCAA. However, the survey purports to examine “Manufacturing – all industries” which does not coincide with Contractor’s industry of engineering services.  So it is doubtful whether DCAA will substitute its findings with the Salary.com survey results. At best, it may use the survey as a fourth source and take an average of the four surveys.

Contractor also provided us with information that indicated its sales and earnings growth were significantly higher than industry norms.  This may be the most productive avenue to take - demonstrate the superior financial performance of Contractor over its peers in order to justify use of a higher percentile (75-90%) and hence a higher salary benchmark.  We have not yet received any other word.

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