In the wake of recent stock options scandals, the Defense Contract Audit Agency has issued guidance to its auditors to be “alert to unallowable costs related to employee stock option awards” when conducting their normal audits.  The guidance stresses that the measurement and allowability of such costs are governed by the Cost Accounting Standard 415 rather than relevant sections of Financial Accounting Standard (FAS) 123(R) because the latter addresses only financial accounting and not government contract accounting and advices auditors to question any stock option cost in excess of the amount measured by CAS 415.

CAS 415 requires that compensation costs arising from stock options be measured by the difference between the fair market value of the stock and the option’s exercise price at the measurement date which is the first date both the number of stock options awarded and the option price is known.  Since most companies award stock options to their employees at an option price that is equal to or higher than the market price of the stock at the measurement date, there is generally no allowable compensation cost resulting from the stock options.  However, in rare cases where the stock options are awarded at an option price lower than the market price, the difference constitutes compensation costs under CAS 415 and would be considered allowable.  For non-CAS covered contractors, auditors are told to cite FAR 31.205-6(k) when questioning the cost because that section of the FAR incorporates CAS 415 in its entirety (06-PAC-023(R).

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