Is Your Company At-Risk for an Executive Compensation Disallowance by DCAA?

By David J. Lundsten, Cherry, Bekaert & Holland, L.L.P. (CB&H)
Email: dlundsten@cbh.com

While compensation cost has, in the past, been subject to review during a DCAA audit, the level of that review by the DCAA increased significantly in 2006, and a compensation review is now an expected part of the audit. Many companies (in different parts of the country) have discovered that the DCAA was disallowing portions of their executive compensation, and have wondered why they are now subject to this increased scrutiny.

The increase in scrutiny is probably the result of a memorandum from DCAA’s Assistant Director for Policy and Plans issued on June 30, 2005. 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.”
• The Mid-Atlantic Compensation Team (MCT) 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 MCT. Located in Philadelphia, the MCT was formed to specialize in compensation auditing. As noted in a November 2007 presentation, the MCT describes itself as:

• “Skilled in resolution of audit issues with contractors/consultants
• Involved with [compensation] audits Agency-wide....
• [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 the MCT’s determination of a reasonable amount of compensation.

Regulatory Rules Guidance
The Federal Acquisition Regulations (FAR) and two court cases comprise the regulatory rules and guidance in executive compensation matters. It is important to note that many of the regulations and court cases are guidance, not requirements.

The most important section in the FAR relating to compensation is at 31.205-6. This is one of the longest cost principles in the FAR, and government contractors should become very familiar with it.

The MCT pointedly cites several passages that you should keep in mind:

• No presumption of allowability exists for major revisions or new plans that have not been reviewed by the government (FAR 31.205-6(a)(4)).
• Compensation must be reasonable for the services delivered; it must not be a distribution of profits (31.205-6(a)(6)). Note that distribution of profits is not an allowable cost.
• Compensation is reasonable if the aggregate of each measurable and allowable element sums to a reasonable total (31.205-6(b)(2)).
• Among the factors that “may be relevant” are the compensation practices of firms of the same size, industry, geographic area, and firms engaged in non-government work (31.205-6(b)(2)). However, the MCT drops the “may be relevant” and takes the position that these four criteria are essential and complete.

The MCT also emphasizes that FAR 31.201-3 places the burden of proof on the contractor to prove a cost is reasonable.

Two court cases are often cited by MCT 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/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 looked at to determine an appropriate percentile in a salary survey
• 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 – exclude larger company data
• Multiple surveys should be used
• A 10 percent “range of reasonableness” is acceptable.
• Survey data should be “aged” to the midpoint of the company’s current fiscal year

MCT’s Methodology
Although the FAR does not lay out any specific method to analyze compensation cost, the MCT has developed a standard methodology.

1. The MCT selects one or more (usually 2-4) 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 interpret them.

2. The 50th percentile compensation amount for each of up to the five highest paid executives is determined.

a. MCT often must make a judgment as to the appropriate job title.

b. Many surveys do not have comparable 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 the MCT.

4. The various components of an executive’s compensation are summed and compared to the MCT-determined amount. Any excess is disallowed.

As illustrated above, 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, the MCT treats the methodology as a given, and will rarely agree to any variation.

Compensation Surveys
The 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 your company (and, if applicable, the five highest-paid executives in business segments that report directly to the home office.)

Since the MCT picks and chooses the surveys that support their determination of reasonable compensation, it is not an uncommon occurrence for the MCT to disallow a significant amount of compensation. When a contractor disagrees with their finding, the 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 DCAA uses. Most small and midsize companies can’t afford to do that. Many are forced to accept DCAA’s findings even though it costs them thousands or even hundreds of thousands of dollars.*

Now that you have a better understanding of the way the MCT makes a determination of reasonable compensation, and the difficulty in challenging this determination, you are no doubt thinking how to best determine in advance what “reasonable compensation” will be so that you can either adjust compensation or treat the excess as unallowable. Wouldn’t it be nice if the MCT issued some “safe harbor” guidelines?

Unfortunately, the MCT does not issue any such guidelines. However, in the November 2007 briefing, it did suggest what revenue level in 2006 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.” Based on the 2006 data mentioned in the MCT presentation, we have indexed the 2006 revenues to bring to 2007 amounts, using the increase in the Compensation Cap as the index. In order for your company to be able to pay the cap amount of $612,196 in 2007, your 2007 revenues would need to be as follows:

If your 2007 revenues are less than these amounts, you can be reasonably sure that any compensation amount near the compensation cap will be challenged and a significant amount disallowed. But when attempting to determine what percentage of the compensation cap you should set as your executive compensation, these guidelines do not help you very much.

For small and midsize companies, the only way to determine and defend your executive compensation as reasonable is to obtain several “acceptable” (as defined by DCAA) compensation surveys covering companies like yours, and determine if your company’s performance as compared to the “average performance” justifies a higher (or lower) compensation.

This is one situation where it might be worth engaging 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).

* 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. So the amount at stake can be very significant.

Dave is a Partner with CB&H and a member of the Firm’s Government Contractor Services Group.