(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.
1. Can’t afford it. The financial condition of the company cannot affect the allowability of the cost. There are instances, for example, where companies in bankruptcy have successfully shown they are entitled to similar costs.
2. The deferred compensation is not tax deductible. The contractor’s accountant countered the auditor, stating that for tax purposes, the payment would be deductible when paid so that does not mean it is not unallowable. For contract costing purposes, deferred compensation is recognized when it is incurred while for tax purposes it is recognized when paid so the deferred compensation is allowable because it will presumably be deductible when paid.
3. No plan exists. The contractor countered this assertion indicating a plan did exist. It provided documents describing the deferred compensation plan and showed the auditor minutes of the Board of Directors meeting that approved the amount of deferred compensation.
4. Relevance of CAS 415. Yes and no. The auditor told us that FAR 31.201-2(b) generally states that certain cost principles do incorporate the measurement, assignment and allocability rules of selected cost accounting standards. FAR 31.205(k)(2) further states that CAS 415 will be one of the standards where FAR incorporates its rules where it states “costs of deferred awards shall be measured, allocated and accounted for in compliance with the provisions of 48 CFR 9904.415, Accounting for the Cost of Deferred Compensation.” However, as we pointed out, FAR 31.201-2(b) further states only those sections of the CAS that address “measurement, assignment and allocability” rules will apply, indicating that other sections of the relevant cost accounting standards need not apply. The FAR section states “Only those CAS or portions of standards specifically made applicable by the cost principles in this subpart are mandatory unless the contract is CAS-covered.” So, whether the CAS sections addressing the nature and conditions for bona fide obligations applies to the contractor is debatable – on the one hand, obligation considerations are not strictly part of the “measurement, assignment and allocability” rules of the standard that applies while on the other hand, it would seem that the discussion of obligation in CAS 415 is a reasonable basis for determining whether an actual expense is incurred and hence is allowable whether or not a contract is CAS covered.
5. Compliance with CAS 415. The standard contains numerous provisions and we will save a more detailed discussion for a later date. Rather, we will only briefly address the relevant sections.
(a) CAS 415-40(a) requires that the contractor “incurs an obligation to compensate the employee.” If such an obligation is not incurred before payment, then the amount of deferred compensation will be the amount that is paid and the period assigned for the cost will be the period it is paid.
The contractor’s provision of documentation of the deferred compensation plan and minutes of its board meeting should provide sufficient documentation that an obligation is intended. You would likely need to produce other evidence indicating the obligation is not intended.
(b) CAS 415-50(a)(1-6) lists six conditions for an obligation to be deemed to occur where the most relevant condition is section (1) that provides there is a requirement to make the future payment(s) which the contractor cannot unilaterally avoid.
Though it is probably true the owner could unilaterally avoid payment, similar assertions could be made against all closely held companies. If this possibility that the closely-held nature of the contractor allows it to unilaterally avoid payment were put forth as a basis to question the deferred compensation, then all such companies would not be entitled to deferred compensation, a result that would not stand up. There would probably need to be additional evidence that there is no intention to honor the obligation.
(c) CAS 415-40(b) provides that the amount of the deferred compensation will be the present value of the future benefits to be paid by the contractor.
You indicated the contractor said the deferred compensation will be paid “sometime in the future, perhaps when the company is sold.” This indicates that neither a future payment was established nor was it discounted to the present period. This would seem to violate the “measurement, assignment and allocability” provisions of CAS 415.
6. The deferred compensation should be considered direct labor. It is true that eliminating the $175,000 deferral from overhead and adding it to direct labor base would decrease the overhead rate the contractor can apply. However, such a move would substantially increase the direct labor rate applicable to the contract. As long as all direct costs are reimbursable where an upward adjustment is not prohibited, your agency would be vulnerable to paying the difference between what was billed (based on an $150,000 salary) and what should have been billed ($150,000 plus the $175,000).
7. Compensation was excessive. When executive compensation is evaluated for reasonableness, compensation includes salary, bonuses, defined-benefit contributions for pensions and deferred compensation. You indicated that the four elements mentioned appeared high but was lower than the senior executive salary set by the Office of Federal Procurement Policy. However, it is long established that this OFPP cap does not apply to all companies – it is based on a survey of large publicly traded companies whereas lower thresholds should apply to smaller companies. You indicate the owner receives approximately $150,000 in salary and bonus plus the $175,000 deferred compensation for a total compensation of $325,000. True, this is below the 2005 OFPP cap of $473,318 but lower thresholds commonly apply to smaller companies. You may want to compare the total compensation paid the contractor to compensation survey results of comparable companies and use that figure plus 10% as the threshold for reasonable compensation, questioning the difference.
8. The current year amount is an unreasonable increase. The fact that the current proposed amount varies significantly from prior year amounts does indicate it is an unreasonable increase. In order to prove the amount is reasonable, the burden should fall on the contractor to justify the increase.
In conclusion, if you are determined to disallow the deferred compensation, you would best assert that (1) it was not computed in accordance with FAR and CAS requirements (2) the total amount of compensation is unreasonable and (3) the huge increase in the current year is an unreasonable increase over prior years. This will likely result in allowing some but not all of the amount.
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