(Editor’s Note. We have found that bonus expenses are one of the most common cost elements being scrutinized by auditors these days and some of the most common areas of questioned costs. Bonus expenses offer auditors two bites of the apple –
if they don’t find such expenses to question as unallowable bonus costs they can still question some or all costs when added to other compensation costs that exceed survey amounts their Mid-Atlantic compensation team determine or GSA compensation caps because bonuses are one of the four cost elements of compensation. Given the interest expressed by our clients and subscribers we thought bonuses would be a good area to explore here. Our sources for this article include (1) one of our favorite texts – Accounting for Government Contracts, Federal Acquisition Regulation (2) an article by Karen Manos in the Dec. 2007 issue of Briefing Papers (3) the Defense Contract Audit Manual (DCAM) and (4) our own experience helping clients either challenge questioned bonus costs or helping them develop bonus policies that would be acceptable by auditors.)
There are several common types of bonuses and incentive compensation that are usually allowable: incentive compensation for management employees, cash bonuses, suggestion awards, safety awards and incentive compensation based on production, cost reduction or efficient performance. In addition, deferred incentive compensation and bonuses are also allowable if they meet certain conditions discussed below. In order to be allowable, bonuses must be (1) granted under an agreement entered into in good faith between employer and the employee before services are rendered or (1) granted pursuant to an established plan or policy followed consistently to the point of implying an agreement. (Editor’s Note. For some inexplicable reason, we are seeing auditors recently interpret the “agreement” provision as equivalent to a “written agreement” where there is no such provision in the FAR but nonetheless they are questioning otherwise acceptable bonus costs on that basis. DCAA management is simply accepting this revised interpretation of the requirement and one of our clients is litigating the issue.)
The government has a long history of sometimes challenging bonus plans that were not strictly based on production, cost reduction or efficient performance. In recognition that this was too narrow a criteria, FAR 31.205-6(f) was changed to distinguish management employees from the rank and file employees. In Bell Helicopter Company (ASBCA No. 9625) the board ruled that incentive compensation for management employees need not be limited to actions based on production, cost reduction or efficient performance because management may not affect such operations performance but rather by successful operations as a whole where such success is commonly measured by the profit of the company. In recognition of this distinction, FAR 31.205-6(f) was changed in 2003 to delete the reference to production, cost reduction or efficient performance where accompanying comments to the new rule stated though those three elements may be “good standards for allowability” they should not be the only criteria for allowing incentive compensation.
Some cases have addressed the allowability of specific employee plans. In one case, a plan based on longevity and other factors was questioned where the government did not believe longevity was an appropriate factor. In Lulejian and Associates (ASBCA No. 20094) the board upheld the government’s challenge on profit sharing and life insurance costs on the grounds the costs for these two elements where more than twice the amounts paid as salaries. In Cesesco Industries (ASBCA No. 20569) the government challenged an incentive plan because a large government contract contained a provision for incentive fees where such payment was considered to be a distribution of profit but the appeals board disagreed holding the contractor was not obligated to pass the profits onto employees by means of an incentive plan and therefore the merits of the incentive plan should be judged on its own.
Bonuses for closely held corporations are quite closely reviewed to ensure that those payments are not disguised dividends which are unallowed. In Digital Solutions Systems (NASA BCA 975) the Board agreed that bonuses based on profits exceeding the contractor’s total profit for the year were unallowable. In Martin Marietta Corporation (ASBCA 12143) bonuses paid to induce employees to continue employment through the end of the contract were accepted by the Board because the contractor could establish that low turnover was critical and the training costs for new employees were high.
Deferred Bonuses
Deferred compensation is considered payment for services rendered in previous accounting periods. It does not include year-end accruals that are paid within a reasonable time after the end of an accounting period. (Editor’s Note. Most auditors will consider the “reasonable time” period to be by the due date for federal taxes. We have been successful in extending this “reasonable time” period for tax payment extensions to September or October, even further when a later period can be shown to be reasonable.) Deferred bonus is considered to be unallowable if it is awarded in an accounting period subsequent to the period related to the services rendered – in other words, bonuses cannot be awarded retroactively. Of course, deferred bonuses are allowable when entitlement is based on current or future services. Even if not CAS covered, the measurement, allocation and accounting rules are covered by CAS 415, Accounting for the Cost of Deferred Compensation. Basically, CAS 415 requires (1) the assignment of costs to the period when obligations are incurred and (2) the use of the present value of future payments as a means of determining the liability in the period incurred.
If the otherwise allowable bonus does not meet the conditions to be deferred – recognized in a prior period than it is paid, then the cost will be considered to be incurred during the period it is paid. Decisions on deferring bonuses provide a very flexible tool for determining the timing of when the bonus is considered to be incurred. For example, if higher levels of government contracts are expected this year rather than in subsequent periods, it may behoove you to establish a deferred bonus program this year to be paid out in subsequent periods; or conversely, if higher levels of contracts are expected in subsequent periods, then you need to ensure future payments of bonuses are not deferred plans e.g. a bona fide liability this year is not established. Or, if bonus payments cannot be afforded in the current year, then it may benefit you to establish the deferred bonus program this year to allow for entitlement this year of future payments. Be sure to establish the conditions set forth in CAS 415 e.g. a bona fide obligation, etc.
Elements of Essential Written Policies
The most effective way of establishing the allowability of bonus costs and to challenge attempts to question the costs is to have a written policy in place before payments or deferrals are established. Though a written policy can be prepared to meet a variety of needs, we find policies that are usually accepted by auditors need to have at least the following features:
Identification of all bonuses for owners, officers, management and rank and file employees.
Except for spot or morale boosting bonuses, establish the basis for the bonus pool. For example, 5-10% of net profits, 1% of sales, etc. I find a range rather than specific numbers to be the best.
Establish what categories of employees will participate in each bonus pool and criteria of distribution to demonstrate a bona fide policy exists but broad enough to provide flexibility.
Establish that each bonus pool is dependent on the discretion of management to again provide flexibility.
Identify who is to approve of the bonuses.
DCAA Guidelines
In researching this article, we were quite surprised to see how little guidance there is in either the DCAA Contract Audit Manual (DCAM) or in DCAA’s audit programs considering how extensive this area is audited. The absence of audit guidance in this heavily scrutinized area is we suspect at least a partial explanation for the wide variety of positions we see auditors take, some of which are quite “creative.”
In the Chapter 5.803-1 section of the DCAM addressing audits of executive compensation, bonuses are considered to be one of the elements of such compensation and the audit guidance states there should be a “determination that the policies and procedures provide a description of how executive compensation levels are established, who approves these levels, and eligibility criteria and bases” for how they are established. The section also addresses long term incentive plans where award periods are for two or more years with the goal of retaining key executives. So a reading of this very brief DCAA guidance indicates there should be written policies and procedures with a description of how the bonus levels are established, who must approve these levels and the criteria for eligibility.
The DCAM also addresses bonuses that result from a business combination. Section 6-614.7 states that bonuses or other forms of payments that are in excess of the employee’s normal salary level or unallowable in accordance with DFARS 231-205-6(f)(1). However, this limitation does not apply to severance or early retirement incentive payments where such costs, if reasonable, are allowable in accordance with FAR 205-6(g).
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