Historically, executive compensation has been a rich source for cost challenges and disallowances by the Defense Contract Audit Agency. The current thinking of the Obama administration and many in Congress is that executives of contractors are overpaid. Indeed, the compensation cap set annually by the Office of Management and Budget is currently $763,029 and has tripled since the mid-1990’s. Small businesses can run afoul of what the government deems to be reasonable, given the size and scope of the contractor. The burden of proof on compensation disallowances is on the contractor, and litigations have been infrequent, primarily because of the costs involved. Many contractors feel that challenging the government is a waste of time. However, due to two recent court cases in 2012, there is a greater chance that contractors can prevail in a dispute with the DCAA over executive compensation.

A Little Case History

The DCAA has been relying on two Board of Contract Appeals cases to assess the reasonableness of executive compensation. The TechPlan (ASBCA No. 45387, 96-2 BCA) case established the audit process that DCAA would follow:

• 1. Determine positions to evaluate.
• 2. Identify compensation surveys to utilize (generally three to six surveys; the surveys may not be favorable to the contractor.)
• 3. Arrange data into percentiles, with the 50th percentile being the default.
• 4. Determine what numbers to use. Throw out outliers.
• 5. Apply a 10% Range of Reasonableness.
• 6. Adjust actual total compensation for less than normal fringe benefits.
• 7. Compare adjusted total compensation to the Range of Reasonableness. Anything exceeding the range is excess.

TechPlan also introduced the utilization of various financial performance metrics (revenue growth, net income, market share, etc.) to justify above-average salaries.

The ISN case (ASBCA No. 47849, BCA 97-2) eliminated the argument of “multiple hats” (paying of additional compensation to executives who handle more than one function; for example, CEO and CFO). Compensation is evaluated based on the highest-rated position with no premium for multiple functions. ISN also established the DCAA’s usage of a 75th percentile cap and a 10% Range of Reasonableness for absolute compensation limits.

The TechPlan and ISN cases became the foundation of all future DCAA compensation evaluations. The procedures established by these cases sometimes have been referred to as “Generally Accepted Compensation Principles,” although these principles have not been formally recognized by any professional regulatory body. Nevertheless, they have become widely used by DCAA and a de facto addition to the FAR.

Current Developments

DCAA continued this methodolgy until 2012, when the J.F. Taylor, Inc. (ASBCA Nos. 56105, 56322) and Metron, Inc. (ASBCA Nos. 56624, 56751, 56752) cases were heard. These cases will change the landscape with respect to executive compensation challenges by DCAA.

Taylor challenged DCAA’s methodology across the board and pointed out no less than nine separate flaws in the methodology, including the blanket 10% Range of Reasonableness, which Taylor was able to prove was statistically unreliable and therefore unreasonable. Additionally, the plaintiffs successfully argued that DCAA used an oversimplified “cookie cutter” approach, failing to take into consideration characteristics specific to Taylor.

The Metron case was notable in that the company specializes in mathematical modeling and employs many high level mathematicians and statisticians. DCAA utilized many different compensation surveys in its analysis while Metron used only one. Metron was able to prove that its sole salary survey was most relevant to the company and that DCAA had used multiple surveys that were not appropriate to its business.

Strategies to Consider

Contractors should think ahead and plan for potential compensation challenges by:

• 1. Developing written policies for bonus, deferred compensation, 401K, and stock plans.
• 2. Performing independent survey analysis of compensation.
• 3. Benchmarking key metrics that most pertain to your business and tie in to executive performance, including metrics such as customer satisfaction or company reputation.

Bear in mind that the burden of proof once the government challenges executive compensation is on the contractor. DCAA will try to take advantage of uninformed contractors. You can fight back by:

• 1. Challenging the validity of specific surveys used (i.e, Metron).
• 2. Challenging the utilization of the 50th percentile by DCAA (its default position).
• 3. Pointing out other discriminators not often considered by DCAA, such as the number of security clearances held, high proposal win rates and company reputation, all of which would argue for a higher compensation level as being reasonable.

Contractors don’t have to just roll over and surrender to the dictates of DCAA. If you believe that executive compensation is reasonable for your firm, you can fight back and have a chance of winning. Seek the advice of consultants in the industry who can aid you in recovering the maximum amount of compensation when challenged by DCAA.

Jeffrey S. Burr, CPA/CFF, CFE, MBA is a Director with Federal Strategies Group, LLC, a government contracting, management consulting, M&A advisory, and forensic accounting firm to the government contracting and high technology industries. He can be reached via email at JeffB@FedStrat.com.