Executive Compensation – Fighting Audit Challenges By Michael Smigocki One of the most consistently challenged areas of incurred cost audits for closely held corporations has been that of executive compensation. The primary reason for this is that closely held corporations are not subject to the same oversight and scrutiny of publicly traded companies. Executives of closely held corporations, for the most part, can set their compensation at any levels they wish. Their compensation may include amounts that could be distribution of profits – an unallowable expense. Because of this situation, and the high degree of successful challenges in the past, the Defense Contract Audit Agency has become increasingly aggressive in its challenges of executive compensation. They have even established an audit team whose sole purpose is to analyze executive compensation and to determine the amount that should be includable in the company’s rate structure. Their sophistication for these audit challenges has been improving significantly over the past few years, so it is imperative that contractors understand the approach utilized by DCAA as well as possible means of responding to audit challenges. DCAA Approach The following are the steps taken by DCAA when evaluating the reasonableness of executive compensation: 1. Determine the position to be evaluated. The contractor’s organizational structure should identify the executive’s positions. This would generally include persons with the title of vice president or above. 2. Identify survey(s) of compensation for the position to be evaluated that match the company being audited. DCAA subscribes to many different surveys for purposes of determining reasonableness of executive compensation. Company characteristics that are considered when analyzing survey data include: •Companies of the same size •In the same industry •In the same geographic region •Firms engaged in predominantly non-government work •Cost of comparable services obtainable from outside sources. 3. Update the surveys for each year through the use of escalation factors. This is performed if the survey information is dated. 4. Determine which numbers to use for comparison purposes. In most cases, DCAA will begin by utilizing the average or median data (50th percentile) for purposes of determining reasonableness. 5. Apply a range of reasonableness to the numbers selected. Typically, the range of reasonableness applied is 10%. Thus, DCAA will question compensation in excess of 110% of the median compensation amount. 6. Adjust the actual total compensation for lower than normal fringe benefits. If the company pays lower-than-normal fringe benefits, these amounts can be used as an offset to higher-than-normal compensation amounts. 7. Question the difference between compensation and the range of reasonableness determined in the above steps. At this point, it is now up to the contractor to prove why DCAA is wrong with these calculations, else these are the amounts that will be includable in the company’s rate structure. Responding to Audit Challenges As was previously mentioned, DCAA has become quite sophisticated with its challenges of executive compensation as well as the sustention rate of questioned costs in this area. There are, however, some specific strategies that a contractor can follow to maximize the recovery of costs relating to executive compensation. 1. Develop written policies, procedures and bonus plan. Your first line of defense for any compensation challenge is your written policies and procedures as well as having a written bonus plan in place. These should include: •Provide position descriptions emphasizing rank, function, responsibility areas, goals to be attained, impact of decisions, and number of employees directed, to name a few. •Communication of how executive compensation levels are determined (i.e. compensation committee, Board approval, etc.). •Documentation of the various levels of approval. •Eligibility criteria and basis for determination of how base salary, cash bonuses, long-term perquisites, benefits, services, and incentive pay bonuses are established. 2. Challenge the surveys that were utilized. DCAA subscribes to many different types of salary surveys. They will generally choose three surveys for purposes of their analysis. The contractor should ensure the surveys as well as the data are correct and comparable including: •Making sure the survey is for the industry you are working in. •The proper job titles were utilized. •The proper NAICS codes were used. •The proper size and geographic locations were utilized. 3. Challenge the percentile utilized. The survey information is on a typical bell curve. The DCAA will generally utilize the 50th percentile or the median compensation level for purposes of this analysis. You must be able to demonstrate why the performance of the individual executive, as well as that of the company, are superior to average performance and thus would warrant a higher percentile. Performance metrics could include: •Revenue growth and net income •Return on shareholder’s equity and assets •Return on sales •Earnings per share •Return on capital •Cost savings experienced •Market share attained. Conclusion Executive compensation continues to be a hotbed of controversy for government contractors. With a Democrat-controlled Congress wanting to restrict compensation of government contracting executives along with shareholder dissatisfaction of the amount of compensation taken by executives of publicly traded corporations, we can expect continued scrutiny of compensation in the future. When coupled with the increased scrutiny and aggressiveness of challenges by DCAA, it is important that contractors stay well versed in the continued developments in this area. (Michael Smigocki, CPA, CVA, ABV is the Senior Managing Director of Federal Strategies Group, LLC. He provides government contract and management consulting, M&A advisory, forensic accountingt and expert testimony to the government contracting and technology industries. He can be reached via email at MikeS@FedStrat.com.)