Column: Bonus & Incentive Compensation - Maximizing Recovery

      Bonuses and other forms of incentive compensation continue to be heavily scrutinized by the Defense Contract Audit Agency (DCAA) and other government auditors. These costs tend to be a large component of a company’s indirect costs, thus an allowability challenge of such expenses can have a material impact on its cost recovery. However, with some proper planning, contractors can reduce the risks associated with such audit challenges and ensure maximum recovery of these costs.

Regulatory Framework

      Bonuses and incentive compensation are governed by cost principles under FAR 31.205-6 – Compensation for Personal Services. The clause states that compensation for personal services is allowable as long as:

• It is for work performed by the employee in the current year;
• Total compensation for the employee must be reasonable;
• Compensation must be based upon the terms and conditions of the contractor’s established plan or followed so consistently as to imply a plan;
• Major plan revisions have been presented to the cognizant Administrative Contracting Officer for review.

      In addition, FAR 31.205-6(f) states that bonuses and incentive compensation are allowable providing that:

• Awards are paid or accrued under an agreement entered into before the services are rendered, and
• Basis for the award is supported.

      In addition, stock-based compensation awards are governed by additional regulations beyond the scope of this article.

Types of Incentive Plans

      Contractors have adopted a variety of bonus and incentive compensation plans to reward employees and attract new talent including:

• Cash bonuses;
• Stock bonuses and stock options;
• Stock appreciation rights;
• Phantom stock;
• Combinations of these.

      Before initiating any type of stock-based incentive plan, the company should consult legal and compliance assistance to design a plan meeting the regulatory guidelines necessary to maximize allowability. Regardless of the form of plan, it is important to note that recovery of these costs will depend on the reasonableness of the contractor’s total compensation package.

Structuring Bonus Plans

      In order to reduce audit risk and maximize recovery of bonus and other incentive compensation, contractors should:

• Develop a written bonus plan.

      An incentive bonus plan should be documented in writing describing it as a means to reward management and employees for making specific contributions to the success of the organization, and to recruit talent. The most common reason for DCAA to disallow bonus expenses is to say they were not pursuant to a written plan. A written plan will meet the DCAA criteria of documented policies and procedures.

• Provide flexibility in award basis.

      Having a rigid basis for award of bonuses, such as a specific formula, does not provide for deviating from this formula. Any deviation would be challenged by DCAA as not being in conformity with the plan.

      A well-crafted bonus plan should state several factors considered in the determination of the overall bonus pool and allocation to individual employees. Factors such as revenue growth, new business awards, contractual profitability, overall company profitability, indirect rate management and customer satisfaction, among others, are common factors that most contractors utilize. By structuring the plan with various factors, the contractor now has the flexibility to determine the amount of the bonus pool and awards to individuals. It should be noted that bonus amounts to executives who are also owners of the company will receive additional scrutiny to determine whether the bonus is actually a distribution of profits, an unallowable cost item.

• Do not give the appearance of “managing” indirect rates.

      Many contractors will utilize year-end bonuses as a mechanism to manage their indirect rate differential (difference between provisional billing and actual indirect rates). Having a large year-end accrual for bonuses that magically brings the actual indirect rate equal or close to the provisional rate is an indicator to DCAA that bonuses are being used to manage the indirect rates. Thus, DCAA would challenge such bonus accrual. A strategy to alleviate this issue is to record a monthly accrual for bonuses, then having a minor “true-up” of the final bonus amount as a year-end adjustment.

• Ensure that the written plan states the evaluation period and payment of bonuses.

      The evaluation period should be consistent with the period that the company would like the expense included in the rates (i.e. evaluation period of Jan. 1- Dec. 31, 2018 for the 2018 indirect rates). In addition, failure to pay bonuses in a timely fashion runs the risk of the bonuses being classified as deferred compensation and not being recorded as a cost until the actual payment is made.

Conclusion

      With the increased scrutiny of bonus and incentive compensation by DCAA, contractors should design their plans to comply with the applicable regulations and to ensure maximum recovery of these costs. Failure to do so can result in significant cost disallowances.

Michael Smigocki, CPA, CVA is the Senior Managing Director of Federal Strategies Group, LLC. He provides government contract and management consulting, M&A advisory, litigation support and expert testimony to the government contracting industry. He can be reached at MikeS@FedStrat.com.

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Column: Bonus & Incentive Compensation - Maximizing Recovery

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