Column: Bonus & Incentive Compensation - Maximizing Recovery
by Michael Smigocki, CPA, CVA
Senior Managing Director, Federal Strategies Group LLC
Bonuses and other forms of incentive compensation have come under increased scrutiny by the Defense Contract Audit Agency (DCAA) and other government auditors. An allowability challenge of such expense can have a material impact on the company’s recovery of indirect costs. However, with proper planning, contractors can reduce the risk of audit challenge and ensure maximum recovery of costs incurred. This article will discuss these planning strategies.
Regulatory Framework
Bonuses and incentive compensation are governed by the cost principles under FAR 31.205-6 – Compensation for Personal Service . This FAR 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 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 provided the awards are paid or accrued under an agreement entered into before the services are rendered, and the basis for the awards is supported.
Finally, 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, stock options, stock appreciation rights, phantom stock and combinations of these as well as others.
Before initiating any type of stock-based incentive plan, the company should consult legal and government contract accounting assistance to design a plan that meets the regulatory guidelines 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
The most common form of incentive compensation among contractors is cash bonuses. DCAA has been increasingly challenging the allowability of such payments on a number of fronts. In order to maximize recovery of these expenses, contractors should:
1. Develop a written bonus plan.
An incentive bonus plan should be written as a means to reward management and employees for making significant contributions to the success of the organization, as well as a recruiting mechanism to attract talent. By having a written plan, it will meet the DCAA criteria of documented policies and procedures. The most common tactic of DCAA to disallow bonus expenses is to say they are not pursuant to a written plan.
2. Provide flexibility in your basis for award.
Having a rigid basis for award, such as a specific bonus formula, does not provide the contractor with flexibility in deviating from this formula. Any deviation would be challenged by DCAA as not being in conformity with the company’s established 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 are factors commonly utilized by contractors. The contractors now have the flexibility to determine the amount of the bonus pool and awards to individuals. It should be noted that bonus amounts to executives who also are owners of the company will receive additional scrutiny to determine whether the bonus is actually a distribution of profits, an unallowable cost item.
3. 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 rates 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 claim it is not pursuant to plan. 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.
4. 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 – December 31, 2015 for the 2015 indirect rates). In addition, failure to pay bonuses in timely fashion runs the risk of them being classified as deferred compensation and not being recorded as a cost until the actual payment is made.
When adopting or modifying bonus and incentive compensation plans, it behooves the contractor to address the FAR regulations 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 can be reached at MikeS@FedStrat.com.
