Accounting for Employee Stock Options
Most of us don’t get offered stock options. But some companies do offer them, even if offered primarily to executives. The question is how to account for the costs.
A stock option is an option buy company stock at a certain price. You don’t have to buy the stock today (in fact some plans require you to wait a certain number of years before exercising the option). If the stock price increases between the time you were awarded the option and the time you exercise the option, then you make money. The idea is that if you stand to make money, you’ll put the best interests of the company foremost in your decision-making. The better the company does—at least in the eyes of the market—then the better you will do.
How does a company measure the cost of such options? If the option price is equal to today’s market price, then there is no cost to the company. It is providing shares at market price and there is nothing to account for. It can take shares from its treasury shares and put them away, and that’s the end of the story.
But that’s not the end of the story. A commonsense approach to this topic ignores all the complexities.
First, just because an employee has an option doesn’t mean that employee will exercise that option. The stock price could fall; and who would want to pay $10.00 per share for something that’s worth $5.00 per share. Further, the employee could leave the company and forfeit the right to acquire stock. For those reasons, if no others, a company will not set aside stock today to cover options that might be exercise tomorrow.
What remains is deferred compensation. Employees may exercise options at some point in the future, and the price of the stock may be different from what it is today, and so the company may have to “acquire” stock from treasury (or from the open market) at a price higher than the employee will pay for that stock. The company won’t know the quantity of shares it will issue, or the price it will pay, until the employees actually exercise their options.
Generally Accepted Accounting Principles (GAAP) requires a company to expense some amount today, as an estimate of what it expects to pay later.
The FAR does not permit government contractors to comply with GAAP requirements.
But before we get into that issue, let’s acknowledge that there are several legal cases that discuss the allowability of Employee Stock Ownership Plans (ESOPs) and Stock Employee Compensation Trusts (SECTs). If you are dealing with those issues, then you will want to research those cases (e.g., Ball Corp., ASBCA No 49118, and Newport News Shipbuilding, 57 Fed.Cl. 734, 2003). What we are discussing today is neither of those things: we are talking about employee stock options and how to value them for purposes of determining allowable costs.
Luna Innovations, Inc. was one company faced with that challenge. In June, 2006, Luna issued an Initial Public Offering (IPO) of its stock. It offered stock options to selected employees and corporate officers. Generally, the stock options had a 10-year term with a strike price set equal to the market price on the day the options were awarded.
Because Luna was a publicly traded company, it had to comply with FAS 123r. “The purpose of FAS 123r is to recognize, in the current period financial statements, the contingent financial liability represented by the employee stock option. … Thus, FAS 123r requires companies to recognize, at the time of award, the expected future liability, including possible appreciation, in the security price.” In order to comply with FAS 123r, companies typically use the Black-Scholes Model to establish a value for the future stock price as well as to determine what that future stock price is worth today.. “In essence the model treats the stock option as a forward contract to deliver the stock at the end of the option period.”
The problem with the Black-Scholes Model, from the point of view of a government contractor, is that one of its inputs is the volatility of the stock price, as measured from prior year price changes. Why is that a problem? It’s a problem because the cost principle at FAR 31.205-6(i) states that “Any compensation which is calculated, or valued, based on changes in the price of corporate securities is unallowable.” Because one of the Black-Scholes Model inputs was stock price volatility, Luna was going to have a problem with DCAA if it used the Model to measure the current period expense associated with its employee stock options.
Luna used the Black-Scholes Model to measure its current period stock option expense, and claimed $2,291,790 in allowable compensation in its FY 2007 proposal to establish final billing rates. DCAA questioned those costs and the administrative contracting officer (ACO) agreed. Further, the ACO slapped Luna with a demand for an additional $834,441 because the claimed compensation costs were “expressly unallowable”—plus the government demanded an additional $211,647 in interest. As part of the process, the ACO unilaterally established Luna’s FY 2007 final billing rates without the disputed stock option expense included therein and, as a result, determined that Luna had previously overbilled the government in the amount of $95,333 (based on the difference between provisional billing rates and final billing rates). In total, the government demanded that Luna pay $1,141,421, calculated as $834,441 plus $211,647 plus $95,333. Luna appealed the ACO’s COFD to the ASBCA.
(As you can see from the above, the amount associated with the unallowable compensation was rather insignificant. It was the penalty and interest that was the killer.)
Long story short, Judge D’Alessandris, writing for the Board, found that Luna’s claimed stock option expense was indeed unallowable. (“Luna's employee stock option costs are unallowable under the plain language of the FAR….”) However, the Board found that the costs were not expressly unallowable. Judge D’Alessandris wrote—
Given the complexity of the circumstances, the fact that the use of the Black-Scholes model is a question of first impression, the need to review the differential equations comprising the Black-Scholes model, and the fact that there could be a reasonable difference of opinion regarding the costs, we hold that it was not ‘unreasonable under all the circumstances’ for Luna to claim the employee stock option costs, and hold that the employee stock option costs are not expressly unallowable.
Therefore, it was rather a hollow victory for the government. The government will recover less than ten cents on the dollar.
To us, the more important question is “why are GAAP accounting requirements unacceptable for use in government contract cost accounting?” It’s not as if Luna had much of a choice. As a publicly traded company, it was required to comply with FAS 123r. Why does the government reject required accounting treatment in favor of a unique approach to contract costing?
It’s not enough to say that “public policy” requires a unique treatment. Nor is it sufficient to say that compensation based on stock price changes “does not represent work actually performed.” Those points should be irrelevant to the question of cost allowability, or at least should be superseded by the need to comply with GAAP.
The reason this question matters is because the Department of Defense has been attempting to woo non-traditional defense contractors. It has been actively working to attract Silicon Valley and other technology companies in an attempt to leverage the R&D budgets of those companies. It has been looking for start-ups and for innovators and for small businesses that are agile and flexible. It has created the Defense Innovation Board to help it change to better attract such companies.
And yet the Department of Defense and other government agencies create high barriers to market entry through onerous regulations that require deep expertise and which contain stiff penalties for non-compliance. This issue in particular is quite important to technology start-ups that base a large amount of compensation on employee stock options. If you make that aspect of their compensation plans unallowable, you significantly limit their ability to recover their costs. That limitation becomes a "toll" for doing business with the Federal government. Why should non-traditional defense contractors pay a “toll” for entering the defense marketplace, where the “toll” is measured not only in lost compensation recovery, but also in additional overhead costs associated with adjusting GAAP-compliant books to meet arcane government accounting regulations--and where the "toll" is also likely to include provision for contingent liabilities associated with the probability that those companies will not be able to comply with the rules and will end up before a Board of Contract Appeals.
It makes no sense.
It makes no sense to make companies adjust their GAAP-compliant books to meet arcane regulatory requirements, and then to penalize them for failing to do so satisfactorily.
It makes no sense if you want to attract non-traditional companies into the defense marketplace.
Meanwhile, “The Center for Strategic and International Studies study said the number of first-tier prime vendors declined by roughly 17,000 companies, or roughly 20 percent, between 2011 and 2015.” See this article at DefenseNews.com, citing the upcoming release of a formal study by CSIS.
So while the Federal government is busy penalizing contractors for following GAAP and for failing to follow the FAR, the defense industrial base is shrinking and companies are finding sales channels elsewhere.
Section 809 Panel – are you getting this picture?
The 2018 National Defense Authorization Act—IP Stuff
Continuing the series of articles exploring the 2018 NDAA, courtesy of Bob Antonio’s annual analysis of the final language. As noted in the prior article, we are not going to talk about every single little thing. We’re going to talk about stuff that interests us. You may want to do your own research, using the link above. Today’s article is going to focus on stuff related to Intellectual Property.
As you may know, 2016 and 2017 saw a number of attempts by the DoD to attack contractors’ ownership and control of their IP rights. Let’s see how the 2018 NDAA reacts to those attempts.
Section 803 requires the Secretary of Defense and the USD (A,T&L) to—
… develop policy on the acquisition or licensing of intellectual property--(1) to enable coordination and consistency …in strategies for acquiring or licensing intellectual property and communicating with industry; (2) to ensure that program managers are aware of the rights afforded the Federal Government and contractors in intellectual property and that program managers fully consider and use all available techniques and best practices for acquiring or licensing intellectual property early in the acquisition process; and (3) to encourage customized intellectual property strategies for each system based on, at a minimum, the unique characteristics of the system and its components, the product support strategy for the system, the organic industrial base strategy of the military department concerned, and the commercial market.
What all that seems to mean is that we should expect to see DFARS rule-making focusing on IP decisions “early in the acquisition process,” and acknowledging that one size does not fit all in these matters.
Section 803 further requires SECDEF to “establish a cadre of personnel who are experts in intellectual property matters [so as to] ensure a consistent, strategic, and highly knowledgeable approach to acquiring or licensing intellectual property by providing expert advice, assistance, and resources to the acquisition workforce on intellectual property matters …”
There is very explicit direction in Section 803 telling SECDEF and USD (A,T&L) how to go about creating this cadre of IP experts, and what they should be doing, and how they should be doing it.
Almost as if Congress doesn’t trust DoD in this area.
Section 835 requires the DOD “to work with contractors to determine prices for technical data the Department plans to acquire or license before selecting a contractor for the engineering and manufacturing development phase or the production phase of a major weapon system. Additionally, this provision would encourage program managers to negotiate with industry to obtain the custom set of technical data necessary to support each major defense acquisition program rather than, as a default approach, seeking greater rights to more extensive, detailed technical data than is necessary.”
In our view, Section 835 seems to complement Section 803 nicely.
Section 871 focuses on technical data in acquisition of software. Section 872 directs SECDEF to have the Defense Innovation Board initiate a study on “streamlining software development and acquisition regulations.” The DIB report is due one year after SECDEF provides direction to the DIB.
Congress is (apparently) so concerned about software development that Sections 873, 874, and 875 each provide for “pilot programs” to streamline the process and (by direction) lower program costs. What’s up with all this concern? According to the Conference Report—
The conferees note that the Department of Defense’s warfighting, business, and enterprise capabilities are increasingly reliant on or driven by software and information technology. The conferees note with concern that the Department is behind other federal agencies and industry in implementing best practices for acquisition of software and information technologies, to include agile and incremental development methods. The conferees note that existing law and acquisition regulation provide significant flexibility to the Department and that the Department has explicitly provided for tailoring in its acquisition directives and instructions. The conferees note with concern that the organizational culture and tradition of acquiring capabilities using a hardware-dominant approach impedes effective tailoring of acquisition approaches to incorporate agile and incremental development methods.
As always, we strongly suggest you do your own research. The three separate articles we’ve authored this year are what caught our eyes; perhaps you will find something we missed. If so, feel free to bring it to our attention.
|
DCAA Continues Productivity Trends
How do we choose what to write about? How can we find topics that seem interesting (at least to us) in this small world of government contracting, cost accounting, and compliance?
Well, some topics choose us.
For example, every six months the Department of Defense Office of Inspector General (DoDOIG) publishes its Semi-Annual Report to Congress (SAR). And every six months we review Appendix E (Contract Audit Reports Issued) and Appendix F (Status of Action on Post-Award Contracts) to see what insight can be gleaned regarding DCAA performance. If we see something interesting (at least to us), then we write about it. Thus, every six months we get an article essentially “pushed” to us from the DoDOIG.
And every two SAR reports gives us a full government fiscal year’s (GFY) worth of data.
What does the latest DoDOIG SAR, covering the six-month period April 1, 2017 through September 30, 2017 (and completing GFY 2017) have to tell us?
It tells us that DCAA is continuing to experience declines in productivity.
Clearly, this trend is not news to our readership. Clearly, this trend is not news to anybody who supports DCAA audits in any significant volume. Further, this trend is not news to Congress, which has, for the past two or three years, been “helping” DCAA reduce its embarrassing backlog of unperformed audits of contractor annual proposals to establish final billing rates (also known as “incurred cost” audits).
The news is that there is no news. DCAA has not turned around its productivity. Auditors continue to do less, year after year.
Let us be more specific.
Of course, the issuance of audit reports doesn’t tell the whole story, because DCAA doesn’t issue audit reports for every assignment it completes. In fact, in GFY 2017, 69 percent of all DCAA audit assignments were completed without issuance of a formal report. (It was 68% in GFY 2016.) Roughly two-thirds of DCAA's audit assignment workload is being completed without issuance of a formal audit report—which means that only one-third (at most) of all DCAA activity is subject to GAGAS (or GAS as they are calling it this year). Remember that statistic, because it will come up later.
If the issuance of audit reports doesn’t tell a fair story, would you accept total number of assignments completed? Because that trend isn’t so hot either.
-
In GFY 2017, DCAA completed 11,068 assignments. We don’t have a report showing number of auditors yet, but if we assume flat staffing then 4,023 auditors completed 11,068 assignments—for a ratio of 2.75 reports per auditor per year. (We’re not claiming that’s an accurate number, but we believe it is definitely in the ballpark. Call it a ROM.)
-
In GFY 2016, DCAA completed 13,520 assignments. That means that the number of completed assignments in GFY 2017 was 2,452 less than was completed in GFY 2016. There was a YOY drop of 18 percent.
-
In GFY 2015, DCAA completed 15,715 assignments. In GFY 2014, DCAA completed 15,837 assignments. You get the picture. (Though in fairness, GFY 2014 was an improvement from GFYs 2011 and 2012. But in GFY 2010, DCAA completed 17,159 assignments. You really don’t want to compare GFY 2017 to GFY 2010, because that drop looks really really bad. Hint: in GFY 2010 DCAA completed 3.8 assignments per staff workyear.)
What about dollars examined? Can that trend tell us anything about DCAA?
Let’s look:
In GFY 2017, DCAA examined $281.05 billion dollars of contractor costs through various audits. That’s quite a lot, no doubt about it. But in GFY 2016, DCAA examined $286.8 billion dollars. It you put the all the stats reported so far together, you see that DCAA audited roughly the same amount of dollars YOY, and completed roughly the same amount of assignments but issued 19 percent fewer audit reports.
In fairness, DCAA examined a bit less in GFYs 2014 and 2015, so we need to give that to the audit agency. Further, it should be fairly clear that DCAA cannot control the dollar value of what it audits. Fluctuations are to be expected.
Maybe looking at dollars examined doesn’t tell a complete story.
Would you accept a trend about dollars questioned? What about dollars questioned as a percentage of total dollars examined? What might that tell us?
(Before we go there, we have to tell you that we are including DCAA’s findings in its pre-award proposal audits, which it calls recommendations for “funds put to better use.” They are not officially questioned costs but we are including those values in our analyses—because if we didn’t do so, then we would have to exclude all the numbers related to “forward pricing proposal” audits from all the statistics we’ve reported so far.)
-
In GFY 2017, DCAA questioned $7.15 million, or 2.55 percent of total dollars examined. In GFY 2016, DCAA questioned $9.98 million, or 3.5% of total dollars examined. DCAA questioned roughly one percent fewer dollars, YOY, for every dollar auditors examined.
Do we need to go on?
If you look only at the category called “incurred costs, operations audits, special audits,” the trend is even more stark. In GFY 2017, DCAA questioned almost exactly one percent of dollars examined in those audits. In GFY 2016, DCAA questioned 1.82 percent of total dollars examined. In GFY 2015, DCAA questioned 2.45 percent of total dollars examined. In GFY 2014, DCAA questioned 2.81 percent of total dollars examined in those audits. In GFY 2013, DCAA questioned 6.35 percent of total dollars examined.
Do we need to go on?
What about sustention rates, we hear you asking.
Well, there’s a bright spot for DCAA. In the second half of GFY 2017, contracting officers sustained 30.7% of dollars questioned by DCAA, an increase from the first half value of 25.5%. By our rough math (which includes forward priced proposal findings), the GFY 2017 value was about 29 percent. Which is okay, perhaps, until one realizes that more than 70 percent of all DCAA questioned costs are not being sustained.
Or until one realizes that, historically, sustention rates have been much higher.
For example, the GFY 2016 sustention rate was about 34.4%. The GFY 2015 sustention rate was about 48 percent. The GFY 2013 sustention rate was about 71.5%.
In other words, even though DCAA questioned costs rates are falling, CO sustention of those questioned costs is falling as well. If you compare GFY 2017 to GFY 2013, that represents a complete reversal of sustention rates. Instead of sustaining more than 70 percent of questioned costs, COs are now non-sustaining more than 70 percent of questioned costs.
Where is that coming from?
Well, perhaps one driver is the lack of DCAA audit quality.
Even though roughly two-thirds of all DCAA audit activity is completed without issuance of a formal audit report—which would subject the audit to a review for compliance with GAGAS/GAS—the roughly one-third of audit reports that are issued are full of deficiencies.
What do we mean? We wrote about it here.
In that article, we explored the latest external peer review performed on DCAA’s quality control system. That review—which was (perhaps not coincidentally) performed by the DoDOIG—found that nearly 40 percent of all DCAA audit reports had one or more quality deficiencies. In other words, although DCAA is subjecting only one-third of its activity to scrutiny, nearly 40 percent of that one-third failed the external quality audit. (Yet, as we wrote, DCAA passed its external peer review, baffling people who deal with audits for a living.)
Thus, if 40 percent of DCAA’s best audit reports are no good, then perhaps that explains why contracting officer sustention rates keep falling, year-over-year.
In summary, the latest DoDOIG SAR confirms the trends that we’ve been reporting on for years. Auditor productivity down. Audit quality down. Sustention rates down.
Not a pretty picture.
But that picture didn’t stop the U.S. Department of State from recently amending its Acquisition Regulation (DOSAR) to make DCAA the official auditor of choice for audits of contractor annual proposals to establish final billing rates. As the notice of rule-making stated, “The Department has an interagency agreement with the Defense Contract Audit Agency (DCAA) to perform incurred cost audits on cost-reimbursement contracts.” DOSAR Part 604 was revised “to specify the office through which audits are coordinated, from the Office of the Inspector General to the Audit Team in the Office of Acquisitions Management's Quality Assurance Branch.”
Thus, regardless of our view of DCAA’s trend lines, the Department of State is happy to continue to use DCAA as its “go-to” audit agency.
Two Flavors of Procurement Fraud
Stories of fraud aren’t that interesting unless they contain little nuggets of “lessons learned.” If our readers can’t learn something from such stories, we tend to not discuss them. Today we present two stories that might provide fodder for more managerial oversight or perhaps for process improvements. Unfortunately both stories involve CEOs. What do you do about a corrupt CEO?
The first story is simple. If you submit an invoice to the U.S. Government, and that invoice includes subcontractor costs, and you never paid the subcontractor, then you may be accused of committing fraud.
Which is a lesson learned by M. Cleve Collins who, on November 30, 2017, entered a guilty plea admitting to one count of “major fraud” after two days of a court trial. Collins was indicted a year ago for executing “a scheme to defraud the United States on a construction contract valued at approximately one and one-half million dollars … for the replacement of the roof and the air conditioning system at the Ed Jones Federal Courthouse and Post Office in Jackson, TN. As part of the scheme to defraud, Collins caused the roofing subcontractor, a small Memphis-area business, to perform work for which he was never fully paid. Additionally, Collins filed false and fraudulent certifications with the U.S. Government indicating he had, in fact, paid the subcontractor. The value of the funds obtained because of this scheme was over $580,000.”
From the DOJ press release: “‘Federal contractors are obligated to follow through on their promises to make payments to their subcontractors,’ said GSA Inspector General Carol Fortine Ochoa. ‘When contractors fail to meet their obligations, we will hold them accountable.’"
FAR 32.009-1 provides that the government “shall ensure” that prime contractors pay subcontractors on an accelerated schedule to the maximum extent practicable, when the primes receive accelerated payments. There is a contract clause (52.232-40) that implements this policy. Clearly, the government is concerned that small businesses get paid. Prime contractors may also want to review the FAR at 32.112, especially 32.112-1 (“Subcontractor Assertions of Nonpayment”).
Early payment is better; on-time payment is tolerated. But if a prime contractor isn’t paying its small businesses on time or—worse yet—not paying them at all, there may well be trouble ahead.
In the case of Cleve Collins, he seems to be a smallish construction contractor who thought he could float his company’s cash flow on the back of his small-business subcontractor. That plan didn’t work out for him.
Our second story is a bit more complex.
Global Services Corporation (Global) was founded in 1997 and employs about 150 people, many of them veterans, to provide various services to the Department of Defense. A noble undertaking, perhaps; but one that was tainted by the actions of its owner, Philip Mearing. Mearing was Global’s President and sole owner since 2007. In June, 2017, Mearing pleaded guilty to overbilling the U.S. Government though a fairly complex scheme, according to this article at the Virginia-Pilot, written by Scott Daugherty. The article states that Global billed the government “for $13.6 million in work that was never performed” and also “conspired to double-bill the government for nearly $3 million in work that was already performed under another contract.”
Apparently the primary scheme started in 2004 (prior to Mearing taking over the company) and ran until 2014. Putting together the Virginia-Pilot story with the DOJ press release, our perception is that Mearing conspired with another Global “executive” (Kenneith Deines) to allow two fake companies, both owned by the same person, to bill Global for services that were never provided.
The two sham companies (Tempo Consulting and Bricker Property Management) were both owned by Ken Bricker. Global paid Bricker $13.6 million over the ten-year period for … nothing. Indeed, neither company had any employees. Hundreds of false invoices were submitted from the two companies and paid by Global. Bricker kept about five percent of the payments ($558K) and then transferred 95% of the payments “to Mearing or [another] company owned by Mearing.” That other company, DeShas, was an Ohio LLC that Mearing controlled. Fortunately (or unfortunately, depending on your point of view), Bricker paid Mearing or DeShas via check, leaving a nice paper trail easy to follow, and easy to show a jury.
Mearing was sentenced on December 1, 2017, to five years in prison.
Getting back to the question at the top of this article … how do you detect and/or prevent a conspiracy to commit procurement fraud in which one of the conspirators is the company CEO? How do you deal with a problem where the President or even the Vice-President is a big part of it?
Those are tough questions. In both of these stories, there were no checks and balances. The company President was the sole owner and you did what he said or you found another job. In larger corporations, there would be a Board of Directors or a General Counsel to whom one might go with suspicions of misconduct at the highest levels.
Looking at controls, we have to ask who approved the fictitious invoices? Was it Mearing or was it Deines? (And we don’t know Deines’ role, other than that he was an “executive.”) Who normally approves subcontractor invoices, and who makes sure that services were delivered as being claimed? Are those the same people? What evidence is retained to show that services were delivered? FAR 31.205-33 requires that all consultants provide some evidence of work product. Certainly, that’s a pain and a problem during DCAA audits of claimed incurred costs; but maybe there’s a good reason for that requirement.
Did anybody perform a background check on DeShas LLC, which perhaps would have revealed that the LLC was controlled by Mearing?
These stories could happen in your company. What would you do if they did? Would you shut up and carry on as if nothing out of the ordinary were happening, or would you report the wrongdoing? Where does your personal boundary of integrity lie? It’s something that (thankfully) doesn’t come up too often; but when it does, you had better know where you stand.
In the meantime, we suggest you think about what you can learn from these two stories in the design and implementation of control activities within your procurement and accounts payable systems.
|
