The granting of stock options has become one of the most common modes for compensating employees. As a government contractor, accounting for this type of consideration brings additional challenges, including the determination of allowability. Recently, the company Luna Innovations, Inc. (Luna) encountered this exact challenge, when their stock compensation expense was questioned. In the end, the Armed Services Board of Contract Appeals (ASBCA) ruled in case 60086 surrounding the disallowance of stock compensation expense.
Luna was required to adhere to Generally Accepted Accounting Principles (GAAP), which involved accounting for the fair market value of the stock options granted to employees that may be exercised in later years at the time of award. Luna, like many companies, valued these stock option awards using a “Black-Scholes” approach. This approach utilizes five variables to value the options as of the award date, one of those variables included the variance of the stock price. The variance can be further defined as how much the share price has fluctuated over time or is expected to fluctuate over time. The value of the stock compensation expense was claimed by Luna’s management as a G&A expense for the year ending December 31, 2007.
Upon DCAA’s review of Luna’s 2007 Incurred Cost Submission, the organization questioned the stock compensation expense under Federal Acquisition Regulation (FAR) 31.205-6(i), which states that compensation based on changes in the prices of corporate securities is unallowable. When the case was reviewed by the Board, they agreed with DCAA, that compensation expense recognized using the Black-Scholes approach is unallowable. However in Luna’s case, there were differences of opinion likely stemming from the mathematical complexity, so, the costs were not expressly unallowable and therefore, penalties were avoided.
The Luna decision provides some food for thought for contractors when determining the various methods of valuing their stock compensation expense. For contractors to reduce the risk of stock compensation disallowance, they should consider various methods for valuing the compensation expense to determine a range of reasonableness, but this is not a guarantee, ruling the cost allowable. Additionally, the Board in the Luna ruling appears to emphasize that going forward the use of the Black-Scholes model by contractors should be a source of concern, not only regarding the disallowance of the compensation costs but potential penalties as well.
So what should a contractor do if stock compensation expense was calculated using the “Black-Scholes” method?
- Review open years’ submissions to ensure costs are unallowable OR are reasonable using valuation methods that exclude the changes in stock prices.
- If costs were included in rates and are unreasonable, recalculate and resubmit open years.
If you would like more details on how to maximize stock compensation recovery, please contact our government contracting consulting experts at 301.231.6200.