Audit of Executive Compensation

Audit of Executive Compensation

a. The contractor's executive compensation system should be evaluated separately, even if the contractor does not have a separate pay structure for executives. FAR 31.205-6(b)(2) provides compensation is reasonable if the aggregate of each measurable and allowable element sums to a reasonable total. Policies and procedures for administering the compensation of executives should be evaluated using the guidance in 5-808, as appropriate to the circumstances. Some executives are also owners or in some other manner may directly influence their own compensation levels. See 6-414 for criteria to use in evaluating compensation under those circumstances.

b. The contractor's organizational structure should identify the contractor’s executive positions. Generally, the list of contractor executives would include anyone with the title of vice president or above, and normally includes all individuals responsible for managing these primary functional areas:

(1) executive office,

(2) controller-accounting,

(3) legal counsel,

(4) engineering,

(5) manufacturing,

(6) purchasing,

(7) contracts, and

(8) individuals responsible for major programs or product lines.

c. Top executive positions are unique and must be audited individually. Position descriptions emphasize rank, function, responsibility areas, goals to be attained, impact of decisions, and number of employees directed. Divisional executives can be distinguished from corporate home office executives by their reporting level. Executives are not a class of employees. Overpayment of one cannot normally be offset against underpayment of another. However, in large organizations there may be a class of vice presidents who have similar rank, function, and responsibility. In these cases, offsets may be appropriate.

d. Executives may be rewarded not only for their contribution to the organization, but also on the profitability of their functional unit, as well as the overall profitability of the company. Pay packages include short- and long-term incentive pay, as well as base pay, benefits, perquisites, and services.

Amounts reimbursed for the executives for the payment of taxes may also be included. These are a directly associated cost (see 5­ 1009.1), which may be allowable or unallowable, that are generated solely as the result of the incurrence of another cost.

For publicly traded companies, the board of directors normally sets executive pay packages based on the compensation committee’s recommendations. Details of the compensation committee’s meetings and research are available in the proxy statement.

e. An audit of the contractor's executive compensation system should include:

(1) Evaluation of the compensation system, as appropriate, in 5-806 to 5-811.

(2) Determination that the policies and procedures provide a description for how executive compensation levels are established and who approves these levels; and eligibility criteria and basis for determination of how base salary, cash bonuses, long-term perquisites,

benefits, services, and incentive pay bonuses are established.

(3) Determination that the policies and procedures provide for the identification of the executives subject to the compensation cap (FAR 31.205-6(p)), and the proper application (6-414.8e) of the cap in preparing submissions to the Government.

(4) Supplemental Benefits. In many cases, executives have available to them enhanced or supplemental benefits which are not available to the majority of the workforce. These supplemental benefits or executive benefits should be evaluated on a case by case basis. The supplemental plans should be evaluated in accordance with the applicable subparts of FAR 31.205-6 and CAS. These benefits should be evaluated for reasonableness based on market surveys or any other available data. The prevalence of such plans should also be considered in determining reasonableness.

For example, if a survey states that the average Long-Term Incentive (LTI) Payment for a contractor is 10% of base salary, a 10% LTI plan would not necessarily be reasonable. The reasonable amount could be significantly different, or the payment could be unreasonable altogether if only a small percentage of the participating companies have LTI plans.

A few of the supplemental or enhanced executive benefits that should be audited in detail are described below:

(a) Supplement Executive Retirement Plans (SERPs)

These plans are designed to provide the executive with earned benefits in excess of amounts payable under qualified retirement plans. These plans are often referred to as ERISA Excess Plans. These plans should be evaluated in accordance with FAR 31.205-6(j) and CAS 412. It is the contractor’s responsibility to demonstrate the reasonableness of a SERP by providing the auditor with comparable market data. If the contractor is unable to provide measurable market data for comparison purposes, the auditor should attempt to determine a reasonable amount or reasonable percentage of base salary for total pension expenses based on surveys or other sources. If the auditor is unable to obtain comparable market data to demonstrate the reasonableness of material SERP costs, the auditor should challenge the costs and report this as a significant deficiency.

(b) Deferred Compensation.

Deferred compensation is an award given by an employer as compensation to an employee in a future cost accounting period or periods for services rendered in one or more cost accounting periods before the date of receipt by the employee. The cost of deferred awards shall be measured, allocated, and accounted for in compliance with CAS 415 in order to be allowable. There are many forms of deferred compensation, such as Split-Dollar Life Insurance and “rabbi trusts.”

Split Dollar Life

Insurance is a plan that gives both the employer and employee an interest in a cash value life insurance policy on the employee’s life. A rabbi trust is used to accumulate deferred compensation, usually to fund a SERP. The amount of the award should also be evaluated for reasonableness if the contractor’s award is determined to have been made in accordance with CAS 415.

(c) Long-Term Incentive plans

LTI plans are compensation plans that have an award period of two or more years. These payments are typically based on achievement of long-term business goals or as a method of retaining key executive talent. LTI plans may be based on stock options that should be evaluated for allowability and allocability considering the requirements of FAR 31.205-6(i), FAR 31.205(k), and CAS 415. Long Term Incentive payments should be evaluated on a case-by-case basis, including prevalence of such plans, in order to determine reasonableness.

(d) Executive Severance

Severance payments should be evaluated in accordance with FAR 31.205-6(g). Most severance policies are based on a formula that relies on length of service/employment as the determining criterion in the calculation of the severance amount. In many cases, executives are awarded severance in excess of the normal or established policy. Contractors often argue that severance payments are based on executive employment contracts. However, the fact that a severance payment is based on an executive employment contract does not necessarily support the amount as reasonable. This amount should be evaluated based on severance policies of comparable executive positions in accordance with FAR 31.205-6(b)(2). Refer to 7-2107 for additional guidance on severance payments.

Golden Parachute

(5) The costs of “golden parachute” benefits were made expressly unallowable in FAR 31.205-6(l)(1), effective April 4, 1988. Refer to 7-2107.8 for additional guidance on the evaluation of "golden parachute" benefits.

Past Year Comparisons

(6) A comparison of executive pay (salaries, bonuses, and deferred compensation) for the current year to several past years for the purpose of establishing trends. The auditor should obtain the contractor's explanation and justification for significant increases. Also, consider the company's financial performance trends relative to the trends in executive compensation. (See 6-414)

Market Comparisons

f. When evaluating the contractor’s market comparisons of top executive pay (see 5­ 808.8), the executive compensation components being evaluated should be consistent with that shown in executive compensation survey data. Survey data most frequently includes base pay and cash bonuses combined and long-term incentive pay as a percentage of base pay.

g. Often contractors will propose that their executives should be paid more than 110 percent of the reasonable compensation based on the average compensation paid by comparable firms for executives with similar duties. For an executive with responsibility for overall management of a segment or firm, such a proposal may be justified by clearly superior performance, as documented by financial performance that exceeds the particular industry's average.

(1) Examples of such financial performance measurements may include the following:

• Revenue Growth

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• Net Income

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• Return on Shareholder's Equity

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• Return on Assets

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• Return on Sales

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• Earnings per Share

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• Return on Capital

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• Cost Savings

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• Market Share

(2) The contractor must show that the measure chosen is representative of the executive’s performance. Consideration should be given to the competitive environment in which the contractor operates. There should be no extra compensation awarded because of high performance measured by a standard which is not affected by the executive’s performance, and certainly there should be no extra compensation due to performance which results primarily from the contractor being a Government contractor.

(3) Use of a particular criterion to justify higher than average compensation should be applied consistently over a period of years, with both increases and decreases in the performance measure reflected in the changes to compensation claimed as reasonable.

Deficiencies and Unreasonable Compensation

h. If the audit of the contractor's executive compensation system determines that significant system deficiencies exist or the contractor has established pay policies or procedures that appear to promote unreasonable compensation levels, conduct specific testing of the reasonableness of the executive compensation under FAR 31.205-6(a)(6), as outlined in 6­ 414.