Compensation System Internal Controls

Compensation System Internal Controls

Background Information

a. Compensation for personal services is one of the largest components of cost incurred under Government contracts. It includes all remuneration paid currently or accrued, in whatever form, and whether paid immediately or deferred, for services rendered by employees to contractors during contract performance. The objective of a compensation system is to provide the level of pay and benefits necessary to attract, retain, and motivate employees to direct their efforts toward achieving the goals of the organization. To be considered adequate, a contractor's compensation system must be reliable, be subject to applicable management control objectives and activities, and result in allowable, allocable and reasonable compensation costs charged to Government contracts in accordance with FAR provisions.

b. The regulatory foundation for audits of contractor compensation systems resides in FAR 42.302, FAR 31.201-3, and FAR 31.205-6. FAR 42.302(a)(1) provides that the contract administration office will review a contractor’s compensation structure. FAR 31.201-3, Determining reasonableness, provides general criteria for determining whether a cost is reasonable in its nature and amount, and FAR 31.205-6, Compensation for personal services, provides both general criteria and additional requirements for evaluating the allowability, allocability, and reasonableness of the different elements of compensation.

c. As provided in FAR 31.205-6(a), to be allowable, total compensation:

(1) must be for work performed by the employee in the current year and must not represent a retroactive adjustment of prior years' salaries or wages,

(2) for individual employees or job classes of employees, must be reasonable for the work performed,

(3) must be based upon and conform to the terms and conditions of the contractor's established compensation plan or practice followed so consistently as to imply, in effect, an agreement to make the payment,

(4) is not presumed to be allowable where the contractor introduces major revisions of existing compensation plans or new plans and the contractor has not provided the cognizant ACO, either before implementation or within a reasonable period after implementation, an opportunity to review the allowability of the changes,

(5) costs that are unallowable under other paragraphs of FAR 31.2 are not allowable under FAR 31.205-6 solely on the basis that they constitute compensation for personal services, and

(6) costs for certain individuals (e.g., owners of closely held corporations, immediate family members, and others with a substantial financial interest) require special consideration. For these individuals, compensation must be reasonable for the personal services rendered; and not be a distribution of profits (which is not an allowable contract cost). Refer to 6-414 for guidance on evaluating the reasonableness and allowabilty of compensation costs to individuals who pose a higher risk of unreasonable compensation.

d. As provided in FAR 31.205-6(b)(2), Compensation not covered by labor management agreements, compensation for each employee or job class of employees is considered reasonable if the aggregate of each measurable and allowable element sums to a reasonable total. In determining the reasonableness of total compensation, consider only allowable individual elements of compensation. The reasonableness of compensation is directly influenced by the compensation practices of other firms and by the supply and demand for a job as measured in the labor market for the job being evaluated. In addition to the provisions of FAR 31.201-3, in testing the reasonableness of compensation for particular employees or job classes of employees, consider factors determined to be relevant by the contracting officer, as well as those factors identified at subparagraph (b)(2) of the cost principle. Examples of factors that may be relevant include, but are not limited to, conformity with compensation practices of other firms: 

• of the same size,

• in the same industry,

• in the same geographic area; and

• engaged in similar non-Government work under comparable circumstances.

e. Certain elements of compensation are made expressly unallowable by FAR 31.205-6. These include compensation based upon changes in the prices of corporate securities (31.205-6(i)) and compensation in excess of specific limitations on the allowability of compensation for certain contractor personnel (31.205-6(p)).

f. As provided in FAR 31.205-6(b)(1), special provisions exist for determining the reasonableness of compensation amounts established under “arms length” labor management agreements.

Description of a Compensation System

a. An adequate compensation system is considered an inherent part of establishing reasonable compensation. A system includes the organizational structure; established lines of authority, duties, and responsibilities; internal controls and managerial reviews; internal and external consistency; pay structures; budgeting; merit and incentive pay programs; and benefits program. A contractor may establish one compensation system to administer the compensation programs for hourly, administrative, technical, professional, and executive employees or establish separate systems for each group. The guidance provided is generally applicable to each situation, but should be adapted to the circumstances of the audit.

b. When auditing a contractor's compensation system, consideration should be given to the presence of characteristics that are generally indicative of an adequate system. An adequate compensation system:

(1) Requires periodic internal reviews of policy compliance, administrative process measures, and adequacy of documentation; reports to management on the results of reviews and recommendations for improvements; and requires corrective action plans to be developed, implemented, and tested.

(2) Is organized based on a definitive flow of authority.

(3) Includes written policies and procedures that specifically:

• (a) set forth the contractor’s compensation package, including cash and fringe benefit items, jobs, job families and career levels, pay grade assignments and changes to the pay structure, job analysis and job description requirements, external equity and market comparison process, performance management system, and employee benefits programs, and

• (b) ensures that compensation paid to employees for services rendered under Government

contracts complies with FAR 31.205-6.

(4) Provides for sufficient training, experience, and skills to perform pay administration tasks in accordance with the contractor's established policies and procedures and current compensation theory.