The Defense Contract Audit Agency (DCAA) assists contracting officers with assessing the reasonableness of contractors' executive compensation in accordance with FAR 31.201-3 and 31.205-6. Executive Compensation Reviews (ECRs) are typically conducted as part of annual incurred costs audits. While the compensation of owners of closely-held companies is singled out for "special consideration" under FAR 31.205-6(a)(6), all contractors with a significant percentage of work in flexibly-priced government contracts can expect to undergo ECRs on a regular basis.

In general, the DCAA's ECR methodology involves an almost exclusive reliance on two or more national executive compensation surveys to derive average compensation for the contractor's industry and size (typically as expressed in sales), "benchmarked" to the executive positions under review. For example, a company with sales of $100 million in the construction industry will have its top four to ten executives compared to similar positions in companies of roughly the same size and industry. Compensation survey data for companies responding to the survey will yield median salary for each position for each survey. These data are averaged for each position and increased by a 10 percent "range of reasonableness" factor to account for inherent data variability. If the survey data median compensation is lower than the company's, the difference between this figure and the company's compensation may be questioned as unreasonable, and a disallowance recommendation could be made to the Administrative Contracting Officer (ACO).

Since 2001, when the DCAA stood up its Mid-Atlantic Compensation Team, more and more contractors have experienced the pain of ECRs. Although contractors have disagreed with the Team's findings, for many contractors, the cost of litigating an executive compensation dispute is prohibitive, given the amounts typically at stake. Thus, the best practice is to head off a potential dispute before the DCAA position has solidified and been conveyed to the ACO.

Here, in order of least to greatest importance are the top five things a company can and should do to prepare for or deal with an ECR:

5. Set Executive Compensation by Committee. Although not all decisions are best made by committee, executive compensation may be the exception. A chartered compensation committee, typically reporting to the board of directors, should perform a rigorous study of all relevant market data and circumstances bearing on compensation decisions, if possible, with the assistance of independent external compensation consultants. Compensation committee meetings should have detailed minutes, and compensation decisions should be based on written criteria. Small, closely-held companies often forego such infrastructure; however, lack of documentation and rationale for questionable compensation decisions can be a red flag for the DCAA. Moreover, contemporaneous explanations for seemingly anomalous decisions are more persuasive than those made after costs have been challenged as unreasonable.

4. Maintain Accurate Position Descriptions. The DCAA will, as a default approach, evaluate top division executives using divisional rather than company-wide revenue. Compensation survey data have a rough direct relationship with compensation (i.e., the higher the revenue, the higher the reasonable compensation), so reasonable compensation will generally be deemed lower for executives with only parochial divisional responsibilities. However, if top division executives do have substantial company-wide responsibilities, these should be clearly documented so that when an ECR is performed, these executives will be evaluated using the more advantageous company-wide revenue amount. Consider the example in Table 1, below:

Table 1

The executive vice president may have the same background, qualification level and tenure in position as the top divisional executive, but if the company cannot demonstrate that the latter has company-wide responsibilities, the DCAA will evaluate the Top Division Executive's compensation using the revenue for the division rather than the company as a whole. Where such an evaluation does not reflect the reality of the situation, the company should ensure that it can document any broader responsibilities, and these should be brought to the ECR reviewer's attention early in the process.

3. Compile Complete and Accurate Data on Company Performance. The DCAA may, if requested, analyze a company's financial performance to determine whether the company should be "marketed" at higher than the median or 50th percentile compensation level. In most cases, as in the example in Table 1, there is a substantial difference in compensation level between companies at the 50th and 75th percentiles. Thus, companies should:

  • Assert, if accurate, that company performance is above the median. The DCAA will not undertake a performance analysis unless specifically requested to do so and will otherwise use the 50th percentile as a default position. Therefore, companies must request that the DCAA evaluate financial performance.
  • Be prepared to discuss financial performance with the DCAA to argue for marketing at higher percentiles. The DCAA typically looks at metrics such as sales growth, return on sales, return on assets and return on equity, and compares the company to others in its peer group. It is essential that unique circumstances unrelated to company performance affecting any of these metrics in a given market be well documented, and that these be brought to DCAA's attention early in the process.

2. Be a Member of the ECR Team. The easiest way to get a bad ECR report is to treat the event as a nuisance and simply hope that it will be over soon. Thus, companies should engage with the DCAA as early as possible in the ECR process, before the reviewer begins to form firm impressions. Be aware of any areas of weakness in compensation practices or company performance, and be ready with explanations and supporting documentation to minimize the impact. Make sure that you give a complete in-briefing to the reviewer concerning the company overall and any unique circumstances that might affect the ECR. Introduce the reviewer to the executives whose compensation is to be evaluated, and provide complete information regarding the executives' background, experience and accomplishments. With the assistance of legal counsel as appropriate, be responsive and timely with regard to all requests for information and documents. Insist on an out-briefing, and follow-up to correct any misunderstandings or inaccuracies on the reviewer's part before he or she puts pen to paper on the ECR. Submit a complete and timely rebuttal to any preliminary findings that are inadequate or legally insufficient.

And the number-one thing a company can do to ensure a good ECR is ...

1. Engage the Contracting Officer. Although the contracting officer is, by law, the decision-maker on disallowance decisions, in practice, contracting officers will rarely even be aware of an ECR until it is over and the report is on his or her desk. By then, it is often too late to sway the contracting officer with the facts and the most compelling analysis. As soon as an ECR is started, the company should be talking to the ACO in much the same way as it is engaging with the ECR reviewer. Where the DCAA's analysis is off track, this should be immediately (and diplomatically) brought to the ACO's attention, and any mistakes or misunderstandings corrected. That way, when the ECR comes in, he or she may be predisposed to question the DCAA's views if a dispute comes up.

Executive Compensation Reviews are increasingly a fact of life for more and more contractors. There are many facets to this problem, and this note gives only general tips on how best to survive an ECR. DCAA ECR methodology is subject to numerous criticisms, and, on a case-by-case basis, many issues and objections can be raised.