Construction Auditing

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Construction Audit

Construction Auditing Risk and Cost Segregation Strategies for 2013 and Beyond

IIA Atlanta Chapter Atlanta, GAJune 14, 2013AgendaOutcomes of this presentationWhat is a Construction Audit?Why is it important to internal auditors?Variations of Construction AuditsWhat is a Cost Segregation Study?Types of construction contracts and associated risks to your organizationWhat to look for during an auditHigh-risk areas and common issuesExamples and case studiesOutcomes of this PresentationWhat a Construction Audit is and the variations of a Construction AuditWhy a Construction Audit is important to your organizationDetermination if a construction project at your organization is a candidate for an auditThe various scopes of a construction review Key high-risk areas to audit during a reviewWhat is a Construction Audit?First, we must define what we mean by construction:Not just new construction but also renovations, remodels, demolitions, etc.Across all industries worldwide health care, entertainment, higher education, government, etc.Includes schools, casinos, buildings, stadiums, highways/bridges, etc.Can include construction costs less than $1M but oftentimes $1M or more to accumulate larger cost recoveriesWhat is a Construction Audit?Audit is defined as an all-encompassing scope of the construction process from solicitation of bids to final payment.Not just looking for cost recoveries or overbillings, but also provide process improvement recommendations for the project management team

Is not just a cost recovery review but cost preventionShould involve auditors prior to contract executionShould act as intermediary between owner and General Contractor (GC)Should assist with disputes and litigationTherefore, a Construction AuditWhy is it Important to Internal Auditors?What does it mean to us and why are these audits necessary?The risk - billions of dollars spent by organizations on capital expenditures each yearOur job is to provide independent and objective assurance that company money is handled appropriatelyLack of resources and sound processes/procedures by project management team to adequately safeguard assetsImprove internal controls around the owner project management function

Why is it Important to Internal Auditors?What does it mean to us and why are these audits necessary?In some organizations, cost recoveries from contract audits exceed the entire annual budget for the internal audit department, . . .From Construction Contract Auditing as published in INTERNAL AUDITOR, February, 1999, by James D. Cashell, CPA, MBA, PHD; George R. Aldhizer, III, CPA, PHD; and Rick Eichmann, CIATypical recoveries are 1 to 3% of total project cost

Common rebuttal:

We hire a construction management firm to monitor and manage the project.

Risk still exists even with outsourcing the project management functionMay not have the owners best interest in mind Possible collusion between GC and CMPriorities such as schedule could take precedence over costScope and contract changes between GC and PM could occur without proper oversightOwner and/or auditors still need to stay involved throughout the process!

Common rebuttal:

We have worked with the same GC and no issues or cost overruns have occurred in the past.

Just because a project is on budget or was completed under budget does not mean all costs were appropriateWas the original budget a sound figure?Sound bidding and budget policies and procedures are neededAggressive GC savings established Incentive to come in under budgetScope completed as plannedScopes of work eliminated to maintain budgetSubstitution of materialsUtilize materials of lesser value and quality to limit cost

Common rebuttal:

GCs that work on our jobs have never been convicted of fraud.

Generally overcharges or unallowable costs are not due to fraudulent activityRegardless of contract This is how it has always been done.Lack of resources by owner and/or GCLack of communication between owner and GC/architectExcessive change orders/scope changesMathematical errorsAbundance of paperwork

Why is it Important to Internal Auditors?However, some of these costs do turn out to be fraudulent Lend Lease (Bovis)Cheated clients out of millions of dollars in overbilling schemeUndercut competition to get a job, then padded the books with change orders often with the clients knowledgeSubmitted falsified invoices to clients for labor when contractors were on vacation or sick Occurred over a decades time!Agreed to pay $56M to settle charges of over billing clients

Variations of Construction AuditContract reviewJob walksLimited scope/full scopeOnly audit select Change Orders (CO) or pay applicationsAudit from bidding to project close outBased on contract type (GMP, lump sum, etc.)Cost segregation studies hidden tax savings

lets dig inCost SegregationWhat is a cost segregation study?What types of buildings are good cost segregation candidates?What does a cost segregation study apply to?What are the benefits of a cost segregation study?How is a cost segregation study performed?

What is a Cost Segregation Study?Comprehensive analysis of hidden personal or tangible property for commercial buildings.Analyze cost data including the contractors application of payments (AIA), change orders, owner incurred costs, and indirect disbursements.CSS is not a component study.Must be an income tax-paying entity.

What is a Cost Segregation Study?Analyze purchase price of property to segregate assets from the building costGenerally 10-50% of costs can be segregated to shorter lived assetsAllows indirect costs to be allocated to various depreciable lives

Type of StructurePercentage MisclassifiedRetail10 40 %Grocery stores15 40%Office building10 15%Hotels20 40%Warehouses8 12%Light manufacturing15 40%Heavy manufacturing25 70%Processing plants50 90 %Nursing homes15 30%Restaurants15 40%Potential benefits of reclassificationAlso common for:Amusement parksApartment complexesAuto dealershipsBanksCasinosDistribution centersFranchises Medical centersShopping mallsSports stadiums

What does a cost segregation study apply to?New commercial buildings under construction Existing commercial buildings undergoing renovation or expansionOffice leasehold improvements and fit-outsPurchases of existing commercial properties. All post-1986 real estate construction, building acquisitions or improvements

Building should be worth $500,000 or more

Benefits of a Cost Segregation StudyIncreased depreciation in earlier years and/or one time catch up in one year (Form 3115)

Results in less federal and state income taxes Results in increased cash flow A dollar today is worth more than a dollar tomorrow (Time Value of Money)

How is a Cost Segregation Study Performed?Various approach types:

Detailed Engineering approachActual cost records (new construction)Cost estimate approach (purchase) Survey or letter approach Residual estimation approachSampling method approachRule of Thumb approach

How is a Cost Segregation Study Performed?10 elements of a quality cost segregation study:

Prepared by an individual with expertise & experienceDetailed description of the methodologyUse of appropriate documentationInterviews conducted with appropriate partiesUse of common nomenclatureExplanation of legal analysisExplanation of treatment of overhead costsConsideration of related aspects (other deductions)Identification of 1245 propertyReconciliation of total allocated costs

Contract TypesWhat are the types of contracts and the associated risks:Lump SumTime and MaterialCost Plus Guaranteed Maximum PriceCONTRACT TYPESLump Sum

One price which includes fee, cost of work, and general conditionsAssigns majority of the risk to the contractorPotentially higher markup by GC to take care of unforeseen contingenciesElimination of scope or low quality materials to stay within budgetChange orders should be scrutinizedTime and Material

Owner pays for actual cost of work (labor, material, equipment cost, etc.) plus a markupMarkup is generally a set percentageNo incentive for GC to reduce costs Low productivity by GCOwner must establish labor rates, material costs, and equipment rates prior to contractOwner requires additional supervisionCONTRACT TYPESCost Plus

GC is reimbursed for specified allowable costs plus a fixed feeNo incentive by GC to reduce costOwner assumes risk for cost overrunsMore supervision required by ownerLow productivity by GCCONTRACT TYPESGuaranteed Maximum Price (GMP)

GC guarantees the project will be built within a predetermined amountGC is reimbursed for actual cost plus a fixed feeSavings are generally shared with the GCGC may not use best personnel on jobMust audit job cost ledgerCONTRACT TYPESGuaranteed Maximum Price (GMP)

Example savings model (50/50 split)GMP amount of $10,500,000

Cost of work: $10,000,000Savings (50% of $500K): $250KAmount due to GC: $10,250,000

CONTRACT TYPESWhat should be included in your audit approach?If possible, auditor involvement should occur before contract signing

Contract language should be updated to reflect the type of project and contractIdentify contradictory languageLack of specific provisions (insurance, audit clause, etc.)Clarification on allowable and unallowable costsPenalties in place for nonconformance with contractInclude requirements for a detailed breakdown of construction cost for cost segregation studies once work is completeGetting started: Who are the players?Owners project management team or third-party construction managerGeneral contractor and subcontractorsArchitect

Utilize a questionnaire to get a perspectiveWho, what, when, where, how, and why

Process and procedure control reviewCompetitive bidd

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