Forensic contract reviews - EYFILE/...re… · 2 Forensic contract review ... experiences and observations of forensic contract reviews and arrangements that went wrong, ... and audit?

Commercial accountability Forensic contract reviews

2 Forensic contract review

Introduction Companies can better manage risks and improve contract performance through proactive forensic reviews of the contracts they have with third parties. The increase in the importance of intellectual property, procurement optimisation, outsourcing of non–core processes and demand for stronger corporate governance, coupled with the challenging economic climate, has led to a growth in demand for forensic contract services.

Business relationships with suppliers and contractors form the backbone of successful businesses and ventures. These relationships are managed through the terms and conditions contained within contracts. A great deal of reliance is placed on the contract to mitigate the risks the business may be exposed to, such as the security of future revenue or the security of sustainable supply at manageable costs.

The effect of poor contract management is not isolated to either small or large companies. For small companies, it may result in the inability to continue business. Large companies may be able to sustain the financial losses resulting from a poorly managed contract, but the potential effect on its reputation may ward off future business partners.

In this document, we share our views on a number of sound contract compliance principles. This is built on our experiences and observations of forensic contract reviews and arrangements that went wrong, often resulting in a commercial dispute resolution process to put arrangements back on track or to compensate parties for resulting damages.

We also highlight the benefits of a forensic contract review which allows you to identify, separate and quantify the financial and business impact that can support you in any potential recovery action.

Ernst & Young’s forensic team comprises of accounting, data and litigation consultants. Our team have experience in assisting our clients to reduce their contract risks, as well as identify and recover potential losses when contractor arrangements are entered into or re–negotiated. Further, our experience in forensic data analytics and forensic contract compliance reviews allows us to identify potential savings quickly, and provide you with the necessary assurance that you require.

Ernst & Young forensic contract reviews can mitigate risk, generate savings, identify areas for improvement and provide practical input to future contract negotiations.

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3Forensic contract review

How would you respond to the following questions? Your response may be indicative of the magnitude of the inherent risks, including internal and supplier conflicts and fraud risk, associated with contract management, as well as the perceived effectiveness of existing mitigating controls.

• ►Does your organisation have supplier relationships which are managed on the basis of complex contracts and policies which are hard to administer and audit?

• ►Do you know or suspect that you are overpaying suppliers through an inability to monitor payments effectively?

• ►Do you face the challenges of:

• A complex domain where the delivered value of suppliers services is not readily transparent?

• Operating in remote locations or emerging countries, whilst facing challenges of resources and limited supply?

• A small number of experts who are able to identify overpayments with confidence?

• Technical complexities dealing with large volumes of data from which information needs to be extracted?

• Issues with cost effective verification of identified anomalies and subsequent reclaim of monies from suppliers?

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The contract management framework

Contract life cycleThe various stages of a contract pose risks and require strategies to manage and mitigate the associated risks.

Contract negotiation — having the right team Large contracts often require multi–faceted teams to assist with the drafting of the contract. Lines of responsibility can become blurred which may result in wording changes without the proper appreciation of its impact on the organisation’s exposure. Having clear responsibilities prior to the drafting of contracts will save time and effort during the drafting phase. It will also assist in clearer understanding of the meaning and implication of contract clauses, and assist in effective mitigation of the various risks associated with the contract.

Definitions used in the contractThe purpose of defining terminology within a contract serves to remove any ambiguity in respect of its interpretation. It is often the interpretation of a definition used in a contract that leads to misunderstanding and disputes. The value of clear definitions is often only measured when a dispute arises. Some common definitions that we encounter during contract reviews and disputes include:

• ►Financial terminology, for example profit, gross margin, revenue

• ►Product specification

• ►Key milestone dates, especially where periods rather than specific dates are included

• ►The meaning of ‘books & records’, especially in light of a right to audit clause

• Requirement that the contractor or vendor maintain appropriate records in adherence to applicable legislation, including anit–bribery and corruption laws

Right to audit clause Good controllership is the first wave of defense against potential issues arising, particularly when information pertaining to the management of a contract is often not freely available to all parties to the agreement. For example, in a large construction or services contract, where portions of the work may be subcontracted to third parties, the ultimate client may have minimal or no visibility over the arrangement between the contracting party and subcontractors. Other examples include:

• ►Questionable amounts reported for revenue or payment purposes

• ►Concerns relating to compliance with the terms and conditions of the contract

• ►Unethical practices, for example making use of unauthorised or risky labour practise which will have a negative reputational impact

Parties’ rights can be protected through a right to audit clause, which will allow them access to information pertaining to the contract, maintained by other parties to the contract. The conditions of the access will be determined by the wording of the contract. Such a clause normally provides for:

• ►The type of information that can be accessed

• ►Who can make such a request

• ►Any notice periods that may apply

• ►Whether an external party may be allowed access

Pre–signing


The contract management framework

Our experience in assisting companies when contractual relationships deteriorate, enables us to offer insights and advice throughout the contract lifecycle.

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• Achieve clarity in financial drafting• Help ensure appropriate provision for

access and dispute resolution• Compliance with legislation

• Provide support in contract re–negotiations

• Achieve more beneficial contract terms

• Help enhance supplier relationships

Pre–signing

Re–negotiation

Ex

ecut

ion

Contract lifecycle

Contract lifecycle

• Perform risk assessment of contract portfolio

• Understand reasons for performance gaps

• Identify areas for potential financial recovery

Forensiccontract review

• Understand strengths and weaknesses of dispute • Identify cost and time implications• Help ensure robust quantum assessment

Exit

Figure 1: Generic contract life cycle

There are four stages in a generic contract life cycle.

Pre–signing

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Lack of proper hand over The team responsible for preparing and finalising a contract is often separate from the team responsible for the execution of the contract. In many larger organisations, we found that a dedicated team is responsible for the preparation and negotiation of the contract terms. At the commencement of the project, the management of a contract is handed over to the project team, supported by a contract management officer. We have found that a poor handover may result in incorrect interpretations of key contract terms and conditions, which may result in the execution contrary to the intended spirit of the contract. Such hand–over should include an explanation of specific key inclusions or omissions so that the project team is aware of its impact. The same principle applies in the rotation of contract managers during the lifecycle of a contract.

Contract management plans To manage the diverse risks associated with specific contracts, it is important to develop a contract management plan tailored to address the key risk areas and performance indicators as part of the overall contract management process. The exact extent of the contract management plan should be balanced with the risk associated with the contract and the organisation’s appetite for risk.

Listed below are some of the key contract clauses to be included in a contract management plan:

• Contract risks

• Key dates

• Assignment of responsibilities of all parties

• Deliverable and payment metrics

• Key perforance indicators (KPIs)

• Issue escalation procedure

• Periodic review of the plan

Execution

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Pitfall Potentialfraudrisk

No formal performance management structure

Delayed detection of manipulation, overcharges, budget blowouts and product quality as a result of fraud

Responsibility of contract management not assigned

Duplicate payments or overcharging. Lack of record keeping that may delay detection. It further limits the ability to respond timeously in the event of a breach.

Purchasing of goods outside of the agreement

Purchasing of goods which may not be required, or that may be sourced cheaper from other suppliers.

Using technology for cost verification and recovery

For many organisations, ensuring the legitimacy of payments can be a highly complex exercise for a number of reasons:

• Skilled resources: For many organisations cost verification requires very specific skills, such as familiarity with suppliers’ services and agreed rules of engagement, as well as some analytical and technical skills. In many cases, the bulk of the work is mainly administrative, but expert knowledge is required to make the critical judgments, meaning that work cannot be completed by other staff.

• Data volume and quality challenges: Addressing large data volumes and quality issues can be beyond the abilities of non-technical staff. Failure to deal with such issues early in the validation process can result in a cascade of complications.

• Tools: The lack of correct tools, technologies and methodologies that use financial accounting data and training are not available to allow the work to be done effectively.

• Prioritisation and investigation: There is a cost associated with reviewing potential overpayments, contacting and communicating with suppliers. It is important to ensure that the payments most likely to result in recovery are prioritised, and that associated information is presented in a manner which allows efficient decision making.

Contractor governance pitfallsIf good governance is not applied, certain pitfalls associated with poor contract performance management can give rise to risk. The table below highlights some common pitfalls.

ExecutionWe use tailored forensic techniques, including dedicated forensic data analytical tools, to analyse the reasons for divergence between expected and actual performance.

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Example of contract specific checks

Site labour costs claimed vs. actual wages paid

Hours worked claimed vs. timesheets

Targeted sample testing on invoices to establish whether discounts/rebates have been applied

Reconciliation of payments to subcontractors to the reported subcontractor costs

Substantiating reported costs by reference to a sample or original subcontractor records

Review of calculation of Works Fee with respect to treatment of allowable items

Ghost sub contractors/fictitious invoices

Duplicate postings/invoice payments

Invoice values paid to the contractor for a lower amount than per payment run data from the contractor’s accounting system

Payments to one-time vendors or vendors with missing details

Recurring payments just below authorisation thresholds

Manual journal entries removed in subsequent periods

Example of standard automated forensic checks

A contractor or third party’s governance structure around electronic and manual cost recording systems (i.e. processes, procedures and controls) is critical to minimise contract risks and will differ from one contract to another. Ernst & Young can evaluate the adequacy and effectiveness of the systems in enabling accurate capture, recording and reporting of allowable costs under the contract, and consider whether they are transparent and robust in their operation. We for example, can also consider the effectiveness of the processes used by the organisation to review and monitor the invoices presented for payment by contractors or third parties.

Figure 2


We will identify patterns or trends in data held by you and/or the contractor through the use of forensic data analytical techniques. Individually, transactions may appear to follow a consistent format, but such analytical techniques ‘draw out’ or highlight data so that previously hidden patterns are revealed.

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”A key element of contract management is the need for accurate and robust data. Typically errors and overspend are the result of a combination of inaccurate or incomplete data and the reporting and reliance on the wrong performance measures.

Through a forensic automated contract verification approach, the first step would be to determine the key performance indicators to be monitored and managed effectively at the individual contractor/project level. Using this approach, it is possible to identify invalid payments, through the creation of scenarios formed from a combination of policy rules, client domain knowledge and advanced analytical techniques. These scenarios can then be systematically tested against payments to highlight and prioritise anomalies, which can be investigated accordingly. The automated nature of this method allows the tests to be run against multiple batches over multiple years.

Typically an analysis of the following cost headings is covered:

• Salaried staff

• Labour

• Plant

• Materials

• Subcontractors

• Overheads and expenses

Specific detailed tests will vary by contractor and will be dependent on their risk profile and the results of our analysis of data. Examples of this will include vendor stratification and clustering by amount and over time and for text mining and keyword searching of suspicious payment descriptions etc.

Figure 2 sets out examples of the types of checks that can be performed. These are designed to identify potential indicators of non-compliance, errors, inaccuracies, misunderstanding, over–recovery, fraud and corruption.


Real value can be derived from re–negotiating and extending a contract of a supplier following the completion of a contract period, which includes the following:

• ►A shorter timeframe to have an agreement in place, compared to a new tender process

• ►Cost savings can be achieved, as there is not a need to complete an extended tender and evaluation process

• ►No learning curve, which would be associated with a new supplier, for example a services contract

• Limited cost blowout surprises, which are often associated with the commencement of a new contract

• ►Limited potential production losses due to handovers, with the associated increase in cost or losses in revenue

• ►Maintaining the expected quality of service or product

The re–negotiation period is also an opportune time to incorporate the lessons learned from the previous contracting period in the updated contract, which may result in the more effective management of a contract and the reduction of potential fraud, corruption or litigation risks. To ensure an organisation gets the most out of this opportunity, it is beneficial to have a process in place whereby feedback and input is recorded and considered, especially from the end-user of the product or service that is procured.

There is, however, a fine balance between re–negotiation of a contract to reap the benefits for the organisation, or re-negotiation of a contract to continue an already existing conflicted or corrupt relationship with a supplier.

There are a number of red flags within the contract re–negotiation process that may indicate potential fraud risk. These red flags include:

• ►The re–negotiation of terms is limited to one employee, or key employees are being left out, for example in–house legal counsel or chief procurement officer

• ►Limited consultation with regards to the supplier’s performance to date

• ►Changes to the terms and conditions that favour the supplier to the detriment of the organisation

• ►Undue pressure being exercised not to invite other companies to tender

Prior to commencing negotiations, Ernst & Young can assist you in developing a negotiation strategy for each contractor. This will draw upon all work undertaken, including stakeholder consultation, industry benchmarking and evidence from dataset analysis. Together, we can prepare for negotiations through the use of carefully worded communications prepared in structured workshops, coaching and rehearsals.

Contract re–negotiation


Contract re–negotiation

The following measures can be considered to mitigate potential conflicts, disputes and the risk of bribery and corruption in the contract re–negotiation phase:

• ►A properly maintained contract database that can identify contracts close to their expiry date and notify relevant stakeholders

• ►Regular performance assessments during the initial and re–negotiated contract period

• ►The rules for re–negotiation of contracts to be clearly defined in procurement procedures, including:

• Approval to be obtained prior to re–negotiating a contract

• Documentation requirements

• The number of times that a contract can be re–negotiated

• Relevant approval limits and required sign-offs including the Board of Directors where appropriate

• ►Clear qualification criteria based on performance

• Regular independent post–re–negotiation reviews, which will also act as a deterrent to offenders.


Exit

Contracts can be terminated in a number of ways, for example:

• ►Reaching the natural end of the contract period

• ►By mutual agreement between parties

• ►By one of the parties based on the termination clauses included in the contract, or based on a party’s common rights

• ►Force majeure

It is often the termination of a contract that results in a dispute between parties, especially if the termination is a result of the inability of a party to fulfil its stipulated obligations. Parties may have to apply to the courts to resolve a dispute, which is not only costly, but removes the focus of an organisation away from its core activities.

Following are a number of reasons why a dispute can arise:

• ►Inability of a party to deliver the product or service

• ►Inability to complete a project within the specified time frames

• ►Unplanned contract cost overruns

• ►Breakdown in the relationship between parties

• ►Fraudulent or corrupt activity

Whilst sound contract management principles can reduce the risk and impact of disputes, disputes with contractors over time are inevitable, especially in an environment where organisations deal with a magnitude of contracts.

There are certain measures an organisation can take to prepare themselves should a dispute or litigation eventuate, which may reduce the cost associated with litigation and the time to take action, or respond to a claim from another party. These include:

• ► Development of a litigation readiness program, which includes a data retention policy

• ► Having a team that are familiar with the company’s response strategy that comprises relevant skilled employees such as legal counsel, financial and operational employees

• ► Documented record keeping procedures

• ► Back-up and restoration procedures of electronic data, including electronic communication such as emails

• ► Clear communication and reporting protocols

The independent assessment of your litigation readiness plan and strategies may highlight possible improvement opportunities that can contribute to the effectiveness of your strategy.


How healthy are your contract management practices?Below are some questions we ask organisations in order to help them understand the maturity of their contract management practices and to identify control improvement opportunities.

• Do you understand the risks in your contract portfolio?

• Do you have control over all the contracts that you entered into and are currently in the execution phase?

• Do you have a process for assessing the risks associated with entering into third party contracts and are you clear on how to mitigate these risks?

• Are the risks associated to contracting with a vendor factored in the adjudication process?

• Once entered into, is there clear responsibility for the management of contracts?

• Are the rights to verify performance and enforce terms exercised?

• How is performance monitored, and non-compliance addressed?

• What are the income and costs associated with contracts?

• Do your contracts clearly define all contractual terms so that both parties have the same understanding of how licence fees, commission, royalties, revenues, costs, etc., are defined and calculated?

• If you acquire a company, do you know what contracts you will be taking on and have you properly assessed this risk?

• How well are the fraud and corruption risks and risk appetite defined, communicated and understood at your organisation?

Exit


Supporting you with your contract management

Having an effective contract review process will help you with your contract management to achieve the right commercial outcomes. Therefore, ensuring that your contracts are well designed, negotiated, executed and closed out, will significantly assist in managing this known risk. Through our knowledge of forensic contract reviews we can support you throughout the following phases of your contracts.

Pre-signing

• Achieve clarity in financial drafting

• Help ensure appropriate provision for access and dispute resolution

Execution

• Perform risk assessment of contract portfolio

• Understand reasons for performance gaps

• Identify areas for potential financial recovery

Contract management

• Targeted forensic analysis on selected contracts

• Identification of irregularities, inefficiencies and/or process breakdowns

• Advise on contract management processes and procedure improvements

Re–negotiation

• Provide support in contract re-negotiations

• Achieve more beneficial contract terms

• Help enhance supplier relationships

Exit

• Understand strengths and weaknesses of dispute

• Identify cost and time implications

• Help ensure robust quantum assessment

• Test litigation readiness

Conclusion

Our Fraud Investigation & Dispute Services team consists of professionals with a variety of skills and experience, which enables us to provide you with a responsive solution throughout Australia and New Zealand.

Contact us

Oceania Paul Fontanot Managing PartnerErnst & Young, AustraliaTel: +61 2 8295 [email protected]

With representation in local areas:

Melbourne and Adelaide Roger Darvall-Stevens Partner Ernst & Young, Australia Tel: +61 3 9288 8064 [email protected]

Sydney Rob Locke Partner Ernst & Young, AustraliaTel: +61 2 8295 [email protected]

Perth Brenton Steenkamp Partner Ernst & Young, Australia Tel: +61 8 9429 2244 [email protected]

Canberra Matthew O’Donnell Tel: +61 2 6267 3888matthew.o’[email protected]

Brisbane TJ Koekemoer Tel: +61 7 3011 [email protected]

Auckland (New Zealand) Matthew Hammond Tel: +64 9 308 [email protected]

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Commercial accountability Forensic contract reviews

Ernst & Young

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About Ernst & YoungErnst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 152,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential.

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© 2012 Ernst & Young, Australia. All Rights Reserved. SCORE No. AUNZ00000267

This communication provides general information which is current as at the time of production. The information contained in this communication does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Ernst & Young disclaims all responsibility and liability (including, without limitation, for any direct or indirect or consequential costs, loss or damage or loss of profits) arising from anything done or omitted to be done by any party in reliance, whether wholly or partially, on any of the information. Any party that relies on the information does so at its own risk.

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Forensic contract reviews - EYFILE/...re… · 2 Forensic contract review ... experiences and observations of forensic contract reviews and arrangements that went wrong, ... and audit?