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 biddingCapital approvals/expendituresCompliance with policy and proceduresPayment applicationsChange order processEstimating and scheduling

Financial reviewReporting system - internalFinancial reports Reports agree with actual costs incurredPayment application processingChange order costs

High-Risk Areas and Common IssuesAuditing internal procedures, bid processes, change orders and pay applications are not the beginning and the end. There are several key risk areas that lend themselves to unnecessary costs that effect your organizations performance.

Of course this list is not the beginning or the end High-Risk Areas and Common IssuesChange ordersGeneral conditions (allowable vs. unallowable cost)Material costsEquipment rental costsLabor and labor burdenSubcontractor paymentsBid processSubcontractor contractsHigh-Risk Areas and Common IssuesChange OrdersHigh riskOwners contract must include detailed requirements for estimating/pricing and the ultimate billings of costsStrong procedures and processes must be in placeMarkup percentages vary by level of contractor Adequate support often not providedReview of labor rates, if not agreed upon in advance, is time consumingHigh-Risk Areas and Common IssuesGeneralConditionsHigh riskOwners contract must include detailed requirements on what is considered allowable and unallowableToo many supervisors on siteExcessive entertainment and travelSales tax on exempt projectsRebates or cash discounts not passed to ownerExcessive relocation, moving, transportation, and communication costsHigh-Risk Areas and Common IssuesMaterialCostsHigh riskOwners contract and plans must include detail requirements as to what material is requested and to be used during the construction processMaterials charged from another jobExcessive order of materialsExcessive material storage chargesCredits not received for returned materialsHigh-Risk Areas and Common IssuesEquipment& RentalCostsHigh riskOwners contract and plans must include detailed requirements as to what equipment is expected to be used on the jobContract should indicate what equipment is anticipated to be rented through the GCContract needs to specify what is allowedUse industry benchmark dataCharges in excess of total value- AED Green Book for example

High-Risk Areas and Common IssuesLabor & LaborBurdenLabor burden percent used is often incorrectLabor burden often includes non-reimbursable items:- Bonuses- Parties- EducationUnemployment tax still charged after maximum reachedEase on owner and auditors if rates, including labor burden, are agreed upon for all crafts before work startsIf not, contracts must define what is allowable in labor burden build upsHigh-Risk Areas and Common IssuesSubcontractorPaymentsBack charges not passed throughMarkups calculated incorrectly Duplicate COsErrors in payment applicationBidProcessNeed sound internal policies, procedures, and processesAdequate bid scheduleGeneral Contractor/Project Managers competing for packages of workDesign documents completedHigh-Risk Areas and Common IssuesSubcontractor ContractsCritical for contracts with a Guaranteed Maximum Price (GMP)Variances (under-runs) accrue to the ownerRisks

Buyouts are not reviewed/managed by owner The GC transfers the variance to its self-performed budgeted line items

Case Study #1Case Study #1Background and business objectiveThe project, a new retail facility completed for $9M, was 100% complete when the client requested audit assistance.

The construction agreement was for a Guaranteed Maximum Price. The audit scope included analysis of the construction contract and an evaluation of the contractor's billing to determine compliance.

The owner also requested recommendations for best practices and/or procedural improvements that could be incorporated into the owner's project management process.

Case Study #1Case Study #1Approach and solutionThe first objective of the audit was to review documentation of costs incurred and paid for by the owner in completion of the project to determine if the requests for reimbursement were in alignment with the applicable contracts.

The scope of the audit included all costs invoiced by the general contractor including subcontractor costs, in addition to direct costs paid for by the owner.

The second objective of the audit was to obtain an understanding of the control environment surrounding this particular project to determine if any control deficiencies were noted.

Case Study #1Case Study #1Outcomes and results achievedPotential overcharges totaling $250,000 (2.8% of the contract value) was identified due to inaccurate labor burden billing rates. The general contractor billed labor billed ups (FUTA, SUTA, workers compensation, insurance, etc.) at full regulatory rates rather than the actual rates incurred and to be billed per contract requirements. This was identified by viewing actual detailed labor records provided by the General Contractor.

Provided the owner with over 10 process and procedural improvements to easily identify and prevent these costs from being passed through during the course of projects going forward.

Case Study #1Case Study #2Background and business objectiveThe project, a new outpatient facility completed for $42M, was approximately 50% complete when the client requested audit assistance.

The construction agreement was for a Guaranteed Maximum Price.

The audit scope included analysis of the construction contract and an evaluation of the contractor's billing, specifically equipment rental rates and general contractor markups, to determine compliance.

Client PM identified what he thought were excessive equipment rates on job cost report.

Case Study #1Case Study #2Approach and solutionThe objective of the audit was to review documentation of costs incurred and paid for by the owner in completion of the project to determine if the requests for reimbursement were in alignment with the applicable contracts.

Specifically, a full detailed review of equipment rental rates and markup percentages on change orders was performed.

Approximately $8M was added via change orders for the project. The scope of the audit included all costs invoiced by the general contractor including sub-contractor costs, in addition to direct costs paid for by the owner.

Case Study #1Case Study #2Outcomes and results achievedPotential overcharges totaling $100,000 were identified due to: General contractor owned rental equipment billed in excess of the fair market value. Overhead and profit were calculated by applying 5% overhead before applying 10% profit by general contractors and subcontractors resulting in a tiered profit margin.

These overcharges were identified by reviewing general contractor rental equipment charges applied to the job and comparing their fair value to the charges applied to the job.

Approximately 90% of the tools/equipment charged to the job were billed in excess of the fair market value. The tiered markup was identified by recalculating markups applied by the general contractor and subcontractors on change orders

SummaryProcurement of capital construction assets involves high risk activities and complicated execution processes.Construction Audits and Cost Segregation Studies are not an expense they are necessary for sound, effective cost management that reduces total project costs.Construction Audits are an essential internal control process to maximize capital program effectiveness.Auditor involvement in the beginning provides a tone of oversight and often results in limited cost overruns or overcharges/billing errors.Thank you!Questions?

Ryan J. Hauber, MBA, CFE, CCA, CCPPartner Construction Audit ServicesHonkamp Krueger & Co., P.C. | 888-556-0123rhauber@honkamp.com | www.honkamp.com

Matt R. Gardner, CCA, CICA Practice Leader Construction Audit ServicesHonkamp Krueger & Co., P.C. | 888-556-0123mgardner@honkamp.com | www.honkamp.com

Adam R. Reisch, CPA, CFP , CCA, CGMAPartner Cost Segregation ServicesHonkamp Krueger & Co., P.C. | 888-556-0123areisch@honkamp.com | www.honkamp.com