Introduction
Our first article in this series discussed the reasons and benefits of performing project audits. This follow-up article discusses the types of audits and ties back to the first article's specific reasons for each audit.
There are several types of audits: audits performed at project initiation to set labor and equipment rates for ease of billing, interim audits, final audits, claim or request for equitable adjustment (REA) audits, and specialty audits. Each audit type, as well as the main issues it addresses, is discussed below.
Plan Phase
Pre-Construction Audits:
- Rate Audits: Labor, equipment, and overhead rate audits are
conducted to verify the accuracy of costs for establishing
cost-based rates in time and material (T&M), guaranteed maximum
price (GMP), and lump sum contracts, especially for change orders.
- Labor audits check base wages, benefits, and taxes.
- Equipment audits verify ownership, operating costs, and rental rates.
- Overhead audits assess indirect costs like administrative expenses.
For T&M contracts, rates are based on actual costs plus markup; GMP contracts reimburse up to a maximum price; lump sum contracts have a fixed price, with separate pricing for change orders. The aim is to ensure transparency, fairness, and compliance.
- Project Records: There are key documents needed to perform audits. For example, the primary tool of a construction cost audit is the job cost transaction detail report. This report can be referred to by many names (the job cost report, the job cost detail report, the job cost transaction detail report, etc.). Still — regardless of the name — the job cost transaction detail report contains each cost transaction comprising the total project costs. This may be difficult for an owner or general contractor to obtain without the help of an auditor, but without it, the overall financial picture would be incomplete.
- Contract Clause Development: By incorporating these critical
clauses into contracts, organizations can ensure robust support for
various audit activities, promoting transparency, accountability,
and compliance in project execution.
- Right to Audit: This clause grants the client or an appointed auditor the authority to examine and verify the contractor or vendor's financial records and performance data. It ensures transparency and accountability by allowing the client to conduct audits periodically or upon request to confirm compliance with contractual terms and detect any discrepancies or irregularities.
- Project Records: This clause mandates that the contractor or vendor maintain comprehensive and accurate records related to the project, including contracts, invoices, change orders, and correspondence. By ensuring that all relevant documentation is systematically recorded and accessible, this clause facilitates efficient auditing and helps verify that all project activities align with agreed-upon terms and conditions.
- Access to Information: This provision ensures that auditors have unhindered access to all necessary documents, systems, and personnel for a thorough audit. It is critical for verifying compliance with contractual obligations and assessing the accuracy and completeness of project records.
- Retention of Records: This clause specifies the duration for which project records must be retained by the contractor or vendor, typically extending beyond the project's completion. It ensures that relevant documentation remains available for future audits or reviews, supporting long-term accountability and transparency.
- Confidentiality: This clause outlines the obligation of all parties to maintain the confidentiality of sensitive information accessed during an audit. It protects proprietary data and ensures that the audit process does not compromise business interests or competitive advantage.
- Non-Compliance Penalties: This provision details the consequences of failing to comply with audit requirements or rectifying identified issues. It incentivizes adherence to contractual terms and promotes proactive resolution of discrepancies uncovered during audits.
By incorporating these critical clauses into contracts, organizations can ensure robust support for various audit activities, promoting transparency, accountability, and compliance in project execution.
Rate-Setting Audits at Project Initiation
The main issues addressed include: deterrence, transparency, and issue resolution.
As owners venture into different contracting methods, they have begun to require setting certain cost-reimbursable elements at the project's outset. Two common examples are labor and equipment rates.
Setting billable labor rates, labor burden rates, or indirect cost multipliers on labor rates at the outset of projects deters overbilling, provides transparency into reimbursable costs, and resolves the issue of rates for cost-reimbursable and change-order work at the outset of the project rather than during the project, which can be disruptive and lead to inefficiencies.
Auditing indirect cost rates for designers and engineers involves reviewing expenses not directly tied to projects, leading to billing based on actual costs rather than hourly rates. State and federal agencies limit indirect costs tied to base wages and require annual audits to ensure compliance. Profit margins are negotiated separately and are not part of indirect cost calculations, maintaining transparency in cost and profit calculations.
One of the most common labor rate overstatements results from the wage base limit (cap) on payroll taxes. If rates are audited upfront, change orders are more easily negotiated, billings are more easily audited, and the potential for claims and disputes related to labor rates is significantly reduced.
Similarly, setting and auditing equipment rates at the beginning of a project ensures that equipment costs remain transparent and predictable. By establishing these rates upfront, project owners and contractors can avoid disputes over equipment usage and costs during the construction phase. This practice also prevents the potential inflation of equipment rental or operation costs, which can lead to overbilling. Regular auditing of equipment rates can further enhance cost control, making adjustments for any necessary change orders or additional equipment needs easier. Clear equipment rate agreements contribute to smoother project management and financial accountability.
Execute and Protect Phases
Interim Audits/Final Audits:
The main issues addressed include: compliance, risk mitigation, and deterrence.
Interim audits, or audits performed at 30% - 50% project completion, allow for "course correction." Adjustments can be made on a going-forward basis, or costs can be adjusted on a future pay application instead of being "clawed back" at the end of a project. For example, the contractor did not read the contract on one university project and assumed it was a lump sum contract instead of a design-build cost-reimbursable contract. At the end of the project, the university initiated a "final audit" from an outside firm, and the contractor had to return $200,000 to the owner. Had an interim audit been performed before project completion, the remaining pay applications after the interim audit could have been adjusted to avoid the "clawback" situation at the end of the project.
For GMP contracts, it is best if the contractor bills and "substantiates" costs each month, even if the billing is on a percentage completion basis. A project billed on a percentage completion basis with no reconciliation to substantiated costs (costs recorded in the contractor's accounting system) each month, the project billings can be greater than the substantiated (recorded) costs. Performing an audit and requiring a reconciliation of billings to project costs can discourage the contractor from front-loading or billing "ahead" to increase their cash flow on the project.
The content of interim and final project audits is generally similar; however, as previously summarized, the interim audit allows course correction before project completion, whereas there is limited (if any) time after a final audit, which often leads to a dispute. In addition, if both interim audits and a final audit are performed, the final audit will typically contain a section on follow-up or resolution of recommendations during the interim audit. The scope of an interim and/or final audit can include:
- A reconciliation of invoiced/billed amounts to substantiated/recorded costs.
- Comparison of the types of substantiated/recorded costs against contract terms to determine if the substantiated/recorded costs are allowable components of the billable cost of the work or if they should be recovered through a fee.
- Testing of the substantiated/recorded costs against source
documentation, including:
- Sample testing of labor hours against timecards and other source documentation.
- Sample testing of labor costs against contractual labor rates, payroll documentation, union wage/benefit documentation, payroll tax/workers' compensation rate schedules, and other relevant documentation, including sample employer-paid benefits documentation.
- Sample testing of recorded non-labor costs for material, equipment rental, and other invoices.
- Sample testing of recorded subcontractor costs to subcontractor pay applications.
- Analysis of recorded owned equipment and vehicle costs.
- Analyze and test any calculated cost amounts included in the recorded costs.
- Review any billed markups to determine if the markup calculations are accurate, allowable, and consistent with the contract terms. This may include markups for various types of insurance, fees, and any other calculated amounts included in the billings.
- Scheduled risk assessments can also be performed to analyze current construction schedules, key milestones, and critical issues to identify potential delays.
Separate from the above, cost audits may also evaluate the owner's and/or contractor's process for reviewing and approving payments and processing of change orders.
Claim, REA, or Change Order Audits:
The main issues addressed include issue resolution and risk mitigation.
If an owner or contractor receives a change order request, REA, or claim, a cost audit can be performed to ensure that requested amounts align with costs and overruns and contract terms.
Claims should follow the matching principle; their costing should be similar to the original estimate, the job cost report, and the change order request or claim.
A common area for a matching discrepancy relates to contractor or subcontractor-owned equipment.
A specific example focuses on a contractor's methodology for estimating, budgeting, and recording company-owned equipment. In this scenario, the contractor had a set of standard blended owned equipment estimating rates established in the past and used for calculating all the contractor's projects for several years. The contract was a general contractor/construction manager (GC/CM) contract that specified the contractor would be reimbursed on an actual cost basis. However, the agreement did not specify how costs for owned equipment would be determined, nor was there an initial rate-setting agreement at the outset of the project. For recording owned equipment costs for the project, the contractor relied on a separate set of owned equipment rates for a piece of equipment obtained from a third-party rental equipment supplier. By default, the third-party rental equipment rates include components for profit and overhead.
At the end of the project, the contractor made a claim for increased costs due to what the contractor considered to be unforeseen increased scope. A large part of the claimed cost amount is related to company-owned equipment. The bid documents were escrowed, and the owner had access to the estimated initial equipment costs and rates. The owner compared the claimed owned equipment rates, which matched the recorded cost owned equipment rates, to the estimated initially owned equipment rates. The claimed owned equipment rates were higher than the estimated rates. Per the contract, a disputes review board was convened to review the claim. The owner summarized the analysis that resulted in a significant deduction to the claimed owned equipment amount. However, the owner also pointed out that the contractor knowingly claimed owned equipment rates that were not based on actual costs and used the inconsistency as a stronghold to call into question the veracity of the remaining claim cost amounts. Ultimately, the contractor settled for a reduced claim amount. Had the contractor recorded and claimed owned equipment consistent with the contract, basing their equipment on actual costs, they may not have had to accept a lower settlement offer and not have had the veracity of their overall claim and costs called into question.
Consistency in estimating, allocating, and accumulating costs has clear benefits, such as better estimates and proposals, better historical cost and profitability measures, easier audits, change orders, and claim negotiations.
Conclusion
This article explored the various types of capital project audits, illustrating how each serves distinct purposes and addresses specific challenges inherent in project management. Organizations can achieve greater transparency, compliance, and financial accuracy by understanding and implementing these audits, ranging from pre-construction rate setting to interim and final audits, claims, and REA audits. These audits ensure that costs remain aligned with contractual obligations and facilitate proactive issue resolution and risk mitigation, ultimately enhancing project outcomes. As we transition to our next article, we will explore the transformative role of artificial intelligence (AI) in capital project audits, highlighting how technology can further streamline processes and enhance audit effectiveness through real-world case studies.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
