Construction Auditing Risk and Cost Segregation Strategies for 2013 and Beyond IIA Atlanta Chapter Atlanta, GA June 14

1. Construction Auditing Risk and Cost Segregation Strategies for 2013 and Beyond IIA Atlanta Chapter Atlanta, GA June 14, 2013

2. Agenda • Outcomes of this presentation • What is a Construction Audit? • Why is it important to internal auditors? • Variations of Construction Audits • What is a Cost Segregation Study? • Types of construction contracts and associated risks to your organization • What to look for during an audit • High-risk areas and common issues • Examples and case studies

3. Outcomes of this Presentation • What a Construction Audit is and the variations of a Construction Audit • Why a Construction Audit is important to your organization • Determination if a construction project at your organization is a candidate for an audit • The various scopes of a construction review • Key high-risk areas to audit during a review

4. What 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 recoveries

5. What 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

6. Therefore, a Construction Audit… • Is not just a cost recovery review but cost prevention • Should involve auditors prior to contract execution • Should act as intermediary between owner and General Contractor (GC) • Should assist with disputes and litigation

7. Why 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 year • Our job is to provide independent and objective assurance that company money is handled appropriately • Lack of resources and sound processes/procedures by project management team to adequately safeguard assets • Improve internal controls around the owner project management function

8. 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, CIA • Typical recoveries are 1 to 3% of total project cost

9. Common rebuttal: “We hire a construction management firm to monitor and manage the project.” • Risk still exists even with outsourcing the project management function • May not have the owner’s best interest in mind • Possible collusion between GC and CM • Priorities such as schedule could take precedence over cost • Scope and contract changes between GC and PM could occur without proper oversight • Owner and/or auditors still need to stay involved throughout the process!

10. 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 appropriate Was the original budget a sound figure? Sound bidding and budget policies and procedures are needed Aggressive GC savings established Incentive to come in under budget Scope completed as planned Scopes of work eliminated to maintain budget Substitution of materials Utilize materials of lesser value and quality to limit cost

11. Common rebuttal: “GCs that work on our jobs have never been convicted of fraud.” Generally overcharges or unallowable costs are not due to fraudulent activity Regardless of contract – “This is how it has always been done.” Lack of resources by owner and/or GC Lack of communication between owner and GC/architect Excessive change orders/scope changes Mathematical errors Abundance of paperwork

12. 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 scheme • Undercut competition to get a job, then padded the books with change orders – often with the client’s knowledge • Submitted falsified invoices to clients for labor when contractors were on vacation or sick • Occurred over a decade’s time! • Agreed to pay $56M to settle charges of over billing clients

13. Variations of Construction Audit • Contract review • Job walks • Limited scope/full scope • Only audit select Change Orders (CO) or pay applications • Audit from bidding to project close out • Based on contract type (GMP, lump sum, etc.) • Cost segregation studies – hidden tax savings …let’s dig in

14. Cost Segregation • What 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?

15. What is a Cost Segregation Study? • Comprehensive analysis of hidden personal or tangible property for commercial buildings. • Analyze cost data including the contractor’s 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.

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

17. Potential benefits of reclassification

18. Also common for: • Amusement parks • Apartment complexes • Auto dealerships • Banks • Casinos • Distribution centers • Franchises • Medical centers • Shopping malls • Sports stadiums

19. What does a cost segregation study apply to? • New commercial buildings under construction • Existing commercial buildings undergoing renovation or expansion • Office leasehold improvements and “fit-outs” • Purchases of existing commercial properties. All post-1986 real estate construction, building acquisitions or improvements → Building should be worth $500,000 or more ←

20. Benefits of a Cost Segregation Study Increased 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)

21. How is a Cost Segregation Study Performed? Various approach types: • Detailed Engineering approach • Actual cost records (new construction) • Cost estimate approach (purchase) • Survey or letter approach • Residual estimation approach • Sampling method approach • “Rule of Thumb” approach

22. How is a Cost Segregation Study Performed? 10 elements of a quality cost segregation study: Prepared by an individual with expertise & experience Detailed description of the methodology Use of appropriate documentation Interviews conducted with appropriate parties Use of common nomenclature Explanation of legal analysis Explanation of treatment of overhead costs Consideration of related aspects (other deductions) Identification of 1245 property Reconciliation of total allocated costs

23. Contract Types What are the types of contracts and the associated risks: • Lump Sum • Time and Material • Cost Plus • Guaranteed Maximum Price

24. CONTRACT TYPES Lump Sum One price which includes fee, cost of work, and general conditions Assigns majority of the risk to the contractor Potentially higher markup by GC to take care of unforeseen contingencies Elimination of scope or low quality materials to stay within budget Change orders should be scrutinized

25. Time and Material Owner pays for actual cost of work (labor, material, equipment cost, etc.) plus a markup Markup is generally a set percentage No incentive for GC to reduce costs Low productivity by GC Owner must establish labor rates, material costs, and equipment rates prior to contract Owner requires additional supervision CONTRACT TYPES

26. Cost Plus GC is reimbursed for specified allowable costs plus a fixed fee No incentive by GC to reduce cost Owner assumes risk for cost overruns More supervision required by owner Low productivity by GC CONTRACT TYPES

27. Guaranteed Maximum Price (GMP) GC guarantees the project will be built within a predetermined amount GC is reimbursed for actual cost plus a fixed fee Savings are generally shared with the GC GC may not use best personnel on job Must audit job cost ledger CONTRACT TYPES

28. CONTRACT TYPES Guaranteed Maximum Price (GMP) • Example savings model (50/50 split)GMP amount of $10,500,000 Cost of work: $10,000,000 Savings (50% of $500K): $250K Amount due to GC: $10,250,000

29. What 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 contract • Identify contradictory language • Lack of specific provisions (insurance, audit clause, etc.) • Clarification on allowable and unallowable costs • Penalties in place for nonconformance with contract • Include requirements for a detailed breakdown of construction cost for cost segregation studies once work is complete

30. Getting started: Who are the players? • Owner’s project management team or third-party construction manager • General contractor and subcontractors • Architect • Utilize a questionnaire to get a perspective • Who, what, when, where, how, and why

31. Process and procedure control review • Competitive bidding • Capital approvals/expenditures • Compliance with policy and procedures • Payment applications • Change order process • Estimating and scheduling • Financial review • Reporting system - internal • Financial reports • Reports agree with actual costs incurred • Payment application processing • Change order costs

32. High-Risk Areas and Common Issues • Auditing 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 organization’s performance. Of course this list is not the beginning or the end …

33. High-Risk Areas and Common Issues • Change orders • General conditions (allowable vs. unallowable cost) • Material costs • Equipment rental costs • Labor and labor burden • Subcontractor payments • Bid process • Subcontractor contracts

34. High-Risk Areas and Common Issues

35. High-Risk Areas and Common Issues

36. High-Risk Areas and Common Issues

37. High-Risk Areas and Common Issues

38. High-Risk Areas and Common Issues

39. High-Risk Areas and Common Issues

40. High-Risk Areas and Common Issues

41. Case Study #1

42. Case Study #1

43. Case Study #1

44. Case Study #1

45. Case Study #1

46. Case Study #1

47. Summary • Procurement 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.

48. Thank you! Questions? Ryan J. Hauber, MBA, CFE, CCA, CCP Partner – Construction Audit Services Honkamp Krueger & Co., P.C. | 888-556-0123 rhauber@honkamp.com| www.honkamp.com Matt R. Gardner, CCA, CICA Practice Leader – Construction Audit Services Honkamp Krueger & Co., P.C. | 888-556-0123 mgardner@honkamp.com | www.honkamp.com Adam R. Reisch, CPA, CFP®, CCA, CGMA Partner – Cost Segregation Services Honkamp Krueger & Co., P.C. | 888-556-0123 areisch@honkamp.com | www.honkamp.com