Construction Auditing Risks and Capital Project Recovery Strategies for 2014 and Beyond

1. Construction Auditing Risks and Capital Project Recovery Strategies for 2014 and Beyond Presented by: Matt R. Gardner, CCA, CICA Practice Leader – Construction Audit Services

2. Agenda • Outcomes of this presentation • What is a Construction Audit? • Construction statistics • Why is it important to internal auditors? • Variations of Construction Audits • 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 $1million but oftentimes $1million 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

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8. Don’t forget: You can copy-paste this slide into other presentations, and move or resize the poll.

9. Construction Statistics • During the second quarter of 2013, the U.S. economy has expanded 1.7% • However, non-residential construction has not • 1% decline in June 2013 • $545 billion in construction costs – June 2013 • Down from $551 in May 2013 Source: Marcum Commercial Construction Index

10. Construction Statistics The ups…. • Power segments up 3.6% • Communication up 2.5% • Health care up 1% • Amusement/recreation up .4% And the downs…. • Conservation and development down 9.4% • Religious down 6.8% • Water Supply down 5.5% • Sewage and Waste down 5.3%

11. Construction Statistics The forecast? • Non-residential and residential construction are moving in opposite directions. • Over a 12-month period, non-residential slumped down 4% while residential rose 17.6%. • Pipeline of projects in various stages is very dense • Time will tell • Industry is the first the fall and last to recover

12. Why is it Important to Internal Auditors? What does it mean to us and why are these audits necessary? • Billions spent on capital expenditures each year • Lack of project management resources and sound processes/procedures • Improve internal controls around project management function • Project management may not have sufficient independence to aggressively prevent all unreimburseable costs

13. Why is it Important to Internal Auditors? What does it mean to us and why are these audits necessary? • Risks to your organization can be significant • Loss of capital funds • Fraud • Impact to operations • Impact to strategic objectives • Lack of management/committee trust for future expenditures • Litigation

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15. 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

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17. 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!

18. 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

19. 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

20. 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 $56million to settle charges of over billing clients

21. Variations of Construction Audit • Contract review • Job walks • Limited scope/full scope • Only audit select change orders or pay applications • Audit from bidding to project close out • Based on contract type (GMP, lump sum, etc.) • Cost segregation studies – hidden tax savings

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

23. 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 Risk of elimination of scope or use of low quality materials to stay within budget Change orders should be scrutinized

24. Time and Material Owner pays for actual cost of work (labor, material, equipment cost, etc.) plus a markup Markup is a set percentage Owner must establish labor rates, material costs, and equipment rates prior to contract No incentive for GC to reduce costs Risk of low productivity by GC More supervision required by owner Job cost ledger must be audited CONTRACT TYPES

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

26. Guaranteed Maximum Price (GMP) GC is reimbursed for specified allowable costs plus a fixed fee GC guarantees the project will be built within a predetermined amount / assumes risk for cost overruns Savings can be shared with the GC as incentive Job cost ledger must be audited CONTRACT TYPES

27. 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

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29. What project(s) should be selected for an audit? • Size (Contract Value) • High Profile/High Risk • Fast-Track Schedule • Complex Contract Terms • Type of Contract • Experience of Owner Representative • Experience of internal Project Management Team • Experience of General Contractor

30. 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

31. Getting started: Who are the players? • Who, what, when, where, how, and why • 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

32. 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

33. 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 …

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

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. Exercise # 1 See handouts

48. Exercise #2 You have been asked to review equipment rental charges submitted by the General Contractor (GC) to ensure they are in line with regional market rates Contract states the GC will pass along 100% of the AED Green Book costs to the owner You select a few charges to determine accuracy and compliance with contract

49. Charges per pay applications

50. 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.