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. –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 Therefore, a Construction Audit…

7. Does your organization currently conduct construction audits/cost recovery reviews? 1.Yes 2.No 3.No, but it in the audit plan for the future

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9. Do you have to be licensed to do a construction audit? 1.Yes 2.No

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11. 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 Construction Statistics

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

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

14. 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

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

16. Who is responsible for ensuring the accuracy of construction costs? 1.N/A 2.Project management 3.Owners rep 4.IA 5.No one 6.Do not know 7.3 rd party service provider

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18. 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

19. Compared to actual construction costs, what is the average recovery percentage you have identified and recovered on your audits? 1.Less than 1% 2.2% 3.3% 4.More than 3%

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21. 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 owners 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!

22. 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

23. 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

24. 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 clients knowledge – Submitted falsified invoices to clients for labor when contractors were on vacation or sick – Occurred over a decades time! – Agreed to pay $56million to settle charges of over billing clients

25. 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

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

27. 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

28. 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

29. 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

30. 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

31. 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 CONTRACT TYPES

32. 1.Scheduled times during the construction process (interim and closeout) 2.Periodically throughout the construction process (change orders/pay applications) 3.Closeout before final payment is made 4.After project is completed Typically, for the audits you have performed or have performed in the past, how are they audits structured?

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34. 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

35. 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

36. Getting started: Who are the players? –Who, what, when, where, how, and why –Owners 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

37. 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

38. 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 organizations performance. Of course this list is not the beginning or the end …

39. 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

40. High-Risk Areas and Common Issues Change Orders High risk Owners contract must include detailed requirements for estimating/pricing and the ultimate billings of costs Strong procedures and processes must be in place Markup percentages vary by level of contractor Adequate support often not provided Review of labor rates, if not agreed upon in advance, is time consuming

41. High-Risk Areas and Common Issues General Conditions High risk Owners contract must include detailed requirements on what is considered allowable and unallowable Too many supervisors on site Excessive entertainment and travel Sales tax on exempt projects Rebates or cash discounts not passed to owner Excessive relocation, moving, transportation, and communication costs

42. High-Risk Areas and Common Issues Equipment & Rental Costs High risk Owners contract and plans must include detailed requirements as to what equipment is expected to be used on the job Contract should indicate what equipment is anticipated to be rented through the GC Contract needs to specify what is allowed Use industry benchmark data Charges in excess of total value - AED Green Book for example

43. High-Risk Areas and Common Issues Labor & Labor Burden Labor burden percent used is often incorrect Labor burden often includes non-reimbursable items: - Bonuses - Parties - Education Unemployment tax still charged after maximum reached Ease on owner and auditors if rates, including labor burden, are agreed upon for all crafts before work starts If not, contracts must define what is allowable in labor burden build ups

44. High-Risk Areas and Common Issues Subcontractor Payments Back charges not passed through Markups calculated incorrectly Duplicate COs Errors in payment application Bid Process Need sound internal policies, procedures, and processes Adequate bid schedule General Contractor/Project Managers competing for packages of work Design documents completed

45. High-Risk Areas and Common Issues Subcontractor Contracts Critical for contracts with a Guaranteed Maximum Price (GMP) Variances (under-runs) accrue to the owner Risks Buyouts are not reviewed/managed by owner The GC transfers the variance to its self-performed budgeted line items

46. Case Study #1 Background and business objective The project, a new retail facility completed for $9 million, 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.

47. Case Study #1 Approach and solution The 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.

48. Case Study #1 Outcomes and results achieved Potential 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.

49. Case Study #1 Case Study #2 Background and business objective The project, a new outpatient facility completed for $42 million, 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.

50. Case Study #1 Case Study #2 Approach and solution The 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 $8 million 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.

51. Case Study #1 Case Study #2 Outcomes and results achieved Potential 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

52. Exercise # 1 See handouts

53. Exercise #2 1.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 2.Contract states the GC will pass along 100% of the AED Green Book costs to the owner 3.You select a few charges to determine accuracy and compliance with contract

54. EquipmentTime usedAmount charged Telescopic Boom Self-propelled 51-60ft 3 wks, 1 day$3,390 Crane-Hydraulic 35-39.9 ton 3 days$1,533 Fork lift 2k-3k lbs. 5 days$600 EquipmentMonthly $Weekly $ Daily $ Telescopic Boom Self-propelled 51-60ft $2,847$1,019$333 Crane-Hydraulic 35-39.9 ton $4,600$1,533$511 Fork lift 2k-3k lbs. $1,124$369$120 Charges per pay applications

55. 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.

56. Does your organization currently have projects $5 million occurring? 1.Yes 2.No

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58. Thank you! Questions? Matt R. Gardner, CCA, CICA Practice Leader – Construction Audit Services Honkamp Krueger & Co., P.C. | 888-556-0123 mgardner@honkamp.com | www.honkamp.comwww.honkamp.com