Internal Controls Save Time and Money

In the past five years, the construction industry has experienced a shift in the way construction contracts are managed.

First, a movement emerged where building owners favored cost-reimbursable contracts as opposed to the more traditional firm, fixed-price or stipulated sum projects. Second, adhering to the Sarbanes-Oxley (SOX) Act of 2002 has required building owners to conduct audits of construction spending, leading to a sharp increase in construction audits. With the increased level of accountability in the building owner’s camp, contractors have been forced to undergo their own process improvements.

Construction audit specialists can help building owners in every stage of the construction process, from negotiating a favorable contract; identifying critical tasks for the project management team; and identifying and managing risks; to developing and maintaining financial controls; identifying overcharges and undercharges; and helping building owners avoid conflict and litigation.

At close-out, Jefferson Wells, a professional services firm, typically identifies 1 percent to 2 percent of project costs as overcharges. During the planning stage, the value-add of a construction audit specialist can be five to ten times that of close-out. Although there are instances of fraud and waste, many overcharges uncovered by construction audits are due to a lack of financial and management controls.

A Common Scenario

After completing the construction of two fixed-price parking garages built by the same contractor, a private university with more than 20,000 students was charged more than they had expected. University administrators decided to audit the twelve change orders it received from the contractor.

This is what the audit uncovered:

• The general contractor charged more per hour than the approved union labor rate, along with an unapproved 15 percent fee on overtime
• Overcharges of $7,800 for concrete already included in the base bid and $11,500 for concrete and rebar price escalations, despite the fact that the contracts were for a lump sum
• An additional $23,300 in fees on general conditions that already included markups for overhead and profit.

In total, the construction audit found more than $50,000 in unauthorized charges by the general contractor.

If the university had not noticed or recovered the $50,000 in unauthorized charges, it could have been held liable for the misuse of university revenue and endowment dollars. Even if this were a legitimate oversight, the contractor could have been accused of fraudulent charges.

Jefferson Wells found that approximately one-third of potential overbilling pertains to the contractor invoicing the building owner in excess of the actual costs incurred. A contractor can put several controls into place to ensure internal adherence to the contract agreement and that the audit is an efficient and effective process.

Settle Allowable and Unallowable Costs Prior to Groundbreaking

Building owners typically refer to the American Institute of Architects (AIA) for agreements when entering into construction contracts. The AIA agreements identify considerations for a contract agreement, including the parameters for allowable and unallowable costs. Generally, costs incurred at the project construction site are allowable, while any costs incurred at the contractor’s office are unallowable and included in the construction fee.

After discussing what costs would be considered allowable and unallowable during negotiations with the building owner, contractors should clarify in the contract agreement any costs that will be billed to the building owner. For example, if the contractor plans to invoice for accounting and data processing services, and there is a possibility that the services may be provided from a location other than the project site, the agreement should be modified to ensure that it identifies these costs as allowable costs for the project.

The contractor may incur some costs that are not identified in the contract as allowable or unallowable. In this case, either the contract should be modified or there should be other supporting documentation, such as correspondence, where the parties to the contract agree that the costs are allowable. An example of such costs would be bonuses. AIA agreements do not address bonuses as allowable or unallowable costs. Therefore, if the contractor wants to be reimbursed for such costs, the agreement should clarify that point.

Establish Processes for Payment Application

The AIA agreements allow the contractor to invoice for costs and materials stored to date. However, it is generally restricted in that the amount to be invoiced will be the lesser of costs incurred and percent complete. During an audit, the auditor will need to obtain the job cost report to reconcile the job cost to the amount invoiced.

The contractor should have a process in place to ensure compliance with the payment provisions of the agreement, including being able to account for and identify allowable and unallowable costs. To accomplish this objective, a contractor can establish separate accounts or subaccounts for unallowable costs. Then, when the payment application is prepared, it can be based upon the current allowable costs included in the job cost system. After the contractor has identified and separately accounted for unallowable costs, he or she can invoice for the allowable costs incurred.

Operating systems provide the contractor resources to submit real-time and accurate invoices to the building owner. Operating systems can be programmed to tag costs by using a double-entry method. Under this method, allowable costs are incurred and then tagged and recorded into an “unbilled revenue” account. The system can then generate invoices by reversing the costs in the unbilled revenue account and post the costs to revenue.

The alternative is to prepare the invoice manually. Under this method, the job cost report should be generated to reflect the costs incurred to date. The total cost incurred to date would be reflected in the invoice and would be reduced by the previous amount invoiced to derive the current amount due for the period.

Regardless of which method is used, monthly reconciliations should be performed to check the costs incurred against the amount invoiced. This reduces the risk of the contractor having to write off unbilled costs at the end of the project.

Segregate Firm Fixed-Price and Cost-Reimbursable Contracts

Some contracts may have certain tasks that are both firm fixed price and cost-reimbursable. The best example of this is Construction Manager at Risk type contracts.

Construction Manager at Risk agreements may provide for the contractor to participate in the preconstruction phase of the process. The contractor is normally compensated in the form of a firm fixed price to participate in the phase of the process. Once construction begins, the contractor is under a cost-reimbursable type contract. Therefore, the contractor will be incurring costs under two different forms of payment: firm fixed price for preconstruction and cost-reimbursable for actual construction.

The contractor must segregate the cost between the firm, fixed-price portion of the agreement versus the cost-reimbursable portion. The most efficient way to accomplish this is to establish separate projects or subprojects within the accounting system. This process will help prevent billing costs associated with the firm fixed-price phase as a cost-reimbursable expense.

Implement Processes for Subcontractors

Major subcontractors can participate in the preconstruction phase of Construction Manager at Risk projects and then enter into a cost-reimbursable contract with the contractor. Subcontractors typically provide services under firm fixed-price contracts, therefore they may not be familiar with the requirements of cost-reimbursable contracts.

As noted above, for cost-reimbursable subcontracts, the subcontractors should invoice the contractor for actual cost incurred. The contractor should require the subcontractor to provide a reconciliation document between the costs incurred and the amount billed with each invoice.

For firm fixed-price contracts, the contractor should require the subcontractor to attach the appropriate lien releases with his or her payment application. The lien releases can be included with the invoice to the owner to validate that the subcontractor was compensated in accordance with the terms of the contract.

Operational Efficiencies Benefit All Parties

There are many processes and controls that construction business owners can implement to assist in meeting the objectives of the building owner, whether or not an audit is performed. During the contract negotiations, the contractor should address potential objectives even if the building owner does not bring them to the forefront, such as the nature and extent of supporting documentation that should be included with the payment application.

Enhanced financial and management controls optimize any business operation. Once controls are established, a contractor might want to encourage an audit when the project is approximately 30 percent complete. A review of costs incurred and contract compliance may identify issues on either side of the agreement that can be mitigated before they become a larger problem.
 

Construction Business Owner, November 2008