The importance of internal controls during a construction project

Using Construction Audit and Review Techniques to

Evaluate and Mitigate Project Risk for Energy Infrastructure

Baker Tilly 1 March 2013

 Executive Summary

The need for infrastructure improvements in the energy industry continues to be a challenge for energy
providers. Whether or not a utility has an internal audit group, the use of construction audit and review
techniques is critical in mitigating enterprise risk for large construction projects. Efforts in assembling a
construction compliance review team, no matter its size, may yield some project cost savings. When a
utility undertakes a construction project for power supply, buildings, or large transmission or distribution
projects, they should consider review techniques to ensure effective spend and allocation of resources
has been made. Establishing a robust internal control process over the construction segment can yield
risk mitigation and positive results no matter the size or spend of construction activities.

In order to create a collaborative environment between the internal audit or compliance professionals for
a review of construction activities, it is necessary to build construction chops, i.e. to demonstrate a
working knowledge of the construction process. It is imperative that internal teams are able to speak the
language of contractors. Without this knowledge, the team will be unable to ask probing questions of
senior leaders, construction project managers and personnel to determine proper application of controls
or areas for further review.

The following information provides details around the approach and steps taken to proactively use
construction audit reviews to evaluate and mitigate risks with projects. This process allows not only for
mitigated risks, it provides a high level of value along each step. These value added insights allow for
direct savings that can more than cover the cost of the audit.

Determining an effective approach

In order to best utilize a construction review, consider the deployment of the efforts.

 Will the team be involved from the beginning of a construction project?

 Will the construction review be made an integral part of the construction activities?
 Will the review be part of the project close prior to final payments or release of retainages?

Each approach will provide value, however having construction compliance professionals involved from
project initiation will instill a spirit of “trust but verify” to the overall project and may lead to more compliant
behavior by contractors

Baker Tilly 2 March 2013

Risk Assessment
Risk assessmentand
andCreating a Collaborative
creating Environment
a collaborative environment

The first step in the process is to perform a risk assessment of the common risk areas in a construction
project and ensure that high level risks are mitigated. Common areas to consider are

1. Contract term definitions are understood by all parties

2. Record accessibility to review compliance
3. Costs charged are within the scope of the construction contract
4. The contractor has the financial strength to pay subcontractors and finance its construction
financial and operational requirements
5. What has been promised in the contract is delivered

Some questions to ask in the project planning phase to help mitigate risks:

1. Are key terms (e.g. substantial completion) defined?

2. Have allowable and non-allowable costs been specified?
3. Does the contract have provisions for review of supporting documentation such as subcontractor
invoices, time records, payroll burden calculations, etc. and other record access?
4. Are delivery timelines specific?
5. Are contract pay rate schedules and fee calculation formulas detailed and unambiguous?
6. How does the financial stress test of the prime contractor look?

Time should be budgeted by the compliance project team to participate in ongoing construction
operational meetings. Expectations should be set of how the compliance team will provide feedback to
your organization’s construction project manager and the contractor and agreed upon protocols should be
established.

Audit the First Pay Application

Audit the first pay application

In Baker Tilly’s work in this area, one effective practice we have found is for the compliance team to audit
the first pay application to:

1. Verify arithmetic
2. Review supporting documentation for labor and equipment and compare to amounts billed on the
pay request
3. Confirm pay rates and burden calculations
4. Measure labor efficiency

This activity, while it is basic auditing, does serve to put the prime contractor on notice that areas will be
reviewed and the contractor’s documentation needs to support amounts requested, thus setting the stage
for future pay request documentation.

Baker Tilly 3 March 2013

Where
Whereare
arethe
theKey
keyInternal
internalControls
controlsin in
thethe
Process?
process?

Any major construction project involves the dance of four main participants:

 Owner’s Rep or your organization’s project manager,

 Internal controls
 Architect or project designers
 Construction Manager.

The common roles and responsibilities of each are shown in the following chart:

Baker Tilly 4 March 2013

While duties by position vary throughout the project depending on the project activities, the internal
control review function permeates almost each step of the process. All of the controls on the chart above
are designed to mitigate or address a key project construction risk. This process of continuous monitoring
is the most involved and will yield the highest level of results, providing the most comfort that project risk
is being analyzed, documented, tested and reported on to management.

Providing
ProvidingValue
valueThrough
at eachEach
stepStep
of the project

The following table shows the value added outputs from properly utilizing a compliance team.

Project Step Value Added Activities by the Compliance Team

1. Contractor selection and due diligence  Establish contractor technical qualifications
 Assist in assembly of bid package
 Analyze contractor financial qualifications
2. Contracting  Assisting in analyzing contractor terms and
performing a contract risk assessment
 Documenting and evaluating effectiveness
of change order process
 Evaluating documentation to be received
under right to audit clauses
 Analyzing basis for proposed labor and
overhead burden rates
3. Construction phase  Monitoring performance under right to audit
contract clauses
4. Developing a construction audit program  Develop a construction audit budget that
addresses these potential key risks
o Overcharging for labor and
materials
o Over priced change orders
o Charges for rework
o Overcharges for labor burdens and
equipment
o Lost incentives and credits
o Failure to deliver contracted scope
o Charges for non-allowable costs
5. Closeout audit  Develop construction audit program to
analyze final project costs prior to release
of final project retainages
6. Negotiation support  Utilize documentation and testing to
support settlement negotiations

Baker Tilly 5 March 2013

ExpectedSavings
Expected savings from
from thethe audit
Audit process
Process

The industry rule of thumb is to budget audit hours of 0.001% times the construction project cost, i.e. a
$50 million project should have 500 audit hours.

The cost of the construction audit is a capitalizable project cost just like project management, engineering
services and construction materials. There are various funding options available to pay for the
construction audit, these can include:

 Capitalize the cost with other construction costs

 Charge back the costs to facilities management
 Include as part of the annual internal audit budget

Based on Baker Tilly’s experience in construction audits, an organization can expect findings and cost
savings in excess of 1% of the construction budget. This means a $50 million project should identify
$500,000 or more in findings. This assumes a well-managed project with good project controls.

Results that
Results that Matter
matter

Utilizing a compliance team as part of the construction audit process will provide greater assurance,
comfort and risk mitigation over large construction projects. In the continuum scale, greater use of
construction audit techniques will provide greater assurance that the cost side of the equation has
stronger controls and those controls are being utilized for your benefit.

Whether your organization makes use of internal audit resources, assembles a group of individuals from
within the organization, or outsources these services to an internal audit consultant, you should expect
positive results.

Baker Tilly 6 March 2013

Contributing Authors
For more information, please connect with us:

Russ Hissom, CPA, Partner Tony Ollmann, CPA, CCA, Director

russ.hissom@bakertilly.com tony.ollmann@bakertilly.com

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Baker Tilly 7 March 2013