BY JEFF WITT, CPA
PEDER JENSEN, MANAGER
MOSS ADAMS LLP
A construction cost audit can turn a project sideways if you aren’t prepared.
There are many different compliance issues that arise during the contract audit process. However, almost all of these can be boiled down to four root causes:
- Contract. It all begins here. We have seen how a lack of specificity in contract language or lack of understanding concerning the meaning of contract language can spell trouble later.
- Unallowable costs. Set up billing processes and controls to consistently identify and exclude these from billings.
- Documentation. We cannot emphasize enough how important it is to maintain documentation to support allowability and contract compliance.
- Change orders. Make sure you have good controls for change order request preparation, which also has everything to do with documentation.
These issues could be avoided altogether or handled more efficiently with the right approach. We have some practical steps that contractors can implement to alleviate audit issues, enabling a project to run smoothly with fewer disputes.
Here is a closer look at the four root causes of compliance issues.
UNDERSTAND YOUR CONTRACT
This might sound simple enough, but a lot of issues come into play because contractors don’t make sure the contract reflects the correct intent with regards to cost allowability. In other cases, there are instances when contractors don’t understand the contract as written, and believe that verbal discussions or other noncontractual methods of defining allowability will allow them to prevail when the costs are questioned.
It’s important to understand that contract auditors must apply the contractual language when conducting an audit, notwithstanding contractor perceptions of the intent of the wording. Contractors need to push back and get things clarified before they sign the contract.
Make sure that everything in your contract is clear, which goes beyond carefully reading it. Look at the expectations of your contractual agreement. As a contractor, you want to have full clarity regarding cost allowability. Eliminate the possibility of those gray areas being open to interpretation. Often, the owner is OK with the billable item. Account for it in the contract to ensure you get compensated for it.
It’s important to be very specific with your expectations. Here are some questions that you must answer when it comes to the following areas, which often lack sufficient clarification in the contract:
- Defining labor. How will it be compensated? Will it be billed at a rate or true cost incurred? If billed at a rate, how are labor categories established? How do you know an employee will qualify for a specific category? Are there certain employees that can’t be billed as a direct cost to the contract? If the contract allows for actual incurred costs for labor to be billed, then make sure your cost system is able to provide this information and accurately account for all costs.
- Home office costs. In what circumstances can you allocate home office costs? In what circumstances can they be specifically identified to the contract?
- Equipment. What is the fair value on equipment and rental rates? Do you have documentation to support this value? How does fair value impact cost allowability?
- Self performed work. Have you followed all the contractual requirements related to using general contractor personnel to perform scope of work instead of subcontractor personnel?
- Fees. Does the contract account for and offer documentation for insurance, markups, and other fees?
Contractors need to account for allowable expenses by implementing billing processes and controls. They should also understand how to segregate unallowable costs (unallowables) in their job cost detail.
While the amount of unallowables in reality is probably small, auditors may assume the worst if you don’t have sufficient controls to identify and segregate unallowables. To protect the owner in this scenario, auditors may recommend significant adjustments to cover the maximum potential impact of unallowables that weren’t identified and segregated. This involves the development of policies and procedures that target those contractual compliance issues and develop specific controls to prevent billing of unallowables.
Controls over “directly associated costs” is also needed. These are the costs that may be associated with unallowable activities. For example, if the costs of an event attended by contractor personnel were considered unallowable, the labor costs would also be an “associated” cost that should be segregated from billable costs. Auditors will often look at unallowable costs that contractors have identified with the purpose of identifying “directly associated” unallowable costs.
Most costs related to a construction project are allowable, but these costs may be questioned during the audit if you don’t have good documentation. Three points to follow as diligently as possible:
- Be transparent
- Get it done in a timely manner
When we prepare our construction cost audit reports, there are two costs that we will typically outline:
- Questioned costs. These are billed items that in fact aren’t allowed according to the contractual agreement.
- Unsupported costs. These are items that could be allowable, but requested documentation wasn’t provided to the auditor. The auditor has no choice but to report the lack of documentation.
Of the two categories, unsupported costs are often harder to deal with during negotiations following a contract audit. Owners have a report that indicates there’s a problem, but they don’t know how to resolve it. Contractors often are unwilling to accept a contract decrease just because auditors identified unsupported costs. This can lead to a stalemate that becomes hard to resolve.
Change orders are often the most contentious issue during contract performance. The change order is a visible indicator that something didn’t go as planned. Contractors need very good controls in this area to protect their reputation and increase the likelihood that change orders will be approved.
One important consideration: The contract adjustment needs to happen before the additional work begins. While it might seem better to wait for the work to be completed and then submit actuals, it’s important for contractors to negotiate based on estimates you have at the time and before you incur the cost. Otherwise, you may never recover the costs.
The relationship between contractors and owners doesn’t have to be contentious. To eliminate issues and make the audit easier and better, contractors benefit from strengthening contract terms, particularly the terms for reimbursables, and working with owners in a transparent fashion from the beginning with detailed documentation. Understanding — and communicating — the ramifications of a construction audit can help improve relationships with owners and create a culture of shared responsibility for success.