Building Foundation Contract Audit

Building a
foundation
for a contract
audit
kpmg.com
1 / Building a foundation for a contract audit
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Building a foundation for a contract audit / 2
For major engineering and construction (E&C) projects,

the contract audit can be an effective tool to do more
with less and help eliminate wasteful spending and cost
overruns. Construction owners, real estate developers,
joint venture partners, and project stakeholders are
incorporating contract audits into their standard operating
procedures for monitoring and controlling building
projects. This paper provides guidance for contractors
on how to prepare for a contract audit, offers insight into
how auditors approach contract audits, and recommends
procedures for managing the audit process.
Why prepare before you have to? E&C companies may also proactively Tailoring contract audits
Contract audits are not going away. perform contract compliance self- Construction contract audits vary
Every year, corporate and government assessments, which can be very by circumstance (project time line
audit teams review hundreds of billions effective in preparing for owner contract or operational need), type of client
of dollars in spending, identify billions of audits and can benefit an E&C company’s (government or private), and contract
dollars of potential audit issues, and contracts overall. Demonstrated type (fixed-price or cost-based). Audit
recover millions of dollars in contract compliance with client contract emphasis varies accordingly and the
overpayments on individual projects.1 provisions encourages strong, mutually approach must be tailored to the entity.
Frequent news reports about cost beneficial owner-contractor relationships. They may occur at various stages of
overruns and delays on large construction A track record of reliability can help a construction project. Common E&C
projects fuel concerns for more position an E&C company to compete contract audits include:
accountability and increased scrutiny of for lucrative contracts. Effective controls
• Contract closeout audits—typically
contractor spending. help them strengthen their competitive
completed before final payment is
posture, avoid mistakes, and deliver
As pressures mount for E&C companies made.
successful projects.
to win and deliver successful results on
• Two-phase audits—the first phase
construction contracts, demonstrating Auditing of construction contracts is
typically is scheduled near the
sound project management and no longer confined to unique project
beginning (such as at 20 percent
cost control practices has become or contract circumstances, or initiated
project completion) and the second
increasingly important. For example, primarily by state, local, or federal
before final payment is made.
many E&C companies are implementing governments or cost-conscious owners.
more robust monitoring processes Such audits are becoming standard • Monthly payment audits—these
to periodically inspect contractor and protocol on many major construction keep a close watch on contract cash
subcontractor cost reporting systems, projects. KPMG has the experience outflows and help to resolve potential
purchasing documents, payroll records, to help contractors identify the proper problems before they lead to delays
employee timesheets, bank records, strategies and controls needed to and cost overruns.
invoices, canceled checks, transaction succeed in working with a wide variety
• Other—quarterly, semiannual,
records, and operations logs. of government, corporate, nonprofit,
or annual audits are common for
and private entities through our global
long-term projects.
network of member firms.
1
ontract Audits: Role in Helping Ensure Effective Oversight and Reducing Improper Payments, U.S. Government
C
Accountability Office, http://www.gao.gov/new.items/d11331t.pdf
Government entities may require contract companies use a comprehensive set

How contract audits can audits that are tailored to regulatory of objective criteria, which serve as
benefit your business requirements such as prevailing wage a consistent baseline for controls
laws, use of disadvantaged business evaluation and measurement. Such
A well-executed contract audit can enterprises, limitations on overhead and standards also can provide needed
offer many benefits, including: profit, and how costs are categorized. assessment criteria for internal audit
Contract audits for private companies, departments.
• Stronger contractor–owner
in contrast, focus on cost recovery of
relationships A strong controls foundation can increase
overbillings or credits for work that was
the likelihood that project outcomes are
• Averted penalties billed but not performed. Government,
achieved and can lower audit surprises
corporate, nonprofit, and private
• Early identification of potential (such as the number and significance of
clients may all require verification of
compliance issues identified deficiencies during an audit) by:
regulatory compliance with, for example,
• Support for favored vendor status U.S. Occupational Safety and Health • Clearly defining project and contract
Administration (OSHA) regulations. roles and responsibilities
• Improved safety
Fixed-price and cost-based contracts are • Documenting a consistent process for
• Fraud deterrence
the two basic types of contracts. Audits of contract bidding, negotiation, approval,
• Fewer risks, costs, and delays fixed-price contracts focus on compliance and fulfillment of administration
with contract requirements and change requirements
• Identification of areas for process
orders. Audits of cost-based contracts
improvement • Establishing clear and objective
focus on verification of the underlying costs
standards for managing and reporting
• Good publicity in the marketplace. and validation that costs are legitimate.
all projects and contracts including
Controls are the key to passing a change management, payment
contract audit administration, and cost reporting
Contractors with good internal controls in
• Establishing clear guidelines for
place and those that employ a systematic
identifying, tracking, and reporting
approach to fulfilling contractual obligations
project issues or risks.
are generally less likely to have significant
issues identified during the audit when Developing a controls-focused approach
compared to less-organized contractors. Developing and implementing a controls-
Those that establish a strong controls focused approach to help manage a
foundation and a standard and repeatable project’s contract fulfillment process
approach to controls can minimize can help reduce risks, confirm that
construction risks and facilitate project incremental project goals are being met,
success, especially on major capital and reduce costs. Properly designed and
projects spanning several years; their implemented internal controls can make
companies are better prepared to meet the difference between extensive cost
audit requirements. KPMG previously overruns and a project delivered on time
highlighted the importance of consistency and within budget. We have found that
in control standards in A Controls- these broad guidelines can help:
Focused Approach to Construction Risk
• Set priorities. Before determining the
Management,2 which noted:
specific program governance structure,
In our experience, one of the most understand the objectives of the
common reasons for inconsistent oversight program and the needs of
controls and insufficient strategic the company as validated by company
risk management on construction management and key stakeholders.
projects is a lack of objective control Then establish project priorities.
standards. ... Industry-leading
2
A Controls-Focused Approach to Construction Risk Management , KPMG, 2009
• Develop a framework. Develop and likely than nongovernment projects to

adapt a controls framework based on require contract audits (and, in some
the company’s needs, the program cases, are mandatory). Larger projects
objectives, and priorities. Address are more likely to require contract audits
critical areas, especially as they than smaller ones. High-profile projects
pertain to higher risk or cost. (whether private or government) are
more likely to require audits than low-
• Assess current controls. Based on the
profile projects. Other factors that can
determined framework, the company
precipitate a contract audit include
should perform a gap analysis of its
poor contractor-owner relationships,
existing core policies, procedures,
funding-source requirements, large
and processes in order to identify
project overruns, allegations of fraud or
gaps, overlaps, and areas of
misconduct, and regulatory mandates.
strength and weakness.
The probability of an audit may increase
• Strike the right balance. Before if there is a large liquidated-damages
implementing control recommendations, element or lost-profits issue.
critically evaluate the controls that
are being modified, implemented, Cost, schedule, and scope
or removed. Too many controls, or are chief concerns
improper implementation of new Auditors approach a contract audit with
controls, may be problematic. costs, schedule, and scope in mind.
Among other procedures, auditors
• Phase the implementation. Modify
will likely verify that costs billed to
controls or implement new ones in
the project are valid and reimbursable
phases so that implementation issues under the terms of the contract, review
can be addressed as they arise. Not key contractual deliverables, and
all control changes may need to be verify compliance with the agreed-on
implemented right away; for example, completion time line.
some may be needed only as a
company grows. • Cost: Auditors likely will start with
the contractor’s latest job cost report
• Strive for continuous improvement. and reconcile the amounts billed to
Controls should not be stagnant. the latest application for payment.
Rather, they need to be reassessed on A cost reconciliation prepared by
an ongoing basis in order to monitor the contractor that is included with
their effectiveness and ability to the billings can help to facilitate
address new or emerging risks such as this process. Based on the job cost
organizational changes or changes in the report, auditors may select sample
company’s environment such as new transactions for different types
regulations. Monitoring the company’s of costs such as materials, labor
controls and relevant risks is a critical (exempt and nonexempt), equipment,
component to maintaining an effective subcontractors, general conditions,
(and cost effective) controls framework. administrative, and overhead costs.
Prepare for an audit on every project They also will look for known “red
Every E&C company would like to be flags” such as significant overtime,
prepared for an audit. In some situations, reclassification of costs, cost accruals,
the contract specifies the time and type unusual or missing cost descriptions,
of audit that will or may be performed. large dollar amounts, round dollar
In other situations, audits may be amounts, costs incurred before the
random or unplanned. Certain factors contract was executed, and home
increase the likelihood of a contract office overhead costs.
audit. Government projects are more
• Schedule: The auditor will look at the represents time and materials charges
Good controls often result in contractor’s project schedule and is expected to contain an adequate
fewer and less-severe deficiencies make sure the project was completed breakdown of units and unit costs.
identified during an audit within the original contractual time
Sometimes a contract is unclear about
period plus any additional days
what constitutes a reimbursable cost. If the
Control examples include: authorized through change orders.
contract is ambiguous, the auditor often will
If applicable, liquidated damages will
• Bid proposal review and approval quantify the amount of the questionable
be calculated on any delays occurring
• Legal review and approval charges, categorize it as a “gray area,” and
outside the authorized contract time.
of agreements (including discuss the intent with the owner and the
subcontracts) • Scope: The auditor may also verify contractor. Contract costs that frequently
the receipt of required contractual fall into this category include:
• Review and approval of all change deliverables. This is most commonly
orders (including pricing) • Costs allocated to the contract that
done during a contract closeout
are intended to be captured though
• Review and approval of payment audit. The contractor may verify that
overhead mark-ups
application package key project closeout documentation
such as warranties, operation and • Costs allocated to and included in the
• Frequent reconciliation of job cost
maintenance manuals, as-built labor burden
report
drawings, and lien releases were • Training
• Quarterly project financial review appropriately produced by the
• Weekly or biweekly schedule contractor and provided to the owner. • Legal
reviews • Travel and entertainment costs
Auditors may test a number of transactions
• Internal auditing of all projects for from the job cost report and ask for • Personnel in similar roles (potential
contract compliance. supporting documentation. To check labor, duplication)
they will likely ask for time cards, proof of
• Major equipment purchases
payment, and labor detail reports. Additional
support may be required to substantiate • Equipment rental charges
various components of the labor burden. • Significant equipment repairs
For subcontractors and vendors, auditors
typically want to review the original invoice • Charges from related parties
and proof of payment. Any invoice that • Certain change order costs
• Living and relocation expenses only provide document copies. If original
documents are provided to auditors,
• Project executive (or employees
contractors should keep a copy of what
stationed in home office)
is provided to the auditor and label the
• Vehicles. documents with the corresponding
number from the document-request list.
If the contract is silent about whether an
expense is reimbursable, ask: Contractors should organize change
documentation on the job cost report in
• Was this cost project specific? (That is, such a way that it can be easily reconciled
did any other project benefit?) to the amount shown in the report. This
• Would the expenses have been will allow the auditor to perform the audit
incurred regardless of the project? without engaging in excessive searching
and number crunching. If an explanation
• Is the cost reasonable, and is there is needed, the contractor should discuss
appropriate support? the item with the auditor to avoid
• Does the expense fall within the misunderstandings.
owner’s specifications (mileage rate, E&C companies should consider the
per diem, etc.)? feasibility of using a fully integrated job
The contractor can be better prepared for cost reporting and accounting system if
an audit if it follows sound record-keeping one has not already been implemented.
practices. For example, relevant project Such a system may provide visibility
documents should be filed and organized and control over project costs and can
while the project is under way. Complete, help minimize the likelihood of incurring
readily accessible files help the auditor project costs that are not reimbursable
collect essential documents. A delay may or not visible to the project team.
raise the auditor’s suspicion and cause An integrated system can make a
the scope of the audit to expand. If an contract audit much easier and may help
auditor’s request is unclear, the contractor avoid the necessity of having the project
should ask questions and work with the team manually reconcile project costs
auditor to clarify understanding. Unless from multiple sources.
specifically required, contractors should
Good communication and

documentation help ensure
a smooth audit
A successful audit depends not only on and explain why the contractor’s invoiced
good internal controls and sound business costs should be adjusted or disallowed.
practices, but also on well-organized The auditor should provide the contractor
processes and good contractor–auditor with the opportunity to respond to
communication. The contractor should each finding and to present additional
appoint a primary contact for the supporting documentation to refute or
auditor—preferably the project manager clarify the contractor’s accounting.
or individual with the most knowledge
A contractor’s defensive reaction to a
of the project. The auditor should set
contract audit can cause the owner and its
expectations for the audit’s scope,
auditor to also take a defensive position
process, and time lines and submit an
during discussions on audit findings or
initial documents-request list.
during claim-settlement discussions.
After completing field work but prior Contractors that are prepared, however,
to issuing an audit report, the auditor and provide adequate support may be
usually will discuss potential audit able to influence the direction of the
findings and issues with the contractor. audit in their favor. Being prepared and
The auditor may propose audit gaining consensus on any gray areas of
adjustments based on the requirements the agreement are important goals for the
of specific clauses in the contract. contractor and should help to ensure a fair
The auditor will note the relevant clause, audit process.
present the auditor’s calculated cost,
Build a foundation for a contract audit / 8
Sound business practices may reduce the audit burden

Whatever the E&C project, these common business practices, if followed, can help
reduce project risks and may reduce the audit burden (such as cost, time, or other disruptions):
1. Organize and assign clear 5. Solicit proposals from an adequate 9. Establish and maintain policies
responsibilities for managing and number of subcontractors and and procedures to manage and
executing contract requirements at thoroughly review all pricing/ administer contracts, and establish
the outset of the project. proposals. high standards for documenting
change orders and reimbursable
2. Have the project manager and project 6. Maintain professional contract
costs.
controls team take an active role in administration and document-
drafting all nontechnical documents. management practices to protect 10. Thoroughly monitor quantity and
All contract documents should be the integrity of contracts (formal quality of work installed.
consistent and complementary. communication, document control,
11. Integrate an effective construction
bill payment, timeliness).
3. Perform a check of special contract audit function within the project
terms such as allowance adjustments 7. Maintain detailed files of all costs policies and procedures.
or insurance requirements, and billed to the owner and maintain
12. Develop and review contract
do not guarantee new or untested adequate backup information for
estimates to complete on a periodic
processes or technologies. rates, markups, and pricing sources.
basis.
4. Spend adequate time prequalifying 8. Independently validate
subcontractors and work only with subcontractors’ price estimates
subcontractors with sufficient for major scope packages, and
bonding capacity. implement enhanced controls for
self-performed work.
Conclusion: Feedback fuels KPMG can help

improvement KPMG’s construction advisory specialists
E&C companies have strong incentives understand the nuances of complex E&C
to assess and enhance their project projects and contract requirements.
controls and maximize accountability We can work with your company to:
and transparency. A contract audit may
reveal misinterpretation of contract • Implement an overall project control
requirements, highlight discrepancies structure to help reduce project risks
in key construction management and to better prepare for contract
processes, identify shortcomings in audits
project documentation, or reveal errors • Review construction contracts
in progress billings. The good news is
to address potential contract
that contractors can use this input to
compliance issues
clarify misunderstandings and incorrect
assumptions and improve controls and • Develop a self-auditing process
procedures. to proactively address contract
Small, medium, and large E&C compliance issues
companies face similar challenges • Develop a protocol for preparing
as they attempt to manage the risk and managing contract audits once
exposures and avoid the pitfalls initiated
associated with construction contract
audits. Given the intense scrutiny • Analyze and address the results
of construction cost overruns by of a contract audit.
government entities and private firms
KPMG member firms in the United
as well as the public’s demand for
States and around the world offer clients
transparency and accountability, E&C
the scale, global reach, industry insight,
companies cannot afford to be reactive
and multidisciplinary range of services
when addressing contract audits.
Each contract audit represents an to enable your organization to make
opportunity to improve management and better business decisions and realize
administrative processes, strengthen long-term value. Our knowledge of the
internal controls, and develop stronger E&C sector combined with our Audit,
contract fulfillment skills. Tax, and Advisory services equip us
to give your business the support it
For contractors, implementing process deserves and needs. KPMG LLP’s
changes based on “lessons learned” partners and professionals provide a
from the audit experience can minimize
wide range of experience that makes
audit surprises and improve overall
us a significant resource in your current
operations. Because the contractual audit
markets and in those locations where
clause often requires the contractor to
you may want to expand.
absorb the cost of the audit if significant
overcharges are identified, process
improvements also can lead to a better
bottom line. By assessing the state of
construction project controls, applying a
control structure that takes into account
the requirements of construction
contracts and implementing controls and
sound business practices, organizations
will be better prepared to deal with any
construction audits that lie ahead.
Contact us
For more information about this white
paper, please contact:
Clay L. Gilge
Managing Director, Advisory
T: 206-913-4670
E: cgilge@kpmg.com
Erika Alvord
Director, Advisory
T: 503-820-6603
E: ealvord@kpmg.com
Geno Armstrong
International Sector Leader,
Engineering and Construction
T: 415-963-7301
E: garmstrong@kpmg.com
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or
entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as
of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate
professional advice after a thorough examination of the particular situation.
KPMG LLP, the audit, tax and advisory firm (www.us.kpmg.com), is the U.S. member firm of KPMG International Cooperative (“KPMG
International”). KPMG International’s member firms have 140,000 professionals, including more than 7,900 partners, in 146 countries.
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Building Foundation Contract Audit

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Building Foundation Contract Audit

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Building a

For major engineering and construction (E&C) projects,

Government entities may require contract companies use a comprehensive set

• Develop a framework. Develop and likely than nongovernment projects to

Good communication and

Sound business practices may reduce the audit burden

Conclusion: Feedback fuels KPMG can help

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