This feature is a part of "The Dotted Line" series, which takes an in-depth look at the complex legal landscape of the construction industry. To view the entire series, click here.
There’s just something about the word “audit.” Whether it appears on a notice from some taxing authority or in a construction contract, the prospect of a third party poking around company records can be unsettling, even if there’s nothing to hide. Yet, project audits are something with which many contractors have to contend.
From a financial perspective, audits on projects delivered via contracts like cost-plus-fee, cost-plus-fee with a guaranteed maximum price (GMP) and time and materials are fairly common. That’s because the risk to the owner is greatest in these arrangements.
For example, in a cost-plus-fee arrangement, the contractor is reimbursed for actual expenses, plus some agreed-upon percentage based on costs. The higher the costs are, the higher the percentage is. Time and material contracts are similar in that the contractor is paid for costs and then some multiple for profit and overhead.
A cost plus-fee with a GMP will also usually contain a contingency amount to be used by the contractor for reasonable construction costs like equipment or materials. If that contingency isn’t spent during the course of a project, the contractor and owner will usually split the savings.
In these cases, it’s understandable that the owner would want to recoup the maximum amount of savings available and certainly not pay a markup on padded bills.
Financial records for lump-sum contracts are usually not subject to an audit because the owner has agreed to pay one fixed price regardless of whether the documentation backs it up. As long as the work is per the specifications and delivered on time, the construction firm is entitled to keep any savings it manages to realize. On the flip side, the contractor is stuck with any budget overruns.
The exception to this, according to attorney Michelle Schaap, of New York City-based Chiesa Shahinian & Giantomasi, is if there are change orders or claims for liquidated damages. Even if the contract was awarded under a lump-sum agreement, she said, the owner will typically have the right to look at the documentation that backs up those numbers.
The likelihood of an audit, Schaap said, depends on, of course, what the contract says and also how savvy the owner is. “A sophisticated owner may, as a routine matter, conduct an audit,” she said. “If a small, unsophisticated owner … is happy and satisfied with the results — chances are they're not conducting an audit.'
Sometimes the owner will simply use the threat of an audit as a motivator for the contractor to keep accurate and thorough records. “Hopefully, that will keep the contractor on the straight and narrow,” said Joshua Atlas, partner at the law firm of Saul Ewing Arnstein & Lehr in West Palm Beach, FL.
Barring that scenario, he said, audits can take place at regular intervals through the course of a project or at the end as part of the project closeout.
A contractor shouldn’t be surprised, however, if the owner wants to look at more than just invoices and receipts. “Defining the word audit is tough,” Atlas said. Owners, particularly public agencies, want to make sure the contractor is in compliance with a number of contract provisions including safety procedures, immigration requirements, small business and minority set-aside requirements, and prevailing wage laws as evidenced by certified payroll forms.
“If it’s a public project, Schaap said, “[an audit] could be to make sure you’re not taking bribes.” For example, there could be questions around bringing in crews from outside the state instead of employing locals, she said, in an attempt to find out if there was a cash payoff to the hiring contractor or some other quid pro quo.
Atlas said ensuring safety protocols is typically an owner priority because of a genuine concern for workers on the project, but also because a serious accident can result in expensive lawsuits and profit-eating downtime.
Not only that, said Carl Oliveri, partner-in-charge of the construction practice at New York-based accounting and business consultancy firm Grassi & Co., but if there are financial irregularities like misreporting of wages on projects that require a prevailing wage or using a minority-owned business as a mere pass-through, criminal charges aren't out of the question, especially in New York City where the Manhattan District Attorney’s office operates an aggressive construction fraud task force.
So, what can contractors do in preparation for an audit?
Know what the contract says
Audit provisions, Schaap said, can dictate how often the owner is allowed to audit, what documentation the contractor is required to retain, and how long those records must be kept and made available to the owner. Some contracts even give the owner rights to audit the project well after the project is complete.
“To the extent you have to look down the food chain to subcontractors and suppliers, you want to make sure you can justify any claims,” she said.
Atlas noted there’s usually very little conflict when it comes to hammering out an agreement that includes an audit. One of the exceptions to that, he said, would be negotiations over the exclusion of audit rights for a contract that involves set fees for certain items, similar to the provisions of a lump-sum contract.
Project management software can help organize and maintain records in one place, making the audit process faster and less complicated, Atlas added.
“Well-organized documentation is a lawyer and accountant’s dream,” Atlas said, “and gives you a clear picture of what you’re looking at. This documentation includes subcontractor invoices with corresponding lien waivers, daily activity and meeting logs and other project documents.
Schaap said it’s also important for contractors to think about the audit document requirements as they go about their day-to-day operations and tailor forms and procedures accordingly.
Do a trial run
Grassi's Oliveri said clients engage his firm to be a third-party auditor, but he added, some contractors also want an audit “dress rehearsal” in order to make sure they're ready for the real thing.
Grassi looks at the percentage a project is complete, Oliveri said, and reconciles that with progress billings, tracks gross profit, and tries to identify incidents of profit fade or any signs of job-cost shifting that would make a project appear more or less profitable than it really is. Those things would give the user — the bank, owner, business partners, etc. — an inaccurate depiction of the company’s financial condition and quality of management.
In the course of trial runs, Oliveri said, Grassi also checks for compliance with contract provisions to minimize other areas of risk. “We get outside the debits and credits,” he said. “We get off the financial statement and it’s there where we drive value."
As part of its consultancy work, the firm promotes proactive toolbox talks, not cutting corners in policy enforcement or production, an upstanding ethical code, and an outlet for employees to report issues to up the chain of command.
"An audit goes beyond financial risk," Oliveri said. "It's really about the overall corporate risk and what is the exposure there."
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