Construction Audits:
Background and Perspective

Construction Auditing is really a “specialized” form of contract compliance auditing. Construction audits are typically performed by owners as part of a review of a specific project, a specific contract or both. Audits are often desired by an owner organization to identify deficiencies in the overall project documentation or processes that may lead to overcharges, which may otherwise go undetected in the absence of an audit. Ideally, an agreement (contract) would contain a right-of-audit provision that provides specific contractual rights for an owner to conduct such audits. This type of arrangement is sometimes referred to as “open-book” accounting. In addition, these types of relationships are often characterized as “transparent” because the contracting entity subjecting themselves to such open-book accounting would theoretically have “nothing to hide.”

Owner audits are normally designed or intended to accomplish certain objectives, which may vary for any given contract or project. The basic objective of any contract audit (including construction) should be to ensure that the contractor is in full compliance with the contract (hence the term “contract compliance”) and is essentially a process to evaluate all terms and conditions set forth in the contract documents. Ultimately, compliance manifests itself in the contract billings and related payments. As such, audits allow for the evaluation of underlying cost transactions, actual cost data and other components of cost that are normally not readily transparent in the billing process. Specifically, an audit may include the evaluation of the compensation basis specified and the related definitions of reimbursable cost, non-reimbursable cost, markup percentages, fixed or lump sum amounts, allowances, contingencies, savings sharing provisions and fees. Audits may also include an evaluation of the base contract amount, change orders (both prime and lower tiered subcontract) and the related pricing of same.

However, having a right-of-audit provision in the agreement does not necessarily mean that contractors will fully comply with such provision. Likewise, the lack of a right-of-audit provision does not necessarily preclude an owner’s ability to conduct audits or that contractors would not cooperate with same. Regardless, we recommend that owners include an effective and well defined audit provision in all contracts, regardless of compensation basis. At a minimum, an audit provision should: (1) provide clarity as to what records are subject to audit, (2) define the purpose or objectives of the audit, (3) provide for access to specific documentation including computerized data, (4) the right to photocopy, reproduce or obtain information in a computerized format and (5) the right to audit lower-tiered trade contractors (by inclusion of specific audit rights in those lower-tiered contracts).

As a practical matter, we recognize that many owners and contractors have differing opinions over what constitutes an audit, what practices are acceptable, what records are subject to audit, etc. Moreover, we recognize that some contractors perceive audits as “witch hunts, fishing expeditions or tools to renegotiate signed contracts.” We do not believe that audits should necessarily be used as a process to ignore contracts, “undo” executed contracts, re-negotiate contracts or otherwise used as a tool to re-price or re-estimate what something should have cost, though we again acknowledge that owners sometimes use audits for these purposes. Rather, contract audits should normally be performed in accordance with the basic structure of the contract (which means that applicable provisions of the contract must be evaluated and interpreted).

However, we also believe that certain situations may warrant such non-typical audit processes and analysis. In that context, it becomes apparent to most industry observers that “standard” contract audit procedures do not exist that could be uniformly applied to any given contract, construction or otherwise. Often, many areas are not “black and white”. Rather they are “grey” (perhaps containing several shades). Therefore, most contract audits (including construction) are performed using “agreed-upon” procedures. The specific procedures to be performed or applied are a matter of judgment, experience and discernment. Whether or not such procedures will be allowed or agreed to by the contractor, is yet another matter altogether. At the most elementary level, we believe the professional practice of contract auditing is simply a process to identify and substantiate facts.

Regardless of perceptions or differences of opinion regarding the manner, scope or application of audits, each contracting party should look first to the contract, including the right-of audit provision, to understand what has been set forth in the agreement. Secondly (or in the absence of an audit provision), the contracting parties should try to understand the intent of the deal by discussing same with the deal-makers or executors of the agreement. If that fails to yield a consensus among the parties, then additional discussions by others may become necessary. When all of the aforementioned fails, legal processes involving attorneys, arbitrators or others may become necessary. However, that is generally considered a “last resort” and seldom becomes necessary for the purpose of gaining approval to merely conduct an audit.

Who Can Be Audited?

Generally speaking, anyone can be audited. The ability to conduct audits is dependent upon two primary factors:

1. The inclusion of a “right-of-audit” provision in the agreement that provides an owner with specific contractual rights to perform such audits. This is often referred to as an “open book” business arrangement.
2.  The willingness of the auditee to cooperate with an owner (or their authorized agent) to allow for the review and evaluation of the auditee’s books and records. This may or may not be dependent on specific contractual rights. For example, an owner may encounter a situation where a right-of-audit provision does not exist, yet the auditee is willing to allow an audit (as a good faith gesture) to demonstrate that they value the business relationship and have nothing to hide. Conversely, an owner may also encounter a situation where a right-of-audit does exist and yet the auditee refuses to cooperate, does not cooperate fully or otherwise tries to inhibit an owner’s ability to conduct such audits. Obviously, such situations may require additional measures or possibly legal action to enforce the audit provision of the contract.

Owners may wish to conduct audits of any organization that provides services to them. Specifically, this includes:

• General Contractors
• Construction Managers
• Program Managers
• Project Management Oversight Contractors
• Remediation Contractors
• Specialty Trade (subcontractors) Contractors
• Architects
• Engineers
• Consultants
• Attorneys