Auditing construction contract change orders

Baker Tilly refers to Baker Tilly Virchow Krause, LLP, an independently owned and managed member of Baker Tilly International. Auditing construction contract change orders

Presenter Tony Ollmann, CPA, CCA Director Baker Tilly 22

Auditing construction contract change orders Baker Tilly refers to Baker Tilly Virchow Krause, LLP, an independently owned and managed member of Baker Tilly International. 2013 Baker Tilly Virchow Krause, LLP

About Baker Tilly > Established in 1931 > One of the top 20 largest accounting and advisory firms in the United States according to Accounting Today s 2013 list of Top 100 Firms > More than 1,400 professionals > Baker Tilly Virchow Krause, LLP is the largest US Baker Tilly International independent member firm > Baker Tilly International is the eighth largest public accounting network with representation in more than 131 countries > Convenient, seamless resource for worldwide needs 4

About Baker Tilly From concept and funding to controls and compliance, Baker Tilly has more than 250 dedicated construction and real estate industry professionals to assist with your facility development project through h all stages of the development lifecycle. l 5 5

Overview Today s topics: Auditing construction contract change orders What are change orders? Audit risks Change order red flags Change order testing Case studies 6

Learning objectives > Learn how to identify change orders > Learn how to decompose a change order > Determine the underlying change order driver > Understand the risk associated with different types of change orders > Develop strategies for auditing change orders and managing construction professionals 7

What are change orders? 7.3 CONSTRUCTION CHANGE DIRECTIVES 7.3.1 A Construction Change Directive is a written order prepared by the Architect and signed by the Owner and Architect, directing a change in the Work prior to agreement on adjustment, if any, in the Contract Sum or Contract Time, or both. The Owner may by Construction Change Directive, without t invalidating the Contract, t order changes in the Work within the general scope of the Contract consisting of additions, deletions or other revisions, the Contract Sum and Contract Time being adjusted accordingly. Source: AIA 133 Standard Form of Agreement Between Owner and Construction Manager 8

What are change orders? Change orders are referred to in a number of ways: > Change orders > Change directives > RFI > Engineering change notice > Field change request All amount to the same thing, an owner s authorization to change the terms of the prevailing contract 9

AIA change directive documentation 7.3.3If the Construction Change Directive provides for an adjustment to the Contract Sum, the adjustment shall he based on one of the following methods:.1 Mutual acceptance of a lump sum properly itemized and supported by sufficient substantiating data to permit evaluation;.2 Unit prices stated in the Contract Documents or subsequently agreed upon;.3 Cost to he determined in a manner agreed upon by the parties and a mutually acceptable fixed or percentage fee; or.4 As provided in Section 7.3.7. Source: AIA 133 Standard Form of Agreement Between Owner and Construction Manager 10

Why do change orders occur? > Owner initiated change to the project > Contingency expenditure > Change in construction conditions > Change in specifications > Change in building code > Change in market conditions 11

Change in specifications Due to completion of construction documents, changes in building code or refined materials specifications additional labor and materials are required to deliver the scope of work Resulting from: > Bids based on incomplete construction documents > Regulatory design review demands design changes > Equipment specified is modified or changed 12

Change in market conditions The cost of procuring construction services, supplies and equipment are materially different than the estimated costs Resulting from: > Dramatic material shortages > Labor shortages > Commodity price speculation 13

Change in field conditions Construction conditions are not what was expected or reported to the contractors t May include: > Unusually inclement or adverse weather > Unreported soil conditions > Environmental hazards 14

Owner initiated change orders Represent new or additional work not planned for in the estimated t scope May result in: > Increase to the GMP > Change to the construction schedule > Use of contractor s contingency budget > Use of owner s contingency budget > Reduction to another part of the project budget 15

Change order audit risks Audit risk categories > Unauthorized change orders > Unnecessary change orders > Redundant or duplicate change orders > Overpriced change orders 16

Unauthorized change orders Work that is performed and charged for without having been authorized by the owner Why does this happen? > Miscommunication > Procrastination > Budget overruns > Schedule delays > Rework > Warranty work > Quality issues 17

Unnecessary change orders Change orders that have been properly approved dbut tdeliver no apparent value to the project Resulting from > Existing scope > Unnecessary add on 18

Overpriced change orders Change orders that have been approved but are overpriced for the scope of work proposed Overpricing i comes from: > Inflated labor rates > Inflated hours > Exaggerated profit margins > Compounded fee computation (fee on fee) 19

Contingency budgets and allowances Contractors contingency: Contractor s budget for in scope budget changes Owner s contingency: Owner s budget for scope changes Allowances: Segregated construction budget dedicated for a specific use that may not have a budget and contract or GMP time. 20

Change order red flags > No rejected change orders > Project end change orders > Significant value engineering adjustments > Changing contractors t during construction > Too few change orders > Material substitutions > No contractor s contingency reconciliation > No negotiated change orders > Remodeling projects > Too few change orders > Change order value greater than 10% of original i budget > Bids prepared at less than 100% of construction documents > Remodeling projects 21

Audit program Change order audit program planning: > Documentation ti and control > Authorization > Price analysis > Scope analysis 22

Documentation and control Change Order Date Date 3% Total change Number Submitted Approved Contractor Description Change Order Reason Submitted Change Submitted Fee order amount 1 11/5/2007 Footing corrections, backfill and pumping Change in conditions $ 12,927.57 $ 387.83 $ 13,315.39 1 8/15/2007 Sand, 90 loads Change in conditions $ 5,450.00 $ 163.50 $ 5,613.50 1 11/5/2007 Undocumented change order Change in conditions $ 12,421.80 $ 372.65 $ 12,794.46 1 Change Order Adjustment Change Order Adjustment $ 1 7/27/2007 Lobby floor change Owner initiated change $ 3,986.00 $ 119.58 $ 4,105.58 1 Change in conditions $ (1,410.00) $ (42.30) $ (1,452.30) 1 Landscaping changes Owner initiated change $ 1,477.39 $ 44.32 $ 1,521.71 1 Owner initiated change $ 2,128.00 $ 63.84 $ 2,191.84 1 Sanitary Sewer Change Change in Scope $ 16,962.50 $ 508.8888 $ 17,471.38 1 Change Order Adjustment Change Order Adjustment $ $ 1 Substitute granite for marble Owner initiated change $ (358.00) $ (10.74) $ (368.74) 1 Plumbing changes Owner initiated change $ 8,811.00 $ 264.33 $ 9,075.33 Revisions resulting from state plan 1 review Code Compliance $ 8,584.00 $ 257.52 $ 8,841.52 1 Change OrderAdjustment Change OrderAdjustment $ $ Revisions resulting from local code 1 compliance Code Compliance $ 61,317.00 $ 1,839.51 $ 63,156.51 1 Change Order Adjustment Change Order Adjustment $ $ Eliminate vinyl trim and substitute 1 vinyl for stone Owner initiated change $ (4,157.00) $ (124.71) $ (4,281.71) 1 Owner initiated adds and deletes Owner initiated change $ 4,088.00 $ 122.64 $ 4,210.64 1 Code compliance from reviews Code Compliance $ 6,150.00 $ 184.50 $ 6,334.50 1 Owner initiated adds and deletes Owner initiated change $ (19,417.00) $ (582.51) $ (19,999.51) 1 Owner initiated adds and deletes Owner initiated change $ 7,691.00 $ 230.73 $ 7,921.73 1 Change Order Adjustment Change Order Adjustment $ $ 1 Additional cultured stone Owner initiated change $ 6,936.00 $ 208.08 $ 7,144.08 1 Design oversight. No towel bars Design deficiency $ 1,585.00 $ 47.55 $ 1,632.55 1 1 Substitute Western doors for Legace Owner initiated change $ 72,370.88 $ 2,171.13 $ 74,542.01 Added one month of general conditions to compensate for lost production time resulting from permit issues Change in conditions $ 46,700.00 $ 1,401.00 $ 48,101.00 1 Change Order Adjustment Change Order Adjustment $ $ 1 Total Change Order #1 $ 230,148.11 23

Change order schedule checklist > Verify all change orders are authorized Look for rejected items being resubmitted > Decompose consolidated change orders into individual line items > Look for duplicate change orders Same value at with different dates Same documentation used individually and consolidated > Verify all computations > Look for old line items 24

Change order pricing Case Study Facts Scope: Add outlets, lights, dimmers per owners request Electrical contractor s invoice Labor cost: 280 hours @ $95 $26,600 Material cost: Outlets, switches, lights. Supported with supplier invoices $15,000 Analysis: > Materials were passed through at cost > Overhead and profit were at contract t terms > Labor was at contracted rate > Owner was overcharged $2,660 or 6% of the change order value Subtotal $41,600 Why? Labor rate Overhead and profit 10% already included $4,160 (per contract terms) overhead and profit Total $45,760 25

Change order pricing audit checklist > Request detail backup for lump sum change orders > Verify labor rates with base contract > Verify hours are appropriate for scope of work > Verify quantities are appropriate for scope of work > OCIP projects make sure to discount labor rates for owner paid workers compensation insurance > Negative change orders should include a CM fee credit > Verify that general conditions changed before accepting a GC fee adjustment Resources > TRA-SER > Equipment Watch > Composite crew rate analysis > RS Means > Labor burden analysis 26

Polling question #4 What is a composite crew rate? A. Average crew billing rate B. Weighted average crew billing rate Please respond using the polling section in the WebEx screen to the right. 27

Composite crew rate analysis Labor Burden Total Hourly Fully Loaded Composite Composite Crew Planning Rate Rate Wage Quantity Hours Daily Wage Rate Raw Wage Raw Wage 2009 Superintendent 40.15 0.00% $ - $ 40.15 1 8 $ 321.20 $ 321.20 General Foreman 36.15 0.00% $ - $ 36.15 1 8 $ 289.20 $ 289.20 Foreman 34.35 0.00% $ - $ 34.35 2 16 $ 549.60 $ 549.60 Journeyman 30.65 0.00% 00% $ - $ 30.65 13 104 $ 3,187.60 $ 3,187.60 Apprentice 19.25 0.00% $ - $ 19.25 5 40 $ 770.00 $ 770.00 0.00% 22 176 $ 5,117.60 29.0772727 $ 5,117.60 29.077273 2010 0.00% Superintendent 41.58 0.00% $ - $ 41.58 1 8 $ 332.64 $ 332.64 General Foreman 37.58 0.00% $ - $ 37.58 1 8 $ 300.64 $ 300.64 Foreman 35.67 0.00% $ - $ 35.67 2 16 $ 570.72 $ 570.72 Journeyman 31.85 0.00% $ - $ 31.85 13 104 $ 3,312.40 $ 3,312.40 Apprentice 20 0.00% $ - $ 20.00 5 40 $ 800.00 $ 800.00 0.00% 22 176 $ 5,316.40 30.2068182 $ 5,316.40 30.206818 0.00% 2012 0.00% Superintendent 41.8 0.00% $ - $ 41.80 1 8 $ 334.40 $ 334.40 General Foreman 37.8 0.00% $ - $ 37.80 1 8 $ 302.40 $ 302.40 Foreman 35.9 0.00% $ - $ 35.90 2 16 $ 574.40 $ 574.40 Journeyman 32.05 0.00% $ - $ 32.05 13 104 $ 3,333.20 $ 3,333.20 Apprentice 20.15 0.00% 00% $ - $ 20.15 5 40 $ 806.0000 $ 806.0000 22 176 $ 5,350.40 30.4 $ 5,350.40 30.4 28

Third party pricing: RS Means 29

Labor burden analysis Contractor Name: Rate Applicability Period: Contractor Labor Rate Calculation Occupation: Superintendent Straight Time Reported Base Wage ($ Per Hour) $ 42.37 $ 42.37 Taxable Benefits (Vacation -As applicable Subtotal Taxable Wages & Benefits $ 42.37 $ 42.37 Union Benefits 401K assume 2% of wages $ 0.77 Health & Welfare assume $1000 per month $ 5.77 Safety $ 0.03 Substance Testing $ 0.04 Skills Training $ 1.00 Reported 35% $ 14.83 Total Benefits $ 7.61 $ 14.83 Subtotal t Base Rate + Fringes $ 49.9898 $ 57.20 Insurance Workers Compensation (2%) $ 0.85 Liability Insurance (1.5%) $ 0.64 Payroll Taxes: State Unemployment e (3.9% of $12,300) $ 0.23 Fed Unemployment (6.2% of $7,000) $ 0.21 Medicare (1.45%) $ 0.61 F.I.C.A. (7.65%) $ 3.24 Reported 50% $ 28.60 Total Tax & Insurance $ 5.78 $ 28.60 Cost Per Hour $ 55.76 $ 85.8080 Contract Hourly Rate $ 85.80 Premium (Discount) $ 30.04 30

Change order scope analysis Know what is allowed in the contract!! > Examine the change order scope for the source of the change > If you can t discover the source from the documentation ask the subcontractor for an explanation. > Examples of typical non-allowable change orders Rework for quality Rework for plan and specification compliance It is already in the plans and specifications i It should have been in the plans and specifications. An owner has a realistic expectation that the construction drawings will satisfy local and state building code. Design oversight may result in the architect compensating the contractor for rework 31

Contractor s contingency Case study facts: > Original lump sum contract value: $6,000,000 with a $50,000 contractor s contingency budget > Change orders reviewed and approved of $750,000 increasing the contract value to $6,750,00 > Contract requires the owner to approve any use of the contingency budget Analysis: > Review of the change order log shows no documented use of contingency budget > Contractor billed through 100% of the change orders with 9% for CM and GC fees > The final application was adjusted for the contingency and the owner was credited $54,500 500 32

Upcoming webinar Wednesday, June 5 Noon to 1:00 PM CT Subcontract default insurance Guest Speakers: Tim Cleary, M3 Insurance and Tim Anderson, Construction Risk Underwriters Registration for this event, today s presentation and other topics in this webinar series can be found at www.bakertilly.com/construction-audit-webinar 33

Questions? Tony Ollmann, CPA, CCA Director 608 240 2618 tony.ollmann@bakertilly.com Reminder To qualify for the CPE credit, you must complete the evaluation form at the end of the webinar. 34

Disclosure Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice di in this communication in promoting, marketing, kti or recommending a partnership or other entity, investment plan, or arrangement to any other party. Baker Tilly refers to Baker Tilly Virchow Krause, LLP, an independently owned and managed member of Baker Tilly International. The information provided here is of a general nature and is not intended to address specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. 2012 Baker Tilly Virchow Krause, LLP 35