Financial Audits in Construction: How to Prepare for & Manage an Audit

Financial audits are not something people look forward to facing — the process is intended to find mistakes and weak points — but regular audits can improve the overall health of a company and its relationships with financial partners. Audits in construction help contractors assess their spending and accounting processes, and better prepare financial documents for lenders and bond sureties.

This article will discuss the different types of financial audits in construction, what happens during an audit, and how to best prepare a contracting business for them.

What is a construction financial audit?

A construction financial audit is the detailed and methodical review of a contractor's financial statements and the transactions that comprise these statements by an independent third party. During the course of a financial audit, contractors should expect auditors to perform testing and sampling of their general ledger accounts for accuracy and completeness, as well as confirm their work-in-progress (WIP) schedule.

A construction financial audit confirmation verifies the contracts on a contractor's WIP schedule are accurate — the auditor ensures that the clients are real-life entities, the contract dates line up, and the change orders are correct. The auditor then takes a small sample of the company's payables accounts, including subcontractors and material suppliers, to verify the contracts are accurate and that the contractor has paid them as claimed. The process can be extensive, but the quicker it is for a contractor to find the supporting documents, the quicker it may go.

Financial audits are conducted by a third party, usually an accountant. The certified public accountant (CPA) firm will provide management with an engagement agreement that outlines the scope of their audit before commencement. Contractors would be wise to ensure the scope of the audit will sufficiently satisfy the requirements of the intended users of the audited financial statements. The audit firm will then work with the accounting department of a general contracting firm to locate the required samples. Once the audit is complete, the accountant provides the contractor with an audit package that proves the business's trustworthiness. 

Contractors often keep up-to-date financial audits on file for lenders, investors or construction project owners to view upon request. Financial audit packages covering a few years are usually required during the project bidding process, and it’s common for contractors to be audited on a regular basis — often yearly.

Internal vs. external audits

During an external audit, the auditor prepares or reviews a company's financial statements for third-party use, such as sharing them with a bond company.

Contracting firms may also conduct audits for their own purposes to ensure appropriate internal controls and procedures are followed and identify any gaps in procedures as new accounting requirements are published. This process would be considered an internal audit, although an objective third party would still perform the review. An internal audit is focused more on processes than a financial result, results are not made public. 

Companies may also perform internal audits to identify any deficiencies in their internal processes and correct them and any resulting financial misstatements ahead of an external audit. An interim external audit can also be performed ahead of the annual audit to speed up the external audit process at the end of the year as well as allow the company time to mitigate any deficiencies identified in the interim.

In either case, the contractor is the party hiring the third-party firm to conduct the audit.

How does a construction audit work?

The purpose of an audit is to confirm that construction invoices are correct and ensure the project is going as contracted. An auditor may:

• Cross-reference payrolls, invoices, and contracts to ensure they comply with the contract
• Judge the adequacy of internal controls and work processes to control finances
• Verify payables listed are correct
• Determine that assets are properly classified 

The audit may follow a series of steps to accomplish these objectives.

1. Review of standard operating procedures: The auditor becomes familiar with how the company works and what its internal controls look like, and evaluates potential risks. For instance, many contractors will only include projects over a certain dollar value in the WIP schedule. The auditor would need to understand that threshold and why it applies. They may make suggestions on adjusting the threshold depending on the scope of their engagement. If the company policy is to get two signatures on an invoice before accounts payable cuts a check, the auditor will learn that fact.
2. Look at financial statements: The auditors may review internal financial statements for any glaring variances or concerning ratios. Supporting reconciliations of asset accounts may be requested and any unreconciled accounts may warrant additional time and review. A detailed register of general ledger transactions may be requested to assist the auditor in compiling their sample sizes.
3. Sample selection: The auditor will work with accounting staff to select a sample of projects to inspect from the WIP schedule — for example, all highway projects, certain types of customers or all projects over a million dollars that closed the previous year. 
4. Gather backup data: The contractor’s internal accounting staff provides support for all samples. The auditor reviews the information to determine how complete it is. 
5. Conduct internal verification: The auditors will speak with project managers on sampled projects to get their perspective. For instance, if a specific project was underbid, there may be notes explaining why. The auditor would check with the project manager separately to get another opinion on whether the numbers or the explanation for the underbid makes sense based on what happened during the project. 
6. Conduct external verification: The auditor will check with the subcontractors and vendors of the sample jobs to ensure the invoices line up. If a general contractor owes a subcontracting firm a hundred thousand dollars and has records of paying them $900,000 to date, the auditor will ask the subcontractor to check their accounts payable to verify those payments happened. 
7. Compile the audit package: Finally, the auditor will put together a finalized audit package that has the audited financial statements in it. 

Throughout the process, the auditor will keep an eye out for anything else that looks suspect. For ecample if a company has a standard of paying everyone in 30 days but is suddenly paying everyone in 60 days and getting behind on due dates, the auditor will seek to find out why. 

Auditors also complete checks on financial statements as a whole. If a company ended this year with $100,000 in overbilling, but last year ended with $3 million in overbilling, what could be the reason behind that? What's different year over year to account for that giant swing on the balance sheet? By testing those individual accounts, the audit can sniff out other issues or inconsistencies. 

What Happens When the Audit Reveals a Problem

The auditor is there to identify any potential red flags that could mar a company's good financial standing, every firm that goes through an audit hopes only small discrepancies come up. 

Any kind of material deficiency will have to be explained during bidding prequalification or on loan applications. A company will have to provide context for the problem and explain what processes have changed so it won't happen again. 

If the audit identifies something that the owners weren't expecting, it can prompt a serious examination of internal controls and their failures. 

Here's an example of how an internal control failure could happen: One employee has a credit card with a $3,000 limit. That employee is trusted and vetted and frequently makes company purchases that justify a bit of leeway. On a particularly busy day, that employee gives the card to another worker to run out and make a purchase. 

Instead of the approved purchases, the worker makes a large and unnecessary purchase — a vehicle accessory that actually winds up doing damage to the vehicle. 

Now, the business had to come up with new internal controls to address this problem — in this case, who is authorized to make purchases and who needs to sign off on vehicle installations. Internal controls can always be broken, but the more checks and balances there are, the less chance there is of a serious problem occurring. 

Internal controls protect both a company and its employees. A single employee can't be held solely liable for a mistake if two managers signed off on the decision. By following controls, employees take a step to distance themselves from any large mistakes.  

What do construction audits reveal about contracting businesses?

The auditors can tell a lot about a business' operation by looking into construction contracts. One of the main things they look for is whether the contractor is invoicing honestly. For instance, if a contractor invoices for 50% complete based on cost and is bringing in all that revenue accordingly, an auditor will determine if corresponding invoices exist or if the contractor has those costs booked based on fluff invoices to recognize more revenue.

Auditors can follow those little breadcrumb trails that indicate the business is making some bad decisions, and it's worthwhile for the auditor to look at more contracts and invoices for further information. A business that can't substantiate its invoices will be a big red flag for lenders.

If the math doesn't add up because of a genuine mistake, it could mean the business has some holes in its accounting processes. On the other hand, the business could be attempting to get away with fraud. Either situation may give lenders pause — they may still go ahead and lend the contractor money, but also charge a higher interest rate or require more collateral. 

Here's an example of innocent-seeming process issues that could lead to trouble later on: Consider a member of the financial team who's in charge of getting manager signatures on loan documents and then notarizing the signed sheets to sign off on their integrity. The worker has thousands of such documents to process each week. She realizes it's easier to gather all the documents and notarize them together, then get the manager to sign them afterward instead of the other way around. The worker never intended to deceive anyone or to cause problems, but the broken process could lead to trouble if an issue cropped up with one of the documents that was notarized but not signed.

Best Practices for Managing Construction Audits

1. Reconcile regularly.

Even with good accounting systems in place, sometimes things get missed. Regular reconciliation helps ensure proper documentation on each project can catch small problems before they become larger patterns.

For example, a contractor may require all subcontractors to have a certificate of insurance on file or a lien waiver for every single invoice, but an off day leads to a gap in these file records. For instance, someone in accounts payable may have paid invoices without attaching lien waivers. 

Reviewing project files to ensure that invoices have the right lien waivers, all certificates are attached and there are signed, fully executed subcontract documents on file before closing out the project or even periodically throughout the cycle can fill those gaps before they become problematic. 

2. Hold regular progress meetings.

Hold regular financial progress meetings with staff over the course of each project. Talk about expenditures and outliers and process errors to get ahead of any audit that happens. 

3. Always follow company procedures.

Adhere to the company procedures, including paperwork and signature requirements. Keep those records accurate and up to date, knowing at some point there will be an audit that requires them. I

4. Don’t fear surprises — expect them.

Companies can't ever be completely prepared for audits. It's the auditor's job to find errors in the company's paperwork. Be prepared to confront issues head-on to prevent problems in the future.

Technology is Changing Construction Audits

Systems that allow for accurate and easy record-keeping improve the audit process for contractors — for them, the most difficult thing about the process is finding and pulling sample data. A standardized repository for invoices and contract documents makes it very easy to just find that information and turn it over.

If a company finds a process error internally, the accounting team can call it out in a note as a known error, and explain the steps in place to fix it. A simple explanation can demote an internal error from a material weakness, which points to serious troubles within a business.

Standardized processes can make the audit process cheaper, too. The auditors bill for their time in sifting through all the information a contractor provides to them. If the data is incomplete or incorrect, the auditor will have to bill for the time it takes to read it and figure out that it was incomplete. Systems that allow contractors to keep complete and organized records make audits a lot easier and help them find problems before the auditor does. 

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