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The Institute of Chartered Accountants of India
(Set up by an Act of Parliament)
Technical Guide on Internal Audit of Construction Industry
DISCLAIMER: The basic draft of the Technical Guide was prepared by CA. M. Guruprasad. The views expressed in this Technical Guide are those of the author and may not necessarily be the views of the organisation he represents.
The Institute of Chartered Accountants of India
(Set up by an Act of Parliament)
© The Institute of Chartered Accountants of India All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior permission, in writing, from the publisher.
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Internal Audit Standards Board
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Rs. 150/- (Including CD) 978-81-8441-345-8 The Publication Department on behalf of The Institute of Chartered Accountants of India, ICAI Bhawan, Post Box No. 7100, Indraprastha Marg, New Delhi -110 002. Sahitya Bhawan Road, Agra-3. Publications, Hospital
April/2010/1,000 Copies ii
The construction industry is a key indicator and driver of economic activity and wealth creation. This industry has a profound impact on the society and the products of this vital industry are of various types like, buildings, roads and bridges, utility distributions systems, railways, airports, harbours, etc. The future of this investment laden industry depends upon its capacity to evolve on business, technological and environmental fronts. Internal auditors have a key role to play in construction industry with respect to multi-dimensional challenges faced by this industry like, project risk, funding strategies, cost reduction, project monitoring, etc. This demands that internal auditors understand the basic concepts and peculiarities of this industry and brace them up to newer challenges. I am happy to note that the Internal Audit Standards Board has brought out this Technical Guide on Internal Audit of Construction Industry. This Technical Guide provides the readers a crisp insight into various technicalities arising in the operations of this industry and covers the relevant issues which the internal auditors must be aware of. I congratulate CA. Shanti Lal Daga, Chairman, Internal Audit Standards Board and the members of the Board on issuance of this Technical Guide. This Technical Guide comprehensively deals with the peculiar aspects of construction industry and provides a step-wise approach for internal audit. I am sure that this Technical Guide will assist the members and others in efficiently discharging their responsibilities.
February 16, 2010 New Delhi iii
CA. Uttam Prakash Agarwal President, ICAI
The construction industry in India accounts for more than 8% of the GDP and has been on a high growth trajectory. Despite the high growth potential, the industry is subjected to more risk and uncertainty than many other industries. Many of the risks emerge over time and are linked to the life cycle of the project. Thus, the potential for improving the management for construction projects is significant. Internal auditors who understand the basic structure and processes of construction project management and tailor their internal audit work to the unique time and organisational framework can play a meaningful role. They can assist in implementing controls that provide reasonable assurance of mitigating cost, schedule and technical risk to an immaterial level. The Institute had in 1987 issued the Guidelines on Internal AuditConstruction Industry. Since then the construction industry has transformed in view of introduction of the new trades and work practices, better safety and quality standards, productivity benchmarks both by government organisations and by the industry. The Guidelines have been thoroughly revised to reflect these changes, especially, those arising out of the significant developments in regulatory environment. This revised version of Technical Guide on Internal Audit of Construction Industry is aimed to help the readers in understanding not only the regulatory framework and technical aspects of the construction industry but also the procedures to be undertaken by the internal auditor. This Guide has been divided into various chapters dealing with the fundamental concepts in construction industry. These chapters deal with the introduction, technical aspects, regulatory framework of the construction industry, methodology for internal audit and internal audit checklists of functional areas. The Appendix containing flow charts regarding various processes carried out in
the industry and a glossary of terms used in the construction industry provide valuable guidance to the readers. At this juncture, I am grateful to CA. M. Guruprasad for sharing his experiences and knowledge with us and preparing the draft of the revised Guidelines and bringing them in line with the latest developments in the field. I also wish to thank CA. Uttam Prakash Agarwal, President and CA. Amarjit Chopra, Vice President for their continuous support and encouragement to the initiatives of the Board. I must also thank my colleagues from the Council at the Internal Audit Standards Board, viz., CA. Rajkumar S. Adukia, CA. Ved Jain, CA. Abhijit Bandyopadhyay, CA. Bhavna G. Doshi, CA. Pankaj I. Jain, CA. Sanjeev K. Maheshwari, CA. Mahesh P. Sarda, CA. S. Santhanakrishnan, CA. Vijay K. Garg, Shri Krishna Kant, Shri Manoj K. Sarkar and Shri K. P. Sasidharan for their vision and support. I also wish to place on record my gratitude for the coopted members on the Board, viz., CA. N. K. Aneja, CA. Verendra Kalra, CA. Dilip Kumar Vadilal Shah and CA. K. S. Sundara Raman as also special invitees on the Board, viz., CA. K. P. Khandelwal, CA. S. Sundarraman, CA. Ravi H. Iyer, CA. Rajiv Dave, CA. Pawan Chagti, CA. Ram Mohan Johri and CA. Arindam Guha for their devotion in terms of time as well as views and opinions to the cause of the professional development. I also wish to place on record the efforts put in by CA. Jyoti Singh, Secretary, Internal Audit Standards Board and her team of officers, viz., CA. Arti Aggarwal and CA. Gurpreet Singh, Senior Executive Officers, for finalising this publication. I am certain that the readers, especially members of the Institute, working as internal auditors in construction industry would find this Technical Guide immensely useful.
February 10, 2010 Hyderabad
CA. Shantilal Daga Chairman Internal Audit Standards Board vi
Actionable Claim As defined in the “Transfer of Property Act, 1882”. Means a claim to any debt, other than a debt secured by mortgage of immovable property or by hypothecation or pledge of moveable property, or to any beneficial interest in immovable property not in the possession, either actual or construction, other claimant, which the civil courts recognise as affording grounds for relief, whether such debt or beneficial interest be existent accruing conditional or contingent. Bid Bond A debt secured by a bidder for a construction job or similar type of bidbased selection process for the purpose of providing a guarantee to the project owner that the bidder will take on the job if selected. The existence of a bid bond provides the owner with assurance that the bidder has the financial means to accept the job for the price quoted in the bid. Sector engaged in preparation of land and construction, alteration and repair of buildings, structures and any other real property.
It is an interest in property, which is available to a person only at a future date on the happening or not happening of an uncertain event. A written document which specifies the terms for construction as agreed between the parties. It is a contingency period during which any modification, alterations, repairs or rework to the scheduled premises is performed by the entity as compliance with the contract is liable to be performed. Includes Companies, Partnership Firms, Limited Liability Partnerships, Cooperative societies, Trusts, Hindu Undivided Families and any other legal form under which business operates. It is the certificate given by the client at the completion of defects liability period. Goods as defined under Sales Tax Laws. Goods means all kinds of movable property (other than newspaper, actionable claims, stocks and shares and securities) and includes livestock, all materials, commodities, and articles (including goods or in some other form) involved in the execution of works contract or those goods to be used in the fitting out improvement or repairs of
Defects Liability Period (DLP)
Final Acceptance Certificate (FAC) Goods
movable property and all growing crops, grass, or things attached to or forming part of the land which are agreed to be severed before sale or under the contract of sale. Immovable Property As per the General Clauses Act, 1897 “shall include land, benefits to arise out of land, and things attached to the earth, or permanently fastened to anything attached to the earth”. Inheritance is an estate descended to their heir immediately on the death of the ancestor by virtue of his rights as a descendant. It is a legal right in rem which becomes an interest when it is attached to a land, building, chattel, object, article or thing and which is both recognised and protected under law. It is both inheritable and transferable in accordance with law. It is basically of two types:
Vested Interest Contingent Interest.
As defined under section 105 of the “Transfer of Property Act, 1882”. A Lease of immovable property is a transfer of right to enjoy such property, made for a certain time, express, or implied, or in perpetuity, in consideration of a price paid or
promised, or of money, a share of crops, service or any other thing of value, to be rendered periodically or on specified occasions to the transferor by the transferee, who accepts the transfer on such terms. Movable Property As per the General Clauses Act, 1897 “Anything not a immovable property”. Performance Bond A bond issued to one party of a contract as a guarantee against the failure of the other party to meet obligations specified in the contract. For example, a contractor may issue a bond to a client for whom a building is being constructed. If the contractor fails to construct the building according to the specifications laid out by the contract, the client is guaranteed compensation for any monetary loss. Property Refers to the legal right and interest of a person in and attached to land, building or object, article or thing or in respect of any intangible assets like, goodwill, copyrights, etc, held and enjoyed by him to the exclusion of others, which is both recognised and protected under the law. Such a right and interest is transferable, inheritable and is capable of being mortgaged, hypothecated or otherwise encumbered. It is the certificate given by the client at the time of the handover of the
Certificate (PAC) Real Estate or Real Property
scheduled premises by the entity to the client. Denotes all lands, buildings, super structures, infrastructures and all improvements accretions thereto and all rights, interest and titles attached to them. It is something, which enable a person to do or not to do some act, deed or thing, generally or in relation to a land, building, chattel, object, article or thing. The term ‘thing’ includes intangible assets too. An immovable property is the subject matter of various rights like, the right to posses, use, enjoy, alter, consume, destroy, alienate, hypothecate, transfer, bequeath, inherit, succeed to, etc.
Right in Rem
A right against or in respect of a thing.
Spes Successions It is a mere right to succeed to a property in the future. Succession Succession is the transmission of rights and obligations of deceased to their heirs. The title is the documentary base by which the legal right and interest to property is recorded, established and evidenced.
A transfer is an act or transaction by which one person conveys a property in favour of another person. The term has been defined in various enactments including tax laws with various meaning and connotations to cover transactions of wider nature. As defined under Section 5 of the “Transfer of Property Act, 1882”. Means “An act by which a living person conveys property in present or in future, to one or more other living persons, or to himself, or to himself and one or more other living persons, and “to transfer property” is to perform such act. In this section “living person” includes a company, or association of persons or body of individuals”.
Transfer of Property
Turnkey or a A turnkey is one in which a contractor Package Contract undertakes to finance, design, construct and commission a project in it entirety. Vested Interest It is an interest in property, which is available to a person at present or at a future date on the happening of a certain specified event which must happen.
Foreword......................................................................................iii Preface ..........................................................................................v Glossary......................................................................................vii
Chapter 1: Introduction .................................................. 1-3 Objective and Scope of the Technical Guide ........................2 Chapter 2: About the Indian Construction Industry ...................................................... 4-14 Evolution ...............................................................................4 History of the Indian Construction Industry ...........................4 Stages of a Construction Project...........................................6 Definition of the Project .............................................6 Planning for the Project ..............................................6 Execution Stage .........................................................7 Completion Stage.......................................................8 Post Completion Stage...............................................8 Benefits of the Construction Industry to the Society..............8 Special Features of the Indian Construction Industry............9 Business Process Related .........................................9 Contracts..................................................................10 Employee Related ....................................................11 Others ......................................................................11
Major Operational Challenges Faced by Entities ................12 Chapter 3: Legal Framework...................................... 15-20 Ministry of Commerce and Industry, GOI ............................15 Ministry of Finance, GOI .....................................................15 A Gist of Important Regulations that may be Applicable to an Entity.........................................................16 The Transfer of Property Act, 1882 ..........................16 Special Economic Zone Act, 2006............................16 The Minimum Wages Act, 1948 ...............................17 The Factories Act, 1948 ...........................................17 The Industrial Disputes Act, 1947.............................17 Other Applicable Indian Acts to the Industry .......................18 Governance Laws ....................................................18 Economic Laws ........................................................19 Contract Laws .........................................................19 Labour Laws ............................................................19 Other Laws as applicable to the Industry .................20 Other Applicable International Acts to the Construction Industry ..........................................................20 The Sarbanes-Oxley Act, 2002 ................................20 Chapter 4: A Reference to Statutory Laws Applicable to Indian Construction Industry .................................................... 21-26 Income Tax .........................................................................21 Service Tax .........................................................................22
Availing Input Credit .................................................23 Works Contract ...................................................................24 Input Credit Set-off Scheme .....................................24 Works Contract Tax Deducted at Source .................25 Deduction on the Rate of Works Contract Tax .........25 Special Economic Zone ......................................................25 SEZ Rules, 2006 ......................................................25 Chapter 5: Internal Audit ............................................ 27-39 Factors Contributing to the Evolution of Internal Audit .................................................................................28 Increased Size and Complexity of Businesses.........29 Enhanced Compliance Requirements ......................29 Focus on Risk Management and Internal Controls to Manage Them........................................29 Stringent Norms Mandated by Regulators to Protect Investors ......................................................29 Unconventional Business Models.............................29 Intensive Use of Information Technology .................29 An Increasingly Competitive Environment................30 Methodology for Internal Audit ...........................................30 Standards on Internal Audit ......................................30 Terms of Internal Audit Engagement........................31 Knowledge of the Business .....................................32 Audit Planning, Materiality and Sampling .................33 Internal Control.........................................................33
Internal Audit in an Information Technology Environment .............................................................35 Overview of Compliance ..........................................36 Chapter 6: Major Areas of Internal Audit Significance.............................................. 40-95 Selection of a Project ..........................................................40 Approvals for Registration...................................................43 Procurement .......................................................................45 Material Handling and Storage............................................58 Fixed Assets .......................................................................59 Total Fixed Cost ......................................................62 Asset Utilization ratio................................................62 Cash and Bank ...................................................................67 IOUS ........................................................................68 Revenue Recognition..........................................................72 Recognition of Contract Revenue and Expenses .................................................................74 Payroll .................................................................................78 Operating Costs ..................................................................82 Hiring Expenses .......................................................82 Repair and Maintenance ..........................................83 Logistics ...................................................................83 Agreement with Collaborators.............................................86 Running Account Bill (RAB) ................................................87 Disputed Claims ..................................................................88
Measurement Sheets ..........................................................89 Risks Faced by an Entity Operating in the Construction Industry ..........................................................89 Reduction of Risks ...................................................91 Maintenance of Books of Accounts and Documents...........92 Compliance with Standards and Regulations......................94 Appendix Appendix 1 Process Flow Chart for Procurement of Material and Services..........................................................97 Appendix 2 Process Flow Chart for the Purchase, Transfer and Disposal of Fixed Assets................................99 Appendix 3 Process Flow Chart for General Payments .......................102 Appendix 4 Process Flow Chart for Recognition of Construction Revenue, Service Revenue and Recognition of Work in Progress ..............................................................103 Appendix 5 Process Flow Chart for Making Statutory Deduction with Respect to Payroll, Month-end Processing of Payroll and Payroll Disbursement Process ......................................................106
1.1 Construction activity is an integral part of a country’s infrastructure and industrial development. It includes hospitals, schools, townships, offices, houses and other buildings, urban infrastructure (including water supply, sewage, drainage), highways, roads, ports, railways, airports, power systems, irrigation and agriculture systems, telecommunications, etc. Construction becomes the basic input for socio-economic development as it covers such a wide spectrum. Besides, the construction industry generates substantial employment and provides a growth impetus to other sectors through backward and forward linkages. It is, essential therefore, that, this vital activity is nurtured for the healthy growth of the economy. Moreover, it is one of the earners of foreign exchange as more and more organisations have started to provide services outside India. 1.2 The construction industry has major linkages with the building material industry since construction material accounts for sizeable share of the construction costs. These include cement, steel, bricks/tiles, sand/aggregates, fixtures/fittings, paints and chemicals, construction equipment, petro-products, timber, mineral products, aluminium, glass and plastics. Construction activities also include civil, mechanical and electrical engineering activities. The construction industry is a capital intensive industry. It is also labour predominant industry. In general, the construction industry deals with development of real property. It involves work to be performed at the specific location, where the property is located. Only the administrative works are carried out at the centralized location. It has become specialised in the recent years which have lead to work to be performed on “turnkey” basis. On the other hand, major projects have been awarded to a consortium of contractors. Also, the role of sub-
Technical Guide on Internal Audit of Construction Industry contracting has played a significant part, considering the trend of hiring labour, transporters, electricians, plumbers, welders on sub-contract has increased.
Objective and Scope of the Technical Guide
1.3 This Technical Guide is intended to assist internal auditors in carrying out internal audit of entities operating in the construction industry. The Technical Guide deals with operational areas of entities operating in this industry with emphasis on compliance mandated as per various regulations applicable to the specific industry. 1.4 Today, the scope of internal audit has increased from mere verification of financial transactions to reviewing of proper, efficient and economical usage of resources by the entity. Therefore, it is imperative that an internal auditor familiarises with various management aspects and technical aspects of the construction industry for performing internal audit in a more efficient and effective manner. This Technical Guide covers the following aspects: (i) (ii) Glossary of terms peculiar to construction industry. Scenario in the construction industry, special features and challenges faced by entities operating in this industry. Discussion on Internal Audit and compliance related issues. Legal Framework for entities operating in the Indian construction industry. Major areas of internal audit significance and risks faced by an entity operating in this industry, procedures that an internal auditor can perform. Appendix
(iii) (iv) (v)
Introduction 1.5 This Technical Guide does not cover the following aspects: (a) (b) (c) (d) Special audits Investigations Property Development Companies Construction of Specialised projects such as, airport, dams, ports, railways, etc.
ABOUT THE INDIAN CONSTRUCTION INDUSTRY
2.1 It is important for an internal auditor to gain an understanding of the Indian construction industry, its evolution, special features of the construction industry and the challenges faced by entities operating in the industry in order to understand the critical areas, nuances and knowledge of the business thereby helping him in framing internal audit procedures to perform an efficient and effective internal audit.
2.2 The evolution of Indian construction industry was almost similar to the construction industry evolution in other countries, i.e., founded by government and slowly taken over by private enterprises. After independence the need for industrial and infrastructural developments in India laid the foundation stone of construction, architectural and engineering services. The construction sector became organised since the 1950’s post incentives taken by the government to develop these services.
History of the Indian Construction Industry
2.3 The history of the Indian construction industry dates back to period from early 1950 to mid 60’s which witnessed the government playing an active role in the development of these services and most of construction activities during this period were carried out by state owned enterprises and supported by government departments. In the first five-year plan, construction of civil works was allotted nearly 50 per cent of the total capital outlay. 2.4 The first professional consultancy company, National Industrial Development Corporation (NIDC), was set up in the
About The Indian Construction Industry public sector in 1954. Subsequently, many architectural, design engineering and construction companies were set up in the public sector such as • • • • Indian Railways Construction Limited (IRCON) National Buildings Construction Corporation (NBCC) Rail India Transportation and Engineering Services (RITES) Engineers India Limited (EIL), etc.
In the private sector, companies such as following were incorporated: • • • M. N. Dastur and Co. Hindustan Construction Company (HCC) Ansals.
2.5 In the late 1960s government started encouraging foreign collaborations in these services. The Guidelines for Foreign Collaboration, first issued in 1968, stated that local consultant would be the prime contractor in such collaboration. The objective of such an imposition was to develop local design capabilities parallel with the inflow of imported technology and skills. This measure encouraged international construction and consultancy organisations to set up joint ventures and register their presence in India. 2.6 The importance of this sector in India need not be overemphasized. In India, construction has accounted for around 40 per cent of the development investment during the past 50 years. Around 16 per cent of the nation's working population depends on construction for its livelihood. The Indian construction industry comprises 200 firms in the corporate sector. In addition to these firms, there are about 1,20,000 Class A contractors registered with various government construction bodies. There are thousands of small contractors, which work as sub- contractors of prime or other contractors.
Technical Guide on Internal Audit of Construction Industry The main reason for this is the increasing emphasis on involving the private sector infrastructure development through public-private partnerships (PPP) and mechanisms like, buildoperate-transfer (BOT).
Stages of a Construction Project
2.7 The construction industry has various stages. Based on the nature of the construction to be performed, the following may or may not be applicable in the same sequence:
Definition of the Project
2.8 In the project definition phase, objectives are developed and the scope of the project is specified. This is the most important phase of the project which determines the success or failure of the project. This activity can be split in two broad stages as described below: (i) Site Investigation – This activity is performed at the initial stages, say at the bidding stage. It involves processes like, soil testing, ground landscape, structure, assessment of ground quality, stability and other factors important for ensuring sufficient life to the construction. Feasibility Study Preparation – The feasibility of the project is appraised apart from other processes like, cost analysis, legal documentation, process of entering into various contracts, etc.
Planning for the Project
2.9 Project planning involves marshalling the resources and developing the systems and procedures necessary to control activity during project execution. A successful planning effort would result in development of following three distinct controls: (i) Scope Controls - It ensures that the work performed is within the overall scope of the project. It is also to ensure that all parts of the projects are completed simultaneous and appropriately. 6
About The Indian Construction Industry (ii) Scheduled Controls - Controls should be in place to ensure compliance with schedule of work. This is extremely important to avoid project overruns and compliance with scheduled time. These controls are essential to avoid penalties & Charges for delay in completion of contracted work as agreed by the parties. Cost Controls - The importance of cost controls need not be specifically stated. These controls are most important for completion of project at the estimated cost. This is the most important control to ensure profitability.
2.10 In the execution stage, the following processes are involved: (i) Laying the Foundation – Once the materials are procured, with the help of labour, the foundation for the building is laid. The foundation is based on the strength of the superstructure. Brick and Masonary Work – In this stage, once the foundation has been laid, the building starts rising by construction of steel pillars and brick walls around them as per the approved plan. Laying Pipelines – At the time of construction of the super-structure, various pipes for water, sewage, drainage, & other disposal systems are laid apart from pipes laid for electric wiring. Steel and Wood Work – At the time of rising the building, the wooden frames are made and grills for the windows are also fixed. Wooden work includes work for doors, windows, fixtures, partitions and such other furnishing required are prepared. Completion of Construction – Once the above processes are through, the painting/whitewashing process starts.
Technical Guide on Internal Audit of Construction Industry It involves proper controls to ensure that the execution is as per the planning. If there are any significant deviations, then sufficiency of controls needs to be verified.
2.11 After completion of the project, the project should be reviewed and it is an invaluable tool for making sure that lessons learned carry over to the next project. The level of effort required in this phase varies with the size of the organization and the frequency with which capital projects are undertaken. If the organization is involved in a major expansion activity, with more projects anticipated, a detailed review of each project by management function is probably warranted. The formal reports from the reviews should be compiled to provide a road map for improving future performance.
Post Completion Stage
2.12 The entity might be required to provide fit outs, layouts in accordance with the terms of the contract.Upon completion of the Defects Liability Period, all liabilities with regard to the contract cease.
Benefits of the Construction Industry to the Society
2.13 The following are the benefits of the construction industry to the society: (i) (ii) (iii) (iv) Absorbs rural labour and unskilled workers (in addition to semi-skilled and skilled); Provides opportunity for seasonal employment thereby supplementing workers’ income from farming; Permits large-scale participation of women workers; and Development of Infrastructure, thereby sustaining the growth of economy.
About The Indian Construction Industry
Special Features of the Indian Construction Industry
2.14 The construction industry is unique in certain respects with respect to other industries. These can broadly be classified as following:
Business Process Related
The business of an entity operating in a construction industry has certain unique characteristics, risks, nuances. Some of them are as follows: (i) (ii) The risks for a construction industry are different from any other industry. The construction industry is capital intensive in nature. Huge investment needs to be made by the entity in purchasing of specialised equipment for its construction processes. In some cases, the entity hires specialised equipment from external sources. The entity might provide variety of services from building houses, commercial complexes, factories, ports, railways, roads, airports, etc. The risks for providing each type of service are different. The entity might be required to float tenders for projects, which requires detailed estimation of the costs required for the project. Construction services are required to be provided at the respective sites. Significant part of the operations is at the respective sites. Therefore, the need for proper control procedures need not be over emphasized. Requires high level of planning and execution to prevent escalation of costs, timely completion of projects thereby building brand.
Technical Guide on Internal Audit of Construction Industry (vii) In case, construction companies provide services outside India, they have to comply with foreign laws and regulations. Considering that this is a capital intense industry, and money is received from client only on completion of a certain percentage of work, in most cases, a high working capital is required for proper functioning of the industry. The entity sub-contracts most part of its work such as, welding, carpentry, transportation, plumbing to external parties thereby ensuring professional involvement in the performance of work, timely completion and also limiting the liability for the entity. Certain projects such as, construction of highways, bridges are provided by construction entities on a long term basis and are in the nature of Build, Own and Transfer (BOT) or Build, Own, Lease and Transfer (BOLT) basis. The entity post constructing the said infrastructure collects charges (toll) from the users of the facility to cover its cost over a long period of time, say 20 years. During the period, they are responsible to maintain them too. Post completion of the tenure, they are required to transfer ownership to concerned government department.
In general, contracts are entered for the work to be performed to ensure proper determination of scope of work, nature of work, fixation of responsibility, payment terms, escalation clauses, and so on. Some important aspects are as follows: (i) Different processes are handled for different clients and billed as agreed specifically between parties. Contracts are custom made and could be fixed price contracts or cost plus contract.
About The Indian Construction Industry (ii) Agreements are entered into between the client and the entity as regards the scope of work to be performed, the legalities involved, scheduled period of completion, billing details, escalation clauses, penalties and other charges. Billing is done in accordance with the work completed and as agreed between parties.
The employee related area in a construction industry is usually need based and the industry is also labour intense. Some special features are as follows: (i) Apart from being capital intensive, the industry is also predominantly labour dependant. Cheap and experienced labour is an important prerequisite for the success of the industry. Most workers who are involved in the construction activity are not highly educated. Only the supervisors are educated. The requirement of labour for the construction site is not constant and it keeps varying with level of specialisation, deadlines, nature of work, percentage of completion amongst other factors. In general, workers involved in the construction activity are paid on the basis of per day wages.
Data Security, reliance on external conditions are amongst the other peculiar features of the construction industry: (i) The level of construction activity is related to the government policy towards construction industry, importance given to infrastructure development, economic activity and schemes providing benefit for both individuals and entities.
Technical Guide on Internal Audit of Construction Industry (ii) The importance of data security need not be overemphasized. Critical data such as plans, profitability ratios, designs and unique strategies should be sufficiently safeguarded.
It is therefore, extremely important for an internal auditor to understand these special features for conducting the internal audit of the entity.
Major Operational Entities
2.15 The construction industry is a delivery based Industry. The construction industry in India is not yet completely organised. These service providers have unique challenges faced by the industry and also the risks are unique in nature. This section is intended to highlight some of the significant challenges that the construction industry faces so as to enable the internal auditor to plan and perform the internal audit accordingly. 2.16 The internal auditor is required to perform such audit procedures specific to the entity as deemed necessary to ensure systematic evaluation of risk management, control and governance processes. Some of these challenges are given below: (i) Challenges of meeting time schedules, cost schedules and compliance with the scope of work has been key for success and, thus,meeting them has been the greatest challenge for any entity operating in the construction industry. The internal auditor can assess the business risk, and also brand and reputation risk on not complying with deadlines. The effectiveness of controls can also be assessed by the internal auditor. (ii) The biggest challenge faced by an entity operating in the construction industry is availability of adequate manpower with appropriate skill sets at a reasonable 12
About The Indian Construction Industry cost. This is the most important factor to control for sustained growth of the entity. The internal auditor might analyse and assess the prospects of the business in future, apart from business risk. (iii) The client’s capacity to make payments as per the contract agreed also poses a big challenge considering that the funds get blocked up, increasing the working capital requirements significantly. The management also faces the challenge of managing the working capital requirements for the projects considering that some clients make the schedule payment only post completion of certain percentage of work. It is the management effectiveness in keeping the cost of borrowed funds as low as possible thereby ensuring that the profitability is not significantly affected. The internal auditor can assess the effectiveness of management in assessing clients and managing cost of borrowed funds before selecting them. The challenge of fair recognition of revenue and profit ever exists in the construction industry owing to the difficulty in estimating the exact percentage of work completed. The internal auditor can assess financial risk of recognition of revenue and incorrect billing apart from the effectiveness of the accounting process. Material handling has been a major problem for the industry. Improper handling and storage of materials leads to significant storage costs, wastage, and non– availability of critical materials at the appropriate time. The internal auditor needs to assess the efficiency of management with regards to handling of inventory. The construction industry is more prone to accidents than any other industry. Safety precautions of workers are extremely important and have been extremely difficult to achieve by most entities. The internal auditor has to assess such types of risks and precautions taken by management to avoid them. 13
Technical Guide on Internal Audit of Construction Industry (vii) The costs of materials at the time of contract are significantly different compared to cost at the time of performance of the work. In cases where the cost of materials required has escalated, the management might be finding it difficult to maintain profitability. The internal auditor should assess the process of making budgets and whether management is effective in determining the future costs. Legal Compliance has been relatively high considering many other Industries. Every contract entered by the entity has unique terms and conditions to be complied with, failing which may lead to penalties and other arbitration. The internal auditor can assess operational risks of business. Some projects require minimum criteria such as Minimum Turnover requirement/Minimum Net Worth requirement for bidding of clients. If the entity does not meet these criteria, they are not qualified to bid, thereby hindering their growth. The internal auditor can assess such types of business risk also. Certain regulatory requirements mandate the submission of specific financial statements. For e.g., an entity might be operating in SEZ and non-SEZ unit. In such a case, it is required to maintain separate books of accounts in order to ensure proper determination of profit for claiming of deduction/exemption with respect to units from these respective units from the perspective of Income Tax and Service Tax. The internal auditor can assess sufficiency of legal compliance. As an entity grows, the balance between machinery and manpower should be maintained at the optimum level. In general, greater level of mechanizing is required as the entity grows to sustain volumes and manage professionally and cost effectively. The Internal auditor can verify whether sufficient controls are in place for ensuring sustained development and growth. 14
3.1 This Chapter details the various acts applicable, and also organisations that supervise and regulate the construction industry in India.
Ministry of Commerce and Industry, GOI
3.2 The mandate of the Department of Commerce is regulation, development and promotion of India’s international trade and commerce through formulation of appropriate international trade and commercial policy and implementation of various provisions thereof. This Ministry formulates the regulatory provisions pertaining to the Special Economic Zones and EXIM Policy in India. 3.3 The Department of Industrial Policy and Promotion, setup under the Ministry of Commerce and Industry is responsible for Intellectual Property Rights relating to Patents, Designs, Trade Marks and Geographical Indication of Goods and oversees the initiative relating to their promotion and protection. This Department also formulates, promotes, approves and facilitates the Foreign Direct Investment (FDI) Policy. 3.4 Director General of Foreign Trade (DGFT) is a government organization in India responsible for the formulation of Export – Import guidelines and principles for Indian importers and Indian exporters of the country. The basic role of the Department is to facilitate the creation of an enabling environment and infrastructure for accelerated growth of international trade.
Ministry of Finance, GOI
3.5 The Ministry of Finance, India looks after the various financial affairs of the state of India. The Ministry of Finance,
Technical Guide on Internal Audit of Construction Industry India is responsible for monitoring the various aspects of the Indian economy and it operates through various departments. • • • • • Department of Economic Affairs Department of Disinvestment Department of Expenditure Department of Financial Services Department of Revenue
Various statutes such as Customs Act, 1962, Foreign Exchange Management Act, 1999, Income Tax, 1961 to name the significant ones, as applicable to the construction industry are formulated and governed by this Ministry.
A Gist of Important Regulations that may be Applicable to an Entity
The Transfer of Property Act, 1882
3.6 • • • The Transfer of Property Act, 1882 has been enacted for Enacting provision for transfer of property between living persons; Supplementary to Law of Contract; and To support and compliment succession Laws.
The scope of the act deals with transfer of immovable property. It does not include transfer operational by law.
Special Economic Zone Act, 2006
3.7 A Special Economic Zone (SEZ) is a trade capacity development tool, with the goal to promote rapid economic growth by using tax and business incentives to attract foreign investment and technology. The Central Government has framed the policy framework for SEZs through the SEZ Act. The State Governments play a significant lead role in the development of SEZs in their respective States by stipulating the conditions to be adhered to by an SEZ and granting the 16
Legal Framework necessary approvals. These supporting procedures are laid down in SEZ Rules as framed by the State Governments.
The Minimum Wages Act, 1948
3.8 The Minimum Wages Act, 1948, extends to the whole of India and applies to scheduled employments in respect of which minimum rates of wages have been fixed under this act. The objective of this Act is to fix minimum rates of wages in certain employments. The appropriate government (State Government or Central Government as the case may be) shall fix the minimum rates of wages payable to employees employed in a scheduled employment.
The Factories Act, 1948
3.9 The Factories Act, 1948 is a social legislation which deals with following aspects: (i) (ii) (iii) (iv) (v) (vi) (vii) Health; Safety; Welfare facilities; Working hours; Employment of young persons; Annual leave with wages; Contract employees and so on.
It requires compliance for enterprises which employ more than 10 employees.
The Industrial Disputes Act, 1947
3.10 The Industrial Disputes Act, 1947, extends to whole of India and applies to every industrial establishment carrying on any business, trade, manufacture or distribution of goods and services irrespective of the number of workmen employed therein. Every person employed in an establishment for hire or reward including contract labour, apprentices and part time 17
Technical Guide on Internal Audit of Construction Industry employees to do any manual, clerical, skilled, unskilled, technical, operational or supervisory work, is covered by the Act. The objective of the Act is to secure industrial peace and harmony by providing machinery and procedure for the investigation and settlement of industrial disputes by negotiations. 3.11 (i) The Industrial Disputes Act also lays down following: The provision for payment of compensation to the Workman on account of closure or lay off or retrenchment. The procedure for prior permission of appropriate Government for laying off or retrenching the workers or closing down industrial establishments. Unfair labour practices on part of an employer or a trade union or workers.
Other Applicable Indian Acts to the Industry
3.12 The various acts enacted by the Government to govern any industry and so also applicable to the construction industry are as follows: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) The Companies Act, 1956 Partnership Act, 1932 The Benami Transactions (Prohibition) Act, 1988 The General Clauses Act, 1897 The Land Acquisition Act, 1894 The Indian Easements Act, 1882 The Indian Stamp Act, 1899 The Negotiable Instruments Act, 1888 Land Reform Regulation of the respective states. The Indian Penal Code. 18
3.13 The various economic laws to which the construction industry may be subject to include: (i) (ii) (iii) (iv) (v) The Income Tax Act, 1961 Central Excise Act, 1944 The Customs Act, 1965 Chapter V of the Finance Act, 1994 relating to Service Tax Value Added Tax and Sales Tax Act
3.14 The various contract laws to which the construction industry may be subject to include: (i) (ii) The Indian Contract Act, 1872 Securities Contracts Regulation Act, 1956
3.15 There are a number of labour laws governing the construction industry. A few of the important ones are as follows: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) Employees Provident Fund Scheme, 1952 Employee State Insurance Act, 1948 Payment of Gratuity Act, 1972 Payment of Bonus Act, 1965 Professional Tax enacted by the respective states Shops and Establishment Act enacted by the respective states The Trade Union Act, 1926 Factory Rules of respective states.
Technical Guide on Internal Audit of Construction Industry
Other Laws as applicable to the Industry
(i) (ii) (iii) Securities Exchange Board of India Act, 1992 Foreign Exchange Management Act, 1999 Arbitration and Conciliation Act, 1996
The internal auditor is also expected to be aware of various circulars Issued by the RBI towards foreign currency transactions.
Other Applicable International Acts to the Construction Industry
3.16 Apart from the above, regulations of the respective country in which construction and related services are provided by the entity are also applicable to the entity. In such cases the agreement between the parties specifies the jurisdiction in case of arbitration, if any. In cases where the entity is listed in a stock exchange other than India, there might be regulatory requirements from the respective governing body of the company.
The Sarbanes-Oxley Act, 2002
3.17 This Act is applicable for Companies, wherein the Company or its holding company is incorporated and listed in the United States. The legislation has been enacted to set new or enhanced standards for all U.S. public company boards, management and public accounting firms. It does not apply to privately held companies. The act contains 11 titles, or sections, ranging from additional corporate board responsibilities to criminal penalties, and requires the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the new law.
A REFERENCE TO STATUTORY LAWS APPLICABLE TO INDIAN CONSTRUCTION INDUSTRY
4.1 This section is intended to provide broad guidelines of various laws, compliances required for entities opting for special status such as STPI, SEZ or EOU status. The internal auditor should refer to bare act of these laws and regulations and study the different cases and judgements by competent authorities. 4.2 Considering that these regulations undergo frequent amendment/changes, a detailed checklist has not been prepared. The internal auditor must update himself with the amendments, pronouncements and any new regulations enacted from time to time to ensure effective performance of internal audit.
4.3 Companies might have deduction either under Section 10A or Section 10B of the Income Tax Act, 1961. These provisions offer tax sops to SEZs (Special Economic Zones). As such, most units registered as STP or SEZ need not pay any corporate tax except MAT (minimum alternative tax). However, it is important that the business profits are determined using ‘arm’s length pricing’. This aspect is generally in the purview of the statutory auditor but it is advisable that the internal auditor understands the various requirements and compliances under these statutes/ regulations and conducts internal audit of the same. 4.4 The Income Tax Act, 1961 provides presumptive taxation for small construction entities. The Income Tax Act, 1961 also provides for deduction as a percentage of profits for entities operating in the Infrastructure Development.
Technical Guide on Internal Audit of Construction Industry
4.5 The definition of construction service given under clause (30A) of Section 65 is as follows: “Construction service" means, • • Construction of new building or civil structure or a part thereof; or Repair, alteration or restoration of, or similar services in relation to, building or civil structure,
which is • • • Used, or to be used, primarily for; or Occupied, or to be occupied, primarily with; or Engaged, or to be engaged, primarily in,
commerce or industry, or work intended for commerce or industry, but does not include road, airport, railway, transport terminal, bridge, tunnel, long distance pipeline and dam. 4.6 The definition of construction services is quite wide. It not only covers construction of new building/civil structure or part thereof but also includes repair, alteration or restoration of building. However, service tax will be applicable when such construction services are rendered in respect of the building/civil structure for the commerce and industry. In other words, construction services in respect of commercial building are taxable whereas construction services for residential premises/ building or non-commercial buildings are not covered under the ambit of service tax. However, construction services for following are excluded from ambit of service tax, namely, • • • • road; airport; railway; transport terminal; 22
A Reference to Statutory Laws Applicable to Indian Construction Industry • • • • bridge; tunnel; long distance pipeline and dam.
Availing Input Credit
4.7 The following is an illustrative list of major capital goods, inputs and input services on which CENVAT can be availed: • • • • • • • • • • • • • • • CED/ Additional Duty of Customs (CVD) on machinery or equipments CED on office equipment and computers CED on consumable tools and packing materials CED on chemicals used or consumed Construction of office or factory Transportation of goods by road service Internet charges Market research and market survey Recruitment and supply of manpower service Rental and insurance for premises and goods Telecommunications Consulting engineering Designing Other services used for providing the business auxiliary service Other services used in business.
4.8 The input credit can be availed only on payments made and it cannot be availed on accrual basis. However, in case there is excess credit during the month, the same can be 23
Technical Guide on Internal Audit of Construction Industry carried forward to the following month and can be set-off, whenever service tax liability arises. Abatement may be prescribed from time to time on the total value of contract on satisfaction of certain conditions such as, no credit of duty paid on inputs or capital goods has been taken under the provisions of the CENVAT Credit Rules, 2004.
4.9 Works Contract comes under the preview of Sales Tax/Value Added Tax as applicable to the respective States. The definition of “Sale” under the respective Sales Tax/Value Added Tax of the respective states includes Works Contract. Works Contract includes any agreement for carrying out for cash, deferred payment or other valuable consideration, the building, construction, manufacture, processing, fabrication, erection, installation, fitting out, improvement, modification, repair or commissioning of any movable or immovable property. 4.10 The entity needs to verify applicability of provision of Works Contract in accordance with the respective governing Sales tax/Value Added Tax. Works Contract can be broadly classified as: • • Works Contract including transfer of property in Goods– Covered under Sales Tax/Value Added Tax. Works Contract Not including transfer of property in Goods–Covered under Service Tax and other applicable acts as the case may be.
The rate of tax for Work Contract Tax varies from State to State.
Input Credit Set-off Scheme
4.11 “Input” means any goods, including capital goods purchased by a dealer in the course of his business for re-sale or for use in the manufacture or processing or packing or storing of other goods or any other use in business.
A Reference to Statutory Laws Applicable to Indian Construction Industry As there is no need to pay VAT on the services provided by the construction entity, they are not eligible to take input credit on purchases made by them.
Works Contract Tax Deducted at Source
4.12 The client shall deduct out of the amounts payable by them to a dealer in respect of any works contract executed for them in the State, an amount equivalent to the tax payable by such dealer under the Act.
Deduction on the Rate of Works Contract Tax
4.13 The Act provides for deduction on the value of contract, computed with respect to the provisions of the respective Sales Tax/Value Added Tax. The respective regulations provide for the basis for deduction based on the percentage of labour involved in the overall scope.
Special Economic Zone
4.14 For an entity providing construction service in a Special Economic Zone (SEZ), these regulations are applicable. Legal Framework for setting up SEZ is defined under SEZ Act and State SEZ Policy:
SEZ Rules, 2006
4.15 The main provisions of the Indian SEZ Rules, 2006 can be summarized as promotion of industrialization and economic 25
Technical Guide on Internal Audit of Construction Industry growth through sustainable development of Indian industries. The main essence of the Indian SEZ Rules, 2006, states that these Special Economic Zones of India shall be offered tax rebates, fiscal incentives and lands at subsidized rates. 4.16 Some of the key provisions of the Indian SEZ Rules, 2006 applicable to an entity operating in the construction industry are given below:
It should be exempted from excise/VAT on domestic sourcing of capital goods for project development. Freedom to develop township in the SEZ with residential areas, markets, play grounds, clubs and recreation centers without any restrictions on foreign ownership. It should be exempted from taxation on business income. It should be exempted from import duty, VAT and other taxes.
5.1 Most entities operating in construction industry are unorganised as related to its operations and a significant percentage of players operating in this sector are small in nature. Effective internal audit provides a tool to ease out all complexities, ensures that systems and processes are adequate to support the growth and are adapted to the changes in various applicable regulations, thereby ensuring sustained growth and development. 5.2 Preface to the Standards on Internal Audit, issued by the Institute of Chartered Accountants of India defines the term Internal Audit as follows: “Internal Audit is an independent management function, which involves a continuous and critical appraisal of the functioning of an entity with a view to suggest improvements thereto and add value to and strengthen the overall governance mechanism of the entity, including the entity’s strategic risk management and internal control system.” The abovementioned definition highlights the following facets of an internal audit: • Internal auditor should be independent of the activities they audit. The internal audit function is, generally, considered independent when it can carry out its work freely and objectively. Independence permits internal auditors to render impartial and unbiased judgment essential to the proper conduct of audits. Internal audit is a management function, thus, it has the high-level objective of serving management's needs
Technical Guide on Internal Audit of Construction Industry through constructive recommendations in areas such as, internal control, risk, utilization of resources, compliance with laws, management information system, etc. • Internal audit's role should be a dynamic one, continually changing to meet the needs of the organization. There is often a need to change audit plans as circumstances warrant. These changes may include coverage of new areas, assistance to management in solving problems, and the development of new internal audit techniques. An effective internal audit function plays a key role in assisting the board to discharge its governance responsibilities. Thus, it contributes in accomplishment of objectives and goals of the organization through ethical and effective governance. Risk management enables management to effectively deal with risk, associated uncertainty and enhancing the capacity to build value to the entity or enterprise and its stakeholders. Internal auditor plays an important role in providing assurance to management on the effectiveness of risk management. Internal audit function constitutes a separate component of internal control with the objective of determining whether other internal controls are well designed and properly operated. Thus, the examination and appraisal of controls are normally components, either directly or indirectly, of every type of internal auditing assignment.
Factors Contributing Internal Audit
5.3 General Guidelines on Internal Audit, issued by the Institute of Chartered Accountants of India, describes the
Internal Audit factors contributing the evolution of Internal Audit in India, which are as follows:
Increased Size and Complexity of Businesses
Increased size and business spread dilutes direct management oversight on various functions, necessitating the need for a full time, independent and dedicated team to review and appraise operations.
Enhanced Compliance Requirements
Increase in the geographical spread of the businesses has also led to crossing of political frontiers by businesses in a bid to tap global capital. This has thrown up compliance with the laws of the home country as well as the laws of that land as a critical factor for existence of businesses abroad.
Focus on Risk Management Controls to Manage Them
Internal auditors can carry out their job in a more focused manner by directing their efforts in the areas where there is a greater risk, thereby enhancing the overall efficiency of the process and adding greater value with the same set of resources.
Stringent Norms Mandated by Regulators to Protect Investors
The regulators are coming up in a big way to protect the interests of the investors. The focus of the latest regulations being ethical conduct of business, and enhanced corporate governance and financial reporting requirements, etc.
Unconventional Business Models
Businesses today use unconventional models and practices, for example, outsourcing of non-core areas, such as accounting.
Intensive Use of Information Technology
Information technology (IT) is invariably embedded in all spheres of activities of a modern business enterprise today, from data 29
Technical Guide on Internal Audit of Construction Industry processing to resource planning to online sales and e-commerce. Use of IT has, however, increased the threat of data thefts or losses on account of systems failure or hacking/espionage, as well as the need to comply with the cyber laws, etc.
An Increasingly Competitive Environment
Whereas deregulation and globalization have melted the political as well as other barriers to entry in the markets for goods and services, free flow of capital, technology and knowhow among the countries as well as strong infrastructure has helped in bringing down the costs of production and better access to the existing and potential consumers. This in turn, has lured more and more players in the existing markets, thereby, stiffening the competition.
Methodology for Internal Audit
Standards on Internal Audit
5.4 The Institute of Chartered Accountants of India has till date issued seventeen Standards on Internal Audit (SIAs), which aim to codify the best practices in the area of internal audit and also serve to provide a benchmark of the performance of the internal audit services. While formulating SIAs, the Board takes into consideration the applicable laws, customs, usages, business environment and generally accepted internal auditing practices in India. The list of Standards on Internal Audit (SIAs) is given below: SIA 1 SIA 2 SIA 3 SIA 4 SIA 5 SIA 6 SIA 7 SIA 8 Planning an Internal Audit Basic Principles Governing Internal Audit Documentation Reporting Sampling Analytical Procedures Quality Assurance in Internal Audit Terms of Internal Audit Engagement 30
Internal Audit SIA 9 SIA 10 SIA 11 SIA 12 SIA 13 SIA 14 SIA 15 SIA 16 SIA 17 Communication with Management Internal Audit Evidence Consideration of Fraud in an Internal Audit Internal Control Evaluation Enterprise Risk Management Internal Audit Environment in an Information Technology
Knowledge of the Entity and its Environment Using the Work of an Expert Consideration of Laws and Regulations in an Internal Audit
Some important aspects on internal audit has been discussed in the following paragraphs:
Terms of Internal Audit Engagement
5.5 The client is expected to formally communicate the appointment to the internal auditor. Upon receiving the communication, the internal auditor should send an engagement letter, preferably before the commencement of engagement so as to avoid any misunderstandings. The internal auditor and the client/auditee should record the terms of engagement in the letter or other suitable form of contract and it shall also confirm objective and scope of internal audit with the client. 5.6 The engagement letter should reference to the following aspects: • • • Objective of the internal audit Management’s responsibilities Scope of internal audit (including reference to the applicable legislation, regulation and various pronouncement of ICAI) generally include
Technical Guide on Internal Audit of Construction Industry • • Access to records, documents and information required in connection with the internal audit Expectation to receive management’s written confirmation in respect to representation made in connection with the audit Basis on which fees shall be computed and the billing arrangements thereof.
Any changes in the terms of the appointment should be communicated in written form. Moreover, the internal audit may be on a continuous basis, monthly, quarterly or even annual. It is important for the internal auditor to ensure that the periodicity of the internal audit is sufficient in the light of overall business condition.
Knowledge of the Business
5.7 Prior to commencement of internal audit assignment, the internal auditor should have or obtain the knowledge of the business. The internal auditor should acquire sufficient knowledge to enable him to identify and understand the events, transactions and practices that can have significant effect on the internal audit process. Such knowledge shall be helpful to the internal auditor in assessing the inherent risk and control risk and in determining the nature, timing and extent of the internal audit procedures. Knowledge of the business assists the internal auditor in: • • • • Assessing the risk and identifying the problems; Planning and performing the internal audit effectively and efficiently; Evaluating audit evidence; and Providing better service to the client.
The internal auditor should prepare the flow of events, transactions, processes and practices within the organisation. This will help him in gaining better understanding of the process
Internal Audit and the existence of the internal controls. Illustrative flowchart of the business process is given as Appendix.
Audit Planning, Materiality and Sampling
5.8 After acquiring the knowledge of business and various laws and regulation applicable to the construction industry the internal auditor should plan out the internal audit activity. Planning helps in achieving the objectives of internal audit function. Adequate planning ensures that: • • • • • Appropriate attention is devoted to significant areas of audit Potential problems are identified Skills and time of the staff are appropriately utilised Work is carried out in accordance with the applicable pronouncements of ICAI Work is carried out in conformity with the applicable laws and regulation.
5.9 In preparing an internal audit program, an internal auditor should obtain an understanding of the accounting and internal control system prevalent within the entity, exercise preliminary judgement regarding the critical areas to be considered during the internal audit. It also helps the internal auditor in determining the audit materiality, nature and extent of audit procedures to be adopted. While designing an audit sample the internal auditor should consider the specific audit objectives, materiality, population from which the internal auditor wishes to select the sample, area of audit significance and the sample size.
5.10 Internal controls are a system consisting of specific policies and procedures designed to provide management with reasonable assurance that the goals and objectives it believes important to the entity will be met.
Technical Guide on Internal Audit of Construction Industry "Internal Control System" means all the policies and procedures (internal controls) adopted by the management of an entity to assist in achieving management's objective of ensuring, as far as practicable, the orderly and efficient conduct of its business, including adherence to management policies, the safeguarding of assets, the prevention and detection of fraud and error, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information. The internal audit function constitutes a separate component of internal control with the objective of determining whether other internal controls are well designed and properly operated. 5.11 Internal control system consists of following inter-related components: • • • • • • • • Control (Or Operating) Environment Risk Assessment Control Objectivity Setting Event Identification Control Activities Information and Communication Monitoring Risk Response.
5.12 The system of internal control must be under continuous supervision by management to determine that it is functioning as prescribed and is modified, as appropriate, for changes in environment. The internal control system extends beyond those matters which relate directly to the functions of the accounting system. 5.13 The internal auditor should obtain an understanding of the significant processes and internal control systems sufficient to plan the internal audit engagement and develop an effective internal audit approach. The internal auditor should use professional judgment to assess and evaluate the maturity of the entity’s internal control. The auditor should obtain an 34
Internal Audit understanding of the control environment sufficient to assess management's attitudes, awareness and actions regarding internal controls and their importance in the entity. 5.14 The internal auditor should examine the continued effectiveness of the internal control system through evaluation and make recommendations, if any, for improving that effectiveness. The importance of internal controls in a construction entity need not be over-emphasized. Internal audit plays a major role in determining the effectiveness of internal controls and highlights areas for improvement. The Internal auditor may also refer to Standard on Internal Audit (SIA) 12, “Internal Control Evaluation” for a detailed discussion on internal control.
Internal Audit Environment
5.15 Computer Information System (CIS) environment exists when one or more computer(s) of any type or size is (are)involved in the processing of financial information, including quantitative data and the significance in relation to the audit, whether those computers are operated by the entity or third party. 5.16 The overall objective and scope of internal audit does not change in a CIS environment. However, the use of computer changes the processing, storage, retrieval and communication of financial information and may affect the accounting and internal control systems employed by the entity. Moreover, the risks involved in an internal audit may too undergo a change. The internal auditor should have sufficient knowledge of the CIS environment to plan, direct, supervise, control and review the work performed. 5.17 The data in an Entity operating in CIS environment is, generally, voluminous. The CIS automatically generates material transaction or entries and exchanges transaction automatically with other organisation as in electronic data interface (EDI) systems. Source documents, computer files and 35
Technical Guide on Internal Audit of Construction Industry other evidential matter exist only for short period and in machine readable form. The use of the computer Assisted Audit Technique (CAAT) shall increase the efficiency in the performance and enable the internal auditor to economically apply certain procedures to the entire population or accounts transaction. 5.18 The internal auditor should understand the CIS Environment in designing audit procedures to reduce the audit risk to an acceptable low level. The internal auditor should also document the audit plan, the nature, the timing and the extent of audit procedures performed and the conclusions drawn from the evidence obtained which may be in the electronic form. The internal auditor should ensure that such electronic evidence is adequately and safely stored and is retrievable in its entirety, as and when required. 5.19 The internal auditor may refer to Standard on Internal Audit (SIA) 14, “Internal Audit in an Information Technology Environment” for guidance on procedures to be followed when an audit is conducted in a computer information systems (CIS) environment.
Overview of Compliance
What is Compliance? 5.20 Compliance means ensuring conformity and adherence to regulatory acts, rules, procedures, laws, regulation, directives and circulars. Standard on Internal Audit (SIA) 17 issued by the ICAI relating to “Consideration of Laws and Regulations in an Internal Audit“ states that when planning and performing audit procedures and in evaluating and reporting the results thereof, the internal auditor should recognize that non compliance by the entity with laws and regulation may materially affect the financial statements. However, an audit cannot be expected to detect non compliance with all laws and regulations. Detection of non compliance, regardless of materiality, requires consideration of the implications for the integrity of
Internal Audit management or employees and the possible affect on the other aspect of the audit. 5.21 Non-compliance with laws and regulations could result in financial consequences for the entity such as, fines, litigation, etc. Internal auditor cannot be expected to detect noncompliance with all laws and regulations; however this argument shall not apply to engagements where the internal auditor is specifically engaged to test and report separately on compliance with specific law and regulations. The management is responsible to ensure that the entity’s operations are conducted in accordance with laws and regulations. The responsibility for prevention and detection of non-compliance shall be that of the management; however the internal auditor should plan and perform the internal audit recognising that the internal audit may reveal conditions or events that would lead to questioning whether an entity is complying with laws and regulations. 5.22 The term “Non-compliance “refers to acts of omission or commission by the entity being audited, either intentional or unintentional, which are contrary to the prevailing laws and regulations. Such acts include transactions entered into by, or in name of the entity or on its behalf by the management or employees. However, non compliance does not include personal misconduct (unrelated to the business activity of the entity) by the entity’s management or employees. Understanding of Laws and Regulations 5.23 Laws and regulation vary considerably in their relation to the financial statements. Some laws or regulations determine the form or content of an entity’s financial statement or the amounts to be recorded or disclosures to be made in financial statements. Other laws or regulation are to be complied with by management or prescribed by the provisions under which the entity is allowed to conduct its business. Non-compliance with laws and regulation could result in financial consequences for
Technical Guide on Internal Audit of Construction Industry the entity such as, fines, litigation, etc. It also has a potential effect on going concern as an entity. 5.24 The internal auditor should plan and perform the audit recognizing that the audit may reveal conditions or events that would lead to questioning whether an entity is complying with laws and regulations. In order to plan the internal audit, the internal auditor should obtain understanding of the legal and regulatory framework applicable to the entity and how the entity is complying with that framework. 5.25 To obtain this understanding, the internal auditor would particularly recognize that non-compliance of some laws and regulations may have a fundamental effect on the operations of the entity and may even cause the entity to cease operation, or call into question the entity’s continuance as going concern. To obtain the understanding of laws and regulations, the internal auditor would ordinarily: • • Use the existing knowledge of the entity’s industry and business. Inquire with management as to the laws or regulations that may be expected to have a fundamental effect on the operations of the entity. Inquire with management concerning the entity’s policies and procedures regarding compliance with laws and regulations. Discuss with management the policies or procedures adopted for identifying, evaluating and accounting for litigation claims and assessments.
After obtaining the understanding, the internal auditor should perform procedures to identify instances of non-compliance with those laws and regulations where non-compliance should be considered while preparing financial statements, specifically: • Inquiring with management as to whether the entity is in compliance with such laws and regulations. 38
Internal Audit • Inspecting correspondence with the relevant licensing or regulatory authorities.
Significance of Compliance 5.26 (a) The significance of compliance is: The benefits to the Industry are: • Helps in compliance with legal terms and covenants and thereby reduces penalties and charges Increased Internal Control Reduction of internal frauds and losses More time available for other core activities Increases efficiency in operations Customer satisfaction.
• • • • • (b)
The benefits to the stakeholder are: • • • • Ensures risk containment and safer market place Better investor confidence Uniform practices Better image, hence, better value for the investor.
MAJOR AREAS OF INTERNAL AUDIT SIGNIFICANCE
6.1 Internal audit procedures that apply to any industry also apply to an entity operating in the construction industry. In this technical guide, specific internal auditing procedures pertaining to construction industry have been specified. These audit procedures are illustrative in nature which can be performed, in addition, to the regular internal audit procedures performed by an internal auditor. 6.2 The internal auditor needs to assess the work performed at the location and the centralised office. Based on the operations performed by the entity, the internal auditor needs to plan his audit procedures.
Selection of a Project
6.3 Incredibly, many construction projects are initiated without even the most basic cost-benefit analysis or feasibility study. Documented evidence justifying the project should be submitted, even though proceeding with a project that will not result in an increase in revenue or financial position can be acceptable in some instances. Sometimes projects are undertaken to maintain market share in a competitive industry or to provide a service or product line that will complement another. 6.4 Internal auditors should determine whether the project has been evaluated before being accepted by the entity, appropriate approvals have been obtained and ensure that the risk on accepting the project has been properly evaluated by the management.
Major Areas of Internal Audit Significance A few Analytical Procedures that can be performed by the internal auditor include:
Evaluation of project wise profitability ratio of projects completed during the period. Evaluation of budgeted profitability of all new projects approved.
These ratios should be compared to the previous periods and explanations for any significant fluctuations needs to be obtained. The following is a model checklist related to bidding and selection of a project: S. No. 1. 1.1 Particulars Is there a written policy with the entity as regards its bidding process? Is the policy complete in all regards including obtaining bid bonds and performance bonds? Is the written policy updated at frequent intervals by the entity based on its previous experience? Has the entity performed site investigation before entering the bidding process? Has the entity obtained sufficient approvals at the appropriate level of authority before accepting the process? Has the entity prepared budgets of the estimated cost of the project in detail with respect to all costs and considered the escalation of costs on a reasonable basis in the case of fixed price contracts? 41 Yes No N/A Bidding Process and Selection of a Project
Technical Guide on Internal Audit of Construction Industry S. No. 1.7 1.8 1.9 Particulars Are the bids approved by appropriate level of authority? the Yes No N/A
Are there written policies/processes for placing bids by the entity? Does the entity enter into contracts for all parties? Are the terms of the contract complete in all aspects such as term of the contract, specifications if any, escalation clauses as agreed, responsibilities, penalties, etc? Does the entity ensure compliance with the terms of the contract? Is the agreement entered into with clients signed by both the parties at the appropriate level before commencement of work? Does the entity provides services to Related Parties? Are there proper systems in place to ensure that there is unbiased pricing in the case of Related Parties so as to ensure that the pricing is done at arm’s length price? Does the entity have the process of evaluating the credit worthiness of the customer? Does the entity requests for a bid bond? If a bid bond is not obtained, does the written policy specifies alternative procedures? On a sample basis, has the internal auditor verified the compliance of this policy? 42
Major Areas of Internal Audit Significance S. No. Particulars Yes 1.17 Does the internal auditor need to verify the risk involved if the entity does not obtain performance bonds? 1.18 Is the minimum limit to obtain these bonds fixed in relation to the risk taking ability by the entity and is it frequently reviewed? Are there any exceptions in complying with the procedures related to performance bonds? Has appropriate approvals for such cases obtained and what are the reasons for not obtaining performance bonds? No N/A
Approvals for Registration
6.5 The entity needs to liaison from various government authorities for approvals right from the start of the construction project. The building constructed without sanctions or deviated more than 5 per cent from approved plan attracts penalty, and authorities have right to demolish the building without any prior notice. The following are the approvals or sanctions required for builder for any construction activity. (i)
Building Plan: A builder should submit building plan before starting the construction activities. Building plans are a graphical representation of what a building will look like after construction. Building plan ensures that building complies with building laws. Once the building plan is approved, builder should commence construction work within two years and there should be no deviation from the sanctioned plan. Layout Approval: The builder has to get approval of layout plan from concerned authorities before starting construction of residential or commercial building. Constructing building in unapproved layout will not be
Technical Guide on Internal Audit of Construction Industry given permission to occupy or such layout plots will be treated as continuing offence and exemplary penalties will be levied as per Municipal laws. Land which is subdivided into plots without permission from competent authority is considered illegal or unapproved layout. No facilities such as, roads, drainage, street lighting will be extended in such areas. (iii)
Basic Amenities: The builder should get approval
from concerned authorities for electricity, water for potable and non-potable use. The building should comply with building laws for sanction or approval of basic amenities.
No Objection Certificate (NOC): The builder has to
get NOC from pollution board on the project. It is essential for the approval for sewer or water supply. It is also important to get NOC from the neighboring properties to prove that builder is not encroaching any neighborhood property. Builder has to get NOC from municipality or respective authority for digging bore well. Digging bore well without NOC or approval will be levied penalty and material used for digging bore wells would be seized. In case of construction of building with lift facility, builder has to get NOC from lift authorities.
Completion Certificate: Completion Certificate is
mandatory for building constructed before selling or being occupied. Issuing of Completion Certificate will ensure that the builder or owner has constructed the building as per approved plan.
Clear Title: The builder has to get clear title for the
land or plot. Clear title ensures that the property is clear, marketable and it traces any charges or encumbrances created on the property and its present status. It enables a prospective buyer to know the chain of holdings, transfers over a period and, thereby, check any dispute on the ownership of the property. 44
Major Areas of Internal Audit Significance (vii)
Approval for Conversion of Land: Some builders
use agricultural land for constructing building for residential or commercial purpose. In such case builder needs to get approval from concerned authority to convert agricultural land to non-agricultural (NA) purpose.
Apart from the above, there may be additional approvals required to be obtained as per the respective State/Corporation in which the entity is operating. The internal auditor is required to verify the various approvals obtained from the statutory authorities with this regard. This plays an important role in reduction of risk of a project.
6.6 Procurement is the most essential part of an entity operating in the construction industry. It refers to the items/services procured by the concern in order to enable it to provide its services. For the construction industry, procurement usually consists of cement, iron, steel, sand, bricks and gravel. Apart from the above mentioned, purchase also includes purchase of services and purchases of labour. 6.7 In general, the entity enters into contracts for supply of materials used for its construction. This ensures procurement of factors of production at the right time. The process of procurement can be shown as below:
Technical Guide on Internal Audit of Construction Industry A brief of each of the factors of productions is given below:
Material: Purchase of material in a construction
industry is as important as for any other manufacturing industry. Hence, proper planning is required for the purchase and storing of such material. These include stores and spares purchased by the entity.
Services: As compared to other industries, construction
industry cannot survive merely on material. Procurement of services from service providers and sub-contractors are highly required. Services may include soothing of wood, electrical contracting, etc.
Labour: Construction industry cannot have the same
number of employees at all time. With time and contracts more or less people may be required on site. Hence, the industry mainly relies on contract labourers. They are supplied by the sub-contractors as and when required.
Vendor Management: The first and foremost activity
in the procurement department would be identifying and selecting vendors. The whole process is covered under vendor management. The decisions taken regarding vendors have a huge bearing on the enterprise. They affect the cost, quality and even timing aspects. Hence, it is very important to manage this particular section. This section involves a series of activities like, calling for quotations, screening the vendors, selection of vendor, maintaining the vendor manual, entering into contracts with vendors, renewing the contracts, etc. Vendor Manual is a document which contains the details of all the vendors called for, and those who have been short listed. Apart from this the enterprise can also resort to means such as, internet, yellow pages, business magazines, trade journals, etc. But vendor manual is important since it saves efforts on the quotation calls each time. Vendors can be assigned codes based on their priority, location, quality or a combination of all. 46
Major Areas of Internal Audit Significance In a construction industry, certain purchases like, purchase of sand, cement and steel is very common and frequent. The enterprise can enter into agreement with the vendors for such purchases. The process involved in the management of vendors will mainly constitute of recognizing the prospective sellers, calling for quotations from them, negotiations with the vendor, screening the list and selecting the vendor, updating of the vendor details in the vendor manual ,entering into a contract if required, periodic review of the functioning of the vendor, etc. (v) Material Provided by the Client: In some cases, the client provides materials for construction purposes. In such cases, the internal auditor needs to verify whether the contract with the client provides for the same. In general, the entity provides controls either as accounting for the materials and the client account. Scrap Sales: It is very common in an industry that the inventory becomes obsolete before it is put to use or it is damaged in some process. In that case the enterprise has to scrap the inventory and dispose it. In most cases it will fetch a nominal amount for such disposal. Generally, this process also is taken care of by the Procurement department. The process consists of intimating the head of the team, project and department about the scrap generated, submission of the report regarding the scrap, approvals by the respective heads, disposing off the scrap, making the necessary accounting entries, updating the stock register, planning for the re-procurement of such inventory, etc. The enterprise must evaluate the scrap generation and take necessary steps to reduce the scrap in case the percentage of scrap is high. A report regarding the same may be sent to the head of the department who will take necessary steps over the enquiry. 47
Technical Guide on Internal Audit of Construction Industry (vii) Maintenance and Administration: The importance of maintenance and administration process need not be over-emphasized. Without proper maintenance of materials procured and proper administration and management of employees and contractors, the enterprise cannot optimize its efficiency. Adequate controls should be created to ensure proper maintenance of materials and proper administration.
6.8 Internal auditor shall review the following processes and make the observations, if any: (i) Vendor Management • • • • • Vendor selection process Vendor database Vendor coding system Annual contracts for main raw material like, steel, cement, sand and aggregates Periodic evaluation of vendor- How often enterprise is doing its vendor evaluation with regard to cost, quality of material supplied and timing of supply Periodic review of vendor selection policy- How often enterprise is reviewing its vendor selection policy
Material/service requisition process • • • Process of identifying the requirement of material Whether it is included within limits of budget, if not then obtain planning department approvals Whether it is raised by an authorized person
Purchase order It should be reviewed with respect to following aspects: • Vendor: Whether vendor is out of approved vendor list 48
Major Areas of Internal Audit Significance • • • • Requisition: Whether requisition is approved Whether cost comparison statement is made and approved Whether the payment terms and delivery terms are as per approval and according to policy Whether the purchase order format includes the information relating to
○ ○ ○ ○ ○ ○
Date and location of delivery, requisition number, material code with detailed description and quantity, agreed rate and total amount, payment terms, other terms and conditions.
Receipt of Material • • • Review of procedure on receipt of material Material received is in match with purchase order raised Ensuring whether goods received note (GRN) is issued only after receipt of material acceptance from quality department and store-in-charge.
Supply Chain Management • • Verify the steps followed by the enterprise to ensure the availability of material at all the times Generally, the enterprise shall cover the following in its supply chain management:
○ ○ ○
Identify materials with high price volatility Identify materials with seasonal nature Identify alternative products. 49
Technical Guide on Internal Audit of Construction Industry (vi) Cash purchases at site • Review the company policy and controls for cash purchases at the site. Generally, the enterprises provide cash at the site to meet any immediate requirement or unplanned material.
Other services • Review the procedure adopted by the enterprise to acquire services such as, Security service, Consultancy services, Travel Services and Courier services. Identification of suitable service and vendor shall be done by procurement department A contract shall be entered with the vendor which provides for:
○ ○ ○ ○ ○ ○ ○
Date of commencement and completion of work Exact outcome expected Any conditions and specifically offered Monitoring and arrangements recommendations evaluation of
Support and supervision arrangement Penal clauses Financial arrangement - payment methods and timing
• • (viii)
The copy of agreement will be provided to accounts and administration departments Procurement department shall performance of vendors periodically. review
Scrap identification and disposal • Review the procedure to identify scrap material 50
Major Areas of Internal Audit Significance • • (ix) Procedure of disposal of sale Periodic interval of scrap sale.
Internal auditor shall review the following MIS reports and verify that the top management is reviewing these reports as per the enterprise’s standard procedures or not: • • • • Purchase order track sheet Project cost analysis – variance report Cash purchase report Quotation tracker.
For model processes of procurement related to Materials, Services and Labour, refer Appendix 1. 6.9 The internal auditor can perform various analytical procedures including following:
Percentage of Scrap Generated over a Period of Time
In case of procurement of lower grade material/defective material or due to defective storage of material, the material procured might have to be scrapped. The internal auditor can assess whether steps are taken by the management for dealing with such ineffective procurement or storage are adequate.
Number of Delays in Receipt of Material
The number of delays in receipt of material helps the internal auditor in analyzing whether the materials are purchased/procured on time. There may be instances where the entity may have to stop its construction activity awaiting receipt of critical material.
Technical Guide on Internal Audit of Construction Industry
Materials Procured over a Period of Time
Sometimes, entities procure huge quantities of materials and store them. These materials might be of use after a substantial period of time but, could have been purchased and stored, thereby blocking working capital apart from depreciation/loss of material. Therefore, the internal auditor may verify the material procured over a period of time and verify that there is no unnecessary hoarding of material and blocking of working capital apart from usage of storage area.
Number of Labourers Employed
The internal auditor can analyze the average number of employees working over a period of time, process-wise and verify whether the process is consistently sufficiently staffed. This helps the internal auditor to assess the delays in schedule due to lack of workers and report accordingly.
Average Cost per Employee
Average cost incurred for an employee (cost includes all direct and indirect cost incurred for employees) based on function can be computed by dividing the total cost incurred for a period to average number of employees during the period. The internal auditor may compare this information between different periods and verify whether there has been significant change in the labour charge per employee.
Average Cost of Contract Worker
Average cost incurred for a contract worker based on function can be computed by dividing the total cost incurred for a period to average number of contract workers employed during the period. The internal auditor may compare this information between different periods and verify whether there has been significant change in the labour charge per contractor. This can also be compared with the contract entered with the contractor and significant fluctuations should be noted and explanations need to be obtained for them. 52
Major Areas of Internal Audit Significance
Cost of Employing a Contract Laborer to an Employee
The internal auditor may make a comparison between costs paid to an employee as against a contract worker. The cost needs to include all direct and indirect costs incurred. This comparison would be of greater help in cases where the entity goes for contracting of a work frequently or routinely.
Interest Cost to Loans
Interest cost to loans provides a basis for the estimation of the average cost of borrowed funds in the entity. The internal auditor can estimate the average cost of borrowing and compare them with the existing rate to verify whether the interest paid is significantly high. These ratios should also be compared to the previous periods and explanations for any significant fluctuations needs to be obtained. Model Checklist Related to Procurement Process S. No. 1. 1.1 Materials Does the entity have a written policy for the procurement process? Is the written policy sufficient and complete in all aspects? Is the policy updated on a frequent basis? Is there a proper requisition note with approval from the appropriate level of authority sent from the concerned department? Does the entity raise an approved request for quotation (RFQ) within reasonable time across various suppliers? 53 Particulars Yes No N/A Audit of Procurement Process
1.2 1.3 1.4
Technical Guide on Internal Audit of Construction Industry S. No. 1.6 Particulars On receipt of various quotations, are there sufficient processes to ensure that the right quotation is approved as regards quality, reliability, price and other factors? On selection of the supplier, has an approved purchase order been placed with the supplier within reasonable time? Are there sufficient controls to trace the purchase order and its status within the entity to ensure receipt of materials without delay? Does the entity ensure penal clauses in case of delays in receipt of critical material to ensure timely supply? Are there any contracts entered by the entity with suppliers for critical materials to ensure adequate supply at a reasonable price? Are there sufficient procedures to inspect materials as regards to specification and quantity, received by the entity at the site before unloading and signing of the delivery note? Are there sufficient documentary controls such as Gate pass for entry of goods? Has a sample compliance of performed? check for procedures Yes No N/A
Major Areas of Internal Audit Significance S. No. 1.14 Particulars Is the process of receipt of material properly co-ordinated to the Finance department to ensure proper accounting? Does the material receiving department maintain sufficient records of receipt and inspection of material? Has the delivery note been approved by the appropriate level of authority before making the entry? In cases where materials are supplied by client, has the internal auditor ensured that there has been appropriate accounting of such material? Does the entity have proper control for materials received from the client? Are they separately identified and demarcated? In case of critical materials or slow moving material does the entity transfer the materials from one site to another rather than from purchasing them from external sources? Labour Does the entity have a written policy for the process? Is the written policy sufficient and complete in all aspects? Is the policy updated on a frequent basis? 55 Yes No N/A
2. 2.1 2.2 2.3
Technical Guide on Internal Audit of Construction Industry S. No. 2.4 Particulars Is there a proper requisition note as regards the skills and educational qualification required for the concerned department? Has the same been approved by the appropriate level of authority? Does the entity raise an approved request for quotation across various service providers? Are there significant delays in raising the request for quotations? Are there sufficient attendance records, in-time and out-time records, and other records maintained? Does the attendance record match with the order placed for labour? Does the entity comply with various regulations with relation to procurement of labour? Are there sufficient controls to ensure that the service is provided without delays? Once the service is provided, has it been approved by the appropriate level of authority? Are proper and appropriate entries made in the books of accounts? Service Contracts and Sub-contracts Does the entity have a written policy for the process? Is the written policy sufficient and complete in all aspects? 56 Yes No N/A
2.12 3. 3.1 3.2
Major Areas of Internal Audit Significance S. No. 3.3 3.4 Particulars Is the policy updated on a frequent basis? Is there a proper requisition note with approval from the appropriate level of authority sent from the concerned department? Is there a valid, proper contract with the service provider/ contractor? Does the entity raise an approved request for quotation across various service providers? Are there significant delays in raising the request for quotations? On receipt of various quotations, are there sufficient processes to ensure that the right quotation is approved as regards quality, reliability, price and other factors? On selection of the service provider, has an approved Work order been placed with the Service Provider within reasonable time? Are there sufficient controls to ensure that the service is provided without delays? Once the service is provided, has it been approved by the appropriate level of authority? Are proper and appropriate entries made in the books of account? Yes No N/A
Technical Guide on Internal Audit of Construction Industry
Material Handling and Storage
6.10 Handling and storing materials involves diverse operations such as, hoisting tons of steel with a crane; driving a truck loaded with concrete blocks; carrying bags or materials manually; and stacking palletized bricks or other materials such as drums, barrels, kegs, and lumber. 6.11 The efficient handling and storing of materials are vital to industry. In addition to raw materials, these operations provide a continuous flow of parts and assemblies through the workplace and ensure that materials are available when needed. Unfortunately, the improper handling and storing of materials often result in costly injuries. It has generally been observed that storage of materials has not been effective in many small construction entities. It is extremely important to store materials in a proper manner to ensure that proper usage is possible. To add further, there are various certifications for handling of materials such as OSHA 2002. Model Checklist Related to Material Handling and Storage S. No. 1. 1.1 Particulars Material Handling and Storage Does the entity have a proper location for storage of critical materials? Does the entity ensures utilisation of materials on First in First Out basis? Are there controls in the entity pertaining to ageing of materials to ensure that proper valuation of nonmoving inventory is done? In cases of write-off of inventory are proper considerations given to excise duty implications? Are materials requested only in accordance with the requirements? 58 Yes No N/A
Major Areas of Internal Audit Significance S. No. Particulars Yes 1.6 In case of materials such as, cement, steel, iron, etc, proper storage facilities exist to prevent spoilage of material? 1.7 In cases of availability of critical material/non–moving material in a location, is it transferred to another location to ensure proper and efficient utilisation of material? 1.8 In cases of transfer from one location to another location are there sufficient controls to ensure accounting of transfer of material and at the right value? No N/A
6.12 Fixed assets in the case of an entity operating in the construction industry normally includes items such as, land and buildings, plant and machinery, furniture, fixtures and fittings, motor vehicles, office equipment, computers, etc. Fixed assets are generally stated at historical cost less accumulated depreciation. Cost includes taxes, duties, freight, levies, insurance, etc., attributable to the acquisition and installation of assets. Cost excludes taxes, duties, etc., recoverable subsequently from the taxing authorities and the exchange differences arising on import of such assets. 6.13 Acquisition, transfer and disposal of fixed assets should be done in accordance with the prescribed accounting procedures. There are three important processes related to Fixed Assets:
Technical Guide on Internal Audit of Construction Industry
Purchase and Maintenance: Fixed assets are very
important to enable the enterprise run its activity. Hence, it is very essential to organize the purchases of such fixed assets. With passage of time, the asset may require remodeling to suite the requirements of the entity. Periodic maintenance activities need to be performed to ensure proper working and life of the asset.
Disposal: Over a period of time, an asset depletes or
becomes obsolete due to usage or improvement of technology. Assets needs to be disposed/scraped and an alternative asset may be required to be procured.
Transfer: Transfer of asset is an internal arrangement
unlike sale and purchase which are external. Transfer involves movement of the asset from one department to another, or from one site to another. It is basically movement of asset from one location to another location involving a change in the charge of responsibility. Internal auditor shall check the following to evaluate the internal control systems with regard to fixed assets: (a) Whether there is proper system of segregation of duties with regard to: • • • • (b) (c) Authorization of acquisition, disposal and transfer of fixed assets Execution of transactions acquisitions and disposals Recording of transactions Physical custody of items. relating to
Review the entity’s procedure to identify the asset requirement. Review the entity’s procedure for deciding the asset procurement or hiring. In case of procurement, on full payment or hypothetication.
Major Areas of Internal Audit Significance (d) Whether the particular capital expenditure is included in capital budgeting? If not, whether the necessary management approvals been obtained for execution? Whether there is a well laid down procedure for acquisition of fixed assets with regard to invitation of quotations, selection of suppliers, approval of prices, payment terms, technical specifications and delivery schedule? Whether the necessary approvals from appropriate level of authority been obtained for transfer of fixed asset from one location to an other location? Whether the date of identified and recorded? installation is rightly
Check the reasonability of identification of depreciation method with regard to useful life of the asset. Are there adequate controls over disposal of fixed assets with regard to • • • Decision of particular asset being retired from use or scrapped; Invitation of quotations, approval of prices; Proper documentation of fixed assets.
Whether the fixed asset register maintained and updated to latest date with regard to: • • • Owned assets, leased assets and hired assets Fully written-off assets Disposable assets.
Whether the physical verification of assets done at periodic intervals? 61
Technical Guide on Internal Audit of Construction Industry (l) (m) (n) Whether the proper coding of asset is done and each asset is identified with that code? Whether the fixed assets are adequately/properly insured and renewed regularly without fail? Procedures to ensure proper compliance with the following Accounting Standards issued by the ICAI: • • • • AS 6 : Depreciation Accounting AS 10: Accounting for Fixed Assets AS 16: Borrowing Costs AS 28: Impairment of Assets
For model processes of purchase, disposal and transfer of fixed assets, refer Appendix 2. 6.14 The internal auditor can perform various analytical procedures over a period of time and compare them for ascertaining any inconsistency such as following:
Total Fixed Cost
Significant increases in the total fixed cost signals expansion activity. In such cases, the internal auditor needs to verify the sufficiency of controls with respect to the growing entity.
Asset Utilization Ratio
Asset utilization ratio is the ratio of total revenue to the total assets. It helps the internal auditor to assess the effectiveness of assets with respect to the revenue made by the entity. In general, the higher the asset utilisation ratio, the higher is the operating efficiency of the entity. If the internal auditor is required to perform fixed asset verification procedures too as a part of the scope of his work, the auditor can refer to Guidance Note on Audit of Fixed Assets.
Major Areas of Internal Audit Significance Model Checklist Related to Fixed Assets S. No. 1. 1.1 Particulars Purchase of Fixed Assets Does the entity have a written policy for the procurement process? Is the written policy sufficient and complete in all aspects? Is the policy updated on a frequent basis? In case, the entity has an option to manufacture the asset, does it evaluate the make option and buy option? Is there a proper requisition note with approval from the appropriate level of authority sent from the concerned department? Does the entity raise an approved request for quotation (RFQ) within reasonable time across various suppliers? On receipt of various quotations, are there sufficient processes to ensure that the right quotation is approved as regards features, price, after sales service and other factors? On selection of the supplier, has an approved purchase order placed with the supplier within reasonable time? 63 Yes No N/A
Audit of Fixed Assets
1.2 1.3 1.4
Technical Guide on Internal Audit of Construction Industry S. No. 1.9 Particulars Are there sufficient controls to trace the purchase order and its status within the entity to ensure receipt of fixed assets without delay? Are there sufficient procedures to inspect and test the assets as regards to its condition and compliance with the specifications placed by the entity before approving the delivery note? Are there sufficient documentary controls such as gate pass for entry of assets In case of commissioning of assets, has a commissioning certificate obtained from the suppliers? Is the receipt of assets properly coordinated to the Finance department to ensure proper accounting? Are the assets tagged and coded in accordance with the firm’s methodology? Has the delivery note been approved by the appropriate level of authority before making the entry? Has the fixed asset purchased been entered in the fixed asset register? Yes No N/A
Major Areas of Internal Audit Significance S. No. 2. 2.1 Particulars Maintenance of Fixed Assets Are there processes in the entity to ensure proper and periodic maintenance? Is it in accordance with the nature of the asset? Does the entity enter into Annual Maintenance Contracts (AMC) for its maintenance? Is there a record of maintenance performed by entity for all major assets? Disposal of Fixed Assets Are there procedures in the entity to determine whether the asset can be disposed off? In case the asset is sold, is a disposal requirement note sent by the concerned department? Does the entity request for quotation before making the sale? Is there a proper valuation process of fixed assets before the price is finalised? Have appropriate approvals been obtained before disposal of fixed assets? Have the sale of assets properly co-ordinated to the Finance department to ensure proper accounting? 65 the the Yes No N/A
Technical Guide on Internal Audit of Construction Industry S. No. 3.7 3.8 Particulars Have the fixed asset register been updated for the sale? In case of scraping of the asset, has the maintenance department confirmed scrapping of the asset? Is there a separate log book maintained by the entity for the assets scrapped along with the location where the scrap is located and is it frequently updated? Transfer of Fixed Assets (From Site to Site) Has there been an approved requisition note by the concerned department? Has there been an approved outward note for transfer of asset from its existing location issued? Has there been an inward note issued? approved Yes No N/A
Has the fixed asset register updated for the transfer on a timely basis? Does the entity have the policy of evaluating the availability of idle fixed assets at other project sites before hiring of equipment? Does the entity have a process of preparing a cost benefit analysis of such transfers before the decision to transfer is taken? Does the entity identify the assets of the sub-contractor separately? Does the entity verify its fixed 66
Major Areas of Internal Audit Significance S. No. Particulars Yes assets on a frequent basis considering its size and level of operations? Does the entity deals with all the deviations noted on physical verification of assets appropriately? No N/A
Cash and Bank
6.15 Cash and Bank plays a vital role for any business entrepreneur. The management of this liquid asset speaks about the ethics of an entity. With all kinds of vigilant measures implemented to safeguard these current assets, yet loop holes, will be there. Bank transactions can be more regularized than cash transactions, as the risks involved in cash is comparatively high. As such in case of construction entities cash transactions are relatively huge ranging from petty to large. The different types of transactions that get covered here include: • • • • • • • Receipts of contract and consultancy fees Payment to vendors and sub-contractors Fund transfers Payment of petty expenses, cash withdrawals and imprest payments Cash and bank book maintenance Recording and transactions reporting of all cash and bank
Recording and reporting of bank guarantees and letter of credits.
In some cases, there might be a requirement to carry enormous sums of money in cash for payment of wages to the workers, meeting expense for purchase of materials, and alike. 67
Technical Guide on Internal Audit of Construction Industry Illustration of how the procedure is normally followed in relation with a construction entity is mentioned here under. In the course of formulating the procedures other areas to be covered are: • • • IOUS 6.16 In case of entities operating in the construction industry, IOUs (I Owe You) are advances commonly issued for purchase of materials, as advance for short travelling and alike. On receipt of the bill from the concerned person and the balance cash, the expense is accounted for. It is important for the internal auditor to verify the IOUs during the period of performance of his internal audit procedures and ensure proper control over IOUs exists in the entity. 6.17 Internal auditor shall review the following important aspects: (i) (ii) Review the effectiveness of entity’s policy of delegation of authority over cash and bank receipts and payments. Ensure whether the entity’s policy is strictly implemented and violations, if any, have been brought to the senior management attention and got ratified. Review maintenance of documentation with regard to: (a) (b) (c) (d) Cash receipts Cash payments Bank receipts Bank payments. Persons Involved for every procedure Key roles and responsibilities of such persons Delegation of authority.
Major Areas of Internal Audit Significance (iv) Ensure that Bank reconciliation statements were prepared regularly and all items have been properly reconciled. Ensure compliance with The Stamp Act, 1899 for stamping of receipts in excess of the prescribed limit.
Refer Appendix 3 for model process flow for general payments. 6.18 Internal auditor can procedures such as following: • perform various analytical
Average Cash Utilization vs Average Cash Maintained The internal auditor may ascertain the average cash utilization project-wise and the average cash level maintained. In cases where there are significant huge cash level maintained, the need for such high cash requirement should be justified by the management. The internal auditor should consider the impact of high cash level with respect to risks of holding cash and interest cost. Cash Insurance vs Cash Balance Internal auditor can assess whether there has been any shortfall in obtaining cash insurance at the respective projects by comparing the cash limit at the project as against the cash insurance obtained.
These ratios should be compared to the previous periods and explanations for any significant fluctuations needs to be obtained. Also, explanations for high cash levels need to be obtained. Model Checklist Related to Cash and Bank S. No. 1. 1.1 Particulars Audit of Cash and Bank Is there a monthly verification of cash and the same is reconciled with books? 69 Yes No N/A
Technical Guide on Internal Audit of Construction Industry S. No. 1.2 Particulars Are there surprise checks performed by the management/ internal auditors to ensure that cash is updated on a frequent basis? Are bank reconciliation statements prepared for all accounts on a periodic basis? Does the entity maintain both bank book and bank statement used for preparation of bank reconciliation statements (BRS)? Has the BRS been verified by appropriate level of authority? Cash Receipts Is there a written process for receipt of cash at the site and the head office? Are there procedures to ensure that the cash is received by the appropriate authority at the site/ head office? Are there significant delays between cash receipt voucher given and the accounting of the receipt? Are there proper procedures to transfer the cash to head office/deposit at bank at frequent intervals? Petty Cash Payments Is there a written process for receipt of cash at the site and the 70 Yes No N/A
1.5 2. 2.1
Major Areas of Internal Audit Significance S. No. 3.2 Particulars head office? Has proper approval been obtained in accordance with the policy before making payments by the entity? Is there a significant time lag between accounting for the petty expenses in the books? Is the cash being verified and reconciled on a daily basis? Carrying of Huge Cash Does the entity have a proper procedure as regards carrying huge cash? Has the entity obtained Fidelity insurance and Transit insurance to ensure safety to the entity in case of loss of cash on account of theft or on account of loss in transit? Does the entity have a process of job rotation for carrying huge cash? Verification of IOUs. Does the entity have a policy for IOUs? Does the policy provide for the limit in monetary terms that each level of employees can avail the facility, Number of times the facility can be availed during a particular period and the purposes for which the facility can be availed? Does the policy cover the period in which the IOUs should be settled? 71 Yes No N/A
3.4 4. 4.1
4.3 5. 5.1 5.2
Technical Guide on Internal Audit of Construction Industry S. No. 5.4 Particulars Is the accounting of IOUs with regard to the entity’s policy and procedures? Does the entity accounts for the IOUs on a periodic basis? Yes No N/A
6.19 The internal auditor needs to refer to Accounting Standard (AS) 7, “Construction Contracts”, issued by the Institute of Chartered Accountants of India, for detailed understanding of accounting for construction contracts and accounting treatment of revenue and costs associated with construction contracts. Some provisions of AS 7 are as follows:
A construction contract is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.
Fixed Price Contract
A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses.
Cost Plus Contract
A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus percentage of these costs or a fixed fee.
Contract revenue should comprise: (a) the initial amount of revenue agreed in the contract; and
Major Areas of Internal Audit Significance (b) variations in payments: • • contract work, claims and incentive
to the extent that it is probable that they will result in revenue; and they are capable of being reliably measured.
Contract revenue is measured at the consideration received or receivable. The measurement of contract revenue is affected by a variety of uncertainties that depend on the outcome of future events. The estimates often need to be revised as events occur and uncertainties are resolved. Therefore, the amount of contract revenue may increase or decrease from one period to the next.
A variation is an instruction by the customer for a change in the scope of the work to be performed under the contract. A variation may lead to an increase or a decrease in contract revenue. A variation is included in contract revenue when: (a) it is probable that the customer will approve the variation and the amount of revenue arising from the variation; and the amount of revenue can be reliably measured.
Contract costs should comprise: (a) (b) (c) costs that relate directly to the specific contract; costs that are attributable to contract activity in general and can be allocated to the contract; and such other costs as are specifically chargeable to the customer under the terms of the contract.
Technical Guide on Internal Audit of Construction Industry
Recognition of Contract Revenue and Expenses
6.20 When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract should be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the reporting date. An expected loss on the construction contract should be recognised as an expense immediately in accordance with paragraph 35 of AS 7. (i) In the case of a fixed price contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied: (a) (b) total contract revenue can be measured reliably; it is probable that the economic benefits associated with the contract will flow to the enterprise; both the contract costs to complete the contract and the stage of contract completion at the reporting date can be measured reliably; and the contract costs attributable to the contract can be clearly identified and measured reliably so that actual contract costs incurred can be compared with prior estimates.
In the case of a cost plus contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied: (a) it is probable that the economic benefits associated with the contract will flow to the enterprise; and the contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably. 74
Major Areas of Internal Audit Significance 6.21 (a) Internal auditor shall review the following aspects: Whether the method used in determining contract revenue recognized as revenue in the period are in compliance with AS 7, “Construction Contracts” issued by the ICAI. Whether the methods used to determine the stage of completion of contracts in progress are fair and depict true and fair view. Has the entity maintained a proper documentation for advances received and the retention amounts. Whether the procedure adopted for determining the expected losses is adequate. Whether the service income is recognized as per service agreement. Whether the irrecoverable costs incurred in securing the contract are recognized as expense? Whether the procedure adopted for determining WIP is adequate? Whether there are any contingencies in relation to warranty costs, penalties or possible losses and whether the same are being recognized as per AS 29, “Provisions, Contingent Liabilities and Contingent Assets”.
(c) (d) (e) (f) (g) (h)
6.22 Analytical procedures that can be performed by the internal auditor include the following: •
Percentage completed vs scheduled percentage of completion as on the date of review
The internal auditor can analyse the % completed as against the scheduled % of completion for all projects to determine whether the projects are in accordance with schedule and the delays, if any, are noted.
Technical Guide on Internal Audit of Construction Industry •
Actual time taken for completion of project vs budgeted time
The actual time to budgeted time ratio helps the internal auditor to analyse the number of days delay in the projects completed during the period. The internal auditor can also verify whether the management takes sufficient steps towards completion of project in accordance with the schedule.
Time taken for a project vs average time taken for similar projects
In case of construction of similar projects by an entity, the internal auditor can assess the project’s completion in relation to other projects performed by the entity. The internal auditor may also compare the time taken for completion of project with relation to similar projects by any other entity operating in the construction industry.
Work Certified as a percentage of amount billed
The internal auditor can assess the percentage of work certified in comparison to the billing and estimate the value of work and verify whether there is significant portion of work uncertified. In such cases, the internal auditor must obtain reasons for such cases.
These ratios should be compared to the previous periods and explanations for any significant fluctuations should be obtained. This would help the internal auditor gain an insight on internal control weaknesses. Refer Appendix 4 for model flowcharts related to Construction Income and Service Income.
Major Areas of Internal Audit Significance Model Checklist Related to Revenue S. No. 1. 1.1 1.2 Particulars Audit of Recognition of Revenue Does the agreement specify the recognition of income? Does the entity have a proper process of estimating the percentage completed on a periodic basis? Does the entity use an expert to estimate the % completed at the end of the year to ensure proper estimation? Have the invoices been issued in accordance with the agreement? Are there proper controls and procedures for estimation of income? Has the invoice been properly authorised by the appropriate level of authority? Does the entity has a proper process in accordance with the accounting policy for estimating and recognising unbilled revenue? Does the entity has an accounting policy for accounting work certified and work uncertified? Does the entity obtains certificate for the percentage of work completed at the time of billing of contracts? 77 Yes No N/A
Technical Guide on Internal Audit of Construction Industry S. No. 1.10 Particulars Is the work uncertified significant in relation to the work certified? Has proper explanations been obtained in such cases? Yes No N/A
6.23 Payroll process involves selecting, appointment of candidates, computation of the monthly salary and reimbursements, monthly disbursements of salary, monthly deductions, computation of tax deducted at source on salaries, documentation of claims, salary advance, etc. The process of payroll is similar to any other industry and is subject to deductions. The internal auditor through his audit procedures is required to find out whether any fictitious employees (ghost workers) are employed in the entity. The procedures performed could be in the form of inquiries and discussions with the management, verification of employee records, verification of bank records for testing disbursement, etc. Refer Appendix 5 for a typical payroll process. 6.24 Internal auditor shall review the following aspects of payroll process: (i) Review the HR manual to check the HR policies with regard to following: (a) (b) (c) (d) (e) (f) (g) Joining bonus Availability of leave Leave encashment Gratuity Leave travel allowance Availability of perquisites Reimbursements 78
Major Areas of Internal Audit Significance (h) (i) (ii) Salary advances Employment agreement including non-disclosure agreement.
Whether proper documentation has been maintained for employee’s personal information, joining information along with compensation details. Whether the registrations with PF, ESI, professional tax and other statutory authorities have been done and properly renewed. Whether the reimbursements payments are made as per approved policy. Whether recovery and remittance of PF, ESI and Professional Tax from employees is made regularly. Check the calculation, collecting and remitting of income tax from employees, calculation of settlement claims, and perquisites and payments. Whether the procedure adopted and documentation maintained for employees attendance and leave claims is adequate. Ensure that the leave encashment and leave travel allowance payment is as per the approved policy. Check that the provision for gratuity is done correctly. Check the computations and approvals for incentives for employees.
(iv) (v) (vi)
(viii) (ix) (x)
6.25 The internal auditor may also perform additional analytical procedures over a period of time and compare them for ascertaining any inconsistency, such as following: •
Productive Hours Ratio
Productive hour’s estimation is a measure of the efficiency of the workforce during a particular period. In other words, it is the ratio between hours an employee works effectively 79
Technical Guide on Internal Audit of Construction Industry to the total hours he works. By analysing this ratio, the internal auditor can understand the motivation level of employees, steps taken by the management towards maintaining efficiency and to some extent the trend of attrition. •
Average Employee Cost Per Head Per Project
Average cost incurred for an employee can be computed by dividing the total cost incurred for a period on a project to Average number of employees during the period. The internal auditor may compare this information between different periods, or with other projects, where the services rendered are of a similar nature,
Employee Turnover Ratio
Employee turnover ratio helps the internal auditor to verify the attrition rate and assess the entity’s effectiveness and steps taken towards prevention of attrition and retention of key employees. In case of employee turnover ratio being higher than the industry, the internal auditor must obtain explanations for the reason for such high turnover ratio.
Total Employees to Outsourced Workers Ratio
The total employees to outsourced workers ratio help the internal auditor to assess the reliance of outsourced workers and contractors for the entity’s operations. The risk of employing high level of contract workers too must be assessed.
Reconciliation with respect to Changes in the Number of Employees due to Additions, Terminations, Retirements, etc., Between Various Months
The internal auditor can assess the movement in employees for a month in comparison with another through tracing the additions and deletions in month based on each grade and obtain an insight on the plans of the management. 80
Major Areas of Internal Audit Significance Model Checklist Related to Payroll Process S. No. 1. 1.1 Particulars Yes No N/A
Specific Areas of Payroll Processing Does the entity have a payroll process as approved by appropriate level of authority? Is the payroll process complete in all aspects, as applicable to the entity? Is there sufficient attendance register maintained by the entity for all workers (both employees and contractors)? Have all statutorily prescribed registers maintained by the entity with regards to both employees and contractors? Does the entity maintain a checklist of statutory remittances to be made on account of PF, ESI, Labour Welfare Fund and alike? Are cheques prepared and signed by two different employees? If the entity opts for bank transfer, is there appropriate level of authority prescribed to issue a bank transfer instruction to the bank? Is the payroll processing cross checked before payment is made? Are there sufficient manual records maintained by the entity with regard to their recruitment, offer letter, appraisals and increments and all 81
Technical Guide on Internal Audit of Construction Industry S. No. Particulars other correspondences with the employee? 1.10 Have the incentive schemes been verified by the internal auditor on a test basis? Have these controls been tested for effectiveness? Is the attrition rate exceedingly high? Have justifications for such a high rate, if any been obtained? Have the reasons and explanations for any failures and control weakness observed on review of these complaints? Does the entity comply with the accounting requirements for ESOP, ESPP schemes and maintains proper record of the shares opted by the employees? Does the entity have sufficient time records for its employees and leave records as approved by the appropriate level of authority and does this form the basis for the computation of salary? Yes No N/A
6.26 The significant operating costs for any entity operating in this sector include the following:
The hiring expense could be for hiring of carriers, equipments and accommodation. The entity relies on transport vehicles for 82
Major Areas of Internal Audit Significance moving equipment from one location to another. It also depends on hiring accommodation at remote location for its workers and employees. Certain specialised equipment might not be cost effective for the entity to acquire them. In such cases, the other option available to the management is to hire the equipment for the specific construction period. In general, hiring expenses are a significant part of the cost of the entity. The management should have appropriate policy with regards to hiring of equipment.
Repair and Maintenance
Another major expense incurred by the entity is in the nature of repairs and maintenance. This is absolutely important to ensure proper function of machines. In general, repairs and maintenance either be (i) Preventive Maintenance – to ensure machines do not break down; or (ii) Breakdown Maintenance – where the machine break-downs and unless repairs are carried out it will not run.
Considering the labour intensive nature of the construction industry and remote location, logistics plays an extremely important role in the entity. Most employees use the logistics provided by the entity to commute to work place. Considering the significance of this department, usually, entities enter into contracts with logistic providers in order to limit their liability and manage them professionally. The entity must maintain sufficient controls for proper usage of vehicles. 6.27 The internal auditor should verify the systems, processes, controls, procedures built within the system so as enable smooth, proper and order movement of employees to and fro from the work place. There should also be proper controls for usage of logistics for purpose of business only. The internal auditor can perform various procedures such as, cross checking logistics records with attendance registers, verification
Technical Guide on Internal Audit of Construction Industry of in time and out time records with logistic records, cost per employee travelled, etc. 6.28 In case the entity has undertakings in SEZ, STPI, EOU and/or undertaking without any such exemptions, then it is required under Income Tax Act to ascertain profit separately for each of these undertakings. In such a scenario, the entity is required to apportion certain common costs between these undertakings. The internal auditor is required to verify the procedures and controls for capturing of specific expenses with regards to its sufficiency, appropriateness and efficiency. Moreover, the internal auditor needs to ensure that common expenses are allocated across theses undertakings in a justifiable basis. 6.29 The internal auditor may also perform following additional analytical procedures over a period of time and compare them for ascertaining any inconsistency. •
Operating Cost to Revenue (Project-wise)
Every project operates in varied legal environment and different challenges are faced by the entity operating in different environment. The internal auditor can estimate the operating cost (i.e., cost including labour, communication, lease and all other variable expense to the particular undertaking) to the revenue generated by it. This would provide a basis for evaluating the cost effectiveness of operating in each of the undertakings.
Variable Cost per Man Hour per Project
Variable cost per man hour can be computed by dividing the total cost incurred in an undertaking divided by man hours for the same period. This can be compared with different periods to verify whether there has been a significant increase/ decrease in the expense and identifying reasons for the same.
Major Areas of Internal Audit Significance •
Maintenance Cost to Value of Fixed Assets
By estimating the total maintenance cost to fixed asset cost, it can help the internal auditor assess the importance given for maintenance in relation to the value of the asset. It is important to ensure that the entity has a proper maintenance schedule. Model Internal Audit Procedures for Operating Expenses
S. No. 1. 1.1 1.2 1.3
Particulars Repairs and Maintenance Does the entity have a procedure for maintenance of equipment? Is maintenance done on a frequent basis? Are there sufficient records maintained to ensure that maintenance has been performed by the entity? Does the entity enter into Annual Maintenance Contracts (AMC) for specialised equipment? Does the entity have a proper log/register to ensure that maintenance has been provided for all equipments? In case of unforeseen breakdown of equipment, have explanations for such breakdown obtained? In case of frequent repairs required for the equipment, has a cost tradeoff analysis performed to verify whether it is better to purchase an asset against maintenance. Hiring and Logistics Does the entity have approved policy for hiring of transport 85
Technical Guide on Internal Audit of Construction Industry S. No. Particulars Yes vehicles, carriers, accommodations and equipments? Does hiring expenses lead to cost savings? Has the entity analysed the benefits of hiring against purchase of equipments/vehicles? In cases where certain equipments are hired very frequently, is it better to purchase it than hiring it? Has the entity received quotations of prices from different vendors to ensure cost effectiveness and good services before deciding on the vendor? Are there sufficient procedures to transfer from one segment to another and are there proper controls for allocation of costs between these departments? No N/A
Agreement with Collaborators
6.30 Two or more organisations may join hands for the execution of a project. Agreements regarding sharing of income and expenditure, profits, co-operation in execution of contract and similar other aspects form part of such collaboration agreements. An internal auditor should familiarise himself with the essential features of such agreements to ensure compliance of the clauses mentioned in the agreement. In case of agreements with foreign collaborations, then the significance considering its financial, technical and legal implications is more. Clauses such as royalties, scope of work, repatriation, drawings and designs, amongst others are extremely important to be complied with.
Major Areas of Internal Audit Significance Model Internal Audit Procedures for Agreement with Collaborators S. No. 1. 1.1 Particulars Agreement with Collaborators Does the entity keep a track of all the major clauses that are to be complied with respect to the collaboration agreement? Does the entity performs reconciliation of funds remitted, taxes deducted apart from other procedures performed? Does the entity value all gifts in the nature of tools, machinery at a proper valuation, if they are useful? Yes No N/A
Running Account Bill (RAB)
6.31 Running Account Bill is a unique feature in the construction industry. It is nothing but the cumulative amount billed to the client in accordance with the terms of the contract with the client. The entity bills the client on a periodic basis based on the milestones achieved as specified in the contract. 6.32 Generally, at the time of initiation of the contract, the client makes an advance termed as Mobilisation Advance in order to enable the entity to commence the scheduled contract. The said Mobilisation Advance is adjusted against RAB raised by the entity. The client makes the payment for the incremental work certified as adjusted by Mobilisation Advance, Provisional Acceptance and Final Acceptance.
Technical Guide on Internal Audit of Construction Industry Model Internal Audit Procedures for RABs S. No. 1. 1.1 Particulars Verification of RAB Has the entity properly accounted for the adjustments towards Mobilisation Advance, Provisional Acceptance and Final Acceptance? Does the entity has an approved policy for accounting of RAB and recognition of profit? Yes No N/A
6.33 Claims in case of civil construction could be claims against the carriers for losses in transit, claims against the clients for non-fulfilment of contractual obligations by them, claims against suppliers, insurance companies and customs authorities for any loss or destruction of materials, equipments and duty refunds, etc. Such claims may or may not be accounted for. 6.34 The internal audit procedures that the internal auditor perform with respect to disputed claims are given below. Model Internal Audit Procedures for Disputed Claims S. No. 1. 1.1 Particulars Disputed Claims Does the entity have an approved policy for ascertaining losses giving rise to claims from contingent asset complete in all aspects? Yes No N/A
Major Areas of Internal Audit Significance 1.2 1.3 Are the claims properly lodged and registered? Does the entity have a proper method of valuation of claims and is it supported with the corroborative evidence? Have proper follow up action been taken for the realisation of overdue claims and have the claims that are irrecoverable been systematically written off?
6.35 Measurement sheet is a record maintained by the client for the work performed by the entity is being measured and based upon which the work is certified. In general, a copy of the measurement sheet is provided by the client to the entity based on which the entity bills the client. The internal auditor should ensure that the bill process is in line with the measurement sheet provided by the client.
Risks Faced by an Entity Operating in the Construction Industry
6.36 The internal auditor should make a risk assessment of the entity under audit. This is extremely important in order to ensure prevention of any non-compliance or undesirable event. 6.37 The risks of the entity are different at different stages. The stages can be broadly divided into following: • • • • Project Definition Planning Stage Execution Stage Completion of the Project. 89
Technical Guide on Internal Audit of Construction Industry 6.38 The risks faced by an entity operating in the construction industry can be broadly classified as following: • Industry Risk – Growth and demand is dependent on general economic conditions and a deceleration can adversely affect the entity’s business and its earnings. In case of services provided by the entity outside India, the Industry risk affects the entity in a greater manner. Strategy Risk – The risk that skewed business strategy may result in lost opportunities. Competition Risk – Increased Competition from domestic and international construction entities affects market share and profitability. Liquidity Risk – To a large extent the cash flow is dependent on the credit terms extended to the clients and effective recovery of dues from them. Delays in recovery of dues have a direct impact on the liquidity position which will affect the operations and earning of the entity. Government Policy Risk – Uncertainties with government policies can significantly affect the operations of the entities operating in construction industry. Assets and Inventory Risk – Risk of accidents, fire, theft, etc., to entity’s properties and stocks will affect the entity’s operations affecting profitability. Similarly the breakdowns to the entity’s machinery will affect operations and profitability. Operational Risk - Risks in operating the entity such as, competence gaps, equipment breakdowns, health and safety risks, etc. Price Inflation Risk – It includes following types of risks: a) Volatility in prices of inputs and/or changes in assumptions may cause cost overruns affecting the profitability.
Major Areas of Internal Audit Significance b) Delay in completion of project could result in liquidated damages and / or additional costs affecting profitability.
Systemic Risk – Risk of change in regulations and the legal environment where the entity operates. Brand/Reputational Risk – Non compliance of terms of the agreement / non-delivery of the project during the scheduled period of time might lead to reduction in the brand name. Accessibility Risk, Business Continuity, Security Risks– Risks of accessibility of other service providers, infringement of Intellectual property rights and continuity of business to ensure completion of contracts.
6.39 The internal auditor is required to assess risk at each stage to ensure sufficiency of controls and procedures in built within the entity. The internal auditor needs to verify whether sufficient controls are available in the entity to detect such risks and prevent its occurrence by inducing the management to take appropriate steps in the light of overall business environment.
Reduction of Risks
6.40 The entity may reduce its risks by obtaining a Certificate of Insurance (COI) which demonstrates that a contractor has obtained liability insurance, generally for a specific time period. The COI provides some measure of protection to the entity in the event that an accident or damage occurs as a result of actions by a contractor's employee. 6.41 The entity should have a formal written policy concerning the requirement of a COI, as well as a file of COIs for every contractor. The COIs should be obtained before the contractors are on site performing work and should be retained for a specified period of time after project completion. A sample of the COIs should be selected and reviewed for compliance with minimum coverage contained in the bid or contract documents.
Technical Guide on Internal Audit of Construction Industry 6.42 Contractors can often be on the job site long after the insured period has expired or the certificate has become outdated, especially since delays and scope changes may extend the duration of the project. The management also needs to ensure that all areas are covered under Certificate of Insurance. Another way to reduce the risk of future legalities from sub-contractors is through obtaining a "Release of Lien" at the time of making the final payment. This document protects the entity if a sub-contractor or materials supplier sues the primary contractor for non-payment. 6.43 The internal auditor should have a defined policy concerning these releases. Many entities establish guidelines that involve contract amounts, and they further reduce the risk by obtaining partial releases. Internal auditor should verify that the final, executed release of lien is obtained at the time of making the final payment. In addition, the internal auditor should confirm that any amendments a contractor may have written on the release before signing it are appropriate, and that the guidelines established for partial release of lien are followed. The internal auditor may also refer to various Technical Guides on risk management issued by the ICAI.
6.44 The internal auditor is required to verify the sufficiency of controls related to maintenance of books of accounts by the entity. The internal auditor is also required to verify whether the controls for allocation of costs between different projects, are adequate and reliable in the light of the business operations. S. No. 1. 1.1 Particulars Books of Accounts and Documents Does the entity have proper accounting system commensurate with the regulatory requirements? 92 Yes No N/A
Major Areas of Internal Audit Significance S. No. 1.2 1.3 Particulars Does the entity have specific books of accounts for work performed in SEZ? Are the control systems in place for estimating the revenue generated location-wise sufficient to ensure that proper books are maintained for the location? Does the entity have proper and reasonable system to allocate various costs incurred to the respective SEZ undertaking and non-SEZ undertaking as applicable? Does the entity have location-wise employee details to ensure proper allocation of payroll cost to the location? Are the books of accounts closed every month? Are the controls for re-opening of books proper to ensure prevention of manipulation? Does the entity maintain a projectwise profitability statement for ensuring proper recording of revenue based on the state of completion of the project in accordance with its accounting policy or accounting standard? Are there controls in place to ensure that all costs have been allocated to all projects in an appropriate manner? 93 Yes No N/A
Technical Guide on Internal Audit of Construction Industry
Compliance with Standards and Regulations
6.45 As explained earlier regarding the various statutory requirements applicable to construction industry, the internal auditor is required to verify the compliance of these statutes and report thereon as a part of his internal audit. Also, the internal auditor needs to verify registration with various statutory authorities and renewal of the same as a part of his audit procedures. 6.46 Apart from the above regulations, the entity may have obtained certifications under various international and Indian organisations for a process or for the entity as a whole. For e.g. ISO 9001 (International Organization for Standardization) certification for various operation processes of an entity, OSHO 2236 (Occupational Safety and Health Administration), an US Department of Labour standard for material handling and storing of material and safety measures for worker. 6.47 ISO 9001:2000 specifies requirements for a quality management system where an organization: (i) Needs to demonstrate its ability to consistently provide product that meets customer and applicable regulatory requirements, and Aims to enhance customer satisfaction through the effective application of the system, including processes for continual improvement of the system and the assurance of conformity to customer and applicable regulatory requirements.
All requirements of this International Standard are generic and are intended to be applicable to all organizations, regardless of type, size and product provided. The requirements for the certification include the following: • • • A set of procedures that cover all key processes in the business; Monitoring processes to ensure they are effective; Keeping adequate records; 94
Major Areas of Internal Audit Significance • • • Checking output for defects, with appropriate and corrective action where necessary; Regularly reviewing individual processes and the quality system itself for effectiveness; and Facilitating continual improvement.
6.48 A organization that has been independently audited and certified to be in conformance with ISO 9001 may publicly state that it is "ISO 9001 certified" or "ISO 9001 registered". Certification to an ISO 9001 standard does not guarantee any quality of end products and services; rather, it certifies that formalized business processes are being applied. Two types of auditing are required to become registered to the standard: auditing by an external certification body (external audit) and audits by internal staff trained for this process (internal audits). The aim is a continual process of review and assessment, to verify that the system is working as it's supposed to, find out where it can improve and to correct or prevent problems identified. There are other factors such as, choosing a vendor by an entity who has obtained ISO Certification. It is preferred to choose a vendor who is also ISO certified. The internal auditor is required to verify the scope of performance of audit procedures so as to include compliance with these standards also. The internal auditor is required to perform such audit procedures so as to ensure compliance of these standards and effectiveness of the controls prescribed.
PROCESS FLOW CHART FOR PROCUREMENT OF MATERIAL AND SERVICES
A typical process for the procurement of materials and services for an entity operating in the construction industry are given below.
Process Flow for Procurement of Material
Note: Refer to Flow Chart Symbol defined on page 109.
Technical Guide on Internal Audit of Construction Industry
Process Flow for Procurement of Services/ Sub contractors
Process Flow Chart for the Purchase, Transfer and Disposal of Fixed Assets
A typical process for the purchase, transfer and disposal of fixed assets of an entity operating in the construction industry are given below.
Process Flow for Fixed Assets Purchases
Technical Guide on Internal Audit of Construction Industry
Process Flow for Transfer of Fixed Assets
Process Flow for Disposal of Fixed Assets
Technical Guide on Internal Audit of Construction Industry
Process Flow Chart for General Payments
A typical process for general payments of an entity operating in the construction industry is given below.
Process Flow for General Payments
Process Flow Chart for Recognition of Construction Revenue, Service Revenue and Recognition of Work in Progress
A typical process for recognition of construction revenue, service revenue and recognition of work in progress of an entity operating in the construction industry are given below.
Process Flow for Recognising Construction Revenue
Technical Guide on Internal Audit of Construction Industry
Process Flow for Recognising Services Revenue
Process Flow for Recognising WIP
Technical Guide on Internal Audit of Construction Industry
Process Flow Chart for Making Statutory Deduction with Respect to Payroll, Month-end Processing of Payroll and Payroll Disbursement Process
A typical process for making statutory deduction with respect to payroll, month-end processing of payroll and payroll disbursement process for an entity operating in the construction industry are given below.
Process Flow for Processing of Other Statutory Deduction
Process Flow for Month-end Salary Processing
Technical Guide on Internal Audit of Construction Industry
Process Flow for Payroll Disbursement Processing