Internal Audit Procedure in Construction Sector

Updated on April 27, 2024 11:32:02 AM

Construction is a significant component of the global economy, accounting for a significant portion of GDP and employment in many countries. It is also a complex and dynamic sector, with a wide range of risks and challenges.

The purpose of Internal auditing in the Construction sector is to provide independent and objective assurance and consulting, designed to add value and improve an organisation's operations.

In the construction industry, internal audit plays a pivotal and indispensable role in ensuring the financial health and regulatory compliance of companies operating within this sector. This crucial function systematically examines and oversees financial processes, risk management practices, and adherence to industry-specific regulations. As a diligent overseer, internal audit assesses the transparency of financial transactions, safeguards sensitive company data, and evaluates the efficiency of operational procedures.

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Applicable Important Regulations

It is important for internal auditors to be aware of the applicable regulations that apply to their work. This will help them to ensure that they are conducting their audits in a compliant and ethical manner. Below given are some acts that falls under these regulations:

  • The transfer of Property Act,1882
  • The Special Economic Zones Act, 2005
  • The Industrial Dispute Act, 1947
  • The Welfare Cess Act for Building and Other Construction Workers, 1996

Some other applicable Indian Acts to Construction Industry are:

Governance Laws

  • Companies Act 1956
  • Partnership Act, 1932
  • Benami Transactions Act, 1988
  • The Land Acquisition Act, 1894

Economic Laws

  • The Income Tax Act, 1961
  • Central Excise Act, 1944
  • The Customs Act 1965
  • Value Added Tax and Sales Tax Act
  • Prevention of Money Laundering, 2002

Contract Laws

  • The Indian Contract Act, 1872
  • The Securities Contracts Regulation Act, 1956

Labour Laws

  • Employees Provident Fund Scheme, 1952
  • Employee State Insurance Act, 1948
  • Contract Labour (Regulation and Abolition) Act, 1970
  • Building and Construction Workers (Regulation of Employment and Conditions of Service) Act, 1996

There are other laws that apply to the industry:

Securities Exchange Board of India Act, 1992, Foreign Exchange Management Act, 1999, Arbitration and Conciliation Act, 1996, etc.

It is necessary for the Internal Auditor to be aware of the various circulars issued by the RBI regarding foreign currency transactions.

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Engineering Control

Civil engineers are the most important persons in the construction industry. They also hold key positions in the organisation in the areas of planning, site execution, quality assurance, and technical audit, etc. Below given are various activities that comes under engineering domain:

Budgeting and Site Mobilisation Planning

The construction department takes over the tender file and prepares for mobilisation after awarding the contract.

This includes:

  • The client must be informed of any deviations before mobilisation begins by studying the work order terms to ensure compliance with the tender stage decisions.
  • Drafting an action plan for mobilisation of the site, which involves reviewing the contract, estimating the necessary resources, and attending a kick-off meeting with the client/consultant
  • The challenge of preparing a project budget is due to the variability in engineering quantities during actual execution.

Client and Subcontractor Billing and Certification

In order to facilitate quantity reconciliation, both clients and subcontractors should have the same billing period and frequency. To prevent delays in certification and fund release, client RA bills must be prepared and submitted on time, which can negatively impact project fund management. Many organisations keep the cut-off date 5-6 days prior to the month-end to enable bill placement at the month-end.

Delayed client billing can result in delayed subcontractor billing and quantity comparison, resulting in excess quantity being given to subcontractors, which can negatively impact project profitability.

Role of Billing Engineers

Billing engineers are responsible for submitting bills to clients on time. The project manager or a dedicated billing engineer may play this role, depending on the project size and margins. Billing engineers may be located at the head office or the site.

Internal auditors can review the following to ensure that billing engineers are following proper procedures:

Documentation from the site to the head office for billing: This includes drawings, joint measurement reports, and other claims not certified by the client.

Frequency of visits to construction sites:To understand the progress and identify any work that is not part of the original scope, billing engineers must visit construction sites.

Preparation of bills of sub-contractors: Billing engineers should be responsible for preparing bills of sub-contractors and preparing a quantity cross check report.

Reconciliation of Free Issue Material

Contractors typically reconcile FIM usage with work done monthly, but the term 'free' is misleading, which is why accountability of Free Issue Material (FIM) is important. To prevent discrepancies and revenue loss while running accounting bills, reconciliation statements are required to match FIM balances. Assessing physical FIM quantities, especially steel, requires an experienced supervisor. Clients may also insist on returning empty cement bags as a proof of consumption. Contractors may return unusable FIM, such as unused 6mm cement. Work orders may define FIM that is serviceable, such as steel pieces that are over 2 metres in length.

Thus, the internal auditor has to ensure that the reconciliation is prepared on a timely basis. Further, the project needs to have a dedicated team at the site for miscellaneous work, such as segregating scrap/ ensuring that the scaffolding and other materials are not submerged by the debris or sand during backfilling.

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Accounting Controls in the Construction Industry

Accounting plays a significant role in the construction industry. The accounts department must highlight the performance on a regular basis for the project to be monitored properly. To ensure proper monitoring of the project, it is necessary for the accounts department to consistently highlight performance.

The internal auditors need to pay attention to four critical areas when it comes to accounting in the construction sector:

  • Accounting challenges under AS-7 on Construction Contracts.
  • Evaluation of controls in Centralised and Decentralised Accounting Environment.
  • Documentation related Controls.
  • Project performance Report.

Accounting Standards

AS-7, Accounting for Construction Contracts, is an accounting standard that is applicable to the construction industry, which operates solely on a contractual basis. Revenue recognition is solely based on the Percentage Completion Method Accounting (POCM) as mandated by the standard.

To understand the accounting complexities, let's consider the following example:

Value of work order: 100 cr. Estimated completion cost:80 cr.

Cost incurred till date: 20 cr.

Percentage completion: 25% (20/80)

Revenue to be booked: 25 cr. Profit booked: 5 cr.

In the POCM, revenue is recognized based on the percentage of work completed, as measured by the ratio of costs incurred to date to estimated completion costs. In the above example, the contractor has completed 25% of the work, so they can recognize 25 cr. in revenue, resulting in a5 cr. profit.

Quality Assurance/ Quality Control

The two most important parameters for distinguishing construction companies are construction quality and safety. Work methods are the focus of quality assurance (QA), while testing is the focus of quality control (QC).

Construction companies can take specific steps to ensure quality and safety:

  • Maintain standard IS Codes at the site. This includes codes for concrete, steel, and measurement of items. Additional project-specific codes may be issued from the regional or head office.
  • Maintain laboratory equipment as per the system. This ensures that concrete mix designs can be approved by the client or consultant.
  • Document all instances of non-conformity leading to rework. This documentation can be used to support claims for extra items.

Documents Required

Organisations must design their documentation requirements to match their centralised or decentralised model. All documents received from the site must be accompanied by the correct ancillary documents and proper authentication from site personnel.

For Sales Bills, the following documents are required for data entry:

  • Original or duplicate invoice with a mark indicating the original
  • Company's site billing and HO address
  • Company's local TIN number
  • Nature of invoice (tax invoice or retail invoice)
  • Consistency of VAT invoice number in tax invoice and retail invoice
  • Invoice date
  • Buyer's name and site address
  • Buyer's local TIN number
  • Work order number
  • Running account bill number (RA-01, RA-02, etc.)
  • Invoice period
  • Company's central service tax/service tax number
  • Tax invoice with proper transferable material item wise quantity, material rate including transportation and labour/loading/unloading/packing charges with purchase data, profit margin, and VAT rate wise (4%, 12.50%, 16%, etc.), labour and service tax bifurcation
  • Sales bill signed by an authorised person whose signature is registered with the local sales tax department as authorised.

Purchase data entry requires the following documents:

  • Material Indent Note (MRN)
  • Quotations or Price List from at least two suppliers
  • Purchase Order/ price list approved by Manager and Project Director, reviewed quarterly
  • Material Inward Stamp with Cost centre, Quantity, date, stores incharge sign, and specific remarks for short quantity, damaged material etc.
  • Material Receipt Note/ Goods Received Note (GRN) printout after data entry by stores incharge in the books of accounts
  • Quantity checked report, either ok or with discrepancy if any
  • Approval sign of Project Manager on Bill and specific remarks with sign, if any
  • Original Purchase Tax Invoice and challan with readability like Name of Item, quantity, rate, VAT Rate, VAT amount, and authorised sign of supplier on bill.
  • Lorry receipt (LR/ GRN) copy, if any, required with purchase bill.
  • Other supporting documents with details from suppliers (Royalty Challan and Trip slip in case of Sand, Aggregate, Boulder etc.).
  • Printout of data entry voucher with bill duly signed by data entry person.
  • Credit notes required in cases of excess purchase rate, short quantity, damaged material etc. from suppliers in proper format (Format like Tax Invoice).
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Store Operations in the Construction Sector

Store is a very important link in the organisational chain. Manufacturing locations typically have a relatively easy time implementing control due to the well-defined location of stores and the area where the material is issued.

Physical Stock Verification

Physical stock verification in construction sites is a challenging process due to the open environment, multiple locations, and items at height. To mitigate these challenges, follow these steps:

  1. Update stock records and deal with audit questions concerning inward and outward vouchers.
  2. Identify, reconcile, and resolve any negative items.
  3. Label quantities on items and record the physical quantities beside the closing stock with precise location and break up.
  1. If one uses an ERP, then Clearance/ Reconciliation of various system generated Exceptional reports need to be done like:
  • Goods received but bills (document) not received.
  • Bill (document) received but goods not received.
  • Raw Material/ Goods given for job work but finished goods not received.
  1. Identify and resolve any discrepancies.

Control Over Fuel Consumption

Fuel is essential for construction sites, but it is also expensive and needs to be carefully controlled. To minimise fuel theft and ensure efficient usage, the following steps should be taken:

  • Stores should have the necessary equipment to measure and dispense fuel, such as fuel pipes, filters, pumps, barrels, and cans. The fuel tank should be locked and the key kept with the store person.
  • The project manager and HR in charge must approve fuel issue requests for all vehicle and equipment metres in working condition.
  • Physical metre readings should be verified and recorded at the time of fuel issue. The fuel issue document should be signed by the recipient and include the registration number of the equipment/vehicle. If fuel is issued for purposes other than vehicle/equipment usage, the purpose and location must be specified.
  • HR and the project manager should receive a summary of the fuel issued for the required period. Additionally, a debit note should be issued to the recipient for the fuel issued.

Raw Material Analysis

To ensure that material consumption is in line with project standards, it is essential to reconcile principal items at construction sites. This is done by comparing bills to inward and issued quantities, duly authorised by the site engineer/ project manager. Principal items to be included are cement, steel, sand, aggregate, admixture, and binding wire.

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Commercial Procurement

Goods and services should be available at the right time in the right quantity at the site to ensure a smooth process of the job.

Goods

Purchase can be made either from site or HO. Ordering Raw Materials, Bulk Materials, and Capital goods from HO is the usual practice, and other items can be purchased at site if available at competitive rates. Purchasing should be done economically while strictly adhering to quality specifications.

Procurement

It is the most essential part of the 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. Cement, iron, steel, sand, bricks, and gravel are commonly procured for the construction industry.

The Internal Auditor shall review the following processes and make the observations, if any:

Vendor Management: To ensure cost-effectiveness, quality, and timely delivery of materials, construction companies must choose their vendors carefully. This involves maintaining a vendor database and coding system, negotiating annual contracts for main raw materials, evaluating vendors periodically, and reviewing the vendor selection policy regularly.

Material/ Service Requisition Process: Ensure budget approval:

If the material requirement is not within budget limits, obtain approval from the planning department.

Verify authorization: Ensure that the material requirement is raised by an authorised person.

Receipt of Material: Ensure that received materials match purchase orders by reviewing material receipt procedures. GRNs are only issued once quality and store acceptance are verified.

Supply Chain Management: Verify the steps followed by the entity to make sure availability of material. Usually, the enterprise shall cover the following in its supply chain:

  • High price volatility
  • Seasonal nature
  • Alternative products

Cash Purchases at Sites: Ensure proper handling and accountability by reviewing company policy and controls. Define a cash ceiling for site-based purchases and monitor compliance.

Services

Construction sites need equipment that can be either purchased or rented, and the decision is based on the duration of need and the cost-benefit analysis of each option.

Hiring Subcontractors: The subcontractor selection process, which includes vendor qualification, bidding, and contract negotiation, is reviewed by internal auditors. They also assess the subcontractor's performance and compliance with the contract.

Equipments/ Machinery/ Plant/ Tools: The contract value decreases when the client provides all equipment, but this creates dependency on the client.When deciding whether to buy or rent equipment, consider financial parameters such as debt-equity ratio and fixed asset turnover ratio, rather than making instinctive decisions based on rental costs.

Equipments

Specific Issues related to equipment: The capacity of construction equipment is determined by project size, and making wrong decisions can have an impact on profitability, as demonstrated by concrete making. Mixers, mini batching plants, mobile batching plants, and large batching plants can be used. Concrete movement equipment includes transit mixers, concrete pumps, concrete buckets, cranes, and boom placers. Organisations may own or rent equipment depending on needs.

Scaffolding Material: To work on buildings, construction workers utilise scaffolding. Scaffolding can be made from various materials, but the main challenge is ensuring proper control over these materials.

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Conclusion

To conclude, Internal audit in the Construction Sector is an essential process that ensures compliance with legal, financial, and regulatory standards. The project lifecycle is facilitated by its promotion of transparency, risk mitigation, and operational efficiency. By carefully reviewing contracts, ensuring compliance with building codes, labour laws, and environmental regulations, internal auditors are crucial in maintaining project integrity, protecting stakeholders' interests, and upholding the sector's reputation for quality, safety, and ethical practices.

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Frequently Asked Questions (FAQs)

How often should construction companies conduct internal audits?

Frequency varies but is often project-specific, with regular audits during various project phases and an overall annual audit.

Why are audits important in the construction industry?

To ensure compliance with regulations, control costs, maintain safety, prevent fraud, enhance quality, and meet project deadlines, and safeguard stakeholders' interests, audits are essential in construction.

What regulations and standards govern construction internal audits?

Construction audits adhere to local building codes, labour laws, environmental regulations, accounting standards, and industry-specific guidelines.

What is the role of an auditor in the construction industry?

Auditors in the construction industry verify financial records, assess compliance with regulations, review project expenses, and ensure adherence to quality, safety, and contractual standards to mitigate risks and improve project efficiency.

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