EXTERNAL AUDIT SIMULATIONS A MUST FOR CONSTRUCTION MANAGEMENT EDUCATION

INTRODUCTION

The objective of this paper is to introduce construction management students to the major concepts associated with an external financial audit and not to prepare them as auditors. There are primarily three types of financial engagements conducted by an external accounting firm. A compilation engagement represents the lowest level of investigation and simply consists of compiling client-provided financial information and preparing financial and tax statements for the client. The auditing firm would attach qualified statements to this type of engagement. An audit engagement is the highest level of investigation which consists of performing both compliance and substantive testing of the internal accounting system and to ultimately produce unqualified year-end financial and tax statements for the client. First time clients and clients with weak internal and administrative controls typically require a full blown audit. The third type is a review engagement which entails more investigation than a compilation but less than an audit. Reviews are often requested in place of an audit for mid-year financial assessments. Reviews are also appropriate with long standing clients who historically have had adequate internal and administrative controls.

This paper will focus primarily on audit engagements since it is similar to reviews in terms of scope and they are the most commonly requested type of engagement. Furthermore, it is assumed that the constructor has an automated accounting and job costing system. The remainder of this paper will introduce the audit engagement activities which are associated with the auditor, followed by the auditing activities which primarily affect the constructor. The major concepts regarding an external audit engagement will be presented in detail and a description of the simulation activities will be discussed followed by concluding recommendations and suggestions.

AUDIT ACTIVITIES ASSOCIATED WITH THE AUDITOR

Auditor activities are classified into three stages; pre-engagement, on-site engagement and post-engagement. Pre-engagement activities generally include; the preparation of an engagement letter, the solicitation of confirmations from selected client-related business entities, the review of client's permanent file, the review of the previous year's workpapers, the determination of staffing requirements and budget for engagement, to conduct an engagement planning conference with staff and to prepare an audit program for the engagement. The primary on-site engagement activities consist of evaluating the internal accounting and administrative/management controls, preparing working papers consistent with the selected audit program and generating financial documents. The post-engagement activities entail generating an audit report, analyzing financial disclosures, generating financial and tax statements, updating the client's permanent file and reconciling the engagement budget for the following year.

AUDIT ACTIVITIES ASSOCIATED WITH THE CONSTRUCTOR

Constructor activities also occur in the three stages previously mentioned. The pre-engagement activities consist of providing the accounting firm with a list of current vendors, owners, subcontractors, bankers, etc. for confirmation purposes, preparing a working trial balance and preliminary contract schedules and informing the staff of the audit procedures. During the onsite visit, the constructor must furnish a work roan for the audit team and give them access to the contract files and accounting journals and ledgers. Upon request, the constructor's staff should assist the auditing team with the generation of reports, tracking down source documents and conducting job site visits. Once the auditor's post-engagement activities are completed, the constructor should meet with the staff to discuss the auditing team's findings in terms of financial position and suggestions regarding internal accounting and administrative/management controls.

MAJOR CONCEPTS ASSOCIATED WITH AN AUDIT ENGAGEMENT

The first consideration in an audit is the determination of the extent of substantive testing required, which is dependent upon the results of compliance testing. The objective of compliance testing is to evaluate the degree to which the internal accounting control procedures described by management are in use and are operating as planned. Substantive tests consist of all the analytical review procedures and tests of details of the particular classes of transactions and balances that the auditor deems necessary in the circumstances [1].

Internal accounting and administrative/management controls are interrelated and therefore should be evaluated as a whole. Internal control questionnaires are to be completed by auditors through inquiries and observations at the beginning of the field work. The questionnaire, in general, addresses issues such as whether or not a plan of organization is in place which provides appropriate segregation of functional responsibilities, whether or not there is a system of authorization and record procedures adequate to provide reasonable accounting control over assets, liabilities, net worth, revenues and expenses, whether or not the personnel's qualifications are commesurate with their responsibilities and whether or not sound practices are followed in the performance of the duties and functions of each of the organizational departments. More specifically, the evaluation of the internal controls should address the following items:

The change order approval and acceptance process.

Who are the authorized persons? Are standard forms utilized?

The progress payment request process.

Are subcontractor requests approved by the project superintendent? Are change orders segregated within the payment request? Is the level of detail of payment requests appropriate?

The transaction processing procedures.

Are the supplier's purchase terms properly documented? Are the progress billings received on a timely basis? Are progress billings follow-up procedures in place? How are outstanding receivables handled by management? Are invoices matched with purchase orders?

The job cost data input process.

Are cost codes used for each item of work? Are time sheets cost coded? Who approved the time sheets? Are material, equipment and overhead entries made on a timely basis? Are the equipment usage rates appropriate?

The job cost report process.

Who reviews the job cost reports? How often are they generated? Is the format and content adequate for the project at hand? Is the level of detail appropriate? Are variance analysis reports generated in absolute values and/or in percentages?

The verification of the cost to date process.

Are subcontractor request amounts accurately reflected in the general contractor's payment request? Have the project and general overhead costs been appropriately allocated? Are amounts billable by subcontractor/vendor matched against accounts payable? Are retainage amounts appropriately accounted for? Are costs recorded in the period in which they were incurred? Are there any pending claims for extras? Are there any pending backcharges? How is earned revenue calculated? Are billinggs to date consistent with earned revenue to date? What is the unit measure to determine project progress?

The verification of the estimated cost to complete process.

Are the project managers and owner representatives satisfied with the estimated cost to complete? Are costs to date plus estimated cost to complete consistent with original total estimate? Are actual cost to date consistent with estimated cost to date? Are current projected gross profit margins consistent with past performance? Are the projects on schedule?

The verification of subsequent events process.

Does the constructor have a sufficient backlog of work? Was there a significant profit shrinkage between the time of audit and the issue of financial statements? Are there any new contracts with potential for significant loss? Are future market conditions favorable? Are there any plans for major purchases or commitments? Are there any forthcoming lawsuits or claims? Are there any plans to change the capital structure? Are there any pending governmental regulations which will adversely affect the constructor's operations?

The estimating and bidding process.

Are estimating cost codes consistent with accounting cost codes? Are competitor bids recorded for comparison purposes? Are historical data periodically updated to reflect current costs? Are equipment rental rates compared with estimated equipment rates?

The construction equipment accounting process.

How are ownership costs determined? Are subsidiary accounts maintained on each piece of equipment? Are project-related equipment rental costs matched with equipment vendor invoices? Are there any equipment reports which maintain records on their location?

The inventory management process.

Are inventoried materials accounted for on a first in/ first out basis? Are materials and/or supplies obsolete? Are the inventories protected from theft and/or deterioration? Are inventory management and tracking procedures utilized?

Given satisfactory results with compliance testing, the auditors can proceed with the audit program which consists of an analysis of asset, liability, net worth, revenue and expense accounts.

For the purposes of this paper, only the accounts receivables, accounts payables, uncompleted contracts and construction operations audit programs will be discussed since they are the primary concern to both the auditor and the constructor because they have the greatest impact on the financial statements. With regard to the accounts receivables, the auditor's principal activities include the following: 1) reconcile and evaluate all confirmation replies, 2) reconcile the receivable subsidiary records to the general ledger control accounts, 3) compute percentage of receivables which are past due, 4) mute bad debts as a percentage to earned revenue, 5) examine billing adjustments issued after yearend, 6) review propriety of interest income, 7) review old Outstanding balances, 8) review retainages on completed contracts and 9) inquire of appropriate personnel whether any problems exist such as disputed costs, billing revisions, contract cancellations, financial condition of owners on large contracts and unapproved change orders or claims.

With regard to accounts payables, the auditor's activities include the following: 1) reconcile and evaluate all confirmation replies, 2) prepare a listing of accounts payables and reconcile to the general ledger, 3) compare accounts payable listing to selected source documents to determine propriety of cutoff procedures, 4) review unmatched invoices and determine proper recording, 5) examine credit memos received after year-end to determine if appropriately recognized and 6) reclassify material debit balances.

With regard to uncompleted contracts, the auditor's primary activities include the following: 1) prepare a summary of completed and uncompleted contracts at balance sheet date, 2) confirm the original contract price, approved change orders, payment status, estimated completion date and estimated percentage complete with the owner, 3) examine contracts, progress billings and change orders for non confirmed contracts, 4) reconcile earned revenues per the summary of contract activity to the general ledger, 5) reconcile summary of contract activity to the job cost subsidiary ledger and to the general ledger control accounts otherwise trace postings of a sample of disbursements to the general ledger and job cost ledger, 6) verify the accuracy of the cost estimates on uncompleted contracts, 7) review the methods utilized to determine the amount of contract profit earned, 8) review under/over billings which are material, and 9) obtain written representation that the contract activity summary represents the constructor's best estimate of contract results.

With regard to construction operations, the auditor's primary activities include the following: 1) foot and cross foot selected journals and trace totals to the general ledger, 2) scan transaction files and prepare a list of major transactions, 3) examine documentary evidence underlying identified major transactions to ascertain proper accounting, 4) mute gross profit of contracts and compare to prior periods, 5) prepare a comparative schedule of monthly revenues by major contract, 6) compare department payroll costs to prior periods, 7) compute average payroll costs per employee by departmental and compare to prior periods, 8) compare balances of other expenses and income to prior periods, and 9) prepare a list of major customers and verify its accuracy by referencing the constructor's accounts receivable detail records.

Once the prescribed audit program is completed, the auditors can proceed with the generation and analysis of the balance sheet, the income statement and the attached notes. The auditor should compute financial ratios and compare with past performance and with industry wide values. In most situations, the auditor should be able to Obtain sufficient competent evidence that a constructor's accounts are presented in accordance with generally accepted accounting principles to issue an unqualified opinion report. There are situations in which the auditor should not issue a standard report: 1) the auditor is unable to evaluate the propriety or collectibility of significant amounts of contract revenue related to claims, 2) the constructor does not maintain detailed cost records by contract and the auditor is unable to perform extended auditing procedures to obtain sufficient competent evidence that the data purporting to represent accumulated costs to date are reasonably correct and 3) a construction company has cash problems because of undercapitalization or because losses have eroded its net worth and threaten its ability to continue to operate as a viable entity (2).

STUDENT ACTIVITIES ASSOCIATED WITH EXTERNAL AUDIT SIMULATIONS

As previously mentioned, the student activities will focus on: 1) the evaluation of internal accounting and administrative/management controls, 2) the generation of documents, schedules and reports and 3) the analysis of financial statements. With regard to internal controls, the activities consist of: 1) the students will interview a constructor's chief financial officer and complete a basic internal controls questionnaire as a class or as a team, 2) the student teams will visit a job site and interview the project manager and complete a job site operations questionnaire, 3) the student teams will use a prescribed audit program and audit the accounts receivables, accounts payables and uncompleted contracts of an existing computerized database.

With regard to generating documents, schedules and reports, the activities consist of: 1) the student teams will generate source documents consistent with an existing computerized database and divide the transactions either on an equal basis or by category such as owner, subcontractor, vendor, payroll, etc., 2) the student teams will complete confirmations consistent with an existing computerized database, 3) the student teams will enter the source document data into the computer and confirm the outcome with the existing database, 4) the student teams will prepare contracts-in­process schedules based upon the existing computerized database, 5) the student teams will generate job cost ledger and general ledger reports.

With regard to analyzing financial statements, the activities consist of: 1) the student teams will generate a balance sheet and income statement based on the source document data entry previously mentioned and compare to the existing computerized database, 2) the student teams will compute financial ratios such as; current ratio, net profit to annual volume, net profit to net worth, net profit to working capital and annual volume to net worth.

RECOMMENDATIONS

The computerized database should consist of about five projects with a total of about one thousand transactions. Given the complexity of the assignments, it is recommended that the students work in teams of three to five members. The teams could compare each others work which would reinforce the learning process. It would be advisable to conduct this simulation on a class basis the first time around.

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