Construction Industry Intrnal Audit

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The Institute of Chartered Accountants of India(Set up by an Act of Parliament)

New Delhi

Technical Guide

on Internal Audit ofConstruction Industry



i

Technical Guideon 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 arethose of the author and may not necessarily be the views of theorganisation he represents.

The Institute of Chartered Accountants of India(Set up by an Act of Parliament)

New Delhi



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© 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.

Edition : April, 2010

Committee / : Internal Audit Standards Board

Department

Email : [email protected]

Website : www.icai.org

Price : Rs. 150/- (Including CD)

ISBN No. : 978-81-8441-345-8

Published by : 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.

Printed by : Sahitya Bhawan Publications, Hospital

Road, Agra-3.

April/2010/1,000 Copies



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FOREWORD

The construction industry is a key indicator and driver of economicactivity 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 understandthe 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 AuditStandards 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 CA. Uttam Prakash Agarwal

New Delhi President, ICAI





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PREFACE

The construction industry in India accounts for more than 8% of

the GDP and has been on a high growth trajectory. Despite thehigh 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 Audit-

Construction 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 isaimed 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



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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 CA. Shantilal Daga

Hyderabad Chairman

Internal Audit Standards Board



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GLOSSARY

Actionable Claim As defined in the “Transfer of PropertyAct, 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 bid-

based 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 bidbond provides the owner with

assurance that the bidder has the

financial means to accept the job for the

price quoted in the bid.

Construction

Industry Sector engaged in preparation of land

and construction, alteration and repair

of buildings, structures and any other

real property.



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ContingentInterest

It is an interest in property, which isavailable to a person only at a futuredate on the happening or not happening of an uncertain event.

Contract A written document which specifies theterms for construction as agreedbetween the parties.

Defects LiabilityPeriod (DLP)

It is a contingency period during whichany modification, alterations, repairs or rework to the scheduled premises isperformed by the entity as compliancewith the contract is liable to beperformed.

Entity Includes Companies, Partnership Firms,Limited Liability Partnerships, Co-operative societies, Trusts, HinduUndivided Families and any other legalform under which business operates.

Final AcceptanceCertificate (FAC)

It is the certificate given by the client atthe completion of defects liability period.

Goods Goods as defined under Sales TaxLaws.

Goods means all kinds of movableproperty (other than newspaper,actionable claims, stocks and sharesand securities) and includes livestock,all materials, commodities, and articles(including goods or in some other form)involved in the execution of workscontract or those goods to be used inthe fitting out improvement or repairs of



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movable property and all growing crops,grass, or things attached to or formingpart of the land which are agreed to besevered before sale or under thecontract of sale.

ImmovableProperty

As per the General Clauses Act, 1897

“shall include land, benefits to arise outof land, and things attached to theearth, or permanently fastened toanything attached to the earth”.

Inheritance Inheritance is an estate descended totheir heir immediately on the death of the ancestor by virtue of his rights as a

descendant.

Interest It is a legal right in rem which becomesan interest when it is attached to a land,building, chattel, object, article or thingand which is both recognised andprotected under law. It is bothinheritable and transferable inaccordance with law. It is basically of two types:

• Vested Interest• Contingent Interest.

Lease As defined under section 105 of the“Transfer of Property Act, 1882”.

A Lease of immovable property is atransfer of right to enjoy such property,made for a certain time, express, or implied, or in perpetuity, inconsideration of a price paid or



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promised, or of money, a share of crops, service or any other thing of value, to be rendered periodically or onspecified occasions to the transferor bythe transferee, who accepts the transfer

on such terms.

Movable Property As per the General Clauses Act, 1897

“Anything not a immovable property”.

PerformanceBond

A bond issued to one party of a contractas a guarantee against the failure of theother party to meet obligations specifiedin the contract.

For example, a contractor may issue abond to a client for whom a building isbeing constructed. If the contractor failsto construct the building according tothe specifications laid out by thecontract, the client is guaranteedcompensation for any monetary loss.

Property Refers to the legal right and interest of aperson in and attached to land, buildingor object, article or thing or in respect of

any intangible assets like, goodwill,copyrights, etc, held and enjoyed byhim to the exclusion of others, which isboth recognised and protected under the law. Such a right and interest istransferable, inheritable and is capableof being mortgaged, hypothecated or otherwise encumbered.

ProvisionalAcceptance

It is the certificate given by the client atthe time of the handover of the



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Certificate (PAC) scheduled premises by the entity to theclient.

Real Estate or Real Property

Denotes all lands, buildings, super structures, infrastructures and all

improvements accretions thereto and allrights, interest and titles attached tothem.

Right 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 subjectmatter 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.

Title The title is the documentary base by

which the legal right and interest to

property is recorded, established and

evidenced.



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Transfer 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 meaningand connotations to cover transactions

of wider nature.

Transfer of Property

As defined under Section 5 of the“Transfer of Property Act, 1882”.

Means “An act by which a living personconveys 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 “totransfer property” is to perform such act.In this section “living person” includes acompany, or association of persons or body of individuals”.

Turnkey or aPackage Contract

A turnkey is one in which a contractor undertakes to finance, design, constructand commission a project in it entirety.

Vested Interest It is an interest in property, which is

available to a person at present or at afuture date on the happening of acertain specified event which must happen.



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CONTENTS

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...............................................8Benefits 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



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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 beApplicable 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.............................17Other 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 theConstruction 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



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Availing Input Credit .................................................23

Works Contract ...................................................................24

Input Credit Set-off Scheme.....................................24

Works Contract Tax Deducted at Source.................25Deduction 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 InternalAudit .................................................................................28

Increased Size and Complexity of Businesses.........29Enhanced Compliance Requirements ......................29

Focus on Risk Management and InternalControls to Manage Them........................................29

Stringent Norms Mandated by Regulators toProtect 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



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Internal Audit in an Information TechnologyEnvironment .............................................................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 andExpenses .................................................................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



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Measurement Sheets..........................................................89

Risks Faced by an Entity Operating in theConstruction 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 ConstructionRevenue, Service Revenue and Recognition of Work in Progress ..............................................................103

Appendix 5

Process Flow Chart for Making StatutoryDeduction with Respect to Payroll, Month-endProcessing of Payroll and PayrollDisbursement Process......................................................106



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CHAPTER 1

INTRODUCTION

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 isnurtured 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 andelectrical 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 “turn-

key” 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

2

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 internalauditors 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 theconstruction industry for performing internal audit in a more

efficient and effective manner.

This Technical Guide covers the following aspects:

(i) Glossary of terms peculiar to construction industry.

(ii) Scenario in the construction industry, special features

and challenges faced by entities operating in this

industry.

(iii) Discussion on Internal Audit and compliance related

issues.

(iv) Legal Framework for entities operating in the Indian

construction industry.

(v) Major areas of internal audit significance and risks faced

by an entity operating in this industry, procedures that an

internal auditor can perform.

(vi) Appendix



Introduction

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1.5 This Technical Guide does not cover the following

aspects:

(a) Special audits

(b) Investigations

(c) Property Development Companies

(d) Construction of Specialised projects such as, airport,

dams, ports, railways, etc.



CHAPTER 2

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.

Evolution2.2 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

5

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 over-emphasized. 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.




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The main reason for this is the increasing emphasis on

involving the private sector infrastructure development through

public-private partnerships (PPP) and mechanisms like, build-

operate-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.

(ii) 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.




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(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.

(iii) 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.

Execution Stage

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 thebuilding is laid. The foundation is based on the strength of

the superstructure.

(ii) 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.

(iii) 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.

(iv) 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.

(v) Completion of Construction – Once the above processes

are through, the painting/whitewashing process starts.




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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.

Completion Stage

2.11 After completion of the project, the project should bereviewed 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 Stage2.12 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 theSociety

2.13 The following are the benefits of the construction

industry to the society:

(i) Absorbs rural labour and unskilled workers (in addition to

semi-skilled and skilled);

(ii) Provides opportunity for seasonal employment thereby

supplementing workers’ income from farming;

(iii) Permits large-scale participation of women workers; and

(iv) Development of Infrastructure, thereby sustaining the

growth of economy.




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Special Features of the Indian ConstructionIndustry

2.14 The construction industry is unique in certain respects

with respect to other industries. These can broadly be classified

as following:

(a) 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) The risks for a construction industry are different from

any other industry.

(ii) The construction industry is capital intensive in nature.

Huge investment needs to be made by the entity in

purchasing of specialised equipment for its constructionprocesses. In some cases, the entity hires specialised

equipment from external sources.

(iii) 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.

(iv) The entity might be required to float tenders for projects,

which requires detailed estimation of the costs required

for the project.

(v) 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.

(vi) Requires high level of planning and execution to prevent

escalation of costs, timely completion of projects thereby

building brand.




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(vii) In case, construction companies provide services

outside India, they have to comply with foreign laws and

regulations.

(viii) 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 highworking capital is required for proper functioning of the

industry.

(ix) 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.

(x) 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.

(b) Contracts

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.




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(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.

(iii) Billing is done in accordance with the work completedand as agreed between parties.

(c) Employee Related

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.

(ii) Most workers who are involved in the construction

activity are not highly educated. Only the supervisors are

educated.

(iii) 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.(d) Others

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.




12

(ii) The importance of data security need not be over-

emphasized. 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 internalaudit of the entity.

Major Operational Challenges Faced byEntities

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 enablethe 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




13

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 consideringthat 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.

(iv) 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.

(v) Material handling has been a major problem for the

industry. Improper handling and storage of materialsleads 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.

(vi) 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.




14

(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.

(viii) 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.

(ix) Some projects require minimum criteria such as

Minimum Turnover requirement/Minimum Net Worthrequirement 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.

(x) 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 unitsfrom these respective units from the perspective of

Income Tax and Service Tax. The internal auditor can

assess sufficiency of legal compliance.

(xi) 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.



CHAPTER 3 LEGAL FRAMEWORK

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 Zonesand EXIM Policy in India.

3.3 The Department of Industrial Policy and Promotion, set-

up 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 agovernment 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,




16

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 beApplicable 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



Legal Framework

17

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) Health;

(ii) Safety;

(iii) Welfare facilities;

(iv) Working hours;

(v) Employment of young persons;

(vi) Annual leave with wages;

(vii) 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




18

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 The Industrial Disputes Act also lays down following:

(i) The provision for payment of compensation to the

Workman on account of closure or lay off or

retrenchment.

(ii) The procedure for prior permission of appropriate

Government for laying off or retrenching the workers or

closing down industrial establishments.

(iii) Unfair labour practices on part of an employer or a trade

union or workers.

Other Applicable Indian Acts to the Industry

Governance Laws

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) The Companies Act, 1956

(ii) Partnership Act, 1932

(iii) The Benami Transactions (Prohibition) Act, 1988

(iv) The General Clauses Act, 1897

(v) The Land Acquisition Act, 1894

(vi) The Indian Easements Act, 1882

(vii) The Indian Stamp Act, 1899

(viii) The Negotiable Instruments Act, 1888

(ix) Land Reform Regulation of the respective states.

(x) The Indian Penal Code.



Legal Framework

19

Economic Laws

3.13 The various economic laws to which the construction

industry may be subject to include:

(i) The Income Tax Act, 1961

(ii) Central Excise Act, 1944

(iii) The Customs Act, 1965

(iv) Chapter V of the Finance Act, 1994 relating to Service Tax

(v) Value Added Tax and Sales Tax Act

Contract Laws

3.14 The various contract laws to which the construction

industry may be subject to include:

(i) The Indian Contract Act, 1872

(ii) Securities Contracts Regulation Act, 1956

Labour Laws

3.15 There are a number of labour laws governing the

construction industry. A few of the important ones are as follows:

(i) Employees Provident Fund Scheme, 1952

(ii) Employee State Insurance Act, 1948

(iii) Payment of Gratuity Act, 1972

(iv) Payment of Bonus Act, 1965

(v) Professional Tax enacted by the respective states

(vi) Shops and Establishment Act enacted by the respective

states

(vii) The Trade Union Act, 1926

(viii) Factory Rules of respective states.




20

Other Laws as applicable to the Industry

(i) Securities Exchange Board of India Act, 1992

(ii) Foreign Exchange Management Act, 1999

(iii) 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 theConstruction 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 stockexchange 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.



CHAPTER 4

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.

Income Tax

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.




22

Service Tax

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 partthereof; 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 residentialpremises/ 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;



A Reference to Statutory Laws Applicable to Indian Construction Industry

23

• 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




24

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.

Works Contract

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

25

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




26

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 constructionindustry 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.



CHAPTER 5

INTERNAL AUDIT

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 termInternal 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




28

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 to the Evolution of Internal Audit

5.3 General Guidelines on Internal Audit, issued by the

Institute of Chartered Accountants of India, describes the



Internal Audit

29

factors contributing the evolution of Internal Audit in India,

which are as follows:

(i) Increased Size and Complexity of Businesses

Increased size and business spread dilutes direct management

oversight on various functions, necessitating the need for a fulltime, independent and dedicated team to review and appraise

operations.

(ii) 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.

(iii) Focus on Risk Management and InternalControls 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.

(iv) Stringent Norms Mandated by Regulators toProtect Investors

The regulators are coming up in a big way to protect the

interests of the investors. The focus of the latest regulationsbeing ethical conduct of business, and enhanced corporate

governance and financial reporting requirements, etc.

(v) Unconventional Business Models

Businesses today use unconventional models and practices, for

example, outsourcing of non-core areas, such as accounting.

(vi) Intensive Use of Information Technology

Information technology (IT) is invariably embedded in all spheres

of activities of a modern business enterprise today, from data




30

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.

(vii) 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 know-

how 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 Planning an Internal Audit

SIA 2 Basic Principles Governing Internal Audit

SIA 3 Documentation

SIA 4 Reporting

SIA 5 Sampling

SIA 6 Analytical Procedures

SIA 7 Quality Assurance in Internal Audit

SIA 8 Terms of Internal Audit Engagement



Internal Audit

31

SIA 9 Communication with Management

SIA 10 Internal Audit Evidence

SIA 11 Consideration of Fraud in an Internal Audit

SIA 12 Internal Control Evaluation

SIA 13 Enterprise Risk ManagementSIA 14 Internal Audit in an Information Technology

Environment

SIA 15 Knowledge of the Entity and its Environment

SIA 16 Using the Work of an Expert

SIA 17 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 generally include

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)




32

• 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

33

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 auditobjectives, materiality, population from which the internal

auditor wishes to select the sample, area of audit significance

and the sample size.

Internal Control

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.




34

"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 functioningas 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



Internal Audit

35

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 thateffectiveness.

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 in an Information TechnologyEnvironment

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 theaccounting 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




36

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 InternalAudit (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 theICAI 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

37

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 non-

compliance with all laws and regulations; however thisargument 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 iscomplying 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




38

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, theinternal 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.



Internal Audit

39

• Inspecting correspondence with the relevant licensing or

regulatory authorities.

Significance of Compliance

5.26 The significance of compliance is:

(a) 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.



CHAPTER 6

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 theoperations 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 areundertaken 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

41

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. Particulars Yes No N/A

1. Bidding Process and Selection of a Project

1.1 Is there a written policy with the

entity as regards its bidding

process?

1.2 Is the policy complete in all regards

including obtaining bid bonds and

performance bonds?

1.3 Is the written policy updated at

frequent intervals by the entity

based on its previous experience?

1.4 Has the entity performed site

investigation before entering the

bidding process?

1.5 Has the entity obtained sufficient

approvals at the appropriate level of

authority before accepting the

process?

1.6 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?




42


1.7 Are the bids approved by the

appropriate level of authority?

1.8 Are there written policies/processes

for placing bids by the entity?

1.9 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?

1.10 Does the entity ensure compliance

with the terms of the contract?

1.11 Is the agreement entered into with

clients signed by both the parties atthe appropriate level before

commencement of work?

1.12 Does the entity provides services to

Related Parties?

1.13 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?

1.14 Does the entity have the process of

evaluating the credit worthiness of

the customer?

1.15 Does the entity requests for a bid

bond? If a bid bond is not obtained,

does the written policy specifies

alternative procedures?

1.16 On a sample basis, has the internal

auditor verified the compliance of

this policy?




43


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 risktaking ability by the entity and is it

frequently reviewed?

1.19 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?

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 plansare 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.

(ii) 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




44

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 sub-

divided 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.

(iv) 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 neighboringproperties 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.

(v) Completion Certificate: Completion Certificate is

mandatory for building constructed before selling or being

occupied. Issuing of Completion Certificate will ensure thatthe builder or owner has constructed the building as per

approved plan.

(vi) 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.




45

(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 approvalsrequired 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.

Procurement

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 toprovide 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:




46

A brief of each of the factors of productions is given below:

(i) 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.

(ii) 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.

(iii) 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.

(iv) 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.




47

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.

(vi) 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.




48

(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

(ii) 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

(iii) Purchase order

It should be reviewed with respect to following aspects:

• Vendor: Whether vendor is out of approved

vendor list




49

• 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.

(iv) 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.

(v) 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.




50

(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.

(viii) 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 recommendations

specifically offered

○ Monitoring and evaluation of

arrangements

○ Support and supervision arrangement

○ Penal clauses

○ Financial arrangement - payment methods

and timing

• The copy of agreement will be provided to

accounts and administration departments

• Procurement department shall review

performance of vendors periodically.

(viii) Scrap identification and disposal

• Review the procedure to identify scrap material




51

• Procedure of disposal of sale

• Periodic interval of scrap sale.

(ix) 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:

(i) 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.

(ii) 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.




52

(iii) 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.

(iv) 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.

(v) 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.

(vi) 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.




53

(vii) Cost of Employing a Contract Laborer to anEmployee

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.

(viii) 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


Audit of Procurement Process

1. Materials

1.1 Does the entity have a written

policy for the procurement

process?

1.2 Is the written policy sufficient and

complete in all aspects?1.3 Is the policy updated on a frequent

basis?

1.4 Is there a proper requisition note

with approval from the appropriate

level of authority sent from the

concerned department?

1.5 Does the entity raise an approved

request for quotation (RFQ) within

reasonable time across various

suppliers?




54


1.6 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?

1.7 On selection of the supplier, has an

approved purchase order been

placed with the supplier within

reasonable time?

1.8 Are there sufficient controls to

trace the purchase order and its

status within the entity to ensure

receipt of materials without delay?

1.9 Does the entity ensure penal

clauses in case of delays in receipt

of critical material to ensure timely

supply?

1.10 Are there any contracts entered by

the entity with suppliers for critical

materials to ensure adequate

supply at a reasonable price?

1.11 Are there sufficient procedures to

inspect materials as regards to

specification and quantity, receivedby the entity at the site before

unloading and signing of the

delivery note?

1.12 Are there sufficient documentary

controls such as Gate pass for

entry of goods?

1.13 Has a sample check for

compliance of procedures

performed?




55


1.14 Is the process of receipt of material

properly co-ordinated to the

Finance department to ensure

proper accounting?

1.15 Does the material receivingdepartment maintain sufficient

records of receipt and inspection of

material?

1.16 Has the delivery note been

approved by the appropriate level of

authority before making the entry?

1.17 In cases where materials are

supplied by client, has the internal

auditor ensured that there has

been appropriate accounting of

such material?

1.18 Does the entity have proper control

for materials received from the

client? Are they separately

identified and demarcated?

1.19 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?

2. Labour


policy for the process?


complete in all aspects?

2.3 Is the policy updated on a frequent

basis?




56



as regards the skills and

educational qualification required

for the concerned department?

2.5 Has the same been approved bythe appropriate level of authority?


request for quotation across

various service providers?

2.7 Are there significant delays in

raising the request for quotations?

2.8 Are there sufficient attendance

records, in-time and out-time records,

and other records maintained?2.9 Does the attendance record match

with the order placed for labour?

2.10 Does the entity comply with various

regulations with relation to

procurement of labour?


ensure that the service is provided

without delays?

2.12 Once the service is provided, has it

been approved by the appropriate

level of authority?

2.12 Are proper and appropriate entries

made in the books of accounts?

3. Service Contracts and Sub-contracts


policy for the process?






57



basis?





3.5 Is there a valid, proper contract

with the service provider/

contractor?


request for quotation across

various service providers?

3.7 Are there significant delays in

raising the request for quotations?

3.8 On receipt of various quotations,

are there sufficient processes to


approved as regards quality,

reliability, price and other factors?

3.9 On selection of the service

provider, has an approved Work

order been placed with the Service

Provider within reasonable time?


ensure that the service is provided

without delays?

3.11 Once the service is provided, has it

been approved by the appropriate

level of authority?

3.12 Are proper and appropriate entries

made in the books of account?




58

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 suchas 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 usageis possible. To add further, there are various certifications for

handling of materials such as OSHA 2002.

Model Checklist Related to Material Handling and Storage


1. Material Handling and Storage

1.1 Does the entity have a proper

location for storage of critical

materials?

1.2 Does the entity ensures utilisation of materials on First in First Out basis?

1.3 Are there controls in the entity

pertaining to ageing of materials to

ensure that proper valuation of non-

moving inventory is done?

1.4 In cases of write-off of inventory are

proper considerations given to

excise duty implications?

1.5 Are materials requested only in

accordance with the requirements?




59


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 criticalmaterial/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?

Fixed Assets

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:






61

(d) Whether the particular capital expenditure is

included in capital budgeting? If not, whether the

necessary management approvals been obtained

for execution?

(e) Whether there is a well laid down procedure for

acquisition of fixed assets with regard to invitationof quotations, selection of suppliers, approval of

prices, payment terms, technical specifications

and delivery schedule?

(f) Whether the necessary approvals from

appropriate level of authority been obtained for

transfer of fixed asset from one location to an

other location?

(g) Whether the date of installation is rightly

identified and recorded?

(h) Check the reasonability of identification of

depreciation method with regard to useful life of

the asset.

(i) 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.(j) 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.

(k) Whether the physical verification of assets done

at periodic intervals?




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(l) Whether the proper coding of asset is done and

each asset is identified with that code?

(m) Whether the fixed assets are adequately/properly

insured and renewed regularly without fail?

(n) 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 totalassets. 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.




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Model Checklist Related to Fixed Assets


Audit of Fixed Assets

1. Purchase of Fixed Assets


policy for the procurement

process?




basis?

1.4 In case, the entity has an option to

manufacture the asset, does it

evaluate the make option and buyoption?






request for quotation (RFQ) within

reasonable time across various

suppliers?

1.7 On receipt of various quotations,are there sufficient processes to


approved as regards features,

price, after sales service and other

factors?

1.8 On selection of the supplier, has

an approved purchase order

placed with the supplier within

reasonable time?




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trace the purchase order and its

status within the entity to ensure

receipt of fixed assets without

delay?

1.10 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?

1.11 Are there sufficient documentary

controls such as gate pass for

entry of assets

1.12 In case of commissioning of

assets, has a commissioning

certificate obtained from the

suppliers?

1.13 Is the receipt of assets properly co-

ordinated to the Finance

department to ensure proper

accounting?

1.14 Are the assets tagged and coded

in accordance with the firm’s

methodology?

1.15 Has the delivery note been

approved by the appropriate level

of authority before making the

entry?

1.16 Has the fixed asset purchased

been entered in the fixed asset

register?




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2. Maintenance of Fixed Assets

2.1 Are there processes in the entity to

ensure proper and periodic

maintenance?

2.2 Is it in accordance with the nature

of the asset?

2.3 Does the entity enter into Annual

Maintenance Contracts (AMC) for

its maintenance?

2.4 Is there a record of the

maintenance performed by the

entity for all major assets?

3. Disposal of Fixed Assets 3.1 Are there procedures in the entity

to determine whether the asset can

be disposed off?

3.2 In case the asset is sold, is a

disposal requirement note sent by

the concerned department?

3.3 Does the entity request for

quotation before making the sale?

3.4 Is there a proper valuation processof fixed assets before the price is

finalised?

3.5 Have appropriate approvals been

obtained before disposal of fixed

assets?

3.6 Have the sale of assets properly

co-ordinated to the Finance

department to ensure proper

accounting?




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3.7 Have the fixed asset register been

updated for the sale?

3.8 In case of scraping of the asset,

has the maintenance department

confirmed scrapping of the asset?

3.9 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?

4. Transfer of Fixed Assets (From Site to Site)

4.1 Has there been an approved

requisition note by the concerned

department?4.2 Has there been an approved

outward note for transfer of asset

from its existing location issued?

4.3 Has there been an approved

inward note issued?

4.4 Has the fixed asset register

updated for the transfer on a timely

basis?

4.5 Does the entity have the policy of

evaluating the availability of idle

fixed assets at other project sites

before hiring of equipment?

4.6 Does the entity have a process of

preparing a cost benefit analysis of

such transfers before the decision

to transfer is taken?

4.7 Does the entity identify the assets

of the sub-contractor separately?

4.8 Does the entity verify its fixed




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assets on a frequent basis

considering its size and level of

operations?

4.9 Does the entity deals with all the

deviations noted on physicalverification of assets

appropriately?

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 comparativelyhigh. 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 reporting of all cash and bank

transactions

• 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.




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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:

• Persons Involved for every procedure

• Key roles and responsibilities of such persons

• Delegation of authority.

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) Review the effectiveness of entity’s policy of delegation

of authority over cash and bank receipts and payments.

(ii) Ensure whether the entity’s policy is strictly implemented

and violations, if any, have been brought to the senior

management attention and got ratified.

(iii) Review maintenance of documentation with regard to:

(a) Cash receipts

(b) Cash payments

(c) Bank receipts

(d) Bank payments.




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(iv) Ensure that Bank reconciliation statements were

prepared regularly and all items have been properly

reconciled.

(v) 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 perform various analytical

procedures such as following:

• 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 cashlevel 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.


explanations for any significant fluctuations needs to beobtained. Also, explanations for high cash levels need to be

obtained.

Model Checklist Related to Cash and Bank


1. Audit of Cash and Bank

1.1 Is there a monthly verification of

cash and the same is reconciled

with books?




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1.2 Are there surprise checks

performed by the management/

internal auditors to ensure that

cash is updated on a frequent

basis?

1.3 Are bank reconciliation statements

prepared for all accounts on a

periodic basis?

1.4 Does the entity maintain both bank

book and bank statement used for

preparation of bank reconciliation

statements (BRS)?

1.5 Has the BRS been verified by

appropriate level of authority?

2. Cash Receipts

2.1 Is there a written process for

receipt of cash at the site and the

head office?

2.2 Are there procedures to ensure

that the cash is received by the

appropriate authority at the site/

head office?

2.3 Are there significant delays

between cash receipt voucher given and the accounting of the

receipt?

2.4 Are there proper procedures to

transfer the cash to head

office/deposit at bank at frequent

intervals?

3. Petty Cash Payments

3.1 Is there a written process for

receipt of cash at the site and the




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head office?

3.2 Has proper approval been obtained

in accordance with the policy

before making payments by the

entity?

3.3 Is there a significant time lag

between accounting for the petty

expenses in the books?

3.4 Is the cash being verified and

reconciled on a daily basis?

4. Carrying of Huge Cash


procedure as regards carrying

huge cash?4.2 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?

4.3 Does the entity have a process of

job rotation for carrying huge cash?

5. Verification of IOUs.

5.1 Does the entity have a policy for

IOUs?

5.2 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?

5.3 Does the policy cover the period in

which the IOUs should be settled?




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5.4 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?

Revenue Recognition

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:

(i) Construction Contract

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.

(ii) 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.

(iii) 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.

(iv) Contract Revenue

Contract revenue should comprise:

(a) the initial amount of revenue agreed in the contract; and




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(b) variations in contract work, claims and incentive

payments:

• 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.

(v) Variation

A variation is an instruction by the customer for a change in thescope 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

(b) the amount of revenue can be reliably measured.

(vi) Contract Costs

Contract costs should comprise:

(a) costs that relate directly to the specific contract;

(b) costs that are attributable to contract activity in general

and can be allocated to the contract; and

(c) such other costs as are specifically chargeable to the

customer under the terms of the contract.




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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) total contract revenue can be measured reliably;

(b) it is probable that the economic benefitsassociated with the contract will flow to the

enterprise;

(c) both the contract costs to complete the contract

and the stage of contract completion at the

reporting date can be measured reliably; and

(d) 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.

(ii) 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

(b) the contract costs attributable to the contract,

whether or not specifically reimbursable, can be

clearly identified and measured reliably.




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6.21 Internal auditor shall review the following aspects:

(a) 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.

(b) Whether the methods used to determine the stage of

completion of contracts in progress are fair and depict

true and fair view.

(c) Has the entity maintained a proper documentation for

advances received and the retention amounts.

(d) Whether the procedure adopted for determining the

expected losses is adequate.

(e) Whether the service income is recognized as per service

agreement.

(f) Whether the irrecoverable costs incurred in securing the

contract are recognized as expense?

(g) Whether the procedure adopted for determining WIP is

adequate?

(h) 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”.

6.22 Analytical procedures that can be performed by theinternal auditor include the following:

• Percentage completed vs scheduled percentageof 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.




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• 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 stepstowards 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.


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.




77

Model Checklist Related to Revenue


1. Audit of Recognition of Revenue

1.1 Does the agreement specify therecognition of income?


process of estimating the

percentage completed on a periodic

basis?

1.3 Does the entity use an expert to

estimate the % completed at the

end of the year to ensure proper

estimation?

1.4 Have the invoices been issued in

accordance with the agreement?

1.5 Are there proper controls and

procedures for estimation of

income?

1.6 Has the invoice been properly

authorised by the appropriate level

of authority?

1.7 Does the entity has a proper

process in accordance with theaccounting policy for estimating and

recognising unbilled revenue?

1.8 Does the entity has an accounting

policy for accounting work certified

and work uncertified?

1.9 Does the entity obtains certificate

for the percentage of work

completed at the time of billing of

contracts?




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1.10 Is the work uncertified significant in

relation to the work certified? Has

proper explanations been obtained

in such cases?

Payroll

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) areemployed 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 f or 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) Joining bonus

(b) Availability of leave

(c) Leave encashment

(d) Gratuity

(e) Leave travel allowance

(f) Availability of perquisites

(g) Reimbursements




79

(h) Salary advances

(i) Employment agreement including non-disclosure

agreement.

(ii) Whether proper documentation has been maintained for

employee’s personal information, joining information

along with compensation details.

(iii) Whether the registrations with PF, ESI, professional tax

and other statutory authorities have been done and

properly renewed.

(iv) Whether the reimbursements payments are made as per

approved policy.

(v) Whether recovery and remittance of PF, ESI and

Professional Tax from employees is made regularly.

(vi) Check the calculation, collecting and remitting of incometax from employees, calculation of settlement claims,

and perquisites and payments.

(vii) Whether the procedure adopted and documentation

maintained for employees attendance and leave claims

is adequate.

(viii) Ensure that the leave encashment and leave travel

allowance payment is as per the approved policy.

(ix) Check that the provision for gratuity is done correctly.

(x) Check the computations and approvals for incentives for

employees.

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




80

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 andsteps 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 mustbe assessed.

• Reconciliation with respect to Changes in theNumber of Employees due to Additions,Terminations, Retirements, etc., Between VariousMonths

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.




81

Model Checklist Related to Payroll Process


1. Specific Areas of Payroll Processing

1.1 Does the entity have a payroll

process as approved byappropriate level of authority?

1.2 Is the payroll process complete in

all aspects, as applicable to the

entity?

1.3 Is there sufficient attendance

register maintained by the entity for

all workers (both employees and

contractors)?

1.4 Have all statutorily prescribedregisters maintained by the entity

with regards to both employees and

contractors?

1.5 Does the entity maintain a check-

list of statutory remittances to be

made on account of PF, ESI,

Labour Welfare Fund and alike?

1.6 Are cheques prepared and signed

by two different employees?

1.7 If the entity opts for bank transfer,

is there appropriate level of

authority prescribed to issue a bank

transfer instruction to the bank?

1.8 Is the payroll processing cross

checked before payment is made?

1.9 Are there sufficient manual records

maintained by the entity with regard

to their recruitment, offer letter,

appraisals and increments and all




82


other correspondences with the

employee?

1.10 Have the incentive schemes been

verified by the internal auditor on a

test basis?

1.11 Have these controls been tested for

effectiveness?

1.12 Is the attrition rate exceedingly

high? Have justifications for such a

high rate, if any been obtained?

1.13 Have the reasons and explanations

for any failures and control

weakness observed on review of

these complaints?

1.14 Does the entity comply with the

accounting requirements for ESOP,

ESPP schemes and maintains

proper record of the shares opted

by the employees?

1.15 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?

Operating Costs

6.26 The significant operating costs for any entity operating in

this sector include the following:

(i) Hiring Expenses

The hiring expense could be for hiring of carriers, equipments

and accommodation. The entity relies on transport vehicles for




83

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.

(ii) 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.

(iii) Logistics

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




84

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 isrequired 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.




85

• 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


1. Repairs and Maintenance

1.1 Does the entity have a procedure

for maintenance of equipment?

1.2 Is maintenance done on a frequentbasis?

1.3 Are there sufficient recordsmaintained to ensure thatmaintenance has been performed

by the entity?

1.4 Does the entity enter into AnnualMaintenance Contracts (AMC) for

specialised equipment?

1.5 Does the entity have a proper log/register to ensure that

maintenance has been provided for all equipments?

1.6 In case of unforeseen breakdown of equipment, have explanations for

such breakdown obtained?

1.7 In case of frequent repairs requiredfor the equipment, has a cost trade-off analysis performed to verify

whether it is better to purchase an

asset against maintenance.

2. Hiring and Logistics

2.1 Does the entity have approved

policy for hiring of transport




86


vehicles, carriers, accommodations

and equipments?

2.2 Does hiring expenses lead to costsavings?

2.3 Has the entity analysed the benefitsof hiring against purchase of

equipments/vehicles?

2.4 In cases where certain equipments

are hired very frequently, is it better

to purchase it than hiring it?

2.5 Has the entity received quotationsof prices from different vendors to

ensure cost effectiveness and goodservices before deciding on the

vendor?

2.6 Are there sufficient procedures totransfer from one segment to

another and are there proper controls for allocation of costs

between these departments?

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 collaborationagreements. 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.




87

Model Internal Audit Procedures for Agreement with

Collaborators


1. Agreement with Collaborators

1.1 Does the entity keep a track of allthe major clauses that are to be

complied with respect to the

collaboration agreement?

1.2 Does the entity performs

reconciliation of funds remitted,

taxes deducted apart from other

procedures performed?

1.3 Does the entity value all gifts in the

nature of tools, machinery at a

proper valuation, if they are useful?

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.






89

1.2 Are the claims properly lodged and

registered?


method of valuation of claims and is

it supported with the corroborative

evidence?

1.4 Have proper follow up action been

taken for the realisation of overdue

claims and have the claims that are

irrecoverable been systematically

written off?

Measurement Sheets

6.35 Measurement sheet is a record maintained by the client

for the work performed by the entity is being measured andbased 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 theConstruction 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.




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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, theIndustry 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 andprofitability.

• 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.




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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 builtwithin 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 inthe 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.




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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 .

Maintenance of Books of Accounts andDocuments

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 thecontrols for allocation of costs between different projects, are

adequate and reliable in the light of the business operations.

S.

No.Particulars Yes No N/A

1. Books of Accounts and Documents

1.1 Does the entity have proper

accounting system commensurate

with the regulatory requirements?




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S.

No.Particulars Yes No N/A

1.2 Does the entity have specific books of

accounts for work performed in SEZ?

1.3 Are the control systems in place for estimating the revenue generated

location-wise sufficient to ensure that

proper books are maintained for the

location?

1.4 Does the entity have proper and

reasonable system to allocate various

costs incurred to the respective SEZ

undertaking and non-SEZ undertaking

as applicable?

1.5 Does the entity have location-wise

employee details to ensure proper

allocation of payroll cost to the

location?

1.6 Are the books of accounts closed

every month?

1.7 Are the controls for re-opening of

books proper to ensure prevention of

manipulation?

1.8 Does the entity maintain a project-

wise 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?

1.9 Are there controls in place to ensure

that all costs have been allocated to

all projects in an appropriate manner?




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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 variousstatutory 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

(ii) 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 applicableregulatory 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;




95

• 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 andassessment, 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 thecontrols prescribed.





Appendix 1

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.




98

Process Flow for Procurement of Services/ Subcontractors



Appendix

99

Appendix 2

Process Flow Chart for the Purchase, Transfer

and Disposal of Fixed Assets

A typical process for the purchase, transfer and disposal of fixedassets of an entity operating in the construction industry are given

below.

Process Flow for Fixed Assets Purchases




100

Process Flow for Transfer of Fixed Assets



Appendix

101

Process Flow for Disposal of Fixed Assets




102

Appendix 3

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



Appendix

103

Appendix 4

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




104

Process Flow for Recognising Services Revenue



Appendix

105

Process Flow for Recognising WIP




106

Appendix 5

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 StatutoryDeduction



Appendix

107

Process Flow for Month-end Salary Processing




108

Process Flow for Payroll Disbursement Processing



Appendix

109

Flowchart Symbols

