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  1. 1. Technical Guide on Internal Audit of Construction Industry Technical Guide on Internal Audit of Construction Industry ISBN : 978-81-8441-345-8 2010 Price : Rs. 150/- The Institute of Chartered Accountants of India (Set up by an Act of Parliament)www.icai.org New Delhi April / 2010
  2. 2. Technical Guide on Internal Audit ofConstruction IndustryDISCLAIMER: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 i
  3. 3. © The Institute of Chartered Accountants of IndiaAll rights reserved. No part of this publication may be reproduced,stored in a retrieval system or transmitted, in any form or by anymeans, electronic, mechanical, photocopying, recording orotherwise, without prior permission, in writing, from the publisher.Edition : April, 2010Committee / : Internal Audit Standards BoardDepartmentEmail : cia@icai.orgWebsite : www.icai.orgPrice : Rs. 150/- (Including CD)ISBN No. : 978-81-8441-345-8Published 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 ii
  4. 4. FOREWORDThe construction industry is a key indicator and driver of economicactivity and wealth creation. This industry has a profound impacton the society and the products of this vital industry are of varioustypes like, buildings, roads and bridges, utility distributionssystems, railways, airports, harbours, etc. The future of thisinvestment laden industry depends upon its capacity to evolve onbusiness, technological and environmental fronts.Internal auditors have a key role to play in construction industrywith respect to multi-dimensional challenges faced by this industrylike, project risk, funding strategies, cost reduction, projectmonitoring, etc. This demands that internal auditors understandthe basic concepts and peculiarities of this industry and bracethem up to newer challenges.I am happy to note that the Internal Audit Standards Board hasbrought out this Technical Guide on Internal Audit of ConstructionIndustry. This Technical Guide provides the readers a crisp insightinto various technicalities arising in the operations of this industryand covers the relevant issues which the internal auditors must beaware of.I congratulate CA. Shanti Lal Daga, Chairman, Internal AuditStandards Board and the members of the Board on issuance ofthis Technical Guide. This Technical Guide comprehensively dealswith the peculiar aspects of construction industry and provides astep-wise approach for internal audit.I am sure that this Technical Guide will assist the members andothers in efficiently discharging their responsibilities.February 16, 2010 CA. Uttam Prakash AgarwalNew Delhi President, ICAI iii
  5. 5. PREFACEThe construction industry in India accounts for more than 8% ofthe GDP and has been on a high growth trajectory. Despite thehigh growth potential, the industry is subjected to more risk anduncertainty than many other industries. Many of the risks emergeover time and are linked to the life cycle of the project. Thus, thepotential for improving the management for construction projects issignificant.Internal auditors who understand the basic structure andprocesses of construction project management and tailor theirinternal audit work to the unique time and organisationalframework can play a meaningful role. They can assist inimplementing controls that provide reasonable assurance ofmitigating 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 hastransformed in view of introduction of the new trades and workpractices, better safety and quality standards, productivitybenchmarks both by government organisations and by theindustry. The Guidelines have been thoroughly revised to reflectthese changes, especially, those arising out of the significantdevelopments in regulatory environment. This revised version ofTechnical Guide on Internal Audit of Construction Industry isaimed to help the readers in understanding not only the regulatoryframework and technical aspects of the construction industry butalso the procedures to be undertaken by the internal auditor. ThisGuide has been divided into various chapters dealing with thefundamental concepts in construction industry. These chaptersdeal with the introduction, technical aspects, regulatory frameworkof the construction industry, methodology for internal audit andinternal audit checklists of functional areas. The Appendixcontaining flow charts regarding various processes carried out in v
  6. 6. the industry and a glossary of terms used in the constructionindustry provide valuable guidance to the readers.At this juncture, I am grateful to CA. M. Guruprasad for sharing hisexperiences and knowledge with us and preparing the draft of therevised Guidelines and bringing them in line with the latestdevelopments in the field.I also wish to thank CA. Uttam Prakash Agarwal, President andCA. Amarjit Chopra, Vice President for their continuous supportand encouragement to the initiatives of the Board. I must alsothank my colleagues from the Council at the Internal AuditStandards 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, ShriManoj K. Sarkar and Shri K. P. Sasidharan for their vision andsupport. I also wish to place on record my gratitude for thecoopted 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. RajivDave, CA. Pawan Chagti, CA. Ram Mohan Johri and CA. ArindamGuha for their devotion in terms of time as well as views andopinions to the cause of the professional development. I also wishto 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 thisTechnical Guide immensely useful.February 10, 2010 CA. Shantilal DagaHyderabad Chairman Internal Audit Standards Board vi
  7. 7. GLOSSARYActionable Claim As defined in the “Transfer of Property Act, 1882”. Means a claim to any debt, other than a debt secured by mortgage of immovable property or by hypothecation or pledge of moveable property, or to any beneficial interest in immovable property not in the possession, either actual or construction, other claimant, which the civil courts recognise as affording grounds for relief, whether such debt or beneficial interest be existent accruing conditional or contingent.Bid Bond A debt secured by a bidder for a construction job or similar type of 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 bid bond provides the owner with assurance that the bidder has the financial means to accept the job for the price quoted in the bid.Construction Sector engaged in preparation of landIndustry and construction, alteration and repair of buildings, structures and any other real property. vii
  8. 8. Contingent It is an interest in property, which isInterest available to a person only at a future date on the happening or not happening of an uncertain event.Contract A written document which specifies the terms for construction as agreed between the parties.Defects Liability It is a contingency period during whichPeriod (DLP) any modification, alterations, repairs or rework to the scheduled premises is performed by the entity as compliance with the contract is liable to be performed.Entity Includes Companies, Partnership Firms, Limited Liability Partnerships, Co- operative societies, Trusts, Hindu Undivided Families and any other legal form under which business operates.Final Acceptance It is the certificate given by the client atCertificate (FAC) the completion of defects liability period.Goods Goods as defined under Sales Tax Laws. Goods means all kinds of movable property (other than newspaper, actionable claims, stocks and shares and securities) and includes livestock, all materials, commodities, and articles (including goods or in some other form) involved in the execution of works contract or those goods to be used in the fitting out improvement or repairs of viii
  9. 9. movable property and all growing crops, grass, or things attached to or forming part of the land which are agreed to be severed before sale or under the contract of sale.Immovable As per the General Clauses Act, 1897Property “shall include land, benefits to arise out of land, and things attached to the earth, or permanently fastened to anything attached to the earth”.Inheritance Inheritance is an estate descended to their 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 becomes an interest when it is attached to a land, building, chattel, object, article or thing and which is both recognised and protected under law. It is both inheritable and transferable in accordance with law. It is basically of two types: • Vested Interest • Contingent Interest.Lease As defined under section 105 of the “Transfer of Property Act, 1882”. A Lease of immovable property is a transfer of right to enjoy such property, made for a certain time, express, or implied, or in perpetuity, in consideration of a price paid or ix
  10. 10. promised, or of money, a share of crops, service or any other thing of value, to be rendered periodically or on specified occasions to the transferor by the transferee, who accepts the transfer on such terms.Movable Property As per the General Clauses Act, 1897 “Anything not a immovable property”.Performance A bond issued to one party of a contractBond as a guarantee against the failure of the other party to meet obligations specified in the contract. For example, a contractor may issue a bond to a client for whom a building is being constructed. If the contractor fails to construct the building according to the specifications laid out by the contract, the client is guaranteed compensation for any monetary loss.Property Refers to the legal right and interest of a person in and attached to land, building or object, article or thing or in respect of any intangible assets like, goodwill, copyrights, etc, held and enjoyed by him to the exclusion of others, which is both recognised and protected under the law. Such a right and interest is transferable, inheritable and is capable of being mortgaged, hypothecated or otherwise encumbered.Provisional It is the certificate given by the client atAcceptance the time of the handover of the x
  11. 11. Certificate (PAC) scheduled premises by the entity to the client.Real Estate or Denotes all lands, buildings, superReal Property structures, infrastructures and all improvements accretions thereto and all rights, interest and titles attached to them.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 subject matter of various rights like, the right to posses, use, enjoy, alter, consume, destroy, alienate, hypothecate, transfer, bequeath, inherit, succeed to, etc.Right in Rem A right against or in respect of a thing.Spes Successions It is a mere right to succeed to a property in the future.Succession Succession is the transmission of rights and obligations of deceased to their heirs.Title The title is the documentary base by which the legal right and interest to property is recorded, established and evidenced. xi
  12. 12. 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 meaning and connotations to cover transactions of wider nature.Transfer of As defined under Section 5 of theProperty “Transfer of Property Act, 1882”. Means “An act by which a living person conveys property in present or in future, to one or more other living persons, or to himself, or to himself and one or more other living persons, and “to transfer property” is to perform such act. In this section “living person” includes a company, or association of persons or body of individuals”.Turnkey or a A turnkey is one in which a contractorPackage Contract undertakes to finance, design, construct and commission a project in it entirety.Vested Interest It is an interest in property, which is available to a person at present or at a future date on the happening of a certain specified event which must happen. xii
  13. 13. CONTENTSForeword......................................................................................iiiPreface ..........................................................................................vGlossary......................................................................................viiChapter 1: Introduction .................................................. 1-3Objective and Scope of the Technical Guide ........................2Chapter 2: About the Indian Construction Industry ...................................................... 4-14Evolution ...............................................................................4History of the Indian Construction Industry ...........................4Stages 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..............8Special Features of the Indian Construction Industry............9 Business Process Related .........................................9 Contracts..................................................................10 Employee Related ....................................................11 Others ......................................................................11 xiii
  14. 14. Major Operational Challenges Faced by Entities ................12Chapter 3: Legal Framework...................................... 15-20Ministry of Commerce and Industry, GOI ............................15Ministry of Finance, GOI .....................................................15A 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 .................20Other Applicable International Acts to theConstruction Industry ..........................................................20 The Sarbanes-Oxley Act, 2002 ................................20Chapter 4: A Reference to Statutory Laws Applicable to Indian Construction Industry .................................................... 21-26Income Tax .........................................................................21Service Tax .........................................................................22 xiv
  15. 15. Availing Input Credit .................................................23Works Contract ...................................................................24 Input Credit Set-off Scheme .....................................24 Works Contract Tax Deducted at Source .................25 Deduction on the Rate of Works Contract Tax .........25Special Economic Zone ......................................................25 SEZ Rules, 2006 ......................................................25Chapter 5: Internal Audit ............................................ 27-39Factors Contributing to the Evolution of InternalAudit .................................................................................28 Increased Size and Complexity of Businesses.........29 Enhanced Compliance Requirements ......................29 Focus on Risk Management and Internal Controls to Manage Them........................................29 Stringent Norms Mandated by Regulators to Protect Investors ......................................................29 Unconventional Business Models.............................29 Intensive Use of Information Technology .................29 An Increasingly Competitive Environment................30Methodology 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 xv
  16. 16. Internal Audit in an Information Technology Environment .............................................................35 Overview of Compliance ..........................................36Chapter 6: Major Areas of Internal Audit Significance.............................................. 40-95Selection of a Project ..........................................................40Approvals for Registration...................................................43Procurement .......................................................................45Material Handling and Storage............................................58Fixed Assets .......................................................................59 Total Fixed Cost ......................................................62 Asset Utilization ratio................................................62Cash and Bank ...................................................................67 IOUS ........................................................................68Revenue Recognition..........................................................72 Recognition of Contract Revenue and Expenses .................................................................74Payroll .................................................................................78Operating Costs ..................................................................82 Hiring Expenses .......................................................82 Repair and Maintenance ..........................................83 Logistics ...................................................................83Agreement with Collaborators.............................................86Running Account Bill (RAB) ................................................87Disputed Claims ..................................................................88 xvi
  17. 17. Measurement Sheets ..........................................................89Risks Faced by an Entity Operating in theConstruction Industry ..........................................................89 Reduction of Risks ...................................................91Maintenance of Books of Accounts and Documents...........92Compliance with Standards and Regulations......................94AppendixAppendix 1Process Flow Chart for Procurement ofMaterial and Services..........................................................97Appendix 2Process Flow Chart for the Purchase,Transfer and Disposal of Fixed Assets................................99Appendix 3Process Flow Chart for General Payments .......................102Appendix 4Process Flow Chart for Recognition of ConstructionRevenue, Service Revenue and Recognition ofWork in Progress ..............................................................103Appendix 5Process Flow Chart for Making StatutoryDeduction with Respect to Payroll, Month-endProcessing of Payroll and PayrollDisbursement Process ......................................................106 xvii
  18. 18. xviii
  19. 19. CHAPTER 1 INTRODUCTION1.1 Construction activity is an integral part of a country’sinfrastructure and industrial development. It includes hospitals,schools, townships, offices, houses and other buildings, urbaninfrastructure (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-economicdevelopment as it covers such a wide spectrum. Besides, theconstruction industry generates substantial employment andprovides a growth impetus to other sectors through backward andforward linkages. It is, essential therefore, that, this vital activity isnurtured for the healthy growth of the economy. Moreover, it is oneof the earners of foreign exchange as more and moreorganisations have started to provide services outside India.1.2 The construction industry has major linkages with thebuilding material industry since construction material accountsfor sizeable share of the construction costs. These includecement, 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 isalso labour predominant industry. In general, the constructionindustry deals with development of real property. It involveswork to be performed at the specific location, where theproperty is located. Only the administrative works are carriedout at the centralized location. It has become specialised in therecent years which have lead to work to be performed on “turn-key” basis. On the other hand, major projects have beenawarded to a consortium of contractors. Also, the role of sub-
  20. 20. Technical Guide on Internal Audit of Construction Industrycontracting has played a significant part, considering the trendof hiring labour, transporters, electricians, plumbers, welders onsub-contract has increased.Objective and Scope of the Technical Guide1.3 This Technical Guide is intended to assist internalauditors in carrying out internal audit of entities operating in theconstruction industry. The Technical Guide deals withoperational areas of entities operating in this industry withemphasis on compliance mandated as per various regulationsapplicable to the specific industry.1.4 Today, the scope of internal audit has increased frommere 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 familiariseswith various management aspects and technical aspects of theconstruction industry for performing internal audit in a moreefficient 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 2
  21. 21. Introduction1.5 This Technical Guide does not cover the followingaspects:(a) Special audits(b) Investigations(c) Property Development Companies(d) Construction of Specialised projects such as, airport, dams, ports, railways, etc. 3
  22. 22. CHAPTER 2 ABOUT THE INDIAN CONSTRUCTION INDUSTRY2.1 It is important for an internal auditor to gain anunderstanding of the Indian construction industry, its evolution,special features of the construction industry and the challengesfaced by entities operating in the industry in order to understandthe critical areas, nuances and knowledge of the businessthereby helping him in framing internal audit procedures toperform an efficient and effective internal audit.Evolution2.2 The evolution of Indian construction industry was almostsimilar to the construction industry evolution in other countries,i.e., founded by government and slowly taken over by privateenterprises. After independence the need for industrial andinfrastructural developments in India laid the foundation stoneof construction, architectural and engineering services. Theconstruction sector became organised since the 1950’s postincentives taken by the government to develop these services.History of the Indian Construction Industry2.3 The history of the Indian construction industry datesback to period from early 1950 to mid 60’s which witnessed thegovernment playing an active role in the development of theseservices and most of construction activities during this periodwere carried out by state owned enterprises and supported bygovernment departments. In the first five-year plan, constructionof civil works was allotted nearly 50 per cent of the total capitaloutlay.2.4 The first professional consultancy company, NationalIndustrial Development Corporation (NIDC), was set up in the
  23. 23. About The Indian Construction Industrypublic sector in 1954. Subsequently, many architectural, designengineering and construction companies were set up in thepublic 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 wereincorporated:• M. N. Dastur and Co.• Hindustan Construction Company (HCC)• Ansals.2.5 In the late 1960s government started encouragingforeign collaborations in these services. The Guidelines forForeign Collaboration, first issued in 1968, stated that localconsultant would be the prime contractor in such collaboration.The objective of such an imposition was to develop local designcapabilities parallel with the inflow of imported technology andskills. This measure encouraged international construction andconsultancy organisations to set up joint ventures and registertheir presence in India.2.6 The importance of this sector in India need not be over-emphasized. In India, construction has accounted for around 40per cent of the development investment during the past 50years. Around 16 per cent of the nations working populationdepends on construction for its livelihood. The Indianconstruction industry comprises 200 firms in the corporatesector. In addition to these firms, there are about 1,20,000Class A contractors registered with various governmentconstruction bodies. There are thousands of small contractors,which work as sub- contractors of prime or other contractors. 5
  24. 24. Technical Guide on Internal Audit of Construction IndustryThe main reason for this is the increasing emphasis oninvolving the private sector infrastructure development throughpublic-private partnerships (PPP) and mechanisms like, build-operate-transfer (BOT).Stages of a Construction Project2.7 The construction industry has various stages. Based onthe nature of the construction to be performed, the followingmay or may not be applicable in the same sequence:Definition of the Project2.8 In the project definition phase, objectives are developedand the scope of the project is specified. This is the mostimportant phase of the project which determines the success orfailure of the project. This activity can be split in two broadstages 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 Project2.9 Project planning involves marshalling the resources anddeveloping the systems and procedures necessary to controlactivity during project execution. A successful planning effortwould result in development of following three distinct controls:(i) Scope Controls - It ensures that the work performed is within the overall scope of the project. It is also to ensure that all parts of the projects are completed simultaneous and appropriately. 6
  25. 25. About The Indian Construction Industry(ii) Scheduled Controls - Controls should be in place to ensure compliance with schedule of work. This is extremely important to avoid project overruns and compliance with scheduled time. These controls are essential to avoid penalties & Charges for delay in completion of contracted work as agreed by the parties.(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 Stage2.10 In the execution stage, the following processes areinvolved:(i) Laying the Foundation – Once the materials are procured, with the help of labour, the foundation for the building is laid. The foundation is based on the strength of the superstructure.(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. 7
  26. 26. Technical Guide on Internal Audit of Construction IndustryIt involves proper controls to ensure that the execution is as perthe planning. If there are any significant deviations, thensufficiency of controls needs to be verified.Completion Stage2.11 After completion of the project, the project should bereviewed and it is an invaluable tool for making sure thatlessons learned carry over to the next project. The level of effortrequired in this phase varies with the size of the organizationand the frequency with which capital projects are undertaken. Ifthe organization is involved in a major expansion activity, withmore projects anticipated, a detailed review of each project bymanagement function is probably warranted. The formal reportsfrom the reviews should be compiled to provide a road map forimproving future performance.Post Completion Stage2.12 The entity might be required to provide fit outs, layouts inaccordance with the terms of the contract.Upon completion ofthe Defects Liability Period, all liabilities with regard to thecontract cease.Benefits of the Construction Industry to theSociety2.13 The following are the benefits of the constructionindustry 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. 8
  27. 27. About The Indian Construction IndustrySpecial Features of the Indian ConstructionIndustry2.14 The construction industry is unique in certain respectswith respect to other industries. These can broadly be classifiedas following:(a) Business Process RelatedThe business of an entity operating in a construction industryhas certain unique characteristics, risks, nuances. Some ofthem 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 construction processes. 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. 9
  28. 28. Technical Guide on Internal Audit of Construction Industry(vii) In case, construction companies provide services outside India, they have to comply with foreign laws and regulations.(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 high working 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) ContractsIn general, contracts are entered for the work to be performedto ensure proper determination of scope of work, nature ofwork, fixation of responsibility, payment terms, escalationclauses, 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. 10
  29. 29. About The Indian Construction Industry(ii) Agreements are entered into between the client and the entity as regards the scope of work to be performed, the legalities involved, scheduled period of completion, billing details, escalation clauses, penalties and other charges.(iii) Billing is done in accordance with the work completed and as agreed between parties.(c) Employee RelatedThe employee related area in a construction industry is usuallyneed based and the industry is also labour intense. Somespecial 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) OthersData Security, reliance on external conditions are amongst theother 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. 11
  30. 30. Technical Guide on Internal Audit of Construction Industry(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 tounderstand these special features for conducting the internalaudit of the entity.Major Operational Challenges Faced byEntities2.15 The construction industry is a delivery based Industry.The construction industry in India is not yet completelyorganised. These service providers have unique challengesfaced by the industry and also the risks are unique in nature.This section is intended to highlight some of the significantchallenges that the construction industry faces so as to enablethe internal auditor to plan and perform the internal auditaccordingly.2.16 The internal auditor is required to perform such auditprocedures specific to the entity as deemed necessary toensure systematic evaluation of risk management, control andgovernance processes. Some of these challenges are givenbelow:(i) Challenges of meeting time schedules, cost schedules and compliance with the scope of work has been key for success and, thus,meeting them has been the greatest challenge for any entity operating in the construction industry. The internal auditor can assess the business risk, and also brand and reputation risk on not complying with deadlines. The effectiveness of controls can also be assessed by the internal auditor.(ii) The biggest challenge faced by an entity operating in the construction industry is availability of adequate manpower with appropriate skill sets at a reasonable 12
  31. 31. About The Indian Construction Industry cost. This is the most important factor to control for sustained growth of the entity. The internal auditor might analyse and assess the prospects of the business in future, apart from business risk.(iii) The client’s capacity to make payments as per the contract agreed also poses a big challenge considering that the funds get blocked up, increasing the working capital requirements significantly. The management also faces the challenge of managing the working capital requirements for the projects considering that some clients make the schedule payment only post completion of certain percentage of work. It is the management effectiveness in keeping the cost of borrowed funds as low as possible thereby ensuring that the profitability is not significantly affected. The internal auditor can assess the effectiveness of management in assessing clients and managing cost of borrowed funds before selecting them.(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 materials leads to significant storage costs, wastage, and non– availability of critical materials at the appropriate time. The internal auditor needs to assess the efficiency of management with regards to handling of inventory.(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. 13
  32. 32. Technical Guide on Internal Audit of Construction Industry(vii) The costs of materials at the time of contract are significantly different compared to cost at the time of performance of the work. In cases where the cost of materials required has escalated, the management might be finding it difficult to maintain profitability. The internal auditor should assess the process of making budgets and whether management is effective in determining the future costs.(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 Worth requirement for bidding of clients. If the entity does not meet these criteria, they are not qualified to bid, thereby hindering their growth. The internal auditor can assess such types of business risk also.(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 units from 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. 14
  33. 33. CHAPTER 3 LEGAL FRAMEWORK3.1 This Chapter details the various acts applicable, andalso organisations that supervise and regulate the constructionindustry in India.Ministry of Commerce and Industry, GOI3.2 The mandate of the Department of Commerce isregulation, development and promotion of India’s internationaltrade and commerce through formulation of appropriateinternational trade and commercial policy and implementation ofvarious provisions thereof. This Ministry formulates theregulatory 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 responsiblefor Intellectual Property Rights relating to Patents, Designs,Trade Marks and Geographical Indication of Goods andoversees the initiative relating to their promotion and protection.This Department also formulates, promotes, approves andfacilitates the Foreign Direct Investment (FDI) Policy.3.4 Director General of Foreign Trade (DGFT) is agovernment organization in India responsible for the formulationof Export – Import guidelines and principles for Indian importersand Indian exporters of the country. The basic role of theDepartment is to facilitate the creation of an enablingenvironment and infrastructure for accelerated growth ofinternational trade.Ministry of Finance, GOI3.5 The Ministry of Finance, India looks after the variousfinancial affairs of the state of India. The Ministry of Finance,
  34. 34. Technical Guide on Internal Audit of Construction IndustryIndia is responsible for monitoring the various aspects of theIndian economy and it operates through various departments.• Department of Economic Affairs• Department of Disinvestment• Department of Expenditure• Department of Financial Services• Department of RevenueVarious statutes such as Customs Act, 1962, Foreign ExchangeManagement Act, 1999, Income Tax, 1961 to name thesignificant ones, as applicable to the construction industry areformulated and governed by this Ministry.A Gist of Important Regulations that may beApplicable to an EntityThe Transfer of Property Act, 18823.6 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, 20063.7 A Special Economic Zone (SEZ) is a trade capacitydevelopment tool, with the goal to promote rapid economicgrowth by using tax and business incentives to attract foreigninvestment and technology. The Central Government hasframed the policy framework for SEZs through the SEZ Act. TheState Governments play a significant lead role in thedevelopment of SEZs in their respective States by stipulatingthe conditions to be adhered to by an SEZ and granting the 16
  35. 35. Legal Frameworknecessary approvals. These supporting procedures are laiddown in SEZ Rules as framed by the State Governments.The Minimum Wages Act, 19483.8 The Minimum Wages Act, 1948, extends to the whole ofIndia and applies to scheduled employments in respect of whichminimum rates of wages have been fixed under this act. Theobjective of this Act is to fix minimum rates of wages in certainemployments. The appropriate government (State Governmentor Central Government as the case may be) shall fix theminimum rates of wages payable to employees employed in ascheduled employment.The Factories Act, 19483.9 The Factories Act, 1948 is a social legislation which dealswith 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 10employees.The Industrial Disputes Act, 19473.10 The Industrial Disputes Act, 1947, extends to whole ofIndia and applies to every industrial establishment carrying onany business, trade, manufacture or distribution of goods andservices irrespective of the number of workmen employedtherein. Every person employed in an establishment for hire orreward including contract labour, apprentices and part time 17
  36. 36. Technical Guide on Internal Audit of Construction Industryemployees to do any manual, clerical, skilled, unskilled,technical, operational or supervisory work, is covered by theAct. The objective of the Act is to secure industrial peace andharmony by providing machinery and procedure for theinvestigation and settlement of industrial disputes bynegotiations.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 IndustryGovernance Laws3.12 The various acts enacted by the Government to governany industry and so also applicable to the construction industry areas 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. 18
  37. 37. Legal FrameworkEconomic Laws3.13 The various economic laws to which the constructionindustry 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 ActContract Laws3.14 The various contract laws to which the constructionindustry may be subject to include:(i) The Indian Contract Act, 1872(ii) Securities Contracts Regulation Act, 1956Labour Laws3.15 There are a number of labour laws governing theconstruction 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. 19
  38. 38. Technical Guide on Internal Audit of Construction IndustryOther 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, 1996The internal auditor is also expected to be aware of variouscirculars Issued by the RBI towards foreign currency transactions.Other Applicable International Acts to theConstruction Industry3.16 Apart from the above, regulations of the respective countryin which construction and related services are provided by theentity are also applicable to the entity. In such cases theagreement between the parties specifies the jurisdiction in case ofarbitration, if any. In cases where the entity is listed in a stockexchange other than India, there might be regulatory requirementsfrom the respective governing body of the company.The Sarbanes-Oxley Act, 20023.17 This Act is applicable for Companies, wherein theCompany or its holding company is incorporated and listed in theUnited States. The legislation has been enacted to set new orenhanced standards for all U.S. public company boards,management and public accounting firms. It does not apply toprivately held companies. The act contains 11 titles, or sections,ranging from additional corporate board responsibilities to criminalpenalties, and requires the Securities and Exchange Commission(SEC) to implement rulings on requirements to comply with thenew law. 20
  39. 39. CHAPTER 4 A REFERENCE TO STATUTORY LAWS APPLICABLE TO INDIAN CONSTRUCTION INDUSTRY4.1 This section is intended to provide broad guidelines ofvarious laws, compliances required for entities opting for specialstatus such as STPI, SEZ or EOU status. The internal auditorshould refer to bare act of these laws and regulations and studythe different cases and judgements by competent authorities.4.2 Considering that these regulations undergo frequentamendment/changes, a detailed checklist has not beenprepared. The internal auditor must update himself with theamendments, pronouncements and any new regulationsenacted from time to time to ensure effective performance ofinternal audit.Income Tax4.3 Companies might have deduction either under Section10A or Section 10B of the Income Tax Act, 1961. Theseprovisions offer tax sops to SEZs (Special Economic Zones). Assuch, most units registered as STP or SEZ need not pay anycorporate 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 ofthe statutory auditor but it is advisable that the internal auditorunderstands the various requirements and compliances underthese statutes/ regulations and conducts internal audit of thesame.4.4 The Income Tax Act, 1961 provides presumptivetaxation for small construction entities. The Income Tax Act,1961 also provides for deduction as a percentage of profits forentities operating in the Infrastructure Development.
  40. 40. Technical Guide on Internal Audit of Construction IndustryService Tax4.5 The definition of construction service given under clause(30A) of Section 65 is as follows:“Construction service" means,• Construction of new building or civil structure or a part thereof; or• Repair, alteration or restoration of, or similar services in relation to, building or civil structure,which is -• Used, or to be used, primarily for; or• Occupied, or to be occupied, primarily with; or• Engaged, or to be engaged, primarily in,commerce or industry, or work intended for commerce orindustry, but does not include road, airport, railway, transportterminal, bridge, tunnel, long distance pipeline and dam.4.6 The definition of construction services is quite wide. Itnot only covers construction of new building/civil structure orpart thereof but also includes repair, alteration or restoration ofbuilding. However, service tax will be applicable when suchconstruction services are rendered in respect of thebuilding/civil structure for the commerce and industry. In otherwords, construction services in respect of commercial buildingare taxable whereas construction services for residentialpremises/ building or non-commercial buildings are not coveredunder the ambit of service tax.However, construction services for following are excluded fromambit of service tax, namely, -• road;• airport;• railway;• transport terminal; 22
  41. 41. A Reference to Statutory Laws Applicable to Indian Construction Industry• bridge;• tunnel;• long distance pipeline and• dam.Availing Input Credit4.7 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 madeand it cannot be availed on accrual basis. However, in casethere is excess credit during the month, the same can be 23
  42. 42. Technical Guide on Internal Audit of Construction Industrycarried forward to the following month and can be set-off,whenever service tax liability arises. Abatement may beprescribed from time to time on the total value of contract onsatisfaction of certain conditions such as, no credit of duty paidon inputs or capital goods has been taken under the provisionsof the CENVAT Credit Rules, 2004.Works Contract4.9 Works Contract comes under the preview of SalesTax/Value Added Tax as applicable to the respective States.The definition of “Sale” under the respective Sales Tax/ValueAdded Tax of the respective states includes Works Contract.Works Contract includes any agreement for carrying out forcash, deferred payment or other valuable consideration, thebuilding, 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 ofWorks Contract in accordance with the respective governingSales tax/Value Added Tax. Works Contract can be broadlyclassified 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 toState.Input Credit Set-off Scheme4.11 “Input” means any goods, including capital goodspurchased by a dealer in the course of his business for re-saleor for use in the manufacture or processing or packing orstoring of other goods or any other use in business. 24
  43. 43. A Reference to Statutory Laws Applicable to Indian Construction IndustryAs there is no need to pay VAT on the services provided by theconstruction entity, they are not eligible to take input credit onpurchases made by them.Works Contract Tax Deducted at Source4.12 The client shall deduct out of the amounts payable bythem to a dealer in respect of any works contract executed forthem in the State, an amount equivalent to the tax payable bysuch dealer under the Act.Deduction on the Rate of Works Contract Tax4.13 The Act provides for deduction on the value of contract,computed with respect to the provisions of the respective SalesTax/Value Added Tax. The respective regulations provide forthe basis for deduction based on the percentage of labourinvolved in the overall scope.Special Economic Zone4.14 For an entity providing construction service in a SpecialEconomic Zone (SEZ), these regulations are applicable. LegalFramework for setting up SEZ is defined under SEZ Act andState SEZ Policy:SEZ Rules, 20064.15 The main provisions of the Indian SEZ Rules, 2006 canbe summarized as promotion of industrialization and economic 25
  44. 44. Technical Guide on Internal Audit of Construction Industrygrowth through sustainable development of Indian industries.The main essence of the Indian SEZ Rules, 2006, states thatthese Special Economic Zones of India shall be offered taxrebates, 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. 26
  45. 45. CHAPTER 5 INTERNAL AUDIT5.1 Most entities operating in construction industry areunorganised as related to its operations and a significantpercentage of players operating in this sector are small innature. Effective internal audit provides a tool to ease out allcomplexities, ensures that systems and processes areadequate to support the growth and are adapted to the changesin various applicable regulations, thereby ensuring sustainedgrowth and development.5.2 Preface to the Standards on Internal Audit, issued by theInstitute of Chartered Accountants of India defines the termInternal Audit as follows:“Internal Audit is an independent management function, whichinvolves a continuous and critical appraisal of the functioning ofan entity with a view to suggest improvements thereto and addvalue to and strengthen the overall governance mechanism ofthe entity, including the entity’s strategic risk management andinternal control system.”The abovementioned definition highlights the following facets ofan 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 managements needs
  46. 46. Technical Guide on Internal Audit of Construction Industry through constructive recommendations in areas such as, internal control, risk, utilization of resources, compliance with laws, management information system, etc.• Internal audits 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 ofInternal Audit5.3 General Guidelines on Internal Audit, issued by theInstitute of Chartered Accountants of India, describes the 28
  47. 47. Internal Auditfactors contributing the evolution of Internal Audit in India,which are as follows:(i) Increased Size and Complexity of BusinessesIncreased size and business spread dilutes direct managementoversight on various functions, necessitating the need for a fulltime, independent and dedicated team to review and appraiseoperations.(ii) Enhanced Compliance RequirementsIncrease in the geographical spread of the businesses has alsoled to crossing of political frontiers by businesses in a bid to tapglobal capital. This has thrown up compliance with the laws ofthe home country as well as the laws of that land as a criticalfactor for existence of businesses abroad.(iii) Focus on Risk Management and Internal Controls to Manage ThemInternal auditors can carry out their job in a more focused mannerby directing their efforts in the areas where there is a greater risk,thereby enhancing the overall efficiency of the process and addinggreater value with the same set of resources.(iv) Stringent Norms Mandated by Regulators to Protect InvestorsThe regulators are coming up in a big way to protect theinterests of the investors. The focus of the latest regulationsbeing ethical conduct of business, and enhanced corporategovernance and financial reporting requirements, etc.(v) Unconventional Business ModelsBusinesses today use unconventional models and practices, forexample, outsourcing of non-core areas, such as accounting.(vi) Intensive Use of Information TechnologyInformation technology (IT) is invariably embedded in all spheresof activities of a modern business enterprise today, from data 29
  48. 48. Technical Guide on Internal Audit of Construction Industryprocessing to resource planning to online sales and e-commerce.Use of IT has, however, increased the threat of data thefts orlosses on account of systems failure or hacking/espionage, as wellas the need to comply with the cyber laws, etc.(vii) An Increasingly Competitive EnvironmentWhereas deregulation and globalization have melted thepolitical as well as other barriers to entry in the markets forgoods and services, free flow of capital, technology and know-how among the countries as well as strong infrastructure hashelped in bringing down the costs of production and betteraccess 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 AuditStandards on Internal Audit5.4 The Institute of Chartered Accountants of India has tilldate issued seventeen Standards on Internal Audit (SIAs),which aim to codify the best practices in the area of internalaudit and also serve to provide a benchmark of the performanceof the internal audit services. While formulating SIAs, the Boardtakes into consideration the applicable laws, customs, usages,business environment and generally accepted internal auditingpractices in India. The list of Standards on Internal Audit (SIAs)is given below:SIA 1 Planning an Internal AuditSIA 2 Basic Principles Governing Internal AuditSIA 3 DocumentationSIA 4 ReportingSIA 5 SamplingSIA 6 Analytical ProceduresSIA 7 Quality Assurance in Internal AuditSIA 8 Terms of Internal Audit Engagement 30
  49. 49. Internal AuditSIA 9 Communication with ManagementSIA 10 Internal Audit EvidenceSIA 11 Consideration of Fraud in an Internal AuditSIA 12 Internal Control EvaluationSIA 13 Enterprise Risk ManagementSIA 14 Internal Audit in an Information Technology EnvironmentSIA 15 Knowledge of the Entity and its EnvironmentSIA 16 Using the Work of an ExpertSIA 17 Consideration of Laws and Regulations in an Internal AuditSome important aspects on internal audit has been discussed inthe following paragraphs:Terms of Internal Audit Engagement5.5 The client is expected to formally communicate theappointment to the internal auditor. Upon receiving thecommunication, the internal auditor should send anengagement letter, preferably before the commencement ofengagement so as to avoid any misunderstandings. The internalauditor and the client/auditee should record the terms ofengagement in the letter or other suitable form of contract and itshall also confirm objective and scope of internal audit with theclient.5.6 The engagement letter should generally includereference 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) 31
  50. 50. Technical Guide on Internal Audit of Construction Industry• Access to records, documents and information required in connection with the internal audit• Expectation to receive management’s written confirmation in respect to representation made in connection with the audit• Basis on which fees shall be computed and the billing arrangements thereof.Any changes in the terms of the appointment should becommunicated in written form. Moreover, the internal audit maybe on a continuous basis, monthly, quarterly or even annual. Itis important for the internal auditor to ensure that the periodicityof the internal audit is sufficient in the light of overall businesscondition.Knowledge of the Business5.7 Prior to commencement of internal audit assignment, theinternal auditor should have or obtain the knowledge of thebusiness. The internal auditor should acquire sufficientknowledge to enable him to identify and understand the events,transactions and practices that can have significant effect onthe internal audit process. Such knowledge shall be helpful tothe internal auditor in assessing the inherent risk and controlrisk and in determining the nature, timing and extent of theinternal audit procedures. Knowledge of the business assiststhe 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 32
  51. 51. Internal Auditand the existence of the internal controls. Illustrative flowchartof the business process is given as Appendix.Audit Planning, Materiality and Sampling5.8 After acquiring the knowledge of business and variouslaws and regulation applicable to the construction industry theinternal auditor should plan out the internal audit activity.Planning helps in achieving the objectives of internal auditfunction. 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 internalauditor should obtain an understanding of the accounting andinternal control system prevalent within the entity, exercisepreliminary judgement regarding the critical areas to beconsidered during the internal audit. It also helps the internalauditor in determining the audit materiality, nature and extent ofaudit procedures to be adopted. While designing an auditsample the internal auditor should consider the specific auditobjectives, materiality, population from which the internalauditor wishes to select the sample, area of audit significanceand the sample size.Internal Control5.10 Internal controls are a system consisting of specificpolicies and procedures designed to provide management withreasonable assurance that the goals and objectives it believesimportant to the entity will be met. 33
  52. 52. Technical Guide on Internal Audit of Construction Industry"Internal Control System" means all the policies and procedures(internal controls) adopted by the management of an entity toassist in achieving managements objective of ensuring, as faras practicable, the orderly and efficient conduct of its business,including adherence to management policies, the safeguardingof assets, the prevention and detection of fraud and error, theaccuracy and completeness of the accounting records, and thetimely preparation of reliable financial information. The internalaudit function constitutes a separate component of internalcontrol with the objective of determining whether other internalcontrols are well designed and properly operated.5.11 Internal control system consists of following inter-relatedcomponents:• 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 continuoussupervision by management to determine that it is functioningas prescribed and is modified, as appropriate, for changes inenvironment. The internal control system extends beyond thosematters which relate directly to the functions of the accountingsystem.5.13 The internal auditor should obtain an understanding ofthe significant processes and internal control systems sufficientto plan the internal audit engagement and develop an effectiveinternal audit approach. The internal auditor should useprofessional judgment to assess and evaluate the maturity ofthe entity’s internal control. The auditor should obtain an 34
  53. 53. Internal Auditunderstanding of the control environment sufficient to assessmanagements attitudes, awareness and actions regardinginternal controls and their importance in the entity.5.14 The internal auditor should examine the continuedeffectiveness of the internal control system through evaluationand make recommendations, if any, for improving thateffectiveness.The importance of internal controls in a construction entity neednot be over-emphasized. Internal audit plays a major role indetermining the effectiveness of internal controls and highlightsareas for improvement. The Internal auditor may also refer toStandard on Internal Audit (SIA) 12, “Internal ControlEvaluation” for a detailed discussion on internal control.Internal Audit in an Information TechnologyEnvironment5.15 Computer Information System (CIS) environment existswhen 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 theaudit, whether those computers are operated by the entity orthird party.5.16 The overall objective and scope of internal audit doesnot change in a CIS environment. However, the use ofcomputer changes the processing, storage, retrieval andcommunication of financial information and may affect theaccounting and internal control systems employed by the entity.Moreover, the risks involved in an internal audit may tooundergo a change. The internal auditor should have sufficientknowledge 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 generatesmaterial transaction or entries and exchanges transactionautomatically with other organisation as in electronic datainterface (EDI) systems. Source documents, computer files and 35
  54. 54. Technical Guide on Internal Audit of Construction Industryother evidential matter exist only for short period and inmachine readable form. The use of the computer Assisted AuditTechnique (CAAT) shall increase the efficiency in theperformance and enable the internal auditor to economicallyapply certain procedures to the entire population or accountstransaction.5.18 The internal auditor should understand the CISEnvironment in designing audit procedures to reduce the auditrisk to an acceptable low level. The internal auditor should alsodocument the audit plan, the nature, the timing and the extentof audit procedures performed and the conclusions drawn fromthe evidence obtained which may be in the electronic form. Theinternal auditor should ensure that such electronic evidence isadequately and safely stored and is retrievable in its entirety, asand when required.5.19 The internal auditor may refer to Standard on InternalAudit (SIA) 14, “Internal Audit in an Information TechnologyEnvironment” for guidance on procedures to be followed whenan audit is conducted in a computer information systems (CIS)environment.Overview of ComplianceWhat is Compliance?5.20 Compliance means ensuring conformity and adherenceto regulatory acts, rules, procedures, laws, regulation, directivesand circulars. Standard on Internal Audit (SIA) 17 issued by theICAI relating to “Consideration of Laws and Regulations in anInternal Audit“ states that when planning and performing auditprocedures and in evaluating and reporting the results thereof,the internal auditor should recognize that non compliance by theentity with laws and regulation may materially affect thefinancial statements. However, an audit cannot be expected todetect non compliance with all laws and regulations. Detectionof non compliance, regardless of materiality, requiresconsideration of the implications for the integrity of 36
  55. 55. Internal Auditmanagement or employees and the possible affect on the otheraspect of the audit.5.21 Non-compliance with laws and regulations could result infinancial 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 internalauditor is specifically engaged to test and report separately oncompliance with specific law and regulations.The management is responsible to ensure that the entity’soperations are conducted in accordance with laws andregulations. The responsibility for prevention and detection ofnon-compliance shall be that of the management; however theinternal auditor should plan and perform the internal auditrecognising that the internal audit may reveal conditions orevents that would lead to questioning whether an entity iscomplying with laws and regulations.5.22 The term “Non-compliance “refers to acts of omission orcommission by the entity being audited, either intentional orunintentional, which are contrary to the prevailing laws andregulations. Such acts include transactions entered into by, orin name of the entity or on its behalf by the management oremployees. However, non compliance does not includepersonal misconduct (unrelated to the business activity of theentity) by the entity’s management or employees.Understanding of Laws and Regulations5.23 Laws and regulation vary considerably in their relation tothe financial statements. Some laws or regulations determinethe form or content of an entity’s financial statement or theamounts to be recorded or disclosures to be made in financialstatements. Other laws or regulation are to be complied with bymanagement or prescribed by the provisions under which theentity is allowed to conduct its business. Non-compliance withlaws and regulation could result in financial consequences for 37
  56. 56. Technical Guide on Internal Audit of Construction Industrythe entity such as, fines, litigation, etc. It also has a potentialeffect on going concern as an entity.5.24 The internal auditor should plan and perform the auditrecognizing that the audit may reveal conditions or events thatwould lead to questioning whether an entity is complying withlaws and regulations. In order to plan the internal audit, theinternal auditor should obtain understanding of the legal andregulatory framework applicable to the entity and how the entityis complying with that framework.5.25 To obtain this understanding, the internal auditor wouldparticularly recognize that non-compliance of some laws andregulations may have a fundamental effect on the operations ofthe entity and may even cause the entity to cease operation, orcall into question the entity’s continuance as going concern. Toobtain the understanding of laws and regulations, the internalauditor 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 shouldperform procedures to identify instances of non-compliance withthose laws and regulations where non-compliance should beconsidered while preparing financial statements, specifically:• Inquiring with management as to whether the entity is in compliance with such laws and regulations. 38
  57. 57. Internal Audit• Inspecting correspondence with the relevant licensing or regulatory authorities.Significance of Compliance5.26 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. 39
  58. 58. CHAPTER 6 MAJOR AREAS OF INTERNAL AUDIT SIGNIFICANCE6.1 Internal audit procedures that apply to any industry alsoapply to an entity operating in the construction industry. In thistechnical guide, specific internal auditing procedures pertainingto construction industry have been specified. These auditprocedures are illustrative in nature which can be performed, inaddition, to the regular internal audit procedures performed byan internal auditor.6.2 The internal auditor needs to assess the work performedat the location and the centralised office. Based on theoperations performed by the entity, the internal auditor needs toplan his audit procedures.Selection of a Project6.3 Incredibly, many construction projects are initiatedwithout even the most basic cost-benefit analysis or feasibilitystudy. Documented evidence justifying the project should besubmitted, even though proceeding with a project that will notresult in an increase in revenue or financial position can beacceptable in some instances. Sometimes projects areundertaken to maintain market share in a competitive industryor to provide a service or product line that will complementanother.6.4 Internal auditors should determine whether the projecthas been evaluated before being accepted by the entity,appropriate approvals have been obtained and ensure that therisk on accepting the project has been properly evaluated by themanagement.
  59. 59. Major Areas of Internal Audit SignificanceA few Analytical Procedures that can be performed by theinternal 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 andexplanations for any significant fluctuations needs to beobtained. The following is a model checklist related to biddingand 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? 41
  60. 60. Technical Guide on Internal Audit of Construction IndustryS. No. Particulars Yes No N/A 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 at the 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? 42

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