Maturity of an organization is vital to determine the modus operandi of an audit. An organization with robust procedures and established systems, creates new opportunities for auditor to perform his/her duties with utmost efficiency but carries different level of challenges. For a less mature organization, having outdated procedures, manual processing and undefined strategy may create more challenging task for an auditor to perform. In such circumstances, if not effectiveness, having an impact on efficiency is unavoidable.
What is a Variation
The Clause 126.96.36.199 of FIDIC (Red Book) defines ‘Variation’ as any change to the works which is instructed or approved as a variation under clause 13 (Variations and Adjustments).
As per Clause 13.1 of FIDIC Red book, each Variation may include:
- changes to the quantities of any item of work included in the Contract (however, such changes do not necessarily constitute a Variation).
- changes to the quality and other characteristics of any item of work.
- changes to the levels, positions and/or dimensions of any part of the works.
- omission of any work unless it is to be carried out by others.
- any additional work, plant, materials or services necessary for the permanent works, including any associated tests on completion, boreholes and other testing and exploratory work. or
- changes to the sequence or timing of the execution of the works.
Note: Variation Orders or Change Orders are interchangeable terms.
Understanding Types of Variations
Prior to Auditing variations to the contract, understanding the basic concept thereof is essential. Variations are amendments to the original contractual scope and if not administered properly, can create disagreements and disputes. Therefore, variation is generally covered in majority standard construction contracts and provide liberty to the contracting parties, to amend the scope as per changes in the requirements or circumstances.
As a first step, an auditor needs to understand the contractual terms and conditions governing variations. A variation can be initiated by the Employer, Engineer, Contractor or subcontractor due to change in requirement, circumstances or sometimes opportunity framing.
An auditor needs to develop his understanding over various types of variations. Construction contracts carry specific uniqueness having different nature, type or complexity and the parties involved have their own understanding or interpretation contractually, however, variations can take many forms, in the manner they arise, which are defined by FIDIC (Red Book) as below:
- Variation initiated by Engineer or Employer
Variation clause(s) in the contract permits the employer to make amendments in the contract’s elements and this ensures responding to practical needs of the project. These changes can be additional works, modifications or omissions (full or partial descoping or deletion of an activity or element).
Changes can also include ‘Acceleration order or Sequence changes’ which is generally required to complete the works prior to agreed completion of the project. The works included as provisional sums in the BOQ can be executed using variation order. Any other minor or incidental nature of works are required to be carried out in a day work basis (FIDIC, Red book).
- Variations initiated by Contractor
For reasons attributable to the contractor or when value engineering is part of the scope, the contractor may work on an acceleration plan and intends to complete the project earlier than planned. In certain circumstances, contractor may identify certain additional works to be carried out, eventhough not specifically part of scope. In this scenario, contractor identify these works for approval of Engineer and Employer. In a dispute situation, the same can be part of contractor’s claim.
- Other categories of Variations
The other categories may include re-measured contracts, whereby any change in quantities may be claimed via a variation order. There may be other situations like technical errors in contractual terms or design and force majeure which may give rise to variation orders.
A variation for addition in the scope or an omission for descoping can arise from any of the categories.
During Audit Planning Phase (ref: Audit Process) auditor should obtain the basic understanding of the type and complexity of the project, contractual requirements for variations vis-à-vis nature and type of variations. Auditor should update the audit programme considering the special conditions, timelines, agreed methodology, key risk areas and materiality.
The first basic document, which provides an overview of the variations’ status is “Variation Log”. Log provides information about type of variations (generally separate logs are maintained for each category), status of submission, description of variation to the contract, reference to the engineering instruction and reference to the letters and notifications, submission/claim value, internal value and value attributable to the subcontractor. Log may also have certification and/or back to back status of certifications with subcontractors.
Log also provides the status of variation order i.e. approved, rejected, disputed, in process etc. Comprehensive logs may also carry percentage of completion for each variation, showing the status of works.
While selecting a sample, auditor should consider the quantum of engineering instructions received, variations submitted, general status of approvals, values, certifications and work performed. A sample may be selected considering the impact on cost or activity e.g. works on a variation for an activity affects project’s critical path, which results in extension of time.
The key audit objectives for variation reviews are:
- To provide assurance on the design and effectiveness of the internal controls for variation management;
- To ensure compliance with policies & procedures and with applicable rules & regulations;
- To ensure ‘variation workflow procedures’ make the most efficient use of the available resources.
- To ascertain that the required knowledge, skill and competency is resourced.
Review Scope Outline
Following are the recommended scope review areas which should be considered for testing analysis on variations to the contract.
The auditor should always consider circumstances having a material impact on variation management. One of those situations can be absence of robust procedure to capture variations and out of scope works which can directly affect the project’s profitability and can cause cost overruns. With review of correspondence and minutes, an auditor should always be vigilant about situations giving rise to variations.
Another situation can be delayed or missed notifications and submissions, which may not only be classified as noncompliance of the contractual terms but can cause rejections or delay in cash flows.
The following process flow provides the basic understanding of a generic audit process flow, embedded with variations review:
Variation / Omissions Cost Assessment
Under clause 13.3 of FIDIC Red Book, each variation shall be evaluated in accordance with Clause 12 (Measurement and Evaluation).
An auditor should enhance his knowledge over the contractual requirements and special conditions appended to the contract, prior to reviewing variations. A contract would invariably provide a mechanism for variations and method of payment thereof. Any works done via engineering instructions (EIs) or approved variation orders are included in payment application.
By review of EI log or correspondences and minutes of meetings, the auditor should review situations where, works are done without approval. In this scenario contractor has executed works on his own discretion and can be contractually rendered as having no right of payment.
For verification of cost assessed by management, the auditor may select a representative sample of cases. Rates used in the variation orders can be verified against bill of quantity (BOQ). There might be cases where BOQ rates are not being used for e.g. similar items are not available in the BOQ, then, generally a new price is agreed. In case, works must be executed without delay while rate is not agreed, then a provisional rate or amount is approved or on account payment is permitted. An auditor should also look for situation of disagreements on prices and rates and review the same.
Extension of Time Impact
Clause 8.4 (Extension of Time for Completion) and Clause 20.1 (Contractor’s Claims) of FIDIC Red Book are applicable in extension of time claims.
Variations, usually increases the scope and may have an impact on completion time. Auditor needs to ensure that management has implemented a procedure to review impact of variation works on critical path. In such cases, timely notifications are served, and extension of time approval is requested, which should be followed by cost claims for extension of time.
Clause 20.1 of FIDIC Red Book stipulates a timeline of 28 days within which Contractor shall serve a notice to the Engineer, describing the event or circumstances given rise to the claim. The auditor should review EIs, correspondences and minutes of meetings for delayed and unserved notices, in order to ensure that timely action is taken to avoid risk of unserved or delay notices and risk of liquidated damages. In similar perspective, a claim is served by the Contractor within 42 days (Under Clause 20.1).
The parties have right to use different timelines with mutual consent.
Back to Back contract
The auditor needs to gain knowledge of subcontractors claims. The main contractor should incorporate these claims while claiming for a relevant activity. In case of approving or certifying any variations, the approval and certification should not be more than the approval / certification received. The same should be applicable in cases of advance payments, advance payment guarantees, performance guarantees or retention against variations, however some exceptions always remains as the conditions of the specific project desires. The auditor need to understand those conditions and fairly document the same.
Key Risk Areas
1- Unidentified or late identification of Variations:
Absence of procedure or skill to timely capture the variation
2- Unidentified impact over Extension of time:
Absence of procedure or skill to assess impact of variation on critical path
3- Late notifications:
Lack of control over contractual requirement may have impact over approval of variations as late notifications can be considered as noncompliance, therefore can create a risk of rejection of valid claims.
4- Incorrect valuation:
Absence of a robust procedure over variation cost assessment.
Variations may be initiated at any time prior to issuing the Taking-Over Certificate for the Works, either by an instruction or by a request for the Contractor to submit a proposal. The Contractor shall execute and be bound by each Variation (Clause 13.1 FIDIC Red Book).
An auditor must establish an understanding over contractual requirements for variation. The audit program should be prepared around this requirement, considering key risk areas. The materiality should also be considered while allocating resources for the scope. During Planning phase, auditor should allocate weightage to the variations’ review and scope to be covered. This is followed by review of policies and procedures and basic mechanism established to capture variations, valuation, work execution and claim.