control, and governance
How Do I ... Analyze Contracts
Analyzing contracts is becoming an essential skill for internal auditors, even though most are not experienced in legal matters. Auditors may be asked — during audit planning phases — to understand a contractual relationship, confirm that prices paid for goods or services are reasonable, and assess whether the contract terms have been met. Although contract interpretation is ultimately decided by courts of law, internal auditors who understand contracting concepts, risks, and controls will be less likely to overlook major areas of concern.
A contract is a legally binding agreement, entered into by two or more parties, such as an owner and a contractor. There are five key contract elements:
Lump sum and cost-plus are common types of business contracts based on the method of compensation, and each one has advantages and risks for owners. In lump sum contracts, the owner specifies the desired project, and the contractor quotes a fixed price to complete it. Cost-plus contracts are based on the contractor being paid whatever the labor and materials cost plus a reasonable profit (e.g., a fee or percentage of the costs). A cost-plus contract is advantageous because the project could cost less depending on which costs the owner decides to pay.
KNOW THE BASICS
One of the most important sections in any contract is the scope of services, which describes what the contractor is supposed to deliver. If specifications or requirements about the services are not defined, the contractor can use this as a loophole to deliver something less than what the owner expected.
The contract’s payment structure is another vital section that internal auditors must understand. Auditors need to know what the contractor has agreed to deliver in exchange for payment — a contract that does not specifically describe what the contractor is required to deliver can be problematic
THE RIGHT TO AUDIT
Many contracts contain a section that establishes the general conditions and rules for the contractual relationship where much of the legal wording is included, such as definitions of terms, each party’s responsibilities, insurance and bonding requirements, and payment and dispute processes, as well as owner and contractor signatures. A “right to audit” clause is essential for conducting additional audit work but may not be standard in most contracts.
Adapted from "Contract Analysis" by Eric Palmer (Internal Auditor, "Back to Basics," August 2010).
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