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Squandering Capital – Is the party REALLY over?

By Al M. Gray

With returns of several multiples of its costs, Construction Auditing has succeeded in capturing the attention of the auditing profession. However, there is the danger that success in controlling costs from outside contractors is not met with equal vigor in a sustained emphasis on sound internal controls over capital spending.

Loose Controls are the Norm

The reasons are legion. Introspection is unpleasant. Senior management is disinterested because capital projects are not a core business activity. Boards of Directors bless projects, and then essentially go away. A truly disciplined set of capital spending controls eliminates considerable flexibility, as well as temptation at all levels of management, to bury operating expenses as capital expenditures. The combination of these factors produces forces that squander capital at a far more prodigious rate than can be forestalled by construction auditing. Conversely, the financial rewards from sound internal controls from conception to completion of all capital projects dwarf those from construction auditing.

Undoubtedly the corporate accountability and oversight reforms necessitated by the accounting scandals of recent years will produce changes in the realm of capital spending. Beyond the well-publicized fraud at Worldcom Inc., where operating expenses were improperly reclassified as capital expenditures, elements of capital spending fraud were also alleged at Rite Aid, Adelphia, and Astra. Corporations have also experienced outbreaks of fraud in capital projects at every level of management. Changes will come, but will they result in implementation of rudimentary controls geared to absolve managers and boards of liability or comprehensive ones that maximize returns on capital spending projects? Which will your organization opt for?

A few organizations and corporations are very frugal with appropriations of capital and have implemented tough standards designed to preserve capital and maximize project returns. These entities have a competitive advantage over their peers stemming from more productive use of capital.

What are the most valuable practices of these organizations? At the core level they include: appropriation, scope, cost, design, and close-out controls. At the precision level they include engineering, estimating, accounting, tax, legal, transportation, operational process, training, safety, risk management, and procurement controls. Each of these deserves separate discussion and analysis, once an organization chooses to evaluate and implement a comprehensive controls set.

The Scope Deletion Dodge

Doing justice to a topic so complex and important is difficult, so let’s consider one of the primary deficiencies encountered with capital appropriations policies and procedures: Many do not require approval for scope deletions or reductions.

The amount of detail that can be brought to the board level is limited. Organizations compensate for this by only bringing capital spending projects to their boards for approval, with no requirement that the board approve deductive changes. Some go so far as to allow cost overruns of ten or fifteen percent without board approval in the form of an appropriation change. The combination leaves management with broad capability to misrepresent project results. Projects that were actually 30% over budget on the approved scope of work may never receive board attention because management deleted a portion of the approved scope concurrently with incurring an eight or nine percent overrun.

Let’s use a fictional project to illustrate these concepts. (The story is a composite of actual cases, with names, places, project type and numbers changed. Any resemblance to any real project is both coincidental and unintended.)

The project was “under budget” – the CEO said so!

“Tonight on Cashline, Hugh interviews Proudico CEO  Rolle Player, who has engineered a dramatic turnaround in the fortunes of this Fortune 50 manufacturer,”

Upon hearing these words the auditor grabbed his dinner plate from the table and moved into the den to hear the interview with this familiar, highly-regarded CEO.

The interview began. After the usual discussion of Proudico’s financial performance, soaring share price, and rumored acquisitions, Hugh Hobbs turned to the corporation’s growth. “Rolle what areas of growth do you anticipate for Proudico over the next two years?” Rolle Player leaned forward in his chair, then said with a straight face “We anticipate the growth in fireworks papers to explode from the wave of patriotism sweeping the country. Our company just completed a $100 million expansion of its Zany mill to include new production machinery to service this market. The project was completed on time and under budget.”

The auditor nearly choked upon hearing the last comment, before erupting with laughter. His wife came running in to see what was going on. She exclaimed “What is SO funny about a business news show?” The auditor responded “Honey, its one of those auditing things you would not understand. Please excuse the dinner interruption. The chicken casserole was wonderful tonight….” With that he turned the television off and rejoined the family at the dinner table, glad that his cooking duties were over before the show, so the muffins were not in their usual charred state – unlike Proudico’s capital budget.

What the auditor found amusing, yet disturbing, was that the CEO had uttered astoundingly misleading comments to a national television audience, yet the source of the deceit was allowed and condoned by the company’s capital appropriation process. How? The CEO had taken advantage of the Scope Deletion Dodge that is in wide acceptance among corporations and organizations. This trick allows management, nearly always at every level, to mislead shareholders, directors, and even senior management themselves about project costs. Worse, when this dodge is accepted and condoned, it provides opportunities for massive fraud. Finally, it puts the corporation at a competitive disadvantage to peers who are more vigilant in spending capital.

The Scope Deletion Game

Let’s review how this gimmick works.

In reality, the Zany mill project was $28 million OVER BUDGET on the scope of work as approved by the Board of Directors. While it was true that the final project costs of $108 million were under the 10% overrun threshold that would have necessitated approval of board approval of an appropriation change, there were several deductive changes to the project scope that reduced the capacity and future expandability of the plant from the levels approved and funded by the board.

The original project included a line item for a new gas turbine generator at a budgeted cost of $15 Million. This equipment as not purchased and installed under the main plant appropriation. The funds for the equipment were re-appropriated under a separate authorization, without a corresponding reduction in the budget for the main plant. For this item the unrecorded budget reduction was $15 million, leaving an adjusted project budget of $85 million.

The original project included a line item for $5 million in major spare parts within the detailed project budget, which supported the appropriation request approved by the Board of Directors. Very few spares were purchased, due to cost overruns in other areas of the project. For this item the unrecorded budget reduction was $4 million, leaving an adjusted project budget of $81 million.

The main appropriation also contained funding for training. All training costs were charged to operating expense accounts, due to the lack of remaining funds as the project neared completion.

For this item the unrecorded budget reduction was $1 million, leaving an adjusted project budget of $80 million.

Had the original appropriation been adjusted for all of these scope reductions, the approved budget would have been $80 million. With final reported project costs of $108 million the ACTUAL cost overrun was $28 million. Final cost exceeded appropriated costs by 35%, yet the CEO could state with his notion of validity, that the project was “completed within budget.”

How?

Under the policies and procedures adopted for the corporation, there was no requirement for an appropriation change when the scope of an approved project was reduced, creating nearly unlimited opportunity to misrepresent the real results. This deficiency was compounded by the policy that major projects could overrun by tens of millions of dollars without board oversight, due to there being no cap on the 10% overrun allowance.

The Consequences

Why is the lack of a policy requiring board approval of deductive changes costly?

• As is oft said, the tone begins at the top. When the senior executives use this dodge, their behavior is seen all the way down to the project manager level. Project management may further obscure project results in ways not revealed to senior management. The deception feeds upon itself, magnifying the undesirable consequences.
• With this loose standard, unworthy projects can be misrepresented to garner board approval.
• The lack of a deductive appropriation change requirement allows funds to be shifted to purposes not authorized by the Board of Directors. This sometimes extends to fraud.
• This process renders project cost evaluation nearly impossible, particularly in comparison to other projects or planning for future projects.
• Management performance in managing capital projects is irreparably obfuscated at all levels.
• A frequent casualty is increased capacity intended to serve future expansions. The cheaper alternative of reduced scope is adopted. Therefore, subsequent projects may be far more expensive to complete. Boards only learn that this has happened when the next level of expansion follows closely on the heels of the one just completed.

What is lost when the organization allows 10 to 15% overruns without Board approval on large projects (and some senior management approval on small ones)?

• Cost overruns become accepted as the norm, with under-spent projects being unheard of.
• Projects stay open until they are overspent by the allowed percentage.
• Coupled with the lack of deductive change approvals, above, adoption of allowable overrun percentage permits enormous cost overruns with no scrutiny.

Moving Forward

It is not mandatory that the Board of Directors approve ALL deductive changes to achieve good controls. An exceptional set of controls takes into consideration Board oversight limitations and the corporate culture in establishing at what level of management deductive changes must be approved. This should extend throughout the project cycle and down to the level of construction field changes.

A comprehensive set of scope controls substantially reduces the opportunities for fraud and puts tools in place to more readily detect fraud.

With scarce capital project funding in the current business environment and single-digit increases in earnings forecast in nearly every industry for the next decade, can corporations and other organizations really afford such loose capital spending processes? If they do not improve, will their competitors be so lax?

Scope control is critical to successful prosecution of capital projects. Recognizing the Scope Deletion Dodge and its ultimate effects is only a starting point. Starting at the top is usually productive. Once the board and senior management are persuaded, their commitment and example quickly transform the culture to one that preserves capital instead of squandering it.

Then everyone can take pride in knowing that a project completed “on time and under budget” truly was a success, not some accounting fiction.

The author, Al M. Gray, is the founder and Company President of Capital Project Review Services, Inc. (CPRS), a Georgia corporation that offers proactive project auditing and controls methods geared to reduce project costs, project tax accounting programs designed to minimize state sales and use taxes, and cost recovery reviews for projects which are underway or have been completed. Email address Cprsi@mindspring.com