What is a contract audit and how to perform one

A signed contract is just the beginning. You and the other parties involved still need to carry out the terms of the agreement. Over time, things may naturally deviate from the letter of the contract. Because of this, contract audits are necessary.

Not just to catch foul play but to make sure everyone is fulfilling their obligations.

In this guide, you’ll get a deeper understanding of what a contract audit is, why it’s important, and how to effectively carry it out.

Understanding the Basics of a Contract Audit

A contract audit is a systematic and comprehensive examination of a contract or agreement to assess its compliance with the terms, conditions, and requirements specified in the contract document.

Contract audits are typically conducted by organizations or individuals to ensure that all parties involved in the contract are fulfilling their obligations, following agreed-upon procedures, and complying with legal and regulatory standards.

This is especially important when the people who signed the contract and the people who are carrying out the contracts are in different departments. For example, a vendor contract was signed with the finance department but the services or tools are being used in the sales department. Teams in the sales department may not have a clear idea of all the nuances of the contract.

The primary goal of a contract audit is to identify any discrepancies, deviations, or non-compliance issues and to provide recommendations for corrective actions.

Contract audits involve a thorough review of various aspects of the contract, including financial transactions, performance metrics, documentation, and adherence to contractual provisions.

These audits are often performed by internal audit teams, external auditors, or independent third-party specialists with expertise in contract management and compliance.

Why Conduct a Contract Audit?

a. Risk Mitigation: Contract audits help you identify and mitigate risks associated with contract non-compliance, financial losses, or legal disputes. By detecting issues early, you can take corrective actions to prevent more significant problems. Additionally, regular contract audits will let everyone involved know that you attach importance to the agreement and can discourage ‘bad behavior.’

b. Cost Savings: Audits can uncover overpayments, billing errors, or inefficient use of resources. Identifying and rectifying such issues can result in substantial cost savings and improved efficiency when carrying out the contract.

c. Improved Performance: Contract audits assess whether all parties are meeting performance expectations outlined in the contract. This can lead to improved operational efficiency and the delivery of higher-quality products or services.

d. Legal Compliance: Ensuring that contracts adhere to applicable laws, regulations, and industry standards is essential to avoid legal repercussions. Contract audits can help you maintain legal compliance. This is even more important in regulated industries or those that have more public scrutiny EG insurance, finance, or public works.

e. Enhanced Accountability: Audits promote accountability among parties involved in the contract. When responsibilities are clearly defined and monitored, it encourages compliance and reduces the likelihood of disputes.

f. Negotiation Leverage: An audit can uncover deviations from the contract terms that may provide leverage during current or future contract renegotiations.

g. Streamlined Processes: Identifying inefficiencies or bottlenecks in contract management processes can lead to process improvements and reduce administrative burdens.

Types of Contracts Subject to Audits:

Keep in mind that any contract can be audited but not contracts make sense to audit. Usually, you’ll focus on contracts with higher value, higher duration, or a combination of different factors important to you. Below are a few contract types more likely to be audited.

1. Procurement Contracts: These involve the purchase of goods or services from suppliers or vendors. Audits of procurement contracts assess whether the purchased items meet quality standards, are delivered on time, and are priced correctly.
2. Service Contracts: Service agreements often involve ongoing relationships, and audits ensure that service providers are meeting performance metrics, service level agreements (SLAs), and other contractual obligations.
3. Construction Contracts: Audits of construction contracts verify compliance with specifications, building codes, safety standards, and timelines. They also assess financial aspects, such as payment terms and budget adherence.
4. Government Contracts: Government agencies often conduct audits of contracts to ensure compliance with government regulations, cost accounting standards, and contract pricing.
5. Lease Agreements: Audits of lease contracts examine lease terms, rental payments, property conditions, and compliance with lease covenants.
6. License Agreements: License agreements, especially in the realm of intellectual property, are audited to ensure that licensees are using the licensed assets as specified in the contract and paying appropriate royalties or fees.
7. Partnership Agreements: Audits of partnership agreements assess whether partners are fulfilling their financial, operational, and strategic commitments as outlined in the partnership contract.

Contract audits are essential tools for organizations to ensure contract compliance, mitigate risks, and optimize contractual relationships. They help maintain accountability, enhance performance, and safeguard against financial and legal repercussions. The specific type of contract audit conducted will depend on the nature of the contract and the goals of the auditing organization.

Preparing for a Contract Audit

Before action comes preparation. It’ll make sure the process goes smoothly and you don’t miss anything when you’re in the process of auditing. Below, you’ll find the main things to consider before you start a contract audit.

Establishing Objectives and Scope:

1. Define Audit Objectives: Clearly articulate the objectives of the contract audit. Determine what you aim to achieve through the audit, such as ensuring compliance, identifying cost savings, or improving contract performance.
2. Scope the Audit: Determine which contracts will be audited and the specific aspects of those contracts that will be examined. This may include financial transactions, performance metrics, legal compliance, and adherence to contract provisions.
3. Set Audit Criteria: Establish the criteria against which contract compliance and performance will be evaluated. These criteria should be aligned with the contract terms, applicable laws, regulations, and industry standards.

Gathering Contract Documentation:

1. Compile Contract Documents: Collect all relevant contract documents, including the contract itself, amendments, addenda, correspondence, and any supporting documents. Ensure that you have access to both the executed contract and any related agreements.
2. Organize Documentation: Organize the contract documents in a systematic and easily accessible manner. Creating a document index or digital repository can help streamline the audit process.
3. Document Retention: Ensure that all relevant contracts and supporting documentation are retained and accessible for the duration of the audit and any potential follow-up actions.

By following these steps, you can effectively prepare for a contract audit, ensuring that the audit team is well-prepared, the scope of the audit is defined, and all necessary contract documentation is readily available for examination. This preparation is crucial for a successful and thorough contract audit.

Steps to Perform a Contract Audit

After you’ve prepared for the audit, you can then proceed. It’s important to follow a systematic process when you’re running an audit so that, again, you don’t miss anything. There are multiple aspects of a contract audit which include assessing risk, assessing compliance, and creating recommendations. Here are the steps to perform a contract audit:

Risk Assessment:

Begin by identifying the key risks associated with the contract. These risks could include financial risks, operational risks, compliance risks, and reputational risks. Consider both internal and external factors that may impact the contract’s performance.

Of course, some contracts may have more inherent risks and these need to be taken into consideration. For example, construction contracts may carry more risk of cost overruns than a supply contract.

Developing an Audit Plan:

Based on the identified risks, develop a detailed audit plan. The plan should outline the scope of the audit, objectives, audit criteria, and the audit team’s responsibilities. It should also include a timeline and resource allocation.

Audit Testing and Procedures:

Conduct audit testing and procedures according to the audit plan. This may involve:

• Sampling and reviewing contract-related transactions and documentation.
• Interviewing relevant personnel to gather information and insights.
• Performing analytical procedures to assess financial performance.
• Testing the effectiveness of internal controls related to the contract.

Analyzing Compliance:

1. Contractual Obligations:

Evaluate compliance with the contractual obligations outlined in the contract. This includes assessing whether all parties are meeting their respective responsibilities, timelines, and performance standards.

2. Financial Terms and Payments:

Examine financial transactions related to the contract, such as invoices, payments, and billing records. Verify that financial terms, pricing, and payments align with the contract terms and are accurately documented.

Communication and Reporting:

Communicate audit findings and results to relevant stakeholders, including senior management, contract managers, and other parties involved in the contract. Ensure that the communication is clear, concise, and well-documented.

Prepare an audit report that includes:

• Executive summary
• Objectives and scope of the audit
• Audit methodology and procedures
• Audit findings, including identified risks and non-compliance issues
• Recommendations for corrective actions
• Management’s response and action plan (if applicable)
• Conclusion and overall assessment

Corrective Actions and Recommendations:

Collaborate with relevant stakeholders to develop and implement corrective actions based on audit findings. These actions should address identified risks and non-compliance issues.

Provide recommendations for process improvements, risk mitigation strategies, and enhancements to contract management practices.

Monitor and follow up on the implementation of corrective actions to ensure that the issues identified during the audit are effectively resolved.

Throughout the contract audit process, maintain a focus on objectivity, accuracy, and adherence to audit standards and best practices. Effective contract audits contribute to risk reduction, improved contract performance, and the overall success of contractual relationships.

Challenges and Common Pitfalls

Contract audits are essential for ensuring compliance, mitigating risks, and improving contract management. However, they can also present challenges and common pitfalls. Here are some of the challenges and pitfalls associated with contract audits:

Lack of Documentation:

1. Insufficient Record Keeping: Incomplete or inadequate documentation related to the contract, such as missing invoices, correspondence, or amendments, can hinder the audit process. It may be challenging to assess compliance without a comprehensive paper trail.
2. Document Retrieval: Locating and accessing relevant contract documents can be time-consuming and challenging, especially if contracts are stored in dispersed locations or different formats (paper, electronic, etc.).

Incomplete or Ambiguous Contracts:

1. Contract Ambiguity: Contracts that are poorly drafted or contain ambiguous language can make it difficult to determine the parties’ rights, responsibilities, and performance expectations.
2. Missing Terms and Provisions: Incomplete contracts that lack critical terms, conditions, or performance metrics can leave gaps in the audit process, making it challenging to assess compliance.

Data Integrity Issues:

1. Inaccurate or Incomplete Data: If the data used for audit testing and analysis is inaccurate, incomplete, or outdated, it can lead to incorrect findings and recommendations.
2. Data Integration Challenges: When data is stored in disparate systems, integrating and reconciling information for audit purposes can be complicated and error-prone.

Resistance to Audit Findings:

1. Organizational Resistance: Stakeholders or contract parties may resist the findings and recommendations of the audit, particularly if they perceive the audit as a threat or if it could result in changes to established practices.
2. Lack of Follow-Through: Even if audit findings identify non-compliance or areas for improvement, there may be a lack of follow-through in implementing corrective actions and recommendations.
3. Communication Challenges: Poor communication between the audit team and relevant stakeholders can lead to misunderstandings or resistance to audit outcomes.

Post-Audit Activities

Post-audit activities are crucial for ensuring that the findings and recommendations of a contract audit lead to meaningful improvements and ongoing compliance. Here are three essential post-audit activities:

Implementing Recommendations:

1. Corrective Actions: Prioritize and implement corrective actions based on the audit findings and recommendations. These actions should address identified non-compliance issues, risks, and areas for improvement.
2. Action Plans: Develop detailed action plans that outline the steps, responsibilities, and timelines for implementing recommendations. Assign accountable parties to oversee the execution of these plans.
3. Resource Allocation: Allocate the necessary resources, including personnel, technology, and budget, to support the implementation of corrective actions effectively.
4. Communication: Keep all relevant stakeholders informed about the progress of corrective actions and ensure transparency in the process. Effective communication helps maintain trust and accountability.

Monitoring and Follow-Up Audits:

1. Monitoring Progress: Continuously monitor the progress of corrective actions to ensure they are being executed as planned. Regularly assess whether the identified issues are being resolved and compliance is being achieved.
2. Key Performance Indicators (KPIs): Establish KPIs or performance metrics to track progress. These metrics should align with the objectives of the audit and the desired outcomes of the corrective actions.
3. Scheduled Follow-Up Audits: Consider scheduling follow-up audits or reviews to assess the effectiveness of corrective actions. These follow-up audits verify whether the issues have been addressed and whether new issues have arisen.
4. Audit Frequency: The frequency of follow-up audits may vary depending on the severity of the issues identified and the complexity of the corrective actions. Some issues may require more frequent monitoring than others.

Continuous Improvement:

1. Lessons Learned: Gather insights from the audit process, including both successes and areas for improvement. Use this information to enhance future audit procedures and contract management practices.
2. Best Practices: Identify and document best practices that emerged from the audit process. Share these best practices with relevant teams and departments to promote better contract management.
3. Training and Education: Invest in training and education for contract managers, auditors, and relevant stakeholders to enhance their understanding of contract compliance and audit procedures.
4. Process Refinement: Continuously refine and improve contract management processes to prevent similar issues from recurring in the future. Make adjustments based on lessons learned and emerging industry standards.
5. Technology Enhancement: Consider utilizing contract management software and technology solutions that can help streamline contract compliance monitoring and reporting.

By systematically implementing recommendations, monitoring progress, and focusing on continuous improvement, organizations can use contract audits as tools for identifying issues and as mechanisms for enhancing contract management practices and promoting ongoing compliance. These post-audit activities contribute to stronger contractual relationships and better risk management.

Conclusion

The more complex a contract is, the more important the contract audit becomes. It provides many benefits but it also requires effort.

The greatest challenge is not the audit in most cases but implementing the recommendations put forth. That’s why it’s so important to monitor and follow up.

This guide has given you a blueprint for how to perform your contract audits. If you’re having trouble keeping contract documents in a single place, have encountered vague terms that cause issues, or just want to speed up your contracting process then be sure to take a look at our document automation platform DoxFlowy.