A construction project’s success often hinges on trust and transparency, especially in a cost-plus contract. In this type of agreement, the owner pays the contractor for all project costs—like labor, materials, and subcontractors—plus an additional fee for overhead and profit. This structure is common for projects with an uncertain scope, but it exposes the owner to a significant risk of cost overruns and inflated billing. This is where the owner’s audit rights become indispensable.

An audit clause gives the owner the contractual right to examine the contractor’s books and records to verify that all billed costs are legitimate and accurately allocated to the project. Without this right, the owner is largely at the mercy of the contractor’s billing practices.

The Power of an Audit Clause

An audit clause is more than a formality; it’s a critical mechanism for financial oversight and risk management. Here’s why it’s so important for owners to have this right:

• Cost Verification: The primary purpose of an audit is to ensure the contractor isn’t overbilling. This can happen in various ways, such as charging for non-project-related expenses, double-billing for materials, or inflating labor costs. The audit allows the owner to scrutinize invoices, timesheets, and other documentation to confirm that every dollar spent is a valid project cost.
• Discouraging Misconduct: The mere presence of an audit clause can deter a contractor from engaging in fraudulent or careless billing practices. Knowing their records may be reviewed at any time incentivizes them to maintain accurate and detailed documentation.
• Building Trust: While it might seem counterintuitive, an audit clause can actually foster a more transparent and trusting relationship. When both parties know that all financial transactions are subject to review, it creates a foundation of accountability and open communication. It provides a structured way to resolve billing disputes without resorting to litigation.
• Compliance and Accountability: An audit ensures that the contractor is adhering to the terms of the contract, especially concerning what constitutes an “allowable cost.” It holds the contractor accountable for their financial management and record-keeping, which is essential in a cost-plus arrangement where the owner bears the financial risk.

New York State Contract Information and Case Law

In New York, as in other jurisdictions, a cost-plus contract demands meticulous record-keeping from the contractor and a robust right to audit from the owner. New York courts have consistently held that contractors under a cost-plus contract must be able to prove every expense they charge.

A key case that underscores this point is Olmstead Construction, Inc. v. Otter Creek Investments, LLC. While not a New York case, its principles are widely applicable and relevant. The Iowa Court of Appeals in this case held that “a cost-plus contract, by nature, demands that the contractor maintain accurate and detailed expense records.” The court found that if an owner disputes the billing, the burden is on the contractor to prove each and every item of expense. This includes providing documentation for costs, such as the use of contractor-owned equipment. The court rejected the contractor’s attempt to use speculative estimates, highlighting that without a pre-agreed-upon rate schedule, the contractor must prove the actual costs of using the equipment. This case serves as a powerful reminder that an owner has the right to demand backup documentation for any costs charged.

In New York, the General Business Law § 756-b and other related statutes govern payment in construction contracts. While these statutes primarily focus on prompt payment, they are a part of the broader legal framework that emphasizes transparency and fairness. A well-drafted audit clause in a private construction contract must be consistent with New York law.

Resources

• American Institute of Architects (AIA) Documents: The AIA publishes standard contract forms, many of which contain clauses for cost-plus contracts and owner’s audit rights. These documents are a common starting point for many construction agreements.
• New York State General Business Law: Article 35-E of this law (specifically § 756-b) governs prompt payment in construction contracts and is a good resource for understanding the legal landscape of payment disputes in New York.
• Construction Law Journals and Legal Articles: Publications from law firms specializing in construction law often provide analyses of recent court decisions and best practices for drafting and negotiating contracts.
• Professional Organizations: Groups like the Construction Financial Management Association (CFMA) and the American Bar Association’s Forum on Construction Law offer educational materials and resources on construction contract administration, including auditing.

 

John Caravella Esq., is a construction attorney and formerly practicing project architect at The Law Office of John Caravella, P.C., representing architects, engineers, contractors, subcontractors, and owners in all phases of contract preparation, litigation, and arbitration across New York and Florida. He also serves as an arbitrator to the American Arbitration Association Construction Industry Panel. Mr. Caravella can be reached by email: John@LIConstructionLaw.com or (631) 608-1346.