United States

Leaving the door open for fraud can be a costly mistake

INSIGHT ARTICLE  | 

With profit margins averaging around 3.5 percent, construction companies can ill afford to waste money. It is imperative that company owners plug any and all leaks in their financial affairs, including any possibilities of fraudulent acts by employees or outsiders. Unfortunately, fraud has been widespread in the construction industry for a very long time.

About 10 years ago, the U.S. Department of Justice reported that fraud was more prevalent in the construction industry than any corner of the marketplace. Since then, and partly due to a smaller number of contractors, the incidence of fraud has fallen considerably. Today, according to the Association of Certified Fraud Examiners’ 2016 Report to the Nations, 3.9 percent of fraud occurs in the construction industry. However, the median loss per case of construction industry fraud is $259,000—the sixth-highest amount among all industries.

Types of fraud

The most common forms of fraud in the construction industry include:

  • Cash: Without the proper internal controls, those with access to a company’s cash can misappropriate funds in various ways, including skimming, altering cash receipts, creating fictitious refunds and discounts and kiting. Inventing expenses and inflating expense accounts is particularly common. While younger employees are most likely to commit this fraud, managers generally inflated their expense accounts by larger amounts.
  • Inventory: More than a few company owners have learned the hard way that unprotected inventory is a treasure trove for the larceny-minded. The two most common forms of fraud are embezzlement of scrap proceeds and the appropriation of inventory for personal use.
  • Purchasing: Without formal controls and safeguards, purchasing functions can be manipulated for fraudulent purposes. Acts of deception may include fictitious invoices, unapproved paychecks made out to employees, over billing and excess purchasing of property and services.
  • Fixed asset: Many contractors do not pay close attention to fixed assets such as trucks and equipment. Aware of that, unscrupulous employees many find it easy to steal or make personal use of company assets.

Fraud is most prevalent among small and mid-size construction companies, which comprise the overwhelming majority of contracting businesses. Companies of this size often feel they can’t afford anything other than just rudimentary checks and balances. A major problem at some of these firms is that a single employee—a bookkeeper, office manager or even administrative assistant—is often assigned multiple responsibilities. When one of these disparate responsibilities is financial oversight, the environment is ripe for fraud.

Mitigating fraud

One important step construction companies can take is to segregate banking responsibilities from the accounts receivable and accounts payable functions. At the same time, owners should require dual signatures on all checks, one of which should be their own. Some owners request to receive all bank statements before they are opened.

Fraud can be committed by a wide range of people, most of whom do not fit a typical criminal profile. These individuals could be employees or the employees of joint-venture partners. They could also be subcontractors, suppliers or consultants. Many people assume the economic pressures in unsuccessful projects lead to increased fraud, but successful projects and profitable relationships can be equally susceptible.

One of the most common types of construction fraud is false applications for payments. Payment application fraud can occur in various ways, including erroneous totals or line items, roll-forward errors, false invoices or inflated rates in the invoices that do not reflect the actual costs incurred. Fraud also is common in wage rates. Consequently, pay applications from subcontractors need to be monitored and scrutinized closely for errors or irregularities.

A subcontractor may overstate the units of production accomplished, the units of labor or the equipment actually used. This would be considered a false claim under the federal False Claims Act if the project were a government contract.

Change orders also are particularly susceptible to fraud. Certain red flags should be considered as possible fraud indicators: change orders for a base contract’s work scope or ones with missing scope descriptions, excess charges, and omissions of design specifications in the original scope of work or improper price reduction for work substitution. In these situations, project managers should request additional documentation.

Construction company owners also need to watch out for expenses that may be budgeted in a lump-sum amount, but then billed by the subcontractor for time and materials related to those services.

Identifying fraud

There are several steps owners can take to spot irregularities. They include:

  • Schedule out the subcontractor pay applications
  • Compare actual to budget on a line-item basis
  • Reconcile payments to the pay applications
  • Reconcile pay applications to the underlying cost records
  • Track changes in the contingency account
  • Compare change-order signature dates to the actual time the work was completed
  • Inventory the lien waivers
  • Make a list of purchased equipment and inventory the remainder
  • Conduct supplier confirmations
  • Prove reimbursable charges
  • Tie subcontractor bills to the payment applications
  • Compare drawing/spec material volumes to claimed actual volumes
  • Review the subcontractor bid selection process and selection documentation

To reduce opportunities for financial fraud, company owners need to meet with their accountants so that bookkeeping systems can be inspected for vulnerabilities. Industry specialists can recommend accounting processes—including software—that provide the maximum protection against fraud by either employees or outsiders.

Successfully combating fraud requires more than just giving lip service to the issue. Company owners and top managers need to initiate a dialogue about the importance of honest behavior—and the consequences that await employees who act unethically. Moreover, owners and executives need to develop broader awareness about fraudulent activities. While a strong leadership tone is crucial, actions that dovetail with the message are also required. Organizations should implement policies that minimize workplace fraud opportunities.

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