Identifying and minimizing the risk of construction fraud
The numbers can be astonishing: An indictment in Alabama alleged that a project manager inflated subcontractor bids by some $1.3 million and planned to keep much of the overage for himself. A case in the Southwest involved government officials, architects, an engineer and a contractor in a suspected scheme totaling more than $4 million in fraudulent billing charges. The contractor on a hospital construction project in California was accused of overcharging the project's owners more than $5 million in labor rates and executive compensation.
While construction is not among the industries reporting the most incidents of fraud—that dubious distinction is held by banking and financial services, government and public administration, and manufacturing—the losses due to occupational fraud in the industry are significant nonetheless. According to a global fraud study by the Association of Certified Fraud Examiners (ACFE), the median loss in more than 40 construction fraud cases examined was $245,0001.
For small and mid-size companies, the issue is particularly troublesome: A greater percentage of these companies report incidents of fraud than are reported by large companies, according to the ACFE study. Naturally, the impact of any loss will be felt more acutely by smaller companies.
Motivations and red flags
As with any criminal activity, occupational fraud may be the result of opportunity, rationalization and pressure. In this motivational triangle, the fraudster may be in a position to access contracts and maintain relationships with vendors. He or she may believe that any loss could be absorbed by the company–or that there would be no loss at all, only gain. A sudden illness, excessive debt or the expectation of a job loss may provide the pressure needed to actually commit fraud.
Whatever the motivations, there are, in fact, a number of warning signs in the construction industry that may indicate the potential of fraud committed by internal personnel:
- Close relationship with vendors ― Sitting in a worksite trailer day in and day out while working on multiple projects, close relationships can develop between contractors, subcontractors and owners. These interactions can lead to agreements―whatever the intentions of any party involved―that are executed outside of established controls, or that lead to change orders that are not reviewed through a procurement process.
- "Wheeler/dealer" attitude ― Some strong-willed project or facilities managers deliberately work outside of control procedures, using an approach that they perceive is in the best interests of the company. This approach can allow for overbilling and other forms of fraud.
- Control issues ― Other managers simply believe they do not need controls or review procedures to achieve their ends.
Red flags can be raised in situations where an unsuccessful bidder is doing contract work; the same firm is winning bids for one project after another; excessive change orders are submitted; there is a lack of competition in the bidding process; and poor workmanship requires rework.
Fraudsters and their schemes
According to the ACFE study, the majority of occupational frauds in all of the industries examined were committed by staff at the employee or managerial level, most often in accounting, operations, sales, and executive or upper management. Not surprisingly, the higher the fraudster's authority level, the greater the losses. Overall, more than half were with their firms for more than five years.
As the study points out, billing and corruption schemes ranked among the three most common forms of fraud in nearly every industry. In construction, these schemes can take a number of forms:
- Corruption ― This umbrella category rates the highest in frequency for the construction industry, and includes conflicts of interest, bribery, illegal gratuities and economic extortion.
- Bidding – Contractors take advantage of weaknesses in a system or the lack of internal controls to view the bids being submitted and adjust their own bid accordingly. Internal personnel with access to the bid submissions may also pass on this information to bidding contractors. With so much bidding for projects being done online, unauthorized access to bidding information can be even easier to accomplish.
- Billing ― This type of fraud can take a number of forms, such as invoices submitted for costs that were inflated or not allowable under the terms of the contract; invoices for labor that was not completed or even performed; or invoices for work performed on personal projects.
Note that fraud schemes often overlap, and may involve corruption, asset misappropriation and financial statement fraud simultaneously.
What companies can do
The benefits of various fraud prevention efforts and early detection are clear: Proactive methods (such as reviewing a contractor's financial capabilities and pricing) result in earlier detection and lower median losses than more passive methods (such as tips, notification by law enforcement or external audits) can achieve.
Here are some steps that construction companies can take to minimize fraud and its impact:
Establish controls: Active controls that seek out fraud can significantly limit the losses incurred through illegal activity. Controls include a range of activities, from surveillance and monitoring to internal audits and management reviews. When selecting contractors through a non-competitive bidding process, use an evaluation committee with objective members. Segregate duties to ensure that the access to sensitive information or the level of approval authority is limited, as appropriate.
Enforce controls: The most effective way to minimize fraud losses is to prevent it from occurring in the first place. An anti-fraud culture means communicating the importance of prevention, enforcing the procedures, and providing the support and training needed to do so.
Define the cost of work: Often, a fraudulent contractor invoices for costs that are unallowable in the contract. Agreements should include a provision that clearly defines all costs of work that will be compensated for by the owner, including what is allowable and what is not.
Identify the costs of insurance: Insurance coverage, including subcontractor default insurance, can be a complicated issue. For example, it is common for the owner to pay for a higher premium cost than what is actually being incurred by the contractor. Alternatively, the contractor may provide and incur costs for insurance that is not required by the owner. Management should clearly understand what is being charged and why.
Audit contractors throughout the project: External audits normally will not detect irregularities, so management should make sure all negotiated costs and contracts include a right-to-audit clause. Internal audits should be conducted by experienced members of the internal audit staff or outsourced to auditors with experience in construction audits.
Set up a hotline: Although a somewhat passive approach, tips gathered through a hotline or similar method can have a substantial impact on fraud detection.
If a construction company has an internal control system, management should consider testing it for possible holes. In addition to an external audit of controls and financial reporting, if a company suspects or becomes aware of potential fraudulent activity, management should consider launching an internal investigation or hiring an outside firm to handle the task.
Although construction companies should not expect to recover all or even most of any losses due to fraudulent activity―in 2014, nearly 60 percent of the victim organizations in the ACFE survey were unable to recover any losses―fraud prevention measures will help limit the damage and, in most cases that go to trial, will result in convictions that will prevent the fraud from continuing.
1 Report to the Nations on Occupational Fraud and Abuse, ACFE, 2014