Overcoming hidden risks within construction contracts
INSIGHT ARTICLE |
While the funds for construction activity and capital projects are down in recent years, fraud has gradually increased in the construction industry. State and local government entities must implement measures to protect projects against fraudulent activity, ensuring they stay on time, on budget and deliver the expected quality. With more bids for fewer projects and large contracts at stake, you must be aware of warning signs to ensure contractors remain in compliance.
Common risk areas
A recent Association of Certified Fraud Examiners (AFCE) report found a median construction fraud loss of $300,000, the third highest amount of any industry. The most common fraudulent areas were billings (36 percent) and corruption (34 percent). In the case of billings, there is no penalty for overcharging a customer, and often, a contractor is only caught if an audit takes place.
The AFCE also pointed out several behavioral red flags to be cognizant of, including a close association with vendors, a “wheeler-dealer” attitude, excessive pressure and control issues. Each of these characteristics can be associated with construction companies, from both contractor and owner perspectives.
Typical contract structures
State and local government entities typically engage in two types of contracts, lump-sum (fixed-price) or cost-reimbursable projects. Your type of contract may be dictated by state or local regulations, but both carry various levels and areas of risk.
In a lump-sum contract, the project is competitively bid, as multiple offers are collected and the most competitive and responsive bid performs the project. This contract can also be negotiated, but is viewed as high risk for many reasons.
In a federal government environment, the Truth in Negotiation Act dictates that a contractor must provide documentation and information that is current, accurate and complete. Unfortunately, similar regulations do not exist in a state and local government setting. When negotiating, risks arise when the contractor may not provide all of the information and data that they are aware of and does not negotiate in good faith.
The next type of contract is cost-reimbursable, also known as cost-plus. These agreements exist in many different forms, including those paid with a fixed or a percentage fee. In the federal government, it must be a fixed fee, but most state and local entities enter into percentage fee agreements. Other forms of this contract are guaranteed maximum price agreements, as well as time and material contracts.
The type of contract you choose may be predicated on regulations you have to abide by, also by the type of project you require. In other words, if it is a simple design, you may want a lump-sum contract. However, if it is a more complex project, a cost-reimbursable contract may be more beneficial.
Knowing your risks
A construction project is a balancing act, with three primary areas to focus on: cost, schedule and quality. Each of these areas is interrelated and can directly influence each other; for example, some contracts may include incentives to complete a project early, impacting both schedule and cost. Unfortunately, the connected nature of projects leads to complex agreements, and increases the potential for fraud.
Several unique risks are apparent within lump-sum contracts, such as:
- Procurement – Occasionally the bid process is manipulated, or the lowest bid might not be the best bid.
- Specifications – Contractors may take shortcuts when they do the work.
- Change orders – Contractors make up for low bids by submitting change orders, and many have errors in their estimates or insufficient documentation.
- Front-end or top-loading – A contractor bills your organization in advance of performing the work.
- Allowances – Money is set aside for a specific task, but contractors use those funds for other tasks.
- Prevailing wage rates – In the public sector, contractors must meet wage requirements; however, many contractors do not adhere to guidelines.
Cost-reimbursable contracts also include several distinct risks that you must be aware of and manage, including:
- Labor – Many areas are prone to overbillings and risk, such as fringe benefits and worker’s compensation
- Cleanup – Subcontractors are normally responsible for cleanup, but contractors may submit excessive charges for providing services that are the responsibility of subcontractors.
- Negotiations – As mentioned earlier, some contractors fail to negotiate in good faith by not providing accurate and complete information.
- Subcontractor -- Contractors sometimes provide trade work, which is known as self-performed work. In these instances, the contractor manages their own work, potentially resulting in poor craftsmanship, or excessive change orders.
- Insurance – Excessive costs and coverage charges are becoming more common due to recent changes in insurance coverage.
The majority of overbillings come from labor (51 percent), followed by insurance (21 percent), billings in excess (17 percent) and miscellaneous charges (10 percent). However, fraudulent charges related to insurance are rising, and will become more prevalent in the coming years.
With tighter budgets and limited flexibility, state and local governments must perform due diligence to avoid overbillings and fraud in construction projects. In many cases, internal controls must be implemented or adjusted to account for evolving risks. However, a construction audit is also a valuable tool to ensure costs are allowable and in accordance with the contract, and to recover any potential overbillings.