Leaving the door open for fraud can be a costly mistake

With profit margins averaging around only 3.5 percent, construction companies cannot afford to waste money. It is imperative that company owners plug any 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 long time and can be perpetrated through a variety of schemes.

About 10 years ago, the United States Department of Justice reported that fraud was more prevalent in the construction industry than any other corner of the marketplace. Since then, partly due to a smaller number of contractors, the incidence of fraud has fallen considerably. Today, according to the Association of Certified Fraud Examiners (ACFE), 3.9 percent of fraud occurs in the construction industry.

However, the median loss per case of fraud is $259,000—the sixth highest amount among all industries. The most common forms of fraud in the construction industry include:

  • Cash schemes—Without the proper internal controls, those with access to a company’s cash flow can misappropriate funds in various ways, including skimming, altering cash receipts, creating fictitious refunds and discounts and kiting. Inventing expenses is particularly common. In a study conducted by Ipsos Reid, 7 percent of respondents said they knew people who inflated expense accounts. While the study showed that employees under age 35 are most likely to commit this fraud, managers inflated their expense accounts by larger amounts.
  • Inventory schemes—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, as this type of inventory is often easy to use or sell outside of the jobsite.
  • Purchasing schemes—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 assets—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 midsize construction companies. 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, an office manager or even an administrative assistant—is often assigned multiple responsibilities. When one of these disparate responsibilities is financial oversight, the environment is ripe for fraud.

One important step construction companies can take is to segregate banking responsibilities from accounts receivable and account payable functions. At the same time, owners should require dual signatures on all checks, including their signature. Some wise owners request to receive all bank statements before they are opened at an alternate address. Even though requiring multiple employees to handle the banking function may not be feasible, there are other ways to segregate duties that can be beneficial.

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. Often, those you least suspect are those who commit fraud if the conditions are right and the perpetrator can justify the reason.

According to industry studies, false pay applications account for more than half of construction frauds. These actions 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. This is common among vendors or subcontractors who are frequently used for large pieces of the contract. Fraud is also common in wage rates. Pay scales can be inflated with kickbacks to the payroll processors. 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. Without proper use of budgets and project management, fraud would be easy to perpetrate. 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, including 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 to support the change and ensure change orders follow the same approval channels as regular pay applications.

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. While these may not be considered fraud, they will directly affect the planned gross profit margin and need to be monitored closely throughout the job. 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 CPA and banker so that bookkeeping systems can be inspected for vulnerabilities. Industry accountants can recommend accounting processes that provide the maximum protection against fraud by either employees or outsiders. Certain banks also supply software to help mitigate fraud.

Successfully combating fraud requires a forceful stand by owners and top managers. The “tone at the top” is vital to show employees and subcontractors how they should behave. 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.