The Most Common Types of Construction Fraud


Written by:
Jim Schmid and Todd F. Taggart
Published:
November 2, 2011

Don't be a victim: Safeguard your construction company from fraud.

In today's challenging economic environment, fraud is on the rise, driven by economic pressures and tight credit, among other factors. Construction contracts can be particularly vulnerable to fraud, given their many cost inputs, multiple suppliers and subcontractors. Now more than ever, construction business owners- as well as their project managers, foremen and superintendents- need to vigilantly watch for fraud and employee theft.

Fraud can be committed by a wide range of people, most of whom do not fit a typical criminal profile. These individuals could be your 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.

Falsifying Payment Applications

False pay applications account for more than half of construction frauds. These applications can happen several ways- through erroneous totals or line items, roll-forward errors, false invoices or inflated rates in the supporting invoices that do not reflect the actual costs incurred. Project managers or project accountants can falsify pay applications to cover up the purchase of personal items or funnel money to a phantom company that they control. Other areas that can be fraudulent include wage rates and categories, i.e. if a subcontractor bills for a journeyman when an apprentice did the work; overhead and equipment rates; profit or markup formula and fee calculations. Pay applications from subcontractors need to be monitored and scrutinized closely for errors or irregularities.

Billing for Unperformed Work

A subcontractor, for example, might 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. If the contractor passes on a subcontractor's false claim, he or she will likely be treated the same as the offending subcontractor if the false claim is discovered.

Subcontractor Collusion

Another area to watch out for is bid rigging and price fixing. It is important to prequalify and pre-approve subcontractors, give them the full scope of work to bid on, and then pick the lowest-priced, most qualified and responsive subcontractor.

To avoid bid rigging, you must have rules in the contract that guide the subcontractor selection process. Schemes such as bid rotation, bribes and kickbacks, false or inflated change orders, undervalued deductive change orders or phantom subcontractors that consume the buyout savings all fall under this category.

Manipulating Change Orders

Change orders can be problematic if they are not monitored closely. Many times, issues can be resolved based on a successful relationship between the contractor and subcontractor. Yet, even in those relationships, 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, omissions of design specifications in the original scope of work or improper price reduction for work substitution. In any of these situations, seek additional documentation.

Manipulating the Schedule of Values and Contingency Accounts

Failing to update Schedule of Values (SOV) line items as buyouts or as changes are made can provide opportunity to cover up fraud. For example, a project manager or project accountant might conceal buyout savings by providing a place in the SOV to charge phony bills received from shell companies (companies that have no independent assets or operations of their own, but are used solely conduct specific business dealings) under their control. If the savings is left buried in the SOV line, an unscrupulous project manager or project accountant can apply fraudulent bills against this buyout savings amount, and the construction company's upper management will not be able to spot this charge by comparing budget to actual performance. This technique can also be employed by subcontractors for material or supplies billed on a pass-through basis.

Other issues to consider include failing to associate subcontractors/vendors with specific SOV line items, hiding cost overruns during the course of the project or using a contingency to cover non-reimbursable costs.

Substituting or Removing Material

Be sure subcontractors do not use a lower-grade material that requires subsequent change orders to repair/replace later on or materials that can even lead to a structure or system failure. Also, make sure employees have not taken material for personal use.

Diverting Lump-Sum Cost to Time and Material Cost

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 these services. For example, is the subcontractor billing time and materials for an industrial vacuum's rental cost, while a lump sum in the budget should already cover that vacuum?

Diverting Purchases and Stealing Equipment/Tools

Make sure the tools and equipment you pay for are actually used on your jobsites and not for a subcontractor's own project or an employee's or subcontractor's personal use. Watch out for items purchased and shipped to a different project site or project purchases such as equipment or tools that appear to be in excess of project specifications.

False Representations

Many contracts require specific terms about the subcontractor's employees, insurance, purchases, etc. For example, a contract may require that all subcontractors have a percentage of minority workers or city residents. Watch out for subcontractors who falsify these representations. Frequently, the contractor will be held responsible for false representations by his or her subcontractors, particularly as it relates to minority content or quality.

False representations might include using undocumented workers, violating "Buy American" requirements or falsifying minority content reports, test results or insurance certificates. Noncompliance with environmental regulations or misrepresentation of small business status can also be false representations. To minimize this risk, maintain copies of documentation confirming (or related to) the subcontractors' representations.

Understanding and recognizing the most common types of construction fraud and establishing internal controls are the first steps in preventing, deterring and detecting fraud. These steps will help prevent your company from falling victim to fraud.


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