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How Contractors Can Identify and Avoid Fraud

With profit margins averaging around only 3.5 percent, construction companies can not afford to waste money. It is imperative that company owners plug any and all leaks in their financial systems, including any possibilities of fraudulent acts by employees or outsiders. Unfortunately, fraud has been widespread in the construction industry for a 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, 3.9 percent of fraud occurs in the construction industry. However, the median loss per case of fraud is $259,000the sixth highest amount among all industries.

Following are the most common forms of fraud in the construction industry.

  • Cash schemes: 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 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 people. The two most common forms of fraud are embezzlement of scrap proceeds and the appropriation of inventory for personal use.
  • 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.

Avoid Fraud

Fraud is most prevalent among small and mid-size construction companies. Companies of this size often feel they can’t afford anything other than 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.

One important step construction companies can take is to segregate banking responsibilities from accounts receivable and accounts 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.

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 also could 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.

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. 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 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.

There are several steps owners can take to spot irregularities:

  • 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 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; and
  • review the subcontractor bid selection process and selection documentation.

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

Successfully combating fraud requires a forceful stand by owners and top managers. 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.

3 Replies
  1. There are many ways to avoid fraud and one of them is using an electronic Purchase Order system such as rubberstamp.io leaving no room for error.

  2. There are definitely many ways to avoid fraud. The construction industry could benefit immensely by using an electronic purchase order system such as Rubberstamp.io This system will not only increase profits but save valuable time as well, not to mention -no more project overruns and- no more delayed payments. An added bonus is it lends complete transparency to money spent thereby eliminating fraud. https://www.rubberstamp.io/

  3. Great article about how fraud can be identified and avoided. It is also worth considering why this industry seems to be so related with fraud and embezzlement. My company, GenieBelt, has written an article that tries to depict the main reasons of why construction is so prone to corruption.

    Here you can have a look: http://blog.geniebelt.com/construction-prone-corruption
    Feel free to give any feedback and know what you think!

    Best,
    Ana

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