Better Watch Out! — Construction Fraud Can Hurt Your Bottom Line
In its 2014 Report to the Nations on Occupational Fraud and Abuse, the Association of Certified Fraud Examiners (ACFE) estimated that a typical organization loses 5% of its revenues to occupational fraud each year. When it comes to construction, the ACFE found that the median loss suffered due to fraud schemes was in the neighborhood of $250,000.
It’s not just contractors who are victims of such fraud; project owners, investors and creditors also risk losses. That’s why it’s critical to understand common schemes and take steps to prevent them — and steps that will help detect fraud if it does still occur.
There’s a Thief Among Us
Construction projects are particularly vulnerable to the following occupational fraud schemes:
Kickbacks and bid rigging. These schemes usually involve payments to employees of the owner to secure selection of a bid or, later in the process, approval of change orders. The payment isn’t necessarily in cash — the contractor might provide services to your employee in exchange for the employee’s aid. In such cases, the contractor could even end up billing you for those services, disguising the charge in a change order.
Ghost employees. Project owners can easily be billed for nonexistent employees or hours that weren’t worked. How? An employee of the contractor creates a ghost employee and then diverts the ghost’s paycheck to an address where she can pick up the check and later cash it. An employee could also “punch in” his pal on the time clock when the friend isn’t there to do it himself. Similarly, fraudsters may falsify invoices from bogus or “dead” vendors and subs.
Materials waste. Here, a contractor’s employee may order more materials than are necessary for the project. He or she then reports the excess as scrap and sells it — or uses it on another job. An employee also might steal equipment or report it as broken and then sell it — or use it personally.
Duplicate Payments. A contractor’s employee makes duplicate payments to a legitimate supplier for a legitimate invoice related to the project. One check goes to the supplier, but the other check is cashed by the employee. Sometimes the employee is in collusion with the supplier, and they share the duplicate payment.
Fortunately, project owners can take some measures to protect themselves from these and other schemes. Start at the beginning: During the bid management stage, implement internal controls for the solicitation, receipt and evaluation of bids and proposals. For example, require that more than one of your employees be involved in the bid-opening process and establish an evaluation team to award the contract.
Once you’ve selected a contractor, include a right-to-audit clause in the contract — and then use it. The clause grants you and your representatives access to the contractor’s accounting records to validate costs and look for irregularities. Surprise audits often are more effective than regularly scheduled visits.
Your CPA can reconcile estimated vs. actual costs for labor, materials and equipment, considering both the number of hours on the job and the unit rates applied to those hours. He or she also can perform regular reconciliations of material requisitions and deliveries, tying them to the estimate for the job and investigating any significant differences. In addition, performing random onsite audits can keep employees and subs on their toes.
Another way to curb fraud is to ensure accounting-related duties are segregated in your own company as well as in the contractor’s. Different individuals should be charged with reviewing invoices and issuing payments. Ordering, receiving, delivery and payment duties also should be segregated.
Change orders require your special attention. First, limit the number of employees authorized to approve them. Then follow up to validate each change order’s estimated cost with the actual cost. And check to make sure the costs weren’t included in the original bid so you don’t pay multiple times for the same item.
Additionally, run background checks on not just your contractors but also the subcontractors, suppliers and others involved in your project. Employee addresses should be cross-checked with those of subcontractors, vendors and fellow co-workers. Beware of any personal relationships between employees and subcontractors or suppliers.
Finally, create a formal ethics policy that provides zero tolerance for unethical behavior, and make it easy to report suspicions of fraud. According to the ACFE, anonymous hotlines are an effective way to help deter fraud. Establish a hotline for your employees, contractors and suppliers — and their employees — and ensure confidentiality.
Better Safe Than Sorry
In today’s cost-conscious real estate industry, you can’t afford to lose money to construction fraud. By instituting — and requiring your contractors to institute — some simple controls, you can reduce your odds of falling prey to a fraudster. Be sure to contact us if you need help.