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Combatting Construction Fraud

Thu April 06, 2023 - National Edition #8
Lucy Perry – CEG CORRESPONDENT


Remote jobsites challenge asset tracking and theft prevention. Offsite work presents the opportunity to spread fraudulent costs over multiple contracts and thus conceal embezzlement.
Remote jobsites challenge asset tracking and theft prevention. Offsite work presents the opportunity to spread fraudulent costs over multiple contracts and thus conceal embezzlement.
Remote jobsites challenge asset tracking and theft prevention. Offsite work presents the opportunity to spread fraudulent costs over multiple contracts and thus conceal embezzlement. Fraud happens when economic uncertainty, shaky finances and inappropriate actions mix. Pervasive fraud risks include fictitious vendors, ghost employees, vendor kickbacks, materials theft, bid rigging, change order falsifications and cyber threats. Make regular jobsite visits to compare material quantities purchased to the original bid. Consider installing security cameras to identify theft of materials.

Funding sources, competition and thin margins can result in construction fraud. Contractors are often more vulnerable than owners because they juggle so many aspects of the project: materials, vendors, equipment, subcontractors, site safety and their own employees. A limited system of checks and balances can create more fraud risk.

Construction contractors understand the pressures that are simply the nature of their work. Jumping interest rates, volatile material costs, labor shortages and indecipherable project pipelines go with the territory.

Fraud can happen when economic uncertainty hits a company's shaky finances and inappropriate action is taken to mitigate the chaos.

Fraud Crushes Contractors

Procurement and change orders threaten the contractor who doesn't immediately and directly benefit from the fraudulent action.

In these situations, contractors don't get a fair shot at hiring time, according to accounting firm Grant Thornton. They also can be hurt by cash flow issues when funds are drained as a result.

Theft is an even greater risk for contractors who must manage complex logistics while juggling myriad aspects of the job. Material prices alone over the past two years have incentivized asset misappropriation, said Tim Lynch, Grant Thornton construction advisory manager.

The situation has resulted in illegal resale of materials on the black market.

"The theft of valuable material directly affects a contractor's already narrow margin" said Lynch.

Insurance may cover some of the direct cost of the theft, but there is a significant indirect cost, he said.

"Business owners now worry about locking down their inventory and wonder who they can trust instead of focusing on winning the next project."

When project-level staff are tasked with handling labor and wage compliance, violations can occur in this area. These managers and accountants are often incentivized to keep costs down and increase profits.

"Direct financial incentives provide a clear motivation for someone to commit fraud," said Alex Koltsov, Grant Thornton forensics director.

And that's why contractors need proper oversight to monitor those risks, he added.

Other factors that contribute to fraud vulnerability are remote job sites that are inherent in the construction industry. Remote job sites make it difficult to watch over assets and prevent theft, said Steve Thomason of business advisor LBMC.

Offsite work presents the ability to also conceal embezzlement by spreading out fraudulent costs over multiple contracts, he said.

Common construction fraud risks include fictitious vendors, ghost employees, vendor kickbacks and materials theft. Bid rigging, change order falsifications and cyber threats and data theft also can threaten a contractor's business.

"While many of these risks are pervasive to all industries, contractors are uniquely susceptible to fraud schemes," said Thomason.

Lynch and Koltsov believe implementing value-added solutions can prevent and limit fraudulent behavior.

"Implementing compliance programs may sound unnecessary, especially in an unfavorable economic cycle," Koltsov said. "However, we urge companies to recognize that fraud increases during these fragile times."

Failing to develop an effective construction fraud program now can lead to huge financial and time burdens later, he said.

The best way to combat construction fraud is with management oversight, preaches construction payment software developer Levelset.

Give Diligence Its Due

In general, due diligence is crucial to a project, said Alex Benarroche, Levelset legal associate.

"Try to hire local and established contractors to reduce the possibility of fraud," he said.

Inform yourself about local market conditions, availability of competition and bid pricing of comparable projects in the area.

"It's also a good idea to familiarize yourself with their business structure," said Benarroche. "Many times, subsidiary companies may be trying to conceal who the principal is. Know who you are working with."

Designate a chief compliance officer as a communication point between contractors on the project and the owner/management team.

Benarroche believes the compliance officer should not only conduct initial investigations but regular ongoing reviews as well.

"Continuous monitoring is a simple way to decrease the likelihood of fraud," he said. "Your chief compliance officer should have the power to conduct periodic audits and be able to review payrolls, invoices and contracts."

Finally, said Benarroche, stay alert. "Fraud occurs when people stop paying attention."

Implementing these measures early on in the construction project will help long-term, but staying alert will protect a contractor from fraud.

Violations can lead to lawsuits, which costs money. A history of fraud can destroy a company's reputation. "Always be vigilant," he urged.

A system of adequate segregation of duties throughout the accounting and financial processes is what Thomason of LBMC advises.

"There should be multiple employees involved in the responsibilities for authorizing [and] recording transactions."

Multiple trusted employees also should perform reconciliations and access cash funds or assets, he said.

Thomason urged contractors to focus on internal controls and segregate duties. This way, "contractors can limit the opportunities for fraud perpetrated and concealed by the same individual," said Thomason.

For instance, he said, reconciling billings and receivables should be performed by someone who does not have access to incoming payments.

"Carefully review line items and quantities on payment applications for any irregularities."

Thomason also urged contractors to monitor the jobs-in-progress schedules closely for significant overbillings or under-billings.

Always obtain competitive bids for materials and subcontracts over a certain amount. And have an employee other than the project manager review supplier and subcontractor invoices, he added. "Require dual signatures/approval on all checks or electronic funds transfers."

Pre-qualify subcontractors, verifying bonds with bonding agents and prohibiting payments unless surety bonds are on file. Also, watch out for lowest bids that are consistently awarded to the same subcontractor or supplier. Monitor the jobs in progress schedules closely for-profit fade to detect fictitious costs, advised Thomason.

Keep a close eye out for duplicate payroll payments and reconcile the W-2s and payroll tax reports to the general ledger system.

"Perform occasional jobsite visits to compare employee headcount at the job site to time reports and payroll checks/direct deposits."

On the job site, compare material quantities purchased with the original bid. Reconcile purchase orders to delivery tickets and invoices. He advises clients to install security cameras to identify theft of materials and track and monitor scrap sales of materials.

"Implementing strategies in these key areas can help alleviate a contractor's exposure to some of the most common fraud schemes," said Thomason.

Contractors risk fraud or theft because of operating environment, long history of industry fraud and opportunity for fraud post COVID-19.

"Taking the time and committing resources to prevent fraud from occurring will pay off dividends in the long run," said Thomason.

Watch for Potential Threats

When it comes to details, attention is key in Grant Thornton's suggested policies and practices.

The financial consulting firm advises contractors and owners to implement a program for business protection.

  • Keep on dealing with the details.

Incorporate detailed cost estimates throughout the project lifecycle, the accounting firm urged.

"One of the best ways to stop construction fraud is to stop the slush fund from filling up."

Engage qualified cost estimators and quantity surveyors who can deter fraud by monitoring market-reasonable pricing.

  • Vet your vendors before project commencement.

Perform risk-based due diligence, said Grant Thornton. Identify potential conflicts of interest and assess performance risk.

Recognize the regulatory risk in hiring a company or individual with a track record of law enforcement red flags.

"These proactive due diligence steps should be supported by regular site visits during construction," the firm added.

These site visits for the purpose of ensuring the chaos is actually orchestrated properly, should be a regular practice.

  • Fix your eyes on your high-value assets.

Implement enhanced oversight of your investments to prevent inventory shrink and theft, urges Grant Thornton.

"Companies that are already experiencing unacceptable levels of inventory shrink should aggressively minimize the opportunity for theft."

Companies that regularly hold high-value items also should protect against misappropriation.

Install video monitoring and access controls at storage and project staging locations. When scheduling staff in the logistics process, rotate individuals as you make regular assignments.

Perform regular inventory cycle counts to track any discrepancies between system records and supplies on hand. Confirm any allegations are investigated, remediated and communicated throughout your organization.

"These steps deter theft and reduce financial impact by increasing the likelihood that theft is uncovered quickly," said Grant Thornton.

  • Set labor compliance oversight policy from the get-go.

Incorporate a centralized system for oversight for labor compliance, one of the most manipulated costs on a construction project.

Identify and analyze labor rate anomalies against requirements and address them with management, project owner and governing bodies. Companies that manage numerous projects should develop a standardized process to collect, process, analyze and identify labor insights, believes Grant Thornton.

  • Build audit rights into the contract.

Contractors "should include strong audit rights in their construction contracts to deter inappropriate behavior," said the firm. "Companies should message third parties that an objective audit at project milestones or completion is good vendor hygiene and not an allegation of fault."

A third-party audit can trace not only which companies received payment but how much they were paid, notes the firm.

"An objective cost audit is often the most efficient way for a company to validate overbillings or unacceptable behavior."

These solutions and techniques can help protect businesses, believe Lynch and Koltsov.

"The controls are just as necessary in a booming economy as they are in a recession," they said. "But the potential for fraud at this time should cause business owners to pause and make sure their protections are sound." CEG




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