Hidden Risks in Construction Contracts by Richard Pollack, CPA
According to the Association of Certified Fraud Examiners’ (ACFE) Report to the Nations, occupational fraud continues to plague the construction sector, which reported the fourth highest median losses of $203,000 among a total of 22 industries. Topping the list of the industry’s most common fraudulent schemes was corruption followed by improper billing practices and duplicitous payroll and noncash payment arrangements. While these scams can occur at various stages of the construction process, developers and building owners may have the best opportunity to mitigate losses during the construction phase, when they have the negotiating power to set contract terms, assess threats and implement anti-fraud controls. One area that requires careful attention is the selection of appropriate pricing arrangements and an understanding of the potential risks hidden in those agreements.
Fixed-Price and Lump-Sum Arrangements
Fixed-price contracts are the most common pricing arrangement for construction projects. In these arrangements, a property owner defines the scope of a project and solicits bids from various contractors who agree to receive a lump-sum payments for the costs they estimate will be required to complete the project. Because contractors must approximation future costs in advance of beginning any work, they carry the greatest level of risk, leaving property owners free from the risks of paying for excessive cost overruns.
To be sure, contractors build contingencies into their bids to protect themselves from unforeseeable circumstances that would result in increased costs through change orders. In and of themselves, change orders may be a prime breeding ground for corruption. Other risks related to fixed-price arrangements can include kickbacks between contractors and subcontractors, the use of substandard materials or improper installation methods, as well as the practice of billing separately for labor and materials already budgeted for in the original contract terms.
Cost-Plus and Guaranteed Maximum Price Arrangements
With cost-plus contracts, construction contractors receive predetermined fees on top of reimbursements for the costs they incur to carry out a contract’s terms. One drawback to this type of arrangement is the lack of a cap on allowable costs, which puts property owners in the precarious position of having to pay for indeterminate costs incurred at the contractors’ discretion. To address this concern, owners may instead use guaranteed maximum price agreements to limit their liabilities to an amount they negotiate with the contractor at the time of contract. In these scenarios, costs incurred above the contracted amount become the responsibility of the contractor.
Despite the even playing field these arrangements create for owners and developers, there are potential risks. For example, contractors may be tempted to overestimate the maximum project price to protect themselves from overly conservative estimates or rising costs of labor and supplies. Moreover, because they are contracted to receive payments above their actual costs, contractors may not be incentivized to be as cost-efficient as possible. One way to eliminate these concerns is through a shared-savings clause, in which both parties agree to split any savings below the guaranteed maximum price.
Unit-price contracts that define costs for specific tasks or units of work involved in construction projects are commonly used in public projects. In these arrangements, property owners agree to pay contractors only for the work they complete at different phases of the project. The greatest risk in these arrangements is the inability to identify total costs until after work is complete, which makes it easier for cost manipulation to occur.
A Last Word about Change Orders
Even the best-laid plans are subject to unpredictable changes, often for legitimate reasons. However, change-order abuse is an all-too common practice in the construction industry. These deceptions compromise all phases of the construction process – from bidding to project delivery – by taking advantage of the underlying contract terms. To identify these schemes, property owners should look out for the following red flags:
- the use of change orders to “clarify” unspecific contract terms;
- change orders that increase the costs or scope of work outlined in initial construction contracts;
- frequent or undocumented change orders awarded to a particular contractor;
- repeated employee approval of unexplainable change orders, often for the same contractor; and/or
- employee decisions or actions outside the scope of his or her normal responsibilities
Although not a part of the standard American Institute of Architects (AIA) contract, one method for preventing unscrupulous change orders and assuring compliance with original contract terms is the inclusion of a right-to-audit clause. These provisions can protect owners from the onset by detailing how contractors should conduct business on a given project, including progress reporting, and aim to reduce contractor mistakes and improprieties.
Keeping construction contracts and pricing arrangements free of risks requires a commitment of time and resources up front to mitigate challenges and losses in the future. The professionals with Berkowitz Pollack Brant’s Forensic and Advisory Services practice have extensive experience working with developers, contractors and project owners to incorporate appropriate terms in construction contracts and establish accounting and reporting systems that help to keep project costs transparent and on budget.
About the Author: Richard A. Pollack, CPA, ABV, CFF, ASA, CBA, CFE, CAMS, CIRA, CVA, CGMA, is senior director of Forensic and Advisory Services with Berkowitz Pollack Brant, where where he has served as a litigation consultant, expert witness, court-appointed expert, forensic accountant and forensic investigator on a number of high-profile cases. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at firstname.lastname@example.org.