Recognizing Fraud in the Construction Industry by Richard A. Pollack, CPA
According to the Association of Certified Fraud Examiners’ (ACFE) 2014 Report to the Nations, fraud continues to plague the construction industry. Exacerbating the problem is a sector-wide failure to implement strong internal controls and reliable methods for detection, often due to the perceived expenses of such preventative measures. However, these expenses are, in reality, minor compared to the amount of monetary and reputational losses a business will suffer as a result of fraudulent activities.
The first step in stopping fraud in its tracks requires project owners, contractors, engineers and other involved parties to recognize the potential risks and common schemes at each level of the construction process. This includes looking within their own organizations, especially when considering that internal threats often pose the greatest risks.
For simplification, the construction process can be separated into four phases: design, bid, build and completion. Depending on the size and complexity of a project, each stage comes with its own set of schemes, which may be difficult to spot to the untrained eye.
The design phase is of paramount importance in establishing the scope and budget of any given project. Inaccuracies can result in change orders, cost increases and delays to completion.
A common example of design-phase fraud involves the overestimation of costs for labor and materials. These schemes help perpetrators create an environment that facilitates their ability to commit theft and receive kickbacks from suppliers. Other fraudulent activities can include the manipulation of project specifications and use of bribes to influence the construction process and favor one contractor over another.
The bidding process is intended to be a fair and competitive method for selecting the most efficient proposal from a pool of contractors. The criteria for awarding a contract may be based on costs as well as a firm’s reputation and ability to complete the work. However, during this phase, perpetrators may attempt to manipulate or influence the bidding process through a variety of measures, including collusion, kickbacks and bid-rigging schemes.
Red flags that may point to fraudulent bidding activities include:
- The same contractors rotating between high and low bids on different projects
- Bid prices fall after the introduction of a new competitor
- A winning bidder subcontracts work to a losing bidder
- A winning bidder submits excessive change orders after receiving the contract award
One way to help deter and prevent these schemes is to segregate the duties of the individuals involved in the bidding process. For example, owners may assign to one individual the task of developing the bid package of project details and another person to select the winning bid. Additionally, developers and owners may open the bidding process to a larger pool of contractors in order to mitigate the risk of bidding fraud.
The regular monitoring of construction progress helps to ensure that costs and timelines detailed in building contracts are on track and to address any challenges or disputes that may occur. In the building phase, fraud can occur when contractors overbill for labor and materials or bill for materials that are neither required nor received. Other risks can include theft of company assets and excessive requests and approvals of change orders.
Another area rife with fraud involves quality control, including the use of subpar materials and counterfeit parts, which can compromise the integrity and safety of a project. Threats can include collusion between contractors and inspectors, poor workmanship and the exchange of subpar project materials with those that contractors know will pass quality-control tests. Unfortunately, poor quality control often goes unnoticed until long after construction is complete. To mitigate this risk, project owners may consider hiring an independent company, without the knowledge of project contractors, to test and ensure quality standards are met.
Despite the established processes intended to certify that projects comply with building codes and other regulations throughout the construction process, fraud can and often does occur before final delivery. Criminal activities may include inspector bribes, kickbacks from contractors to owners’ representatives and the failure of contractors to report discounts or rebates they received working on the project. Because these criminal activities are often identified after a project is complete, it is important for project owners and contractors to have appropriate controls in place at the time of contract to limit their exposure to these risks.
Right to Audit Remedy
To help deter and even prevent fraudulent activities from occurring throughout any stage of the construction project, owners should consider including right-to-audit clauses in their contracts. These clauses aim to ensure compliance with contractual obligations and allow owners to specify how they expect contractors to use funds and maintain financial records, which the owner may audit at any time. In addition, such language lets contractors and subcontractors know that owners intend to monitor their activities and take the appropriate steps to identify, investigate and prosecute fraudulent schemes.
Rather than accepting fraud as a common business hazard, project owners, contractors and all involved parties should instead recognize that these activities and resulting losses are preventable.
The professionals with the Berkowitz Pollack Brant’s Forensic and Business Valuation Services practice work with owners, developers, contractors and other parties in the construction industry to mitigate risks and assist through each phase of the construction process. Their accounting and advisory services help to enhance cost-beneficial internal controls, ensure contracts contain appropriate wording and safeguards, and facilitate accurate and proper management reporting. Additionally, when claims of fraudulent activities arise, they lead investigations and provide expert testimony in related litigation engagements, as needed.
About the Author: Richard A. Pollack, CPA, ABV, CFF, PFS, ASA, CBA, CFE, CAMS, CIRA, CVA, is director-in-charge of the Forensic and Business Valuation Services practice with Berkowitz Pollack Brant. He can be reached in the CPA firm’s Miami office at 305-379-7000 or via email at firstname.lastname@example.org.