Risks Hidden in Construction Contracts by Richard A. Pollack, CPA
Corruption, improper billing and expense reimbursement top the list of reported frauds in the construction industry, according to the Association of Certified Fraud Examiners’ (ACFE) 2014 Report to the Nations. While these payment schemes can occur at any stage of the construction process, owners may wield greater control over mitigating resulting losses during the contracting phase. It is at this time that owners may negotiate terms for costs and time, assess threats and identify opportunities to implement controls or take actions to mitigate future risk.
One goal of the construction contract is to communicate the scope and specifications of a project with as much detail as possible from the onset, leaving little room for misinterpretation down the road. This includes selecting the appropriate pricing arrangement to meet project budget, timelines and intended purposes as well as understanding the risks hidden in each agreement.
Fixed-Price and Lump-Sum Arrangements
The most common pricing arrangement for construction projects is the fixed-price contract. In these arrangements, an owner defines the scope of the project and solicits bids from contractors, who agree to receive a lump-sum payment for the costs that they estimate will be required to complete the project. Due to these approximate calculations, the contractor takes on most of the risks associated with meeting the agreed-upon construction costs, thereby freeing the owner from the responsibility 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, contractors receive predetermined fees on top of reimbursements for the costs they incur to carry out the contract terms. One drawback to this type of arrangement is the lack of a cap on allowable costs. This puts 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 in order 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 concern is through a shared-savings clause, in which both parties agree to split any savings below the guaranteed maximum price.
Most commonly used in public projects, unit-price contracts define costs for specific tasks or units of work involved in construction projects. Owners agree to pay contractors only for work completed 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. The deception compromises all phases of the construction process – from bidding to project delivery – by taking advantage of the underlying contract terms. Red flags of these schemes can include:
- 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
- An employee’s repeated approval of unexplainable change orders, often for the same contractor
- An employee making decisions or taking 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 audit 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 Business Valuation Services practice have extensive experience working with developers, contractors and project owners to incorporate appropriate terms in construction contracts and to establish accounting and reporting systems that help to keep project costs transparent and on budget.
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.