Construction Fraud: How to Detect, Prevent and Avoid Altogether

Published January 13, 2017 by Whirlwind Team

construction fraud

The Report to the Nations by the Association of Certified Fraud Examiners stated the median fraud loss among construction firms is $245,000, double that of other industries. Construction contractors and companies seem to be particularly prone to fraud schemes.

The main reason for this is the lack of financial expertise on the part of the contractors and owners. Most of them allow all financial activity to be overseen by a bookkeeper, controller, or CFO. There is no owner oversight; internal controls are lacking so the financial staff can perpetrate a range of fraud schemes.

Common construction fraud schemes

False pay applications are the most common fraud perpetrated industry, which made up more than half of all fraud in construction.

  • Erroneous totals or line items
  • Roll-forward errors
  • False invoices
  • Inflated rates on invoices
  • Wage rate fraud

Cash schemes involve misappropriation of funds by people with access to company cash.

  • Skimming
  • Altered cash receipts
  • Fictitious refunds and discounts
  • Inventing expenses
  • Kiting (floating checks)

Inventory schemes are less about the company cash and more about the company assets.

  • Stolen inventory
  • Embezzlement of scrap proceeds
  • Using company inventory for personal use

Purchasing schemes occur when purchasing functions are manipulated for fraudulent purposes.

  • Fictitious invoices
  • Unapproved paychecks made out to the employee
  • Over-billing
  • Excess purchasing

From corruption involving kickbacks and bid-rigging to fake accounts set up to receive payment for goods and services that do not exist, a construction company can suffer cash and asset losses in almost every part of the business. Even the company credit card issued for gasoline purchases is often used fraudulently.

Why is fraud so prevalent in construction?

Unfortunately, many contractors and construction firm owners simply do not have the necessary expertise in the financial end of the business. Finances are left to a bookkeeper or a controller without proper oversight.

Lacking internal controls to keep money from floating out the door, many contractors are completely unaware that fraud is occurring, much less the extent of the loss.

The people committing the fraud usually do not even “look” like criminals. They can be your employees or the employees of a joint-venture partner. They are subcontractors, suppliers, and consultants. The lure of money easily taken is just too compelling to many who would never think of stealing a candy bar.

There is one factor that doesn’t seem to matter at all: the economy. Fraud occurs whether a business is successful or not.

How to detect fraud

You can spot red flags if you put effort into tracking expenses and applications. For example, a change order for the scope of work drawn up in the original contract should be heavily scrutinized. Change orders can also contain excess charges, improper price reductions for substitutions, or inflating design specifications.

You can also detect fraud by being a complete bean-counter about comparing actual expenses to the budget, line by line. Every time you receive a pay application, reconcile it to the schedule. Track every change in your contingency account. Have suppliers provide confirmation. Compare the drawings and specifications material to the actual volume used and charged.

Find a way to track equipment usage, too. Sometimes workers do a little freelance on the side and “borrow” tools and equipment from the company. Inventory develops legs and walks off the site.

By the way, do you know where your bulldozer has been this weekend?

How to prevent construction fraud

Internal controls are your biggest weapon against fraud. As with everything else, prevention is cheaper than the cure. If you can make it difficult or impossible to perform fraud, you are ahead of the game.

Split up financial duties. No one person should have responsibility for every step of a financial transaction. If you need to, outsource some of it to a finance company that specializes in handling small business transactions.

If the same employee can set up new vendors, approve invoices, and make out checks, the situation is ripe for fraud. Each transaction should involve more than one person, and for some situations, that person needs to be you.

Prepare financial statements on a regular basis. Monthly is best but do it at least quarterly. Now you have something to compare to your bank statements, loan schedules, general ledger, and other documentation.

You probably do not need to have the statements audited, but some bonding companies require you to have them reviewed by a CPA.

Establish a fraud hotline. Much more effective than audits, a hotline allows employees, vendors, and others to report suspicious activity anonymously.

Create other internal controls. 

  • Reconcile billings with general ledgers monthly
  • Compare cash receipts to accounts receivable
  • Monitor company credit card statements
  • Require two or more competitive quotes for materials costing over a certain amount
  • Compare job estimates with actual costs after the project is completed
  • Take delivery of and open all bank statements yourself every month, before anyone can tamper with them

Running a construction business is more than playing in the dirt with really big toys. Not everyone wants to mess with numbers but if you want to stay in business and keep what you have earned, paying strict attention to finances and demanding documentation is the way to do it.

Avoid fraud altogether

You can keep temptation at bay with a few other practices that make it more difficult to embezzle.

  • Segregate banking responsibilities from your accounts payable and accounts receivable functions. Require dual signatures on all checks; require your own signature for certain expenses.
  • Monitor the subcontractor pay applications for irregularities, typically overstatement of units of labor or production accomplished. Check on all equipment used, as well. Have your bookkeeping systems reviewed by an expert to pinpoint weaknesses that could be exploited.

A good industry accountant can recommend good software and processes that will protect your business from fraud by employees and others.

It starts at the top

How you comport yourself and the financial affairs of your company will be reflected by those who work for you. If your employees see you cutting corners, taking kickbacks, or over-billing, then they will do the same.

Instead, run your business completely above-board. Make sure everyone who works for you and with you understands you mean to toe the line on finances and wrong-doing will not be tolerated.

Build internal controls and be fair to vendors, employees, subs, and your clients. You will build a reputation as an honest businessperson and protect your company against fraud.

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