Fraud risk is not new to the construction industry. However, in these challenging economic times, the probability of fraud has increased, leading to growing concern. As many construction company owners work to obtain new projects and manage cash flow for survival, it becomes even more important to establish and enforce necessary internal controls to avoid fraud.
There are three common categories of construction fraud:
- Corruption: Generally associated with conflicts of interest, resulting in kickbacks, bribery, illegal gratuities or economic extortion; examples include bid-rigging by contractors or subs and the payment of kickbacks or taking of bribes in return for the award of a contract
- Misappropriation: Theft or misuse of cash, inventory or other assets; examples include inflating rates or markups on change orders and charging the client for materials or expenses related to unassociated projects
- Fraudulent financial or other statements: Information relied upon is not recorded accurately or on a timely basis, leading to inappropriate payments, job creation or increased investment; examples include the issuance of unrealistic schedule, cost or productivity reports to move a project forward
Other common fraud schemes affecting the construction industry include:
- The use of fictitious or shell companies as vendors through which the construction company or its client can be billed for nonexistent services or materials
- Altering check payees or amounts, or forging signatures or endorsements
- The theft of job materials, tools or equipment or unauthorized scrap sales
- Overstating hours worked or billing for nonexistent workers
The Association of Certified Fraud Examiners recently published the 2012 Report to the Nations on Occupational Fraud and Abuse, which indicates the median fraud loss by companies in the construction industry was $300,000. Industrywide, fraud losses are a substantial hit to an industry already suffering the effects of a weakened economy. Through better prevention and deterrence, fraud losses can be reduced.
Fraud prevention begins with the “tone at the top.” Management must implement effective policies and procedures that let employees and vendors know fraud is taken seriously, and that it will be looked for and dealt with appropriately if found. Recommendations include:
- Establishing a code of ethics that sets the standard for ethical behavior for the company’s board, executives, managers and employees in their dealings with each other, clients, vendors/suppliers and all others; this code of conduct can be extended to contractors, vendors and suppliers by incorporating its tenants into contracts
- Establishing policies and procedures that address actions the company will take to prevent fraud, whether by employees or those outside the company
- Training employees to educate them regarding what constitutes fraudulent behavior and how it could look if encountered in their job functions; these programs support an appropriate tone at the top and alert employees to potential red flags for fraud, and what to do if they encounter them
- Establishing effective project controls (internal controls) and monitoring them to ensure compliance; appropriate controls help reduce the risk for fraud by controlling the opportunity to commit fraud without being detected
- Offering an anonymous hotline so employees, clients and vendors/suppliers can let management know if they have concerns regarding potentially fraudulent activity; the 2012 Report to the Nations indicates that approximately 43 percent of all fraud is discovered through a tip from an employee, customer or vendor/supplier
Every organization is at risk for fraud, but companies can reduce risk by taking proactive steps to combat fraud. Companies can address risk head-on by establishing a code of conduct and putting policies, procedures, controls and monitoring in place. Failure to do so can cost construction companies money, the goodwill of their clients and their reputations. Hoping that fraud will not happen to your company is not an effective strategy.