Fraud Prevention Strategies – How to Deter Construction and Contractor Fraud

By Steve Carter, CPA, Principal
ASL Construction Group

Fraud is an ongoing concern for businesses in practically every industry today. But construction firms and contractors have historically been especially susceptible to fraud schemes.

Data from the most recent Report to the Nations, a bi-annual fraud study released earlier this year by the Association of Certified Fraud Examiners (ACFE), bears out this fact once again. The median fraud loss among construction firms in the study was $245,000 — nearly double the median fraud loss among companies across all industries that participated in the study.

Outside the Typical Contractor’s Expertise

There are several different factors that may help explain why construction firms and contractors are so vulnerable to fraud losses. One of the biggest is the fact that many contractors and construction firm owners simply aren’t experts when it comes to the financial aspects of running their businesses.

Let’s face it: Most contractors would rather be out in the field managing job sites than in the office working on financials. So they often entrust financial management to a bookkeeper, controller or CFO, depending on the size of the company. But without proper financial oversight by the owner and adequate internal controls, it can be easy for financial staff to concoct a wide range of different types of fraud schemes.

According to the 2014 ACFE Report to the Nations, the most common fraud schemes at contractors and construction firms fall into these categories:

  1. Corruption – This would include schemes like kickbacks and bid-rigging.
  2. Check tampering – This includes financial employees writing checks to themselves and entering them in the system as checks made out to other vendors.
  3. Expense reimbursements – Here, financial employees write checks to themselves for expenses they didn’t actually incur.
  4. Billing – With this scheme, financial employees set up fake accounts for fictitious vendors. They then issue payments to them for non-existent goods and services and cash the checks themselves.

Other Fraud Schemes

A few other fraud schemes that are prevalent among construction firms and contractors include:

• Theft and misappropriation of physical assets — Often, owners make it too easy for employees to steal equipment, tools and other materials from vehicles and job sites. Many construction employees freelance on their own construction jobs on the side and “borrow” tools and equipment from their full-time employers. Sometimes they return them in good condition … and sometimes they don’t. Other more brazen employees just steal tools and equipment outright, especially items that are smaller and harder to account for.

• Over-purchase of materials — Employees responsible for purchasing knowingly buy more materials than will be needed for a job, sell the excess and pocket the cash themselves. This scheme has become more widespread in recent years as the price of some raw materials like copper has skyrocketed.

• Payroll schemes — The most common payroll scheme is for a financial employee to issue paychecks to non-existent “ghost” employees and cash the checks themselves. Another is for payroll employees to alter their W-2 forms to show that more withholding was taken from their pay in order to get a bigger tax refund.

• Fraudulent use of employee credit cards — Many owners issue credit cards to some of their employees (mainly supervisors) to buy gasoline and other small-ticket supplies while out on job sites. Unscrupulous employees sometimes don’t hesitate to use these cards to fill up their own gas tanks and make other miscellaneous purchases.

Reducing Fraud Exposure

There are a number of steps construction firm owners and contractors can take to reduce their exposure to these and other types of fraud. Perhaps the most important step is to make sure that adequate internal control measures are in place that will prevent, or at least strongly deter, employees from concocting fraud schemes.

One of the most important internal controls is to segregate financial duties among your financial staff. Or in other words, make sure that one single employee is not responsible for handling every step involved in a financial transaction. For example, the same employee should not set up new vendors, approve invoices and issue checks to vendors. Similarly, the same employee shouldn’t order, take receipt of and distribute materials and track material costs.

Segregating financial duties like this can be difficult for small contractors with limited staff. Obtaining outsourcing support in some of these areas — like the preparation of bank reconciliations, for example — can help small contractors achieve segregation of duties.

Another strong internal control is to prepare financial statements on a regular basis — at least quarterly, if not monthly. Then compare them to your bank statements, general ledger entries, loan schedules and other financial documents. Audited financial statements usually aren’t necessary for most construction firms and contractors, though bonding agencies may require that your statements be reviewed by a qualified CPA.

Interestingly, studies have shown that the most effective internal control when it comes to uncovering fraud is establishing a fraud hotline. This is a method whereby employees, vendors or anyone else can anonymously report suspicious activities that might indicate fraud to management, without any fear of repercussions. Fraud hotlines are far more effective than audits in uncovering and stopping fraud schemes.

Other internal control measures that have proven effective in preventing and deterring fraud at construction firms include:

  • Comparing cash receipts to accounts receivable on a monthly basis.
  • Comparing job cost estimates with the actual job costs after jobs are complete.
  • Reconciling actual billings with general ledgers on a monthly basis.
  • Requiring that purchasing receive at least two or three competitive quotes before buying any materials above a minimum amount (such as $500, for example).
  • Carefully monitoring the company’s credit card statements to look for possible personal charges made by employees.
  • Having bank statements delivered directly to the owner or CEO, who then personally opens and reviews them every month.

Set the Right Tone at the Top

Finally, the importance of setting the proper tone at the top of your organization cannot be over-emphasized when it comes to deterring fraud schemes. If employees see that upper management plays things “fast and loose” and has little regard for following ethical business and financial practices, they are more likely to feel like they are justified in playing fast and loose with the company’s money and assets themselves.

Instead, try to be above reproach with regard to how you manage your contracting business and deal with your employees and vendors. When you set this kind of example at the top of your organization, it can trickle down to your employees as well.