Key Takeaways
- Construction companies face elevated fraud risk. The construction industry is especially vulnerable to fraud due to multiple involved parties, remote job sites, and limited accounting controls, placing it among the top five industries for fraud-related losses.
- Internal controls reduce the opportunity for fraud. Segregation of duties is key. Spreading responsibilities across employees for approvals, reconciliations, and access to funds limits opportunities for fraud to occur or go undetected.
- Focus controls on high-risk areas. Key areas like billing, disbursements, payroll, job-site oversight, and change orders should have targeted controls, such as dual approvals, job-site audits, and regular financial reviews, to detect and deter fraud.
The construction industry is known for having a long history of fraud perpetration due to processes and an operating environment more susceptible to schemes than other industries. Fortunately, contractors can implement and follow proven internal control procedures to help mitigate the risk of fraud from occurring, and to limit the size of potential thefts if committed.
Fraud Risks in the Construction Industry
According to the Association of Certified Fraud Examiners (ACFE) Occupational Fraud 2024: A Report to the Nations, the construction industry was in the top five industries with the largest median loss per year. One of the reasons contractors are more vulnerable to fraud is the number of parties involved including vendors, subcontractors, and employees of various levels who can commit and conceal fraud. Employee levels can range from supervisors, foremen, and project managers to accounting/finance staff.
Additionally, many contractors have smaller accounting departments, relative to other types of businesses, resulting in a lack of segregation of duties and fewer checks and balances. Other factors that make contractors vulnerable to fraud include the challenges of monitoring assets at remote job sites and the ease of concealing theft or embezzlement by spreading fraudulent costs across multiple contract jobs.
There are many common fraud-risks specific to the construction industry that are perpetrated, including:
- Embezzlement and fictitious vendors
- Payroll schemes, including ghost employees
- Vendor or subcontractor kickbacks
- Theft of job-site materials
- Corruption (bribery, extortion, bid-rigging)
- Change order falsifications
- Cybersecurity and data theft
While many of these risks are pervasive to businesses in all industries, contractors are uniquely susceptible to fraud schemes involving kickbacks, job-site material theft, corruption, and change order falsifications.
What three factors must be present for construction fraud to be perpetrated?
- Motivation – Something must occur in an employee’s life that causes them to feel they need to obtain more money than they have access to through their normal salary or means.
- Rationalization – The potential fraudster must come to find an acceptable reason in their mind to commit fraud.
- Opportunity – There must be an opportunity for a potential fraudster to perpetrate a scheme.
In recent years, motivation, rationalization, and opportunity for fraud have increased significantly. The only factor that a company can control is an opportunity to commit fraud, which is reduced through strong internal controls and creating an operating environment with a solid tone at the top with active oversight of financial results.
It is much more cost beneficial to make an investment to prevent a fraud from occurring by taking away the opportunity or detecting it quickly, then to fall victim to a scheme that could take years to uncover.
What key internal controls can a contractor implement to prevent and detect fraud?
The principal foundation for strong internal controls is a system of adequate segregation of duties throughout the accounting and financial processes. There should be multiple employees involved in the responsibilities for authorizing transactions, recording transactions in the system, performing reconciliations, and access to cash funds or assets.
Some of the key areas that contractors should focus on internal controls and segregation of duties are:
- Customer billing, payment application, and receipts
- Disbursements to suppliers and subcontractors
- Payroll
- Job-site controls
- Bidding and change orders
Additionally, contractors should carefully review monthly financial results and closely monitor the jobs in progress schedule on a regular basis to identify any significant fraud that may be present. By focusing on these core processes and spreading out responsibilities to multiple employees, contractors can greatly limit the opportunities for fraud to be perpetrated and concealed by the same individual.
LBMC’s Chattanooga advisors help construction companies strengthen internal controls and prevent fraud. With additional offices across the Southeast, we’re here to support your business wherever you build.
This article was contributed by Steve Thomason, Managing Director in LBMC’s Audit practice, based in our Chattanooga office. You can reach Steve at steve.thomason@lbmc.com to discuss how our team can support your organization.