Are You at Risk? Internal Controls Help Deter Fraud

12/1/2014 - By Zachary Farrington

-This excerpt is from our Winter 2015 Dimensions newsletter-

Can your company afford to throw away $300,000? That’s what a typical case of fraud in the construction industry costs the company that is victimized.

Every two years, the Association of Certified Fraud Examiners (ACFE) issues a Report to the Nations on occupational or internal fraud — schemes such as embezzlement, misappropriation of funds, phony expenses, bribes and kickbacks. The most recent 2012 report shows the construction industry remains at risk for larger than average fraud losses.

While industries such as financial services, manufacturing and health care reported larger total numbers of fraud cases in the 2012 study, the construction industry outranked them in terms of the average size of loss. At $300,000, the median loss in construction industry fraud cases was more than twice the median loss for fraud cases overall.

While it is impossible to completely eliminate the threat of internal fraud, a responsible contractor should recognize the most likely fraud scenarios and take steps to mitigate the risk.

Common Fraud Schemes

Occupational fraud can take many forms, and construction companies are vulnerable to just about all of them. In the 2012 ACFE report, billing related schemes accounted for more than 36 percent of construction industry fraud cases. Examples include payments to shell companies, vendor fraud (often with an insider’s help) and charging personal purchases to company accounts.

Construction-related businesses are particularly susceptible to another common type of fraud — theft of materials. Most work is performed at remote sites away from company headquarters, so management oversight is less consistent. Moreover, many of the materials used — such as lumber, concrete, copper pipe, wire and cable, and topsoil and fill — can be difficult to identify and track to a specific job, making it easy to divert materials to other purposes.

A related risk involves the misappropriation of equipment. An example would be employees who operate side businesses using their employer’s supposedly idle equipment.

On a larger scale, contractors are at significant risk from bid rigging schemes and related forms of corruption. Other common fraud schemes include payroll fraud involving phantom employees, as well as gardenvariety frauds such as check tampering and phony expense reimbursement schemes.

Effective Internal Controls

No system of internal controls is foolproof, but effective internal controls can minimize the opportunities for fraud and deter all but the most determined thief.

One of the most fundamental internal controls is also one of the simplest: segregation of duties. The person who sets up vendor accounts should not be the same person who approves payments or reconciles bank statements, and the payroll clerk should not be the same person who disburses paychecks. This principle applies across all aspects of the business, and can be implemented immediately at little or no cost.

Here are some other simple yet effective internal controls you can implement with relative ease:

Personally check all estimates for accuracy of calculations, labor rates and correspondence with drawings.
Compare job cost estimates with actual costs. Require approvals for cost adjustments or transfers of costs between jobs.
Require that materials estimates above a specified amount include quotes from two or more vendors.
Make purchases only with pre-numbered purchase orders, and match them to both receiving reports and invoices before payment is made.
Check vendor invoices against estimates to ensure proper discounts and pricing.
Always refer to specific job numbers, phase codes or work order numbers in onsite communications.
Obtain ink or electronic signatures on change orders before work begins, and revise contract values accordingly.
Record equipment usage weekly, and assign and expense maintenance costs as they occur.
Review all billings for timeliness, accuracy, conformity with contract terms and correct customer information.
Reconcile billings with general ledgers monthly, and document underbillings and overbillings.
Prepare financial statements monthly and support them with ledgers, bank statements and loan schedules.

Getting Started

The majority of contractors are small businesses that cannot afford to maintain a dedicated internal audit function, but there are other practical, cost-effective steps you can take to deter fraud. Your accountant can help you set up effective internal controls and test the controls you already have in place.