Do you consider your construction company too small to being susceptible to fraud? According to the Association of Certified Fraud Examiners (ACFE) Report to the Nations, 2018 Global Study on Occupational Fraud and Abuse, the median loss per fraud scheme in the construction industry was $227,000. For most companies, a loss of this size can be shattering. In the construction industry, schemes are often carried out by employees, owners, subcontractors, vendors, or partners. Construction companies are likely more susceptible to fraud than companies in other industries; companies often have difficulty developing and monitoring controls because authority may be distributed across geographical areas and among multiple people of varying levels, including field supervisors, project managers, or others.
Mitigating fraud risks requires understanding what can motivate fraudsters, how to recognize behavioral red flags, how to assess risk, and effectively implementing controls to mitigate those identified risks.
The universally accepted fraud triangle theory states that individuals are motivated to commit fraud when three elements come together: a perceived pressure, some perceived opportunity, and some way to rationalize the fraud consistent with the individual’s values. The perceived pressures or motivations are typically financial and may arise from external pressure from those outside the company, internal pressures, such as compensation being driven by performance, or personal problems (which are the most common) stemming from living beyond one’s means or financial difficulties caused by things like addiction, divorce, debt, spousal job loss, or health issues.
Some other behavioral red flags to watch for in employee behavior include:
- Unusually close relationships with vendors or customers — Strong relationships are important in the construction business, but close relationships between contractors, subcontractors, employees, and owners could lead to inadequate review processes and informal agreements outside of established controls.
- Control issues/unwillingness to share duties — Employees who are over-protective of data or documents, never take vacations, or refuse to let others help them may need to control their environment to keep their schemes hidden.
- “Wheeler-dealer” attitude — Field supervisors and project managers that intentionally work outside of prescribed control procedures are likely ignoring company best practices.
Fraudsters usually do not have criminal records, and only 4% of perpetrators in the study had a prior fraud conviction. To commit the fraud, they must convince themselves that their acts do not deviate from their belief system, which would normally stop such behavior. They may convince themselves that the money is a loan — that they’ll pay it back when they can. The fraudster may persuade themselves that the company is doing well and won’t miss the assets — that they need it more. Others think that they aren’t compensated fairly or that they have been slighted by a supervisor or management.
While a company may have little to no control over the outside pressures that an individual might feel that push them to commit fraud, controlling the opportunity afforded to employees and other third-parties can greatly reduce the likelihood of fraud. This is especially important for small businesses because they have fewer resources to prevent and recover from a fraud, and they lose almost twice as much per fraud scheme compared to larger companies. The ACFE notes the construction industry’s most common fraud schemes include the following:
- Corruption (occurs in 42% of schemes) — In the construction industry, this category includes conflicts of interest, bribery, kickbacks, and economic extortion. This also can include collusion or bid rigging as well as unauthorized access and subsequent disclosure of confidential information related to bids.
- Billing (occurs in 37% of schemes)— Invoices may be submitted for fictitious goods or services or from fictitious vendors. Materials may be substituted for a lower quality, billings calculated with incorrect labor rates, or for uncompleted work which can result in inflated invoices.
- Expense reimbursements (occurs in 23% of schemes) — Employees make claims for fictitious or inflated business expenses, which also includes inappropriate use of fuel cards or other company credit cards.
- Non-cash (occurs in 23% of schemes) — In construction, there are typically materials, supplies, or other non-cash assets on site that can be stolen or otherwise misappropriated.
- Check tampering (occurs in 19% of schemes) — Fraudsters may intercept, forge, or alter checks drawn on one of the organization’s bank accounts in order to divert assets. Office employees may also be able to write checks to fictitious vendors, while project or field employees may be able to submit for payment fictitious invoices to intercept payment.
A lack of formalized policies and procedures and poor segregation of duties are common control weaknesses that provide these opportunities. Therefore, organizations should periodically perform formal risk assessments and internal control reviews to identify areas of risk. The primary internal control weaknesses that contribute to fraud are: a lack of controls, ease with which to override existing controls, lack of management reviews, poor tone and the top, lack of competent personnel in oversight roles, and lack of independent checks/audit. Therefore, construction companies should also focus on the following to reduce the likelihood of, and increase the chance of catching, fraud if it occurs:
- Establish strong controls and enforce them — Be sure internal controls incorporate reasonable and thought-out segregation of duties, appropriate levels of approval and oversight for bidding, use of subcontractors, vendors, change orders, and controls over the estimation and pay process to prevent and detect issues. Be sure there are formal procedures over cycles such as receipts, payments, payroll, inventory, and equipment and vehicles.
- Keep in mind other tools when staffing is limited, such as lockboxes, direct deposit, and positive pay, as well as the use of data analysis to assess the effectiveness of and compliance with controls.
- Conduct regular (unannounced) job site visits — This can deter unwanted behavior from employees in the field and help with the estimation and pay process.
- Set up a system to receive anonymous tips — 40% of frauds are initially identified by tips, and organizations with tip hotlines detect nearly 50% of their cases by tip.
Additionally, contractors should be sure to monitor potential conflicts of interest, be consistent with their policies and procedures across the organization, and keep in mind the tone at the top, because strong values can trickle down, and employees will reflect the behavior of their bosses.
At Suttle and Stalnaker, we provide clients with the risk management services to help prevent fraud and make recommendations to strengthen your internal control system. If it is too late to prevent the fraud we have Certified Fraud Examiners here to help you recover from the fraud.