Construction and Real Estate Advisory Services

Construction fraud is on the rise: how to mitigate it

by Greg Parker, Construction & Real Estate Advisory Services, Ernst & Young LLP

The prevalence of fraud is of great concern to executives operating in an increasingly cost-sensitive environment.

Fraud appears to be on the increase. A recent Ernst & Young study of global fraud found that worldwide incidents of fraud had increased since the rms last such study in 2008.1 The survey was based on more than 1,400 anonymous interviews with CFOs and other senior executives performed in 36 countries. It is estimated that about 10% of total annual worldwide expenditure on construction, amounting to many billions of dollars, is lost to fraud. While construction spending is generally down in the wake of the global economic crisis, many companies are still making substantial investments in new projects and forecasts suggest that spending is about to increase. In the US, all new construction starts exceeded US$400 billion in 20092 and, despite dropping 2% in 2010, still totaled approximately US$412.5 billion. Construction industry experts McGraw-Hill also forecast an 8% increase in construction starts this year, putting total industry expenditure around US$445.5 billion.3 With such huge numbers involved, there is ample opportunity for fraud. While this risk is not new, the prevalence of fraud is of great concern to executives operating in an increasingly cost-sensitive environment.
1 Driving ethical growth new markets, new challenges, Ernst & Youngs 11th Global Fraud Survey, 2010. 2 2010 Construction Outlook, McGraw-Hill Construction. 3 2011 Construction Outlook, McGraw-Hill Construction.

Construction fraud is on the rise: how to mitigate it

Types of construction fraud

What is fraud? For the purpose of this article, fraud is a deliberate deception practiced so as to secure unfair or unlawful gain that is characterized by deceit, concealment or violation of trust. There are three common types of construction fraud: Corruption. There are conicts of interest, resulting in bribery, illegal gratuities or economic extortion. Common construction examples are as follows: A contractor may interfere with the competitive bid process by submitting unrealistic bids, for example, submitting a high bid to allow another contractor to win in return for the favor being returned on another bid. A company executive may collude with a contractor in awarding a contract to the contractor in return for a kickback. The rates on change orders may be inated and incorrect markups on change orders may be used, resulting in charges for work not completed. Misappropriation of cash, inventory and other assets. Common construction examples include: On time and material contracts, the non-delivery of material or misuse of owner provided equipment Expenditure on non-project related activities Not recording credit received for scrap and salvage Lack of pass through of discounts and pay back of unused inventory Fraudulent nancial or other statements. Information is incorrectly recorded or not recorded in a timely or effective manner that would lead to bonus payments, job creation or increased investment. Some employees in the construction sector intentionally: Provide incorrect root cause identication of cost or schedule overrun Redistribute costs among a contractors projects to overstate the contractors income on certain projects (and to overstate the costs to the companies employing the contractor on these projects) Issue unrealistic cost, schedule or productivity reports to keep the project ongoing Create a ctitious company, such as a subcontractor on a project, and send invoices to the prime contractor for reimbursement for work that was never done or expenses that were never incurred

Construction fraud is on the rise: how to mitigate it

Why fraud happens

The risk of fraud in construction projects is heightened by a number of factors, such as: Growing complexity of organizations. As companies become larger, more complex and expand into new markets, more managers and employees are involved in managing projects, more layers of administration are involved in governance and project management and there are more stress points that existing controls may not cover. As a result, the risks of fraud in the organization increase exponentially. Infrequency of construction projects. Some companies may contract for construction projects infrequently. For the average corporation, construction may not occur more than once every ve to ten years. As a result, companies often do not have contemporary experience in managing projects, and may not be current on best practices or the use of the latest technology in managing those projects, making them more susceptible to overlook fraud. History of inattention. The pressures of managing operating businesses may mean that some corporate executives are not paying sufcient attention to fraud prevention. Understafng of, or ineffective, internal audit functions. Even if companies have proper controls, these may not be effective if there are not enough qualied people to manage them. Increasingly transient employees. The shifting nature of todays workforce, with more employees cycling through companies or the construction contractors hired by those companies, increases the risk that personnel are not loyal and may be interested in short-term gain, including opportunities that may be fraudulent. Personal nancial troubles. Employees with personal nancial difculties may be tempted to commit fraud by taking kickbacks from contractors for selecting them as the winning bidders on contracts. Competitive nature of the construction industry. Pressures on contractors to win business and stay competitive often increase in a weak economy and may cause some contractors to resort to fraud.

Companies may not be current on best practices or the use of the latest technology, making them more susceptible to overlook fraud.

Construction fraud is on the rise: how to mitigate it

It is essential that a company set the proper tone for fraud prevention by having effective prevention policies, a code of ethics and training.

Strategies to mitigate construction fraud

It is essential that a company set the proper tone for fraud prevention by having effective prevention policies, a code of ethics and training. A company can accomplish these goals by: Creating a code of ethics prescribing standards of ethical, honest behavior for a companys board, senior executives, managers and employees in their dealings with one another and with clients, customers, vendors, suppliers, investors and others outside the organization. Every person in an organization should be held responsible and accountable for putting the code of ethics into practice. A company may require employees to sign an annual statement that they have complied with the code. It may extend the code to contractors and suppliers by incorporating the code into contracts. Adopting fraud prevention policies that prescribe actions the company can take to prevent fraud at all levels of the organization and in all dealings with contractors, suppliers and vendors. To prevent kickbacks from vendors, a company should require proper documentation to support the awarding of subcontracts, rotate its buyers among vendors and segregate duties among ordering, receiving, delivery and payment. Developing a training program to educate and train employees in fraud awareness prevention, detection and response. In addition to a formal training program, the company should support the programs message through newsletters, internal meetings and discussions. These programs help to overcome complacency about fraud, and to ensure that managers and employees are alert to signs of possible fraud and know what to do if they suspect it. Establishing effective project controls. This will help the company minimize conicts of interest, segregate duties and have the appropriate levels of approval/authority. Monitoring controls. A company may monitor controls to assess whether those controls are working properly through right to audit clauses and conduct internal and/or third-party audits, including surprise audits. Screening suppliers and subcontractors. A company should screen not only its primary contractor but also those working for subcontractors, suppliers and others involved in a project. These employees should go through the same screening process as a companys own employees. Introducing an anonymous whistleblower hotline. About a third of all fraud cases result from tipoffs. Establishing a hotline enables people in a company to provide anonymous tips about possible fraud without fear of repercussions. The hotline may be contracted out as employees may feel more comfortable speaking with someone outside the organization.

Consequences of fraud
About 10% of total worldwide expenditure on construction, amounting to many billions of dollars, is lost to fraud. Through better fraud prevention, some of these billions might be saved and the savings passed through to shareholders or investors via higher dividends or used for corporate investments or other purposes. Fraud may have repercussions beyond a companys direct nancial losses. For example, a companys stock price could suffer following allegations of fraud. It may risk damaging its reputation and so alienate customers or clients. It may also alienate honest vendors and suppliers. It could incur substantial legal fees to investigate the fraud, take action against those responsible and defend itself against shareholder lawsuits for losses the company incurred.

Risk assessment
As much as 25% of fraud incidents are discovered by accident, but companies cannot afford to leave such discoveries to chance. Companies need to take the initiative in developing and implementing policies and practices to prevent fraud, such as more specic internal/ external audits, awareness training and improvements in relevant controls compliance. A company should be ready for when fraud does occur, and move quickly to address it. The Ernst & Young fraud study found that about a third of companies have never formally assessed their construction fraud risk. Such an assessment helps focus the company in mitigating fraud. Typically, the ndings and recommendations from such an assessment will: Create awareness so that company personnel can prioritize monitoring and training Limit surprises and improve early detection Improve the culture of integrity within the company itself

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Conclusion
Of course, every organization is at risk for fraud. The question is how companies address such risk. Companies can take the initiative by performing fraud risk assessments, establishing a code of ethics and specic fraud prevention policies and training managers and employees in fraud prevention. They can establish strong internal controls and conduct internal audits to detect fraud. And, they can monitor those controls to ensure they are working properly. Most importantly, companies can ensure that fraud prevention is embedded in the corporate culture. For their investment in fraud prevention, companies may reduce the incidence of fraud in their organizations, reduce the cost of fraud and help prevent serious damage to their reputations.

Greg Parker is a senior manager with Ernst & Young LLPs Construction & Real Estate Advisory Services practice. You may contact him at greg.parker@ey.com.

2011 Ernst & Young LLP. All Rights Reserved. SCORE No. DF0123 CSG NY 1104-1251358
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