How Construction Contracts Can Help to Mitigate Fraud During the Payment Process

By Erika Schnitzer, Associate EditorChicago—With construction contracts becoming more cost-based and billed up to a guaranteed maximum price, owners must assume more responsibility for monitoring construction costs, asserted Jim Schmid, CPA, CFE, national construction advisory services practice leader for Grant Thornton LLP, at a recent Webcast, “Construction Contract Terms Critical to Mitigating Fraud During the Payment Process.”Owners should be involved with the first payment application, first change order and first schedule of values in order to set a precedent. Schmid warned against waiting until the end of the project to do a final audit, as he noted that it is much more difficult to fix problems once the money has already changed hands.Furthermore, he said, internal auditors should monitor pay applications, change orders, schedule of values and contingency funds to ensure that owners are not being billed for work that has not been done and that contractors are using their contingency funds appropriately. Since this is really the owner’s money, explained Dennis Schultz, Esq. from Dawda, Mann, Mulcahy & Sadler, the construction contract should require that the owner be given notice and documentation to evaluate whether charges are proper, particularly with respect to errors and defects.Some problems encountered with the payment application process include unusual, inconsistent or incomplete pay application forms—which Schmid noted is a huge red flag and said that it is important for owners to define what they expect in terms of pay application forms—and lack of cost back up. Even if there is a real logistical problem, said Schmid, back ups should at least be done every two to three months. One of the most important things to consider is the format of the payment application, asserted Schultz.  One of the most popular forms is the AIA G702, which is especially useful because it “doubles as a certificate as payment that is usually signed by the project architect upon review of completed construction,” said Schultz. But if you don’t use this particular form, he advised that contract terms should provide for similarly formatted forms. Most important is that the form has a column that segregates change order work by line item, he noted. “The work categories or line items should tie to the schedule of values and contract provisions should make it clear that applications for payment will carry forward the same line items that are in the schedule of values,” said Schultz, which are measured in percentage completion and cost of work—which should be defined by internal auditors, particularly in terms of personnel cost.Additional problems include: documents not being electronic, lack of field documentation, lack of contractor pay application oversights, inconsistent subcontractor pay applications, no subcontractor pay application oversight, no clear definition of cost of work of excluded costs, missing attachments—including lien waivers and certifications—and inaccurate SOV (schedule of values) percent complete status.In terms of the change order process, the biggest problem, said Schmid, arises when work is performed before a price is negotiated. “If that is happening, you need to make sure your contract is stipulating that the contractor is collecting field information on that change order activity so that as you continue your negotiation in price you can maybe settle on something related to cost,” he explained. If there is no field documentation, he added, the change order process becomes a much bigger problem.In addition, when it comes to controlling schedules, Schmid noted that owners often overlook this area as something they need to control. However, if owners don’t keep track of contingency line items, contractors can bury problems later by paying for it with the so-called savings.To prevent this, added Schultz, the construction contract must provide provisions used to measure progress and to evaluate payment applications. The contract should require that an owner can request and receive documentation from construction managers to validate the schedule of values, if there are doubts about how costs are allocated.Click here for MHN’s previous coverage of construction fraud.