What Owners Need to Know about Construction Fraud

By Erika Schnitzer, Associate EditorChicago—With the troubled economy providing greater risks of fraud, as well as allegations of fraud taking over the national spotlight, Grant Thornton LLP’s national Construction Advisory Services group recently hosted a webinar to shed light on the most common forms of construction fraud and provided key tips for how project owners can protect themselves against fraudulent third-party contracting relationships.According to Jim Schmid, CPA, CFE, national Construction Advisory Services practice leader at Grant Thornton, construction fraud has grown significantly over the past three years, as it becomes more complex and difficult to identify. Furthermore, in today’s tough economic times, contractors are facing more pressure to get as much revenue out of their projects, providing more temptation to take advantage of their customers, he said.Over the past 10 years, construction contracts have evolved from basic lump sums to design-build contracts, seemingly to avoid the risk of change orders, Schmid explained. The problem with these types of contracts, however, is that they are built on the actual cost incurred on the project up to the guaranteed maximum price, which—on a large enough project—can provide several million dollars in contingency. Though the owner should rightfully retain these dollars, Schmid asserted that the cost-based documentation often gives contractors leeway with the extra funds.Schmid, along with Carol Esselink, CPA, CFE, Economic Advisory Services manager at Grant Thornton—who noted that any project is susceptible to construction fraud—described the top 10 construction fraud schemes they believe owners need to know.These include: false application for payment, where the owner winds up paying more than the total cost of work and billing for work ahead of time, as well as collusion between bidding parties, which can involve bid rigging or price fixing through bid rotation. “We think it’s important that the owner participates in the prequalification of bidders,” said Schmid, adding that owners can gain a significant amount of control if they are involved early in the process and have proper documentation and contracts that specify bid procedures.Additional fraud schemes include: change order manipulation, manipulation of the schedules of value and contingency accounts, and substituting or removing material. “There’s a saying that you break even with the base contract work and you make money on the change order,” Schmid pointed out, adding, “We frequently see that when you have a change, the risk is the change order will only include the cost for the new system and [won’t] deduct the cost of the obsolete system.”Other schemes include: diverting sum charges to time and material cost, diverting purchases and theft of equipment and tools, non-payment of subcontractors and materials suppliers, and false representations, including undocumented workers—which can have both economic and legal repercussions, noted Esselink.Despite what most people would think, Esselink asserted that the time to scrutinize conditions is when the general contractor’s line items are under budget—one of the many red flags for fraud.So what can owners who suspect fraud at the project site do? Schmid and Esselink highlighted some basic steps for owners to take to protect themselves from fraud. Some of their suggestions include:•    Schedule out the pay applications•    Compare actual to budget on a line-item basis•    Track changes in the contingency account•    Compare change order signature dates to when the work was completed•    Inventory lien waivers•    List purchased equipment and inventory what is left•    Review the subcontractor bid selection process and documentation