Faults in the Foundation: Exposing Fraud in Construction

Would it surprise you to know that, compared to other industries, the construction industry stands out as one of the most susceptible to fraud?

There are many reasons for this. Among them are the general complex nature of construction projects; with each project often including a large number of parties (owner, general contractor, subcontractors, suppliers, the people at the job site that make it all happen, and then the people in the back offices at each of these companies that bill, collect, make payroll, and more.)

Add to this an even more general, and often generally accepted, lack of transparency with the data and details related to these projects, and fraudulent activities are increasing at numbers far greater than we see in other industries.

Then, tack on that the construction industry is often considered one of the industries that lags behind others in adopting sophisticated practices and technologies, and you have an industry that is particularly susceptible to bad actors and fraudulent activities.

No wonder that leading organizations in data, security, and credit risk – such as Kroll, Dodge, and Red Flag Alert – provide regular reports on not only the amount of construction fraud reports globally, but also the negative effects they have on the industry as a whole.

Reports are most useful supported by actual data, so let’s look at some numbers.

Construction Fraud Statistics

In Kroll’s 2023 Annual Global Fraud and Risk Report, four out of five respondents said their organizations had been impacted by fraud or other serious misconduct, 78% had conducted investigations into fraud or related misconduct in the past 3 years, and 98% said their organizations had brought in outside expertise to assist with an investigation of fraud.

The same year, Dodge reported that new U.S. non-residential construction spending was $979.5B, and statistics suggested that fraud accounted for as much as 10% of all construction costs. That amounts to a staggering $98,000,000,000 (or $98 billion dollars) in industry-related fraud.

Then in November of 2024, Red Flag Alert reported that among the many challenges they see facing the construction industry, fraud is one of the most widespread; and all companies are at risk.

But why?

One reasons is that most construction business owners do not believe they are at risk, nor do they realize that fraud risk avoidance begins with them. A second reason is that even though construction is seen as an audit-heavy industry (with financial audits for banking, bonding, and insurance requirements), in general many contractors run their operations in a loose and risky manner.

Common Construction Fraud Schemes

The lax practices that enable fraud are all too common. Businesses may: (i) have too few checks and balances related to financial activities (i.e. billing, payments, payroll), (ii) be slow in adopting modern accounting systems and technologies (i.e., integrated accounting and operations systems, otherwise known as ERP systems), and (iii) generally lack concern when it comes to proactively preventing fraud and potential fraudulent behavior that arises. Factors like these create opportunity for various forms of fraud that are common in construction, including change order (CO) manipulation, diversion of lump-sum costs to T&M cost, diverted purchases, false representations, manipulation of SOV accounts, payroll theft, procurement/purchasing fraud, subcontractor collusion, substituted materials, and theft.

Without proper checks and balances, fraud becomes an elevated risk. To combat fraud, businesses in construction need to refine their practices and take action, particularly when any of the symptoms of the “Fraud Triangle” present themselves.

The Fraud Triangle

The “Fraud Triangle” consists of the following three components: 1) Pressure, 2) Opportunity, 3) Rationalization.

“Pressure” relates to a staff person or other individual that is close to the contractor (such as a staff person at a vendor or subcontractor that is under personal pressure due to any number of circumstances. These can include a sick child or spouse, drug or gambling problems, marital problems, or some other financial hardship that could have them act out in a way that they might not without the pressure.)

“Opportunity” relates to a staff person or other person that is close to the contractor (such as a staff person at a vendor or subcontractor) sees or senses an opportunity and believes the chances of getting caught are minimal. One example might be a Project Manager (PM) that knows that the contractor he or she works for does not have an integrated system for CO’s, thus the accounting department may never know one exists if the PM doesn’t turn it in. The PM then either creates a CO in Microsoft Word (outside of the accounting system) or verbally agrees to it, then colludes with the project’s owner or general contractor to hide the CO so that it does not increase the contract value. Then the PM provides for labor and materials to perform work for which the owner or contractor is never billed for and takes a commission from the owner or contractor (typically, a percentage of the CO’s value.) The added cost to the contractor then reduces the project’s profit percentage, but maybe not by enough that anyone is alerted. Then, the PM may do this again on other projects. Yet another example is a PM colluding with a subcontractor to inflate the cost of a CO and then sharing in the inflated fee and payment.

“Rationalization” relates to a worker that thinks that since the construction company owner drives a Mercedez, lives in a wealthy community, or there is a general sense of wealth associated with the owner, that they owner will not miss a few dollars here or there. So, without any checks and balances to abide by, the worker may steal materials and sell them or throw out or otherwise waste good materials.

Stamping Out Construction Fraud

So how can construction fraud be avoided? Here are a few simple things you can do to prevent it:

• Use a Construction Expert CPA Firm – construction expert CPA firms, as opposed to general practice firms, can often spot reporting anomalies, profit fade, and other “off” scenarios that can help expose fraudulent activities.
• Use Integrated Systems – accounting systems with unified operations components (such as CO’s) can significantly reduce the opportunity for fraudulent activities.
• Use checks and balances – systems where one person creates the payroll or payables, and another reviews, approves, and processes it, reduce the chances of fraud occurring.

And most important, watch for red flags, look out for the “Fraud Triangle” warning signs, and always trust your gut.

This article includes input from Chuck Schwartz, Director, CBIZ