construction advisor spring 2008

Spring 08 - Internal Controls Keep the Ship Tight

Our series on fraud in the construction industry continues with a discussion about the benefits of
internal controls.

Recent scandals and legislation have focused attention on the role of strong internal controls in
deterring fraud in large public corporations. But controls are valuable for contractors too – not only
to prevent fraud, but to improve operational efficiency and reduce unnecessary day-to-day losses.

There are different types of controls, but most revolve around a few central principles. These include
cross-checking of documents, segregation of duties and multiple approvals for transactions.

Losses from Error
Money slips through cracks on construction jobs. A carpenter pays an invoice for more expensive
wood than was actually delivered. Two framing employees draw duplicate checks. A mountain of
sheetrock sits untouched for a year. There’s no malevolence at work in these losses – just oldfashioned
error. Contractors may not notice such leakage, particularly in busy times, but ultimately it
takes cash from their pockets.

Losses from Fraud
Embezzlement is an age-old problem for all industries. During a bookkeeper’s long absence, a coworker
discovers a vendor he’s never heard of. An investigation reveals the bookkeeper had set up
several fake vendors, and over the years had paid them (that is, paid herself) more than a hundred
thousand dollars.

But in construction, theft of materials is just as big a problem. Work is performed at remote locations,
purchasing authority is spread widely and some materials are difficult to estimate precisely before
and after use. So a project manager builds an addition to his kitchen with supplies he pilfered from
his employer’s inventory.

Some capers are discovered long after the fact, but others are never exposed. The heists add up
over time, but each is inconspicuous in itself. And often the perpetrators are able to hide their tracks,
especially if the contractor isn’t tracking job costs closely.

Preventable Losses
Cross-checks could have avoided some of these losses. When paid invoices are compared with
delivery receipts and purchase orders, or time clocks with payroll records, these documents can
reveal errors and deliberate manipulation.

Segregating duties can also prevent losses. In our examples, duties were combined. The person
setting up new vendors was the same approving invoices and drafting checks. The PM who ordered
kitchen tile also received it, distributed it and tracked costs.

Contractors tend to have weaker internal controls than companies in other industries. Owners often
start out keeping the books themselves, and even after they hire a bookkeeper, they stay close to
the process. But as their business grows, they keep the same small accounting staff.

If such contractors hire qualified people to perform those tasks, and also put strong controls in place,
they can be confident knowing that no invoice is paid without multiple approvals, that receipts are
checked against bank deposits, and that these and other checks are performed as a matter of
course by different employees.

Getting Help with Internal Controls
An accountant can help contractors set up new controls or test systems already in place.

Testing is especially important, because even though management believes controls exist, doesn’t
mean they are in practice. For that reason, today’s standards recommend that consultants not
simply ask about controls and document the answers, but walk through transactions alongside
employees.

Necessary But Not Sufficient
Internal controls can minimize leakage and deter fraud. Like burglars who avoid houses with barking
dogs, fraudsters are less inclined to pilfer companies whose transactions are automatically
scrutinized by others.

However, controls may not stop determined thieves, particularly those who work as a team – one in
purchasing, one in payables – and manage to circumvent controls.

Still, a systematic approach to internal controls can make a contractor far less vulnerable.

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The Construction Advisor is produced quarterly by Bober Markey Fedorovich's Construction
Services Team. For questions about fraud, internal controls or to learn more about the
services we provide, please contact Dale A. Ruther, CPA, CIT, CDS at 330.762.9785 or by email.

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