Construction Fraud Auditing

Transcription

1 Construction Fraud Auditing AGA/EEI Utility Internal Auditor's Training August 26, 2015

2 KEVIN MAX Managing Director KPMG LLP Today s Presenter

3 Describe the most common types of construction fraud Identify the indicators, red flags, and control weakness often associated with construction fraud Discuss methodologies employed to detect and investigate construction fraud Describe leading practices and controls designed to prevent construction fraud Understand the key aspects of the most common types of construction contracts Describe the key considerations, techniques, most likely findings and indications of fraud when auditing construction projects Objectives 2

4 Agenda Construction Fraud: Headlines, Surveys and Statistics Fraud Schemes by Project Phase Indicators of Construction Fraud Fraud Deterrence and Prevention Fraud Detection and Response Construction Fraud Investigation Notable Construction Fraud Cases Auditing Construction Projects for Fraud

5 Construction Fraud Statistics 2014 Report to the Nations Occupational Frauds Based On Industry Sorted By Median Loss Industry Percent of Cases Median Loss Mining 1.0% $900,000 Real Estate 1.8% $555,000 Oil and Gas 3.6% $450,000 Wholesale Trade 2.3% $375,000 Technology 2.9% $250,000 Manufacturing 8.5% $250,000 Construction 3.1% $245,000 Agriculture, Forestry, Fishing and Hunting 2.0% $242,000 Transportation and Warehousing 3.5% $202,000 Banking and Financial Services 17.8% $200,000 Services (Professional) 2.7% $180,000 4

6 Construction Fraud Statistics What other surveys say about fraud AFCE 2014 Report to the Nations The typical organization loses 5% of revenues each year due to fraud. 5

7 Fraud Schemes by Project Phase Pre-Construction Phase Pre-Construction Design Development Contract Documents Fraud Risk Contract and Procurement Fraud (Bid Submission and Rigging Schemes) Post- Construction Project Close-Out Construction Claims and Disputes Fraud Risk Inflated Change Orders and Claims Construction Project Execution & Monitoring Fraud Risk Product Substitution Labor & Material Mischarges Kickbacks firms 6

8 Fraud Schemes by Project Phase Pre-Construction Phase (continued) The most prominent schemes involved at this phase of contracting are: Bid Submission Schemes: Collusion between buyer and contractor or contending companies to create an unfair advantage to one of the bidding parties during the bid submission process Bid Rigging Schemes: Conspiracy, usually between competing contractors, to artificially raise prices of submissions and create a larger profit margin firms 7

9 Fraud Schemes by Project Phase Construction Phase Pre-Construction Design Development Phase Contract Document Phase Fraud Risk Submission Schemes Bid Rigging Schemes Post- Construction Project Close-Out Construction Defects Construction Claims and Disputes Fraud Risk Inflated Change Orders and Claims Construction Project Execution & Monitoring Fraud Risk Product Substitution Labor & Material Mischarges Kickbacks firms 8

10 Fraud Schemes by Project Phase Construction Phase (continued) Product Substitution Contractor can increase profit by substituting contract specified products with less expensive or more convenient alternatives Accounting, Material and Labor Mischarges Unallowable charges Raw materials used on different projects Labor charged to various projects Related Party Transactions General Contractor may subcontract with related parties or use vendors owned by the general contractor itself, thus creating hidden profit centers Prevailing Wage Fraud Contractors and subcontractors fraudulently avoid paying the prevailing wage or fringe benefits in violation of the Davis Bacon and Related Act (DBRA) firms 9

11 Fraud Schemes by Project Phase Post-Construction Phase Pre-Construction Design Development Phase Contract Document Phase Fraud Risk Submission Schemes Bid Rigging Schemes Post- Construction Project Close-Out Construction Defects Construction Claims and Disputes Fraud Risk Inflated Change Orders and Claims Construction Project Execution & Monitoring Fraud Risk Product Substitution Labor & Material Mischarges Kickbacks firms 10

12 Fraud Schemes by Project Phase Post-Construction Phase (continued) Inflated and/or Unjustified Change Orders: Contractors may inflate the cost and impact of change orders in order to make additional profit or submit change orders with no merits Inflated and/or Unjustified Claims: Contractors may inflate the claim amount or submit claims with no merits firms 11

13 Indicators of Construction Fraud Contract Development Omitted / modified right-to-audit clause Unclear change order language Omitted termination for convenience clause Missing attachments Weak language regarding to reimbursable expenses, general conditions, overhead Minimal guidance on subcontracting bidding, form of contracts Unreasonably narrow contract specifications 12

14 Indicators of Construction Fraud Bid Submission Schemes Few bidders respond to request for bids Unusual or unreasonable specifications High number of awards to one supplier Allowing an unreasonably short time period to bid Unreasonable pre-qualification procedures Failure to adequately publicize request for bids Splitting purchases or otherwise limiting contract amounts to under competitive bidding limits Winning bid substantially exceeds cost estimates, published price lists, similar jobs, or industry averages Rotation of winning bidders by job, type of work, or geographical area 13

15 Indicators of Construction Fraud Corruption Bribes, Kickbacks & Conflict of Interest Unusual favoritism of a particular contractor or vendor Vendor EIN matches employee SSN Vendor address or telephone number matches one related to an employee Employees appear overly familiar with vendors or bidders An employee who insists that contractors use a certain subcontractor, agent, middleman or broker An employee who takes an unusual interest in certain transactions, contractor or accounts or assumes responsibility for matters beyond the normal scope of his or her duties 14

16 Indicators of Construction Fraud Billing Schemes Frequency of math errors Charging project separately for costs typically included in markup or fee Duplicate copies of invoices Structuring and interpreting incentives clauses Payroll burden, insurance and bond costs calculated incorrectly Product substitution Front-loading projects Change order pricing and negotiation 15

17 Indicators of Construction Fraud Related-Party Transactions Firm continuously contracts with same vendors in order to supply products or services in a competitive and active market Vendors/employees have unique names in billings and invoices, but identical tax ID numbers, billing addresses, or social security numbers Parties involved on opposite sides of a transaction share employment history or similar past 16

18 Indicators of Construction Fraud Prevailing Wage The number of workers on a project exceeds the number reported in the contractor s certified payroll. The contractor pays its worker s salaries in cash Corrupt union officials enter into a wide variety of sweetheart contracts with organized crime. Collusive arrangements between union officials and employers that occur at the expense of union members or corruption within the unions themselves. 17

19 Fraud Deterrence and Prevention Control Weakness That Contributed To Fraud Lack of Management Review, 20.0% Poor Tone at the Top, 8.4% Lack of Competent Personnel in Oversight Roles, 7.1% Lack of Independent Checks/Audits, 3.5% Lack of Employee Fraud Education, 2.9% Lack of Clear Lines of Authority, 1.5% Override of Existing Internal Controls, 18.9% Lack of Internal Controls, 32.2% Lack of Reporting Mechanism, 0.7% The Survey was performed by the American Certified Fraud Examiners Association and was reported in the 2014 Report to the Nations on Occupational Fraud and Abuse 18

20 Fraud Deterrence and Prevention Program Elements Fraud Prevention Program Elements Fraud and Misconduct Risk Assessment Code of Conduct Training Programs Proactive fraud auditing Background checks Fraud hotlines Implementing and Monitoring Internal Controls Employee and Third-Party Due Diligence Process-Specific Fraud Risk Controls 19

21 Fraud Deterrence and Prevention Anti-fraud Programs/Controls Management Guidance to Help Prevent and Deter Fraud Creating a Culture of Honesty and High Ethics Evaluating Anti-fraud Processes and Controls Whistleblower Complaint Procedures Developing an Appropriate Oversight Process Continuous Auditing and Monitoring 20

22 Fraud Deterrence and Prevention Sample Internal Controls Internal Controls Guidance Written policies and procedures Defined processes around key control points and quality control process Changes to payroll require an approval notification from the personnel department Audit trail of changes maintained 21

23 Fraud Deterrence and Prevention Sample Internal Controls (continued) Internal Controls Guidance Vendor screening/pre-qualification Security over site Authorization process for payments, scope changes clear delegation of authority Audit clause built into contracts and exercised Independent review compliance with policies Routine monitoring of costs against baseline, duplicate payments, forecasted cost to complete, etc. 22

24 Fraud Detection and Response Program Elements Fraud Detection Program Elements Forensic Data Analysis Hotline and Whistleblower Mechanisms Auditing and Monitoring 23

25 Fraud Detection and Response Considerations Once (Possible) Fraud is Detected Seek legal advice immediately Identify the type of fraud Employee fraud dismissal or prosecution of employees? Vendor fraud Misconduct involving a high-level officers, executives or managers Financial reporting fraud Complaints involving the Foreign Corrupt Practices Act (FCPA) Certain industry practices 24

26 Construction Fraud Investigation Analysis and Investigation Internal Control Analysis and Investigation Corporate Background Checks Individual Background Checks Net Worth Analysis Surveillance Digital Data Analysis Computer Forensics Tracing illicit funds Interviewing Witnesses and Suspects Confirmation with Customers and Vendors 25

27 Case Study 2014 Billing Scheme Context One of the nation s largest construction firms working on high-profile buildings in Manhattan over a 5 year period General contractor arranged for electrical, plumbing, drywall, and other subcontractors to falsely inflate their bills Company told contractors to raise prices to account for unnecessary contingencies under an addendum whose existence was never revealed to the client Falsified business records defrauded multiple clients out of tens of millions of dollars Resulted in $55 million forfeiture in penalties Billing scheme occurred less than 10 years after the same contractor was involved in a major bid rigging scheme 26

28 Case Study 2012 Billing Scheme Context Large contractor working in New York City Metropolitan area Added unworked hours to labor foremen s timesheets over a ten-year period Overbilling scheme occurred on every project in the city during that decade, excluding the National September 11 Memorial and Museum Company also abused affirmative-action programs designed to aid small businesses and woman/minority-owned businesses DBE-credited work was performed by contractor employees who were transferred to smaller companies payrolls Company forced to pay $40.5 million in fines and $16 million in restitution to victims 27

29 Case Study 2014 DBE Credit Fraud Context Large contractor performing multiple major transportation projects in Chicago Used woman-owned company as a pass-through to obtain required Disadvantaged Business Enterprise (DBE) credits Contractor controlled the DBE-credited portion of the work under the title of the woman-owned business and hired union workers to perform associated work Contractor operated using woman-owned business letterhead for invoices and paperwork Lawsuit filed by project manager of DBE company under Whistleblower Provisions of the Federal and State False Claims Act Resulted in $12 million settlement for contractor 28

30 Case Study 2015 Billing Scheme Context Large general contractor performing work in NYC metropolitan area Contractor added unworked hours to union foremen s time sheets and billed at rates higher than agreed upon contract rates. Addition of a few hours per day over an 8-year time span of projects resulted in over $1 million in overpayment by the owner Contractor owed $7 million in penalties and restitution to the victims 29

31 Auditing Construction Projects for Fraud Contract Types Why and When to Audit Lump Sum Contract Audits Cost Based Contract Audits Construction Audit Workplan Labor Rate Audits

32 Contract Compensation Methodologies 1 Lump Sum (Fixed Price) 2 Time and Materials (T&M) 3 Cost-Plus 4 Guaranteed Maximum Price (GMP) 5 Hourly Not-To-Exceed (NTE) 31

33 Lump Sum (Fixed Price) Contracts A written contract between Owner and Contractor Characteristics: Does not accurately reflect Contractor s Actual Costs Best used when scope of work is clearly defined and/or there is competition Associated with Change Orders Not appropriate for projects subject to change Benefits: Hardest cap/limit on maximum cost exposure Least amount of time to administer payments 32

34 Time and Materials Contracts COST BASED Acquiring supplies or services at an agreed upon rate Characteristics: No agreed to maximum price Highly uncertain labor hours and/or material requirements Owner assumes the risk inherent in the contract No incentive for the contractor to control costs Used when no other contract is suitable Benefits: Work starts without negotiating LS or GMP Project not slowed by changes to LS or GMP 33

35 Unit Price Contracts COST BASED Acquiring construction elements Characteristics: Removes risks of inaccurate estimation of uncertain quantities Includes Engineer s estimate of units needed Permits overage or under-run of number of units Contractor s cost is irrelevant Unit price includes labor, materials, overhead and profit Benefits: No requirement for Owner to pay for uncompleted work Flexibility in changes to the work 34

36 Cost Plus Contracts COST BASED Owner agrees to pay Contractor for all project costs Characteristics: Costs are broken up into: Direct Cost of Work General Conditions Fees Fee: percentage of project costs; not tied directly to labor Shares similar characteristics to T&M Requires clear definition of allowable cost and well-defined scope Benefits: Work starts without negotiating LS or GMP Useful where nature of work may change 35

37 Guaranteed Maximum Price (GMP) Contracts COST BASED Contractor is reimbursed for cost of work plus a fee (not to exceed contract ceiling) Characteristics: Hybrid between Lump Sum and Time and Materials Very few disadvantages to the Owner (assurance that cost will not exceed upper limit) Contractor assumes risk Benefits: Fixed Price Involves Contractor at design phase Owner influence over subcontractor bid and selection process 36

38 Why do we audit a construction contract? Key objectives are to: Address management concerns Identify opportunities for cost savings/ recovery Help ensure controls are adequately maintained Assess compliance with contract terms Provide objective verifications of payments Minimize disputes Keep projects on track/ get them back on track Serves as an important internal control element Document and identify lessons learned 37

39 When do we audit a construction contract? The time is right due to various factors involving: 1. High risk 2. Fast-tracked schedule 3. Possible hidden charges/ cost overruns 4. Complex contract terms 5. Contract size 6. Long-term contracts 7. Scope changes 8. Compensation and payment terms 9. Disputes with Contractor 38

40 Construction Audit of Lump Sum (Fixed fee) Contracts Key Tasks Bid on complete construction documents Verify the initial pricing/ proposal Establish high standards for documenting change orders Monitor quantity and quality of work installed Perform key check of special terms of contract Typical Lump Sum Contract Overcharges Specified quality of materials/equipment not used Specified services or requirements not provided Contract quantities not installed Contract work performed by others Deliverables such as status updates, schedules, inspection reports not provided Requests for additional time Additional Considerations for Lump Sum Contracts Detailed assessment of forecasted costs at completion Identifying root cause of budget overruns (Budget to EAC) Assess adequacy of contingency Review major changes to the contract price 39

41 Construction Audit Work Plan FOR COST BASED CONTRACTS Information Collection and Review High Level 1. Review agreement between Contractor and Owner 2. Prepare document request form 3. Conduct interviews 4. Review payment documentation/calculations Next Steps: Document the Guaranteed Maximum Price (GMP) or contract ceiling Reconcile Job Cost Report to Application for Payment Review Application for Payment for non-reimbursable charges, if any 40

42 Construction Audit Work Plan FOR COST BASED CONTRACTS Select sample of labor charges Detailed Testing of Direct Labor Reconcile hours reported on labor distribution report or certified to time cards Trace hours incurred to the labor distribution reports and to contractor s payroll register; then to cancelled checks or wire transfers Verify rates charged agree with union agreement Trace exempt salaries to their respective annual salaries for sample periods 41

43 Construction Audit Work Plan FOR COST BASED CONTRACTS Detailed Testing of Labor Burden Ascertain basis for Contractor charges Payroll Taxes Insurance Fringe Benefits Test burden for same sample of employees used Determine charges Federal Unemployment Tax (FUTA) State Unemployment Tax (SUTA) Social Security Tax (FICA) Worker s Compensation insurance Review components of burden 42

44 Construction Audit Work Plan FOR COST BASED CONTRACTS Detailed Testing of Reimbursable Expenses Select exempt employees Verify travel-related expenses Detailed Testing of Materials Determine a sample of materials transactions Trace sample to supporting invoices Verify: Dollar amounts are correctly posted Discounts have been taken Compare: Original quantity take-offs of materials to amounts purchased Descriptions of materials on invoices and delivery tickets to specifications 43

45 Construction Audit Work Plan FOR COST BASED CONTRACTS Detailed Testing of Subcontractors Determine a sample of subcontractor transactions Trace sample to supporting invoices Vouch cancelled checks Verify discounts Inquire as to any billing disputes Determine pricing of original subcontract bids Determine compliance with competitive bidding requirements Review subcontractor change orders and basis for pricing Determine extent of review the Contractor provides for subcontract billings Ensure lien waivers are obtained 44

46 Construction Audit of Cost Based Contracts Billable Amount Invoiced Amount = Overbilling or Under Billing 1. What is the contractual value or GMP? 2. What are the contractor s costs? 3. What are the adjustments to the costs? 4. What are the billable costs? 5. What was actually invoiced? 45

47 Construction Audit of Cost Based Contracts Horizontal Analysis Project Start Invoice #1 Invoice #2 Invoice #3 Final Invoice Recurring During the Life of the Project Project Completion & Closeout One Time Analysis Job Cost Report Final Invoice Cost vs. Payment Reconciliation Vertical Analysis JCR Analysis & Sampling Subcontractor Pay App Testing Vendor Invoice Testing Labor Rate Analysis 46

48 Construction Audit of Cost Based Contracts Key Documents to Consider: Getting the Big Picture: 1. Original Contract 2. Change Orders 3. Last application for payment 4. Latest job cost report (JCR) 5. Construction in Progress (CIP) Report 6. Financial Statements 7. Labor Distribution Report (or equivalent) 8. Access to all supporting documentation 1. Reconcile Contract Value to Job Cost Report (JCR) and to Invoiced Amounts 2. Determine Contractor s reimbursable costs 47

49 Construction Audit of Cost Based Contracts Example Contract Terms 48

50 Construction Audit of Cost Based Contracts Performing a preliminary rate audit, contract review and assessment of GMP to identify findings early. Main Components: FICA, Unemployment tax calculations, Benefits, Insurance, paid time off Often Overstated: 1. Statutory rates vs. effective rates 2. Experience modifiers Find: Miscalculations in bonds, fees, and insurance and build up costs with a relatively low investment. 49

51 Construction Audit of Cost Based Contracts Typical Areas of Adjustment LABOR 1. Overhead 2. Double-dipping on home office overhead 3. Inflated burden 4. Parked Labor 5. Vacation, holidays and personal time 6. Incorrect hours charged 7. Rates charged 8. Ghost employees 9. Adjustments due to missing/inconsistent source documentation 50

52 Construction Audit of Cost Based Contracts Typical Areas of Adjustment Labor Burden Description Health and Welfare Pension Association Dues Specialty Training Small Tools Gas and Truck Premium Allocation for Computer SUTA/FUTA/FICA Worker s Compensation Comment Contractor did not pay at rate used Contractor did not pay at rate used Component of overhead Component of overhead Contract specifically excludes Gas cost is not generally considered a labor cost Computers are not generally considered a labor cost Limitations excluded Contractor did not pay at rate used 51

53 Construction Audit of Cost Based Contracts Typical Areas of Adjustment MATERIALS 1. Compromised quality and compliance 2. Unused materials 3. Materials billed; used on different site 4. Overstated haul-in/haul-out quantities 5. Insufficient support/discrepancies from source documents 6. Discounts 52

54 Construction Audit of Cost Based Contracts Typical Areas of Adjustment EQUIPMENT 1. Charges exceed purchase price or rental maximum 2. Major maintenance and equipment overhaul 3. Parked equipment (idle vs. standby) 4. Non-existent equipment 5. Related party transactions and hidden profit centers 6. Small tools, computers and furniture (Where did it all go?) 7. Insufficient support or discrepancies from source document 53

55 Construction Audit of Cost Based Contracts Typical Areas of Adjustment EQUIPMENT RATE REFERENCES 1. Charges exceed purchase price or rental maximum 2. Major maintenance and equipment overhaul 3. Parked equipment (idle vs. standby) 4. Non-existent equipment 5. Related party transactions and hidden profit centers 6. Small tools, computers and furniture (Where did it all go?) 7. Insufficient support or discrepancies from source document 54

56 Construction Audit of Cost Based Contracts Typical Areas of Adjustment SUBCONTRACTORS 1. Pay early discounts 2. Incorrect Mark-up 3. Kick-backs 4. Fictitious vendors 5. Unauthorized overtime 6. Related party transactions 7. Falsified inspection reports or certifications 8. Not a minority or disadvantaged business enterprise 9. Corrective work 55

57 Construction Audit of Cost Based Contracts Typical Areas of Adjustment MISCELLANEOUS 1. Reversals, accruals, adjusting entries 2. Costs incurred prior to start of or after completion of construction 3. Large amounts 4. Payments to individuals 5. Legal costs, training, social events 6. Items covered by mark-up per definition of the contract 7. Non-descriptive/nonsensical entries 8. Warranty work 9. Rework and repairs 56

58 Construction Audit of Cost Based Contracts Contract Deliverables/Documentation Requirements: 1. Progress Reports 2. Submittal Log 3. Schedules and schedule updates 4. Bid documentation 8. Daily Reports 9. Safety Reports 10. Meeting Minutes 11. Punch list progress 5. Inspection and testing reports 6. Warranties and Operation and Maintenance (O&M) manuals 7. Site pictures 57

59 Construction Audit of Cost Based Contracts Labor Rate Audit Analyze the following reports: Job Cost Report Payroll Distribution Report Payroll Detail Report Timesheets Payroll Register or Certified Payroll Detailed Testing of Labor Rates Three most misstated payroll burdens: Taxes Insurance Paid Time Off (PTO) 58

60 Construction Audit of Cost Based Contracts Labor Rate Audit Common Errors of Tax Burden Calculations Using statutory rate for unemployment taxes Multiplying the tax rate times the total payroll Including union envelope deductions Common Errors of Paid Time Off (PTO) Claiming burdens for paid time off when such hours are charged directly to the project rather than to an overhead pool Dividing the costs for the time off by a full year s payroll 59

61 Construction Audit of Cost Based Contracts Labor Rate Audit Common Errors in Other Benefits Calculations Overall payroll burden fringe benefits and union payments Including union envelope deductions payments by the employee to the union Increasing the cost of medical insurance by the amount deducted from the employee s check Confirm handling of payroll register Reducing the cost of medical insurance 60

62 Thank You KPMG Kevin Max

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