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Construction Fraud Auditing

AGA/EEI Utility Internal Auditor's Training

August 26, 2015

Today’s Presenter

KEVIN MAXManaging Director

KPMG [email protected]

Objectives

• 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

2

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

4© 2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.© 2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Occupational Frauds Based On Industry – Sorted By Median LossIndustry Percent of Cases Median Loss

Mining 1.0% $900,000Real Estate 1.8% $555,000Oil and Gas 3.6% $450,000Wholesale Trade 2.3% $375,000Technology 2.9% $250,000Manufacturing 8.5% $250,000Construction 3.1% $245,000Agriculture, Forestry, Fishing and Hunting 2.0% $242,000Transportation and Warehousing 3.5% $202,000Banking and Financial Services 17.8% $200,000Services (Professional) 2.7% $180,000

Construction Fraud Statistics – 2014 Report to the Nations


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.

6© 2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Fraud Schemes by Project Phase – Pre-Construction Phase

Construction ■ Project Execution &

Monitoring■ Fraud Risk

– Product Substitution– Labor & Material

Mischarges– Kickbacks

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


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






Pre-Construction ■ Design Development

Phase■ Contract Document Phase■ Fraud Risk

– Submission Schemes– Bid Rigging Schemes

Fraud Schemes by Project Phase – Construction Phase

Post- Construction■ Project Close-Out■ Construction Defects■ Construction Claims and




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)






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



Fraud Schemes by Project Phase – Post-Construction Phase


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

Fraud Schemes by Project Phase – Post-Construction Phase (continued)


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


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



CorruptionBribes, 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



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



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



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.



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%

Lack of Reporting Mechanism, 0.7%Lack of Internal

Controls, 32.2%

Override of Existing Internal Controls,

18.9%

Lack of Management

Review, 20.0%

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

Fraud Deterrence and Prevention

Control Weakness That Contributed To Fraud


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

Fraud Deterrence and Prevention – Program Elements


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

Fraud Deterrence and Prevention – Anti-fraud Programs/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

Fraud Deterrence and Prevention – Sample Internal Controls


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.

Fraud Deterrence and Prevention – Sample Internal Controls (continued)


Fraud Detection and Response – Program Elements

Fraud Detection Program Elements

Forensic Data Analysis Hotline and Whistleblower Mechanisms Auditing and Monitoring


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


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

Construction Fraud Investigation – Analysis and Investigation


Context

One of the nation’s largest construction firms working onhigh-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

Case Study – 2014 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



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

Case Study – 2014 DBE Credit Fraud


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


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


Contract Compensation Methodologies

Lump Sum (Fixed Price)1

Cost-Plus3

Guaranteed Maximum Price (GMP)4

Hourly Not-To-Exceed (NTE)5

Time and Materials (T&M)2


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

Lump Sum (Fixed Price) Contracts

A written contract between Owner and Contractor


Time and Materials Contracts – COST BASED

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

Acquiring supplies or services at an agreed upon rate


Unit Price Contracts – COST BASED

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

Acquiring construction elements


Cost Plus Contracts – COST BASED

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

Owner agrees to pay Contractor for all project costs


Guaranteed Maximum Price (GMP) Contracts – COST BASED

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

Contractor is reimbursed for cost of work plus a fee (not to exceed contract ceiling)


Why do we audit a construction contract?

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

Key objectives are to:


When do we audit a construction contract?

1. High risk2. Fast-tracked schedule3. Possible hidden charges/ cost overruns4. Complex contract terms5. Contract size6. Long-term contracts7. Scope changes8. Compensation and payment terms9. Disputes with Contractor

The time is right due to various factors involving:


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


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

Construction Audit Work Plan – FOR COST BASED CONTRACTS



Detailed Testing of Direct Labor

■ Select sample of labor charges

■ 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



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



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



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


Construction Audit of Cost Based Contracts

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?

Billable Amount – Invoiced Amount = Overbilling or Under Billing



Horizontal Analysis

Project Start

Invoice #1 Invoice #2 Invoice #3 Final Invoice

…Project Completion

& Closeout

Vertical Analysis

Job Cost Report

Final Invoice

Cost vs. Payment Reconciliation

JCR Analysis & Sampling

Subcontractor Pay App Testing

Labor Rate Analysis

Vendor Invoice Testing

Recurring During the Life of the Project

One –Tim

e Analysis


1. Original Contract2. Change Orders3. Last application for payment 4. Latest job cost report (JCR)5. Construction in Progress (CIP) Report6. Financial Statements7. 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

Getting the Big Picture:Key Documents to Consider:



Example Contract Terms



Performing a preliminary rate audit, contract review and assessment of GMP to identify findings early.

Find:Miscalculations in bonds, fees, and insurance and build up costs with a relatively low investment.

Main Components: Often Overstated:

FICA, Unemployment tax calculations, Benefits, Insurance, paid time off

1. Statutory rates vs. effective rates

2. Experience modifiers


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

Typical Areas of Adjustment




Labor Burden Description

Comment

Health and Welfare Contractor did not pay at rate usedPension Contractor did not pay at rate usedAssociation Dues Component of overheadSpecialty Training Component of overheadSmall Tools Contract specifically excludesGas and Truck Premium Gas cost is not generally considered a labor costAllocation for Computer Computers are not generally considered a labor costSUTA/FUTA/FICA Limitations excludedWorker’s Compensation Contractor did not pay at rate used



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




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




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 equipment5. Related party transactions

and hidden profit centers6. Small tools, computers and

furniture (Where did it all go?)7. Insufficient support or discrepancies

from source document




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




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





1. Progress Reports

2. Submittal Log

3. Schedules and schedule updates

4. Bid documentation

5. Inspection and testing reports

6. Warranties and Operation and Maintenance (O&M) manuals

7. Site pictures

8. Daily Reports

9. Safety Reports

10. Meeting Minutes

11. Punch list progress

Contract Deliverables/Documentation Requirements:


Construction Audit of Cost Based ContractsLabor Rate Audit

Job Cost Report Payroll Distribution Report Payroll Detail Report Timesheets Payroll Register or Certified Payroll

Three most misstated payroll burdens:– Taxes– Insurance– Paid Time Off (PTO)

Analyze the following reports:

Detailed Testing of Labor Rates



Using statutory rate for unemployment taxes

Multiplying the tax rate times the total payroll

Including union envelope deductions

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

Common Errors of Tax Burden Calculations

Common Errors of Paid Time Off (PTO)



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

Common Errors in Other Benefits Calculations

Thank You

KPMG

Kevin Max

212-872-6899

[email protected]

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

© 2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

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