October 30th, 2018 Study Shows Controls Can Reduce Losses By Jason DaPonte, CPA, CCIFP, CIT, Managing Partner None of us like to think that our own employees could steal from the company, but the risk of fraud is an unfortunate fact of life for any contractor. According to a recently released study by the Association of Certified Fraud Examiners (ACFE), among all the various types of fraud your company might encounter, the “largest and most prevalent threat” comes from occupational or internal fraud—that is, fraud committed by your own employees or managers. Every two years the ACFE issues its “Report to the Nations” on internal fraud schemes such as embezzlement, misappropriation of funds, phony expenses, bribes, and kickbacks. Based on information that CFEs report from real fraud cases around the world, the study is widely regarded as the most comprehensive source of occupational fraud data. The new report shows that the construction industry remains at risk for larger-than-average losses from such schemes. In the 2018 survey, the median loss from cases in the construction industry was $227,000. That’s down slightly from earlier years but still large enough to do serious financial damage to almost any contractor or subcontractor. Reducing Fraud Losses While it is impossible to eliminate the threat of internal fraud, the ACFE study found that the median losses in companies with strong anti-fraud controls is considerably lower than the losses in companies without such controls. For example, when comparing fraud losses across companies in all industries, the study found the median loss in companies where there was a written code of conduct was $110,000, while the median loss among companies without such a code was $250,000. Likewise, the median loss in companies that conducted surprise audits or management reviews was half the size of the median loss in companies that did not engage in such practices. There was a similar reduction in median losses among companies that had anti-fraud hotlines in place. While such controls might not prevent fraud altogether, they can help uncover fraud schemes earlier and thus keep the losses from continuing to grow over an extended period. The sooner the fraud is detected, the sooner the bleeding can be stopped. Common Fraud Schemes Occupational fraud can take many forms, and construction companies are vulnerable to just about all of them. Corruption cases such as bid-rigging and bribery were the leading types of reported fraud among construction businesses in the 2018 report, accounting for 42 percent of reported cases. Billing-related schemes—such as payments to shell companies or vendor fraud with insider help—ran a close second, accounting for 37 percent of construction industry cases. Construction businesses are particularly susceptible to another common type of fraud—material theft. Most work is performed at remote sites away from company headquarters. Moreover, materials such as lumber, concrete, copper pipe, wire, and cable can be difficult to identify and track to a specific job, making it easy to divert them to other purposes. A related risk involves the misappropriation of equipment. An example would be employees who operate side businesses using their employer’s supposedly idle equipment. Breaking the “Fraud Triangle” Despite the almost-endless variety of schemes that fraudsters devise, all fraud incidents share three common characteristics. Criminologist Donald Cressey identified these in his landmark 1953 book, Other Peoples’ Money: A Study in the Social Psychology of Embezzlement. As Cressey explained, three conditions must exist for a fraud scheme to develop. These conditions are sometimes referred to as the “Fraud Triangle”: Motive (or pressure)—This could result from unexpected financial pressures such as a spouse’s layoff, unexpected medical bills, or simply from living beyond one’s means. A less-obvious type of pressure is the stress involved in meeting business goals, quotas, or an employer’s expectations. Rationalization—Most employees who commit fraud do not view themselves as criminals. In fact, most consider themselves to be honest and honorable, and have found a way to rationalize their dishonest behavior. Often, they tell themselves that their theft is only temporary and that they’ll pay it back or that the company owes it to them anyway. Opportunity—Regardless of motives and internal rationalization, a fraud scheme cannot begin until a fraudster sees an opportunity to get away with it. This is where you, as an employer, have the greatest ability to deter fraud by establishing a strong system of internal controls. (See the article, “Reducing Losses, Managing Risks” on this page.) It’s also important that company management sets the right tone from the top. Make it clear you are committed to ethical behavior—always treating clients, vendors, and employees honestly and fairly. Stay tuned for our November news brief, which will address certain policies and procedures that will help mitigate some of these fraud risks. For more information on Sansiveri’s Construction and Related Services Group and how we can help implement controls and strategies to help mitigate fraud risks, please contact Jason DaPonte at 401-752-0558.