Lack of Internal Controls Leaves Contractors Vulnerable
During even the best of economic times, fraud is not uncommon in the construction industry. During periods of recession, however, it’s a problem that grows appreciably worse.
For various reasons, contractors historically have had weaker internal controls than in other industries. That’s alarming because even the best of companies are at risk. U.S. businesses lose more than 5% of annual revenues to fraud, according to the Association of Certified Fraud Examiners Inc. That translates to more than $652 billion in fraud losses each year.
Fraud isn’t the only reason contractors need to think about adopting formal internal controls. Controls help streamline processes, reduce waste and strengthen accounting functions. This all helps improved business.
In the construction industry, internal controls are particularly valuable because contractors tend to have operations scattered over various work sites. Fiscal controls are important because contractors, particularly in Texas, tend to be small to mid-size companies that often do not have enough bookkeeping personnel to properly segregate accounting responsibilities. While this lack of gatekeepers makes it easier to commit fraud, it also fosters a higher number of honest mistakes. For example, a masonry contractor may pay for a higher quality of stone than was actually delivered. Or an invoice may not include a discount that was promised. Or an invoice is correct, but inadvertently paid twice.
Mistakes can be prevented when all transactions are cross-checked, but that requires more than one or two people making accounting decisions. Formal internal controls help reduce honest and dishonest accounting mistakes.
There are many ways such controls can be implemented, and contractors can receive guidance from construction industry certified public accounts. The directing document is a contractor’s budget. As a projects completes, the cost should be compared to what was budgeted. Any large or unexpected variances should be researched and documented. Take action quickly. Part of this review should focus on gross profits of each project, with special attention to any shifting of cost from one job to another. Attention should be paid to costs that are included in the results of a job with significant profit fade, or one that will likely generate a loss upon completion. A job that is creating unexpected profit should have its costs compared to the original or updated job budget.
Change orders create the most budget surprises. Internal controls should include a requirement that more than one person approve any change orders.
Internal controls can be developed in various ways, but there are a few key accounting functions that should be closely monitored by any control system. Those areas are:
• Accounts Receivable: All accounts receivable should be reviewed by management each month, with special attention given to accounts approaching 90 days old. Only the owner should have the authority to write off old receivables, and an explanation of such should be kept in a formal record. Some construction companies make it the responsibility of project managers to collect receivables. This helps segregate the accounts receivable duties so that the employee responsible for entering cash receipts is not part of the collection process.
• Accounts Payable: All vendor invoices and other appropriate documentation should be approved for payment by someone other than the purchasing agent. Invoices should be attached to the check when presented for signature. This ensures that excessive quantities are not ordered or higher-than-normal prices paid. When a check is signed, it should not be returned to the person responsible for check preparation.
• Cash: When it comes to protecting cash there can’t be enough safeguards. The best protected contractors have bank statement delivered directly to the owner’s residence, or unopened at their office. Cancelled checks should be reviewed for unauthorized payees, forged signatures and unusually large dollar amounts. Review the statement for debit or credit memos and unusual items. Contractors should consider bonding all employees who handle money.
• Payroll: Management should review payroll journals in a timely manner. This guarantees that employees are being paid reasonable amounts in accordance with the payroll schedule.
• Subcontractors: Credit checks should be performed before hiring subcontractors. Consider the number of jobs a subcontractor is working on and the number of workers it employs. Proof of insurance should be required of any subcontracting firm before it is hired.