What the construction industry should know about financial statement fraud

February 24, 2014 - Spotlights

Livingstone Moyo, Grassi & Co.

Part 1 of 3
According to the Association of Certified Fraud Examiners, there are three types of accounting fraud: asset misappropriation, corruption and financial statement misrepresentation. This is the first of a three-part series that will cover areas of construction fraud that all members of the construction industry should be aware of.
Asset misappropriation occurs when an employee obtains or uses the company's assets - cash, inventory, vehicles, and so forth - for personal gain at the expense of the company. This type of fraud includes larceny, check forgery, theft, skimming, misuse of company property and resources, and other fraudulent cash disbursements.
Corruption is more often associated with government officials than employees of a company, but it can be found in every sector of the economy. Corrupt practices include bribery, invoice kickbacks, extortion, illegal gratuities, conflicts of interest and bid rigging.
The third type of fraud involves the manipulation of an enterprise's financial records that results in financial statements that are not a true or fair presentation of the enterprise's financial well-being. Such fraud may be financial fraud, such as the over or under-statement of account balance or the improper disclosure of financial information, or it may be non-financial fraud, such as the falsification of documents, employment credentials and other disclosures.
Financial statement fraud is defined as the deliberate misrepresentation of the financial position and performance of an enterprise through the intentional misstatement or omission of amounts or disclosures in the financial statements, with the objective of deceiving the financial statement users. These users vary from one entity and industry to the next, but typically include investors, lenders, vendors and customers, tax and other regulatory authorities, and even auditors. In the case of construction companies, the users also include sureties and bonding companies. This type of fraud can take literally any form, but it usually involves the overstatement of assets, revenues and profits/gains, and the understatement of liabilities, expenses/losses.
Financial statement fraud is not always the end result in itself. Usually, the fraudster's goal in "cooking the books" is to present a desired financial picture that masks the entity's true financial well-being; with the ultimate objective of influencing the decisions made by the users. These fraudsters' objectives may range from "buying more time" to quietly fix the business problems that prevent the business from achieving expected earnings, influencing market perception and share prices, achieving compliance with existing and future debt covenants, receiving performance-related bonuses, minimizing or avoiding tax payments, to hiding financial Ponzi schemes. There is virtually an infinite number of reasons a person may, or a group of persons, may collude to manipulate an entity's financial statements.
Such fraud tends to be similarly classified in nature and execution across various industry sectors, but there are certain fraudulent activities that are specific to, or more commonly affect construction companies due to the unique nature and complexities of long-term contract accounting. Due to the large number of estimates inherent to revenue recognition in contract accounting, it can be argued that it is much easier for financial statement fraud to go undetected for longer periods of time for a contractor than for many other entities. Often times, the discovery of such fraud is at the tail end of a construction project when the company has already suffered losses and it is too late to take corrective steps.
Moreover, fraud in the construction industry tends to increase significantly in both frequency and dollar-amounts during difficult economic times. Some companies and employees resort to creative and often necessary survival measures to minimize operating costs and cash outflows in the face of shrinking project margins and bidding pools.
In the construction industry, the three types of fraud mentioned above may be further categorized into two, namely:
* Fraud related to the job site and job management, and;
* Accounting and financial fraud
In either case, a single act of fraud may fall into one or more of the three types. For example, the theft of an asset on the jobsite may be concealed by the falsification of financial records back at the head office, and ultimately the financial statements. The misuse of an asset for personal gain, such as a construction vehicle, may similarly be concealed. Where collusion is involved, the act of fraud may become even more intricate and involve people on more than one job-site, and those within or outside the company, such as vendors, subcontractors, and truckers.
Incidentally, job-site fraud is more frequent than accounting and financial fraud. This is because job-site fraud is typically perpetrated by less financially-savvy construction workers on the site, in small amounts but higher frequency, which if not detected could amount to material losses for the company over time. This pilferage can easily be concealed or attributed to normal losses and breakage inherent to a construction site. The most commonly stolen items in a construction site include fuel and vehicle usage, minor parts such as oil filters, tires, batteries as well as, construction materials such as steel, copper, and cement, subcontractor and vendor over-payments for kickbacks, incorrectly reported labor hours and cash.
On the other hand, accounting and financial fraud in the construction industry tends to be less frequent but much larger in dollar-terms. A single act of financial statement fraud may have a significant impact on the financial statements, and may even be harder to detect because the perpetrators tend to be more sophisticated and more likely to take steps to successfully conceal the fraud.
If successfully concealed, the long-term cost of financial statement fraud may have a devastating impact on the profitability and cash flows of a construction company. When eventually unearthed, as is almost always the case as the extent of the fraud increases, the reputations of both the company and its officers are negatively impacted. In an industry where there is a direct relationship between reputation and successful bids, this may even spell the end of the business. For larger companies, the ripple effects of fraudulent activity may negatively impact the industry, the economy and society as a whole.
It is therefore essential for owners, managers and auditors of construction companies to understand the types and nature of various financial statement fraud schemes that are unique to this industry.
Keep an eye out for part two and three in 2014.
Livingstone Moyo, CPA, CCIFP, is manager of Grassi & Co., Jericho, N.Y.
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