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Recent business scandals and legislation have focused attention on the role of strong internal controls in deterring fraud in large public corporations.

Controls are valuable for contractors too — not only to prevent fraud, but also to improve operational efficiency and reduce unnecessary day-to-day losses. For some companies, internal controls can lead to a significant increase in profit.

There are different types of controls, but most revolve around a few central principles. These include segregation of duties, multiple approvals for transactions and cross-checking of documents.

Losses from Error

Money slips through cracks on construction jobs. A carpenter pays an invoice for more expensive wood than was actually delivered. Another invoice omits a promised discount. A third invoice is correct, but is paid twice.

Meanwhile, two framing employees draw duplicate checks, and a mountain of Sheetrock sits untouched for a year. There’s no malevolence at work in these losses — just old-fashioned error. Contractors may not notice such leakage, particularly in busy times, but ultimately, it takes cash from their pockets.

Losses from Fraud

Laurie, the bookkeeper, never took time off until the flu forced her out for a week. During her absence, a co-worker came across a check made out to an oddly named vendor he’d never heard of. An investigation revealed that Laurie had set up several fake vendors and over several years had paid them (that is, paid herself) more than $100,000.

Theft of materials is a particular danger in construction. Work is performed at remote locations, purchasing authority is spread widely and some materials are difficult to estimate precisely both before and after use.

So a project manager builds an addition to his kitchen, a plumber sells copper pipe for scrap, a framing crew chief operates a renovation business on the side — and all three enterprises are supplied by pilfering from their employer’s inventory.

Some capers are discovered long after the fact, but others are never exposed. The heists add up over time, but each is inconspicuous in itself. And often the perpetrators are able to hide their tracks, especially if the contractor isn’t tracking job costs closely.

Preventable Losses

Cross-checks could have avoided some of these losses. When paid invoices are compared with delivery receipts and purchase orders, or time clocks with payroll records, these documents can reveal errors and manipulation.

Segregating duties can also prevent losses. In our examples, duties were combined. The person setting up new vendors was the same person who approved invoices and drafted checks. The PM who ordered kitchen tile also received it, distributed it and tracked tile costs.

A hands-off ownership style makes shenanigans easy. An owner who’s more involved might review these transactions, as long as the business remains small. But it becomes more difficult as the business grows.

Contractors tend to have weaker internal controls than companies in other industries. Owners often start out keeping the books themselves, and even after they hire a bookkeeper they stay close to the process. But then, as their business grows — larger labor force, more equipment, bigger bids — they keep the same small accounting staff.

If such contractors hire qualified people to perform those tasks, and also put strong controls in place, they can be more confident. They’ll know that no invoice is paid without multiple approvals, that receipts are checked against bank deposits — and that these and other checks are performed as a matter of course by different employees.

Getting Help With Internal Controls

An accountant can help contractors set up new controls or test systems already in place.

Testing is important, because even though management may believe controls exist, actual practice can vary. “Yeah, we’re supposed to do that … but it’s just too detailed. We’ve never actually done it.” For that reason, today’s standards recommend that accountants not simply ask about controls and document the answers, but actually walk through transactions alongside employees.

Necessary But Not Sufficient

Internal controls can minimize leakage and deter fraud. Like burglars who avoid houses with barking dogs, fraudsters are less inclined to pilfer companies whose transactions are automatically scrutinized by others.

However, controls may not stop determined thieves, particularly those who work as a team. When two employees discover a common interest — one in purchasing, one in payables — they may be able to circumvent a control.

Still, a systematic approach to internal controls can make a contractor far less vulnerable.

Our firm can help you identify areas where internal controls can improve your operations. Contact Gary Master at 215-881-8800 to learn more.

Controls for Contractors: A Sampling

Following are some internal controls that contractors can use to improve operating efficiency and deter fraud.

• Check estimates for accuracy of calculations, labor rates and correspondence with drawings.
• Compare job-cost estimates with actual costs. Require approvals for adjustments to costs or transfers of costs between jobs.
• Require that materials estimates above a specified amount include quotes from two or more vendors. Make purchases only with pre-numbered purchase orders, and map them to both receiving reports and invoices before payment is made.
• Check vendor invoices against estimates to ensure proper discounts and pricing.
• Make on-site communications refer to specific job numbers, phase codes or work order numbers. Obtain signatures on change orders before work begins, and revise contracts accordingly.
• Ensure that site conditions at variance with expectations are documented and forwarded to the home office immediately.
• Pay bonuses only on completed contracts, not work-in-progress.
• Record equipment usage weekly, and assign and expense maintenance costs as they occur.
• Review billings for timeliness, accuracy, conformity with contract terms and correct customer information.
• Reconcile billings monthly with general ledgers and record under- and overbillings.
• Prepare financial statements monthly and support them with ledgers, bank statements and loan schedules.