Construction Fraud/Waste/Abuse Case Study II:

Spotting Problem's in the Contractor's Pay Application

We are pleased to provide the second article in our series of articles on construction fraud investigations and construction audits. This series presents the results of what we have learned during the past 30 years performing construction fraud investigations and construction audits. These case studies are presented to educate construction project owners about the types of fraud/waste/abuse that can occur on a construction project.

This article describes the attributes a construction manager's pay application ("PA") should have to help the auditor/investigator benchmark a project's PA's against industry norms. If when benchmarking a project against these characteristics, the investigator discovers an anomaly, the investigator should conclude that the anomaly is pointing him/her to an area that has a higher potential to contain fraud, overbilling, or error. The absence of benchmarking anomalies does not necessarily prove that fraud, overbilling, or error has occurred, it just helps the investigator identify where to focus the investigation's resources.

Construction auditors and construction fraud investigators ("Auditors/Investigators") will generally first study the construction contract before investigating whether fraud, overbilling, or error has occurred. For purposes of this article we will assume that the contract between the owner and the general contractor ("GC") is a typical American Institute of Architects ("AIA") cost based or guaranteed maximum price ("GMP") contract. Once the Auditor/Investigator understands the construction contract, he/she will then look at the GC's pay applications ("PA's"). Following are the key attributes to study when assessing the voracity of the contractor's pay application.

• Form
• Mathematical Accuracy
• Completeness
• Reasonableness

Form:

Deviations from the typical PA form are a significant red flag to the construction auditor and/or construction fraud investigator. Deviations in PA form can provide the opportunity for overbilling the owner through fraud or error. Therefore, the Auditor/Investigator must understand the proper form of a PA before he/she can identify material deviations.

The typical PA is actually a package of documents intended to communicate to the reader the general contractor's payment request and the project's status. Some of these documents will be specific to the project. Most PA's start with two standard forms promulgated by the AIA, the AIA G702 ("Application and Certification for Payment / Contractor's Application for Payment" or "Lead Sheet") and AIA G703 ("Continuation Sheet").

1. The AIA G702 contains three certifications on one page:
   1. Application and Certification for Payment
   2. Contractor's Application for Payment
   3. Architect's Certificate for Payment
2. The AIA G703 is a document in which the columns are standardized while the rows are customized to reflect the project's unique schedule of values ("SOV"). The Construction Specifications Institute ("CSI") has prepared a proposed SOV structure that is widely accepted by the industry. Here is where you can find the CSI Table of Contents.

The GC's Lead Sheet should have all required signatures and should tie to the GC's contract and the approved change orders. The totals from the Continuation Sheet must tie to the Lead Sheet. The Continuation Sheet will show the current status of each of the project's SOV line items. Assuming each SOV line can only contain one subcontractor, then the sum of the SOV lines for which a subcontractor is responsible should tie to the subcontractor's invoice and to the subcontractor's contract, adjusted for approved subcontractor change orders.

The Continuation Sheet will also show retainage for each subcontractor and the GC's mark-up's such as fee mark-up or insurance mark-up.

Mathematical Accuracy:

Mathematical accuracy refers to tracing/confirming data and checking calculations either, 1) within the current PA, or 2) between the current PA and the prior PA. Identification of mathematical errors will most likely indicate that some form of fraud, overbilling, or error has occurred.

Generally, the best way to confirm the mathematical accuracy of the GC's PA's is to set up two roll-forward schedules in Excel:

• PA Roll-Forward
• SOV Roll-Forward

These roll-forward schedules re-compute the data submitted by the GC in its PA's beginning with PA #1 and ending with the final PA. The PA Roll-Forward allows the Auditor/Investigator to confirm the accuracy of the GC's PA's. For example the PA Roll-Forward schedule will help the Auditor/Investigator identify:

• If the paid-to-date is understated resulting in overstating the amount due.
• If the GC's Fee is miscalculated.
• If retainage is miscalculated.

The SOV Roll-Forward provides insight into the movement of funds from contingency, buy-out savings, and change orders, for the entire duration of the project. For example, the SOV Roll-Forward schedule will help the Auditor/Investigator identify:

• If funds were moved from an allowance item to another SOV line in violation of the contract rules
• If buy-out savings were moved into an inappropriate SOV line item (e.g, general conditions or self-performed work).
• If change order funds were used to fund an SOV line item that was outside of the scope of the change order.
• If buy-out savings were used to fund changes in scope not approved by the owner's leadership.

Preparation of the PA Roll-Forward and the SOV Roll-Forward schedules is essential to testing the accuracy of the GC's PA's. These schedules should be among the first schedules prepared in an audit or investigation of billings on a construction project.

Completeness:

Incomplete PA submittals are another red flag that indicates an elevated risk of fraud, overbilling, or error. Missing lien waivers are an obvious example of this, however there are many other possible examples of missing documents that indicate possible fraud, overbilling, or error in the PA.

The submission requirements for the PA should be set contractually or through a pattern of practice established early in the project.

The GC's PA should have all required signatures on the AIA G702 form, including representatives from the GC, the architect/engineer, and the public notary. These signatures confirm to the reader that the GC and the A/E have reviewed the PA and are attesting to the accuracy of the information in the PA for which they are responsible. Additionally, the PA package or submittal should include:

• Invoices and other back-up supporting reimbursable costs claimed by the GC.
• The GC's labor hour and labor rate schedule for reimbursable labor.
• Subcontractor invoices for each subcontractor billing during the current pay period.
• The GC's job cost report showing current pay period costs and cumulative project costs.
• Change Orders ("CO") documentation for CO's approved during the current pay period.
• Conditional lien waivers for the subcontractors being billed in the current month.
• Unconditional lien waivers for the subcontractors that were billed in the prior month.

Other documents that may be included in the PA, or in a monthly project status report are:

• Listing of safety failures and safety initiatives.
• Summary of open issues, resolved issues, and project milestones.
• Project critical path schedule (CPM) updated for any recent changes.
• Meeting minutes.

Reasonableness:

The reasonableness of a PA is determined in the context of the project and what is normal for the industry. To be able to assess the reasonableness of a PA the Auditor/Investigator must first understand what is reasonable given the nature and pace of the project (e.g., how work is scheduled or what is the typical work productivity) and what is reasonable in the industry (e.g., how work is typically sequenced, what are normal productivity rates, or what documentation normally exists).

Assessing the reasonableness of the data in a PA is really a search for patterns and anomalies. The Auditor/Investigator should start by performing data analytics using data from the PA and from the project. Examples of the types of tests that can be performed include:

• Group reimbursable expenses by the time period they likely would occur (e.g., beginning, middle, end of the project) and then compare this to when they were billed.
• Graph general conditions labor by discipline over time and compare this to the project as-built schedule.
• Compare quantities purchased to quantities spec'ed.
• Compare hours of crane operator labor billed to the hours of crane rental billed.
• Compare workers billed by day to ingress and egress reports.

When an anomaly in the PA's data is identified that cannot readily be explained, it deserves further investigation. Following are some examples of fraud and/or overbilling that were discovered because something did not pass the Auditor/Investigator's reasonableness test:

• $3.0 million fraud discovered when the fraudster tried to charge $250,000 in the final PA for the surveyor's service. Since surveyor work occurs at the beginning of the project, it was considered unreasonable for the GC to charge $250,000 for a surveyor in the last PA.
• $500,000 overbilling buried in labor rates because the GC's burden rate included workers' comp on a project with an owner controlled insurance program ("OCIP"). The auditor noted that the labor rate appeared high for an OCIP project and investigated to discover that the GC had included workers' comp in its burden calculation.
• $60,000 in excess rental charges identified because the GC charged for rental equipment significantly beyond the time the workers who were using the equipment had left the project. It was later determined that the GC neglected to record the return of rental equipment to the GC's yard.
• $900,000 in excess supplies charges were identified because the total cost for supplies exceeded the original estimate for supplies by over 100%. It was later determined that the excess supplies were actually shipped to a different project.

Assessing the reasonableness of data in the PA is important and requires both analytics and experience. Once an anomaly is discovered, it then requires follow up in order to determine if it represents something easily understood, or if it is actually represents fraud, overbilling, or error.

Resolution Experts PC, "ResX, PC", provides independent forensic accounting services for construction auditing and construction contract compliance. ResX is based in Michigan and serves clients throughout the United States. For more information and to learn about working with ResX, please visit our website: www.resxpc.com.

The preceding narrative presents concepts that are dependent on facts and circumstances. These concepts can change depending on the specific facts and circumstances of an individual matter.