The Need for Strong Internal Financial Controls

In the American marketplace, there are few, if any, industries with as many moving parts as construction. No one knows that better than contractors, who are routinely required to handle numerous projects at once, each with their own deadlines, goals, subcontractors, schedules, pay systems, work orders, etc.
It’s a fragmented process, that’s for sure. And that can mean there aren’t always enough financial gatekeepers on hand to ensure thorough accounting. This can lead to fraud, which is why construction ranks high among those industries where financial malfeasance most often occurs. Even when there isn’t fraud, however, construction accounting can be challenging.
Here are a few key ways contractors can create reliable internal controls—or strengthen the ones they’ve already implemented.
BUDGET
First, it is important to emphasize that for any system of controls to work, contractors need to be adept at preparing both annual company budgets and project-specific budgets. Throughout the year, these budgets need to be reviewed regularly for evidence of unexpected—and unexplained—variances. This review process can reveal a lot, even when there is no fraud. For example, regular variances are a good sign a contractor isn’t very efficient at bidding and estimating a job.
Along with their project-specific budgets, contractors need a good internal control structure for their company’s financial oversight. All company personnel need to understand the flow of vendor and subcontractor invoices, and owner or contractor billing. This process should include authorization by the appropriate company personnel. The processes for each major transaction cycle (billing, revenue, cash receipts, purchases, accounts payable, cash disbursement, and payroll) should be documented and periodically reviewed.
CHANGE ORDERS
One area where fraud is often found is change orders. The process for authorizing change orders should be documented and include multiple employees and management oversight in the process. If there is one area most susceptible to fraud it is cash disbursements. An important control is to make certain that bank statements are received by the owner unopened. The owner should carefully review the statement and any attachments for propriety before turning them over to an accounting employee to prepare the reconciliation. After the reconciliation is prepared, the owner should review the reconciliation to look for any unusual reconciling items. Ideally, the person performing the reconciliation is not the same person who records the cash receipts and cash disbursements.
CASH DISBURSEMENT
As part of the cash disbursement process, the check signer needs to make certain that all vendor invoices and documentation, such as purchase orders, receiving reports, etc., are approved for payment by only appropriate personnel. Approval from these personnel should be attached to a check when it is presented for signature and should be reviewed by the check signer.
Here are other time-tested steps contractors can take to strengthen internal controls:
Accounts Receivable: Any funds that have not been paid in 90 days should trigger a follow-up that includes an explanation for the late payment.
Accounts Payable: Purchase orders should be pre-numbered similar to sales invoices. All purchase-order numbers should be accounted for at all times as either used, voided, or still available. Once signed, checks should not be returned to the employee responsible for preparation of the checks. This prevents fraudulent modification of a signed check.
Subcontractor Evaluation: Many contractors hire subcontractors based only on limited past experience with them. This is dangerous. Before hiring a subcontractor, contractors should require proof of insurance, including bonding, and monitor the expiration of such insurance. Contractors should closely review a subcontractor’s work history, and as part of the initial vetting process should perform credit checks on potential subcontractors. Contractors should also consider reviewing subcontractors’ financial statements to make certain they have the ability to pay for and complete a job. It’s also important to know how many jobs a subcontractor has going on at once. This is critical in determining whether a subcontractor has sufficient capacity to handle another project.
Payroll Functions: Who should be paid, how much they are owed, and when they are to be paid should be clearly delineated in a contractor’s payroll system. Company owners and senior fiduciaries should have access to this information on a daily basis. There will always be small corrections that are required as a project moves forward—that is common. It’s the large discrepancies that cause problems, and these can be avoided by means of daily reviews.
When it comes to payroll, overtime pay can be challenging. It’s not easy to precisely quantify approval of overtime work and the accompanying expenditures. That’s why timesheets are necessary and should be signed by the employee and the employee’s supervisor.
Ghost employees are another common source of fraud. To combat this, contractors should implement controls whereby new employees who are added to payroll are reviewed and approved on a quarterly basis, at a minimum. Additionally, at least once a year a contractor should conduct a controlled payoff whereby all checks are personally delivered to the jobsite. Each employee has to sign for his check and a log is maintained. If an employee is not at the jobsite, he must come to the office to receive his check.
These are only a few considerations for contractors who need to strengthen their internal controls. The choice of controls, it should be pointed out, is often dictated by the type of work a contractor performs. However, by necessity, construction professionals often venture into new niches. When they do, they may need to adopt controls that better reflect the financial vagaries of the new sector. This, in particular, is a time when contractors should seek guidance from their certified public accountant. ■
About The Author: Denise Bendele has more than 27 years’ experience in public accounting and leads the construction industry practice for Padgett Stratemann, in addition to managing the firm’s audit department. She also works with organizations that specialize in wholesale, retail, and manufacturing.
_________________________________________________________________________
Modern Contractor Solutions, July 2015
Did you enjoy this article?
Subscribe to the FREE Digital Edition of Modern Contractor Solutions magazine.