Avoiding Construction Battles
Article, Risk Management – November 2013
Legal / Property
Garrett Wilson and Aaron Zaske use a case study to illustrate best practices to mitigate risk in construction and avoid legal disputes.
As the economy continues its slow recovery, residential and commercial construction is on the rise. This resurgence, however, has brought greater scrutiny on the economics of every project and a need for greater transparency between general contractors and project owners. In any construction project—especially in a time- and materials-based project—a wide range of cost disputes is possible. Consider this example of a residential project gone awry:
A homeowner hired a contractor to build an addition to a house and provided a deposit against the construction cost. The contractor began the work, using “below market” day laborers and unused materials already in his possession, in addition to new materials specifically purchased for the project.
The initial work on the addition damaged the roof of the main house, leaving gaps that caused water damage inside, all of which had to be repaired. The project was further mismanaged in other ways, and was over budget and behind schedule. To make matters worse, the contractor had a third party builder not involved with the project pull all of the permits. No professional architectural plans were drawn, and changes were not documented by change orders. A conflict over costs, budget, time and overhead burdens halted work before completion.
Unsurprisingly, the conflict escalated to a contentious legal battle, and forensic accounting experts were brought in to perform a cost audit and quantify the economic damages. After evaluating the contractor’s records, the auditors found inadequate recordkeeping, sloppy and unverifiable documentation of material and labor expenses, unverifiable and scrap materials used, a comingled bank account with weak accounting records, and indistinct recordkeeping of overall corporate burdens allocated to the project. Based on the documentation provided, auditors determined the homeowner was overcharged for the materials used and work completed.
Keeping Detailed Records
While there are a number of issues that can lead to a dispute in a construction project, the primary economic risks typically relate to recordkeeping for all expenses, the value of services provided (perceived or actual), use of materials from another job and use of below market labor. One of the primary ways to reduce the risk of an economic dispute is to maintain detailed records throughout the project. There are a number of best practices construction companies can use to help accomplish this goal:
Segregate recordkeeping. For every project, maintain clear and detailed records of materials purchased and used, labor hours and rates. It is also important to keep a record of overall business expenses, including overhead, that can be proportionately allocated to each job.
Use an electronic accounting system. Even a basic electronic accounting system can provide an extra level of protection in mitigating economic risks—provided the system is actually used. Promptly entering every bit of data into an accounting system provides electronic verification documenting all expenses.
Include job identifiers. Many vendors have the ability to include job numbers on invoices and receipts, commonly in the “purchase order” or “ship to” address field. These job identifiers should be included on every invoice and receipt, even for small tools and supplies purchased at local home improvement stores. Having the job number printed on the receipt or invoice aids in recordkeeping and verification of expenses when a dispute arises, showing the intent of the purchase.
Keep thorough notes. Detailed notes of expenses and project reports are vital. Notes that are handwritten on a notepad or receipt should be dated and signed or initialed by the author and recorded into the electronic accounting system regularly.
Record labor costs. Keep detailed records of all labor, linking hours worked to labor rates. A simple weekly timecard—signed by the employee and project manager and regularly entered into the accounting system—provides support for hours worked.
Maintain records of materials. Using inventory or scrap materials from a previous job is not uncommon for many construction projects where purchasing in bulk can afford economic benefits for both the contractor and the customer. However, it is important to maintain clear, detailed records of the amount of bulk inventory or scrap material allocated to each project so that costs can be verified in a dispute.
Understand trust accounting. If using trust accounting, consult an attorney to ensure that your business practices are consistent with the laws in your jurisdiction. Requirements may include that funds be maintained in separate accounts or, at a minimum, are clearly tracked in an accounting system.
In the example above, these best practices were clearly not followed. This dispute may have been avoided if the contractor had kept better records and was able to show the homeowners exactly where their money was spent. When it comes to mitigating construction risks, transparency and rigorous record keeping are more than best practices, they are essential to risk management.
Steven J. Hazel, CPA/ABV/CFF, ASA, CVA, CMC, is a partner, Garrett Wilson, CFA, CVA, is a manager, and Aaron Zaske is a staff forensic accountant, at global forensic accounting firm RGL Forensics.
As appeared in Risk Management, November 2013.