AUDIT OF CONSTRUCTION INDUSTRY

Definition

Construction Industry pertains to the branch of manufacture and trade based on the building,
maintaining, and repairing structures which includes drilling and solid mineral exploration
(Standard Industrial Classification).

Categories

 Building Construction Industry: All general contractors and operative builders primarily
engaged in the construction of residential, farm, industrial, commercial, or other buildings.
 Heavy Construction Industry: All general contractors primarily engaged in heavy construction
other than building, such as highways and streets, bridges, sewers, railroads, irrigation
projects, and flood control projects and marine construction. This includes special trade
contractors primarily engaged in activities not normally performed on buildings, such as highway
grading or underwater rock removal. This does not include special trade contractors primarily
engaged activities performed on buildings.
 Special Trade Construction Industry: All special trade contractors who undertake activities of
a type that are specialized either to building construction, including work on mobile homes, or
to both building and nonbuilding projects. This includes projects such as painting, electrical
work, plumbing, etc. This does not include activities specialized for heavy construction.

IAS 11 | Construction Contracts

IAS 11.3 | Definition

A construction contract is a contract specifically negotiated for the construction of an asset or
a group of interrelated assets.

IAS 11.8-10 | Accounting

 If a contract covers two or more assets, the construction of each asset should be accounted for
separately if (a) separate proposals were submitted for each asset, (b) portions of the contract
relating to each asset were negotiated separately, and (c) costs and revenues of each asset can
be measured. Otherwise, the contract should be accounted for in its entirety. (IAS 11.8)
 Two or more contracts should be accounted for as a single contract if they were negotiated
together and the work is interrelated. (IAS 11.9)
 If a contract gives the customer an option to order one or more additional assets, construction
of each additional asset should be accounted for as a separate contract if either (a) the additional
asset differs significantly from the original asset(s) or (b) the price of the additional asset is
separately negotiated. (IAS 11.10)
 Application of Audit Risk Model to a Construction Contractor

Key Components of the Contract Equation

Original Contract Estimated Costs

Assertion Modifications Costs to Date
Price to Complete

Do all
Do all costs
modifications
reported for this job
included by the
Have contracts been represent
Existence client meet the N/A
properly segmented? capitalizable costs
GAAP
for this job and not
recognition
some other job?
criteria?
Has the client Have all elements
Have all
recognized all of future cost
capitalizable costs
Have contracts been modifications that been included in
Completeness associated with the
properly combined? meet the GAAP the estimate of
job been allocated
recognition costs to
to the job?
criteria? complete?

Has the contractor Have

Have estimated
properly calculated modifications Have job costs been
costs to complete
Valuation the original contract been measure in measured at their
been properly
price based on the accordance with proper amounts?
measured?
terms of the contract? GAAP?

Audit Objectives for a Contractor

The audit of a contractor is essentially the audit of individual contracts. Perform procedures
to help assess inherent and control risk. These assessments are made within the context of
materiality. For example, you would perform procedures to help assess the risk that the client has
recognized a material change order that does not meet the criteria of SOP 81-1. Proceeding on that
risk assessment you would then design your substantive audit procedures to gather evidence to
support that assertion.

Audit Planning and Preliminary Analytical Procedures

Audit planning is performed at two general levels. First, assess risk at the overall entity level.
Understand the contractor’s estimating process and how significant estimates are to the financial
statements. On a second level, assess risk at the individual contract level.
 Audit of a Contractor’s Ability to Estimate

Basic Contract Equation:

Gross Profit to Date = (Est. Total Contract Price – Est. Total Contract Costs) x Completion %

Estimating is a major part of a contractor’s business. An audit of a contractor is an audit of a

contractor’s ability to estimate. Ways in which estimates affect the basic contract equation include
the following:
• Estimated costs to complete. One entire component of the equation is an estimate.
• Contract penalties or incentives. The recognition of penalties or incentives depends on whether
the amount can be reasonably estimated.
• Profit from change orders. Profit on a change order can only be recognized if the amount can be
reasonably estimated.
• Revenue from a claim. Revenue related to a claim can only be recognized if the amount can be
reasonably estimated.
• Allocation of equipment costs. Equipment charges are generally allocated to individual jobs
based on an internally developed use rate. That use rate is dependent on estimates such as the
useful life of the equipment, average idle time, and operating costs.
• Percentage complete. The percentage complete of a project (assuming it is somewhere between
0% and 100% complete) will almost always be an estimate because the denominator (total
costs, labor hours, units-of-delivery, etc.) is usually an estimate.

Planning Phase of the Audit – Three-Phase Approach

Assessing Risk of Individual Contracts

Table of Risk Factors
Factor Lower Risk Higher Risk
Phase One: Review Schedule of Uncompleted Jobs
 0% - 25%
Percent complete  25% - 90%
 > 90%
Size of project Relatively small job Relatively large job

Phase Two: Make Inquiries of Management

 Complex, one of a kind
 Simple, routine
Type of project  Not within contractor’s
 Within contractor’s expertise
 expertise
 Long-term project
 Short-term project
 Work is falling behind schedule
Timing and  Work is on schedule
 Accelerated time frame
scheduling  Comfortable time frame
 Significant penalties for late
 No penalties for late completion
 completion
 Established area with past
 New area
successful projects
Location  Remote area — materials and
 Materials and labor readily
labor not readily available
available
  Low susceptibility to adverse  High susceptibility to adverse
Weather
weather weather
 Significant previous contact  Little previous contact
Owner/investor
 Solid financial position  Weak financial position
 Large portion of work performed  Small portion of work performed
by subcontractors by subcontractors
 Significant previous contact  Little previous contact
Subcontractors
 Solid financial position  Weak financial position
 Significant subcontract  Significant subcontract
agreements finalized agreements not finalized
 Significant variances in bid
Bid spread  Tight bid results
amounts
Phase Three: Obtain Detailed Information

Profit fade  No significant profit fade  Significant profit fade

Underbilling  Normal/nominal underbilling  Unusual/significant underbilling
 Fixed-price
 Cost-type, clear definition of
Type of contract  Cost-type, difficult to determine
 reimbursable costs
 reimbursable costs
Claims  No claims  Significant claims

Internal Control Considerations – Three Elements of Control Structure

Control Environment

General audit manuals and the professional literature (in particular AU section 319) provide
broad guidance on assessing the control environment. The following are some considerations that
are unique for construction contractors:

Working Capital Management philosophy on volume

Working capital should be adequate for the work
An overemphasis on volume will cause the
program of the contractor. Inadequate working
contractor to stray into areas (either type of
capital may jeopardize the completion of the jobs in
project or geographic area) in which they have
progress. It may also affect the bondability of future
no expertise. This is a risky strategy.
work.
Philosophy on Prosecution of Claims Management’s attitude toward job management
Strong control environments are usually characterized by
A contractor has to strike a balance
formal job schedules and methods for communicating
between pursuing amounts to which it
important information such as job status. It is critical that
is entitled and maintaining working
management realizes the importance of periodic comparison
relationships with owners.
of actual costs to budgets (bid costs). An environment should
Undisciplined and misguided efforts at
exist that encourages monthly review by project managers
recovering claims may indicate a weak
and, as a result, regular adjustments to estimated costs to
control environment.
complete.
 Employee Retention Relationships
Low turnover in key positions is usually a Relationships with bankers, sureties, subcontractors,
sign of a strong control environment. and owners.

Accounting System and Control Procedures

 Percentage-of-completion is relatively complex.

 The financial statements of a contractor can be based largely on estimates.
 Progress billings need to be properly managed to provide cash flow.
 Contractors need sureties and sureties rely on accurate financial information.

Bidding and Estimating

Basic controls in the bidding process:
 The bid should be complete and include all elements of cost.
 Costs are generally broken down into quantities and prices.
 Prices should be based on reliable sources and should include any estimated wage and price
escalations during the term of the contract.
The estimating process according to AICPA Audit and Accounting Guide Construction
Contractors:
 The contractor’s ability to estimate covers more than the estimating and documentation of
contract revenues and costs. It covers a contractor’s entire contract administration and
management control system. The ability to produce reasonably dependable estimates depends
on all the procedures and personnel that provide financial or production information on the
status of contracts.
 It encompasses systems and personnel not only of the accounting department but of all areas of
the company that participate in production control, cost control, administrative control, or
accountability for contracts.

Job-Site Accounting and Controls Contract Revenue

Unique feature of the contractor’s business: Some of the features of a contract

decentralized operation. The work is performed at may affect the determination contract
a site other than the contractor’s business price such as penalties, incentives, or
headquarters. This affects the accounting system the definition of reimbursable costs for
and related control procedures. Out of necessity, cost-type contracts. The contractor
much of the accounting system will reside at the job needs to be thoroughly familiar with
site. Decentralized system affects accounting control these provisions. Based on their
in aspects such as financial records, cost control, and judgment, contractors will measure the
overhead control. contract price.

Billing Contract Costs

 Importance of job cost system:
Billing procedures are usually not correlated to performance.
 A record of the
The accounting system in this area should emphasize:
past
 Knowledge of the terms of the contract
 A predictor of the
 Knowledge of the status of the job
future
Unique Substantive Auditing Procedures

Control Areas and Their Impact on the Financial Statements

Contract Equation Components
Substantive Procedure Original Contract Costs to Est. Costs to
Modifications Billing
Amount Date Complete
Read the contract 
Confirmation with owner   
Review unapproved

change orders
Test cost accumulation  
Review estimated cost

to complete
Job-site visits 
 Accounting for Performance – Income Recognition

Types of Contracts Based on Methods of Pricing

 Fixed-Price or Lump-Sum Contracts — an agreement to perform all acts under the contract for
a stated price
 Cost-Type (including cost-plus) Contracts — an agreement to perform under a contract for a
price determined on the basis of a defined relationship to the costs to be incurred
 Time-and-Material Contracts —agreement to perform all acts required under the contract for a
price based on fixed hourly rates for some measure of the labor hours required and cost of
materials
 Unit-Price Contracts — an agreement to perform all acts required under the contract for a
specified price for each unit of output

Revenue Recognition

On long-term construction, contracts revenue may be recognized as construction progresses.

This exception to the realization principle is based on the availability of evidence of the ultimate
proceeds and the consensus that a better measure of periodic income results.

Accounting Research Bulletin No. 45 (ARB No. 45)

Long-Term Construction- Type Contracts | Methods of Accounting

Percentage-of-Completion Method Completed-Contract Method

 Recognizes income as work on a contract  Recognizes income only when the contract
progresses; recognition of revenues and profits is completed, or substantially so, and all
generally is related to costs incurred in costs and related revenues are reported as
providing the services required under the deferred items in the balance sheet until
contract. that time.
 Financial statements present economic  Billings and costs are accumulated on the
substance of company’s transactions and events balance sheet, but no profit or income is
more clearly and timely than financial recorded before completion or substantial
statements based on completed-contract completion of the work.
method, and present more accurately  Precludes reporting on the performance that
relationships between gross profit from is occurring under the enforceable rights of
contracts and related period costs. the contract as work progresses.
 Informs users of the general-purpose financial  May be used as an entity’s basic accounting
statements of the volume of economic activity policy when financial position and results
of a company. of operations would not vary materially
 Depends on the ability to make reasonably from those resulting from use of the
dependable estimates. percentage-of-completion method.
 Discourages its use where inherent hazards  Preferable when estimates cannot meet the
make estimates doubtful. “Inherent hazards” criteria for reasonable dependability
relate to contract conditions or external factors discussed in the section on the percentage-
that raise questions about contract estimates and of-completion method or in which there are
ability of either contractor or customer to inherent hazards of the nature of those
perform his obligations under the contract. discussed in that section.

Combination of Group of Contracts for Accounting Purposes

Allowed if contracts:
 Are negotiated as package in same economic environment with an overall profit margin objective.
 Constitute in essence an agreement to do a single project.
 Require closely interrelated construction activities with substantial common costs that cannot be
separately identified with, or reasonably allocated to, the elements, phases, or units of output.
 Are performed concurrently or in a continuous sequence under the same project management at
the same location or at different locations in the same general vicinity.
 Constitute in substance an agreement with a single customer.

Segmentation of Project
Allowed if following steps are taken and are documented and verifiable
 Contractor submitted bona fide proposals on separate components of project and on the entire
project.
 Customer had the right to accept the proposals on either basis.
 Aggregate amount of the proposals on the separate components approximated the amount of the
proposal on the entire project.

Measuring Progress on Contracts

Methods of Measuring Extent of

Completion Criteria Under the Completed-Contract Method
Progress Toward Completion
 The specific criteria used to determine when a contract
is substantially completed should be followed
Some methods used in practice
consistently and should be disclosed in the note to the
measure progress toward completion
financial statements on accounting policies.
in terms of costs, some in terms of
Circumstances to be considered in determining when a
units of work, and some in terms of
project is substantially completed include, for example,
values added (the contract value of
delivery of the product, acceptance by the customer,
total work performed to date).
departure from the site, and compliance with
performance specifications.

Input and Output Measures

 Several approaches to measuring progress on a contract can be grouped into input and output
measures. Input measures are made in terms of efforts devoted to a contract. They include
the methods based on costs and on efforts expended. Output measures are made in terms
of results achieved. They include methods based on units produced, units delivered,
contract milestones, and value added.
 Acceptability of the results of input or output measures deemed to be appropriate to the
circumstances should be periodically reviewed and confirmed by alternative measures that
involve observation and inspection.

Income Determination – Revenue Elements

Basic Contract Price

 Estimated revenue from a contract is the total amount that a contractor expects to realize from
the contract. It is determined primarily by the terms of the contract and the basic contract price.
Contract price may be relatively fixed or highly variable and subject to a great deal of
uncertainty, depending on the type of contract involved.
 Accounting for change orders depends on underlying circumstances, which may differ for each
change order depending on the customer, contract, and nature of the change. Change orders should
therefore be evaluated according to their characteristics and the circumstances in which they occur.

Contract Options and Additions Claims

Recognition of amounts of additional contract revenue

An option or an addition to
relating to claims is appropriate only if it is probable that the
an existing contract should be
claim will result in additional contract revenue and if the
treated as a separate contract
amount can be reliably estimated.

Income Determination – Cost Elements

Contract Costs Precontract Costs

 Accumulated in same manner as inventory costs and charged to Costs are deferred
operations as related revenue from contracts is recognized. Contract in anticipation of future
costs generally include all direct costs (i.e. materials, direct labor, and contract sales in a
subcontracts, and indirect costs identifiable with or allocable to variety of
contracts) circumstances

Estimated Contract Cost

Contract costs must be identified, estimated, and accumulated with a reasonable degree of
accuracy in determining income earned. At any time during the life of a contract, total estimated
contract cost consists of two components: costs incurred to date and estimated cost to complete the
contract.

Estimated Cost to Complete

Practices in estimating total contract costs vary, and guidance is needed in this area because of
the impact of those practices on accounting. The following practices should be followed:
a. Systematic and consistent procedures that are correlated with the cost accounting system should
be used to provide a basis for periodically comparing actual and estimated costs.
b. In estimating total contract costs, the quantities and prices of all significant elements of cost
should be identified.
c. The estimating procedures should provide that estimated cost to complete includes the same

elements of cost that are included in actual accumulated costs; also, those elements should reflect
expected price increases.
d. The effects of future wage and price escalations should be taken into account in cost estimates,
especially when the contract performance will be carried out over a significant period of time.
Escalation provisions should not be blanket overall provisions but should cover labor,
materials, and indirect costs based on percentages or amounts that take into consideration
experience and other pertinent data.
e. Estimates of cost to complete should be reviewed periodically and revised as appropriate to
reflect new information.

Computation of Income Earned for a Period

Revised estimates
Under the Percentage-of-Completion Method

The computation of income earned for Revisions in revenue, cost, and profit estimates
a period involves a determination of the or in measurements of the extent of progress toward
portion of total estimated contract completion are changes in accounting estimates
revenue that has been earned to date and, as such, should be accounted for in accordance
(earned revenue) and the portion of total with FASB Statement No. 154, Accounting Changes
estimated contract cost related to that and Error Corrections—a replacement of APB
revenue (cost of earned revenue). Opinion No. 20 and FASB Statement No. 3.

Provisions for Anticipated Losses on Contracts

 Provisions for losses should be made in the period in which they become evident under either
the percentage-of-completion method or the completed contract method. If a group of contracts are
combined, they should be treated as a unit in determining the necessity for a provision for a loss. If
contracts are segmented, the individual segments should be considered separately in determining the
need for a provision for a loss.
The provision for loss arises because estimated cost for the contract exceeds estimated revenue.
Consequently, the provision for loss should be accounted for in the income statement as an additional
contract cost rather than as a reduction of contract revenue, which is a function of contract price, not
cost. Unless the provision is material in amount or unusual or infrequent in nature, the provision
should be included in contract cost and need not be shown separately in the income statement. If it is
shown separately, it should be shown as a component of the cost included in the computation of gross
profit.

Transition

An accounting change from the completed-contract method or from the percentage-of-

completion method to conform to the recommendations of this statement of position should be made
retrospectively by restating the financial statements of prior periods. The restatement should be
made on the basis of current information if historical information is not available.

Questions

1. What are the methods of measuring extent of progress towards completion of a project?
a. cost-to-price, variations of cost-to-price, efforts expended, units of delivery, units of work
performed
b. cost-to-cost, variations of cost-to-cost, efforts expended, units of delivery, units of work
performed
c. cost-to-cost, efforts expended, units of delivery, units of work performed
d. cost-to-cost, variations of cost-to-cost, efforts expended, units of completion, units of work
performed

Paragraph 44 of Statement of Position 81-1, provision for Methods of Measuring Extent of

Progress Toward Completion, states that: in practice, a number of methods are used to measure the
extent of progress toward completion. They include the cost-to-cost method, variations of the
cost-to-cost method, efforts-expended methods, the units-of-delivery method, and the units-
of-work-performed method. Those practices are intended to conform to ARB No. 45, paragraph
4.81 Some of the measures are sometimes made and certified by engineers or architects, but
management should review and understand the procedures used by those professionals.

2. The completed-contract method is preferable when which of the following conditions exists?

I. The results would not vary materially from use of the percentage of completion method
 II. Lack of dependable estimates or the existence of inherent hazards cause forecasts to be doubtful

a. I only
b. II only
c. Either I or II
d. Both I and II

It is preferable to use completed-contract method when lack of dependable estimates or

inherent hazards cause forecasts to be doubtful. This is according to the FASB Amended
Pronouncement on Long-Term Construction-Type Contracts. Deviation from this condition is only
allowed up to the extent when the use of completed-contract would not result to a materially
different outcome from the percentage-of-completion method.

3. How is a loss recognized under the completed contract method?

a. Recognized proportionate to the work already performed
b. Must reflect on the income statement retrospectively and currently beginning on the first year of
construction
c. Deferred until project is completed
d. Fully and in the year of discovery

Under FASB pronouncement, ARB 45: Long-Term Construction-Type Contracts, if there is an

expectation of a loss on a contract, record it at once in both project completion method and the
completed contract method; do not wait until the end of the contract period to do so.

4. For long-term construction contracts, what journal entry records construction costs?
a. Work in Progress xx
Cash (and/or Accounts Payable) xx
b. Cost of Construction xx
Construction in Progress xx
c. Construction in Progress xx
Cash (and/or Accounts Payable) xx
d. Construction Expenses xx
Cash (and/or Accounts Payable) xx

Accounting in the construction industry is unlike most other industries. Accounting for
construction industry uses “Construction in progress” account to keep track of construction costs.
The CIP account is basically just an account (with a normal debit balance) for recording all the
different expenditures that will occur during a construction project.

5. The PoC method is best practice when which of the following conditions exist:
I. Reasonably dependable estimates can be made
II. The contract clearly specifies the enforceable rights of both the contractor and the buyer, the
consideration to be exchanged, and the manner and terms of settlement
III. The buyer can be expected to satisfy its obligations under the contract
IV. The contractor can be expected to perform its contractual obligations

a. I & II only
b. I, II, III
c. I, II, IV
d. I, II, III, IV

The Accounting Standards Executive Committee believes that in general when estimates of
costs to complete and extent of progress toward completion of long-term contracts are reasonably
dependable, the percentage-of-completion method is preferable. When lack of dependable
estimates or inherent hazards cause forecasts to be doubtful, the completed-contract method is
preferable. Disclosure of the method followed should be made. While the rest of the statements are
conditions for both methods.