Auditing Construction Contracts

One of the more challenging audits is that of construction companies and other companies using the percentage of completion method of accounting for long-term contracts. This Practice Alert is intended to serve as a reminder of the important concepts, and provide some best practices for auditing such entities.

The primary authoritative accounting literature for construction companies, and entities using contract accounting is SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. A thorough understanding of this literature is critical to auditing such entities. The AICPA's guide entitled "A CPA's Guide to Accounting, Auditing and Tax for Construction Contractors" and the related self-study course, are useful tools in preparing for such audits.

Auditing construction contractors or entities using contract accounting is complex. Such businesses rely on accurate and reliable estimates to operate their business as well as to prepare financial statements in accordance with generally accepted accounting principles. Therefore, it is critical that the auditor gain an understanding of the contractor's significant estimates and assumptions in operating its business. Remember that the audit of a contractor is an audit of a contractor's ability to estimate. There are several things to consider when auditing estimates (also see SAS No.57, Auditing Accounting Estimates): Understand the internal control structure surrounding the estimate, consider the contractor's history of accurate estimates, compare actual to budgeted figures, and review subsequent events.

Best Practices

The PITF has identified certain procedures that should be considered in performing an audit of a construction contractor. They are as follows:

• Read significant contracts. This procedure may seem obvious, but it is necessary in identifying the terms of the contract, any guarantees, penalties and incentives, as well as any cancellation and postponement provisions. For instance, reading the contract might identify the party responsible for additional expenses incurred as a result of weather delays (e.g., a colder than normal winter). Make sure the contracts are approved by the appropriate company personnel.

• Identify unique contracts and increase the amount of testing and professional skepticism relating to such contracts. These contracts increase the risk of improper estimates and thus improperly stated financial statements. If a company cannot reasonably estimate the cost or progress of a contract, it should be accounted for under the completed-contract method. For example, if a Home building company decides to build power plants, they should consider accounting for such contracts under the completed-contract method until they are reasonably confident that its estimates in the power plant portion of the business are reliable.

• Understand the company's cash flow and how it will manage paying out expenses. Often expenses are due prior to receiving all the appropriate cash for the contract revenue. Some companies win long term contracts, but cannot fund the project long enough to realize the revenue earned. It is not uncommon for a customer to withhold 20%–25% of the contract price until they are satisfied with the quality of the completed contract.

• Recognize that the longer the contract period, the greater the risk that an estimate will be incorrect. Also, the farther along a contract is toward completion, the less risk there is of an incorrect estimate. Finally, the more variables inherent in an estimate the greater the risk that an estimate will be incorrect.

• Confirm the terms and conditions of the contract as well as the normal billing procedures. When confirming a receivable the auditor should strongly consider confirming: the original contract price, total approved change orders, total billings and payments, retainage held and whether it accrues interest, detail of any claims, back charges or disputes, and estimated completion date or the estimate of percentage complete.

• Review the unapproved change orders of significant contracts. Change orders often arise during the life of a contract and estimated revenue and cost should be adjusted for changed orders that have been approved both as to scope and price. However, when a change order has been approved as to scope but not price careful evaluation of the specific facts and circumstances is required prior to inclusion in estimated contract revenues. To the extent that change orders are in dispute or are unapproved in regard to both scope and price they should be evaluated as claims. Generally speaking, if there is no verifiable evidence to support the recognition of revenue on an unapproved change order or claim, it should not be recognized.

• Visit construction contract sites. Visiting contract sites can be a very useful audit procedure. Such a visit can provide an opportunity to view the progress of a contract. Consideration of a site visit might include significant contract sites, in which the work is in the very early stages of a contract. Such a visit may identify the complexities of performing the contract. For example, a contract being performed in remote regions of Alaska presents certain logistical risks that may not be appreciated or understood without visiting. The site visit also may provide auditors an opportunity to interview operational personnel and to gain a better understanding for the responsibility the Company is undertaking performing the contract. At the site visit an auditor should also speak with available subcontractors on site to get additional information about the progress of the engagement. Furthermore, the auditor should consider observing equipment and uninstalled inventory on site.

• Meet with project managers. Project managers play an important role in controlling and reporting job site costs. They are also close to the facts and are likely to get more prompt and accurate information than the accounting personnel. For example, a project manager may be aware of a large bill that will arrive relating to his or her project about which the accounting department has not yet been notified. Meeting with the project mangers will also assist the auditor in developing expectations for use in performing analytical review procedures. Also, consider having the project managers of significant contracts complete a questionnaire regarding the status of their contracts.

• Identify and understand the significant assumptions and uncertainties. This procedure is fundamental to performing an effective audit of an entity using contract accounting. Not performing this function results in an audit that does not comply with GAAS.

• Test contract costs to make sure that costs are matched with appropriate contracts. In some instances a company may shift costs from unprofitable contracts to profitable ones in an effort to defer losses.

• Audit estimated costs to complete. The focus should be on the key factors and assumptions, such as those that are (a) significant to the estimate, (b) sensitive to variation, (c) deviate from historical patterns, and are (d) subjective and susceptible to bias or misstatement. A review of revised or updated estimates of cost to complete and a comparison of the estimates with the actual costs incurred after the balance sheet date is also a useful procedure.

• See that losses are recorded as incurred, regardless of whether an entity is using the percentage-of-completion or the completed-contract method of recognizing revenue.

• Analytically review contacts completed and in progress. A detailed analytical review of completed contracts and contracts in progress will provide meaningful information in helping to focus the auditor's efforts on potential problem areas. The look back analysis also reveals significant information about the company's ability to estimate.

• See that there are appropriate disclosures relating to SOP 94-6, Disclosure of Risks and Uncertainties. Entities using contract accounting probably should have more than generic disclosure about the use of significant estimates used in the preparation of financial statements. The AICPA SEC Practice Section has noticed that many companies include excellent disclosure about the risk of contract losses and the possibility of inaccurate estimates in the forepart of their Form 10-K. It is the PITF's view that some of that enhanced disclosure would strengthen financial statement disclosure.

• Review the aging of receivables on contracts. This procedure will provide evidence that a Company is collecting funds on a timely basis.

• Consider the use of specialists in auditing construction contracts in accordance with SAS No.73, Using the Work of a Specialist.

Auditing entities that use contract accounting is challenging in that the main element of the contractor's financial statements are based on estimates of cost, and, importantly, costs not shipments drive the revenue recognition process.

Prior to auditing contractors an auditor should ensure that they have the appropriate expertise to understand the risks of the business. This additional knowledge will lead to an audit that meets or exceeds generally accepted auditing standards.

Previously issued Practice Alerts can be viewed on the AICPA Web site at www.aicpa.org/members/div/secps/lit/practice.htm.