Auditing construction contracts: Some best practices

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.

Much of the auditor’s work involves evaluating subjective estimates relating to future events. AU-C Section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures, provides guidance to auditors on obtaining and evaluating sufficient appropriate audit evidence to support significant accounting estimates in an audit of financial statements in accordance with generally accepted auditing standards (GAAS).

The Center for Plain English Accounting has identified certain procedures, or best practices, that a construction contractor can expect an auditor to perform when auditing a construction company. 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 – for example, a colder than normal winter. The auditor should carefully read the contracts to identify guarantees or contingencies associated with a project to determine whether the contractor has given adequate consideration to the cost of fulfilling contract guarantees. Also, as required by GAAS, the auditor should verify whether the contracts are approved by the appropriate company personnel.
  • Recognize that the longer the contract period, the greater the risk that an estimate will be incorrect. The farther along a contract is toward completion, the less risk there is of an incorrect estimate. The more variables inherent in an estimate, the greater the risk that an estimate will be incorrect.
  • Visit construction contract sites. Visiting contract sites can be a very useful audit procedure. These visits can provide an opportunity to view the progress of a contract. Consideration of a site visit might include significant contract sites where the work is in the very early stages of a contract. These visits may identify the complexities of performing the contract. For example, a contract being performed in remote regions presents certain logistical risks that may not be appreciated or understood without visiting the site. The site visit also may provide auditors an opportunity to interview operational personnel and to gain a better understanding of the responsibility the company is undertaking in performing the contract. Observations and discussions with operating personnel at the job site may also assist the auditor in assessing physical security, the status of projects and the representations of management.
  • Meet with project managers. Project managers play an important role in controlling and reporting job site costs. They also are close to the facts and are likely to get more prompt and accurate information than the accounting personnel. For example, project managers may be aware of large bills that will arrive relating to their projects about which the accounting department has not yet been notified. Meeting with the project managers will also assist the auditor in developing expectations for use in performing analytical review procedures. The auditor also may ask the project managers of significant contracts to complete a questionnaire regarding the status of their contracts.
  • Test contract costs to make sure that costs are matched with appropriate contracts. In some instances, companies may shift costs from unprofitable contracts to profitable ones in an effort to defer losses.
  • Analytically review contracts 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. FASB ASC 275, Risks and Uncertainties, requires specific disclosures. Entities using contract accounting probably should have more than a generic disclosure about the use of significant estimates used in the preparation of financial statements.
  • Consider the use of specialists. Auditing construction contracts can be complex. You may want to use specialists in accordance with AU-C Section 620, Using the Work of an Auditor’s Specialist.

These are a few practices that auditors can consider when auditing construction contracts. Ultimately, auditors need to develop procedures and practices that reflect the results of their planning and risk assessment procedures conducted as part of an audit. – Bob Durak, CPA, CGMA, Director of AICPA Center for Plain English Accounting