Construction Contractor Audits: Percentage of Completion, WIP Schedules and Surety

Construction contractors are a common audit client for small and mid-size firms because bonding companies and lenders ask for statements with a CPA's report. They are also one of the riskier ones. Revenue and gross profit depend on estimates of total contract cost and progress, and those estimates are made by people whose bonus, bonding capacity or bank covenant may depend on the outcome.

This guide covers the accounting under ASC 606, the work-in-process (WIP) schedule that sits at the center of the audit, and what to test.

How revenue is recognized under ASC 606

Many construction contracts meet the criteria in ASC 606-10-25-27 for revenue recognition over time, usually because the customer controls the asset as it is created, or the contractor's work creates an asset with no alternative use and the contractor has an enforceable right to payment for work performed. When the criteria are met, revenue is recognized over time by measuring progress toward complete satisfaction of the performance obligation (ASC 606-10-25-31 through 25-37).

Many contractors still describe this as "percentage of completion," the label from the earlier guidance. The method has not disappeared; it now sits within the over-time model, and the contractor must choose an input or output method that fits the contract.

Cost-to-cost as the common input method

The most common measure is cost to cost: costs incurred to date divided by total estimated costs at completion, multiplied by the transaction price. Revenue recognized is that percentage times the contract price, less revenue recognized in prior periods. The method works when costs incurred are a faithful depiction of progress. The auditor needs to consider costs that do not reflect progress, such as uninstalled materials purchased well before use, or inefficiencies that should not be counted. ASC 606 addresses both situations.

Contract-level issues to identify

Each significant contract needs analysis of:

• Identifying the contract and performance obligations. Combine contracts entered into at or near the same time with the same customer when the criteria are met (ASC 606-10-25-9). Decide whether design and build are distinct.
• Transaction price and variable consideration. Include incentives, penalties, and liquidated damages, constrained to the amount that is probable of not reversing.
• Change orders and claims. Account for approved modifications under the modification guidance (ASC 606-10-25-10 through 25-13). Unpriced change orders and unapproved claims need judgment about enforceability and the constraint on variable consideration.
• Contract costs. Costs to obtain and fulfill a contract fall under ASC 340-40.
• Retainage. Retainage receivable and payable should be presented consistently, with any financing component considered.

The WIP schedule

The WIP schedule is a contract-by-contract listing that sits behind the revenue, the contract asset and liability, and the backlog. Sureties and banks often ask for it. For the auditor, it is the primary information produced by the entity (IPE) and has to be tested for completeness and accuracy. See AU-C 500 audit evidence and the IPE testing worksheet.

A typical WIP schedule shows, for each job:

The balance sheet effect is the difference between revenue earned and billings. If revenue earned exceeds billings, the amount is a contract asset, often called "costs and estimated earnings in excess of billings" in the industry. If billings exceed revenue earned, it is a contract liability, "billings in excess of costs and estimated earnings." ASC 606 requires contract assets and liabilities to be presented on a contract-by-contract basis, so jobs in each position are not netted against each other.

Audit risks

Revenue and the estimate to complete

AU-C 240 presumes a fraud risk in revenue recognition, and a contractor's reliance on estimates of cost and progress makes the presumption difficult to rebut. The estimate of total cost is the main assumption and is subject to management bias. Under AU-C 540, the auditor evaluates the method, the data and the assumptions, and considers indicators of bias. See fraud risk assessment under AU-C 240.

Common manipulation patterns include understating estimated costs to accelerate revenue, deferring cost recognition by delaying invoices from subcontractors, and pushing jobs to look profitable until a large loss is recognized in a later period.

Loss contracts

When the estimated total cost exceeds the contract price, the entire expected loss is recognized in the period it becomes known. The provision for losses guidance for construction-type contracts in ASC 605-35-25-45 through 25-49 was retained when ASC 606 was adopted. Check that the loss accrual includes costs not yet incurred, and remember that contracts combined under ASC 606-10-25-9 are evaluated as a unit, while uncombined contracts are evaluated at the contract level (an accounting policy election also allows the performance obligation level, ASC 605-35-25-47).

Cutoff and unrecorded liabilities

Subcontractor and supplier invoices received after year-end are often the way to find unrecorded costs. Coordinate the work with the search for unrecorded liabilities and cutoff testing. Compare the last pay applications and change orders with the ending cost and billings.

Other risks

• Related parties, such as subcontractors owned by the contractor's owner, and the rates charged. See related party transactions.
• Joint ventures and teaming arrangements.
• Equipment, including ownership, depreciation and impairment.
• Going concern where jobs are fading or bonding capacity is limited. See going concern under AU-C 570.
• Payroll and certified payroll on public works.

Audit procedures to consider

1. Obtain the WIP schedule and tie it to the general ledger, job cost reports and the financial statements. Test the formulas and the roll-forward from the prior year-end.
2. Select jobs for testing by size, margin, risk and age. Include all large jobs and jobs with unusual changes, such as large estimate revisions, low margins or growing underbillings.
3. Read the contracts and the amendments and change orders. Confirm price, scope, retainage, liquidated damages and payment terms.
4. Test costs incurred by tracing job costs to vendor invoices, payroll records and equipment charges, and testing for correct job coding.
5. Test the estimate to complete. Interview project managers, read the latest cost to complete reports, compare estimates with actual cost and with subsequent costs, and consider a retrospective review of jobs closed in the year against their prior estimates.
6. Evaluate billings against pay applications and test for billings that were pulled forward.
7. Test collections and subsequent receipts on receivables and retainage. Confirm balances where appropriate under AU-C 505.
8. Review the fade or gain analysis. Compare the estimated gross profit on each job at the prior year-end with the final result, and look for a pattern.
9. Test disclosures. Include contract asset and liability balances and significant judgments. Remaining performance obligations are required for public business entities; a nonpublic entity may elect not to provide them (ASC 606-10-50-16).

A site visit to at least one or two large projects helps. It lets the auditor compare percent complete from cost with physical progress and talk to the people who make the estimates.

What sureties look for

Surety underwriters commonly ask for annual statements, sometimes interim ones, together with a WIP schedule. They focus on working capital, equity, backlog quality, over and under billings and the pattern of gross profit fade. A contractor with growing underbillings, which may signal that costs are ahead of billings or that revenue has been accelerated, can see bonding capacity affected.

The level of service, whether compilation, review or audit, is typically specified by the surety based on the size of the program. Confirm the requirement with the client before engagement. The surety will often want the WIP schedule included as supplementary information with a report on it in relation to the financial statements as a whole, which requires the auditor to apply the procedures in AU-C 725 to the schedule.

Common problems in the file

• WIP schedule not tied to the general ledger, or tied only at the total.
• No testing of the estimate to complete beyond asking the project manager.
• No analysis of jobs with zero or negative margin.
• No fade analysis, so the pattern of estimate bias is missed.
• Underbillings not evaluated for recoverability.
• Revenue disclosures not checked against the reduced requirements the entity relies on, or a nonpublic entity's election not documented.
• Revenue risk rebutted without documented reasons.

Frequently asked questions

Is percentage of completion still allowed under ASC 606?

The label has gone, but the economics remain. Many construction contracts meet the criteria for revenue over time, and a contractor measures progress with an input or output method. Cost to cost is the most common input method.

What is a WIP schedule?

A work-in-process schedule lists each open contract with price, estimated cost, cost to date, percent complete, revenue earned, billings and over or under billing. It supports revenue, contract assets and liabilities, and backlog, and sureties and lenders often ask for it.

What are overbillings and underbillings?

Overbillings are billings in excess of revenue earned and are presented as a contract liability. Underbillings are revenue earned in excess of billings and are presented as a contract asset. They are determined contract by contract.

How should an auditor test the estimate to complete?

Evaluate how management develops it, read contracts and cost reports, discuss it with project managers, compare it with actual and subsequent costs, and perform a retrospective review of closed jobs.

Do sureties require audited statements?

Requirements vary by surety and by bond program. Many require reviewed or audited statements above a certain size and a WIP schedule. Ask the client for the surety's requirements before accepting the engagement.

Sources

• FASB ASC 606-10-25-9, 25-10 through 25-13, 25-27, 25-31 through 25-37, 45-1, 50-7 and 50-13 through 50-16, Revenue from Contracts with Customers
• FASB ASC 605-35-25-45 through 25-49, Revenue Recognition - Construction-Type and Production-Type Contracts (provision for losses)
• FASB ASC 340-40, Other Assets and Deferred Costs - Contracts with Customers
• AICPA, AU-C Section 240, Consideration of Fraud in a Financial Statement Audit
• AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures
• AICPA, AU-C Section 725, Supplementary Information in Relation to the Financial Statements as a Whole
• AICPA, AU-C Section 500, Audit Evidence, and AU-C Section 505, External Confirmations

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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error