On a cost-to-cost contract, a single number drives revenue, margin, contract balances and the loss accrual: the estimate of total cost at completion. Every other schedule in the file inherits its reliability from this estimate. This guide covers how to audit the estimate and how to audit the provision when it shows a contract will lose money. For the full revenue model and WIP schedule mechanics, see the contractor audit overview.
Why the estimate gets its own work program
Progress equals cost incurred divided by estimated total cost. If the estimate is low, progress and revenue run ahead of the work. If it is high, revenue is deferred. Management has reasons to lean either way: bonding capacity, bank covenants, bonuses tied to profit, or a wish to smooth earnings across years. Under AU-C 540 the auditor evaluates the method, the data and the assumptions, and looks for indicators of bias. The general technique is in estimates and management bias.
Procedures on the estimate
- Understand the process. Who prepares the estimate, how often, from what inputs, and who reviews it? A monthly review by someone independent of the project manager is a control worth testing. Without one, plan for more substantive work.
- Rebuild the estimate from its parts. Agree committed subcontract values, open purchase orders, budgeted labor hours and equipment to the schedule of remaining work. Costs already committed but not yet incurred are the most auditable part of the estimate to complete.
- Test the uncommitted remainder. Compare unit costs and productivity assumptions with actual experience on the same job to date, and with comparable completed jobs.
- Look for omitted cost. Rework, warranty, liquidated damages exposure, delay and acceleration cost, remediation of defects, insurance and bonding premiums, and supervision through the end of the job all belong in the estimate.
- Use subsequent events. Costs incurred after year-end and invoices received after year-end show whether the estimate was reasonable at the balance sheet date. See search for unrecorded liabilities.
- Interview beyond finance. Talk to the project manager and superintendent, read meeting minutes and owner correspondence, and visit at least one large site.
- Run a retrospective review. Compare the estimate at the prior year-end for every job completed in the year under audit against its final cost. A one-directional pattern of overruns is evidence of bias even when each job looks defensible alone.
The loss provision under ASC 605-35
When ASC 606 replaced the earlier revenue guidance, the loss provision guidance for construction-type contracts in ASC 605-35 stayed in place. RSM's national guidance sets out the mechanics.
Unit of account. The contractor elects to recognize and measure the provision at the contract level, with combined contracts as the unit only where they were combined under ASC 606, or at the performance obligation level. The same policy applies to similar contracts. Test the policy election once, then test consistency across jobs.
Trigger and size. A loss exists when the current estimate of contract costs exceeds the current estimate of consideration expected to be received. The entire loss is recognized in the period it becomes evident, not as the job progresses.
Cost side. The estimate includes all fulfilment costs allocable to the contract. On cost-plus contracts, consider whether any costs are nonreimbursable. Include costs of change orders accounted for as modifications.
Consideration side. The estimate is the transaction price, reduced for amounts the contractor does not expect to collect because of the customer's credit risk and increased by the effect of removing the variable consideration constraint. A performance penalty on a contract expected to lose money belongs in the provision. The loss test uses the variable consideration estimate before the constraint is applied, so an incentive constrained out of revenue can still count toward the consideration. That is a judgment the auditor must challenge.
Presentation. The provision is an additional contract cost on the income statement and not a reduction of revenue, shown as a separate income statement line only when the loss is material or the nature of the loss is unusual or infrequent. A significant liability is separately presented as a current liability. Where costs have accumulated on the balance sheet for that unit, the contractor may recognize the provision as a reduction of those costs instead of a liability.
Worked example: a loss accrual
These figures are illustrative. A contractor holds a $1,200,000 contract. At the prior year-end, estimated total cost was $900,000. At the current year-end, cost incurred is $800,000 and the estimate has risen to $1,350,000.
| Measure | Amount |
|---|---|
| Contract price | $1,200,000 |
| Estimated total cost | $1,350,000 |
| Total expected loss | $150,000 |
| Percent complete ($800,000 / $1,350,000) | 59.26% |
| Revenue earned to date | $711,111 |
| Cost incurred to date | $800,000 |
| Loss already in the income statement | $88,889 |
| Provision for the remaining loss | $61,111 |
The income statement bears the full $150,000 loss in the year the loss becomes evident. Revenue and cost to date produce $88,889 of it, and the remaining $61,111 is the provision for the loss on work not yet performed. On the auditor's side, a $450,000 swing in the estimate in one year is a prompt to ask when management knew. If cost reports from earlier months already pointed to the higher number, the loss belongs in an earlier period or in prior interim information, and the question of controls over the estimate becomes a deficiency conversation.
RSM's illustration shows how sensitive the conclusion is. A $100 million hospital contract carries an $8 million early-completion incentive. When costs rise from $85 million to $105 million and management concludes the incentive is likely, the contractor tests against $108 million of consideration and records no loss. If management instead concludes the incentive is not likely, consideration is $100 million and the provision is $5 million. The loss turns on one judgment about variable consideration. Read the contract, the schedule and the evidence behind that judgment. See the variable consideration glossary entry.
PBC items
- Cost-to-complete reports by job at year-end and prior year-end
- Subcontract and purchase order commitment reports
- Project manager memoranda on schedule, delays and disputes
- Change order log, claims and correspondence with the owner
- Loss provision schedule, with unit-of-account policy
- Completed-job schedule showing estimated and final margins
- Subsequent cost and invoice listings
Red flags
- Estimated margin held flat while cost overruns accumulate
- A large estimate increase booked in the final month of the fiscal year
- Jobs at or near break-even with no analysis
- Loss provisions missing on jobs with growing underbillings
- Management relying on unapproved claims to avoid a provision
- Going concern indicators such as fading backlog or reduced bonding capacity; see going concern under AU-C 570
Sources
- RSM US LLP, Revenue Recognition for Construction Contractors (November 2025), section 7.4, Loss provisions on construction-type contracts, https://rsmus.com/content/dam/rsm/insights/financial-reporting/1pdf/revenue-recognition-considerations-for-the-construction-industry.pdf
- FASB ASC 605-35, Revenue Recognition, Construction-Type and Production-Type Contracts (loss provisions), as applied in the RSM guidance above
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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