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Auditing Construction Companies

In the auditing of construction companies, clear understanding and distinction need to be made between revenue, income and capital. In distinguishing income and revenue, IAS 16 specifies that assets which should be recognised as revenue are those which were held for rental and later transferred to inventory at their own caring amount and the sale that arise from these assets. Entities are sometimes considered appropriate when their sale are considered as revenue and their transactions to an extent that they (assets) have the characteristics of inventory and are sold normally in the business course at any given time. Receivable interests may or may not be part of revenue depending on the type of entity, for example, interests that are charged by an entity of manufacturing on customer’s receivables delinquent is not considered as revenue because deriving interest from income is not an ordinary activity for an entity of the manufacturing (PwC guidance 2). A closely related version is that given by IAS 18, it explains revenues as benefits that are economically receivable and received by an entity under its account.

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When it comes to distinguishing capital and income, it is difficult to determine what makes up capital. Cash contributions from the owner, acceptance of equity in satisfaction of a liability and assets when transferred are always made to subsidiaries by the parent companies. According to the revised version of IAS 1, contributions of capital are supposed to be presented within the statements to changes within the equity. Contributions to equity i.e. this type of contributions are not regarded as gains and are therefore in the income statement, they are not included. Determination of the appropriate treatment to contributions by an owner of an entity to the entity, the terms of the transaction substance should be made clear for auditing to be easy (IFRS 7’). When it comes to measuring revenue, IFRS 7’ is used as a guide to financial instrument understanding. It uses the fair value concept by laying down the concept while it maintains the definition as in other standards of fair value. IFRS 7’ operates hand in hand with IAS 32 and 39 guides (PwC guidance 7).

For auditing construction companies, US GAAP is majorly used in specific issues of measuring revenue. It contains the guidance for separating principle working entity and agency transactions, substance reporting for transactions, revenue gross report against net acting as the agent. The factors considered by UK GAAP and US GAAP are very similar to each other and to those contained in IAS 18 the summary includes; customers expectation whether the company in the arrangement of the entity is a primary obligator in its action, whether the entity modifies supplied goods or partly participates in the services provided. The others include whether the entity is moving slowly and changing supplier prices and its exposure to damage risk i.e. entity with inventory risk, whether the entity is operating as an agent, by latitude, within the constraints of its economy and in setting customer prices, whether the credit of transaction is associated with the entity if it has it or assumes its risk, whether there is discretion by the entity in supplier selection (PwC guidance 12).

Note that G in the application, there is a rebuttable when seller does not disclose to the customer that he is the acting agent the seller is therefore assumed to be the principal. This is because the party bearing the risk of the contract is the one the customer assumes to be transacting with for contractual performance completion. Similar to EITF 99-19, stating the primary obligator of an arrangement is the entity, this strongly indicates that the entity is the principal. With IFRS, hierarchy does not exist as an indication and there would be need for equal consideration for the representation of the arranged substance. An indicator that a manager should consider whether an entity is working as an agent or principal and retains the credit risk is detailed in IFRS 7’, the least significant factor is normally identified as the credit risk.

Fees for financial services may arrive in different forms in relation to unit trusts and funds, these include fees for commitment, performance and management fees end even original loan fees. Due to the challenges faced in the determination of financial services relationship between IAS 39 and IAS 18, which provides guidance to IAS 39, IFRS 7’ and IAS 32 in recognition of revenue, the fees for financial services was found to depend on the accounting basis in related instruments of finance and the provided services (PwC guidance 27). The nature of fees charged may not be necessarily indicative on the type and quantity of the provided services.

When determining fees of the interest rate, fair value of loss or profit are classified under IAS 39 with the guidance of IFRS 7’ and IAS 32 as the fees which are originally related to acquisition of asset finance. This type of fees includes the one for transaction and finalising, document preparation and processing, terms of the instruments negotiation, other security and collateral, recording guarantees and evaluation and the position of the financial borrower. When the loan commitment is not within IFRS 7’, receiving commitment fees should be from a loan. If the probability of entering in lending agreement by an entity is high, and commitment of the loan is excluded in IAS 39’s scope, there is deferment of the fee of commitment and the costs that are related are recognised and adjusted to interest rate effect (PwC guidance 13). If a loan has not been made and commitment period has expired, the fee is then considered as revenue during the commitment period expiration.

When mortised costs are measured, issuing of financial liabilities is originated from received fees. This type of fees is integral in generating and involving a liability financially. If this liability is not in any way classified as fair value through loss and profit fees, together with related costs of transactions incurred, they are to be adjusted to affect the rate of interest of instrument and included in the financial liability of the caring amount initially.

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Issues facing auditors – construction companies

Recognition of the Revenue

In the use of assumptions and estimates, revenue recognition of the group would apply to the method of percentage of completion during contracts construction accounting. The method of percentage of completion needs an estimate of the performed construction to the present date as a ratio of the whole construction that is to be performed. Total profit is also a significant uncertainty.

Recognition of revenue occurs when services are delivered separately. When just a service is provided, recognition of revenue is just when the service is performed. If services are ongoing and they are to be connected or delivered, revenue will be allocated to specific services using a method that is appropriate and recognition will only be made when there is delivery of service. Revenue allocations to elements that are multiple are usually considered (Kendrick 25). Connection costs may sometimes be capitalised only to an extent that specific criteria is discussed.

Before revenue can be recognised, one of the criteria to be recognised for the rendering of services or sale of goods, reliable measurement or costs incurred is a major criterion. In some situations, cost timing can significantly vary from the revenue recognition profile. This can happen when contracts are being outsourced where costs may be incurred by the service provider before receiving revenue. When such occasions arise, it may be questionable if it is appropriate to defer the arising cost till recognition of revenue starts in the income statement of income. The balance sheet approach considers how costs and revenues should be recognised. As a realisation, the balance should be recognised only on the balance sheet to an extent that the definition of liability or asset is met within the definition of framework.

In barter arrangement, a case study is used where a travel agency is assumed to sell low priced holidays. The agency makes an agreement with a radio station (broadcaster), the travel agency allows the broadcaster to advertise on the agency’s web page while the radio places an advertisement in the broadcast, the travelling agency will account for the revenue in the following way; the agency will recognise advertising expense and revenue, this in reference to the advertising value of provided service is calculated and exempting the value of received services. The advertising medium is not similar in nature. Therefore, this sale is considered as revenue generated from the transaction.

According to SIC 13, the value of the advertising service can be measured by the seller if it provides an exchange to reference barter transactions. For the evidence to be sufficiently reliable, the barter transaction measurement should involve a similar advertisement to the barter transaction, frequent occurrence, involve a fair form of consideration e.g. cash that is reliable in nature, the same third party should not be involved in the transaction of the same manner, a predominant number of transactions to be represented and when compared to all transactions should amount to an advertising that is similar to the barter transaction.

In calculating the amount of revenue for recognition, the manager may need to do estimation on the sales volume or the settlement discounts expected to be taken. The recognised revenue is reduced therefore by the estimate and this would be a representation of the fair value and the expected consideration to be received. The importance of estimating the expected discount which is to be taken does not include revenue reduction for the discount (Kendrick 47). On the other hand, if a reliable estimate cannot be made, the recognised revenue on the transaction should not be more than consideration amount to be received in the taking of the maximum discounts to be taken.

Recognition of contract revenue and cost

The conditions contained in the recognition of cost and revenue fall into two categories:

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  • Fixed price contract it includes conditions where reliable contract revenue can be measured, the economic flow to the enterprise, cost of the contract, completion strategy at B/S, the actual cost and the cost comparable to prior estimate.
  • Cost plus contract which is made up of measurement of reliability, the probability that the flow of economy to the enterprise will be beneficial and clear identification of the cost.

The following exclusions are normally made in the cost of construction, general costs of administration where reimbursement is not necessarily specified in the contract, costs of selling, costs of R & D which are not specified in the contract, the cost of depreciation for idle equipment and plant. The conditions that are satisfied can be either positive or negative. If they are positive then there can be reliable estimation of the final outcome. If the conditions satisfied are negative, then revenue will be assumed to be equal to recoverable cost, the contract can therefore, be recognised in the period they are incurred. The revenue/ cost are usually in respect to the stage of completion.

Assumptions are made that the contract outcome cannot be estimated reliably in the contract’s early stages. Up to 20-25% of the contract initial stages are considered as the early stages of the contract (PwC guidance 34). Judgemental and subjective limits sometimes have to be made. Other contracts may ignore these stages especially those with high degree of experience. Incentives claims and variations to be recognised are those whose probability is likely to go to an extent that they can reliably be measured and can result in revenue

Other conditions that need satisfaction are the recognition of negotiable claims that can reach advanced stages, contract advanced sufficiently with a probability that the performance specified standard will be exceeded or at least be met. For the conditions of cost of variation inclusion within the cost contract, a sceptics’ degree in recoverability of this type of amount should be used. It is more likely that the judgemental in keys when determining at what point should contingent revenue be recognised, the benefit of economic inflow probability and measurement reliable to contingent is measured. The assessment of these two criteria may be a little bit difficult. Based on the circumstances and facts, these criteria can be done subsequently or upon contract inception.

Accounting Problems in Construction

The revenue of an entity is considered as its most important aspect because it always aids in the business development and determines the size, growth and the general development of the various sectors of the business. The management therefore in its accounting procedures have to consider the revenue as the main indicator and signs of the performance of its financial processes. The accounting results of the revenue will always project the actual impact of the gross margin and the profits of operations plus the various calculations of EPS and the various properties of non –GAAP measures of an entity which will include the EBITDA. It is therefore very important to note that the auditing procedures used in an entity reflects the actual values needed by a company for the purposes of management ,financial sanity and safety and most importantly the sustainability of the business model without creation of unnecessary losses (Isaac & Ronnie 142). The amount that is shown on the audit financial statement of the constructions audit results is the most important aspect of the audit report because it provides the lifeline of the company’s survival or the developments into the future prosperity and sustainability of the business model.

The contracts that fall within the IFFS 4 always include the provision of services having a fixed fee which depend on the agreement of the client and the service provider; however in certain countries these kinds of contracted services are not having insurance contracts making their auditing to be a little complex (PwC guidance 37). For example when a contractor comes to an agreement with a client to fix or carry out a repair of a particular material or structure within a fixed range of fee minus all the legal backings then the auditing becomes a little complex therefore compromising the quality of the resultant auditing due to the lack of benchmarking.

For an auditing processes to carry out a reliable estimation of its processes of service rendering in relation to the revenues of the company, the following major points must be factored and properly implemented in a manner that can be followed throughout the process; the terms of settling the revenue issues at hand and the manner in which the actual auditing is approached, the factors to be considered in a holistic approach for the payable and the receivable parts of the finances under consideration and finally a consideration of the various individual parties rights which can be legally enforced in relation to the services enacted in the contract. For the audits to be reliable and the related estimates to meet the actual demands and intended goals of the process, the business entity should have internal budgeting, auditing and reporting procedure that is effective and undergo regular review for the purposes of efficiency and competence in the sector in relation to other players in the same sector with the aim of achieving a sustainable and effective model of running the auditing process and procedures.

The two accounting methods; the completed contract method and the percentage of completion methods which are both used by auditors in the auditing of the construction companies, both possess great cons and pros for the effective acquisition of the necessary goals of the project under auditing (Shapiro 68). They both present various technicalities in relation to the required end products of the processes under auditing.

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Most of the auditing companies prefer the percentage of completion method for the auditing of the companies in the construction sector who major on the projects having long term duration to the completion or the finalization stages, this is because the wait to the moment of completion before the final auditing is carried might complicate the financial safety of the companies in relation to their financial stability and the safety of the process in relation to the short term financial requirements of the process in general.

The percentage of completion proves complexity in its use because of the need for the revenues to be justified via the need for matching of the revenue amounts in relation to the period hence confronting the auditors with the enormous task of developing massive matching models of the revenues under auditing. The recognition of the percentage of completion in relation to the gross profit and the revenues under investigation during the period under which the construction is in the process even before the finalization of the project develops complexity in that if the final stages of the construction life fail to succeed then the general viability and profitability of the project might not be achieved in relation to the result of this auditing procedure (Shapiro 75). The division of the part or extent to which the project duration has reached in relation to the overall duration the project is expected for the project is expected to cover and the revenue it is to raise or consume forms a matter of extrapolation for the auditors hence the resultant accounting results is kind of complex for the actualization of the findings of the auditing procedures.

This auditing procedure banks majorly on the estimation of: gross profit as per the date of the auditing, the estimation of the percentage of the construction that is completed, the total profit that is estimated and the total cost of the construction. This will obtain results of auditing which are majorly estimated prior to the completion of the construction work without the factoring in of the related risks and shortfalls of the monetary changes to the running of the institution (Isaac & Ronnie 143). Because the journals of entry of the operations of the construction firm is used in this entire process, then if the entries are inaccurately made or errors relate to them then the consideration of the gross profits, expenses of the contract and the revenues collected and extrapolated will be highly compromised.

The complete contract, method of accounting is normally employed by the contractors and the manufacturers, here there is the deferral of revenues, expenses and the general profits until the end of the process, therefore the costs related to the construction process within a year are accumulated within the balance sheet of that fiscal year (Isaac & Ronnie 139). The accumulation of the balance sheet brings up the complexity in the running of the enterprise with minimal losses and meeting of the short term financial gains and stability is highly compromised due to the approach of accounting that is employed. This method is poor for the planning of the construction project in relation to the accurate reflection of the revenues when they are earned, exact period of the profits incurrence and the periods of the profitability cannot be clearly indicated when using this approach (Shapiro 38). However, the approach provides great advantage in relation to the tax remunerations and the amount of tax that is paid post the project completion due to the overall summation approach.

Accounting Methods

Percentage-of-Completion

This method is very crucial for the purpose of tax recognition.

Completion of percentage = construction costs to date / estimated contract cost otherwise called the estimated revenue. It derives gross profit.

The difference between total revenue earned to the present date minus gross profit or revenue recognised in the other years is required to be entered in the journal to determine the current year’s gross profit (revenue). Revenue for the current year = Revenue to date – Revenue in prior years.

Illustration

(Note: This is a simplified illustration for this method and it ignores some events which are specific to construction companies e.g. charge orders and charge estimates.)

e.g.; Contract = Ten thousand dollars costs total = eight thousand dollars Year 1 costs = two thousand dollars

Bills for 1st year = three thousand dollars 2nd year costs = four thousand dollars Year 2 billings five thousand dollars

By 1st year asset account accumulates cost and is entitled to Construction in progress (CIP)

CIP 2, 2,000
Payable accounts 2, 2,000

A contract account is drawn for construction in progress i.e. Progress Billings;

Receivable contracts 3, 3,000
Progress Billings 3,000

Completion by percentage computation is used to divide costs with estimates;

This is journal entry is then made in the reflection of the gross profit, expenses for a ne year contract and the revenues.

CIP 500
Expenses of Construction 2,000
Revenues of construction 2,500

For year two the profit gross is obtained;

Percentage complete = six thousand/eight thousand = seventy five percent.

Gross profit for the current year = 75% X 2,000 – 500 = 1,000

The journal entry below is therefore made for gross profit reflection, expenses for year two contract and revenue.

CIP 1,000
Expenses of Construction 4,000
Revenues of construction 5,000

Completed Contract Method

This is a method that finds common application in both the process of accounting and also the manufacture of the materials that will be used in the construction industry by the related authorities. This method involves the use of the revenue that has been collected as well as the expenses related to accounting and the profits; these are used to determine the entries which might have been deferred up to the point in which all the related entities have been successfully completed and the; it is after ensuring that all the construction processes have been completed that the company which has been allocated the task of carrying out the audit finishes the final process. It is very important to put into consideration all the factors that are involved in this process to ensure that there is no mix-up during the auditing process. The income should be well defined and all the factors and constraints put under consideration to ensure that all the issues that are related to tax and the allocation of revenues as well as profit identification are all well understood before the auditing process takes place.

The completed contract method makes use of an approach that does not include the incurred expenses or revenues; there is also the issue of the profits that might have been accrued during the time that the project has been in operation. Despite all this, the method has an edge in that the approach and methodology that is utilized leads to recognition of even the low tax allowances and hence it can be used to ensure that there is thorough process of auditing and that all the taxes that are due for payment are identified and remitted to the relevant authorities (Shapiro 147). The completed contract method is efficiently applicable to contractors who work with a capital of less than $10 million hence enabling satisfactory auditing of their finances. In the auditing process for the construction industry, this method plays a key role and it should be carefully considered to ensure that all the factors as well as the constraints are put into consideration and the process runs as expected.

Completed and Implemented by IFRS

The percentage of completion approach is considered the most appropriate method to use in the process of the accounting for the construction companies for the purpose of auditing; this is especially applicable for the companies that are working on the contracts that are long term in nature like the IFRS. This method of accounting therefore has the potential of recognizing gross profits and revenues within the financial management of the construction companies. It is on this basis that experts and researchers have identified this approach for playing a key role in the auditing process for the construction companies.

Therefore in the process of auditing the contracts that are given in construction companies, it is very important to ensure that all the relevant laws are followed to the letter, of great importance is the need to ensure that the system that has been chosen to implement the contract is keenly observed. Whether the auditing is done via GAAP of IFRS, the management needs to ensure that the auditing is done as per the regulation and all the taxes that are due are paid promptly. It is clear that there are a number of challenges that need to be addressed in the process of carrying out auditing for the contracts in the construction industry; the assets and the revenue that is due for taxation need to be clearly defined and the. It is also important to clearly identify the method, which will be used for auditing the contracts to ensure that all the thresholds for the contract are met.

Works Cited

Isaac, Shaven., & Ronnie, Navon. “Feasibility Study of an Automated Tool for Identifying the Implications of Changes in Construction Projects.” Journal of Construction Engineering and Management 134, 2 (2008): 139-145. Print.

Kendrick, Katherine. “Demystifying Construction Risk Management and Insurance.” Construction and Infrastructure Law Newsletter. A publication of Miller Thomson LLP’s Construction and Infrastructure Group, 2009. Print.

PwC Guidance. IFRS Manual of Accounting. Web.

Shapiro, Bryan. “Inherent Conflicts in the Construction Industry and the Structure of Contracts.” Fundamentals of Construction Contracts, Understanding the Issues, conference held in Vancouver, B.C., hosted by Lorman Education Services. 2005. Print.

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