Construction Industry Overview

Definition of Construction Industry

• Encompasses building, maintaining, and repairing structures
• Includes drilling and solid mineral exploration
• Classified under the Standard Industrial Classification

Categories of Construction Industry

• Building Construction Industry: Involves general contractors and operative builders
• Primarily focused on residential, farm, industrial, commercial, or other building construction
• Heavy Construction Industry: Includes general contractors involved in heavy construction projects, excluding building construction
• Examples: highways, streets, bridges, sewers, railroads, irrigation, flood control, and marine construction
• Includes special trade contractors for activities not typically done on buildings, such as highway grading or underwater rock removal
• Special Trade Construction Industry: Includes contractors specializing in activities for building and non-building projects
• Encompasses mobile homes, painting, electrical work, and plumbing
• Excludes activities specialized for heavy construction

IAS 11.3 Definition

• Construction contract: A contract negotiated for the construction of an asset or a group of interrelated assets

IAS 11.8-10 Accounting

• Contracts covering multiple assets require separate accounting for each asset's construction if:
• Separate proposals were submitted for each asset
• Contract portions for each asset were negotiated separately
• Costs and revenues of each asset can be measured
• Otherwise, the entire contract is accounted for as one
• Two or more contracts are treated as a single contract if:
• Negotiated together
• The work is interrelated
• If a contract allows the customer to order additional assets, each additional asset's construction is a separate contract if:
• The additional asset differs significantly from the original assets
• The price of the additional asset is separately negotiated

Key Components of the Contract Equation

• Original Contract Price: Is it properly calculated based on contract terms?
• Modifications:
• Are all modifications included that meet GAAP recognition criteria?
• Has the client recognized all modifications that meet GAAP criteria?
• Have modifications been accurately measured according to GAAP?
• Costs to Date: Do they represent capitalizable costs for the specific job?
• Have all capitalizable costs been allocated to the job?
• Estimated Costs to Complete: Are all future costs included and properly measured?

Audit Objectives for a Contractor

• Contractor audits focus on individual contracts
• Procedures assess inherent and control risks within the context of materiality
• Procedures evaluate if clients recognized material change orders meeting SOP 81-1 criteria
• Substantive audit procedures gather evidence

Audit Planning

• Performed at two levels
• Overall entity level: Assess risk, understand the contractor's estimating process, and the significance of estimates
• Individual contract level: Assess risk

Estimating Impact on Contract Equation

• Estimated costs to complete, contract penalties/incentives, profit from change orders and revenue from a claim are considered
• Equipment costs: Equipment charges are allocated depending on the internal use rate, useful life, average idle time, and operating costs
• Percentage complete: Project percentage is considered an estimate

Assessing Risk of Individual Contracts

• Lower Risk: Considers small jobs and previous successful projects
• Higher Risk: Considers large jobs and materials not readily available

Phase One: Review Schedule of Uncompleted Jobs

• Lower Risk: Has jobs with 0-25% complete or greater than 90% complete
• Higher Risk: Has jobs 25%-90% complete

Phase Two: Make Inquiries of Management

• Lower Risk: Considered simple and routine
• Higher Risk: Considers the job complex and unique

Phase Three: More Factors that Influence Project Risk

• Profit Fade: No significant profit fade vs. significant profit fade
• Underbilling: Normal/nominal vs. unusual/significant
• Type of Contract:
• Cost-type with clear definition of reimbursable costs
• Fixed-price or cost-type, difficult to determine reimbursable costs
• Claims: No claims vs. significant claims

Internal Control Considerations

• Working Capital: Adequate working capital
• Management Philosophy: Not overemphasizing volume
• Job Management: Strong control environments with formal schedules and cost comparisons

Other Audit Considerations

• Employee Retention: High retention in key positions indicates a strong control environment
• Relationships: Assess relationships with banks and subcontractors
• Bidding: Bids should be complete with broken down quantities and prices
• Accounting Systems: Should provide clear financial estimates

Job-Site Accounting

• Decentralized operations are unique to contractors
• Financial records, cost control, and overhead control are all performed away from headquarters

Contract Revenue

• Should be measured based on the individual judgment of the contractor
• Dependent on penalties, incentives, and reimbursable costs

Accounting Procedures

• Emphasize knowledge of contract terms and status
• Job cost systems track records and predict the future

Financial Statement Control Areas

Types of Contracts Based on Pricing

• Fixed-Price/Lump-Sum: For a fixed price
• Cost-Type (including cost-plus): For a price determined by costs incurred
• Time-and-Material: Price based on fixed hourly rates and cost of materials
• Unit-Price: Specified price per unit of output

Revenue Recognition

• On long-term construction, revenue can be recognized as construction progresses based on the likelihood of proceeds
• This is an exception of realization

Comparison between Percentage-of-Completion and Completed-Contract Methods

Grouping Methods

Combination of Contracts

• Allowed if contracts are:
• Negotiated in same environment
• Same project
• Interrelated
• Performed at same time
• Agreement with a single customer

Segmentation of Contracts

• Allowed if the contractor submits proposals on project and entire project

Measuring Progress on Contracts

• Input-based: costs, efforts expended
• Output-based: units produced, units delivered, milestones

Basic Contract Price

• Total revenue is determined from the contract, and can be fixed or variable

Claims

• Only recognize if it is probable that they will result in revenue

Contract Costs

• Should be accounted for with inventory costs
• Contract costs include direct (materials, labor) and indirect costs (subcontracts)

Estimated Contract Cost

• Total costs consist of to date costs and estimated completion costs

Revised Estimates

• Changes due to accounting errors
• Should involve systematic procedures to compare costs

Calculating Income based on percentage

Provisions for Loss

• Made when losses become evident

Transition Requirements

• Changes should be made on a retrospective basis with current information

Question 1: Methods of Measuring Progress

• According to Statement of Position 81-1
• cost-to-cost method
• variations of the cost-to-cost method
• efforts-expended methods
• the units-of-delivery method
• the units-of-work-performed method

Question 2: Preferability of Completed-Contract Method

• When dependable estimates are lacking or there are inherent hazards
• This is according to the FASB Amended Pronouncement on Long-Term Construction-Type Contracts

Question 3: Loss Recognition

• Under the completed contract method losses are recognized fully in the year of discovery

Question 4: Journal Entry for construction costs

• Construction in Progress is debited and Cash is credited

Question 5: When to Use PoC Method

• When reasonably dependable estimates can be made
• with specified rights and terms of settlement
• when the buyer and contractor can be assumed reliable