Construction Accounting & Auditing

CONSTRUCTION CONTRACTORS:
ACCOUNTING AND AUDITING
BY JAMES WIEDEMANN, CPA; AND

ROBERT MERCADO, CPA, CCIFP
Notice to readers
Construction Contractors: Accounting and Auditing is intended solely for use in continuing
professional education and not as a reference. It does not represent an official position of the
Association of International Certified Professional Accountants, and it is distributed with the
understanding that the author and publisher are not rendering legal, accounting, or other
professional services in the publication. This course is intended to be an overview of the topics
discussed within, and the author has made every attempt to verify the completeness and accuracy
of the information herein. However, neither the author nor publisher can guarantee the
applicability of the information found herein. If legal advice or other expert assistance is
required, the services of a competent professional should be sought.
You can qualify to earn free CPE through our pilot testing program.
If interested, please visit https://aicpacompliance.polldaddy.com/s/pilot-testing-survey.
© 2020 Association of International Certified Professional Accountants, Inc. All rights reserved.
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ISBN 978-1-119-74650-8 (paper)

ISBN 978-1-119-74658-4 (ePDF)
ISBN 978-1-119-74657-7 (ePub)
ISBN 978-1-119-74659-1 (obk)
Course Code: 733864
CAAT GS-0420-0A
Revised: March 2020
Table of Contents
Overview Overview-1
Chapter 1 1-1
Nature of the Construction Industry 1-1
The construction process 1-7
Characteristics unique to contractors 1-11
Chapter 2 2-1
Significant Changes – Contract Accounting and Lease Accounting 2-1
Chapter 3 3-1
Financial Statements for the Contractor 3-1
Chapter 4 4-1
Working With a Surety 4-1
Chapter 5 5-1
Audit Planning and Risk Assessment Procedures 5-1
Appendix 5A: Job History Reports Chapter 5, A-1
Chapter 6 6-1
Substantive Auditing Procedures 6-1
Chapter 7 7-1
Other Auditing Considerations 7-1
Glossary Glossary 1
Index Index 1
© 2020 Association of International Certified Professional Accountants. All rights reserved. Table of Contents 1
Solutions Solutions 1
Chapter 1 Solutions 1
© 2020 Association of International Certified Professional Accountants. All rights reserved. Table of Contents 2
Overview
Course goal
Provide an application-oriented review of all the specialized accounting and auditing requirements
that affect construction contractors.
Introduction
Construction contracting is a unique and complex industry, and the work of CPAs in providing
accounting, auditing, and tax services to construction contractors is a unique and complex niche in the
accounting profession. The purpose of this course is to give you the specialized and detailed information
you need, whether you are a practicing CPA with construction contractors as clients or on the staff of a
construction contractor.
Organization
The manual is divided into two main sections. The first section explains how construction contracting is
different from other industries. It introduces you to the particular characteristics of the industry with an
emphasis on those that have accounting, audit, or tax consequences. Accounting for long-term construction
contracts is covered in this section. The section closes with a chapter on the contractor-surety relationship
and how sureties use a contractor’s financial statements.
The second section of the course focuses on audit issues and approaches that are unique to construction
contractors. Included here are detailed analytical review procedures for contractors and the typical
substantive procedures performed in an audit. In this section you will also find a description of how the
© 2020 Association of International Certified Professional Accountants. All rights reserved. Overview-1
guidance in the auditing chapters can be adapted to perform a review in accordance with Statements on
Standards for Accounting and Review Services.
Surveys show that more than 90% of all construction bonds are in amounts of $1m or less. In other
words, most jobs are for less than $1m, and most contractors are not very large. Therefore, this course
emphasizes issues that affect the small- to medium-size contractor. Wherever possible, it offers practical
guidance and tips based on the experience of the author and those who helped with the preparation of
the course.
Conclusion
The manual is designed to be a permanent reference tool. We hope your reading of it enriches your
professional learning experience.
© 2020 Association of International Certified Professional Accountants. All rights reserved. Overview-2
Chapter 1
Nature of the Construction Industry
Learning objectives
Recall the predominant types of construction contractors and the work they typically perform.
Identify the common significant steps within the overall construction process.
Recognize select characteristics that are unique to the construction industry and that have
accounting, audit, tax, or consulting consequences.
Introduction
Learning objective: Recall the predominant types of construction contractors and

the work they typically perform.
The construction industry offers many opportunities for the small practitioner. There are several reasons
for this:
The construction industry employs more people and contributes more to the GNP than any other
industry in this country. It is one of the largest segments of the national economy, and, therefore, a
large market for CPAs.
© 2020 Association of International Certified Professional Accountants. All rights reserved. 1-1
Historically, because of the ease of entry into the industry, many construction contractors have been
small, family-owned businesses. These kinds of businesses are well suited to the services provided
by smaller CPA firms.
Most contractors are required to post a bid or performance bond in order to obtain the contract.
These bonds are issued by sureties who require audited (or at a minimum) reviewed financial
statements. In some situations, the surety will also require interim statements.
The taxation of construction contractors can be complex and typically requires the expertise of a
CPA.
If you have ever been involved with a home renovation project or followed the progress of a public
construction project in the newspaper (for example, a highway or an airport), then you know something
about the construction business.
Have you ever remodeled your bathroom or built an addition to your house? Heard your neighbor tell the
story of their remodeling project? If so, then you know how difficult it can be to coordinate the work of all
the trades. You know something about budget overruns and change orders. You know how unforeseen
events are a significant risk for any construction project, even those that are well planned.
This chapter will not make you an expert on the construction industry. The main objective of this chapter
is to point out those characteristics of a construction business that make it different from other
businesses. The focus is on those areas that have the greatest impact on the services you provide to
your contractor clients.
Construction industry overview

The construction industry has a large impact on our nation’s economy, employing more people and
contributing more to the gross national product than any other industry. However, as the industry tends to be
cyclical in nature, some economists state that our nation’s economy follows the construction industry by
about 18–24 months. A negative impact to the construction industry has such a large impact on suppliers
and the labor force that our nation as a whole suffers. Currently, just over a decade after the economic crisis,
the construction industry is once again booming trying to keep pace with demand. This challenge is just one
of the many that make construction accounting a unique and complex practice area.
The construction industry is different from other industries in many ways.
Contributes a significant portion of the U.S. economy

Many types of contractors
Variety of players unique to the industry both inside and outside of the entity
Construction process is different from a typical sale
Risks not found in many industries
Size of the construction industry
The construction industry is one of the largest sectors of the U.S. economy. The Associated General
Contractors of America estimates there are 680,000 construction employers in the United States.1
According to the Bureau of Labor Statistics, as of October 2019, the construction industry employed
7,527,000 workers in the United States; the highest level of employment since March 2008. 2 The most
common occupations in construction are laborers, carpenters, and first-line supervisors of trades.
Finally, the Bureau of Economic Analysis in their last release of data indicates that the construction
industry adds $654.8bn to the economy of the United States.3
Types of contractors
The definition of a contractor can be very broad, so it is important that any adviser understands the
general makeup of the industry. Different types of contractors have different risks and service needs.
Construction contractors can be classified based on their size, the type of construction activity they
undertake, and the nature and scope of their responsibility for the construction project. As a first step
toward servicing your construction clients, you should understand how they fit into the summary in
exhibit 1-1.
Exhibit 1-1 Types of contractors
Contractor type Nature and scope of work
Design-build Also known as a “turnkey” contractor, they specialize in heavy

construction such as power plants, refineries, and hydroelectric
facilities. A design-build project requires extensive management
skill, including the ability to manage projects over a wide
geographical area. A design-build contractor manages all phases
of the project, from the feasibility study through the final
construction.
Heavy construction Can build roads, bridges, dams, airports, or large buildings.
Typically, the work is performed for public agencies or large
corporations that do their own designing and engineering.
1
Associated General Contractors of America, Construction Data, https://www.agc.org/learn/construction-data
2
Bureau of Labor Statistics, Construction: NAICS 23, https://www.bls.gov/iag/tgs/iag23.htm
3
Trading Economics, United States GDP from Construction, https://tradingeconomics.com/united-states/gdp-from-
construction
Exhibit 1-1 Types of contractors (continued)
Contractor type Nature and scope of work
General contractors General (or prime) contractor who enters into a contract with the
owner and who takes full responsibility for its completion. Can
engage subcontractors to perform specific parts or phases of
projects. Specialties might include housing, schools, hospitals,
office buildings, manufacturing plants, or warehouses.
Subcontractors A second-level contractor who enters into a contract with the

general contractor to perform a specific part or phase of a
project. Specialties can include electrical, plumbing, concrete,
mechanical (including heating and air conditioning) carpentry,
drywall, and flooring.
Construction manager Enters into an agency contract with the owner to supervise and
coordinate the construction activity on the project, including
negotiating contracts with others for the work. The distinction
between a construction contractor and a construction manager
is important for tax purposes.
Players in the industry

Just as it is important for us to understand the type of contractor we are dealing with, it is also important
that we understand whom the contractor is dealing with. This understanding should play a major role in
determining client acceptance criteria and who may be affected by the advice we have given to our client.
Exhibit 1-2 Players in the industry
Player Considerations
Project owner Who are the parties that our client serves?
Architect and engineer Where are the plans coming from? What is the reputation? How
aware are they of the contractor implications to the building
plans?
Exhibit 1-2 Players in the industry (continued)
Other contractors What type of subcontractors do we use? What is the capacity of

the subcontractors we use? Are the subcontractors bonded? Can
the subcontractor handle the job?
Surety What does the surety look at? What is the reputation of the
surety? What is our reputation with the surety? Have we provided
the surety the correct information needed to make a strong
decision for our contractor?
Bond agent What is our relationship with our bonding agent? What avenues
of bonding do they provide? Do they understand our line of work?
Is the agent well versed in the construction industry?
Lawyer What experience does the lawyer have with construction law or
labor law?
Banker Who is loaning the funds for the project? What agreements does
our client have in place to fund his cash flows? Is the banker
knowledgeable on the bonded A/R?
CPA What is their reputation in the construction industry? Does the

CPA understand construction financial statements? Do they
understand the role between the contractor, the surety, the bond
agent, and the CPA?
Players within the contractor-client relationship

Within the construction contractor landscape there are a variety of players that can make or break the
success of the business.
Exhibit 1-3 Players within the contractor-client relationship
Owner(s) of the What is his or her character? Reputation? What is his or her
company attitude? Experience? Capacity? How does he or she set the tone
“at the top”?
Controller or bookkeeper What is his or her experience? What is his or her skill? How
reliable is he or she in providing us the information? What is the
difference between the bookkeeper and the controller or are they
one in the same?
Estimator(s) What is the experience level? What is his or her ability? How
effective is he or she? What projects has he or she estimated?
Are we evaluating his or her bidding successes and failures?
Project manager(s) What is his or her experience? What is his or her capacity? Are
we evaluating his or her project management successes and
failures?
Labor force Is the labor force unionized? What is the skill? Labor supply?
What is the legality of the labor force? What are the current
immigration laws? Are there independent contractors?
Knowledge check
1. Which type of contractor is a second-level contractor who enters into contract with the general
contractor to perform a specific part or phase of a project?
a. Subcontractor.
b. Construction manager.
c. Architect.
d. General contractor.
The construction process
Learning objective: Identify the common significant steps within the overall
construction process.
Suppose you get a phone call from a local businesswoman. Her company needs financing, and her
banker told her that she needed an audit of her financial statements. The banker recommended you.
The businesswoman has never hired a CPA to audit her financial statements before, and she is curious
about the audit process.
Without getting into too many technical details about audit risk and assertions, how would you describe
an audit, from the initial bid to the completion of the work? You might describe the audit process as
follows:
Estimate the cost of the job and preparing a bid

Sign an engagement letter
Send the staff to do the work
Manage and perform the work
A construction project follows a similar process. You might describe the construction process as the
process that follows:
Prepare cost estimates and bids

Enter into the contract
Start the job
Project management
Preparing cost estimates and bids

The first thing a CPA will do is review the potential client’s financial statements, operations, books and
records, and then estimate what it will cost to perform the audit. Next, a bid is submitted to the client,
typically with an engagement letter attached.
The contractor’s client is referred to as the owner. When an owner wants to construct a new facility, it is
customary to hire an architect or engineer to prepare plans for the project. The contractor reviews these
plans and estimates what it will take to complete the project. Preparing a cost estimate for a
construction project is similar to estimating the cost of an audit and involves estimates of
the quantities and price of materials;

the hours of various labor classifications;
the types and hours of any required equipment; and
whether subcontractors will be used to perform any phases of the job.
Quantity surveys, or takeoffs of the quantities of materials required for the job prepared by the design
firm or an independent agency, are often available for contractors to use as a check on their own
estimating department.
Like an audit, some construction projects are put out to bid. Other projects are not; the price is negotiated
between the owner and the contractor. Whether a contractor performs bid or negotiated work has an
impact on that contractor’s operations.
Once a CPA firm has determined how many hours it will take to perform an audit, then the firm prepares
a bid. In preparing the bid, the CPA firm will consider the standard billing rates for the staff and partners
as well as other factors that may come into play, for example, whether the work is to be done during the
busy season or during the off season, will travel be required for the engagement team, or will specialists
be required.
Once the contractors have estimated the cost of the project, they are faced with a similar decision – how
much to mark it up. Factors the contractors may evaluate when considering markup are presented in
exhibit 1-4.
Do not overlook the fact that in most situations the contractor should estimate the timing of the cash
disbursements for the job and the cash available to meet them. The resulting cash flow requirements are
vital to help the contractor allocate the contract price among the progress billing points called for in the
contract.
Value-added services
Some types of construction projects require specialized, expensive equipment. Contractors
are often faced with lease or buy decisions that may affect cash flow, profitability, and
income tax expense. The contractor’s CPA should be alert for these situations and help the
contractor choose the best option.
Why it matters
The main elements of a contractor’s financial statements are based on estimates –
estimates of cost and gross profit (that is, cost-plus markup). The estimating process begins
with preparing the bid, and the CPA needs to understand this process to fully understand the
client’s operations and service needs.
Exhibit 1-4 Factors a contractor evaluates when determining markup
In determining how much the bid will be marked up over cost, the contractor ordinarily
evaluates several factors, including, but not limited to
the complexities of the job;
the volatility of the labor and materials markets;
the contractor’s experience or lack of it in doing the kind of work involved;
the reputation of the design agency for reliability and completeness of plans;
the season and weather;
the predicted working relationship with the owner;
the probability of opportunities to negotiate profitable changes to the contract;
the alternate construction methods or specifications included in the bid request;
the competition and the market;
the incentive or penalty provisions of the contract;
the anticipated cash flow characteristics of the job; and
other peculiar risk conditions, including warranty requirements.
Entering into the contract

A CPA and an audit client sign an engagement letter; a contractor and an owner sign a contract. Any given
situation can be covered by different types of contracts, and the risks and concerns may be different for each
contract type. Contract types and their associated risks are discussed later in the chapter.
Starting the job

To start an audit, the CPA has to mobilize the staff and get them to the client’s office along with their
supplies and any necessary equipment, such as computers. A contractor faces similar tasks.
Before construction begins, the contractor usually moves equipment to the jobsite, erects a temporary
field office, and installs temporary utilities. Like an audit, a contractor’s work is usually done at a remote
location, away from the contractor’s headquarters. This form of decentralized operation can affect the
contractor’s internal control structure. These costs are also important to capture for new revenue
recognition rules under FASB Accounting Standards Codification® 606, Revenue from Contracts with
Customers, which will be covered in a later chapter.
Project management
With both an audit and a construction project, the quality of onsite, day-to-day management is a key in
determining the success or failure of a given job. A CPA has an audit senior or manager to perform this
function; a contractor has a project manager. The objectives of both are the same:
Get the job done, according to the requirements of the contract.
Complete the job within budget.
Think of what you require of an audit senior or manager; the requirements of a construction project
manager are similar.
Plan and schedule the staff assignments and the performance of the work.
Ensure the work meets technical standards.
Administer day-to-day projects and interact with the client.
Track job costs and estimate when the job will be completed.
Communicate job progress and other information from the jobsite.
Identify requested procedures that are outside the parameters of the contract. Such requests should
be documented as a change order.
Knowledge check
2. Which would be the construction process equivalent of a CPA signing an engagement letter?
a. Preparing cost estimates and bids.

b. Signing a contract.
c. Starting the job.
d. Project management.
Characteristics unique to contractors
Learning objective: Recognize select characteristics that are unique to the
construction industry and that have accounting, audit, tax, or consulting
consequences.
This section presents information on the characteristics of a construction contractor’s business that
make it different from other clients. Those characteristics and their implications for the CPA are
summarized in exhibit 1-5.
Exhibit 1-5 Characteristics unique to contractors
What makes a contractor

unique? What it means to the CPA?
Contract projects are one-of-a-kind – The contractor’s business is more project-oriented and
the contractor does not do the same less process-oriented.
job twice.
Unique projects increase audit risk.
Contractor usually sets a price for A contractor must have good estimating skills.
the work before the work is done.
Extensive use of estimates creates accounting,
auditing, and tax issues.
Construction work is performed The risk assumed by the contractor varies according to
under contract. the type of contract entered into.
The requirements of the internal control structure may
vary according to the type of contract.
The accounting and auditing of a contractor is
essentially the accounting and auditing of individual
contracts.
Construction projects may take a When the start and completion of a contract stretches
long time to complete. over more than one accounting period, revenue, and
taxable income are based on estimates.
Generally, the longer the project, the greater the risk.
Change orders occur frequently. Change orders, claims, extras, and back charges will
affect the profitability of the job. They must be properly
controlled and accounted for. Documentation is a must.
Exhibit 1-5 Characteristics unique to contractors (continued)
What makes a contractor

unique? What it means to the CPA?
Most contractors need a surety A surety company is an integral part of the contractor’s
company and bonding in order to business and is one of the primary users of the
operate. contractor’s financial statements.
General contractors may use The subcontractor relationship must be managed and
subcontractors on a project. controlled.
As a means of generating working Cash flow is a key element to managing a construction

capital, contractors will typically project.
“front-end” load contracts in order to
Over-billings and under-billings are usually an important
accelerate cash receipts and finance
component of a contractor’s balance sheet.
the construction project.
Unique projects
Every construction project is unique. This makes a contractor different from a manufacturer who
produces the same widget every time. A contractor is more project-oriented and less process-oriented.
This project orientation affects the accounting and auditing of a contractor. Contractor accounting (for
example, percentage-of-completion, completed-contract) is essentially the accounting for individual
projects. The audit of a contractor is an audit of individual projects. These two points will be the focus of
subsequent chapters.
Also, the unique nature of construction projects means that every project may contain significant
unknowns. This increases the risk assumed by contractors.
Unique joint ventures

Public-private partnerships, or P3s, are becoming increasingly common forms of collaboration for
construction projects. Public-private partnerships take the form of contractual agreements between a
public agency (federal, state, local) and a private sector entity. Due to governmental agencies struggling
to obtain financing for large public works projects, these partnerships allow the private sector entity to
share the risks and rewards of these public sector projects.
Pricing
A contractor prices the work before it is completed and before all the costs are known. This represents a
significant risk to the contractor. It also places a premium on estimating skills.
Construction contracts
All contractors typically enter into a contract with the customer that specifies the work to be performed
and the basis for determining the amount and terms of payment, and that generally requires total
performance before the contractor’s obligation is discharged. Contracts may include target penalties and
incentives that are a function of such things as completion dates, plant capacity on the completion of the
project, and underruns or overruns of estimated costs.
There are four basic types of contracts:
Exhibit 1-6 Four basic types of contract
Contract type Considerations

Fixed-price or lump sum Provide for a single price for the total amount of work
to be performed on a project. The price is usually not
subject to any adjustment by reason of the cost
experience of the contractor or the performance under
the contract. In a similar form they are commonly
known as guaranteed maximum price or GMP
contracts.
Unit-price Provide that a contractor will perform a specific project

at a fixed price per unit of output (for example, to
excavate a site at $X per cubic yard). A unit-price
contract is essentially a fixed-price contract with the
only variable being units of work performed.
Cost-type or cost-plus Provide for reimbursement of allowable or otherwise

defined costs incurred plus a fee that represents profit.
Terms of the contract should include terms specifying
reimbursable costs (general conditions), overhead
recovery percentages and fees, which may be fixed or
based on a percentage of total costs.
Time and materials Similar to a cost-plus contract, these contracts

generally provide for payments to the contractor on the
basis of direct labor hours at fixed hourly rates and cost
of materials or other specified costs.
The core differences in each type of contract (for example, fixed price versus unit-price) almost certainly
will affect the risk assumed by the contractor.
Further, as a CPA, you also understand that different types of contracts carry different levels and types of
risk. If you agree to prepare a tax return for a fixed fee, you must absorb any cost overruns on the project;
that is a risk you assume. On the other hand, if you provide CFO-type services to your clients on a rate
per-hour basis, you are not at risk if the job takes longer than anticipated. However, there may be other
concerns you may not have under a fixed fee arrangement.
Different types of construction contracts will also place different demands on the accounting system and
internal control structure. For example, a cost-plus contract seeks reimbursement from the owner for
specified costs. In that situation, the internal control structure should emphasize the documentation of
costs and expenditures for the purpose of minimizing nonreimbursable expenses. In addition, if the
contractor doesn’t provide the owner with a clean list of costs for the period under a cost-plus contract,
the reimbursement process could be slowed, causing a cash flow issue. Contracts performed under a
fixed-price arrangement will also accumulate costs, but the emphasis there is on generating information
that helps management quickly identify over budget or other problem areas that need better supervision.
Exhibit 1-7 summarizes the risks and internal control structure considerations for each type of contract.
Exhibit 1-7 Types of contracts, risk, and internal control consideration
Contract type Risks Control considerations
Fixed-price or Cost overruns Emphasis on cost accumulation for each

lump sum job
Poor or incomplete cost
estimates Reports should help management identify
problem areas and estimate cost to
Job management failures complete.
Unforeseen conditions Management should receive and review
job reports on a regular, timely basis.
Unit-price Unforeseen conditions Emphasis on unit costs
Poor or incomplete cost Reports should help management identify

estimates problem areas and estimate cost to
complete.
Job management failures
Management should receive and review
job reports on a regular, timely basis.
Exhibit 1-7 Types of contracts, risk, and internal control consideration
(continued)
Contract type Risks Control considerations
Cost-type or Time and cost overruns Emphasis on documentation of costs and

cost-plus expenditures
Warranties
Minimize nonreimbursable costs.
Disputes with the owner over
definition or interpretation of Maintain accountability for materials,
reimbursable costs supplies, labor, and equipment.
Time and Job management failures Emphasis on accumulation of time and

materials material costs
Unforeseen conditions
Emphasis on timely billing to the owner
Construction projects take a long time

For a commercial business, the sale is made at a given point in time. For a contractor, the sale – in this
case, performance under the terms of the contract – takes place over a period of time. In some cases,
that period of time can be months or even years.
A major accounting issue for all contractors is determining the point or points at which revenue should
be recognized as earned and costs should be recognized as expenses. Accounting for contracts is
essentially a process of measuring the results of relatively long-term events and allocating those results
to relatively short-term accounting periods. This is true for both generally accepted accounting principles
and tax purposes. This measurement process involves considerable use of estimates in determining
revenue, cost and profits and in assigning those amounts to the proper accounting period. Making the
key estimates is complicated by the uncertainties inherent in the construction process.
The extensive use of estimates is also a key audit consideration, which will be discussed in chapter 6.
Change orders and other contract modifications

Contract changes are a way of life in the construction business. Read example 1-1 as a sample of the
ramifications of contract changes.
Example 1-1 Mr. Watts changes his mind
Return to the analogy introduced at the beginning of this chapter that a construction project
is similar to a home remodeling project. Mr. Watts decided to lay sod in the backyard, a
relatively small, easily managed process. He considered adding a sprinkler system but
ultimately decided against it as a way to keep the cost down. If he wanted one, he could
always add it later.
Watts rototilled the yard and discovered the dirt was much harder and clay-like than he
imagined. He took a sample to the local nursery and they told him that the sod would stand a
much better chance of taking if he added several inches of topsoil to the yard.
The backyard was surrounded by a fence, and outside the fence were some trees. To get the
truck in to deliver the topsoil, Watts had to knock down a portion of the fence and take out
some trees (he didn’t like them anyway).
While spreading and mixing in the topsoil, he thought again about the sprinkler system. It
would be foolish to dig up the yard sometime in the future when it was already dug up now.
What the heck, he figured. He took an advance on a line of credit and called a sprinkler
company for an estimate.
Take the example of Mr. Watts, magnify it 10 or 20 times, and that is what it is like on most construction
projects. Circumstances require a modification to the original contract, or the owner may change his or
her mind and want something else. Modifications to an original contract are referred to as change orders.
Generally, a change order situation is unfavorable to both the contractor and the owner. Change orders
are often unforeseen, but they are frequent in the construction industry. Contractors may not have the
accounting structure that can readily identify the costs incurred due to the change order. Consider that
change orders are not planned and are typically implemented with very little, if any, advance notice;
change order can become problems. The contractor should have internal controls in place to identify the
excess costs that a change order can bring about so that the change order does not bring about a claim
later on in the job.
Claims and back charges represent amounts in excess of the original contract price that a contractor is
trying to collect from the owner. They may result from unapproved or disputed change orders, delays
caused by the customer, errors in plan specifications and designs, and contract termination. Other claims
may result from other unanticipated costs incurred by the contractor that are not part of the existing
contract.
To maximize profitability on the job, management must properly control, document, and collect on any
change orders, claims, extras, or back charges. The accounting for these items is somewhat specialized
and may involve considerable judgment. This is discussed further in chapter 6.
Surety and bonding
A surety company is equally important to the contractor and the owner because it ensures the timely
completion of the project in accordance with the terms of the contract. This guarantee is provided
through the issuance of surety bonds.
A surety bond is a contract between three parties: the contractor, the surety company, and the project
owner. Under a surety agreement, the surety guarantees to the owner that the contractor will perform
according to the terms of the contract. Additionally, a contractor is obligated under a surety bond to
reimburse the surety for any loss the surety incurs as a result of guaranteeing the contractor.
So the surety company issues a surety bond expecting that the contractor will reimburse any losses. In
that sense, a surety bond functions more like a credit guarantee issued by a bank than as an insurance
policy. Exhibit 1-8 shows how the contractor, surety, and owner interact.
Exhibit 1-8 The contractor/surety/owner relationship
A CPA who provides service to a construction contractor must have a working understanding of the
surety process. If you prepare or audit the financial statements of a contractor, you should have a basic
understanding of how those financial statements will be used by the surety. These issues are discussed
in detail in chapter 4.
Subcontractors
On a large contract a general contractor will often hire a subcontractor to perform a specified task or
phase of the project. This is an effective way to spread the risk, the financing, and the operational
problems of the job. However, the general contractor is still responsible to the owner for the work of the
subcontractor and to pay the subcontractor’s labor and material bills.
For this reason, it is important for the general contractor to exercise some control over the
subcontractors, which includes not only supervision of the work, but also monitoring the subcontractors’
financial condition. A subcontractor’s work may be covered by a surety bond, and the general contractor
needs to take necessary precautions to ensure that the subcontractor’s surety is not released until the
work is completely performed. The general contractor will normally withhold retainage of 10% to ensure
completion and payment of costs incurred by the subcontractor.
Managing cash flow

A contractor’s greatest financing need is working capital.
The contractor puts money up front to pay for material, supplies, and overhead. Usually, there is a time
lag between when costs are incurred, and progress payments are received from the customer. That is
why working capital is so important to a contractor.
Traditional lines of credit are seldom extended to contractors, though a working capital line of credit on
specific contracts may be available. Loans from financial institutions against nontangible property are
rare. Receivables of a contractor on a bonded job allow the surety to take precedence over those of the
lending institutions even though there may be a secured financing agreement.
A more common form of financing a construction project is accomplished through the contractor’s
billing practices. Billing practices in the construction industry vary widely and are often not correlated
with the performance of the work. The billing arrangements are specified in the contract and may be
based on the following:
Completion of certain stages of the work

Costs incurred on cost-plus contracts
Architects’ or engineers’ estimates of completion
Specified time schedules
Quantity measures of unit-price contracts, such as cubic yards excavated
Front-end loading is the practice of assigning a higher relative bid price to job components that are
completed early in the job. This is an effective way of financing the costs of construction.
Most contracts call for retention by the owner of a specified amount of the progress billing (typically 5%
to 10%) as a way to ensure the proper performance of the work. A well-managed contractor will be able
to offset the retainage and recover the initial investments early in the job and continue it entirely on funds
received through progress payments. Many contractors, particularly general contractors, are able to
withhold retainage from their subcontractors.
Unlike a commercial business, a contractor’s billings do not match the revenue and cost recognition
practices. Differences between the amount billed and the cost and profit recognized on a job are carried
on the balance sheet. The accounting for over- and under-billings is discussed in chapter 2.
Companies that substantially front-end load their jobs may find themselves in a position where the cash
inflows at the end of the contract may be less than the cash requirements. This is known as job borrow
and is illustrated in example 1-2. Appropriate controls and cash budgeting are an essential part of a
contractor’s financial management.
Example 1-2 Job borrow

XYZ Contractors have a project where estimated costs are $100. The total contract for this
project is $120. The estimated cash flows for this job are as follows:
Period
1 2 3 4 5 Total
Cash outflow: $(15) $(20) $(20) $(20) $(25) $(100)

Job costs
Cash inflow: 25 30 30 20 15 120

Progress payments
Net cash flow $10 $10 $10 $0 $(10) $ 20
In this situation, XYZ has front-end loaded this job, collecting more in the early stages of the
contract than is spent. This helps provide working capital. At Period 3 the contractor has a
job borrow of $10. The contractor’s net cash flow for the job is $30, and the overall total
when the job is complete is estimated to be $20; therefore, the job borrow is $10 ($30 – $10
= $20)
However, at the end of the job, in Period 5, XYZ spends more in job costs than it received in
progress payments. Therefore, the project must be carefully managed to be sure enough
cash is on hand at the end of the job to finish it.
A more thorough explanation and analysis of a contractor’s cash flow is covered in the AICPA advanced
CPE course Construction Contractors: Advanced Issues (CCAI).
Knowledge check
3. Which type of contract provides that a contractor will perform a specific project at a fixed price per
unit of output?
a. Fixed-price contract.
b. Cost-plus contract.
c. Unit-price contract.
d. Time and materials contracts.
4. Which party is critical in the construction contract relationship because it ensures the timely
completion of the project in accordance with the terms of the contract?
a. Surety.
b. Estimator.
c. Project manager.
d. General contractor.
5. Which is not a party to a surety bond?
a. Project owner.
b. Materials supplier.
c. Contractor.
d. Surety.
How the economic environment affects contractors

In addition to gaining an understanding of the contractor’s business, it is important for the CPA to
understand the economic environment in which the contractor operates.
The Construction Financial Management Association publishes an annual financial survey that provides
benchmarking and financial information about the construction industry. The Architectural Record
publishes an outlook for the construction industry each year in its November issue. Check the internet or
look in your local library for a copy.
You should also try to obtain information about the economy and construction industry in the geographic
area in which your clients operate. For information about the local economy, consult the local business
publications, government agencies, local chapter of the Building Industry Association which is affiliated
with the National Association of Home Builders (NAHB), and Chambers of Commerce.
In gaining an understanding about economic and business conditions and how these affect your
contractor clients, keep in mind the following:
“Front-end” contractors such as excavators will be the first to be affected by changes in the economy.
“Finish” contractors, such as electrical, drywall, or carpentry, typically perform their work later in the
contract cycle; therefore, will be affected later by changes in the economy.
All construction markets – retail, commercial, and industrial – are affected by supply and demand.
Construction activity will be slow in areas where supply exceeds demand. The reverse is also true.
Look for indicators such as the vacancy or occupancy rates for commercial buildings or apartments
to gage the general supply and demand for construction.
Look for statistics on housing starts and applications for building permits to gage the residential
housing market. Keep track of trends in interest rates, too, since this market is particularly sensitive
to changes in interest rates.
Nonresidential construction is generally less interest rate sensitive than housing construction and is
more reliant on the overall level of corporate profits. It may also be influenced by the availability of
capital.
Publicly financed projects are typically less sensitive to economic indicators than they are to local
politics and the decisions of the voters. For example, a community may vote to construct more
prisons and fewer schools, or vice versa.
The state of the industry

The state of the construction industry may depend on whom you ask. There is an overall perspective of
the industry nationally, but regions, individual states, and even local economies may vary greatly. And
there will be variations in the state of the industry by type of construction – residential, commercial,
governmental, educational, or medical.
Because construction contracts tend to be long-term, it is important for the contractor and the CPA to
stay up-to-date on the state of the industry and forecasts for the future. Anticipating trends can help
position the contractor to take advantage of opportunities or avoid risk and losses from a negative
downturn.
The following statistics will be the most recent as of the publication date of this course. However, it is
highly recommended that you search the internet for the most recent statistics at the time you take this
course.
Construction spending
In February 2019, the U.S. Census Bureau (www.census.gov) released its Monthly Construction Spending
Report. The report includes the value of construction spending put in place and includes detail by
construction type. The February report put the Value of Construction Put in Place, seasonally adjusted for
September 2019 was $1,294 trillion. Since 2011, construction spending has been steadily increasing.
Exhibit 1-9 Construction spending4
Employment
The Bureau of Labor Statistics expects employment in the construction industry to grow at a rate of 10%,
faster than the average for all occupations. As of May 2018 (last available data), the median annual wage
for all construction occupations was $46,010, 19.1% higher than the median national average for all
occupations of $38,640.5
Again, from the Bureau of Labor Statistics, here is a summary of hourly and annual wages for select
construction occupations:
4
U.S. Census Bureau, Monthly Construction Spending, November 2018,
https://www.census.gov/construction/c30/pdf/release.pdf
5
Bureau of Labor Statistics, Occupational Outlook Handbook – Construction and Extraction Occupations,
https://www.bls.gov/ooh/construction-and-extraction/home.htm
Exhibit 1-10 Construction employment6
Industry outlook
The AGCA in conjunction with Sage publishes an annual Construction Hiring and Business Outlook
Survey. The following are key statistics from the 2020 report:7
The majority of respondents expect an increase in 2020 in the available dollar value of project for
which they compete.
75% of respondents expect to increase their headcount in 2020.
81% are having a hard time filling open positions.
59% of respondents always operate as an open shop or only occasionally employ union labor, and
31% operate as a union shop most or all of the time.
Top five issues in the industry include the following:
– Worker quality
– Worker shortage
– Rising labor costs
– Subcontractor availability
– Safety
However, Dodge Data and Analytics,8 predicts that total U.S. construction starts will slip to $776 billion in
2020, a decline of 4% from the 2019 estimated level of activity. Further,
The dollar value of single-family housing starts will be down 3% in 2020 and the number of units will
also lose 5% to 765,000 (Dodge basis). Affordability issues and the tight supply of entry level homes
have kept demand for homes muted and buyers on the sidelines.
Multifamily construction was an early leader in the recovery, stringing together eight years of growth
since 2009. However, multifamily vacancy rates have moved sideways over the past year, suggesting
that slower economic growth will weigh on the market in 2020. Multifamily starts are slated to drop
13% in dollars and 15% in units to 410,000 (Dodge basis).
6
Bureau of Labor Statistics, Industries at a Glance – Construction: NAICS 23,
https://www.bls.gov/iag/tgs/iag23.htm
7
AGCA, 2019 Sage Construction Hiring and Business Outlook Survey, December 18, 2019,
https://www.agc.org/news/2019/12/18/2020-sage-construction-hiring-and-business-outlook-survey
8
Dodge Data and Analytics, Construction Starts to Slip Back in 2020 According to Dodge Data & Analytics,
https://www.construction.com/news/Construction-Starts-Slip-back-2020-Dodge-Data-Analytics
The dollar value of commercial building starts will retreat 6% in 2020. The steepest declines will occur
in commercial warehouses and hotels, while the decline in office construction will be cushioned by
high value data center construction. Retail activity will also fall in 2020, a continuation of a trend
brought about by systemic changes in the industry.
Overall, there is a mixed outlook.
Exercise 1-1 Group discussion

Working with a partner, or in a small group, review the resources available and
discuss the following questions.
1. Visit the AGCA website for State Fact Sheets: https://www.agc.org/learn/construction-
data/state-fact-sheet. Click on your state. Read the report for your state. How does the
data compare to your perspective on the industry?
2. Visit the Construction Financial Management Association website for its key industry
financial indicators: http://www.cfma.org/news/kifi.cfm. Review the statistics. What do
the measurements indicate about the current and future states of the construction
industry?
Resources for the construction industry
Industry associations
ABC – Associated Builders and Contractors – www.abc.org
– 21,000 members in 69 chapters
AGCA – Associated General Contractors of America – www.agc.org
– 26,000 member firms in 89 chapters
– Key role of construction in each state’s economy
 https://www.agc.org/learn/construction-data/state-fact-sheet
ASA – American Subcontractor Association – www.asaonline.com
– Chapters in every state
CFMA – Construction Financial Managers Association – www.cfma.org
– 8,200 members in 90 chapters
– Key industry financial indicators
 www.cfma.org/news/kifi.cfm
CMAA – Construction Management Association of America – www.cmaanet.org
– 16,000 members in 29 regional chapters
NAHB – www.nahb.org
– 140,000 members in 700 state and local associations
NAWIC – National Association of Women in Construction – www.nawic.org
– 119 Chapters
Industry analytics
Construction Dive – www.constructiondive.com
Dodge Data and Analytics – www.construction.com
Publications
Audit and Accounting Guide Construction Contractors
– Annual publication from AICPA
Journal of Construction Accounting & Taxation
– Published six times per year
Construction Guide: Accounting & Auditing
– Annual publication from CCH
Surety Information Office
– Brochures and presentations about the surety process
Government resources
U.S. Census Bureau – www.census.gov
Bureau of Labor Statistics – www.bls.gov
Federal Reserve Bank Economic Research – www.fred.stlouisfed.org
Federal Reserve Bank Economic Research – www.fred.stlouisfed.org
Conferences
AICPA Construction & Real Estate Conference – December
AGCA Construction Super Conference – December
CFMA Annual Conference – June
NAHB International Builder Show – February
CMAA Annual Conference – October
NAWIC Annual Conference – August
ConExpo-ConAgg – March 2020 (every three years)
Summary
To provide quality service to a construction contractor, a CPA must understand how the business
operates. This chapter begins to introduce you to the construction industry, and it focused on the
construction process and characteristics unique to construction contractors. The emphasis was on
those items that are relevant to the accounting, auditing, tax, and consulting issues to be covered later.
Practice questions (optional)
1. Why is it important for CPAs to distinguish their contractor clients by type (for example, heavy
construction versus drywall subcontractor)?
2. Describe the steps in the construction process.
3. Why is it important for a CPA to understand the contracts the construction client has entered into?
4. Describe the relationship between the surety, the contractor, and the owner. Why is the surety so
important to the contractor?
5. What is a contractor’s greatest financing need? What is the objective of front-end loading?
Chapter 2
Significant Changes – Contract Accounting

and Lease Accounting
Learning objectives
Recall the details in the accounting for construction contracts in FASB Accounting Standards
Codification® (ASC) 606, Revenue from Contracts with Customers, including the appropriate
accounting alternatives for construction-type contracts.
Recall the details in the accounting for leases in accordance with FASB Accounting Standards Update
(ASU) No. 2016-02, Leases (Topic 842).
Introduction
Learning objective: Recall the details in the accounting for construction contracts
in FASB Accounting Standards Codification (ASC) 606, Revenue from Contracts
with Customers, including the appropriate accounting alternatives for
construction-type contracts.
This chapter discusses the accounting for long-term construction contracts—the one accounting area
that is generally unique to construction contractors. The chapter’s emphasis is on revenue and cost
recognition and to a lesser degree on the balance sheet presentation. In addition, this chapter will cover
new lease accounting rules.
FASB ASU No. 2014-09

On May 28, 2014, FASB and the International Accounting Standards Board issued joint ASU No. 2014-09
on revenue recognition to address a number of concerns regarding the complexity and lack of
consistency surrounding the accounting for revenue transactions.
FASB ASU No. 2014-09 is now effective for all entities.
FASB ASU No. 2014-09 provides a framework for revenue recognition and supersedes or amends several
of the revenue recognition requirements in FASB ASC 605, Revenue Recognition, as well as guidance
within the 900 series of industry-specific topics, including FASB ASC 910, Contractors — Construction.
The standard applies to any entity that either enters into contracts with customers to transfer goods or
services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within
the scope of other standards (for example, insurance or lease contracts).
FASB ASU No. 2014-09 introduced a five-step process that profoundly changes the way contractors will
keep track of their contracts. Revenue recognition is no longer an entity level election, but each contract
will be addressed individually. In some cases, depending on when performance is deemed to have been
completed, companies that previously used percentage-of-completion to record revenue may be required
to recognize revenue using a method akin to the completed contract method. For cases in which
progress was previously calculated on the entire contract, a contract may be divided into parts, and the
progress on each part may be tracked and reported separately. Although all contractors will have to
address how they track each contract through the five-step process, a discussion of which follows, some
contractors may see no major effect at all on their financial reporting. CPAs for contractors should
consider how possible changes in the timing of revenue recognition will affect not only revenue, but other
accounting issues such as the calculation of deferred taxes and multi-state taxation apportionment
allocations.
FASB ASC 606
Key point
Highlights of FASB ASC 606:
The new revenue recognition standard is an all-inclusive, general standard that applies
evenly to all contracts with customers. It applies to
– transactions entered into in the normal course of business, and
– transactions outside the normal course of business creating gains.
It is a principles-based approach with very few bright-lines, requiring greater use of
professional judgment and estimates.
The standard applies equally across all industries.
All prior guidance should not be referred to or even considered when implementing the
new standard.
– The standard actually states, “Previous revenue recognition guidance in U.S.
GAAP…should not be used…”
It creates a new GAAP definition of a “contract” where collectibility must be considered
when determining whether a contract exists for revenue recognition purposes.
Revenue recognition will be applied on a contract-by-contract basis.
A single contract must be reviewed to determine whether it should be divided into
multiple separate components.
Revenue recognized will include both fixed, known amounts of revenue as well as
estimates of variable consideration such as penalties, bonuses, and rebates.
As estimates of variable consideration change, adjustments will be made in the current
period to correct year-to-date revenue.
Revenue may be recognized “over time” using a percentage-of-completion approach or
“at a point in time” using a completed contract approach.
The new standard will be applied retroactively to all existing contracts; there will be no
grandfathering.
– The result will be that some revenue recognition may be advanced, some may be
deferred.
– It is possible that some currently deferred revenue may never be recognized in the
income statement, and some previously recognized revenue may be recognized in
the income statement a second time.
Core concept of ASU No. 2014-09

According to the ASU, “an entity recognizes revenue to depict the transfer of promised goods or services
to customers in an amount that reflects the consideration to which the entity expects to be entitled.” The
focus is now on customer control and expected revenue.
Customer control
The revenue recognition perspective is no longer about when the seller performs the work. The
perspective has shifted to when the customer receives control of work the seller has done. For some
contractors this concept will change their use of percentage-of-completion or completed contract.
Let’s use an example of a homebuilder that build homes for customers on lots that the contractor owns.
Under prior GAAP, the contractor would use percentage-of-completion method of accounting to
recognize revenue as the house was completed. The customer does not receive control until the contract
is completed, and he or she receives the keys to the house. Under FASB ASC 606, the homebuilder would
have to use a completed contract method of accounting.
Expected revenue
Under the new standard, revenue recognition must now consider both fixed and variable consideration.
For example, a contractor has a $1m contract to renovate a customer’s house. The customer would like
the renovations to be completed before Thanksgiving, so a penalty clause of $100,000 was included in
the contract. Under old GAAP, the contract price would be $1m. The contractor does not have to account
for the penalty unless it happens. Under FASB ASC 606, the contract has a fixed price of $900,000 and a
variable price of $100,000.
In terms of revenue recognition, the contractor would have to determine whether the penalty is likely to
happen or not. If he or she believes the contract can be completed on time, the contractor can recognize
revenue on a contract price of $1m. If he or she does not believe the contract can be completed on time
and will be subject to the penalty, the contractor can recognize revenue only on a contract price of
$900,000.
Knowledge check
1. With FASB ASU No. 2014-09, Revenue from Contracts with Customers, now effective, guidance for
revenue recognition resides where in FASB ASC?
a. The majority of revenue recognition content resides in FASB ASC 606, Revenue from
Contracts with Customers.
b. Revenue recognition content resides in FASB ASC 606, Revenue from Contracts with
Customers, and FASB ASC 605, Revenue Recognition.
c. Revenue recognition content resides in FASB ASC 606, Revenue from Contracts with
Customers, and, in particular, industry areas of FASB ASC 900.
d. Revenue recognition content resides in FASB ASC 606, Revenue from Contracts with
Customers;, FASB ASC 605, Revenue Recognition;, and in particular industry areas of FASB
ASC 900.
2. Which of the following is not a key highlight of FASB ASU No. 2014-09, Revenue from Contracts with
Customers?
a. It creates a new GAAP definition of a “contract” where collectibility must be considered when
determining whether a contract exists for revenue recognition purposes.
b. Revenue recognized will include both fixed, known amounts of revenue as well as estimates
of variable consideration such as penalties, bonuses, and rebates.
c. A single contract must be reviewed to determine whether it should be divided into multiple
separate components.
d. Revenue may no longer be recognized “over time” using a percentage-of-completion approach
but must be recognized “at a point in time” using a completed contract approach.
Revenue recognition as a five-step process

FASB ASU No. 2014-09 has created the following five-step revenue recognition process:
1. Identify the contract(s) with a customer.

2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
Revenue will be recognized at the end of the five-step process because the performance obligations are
satisfied when the customer obtains control of that good or service.
Step 1: Identify the contract(s) with a customer

The FASB Master Glossary defines a contract as “an agreement between two or more parties that
creates enforceable rights and obligations,” and affects contracts with a customer that meet all of the
following criteria:
a. The parties to the contract have approved the contract (in writing, orally, or in accordance with other
customary business practices) and are committed to perform their respective obligations.
b. The entity can identify each party’s rights regarding the goods or services to be transferred.
c. The entity can identify the payment terms for the goods or services to be transferred.
d. The contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash
flows is expected to change as a result of the contract).
e. It is probable that the entity will collect substantially all of the consideration to which it will be entitled
in exchange for the goods or services that will be transferred to the customer.
Additional considerations under step 1

Under FASB ASC 606, a master service agreement would not be considered a contract. The individual
purchase orders under the master service agreement would be considered the contracts.
With a partner, or in a small group, consider the following:
A developer enters into a contract for the sale of a building for $1m. The customer intends to
open a restaurant in the building. The building is located in an area where new restaurants
face high levels of competition, and the customer has little experience with restaurants. The
customer pays a $50,000 nonrefundable deposit and enters into a long-term, non-recourse
financing arrangement with the seller with the intent of repaying the loan from the cash flow
of the restaurant.
Does the developer have a contract?
A contract does not exist if each party to the contract has the unilateral enforceable right to terminate a
wholly unperformed contract without compensating the other party or parties. This key item was
addressed by the AICPA Engineering & Construction Contractors Revenue Recognition Task Force to
determine what constitutes a penalty to the owner and the contractor. FASB agreed that a contractor and
an owner would be penalized if a contractor was terminated for convenience on a contract due to the
impact on the owner and the contractor related to the cost of demobilization and the impact on the
owner for contracting with a new contractor on the project. This exclusion does not relate to engineering
contracts unless there is a specific penalty provision included in the contract.
If a contract is not legally enforceable or collection of consideration is not probable, then the revenue will
be recognized on a deferred cash basis after
all payments are received, and after the entity has no further performance obligations, or
the contract is terminated, and the consideration received to date is non-refundable.
If the entity is recognizing revenue on the deferred cash basis for a contract, the entity is required to re-
assess such arrangements at the end of each reporting period to determine if they subsequently qualify
as a contract subject to ASU No. 2014-09.

A developer enters into a contract for the sale of a building for $1m. The customer intends to
open a restaurant in the building. The building is located in an area where new restaurants
face high levels of competition, and the customer has little experience with restaurants. The
customer pays a $50,000 nonrefundable deposit and enters into a long-term, non-recourse
financing arrangement with the seller with the intent of repaying the loan from the cash flow
of the restaurant.
Does the developer have a contract?
At times, contracts may be modified for changes in scope or price. The change may be accounted for
with a modification of the existing contract, the addition of a second contract, or the cancellation of the
old contract and reissuance of a new contract.
There are times when a contract modification will result in the contract modification recorded as a new
contract. If both of the following conditions were present, a new contract would be required for the
contract modification:
Scope of the contract changes due to added goods or services that are distinct (i.e. a separate
performance obligation)
Price of the contract increases by the standalone selling price of the added goods or services
An entity may combine contracts if the contracts were entered into at or near the same time and at least
one of the following applies:
The contracts are negotiated as a package with a single commercial objective.

The amount of consideration in one contract depends on the price or performance of the other contract.
The goods or services are a single performance obligation.
Step 2: Identify the performance obligations in the contract

The new standard requires that an entity consider whether there are multiple deliverables, or
performance obligations, contained within the contract.
Key point
The FASB Master Glossary defines a performance obligation as:
A promise in a contract with a customer to transfer to the customer either:
a. A good or service (or a bundle of goods or services) that is distinct
b. A series of distinct goods or services that are substantially the same and that have the
same pattern of transfer to the customer.
At the contract’s inception, the goods or services promised in the contract with a customer are assessed
to determine whether there are multiple performance obligations that should be separately identified.
Performance obligations may include the following:
Sale of goods produced by the entity

Resale of goods purchased by an entity
Resale of rights to goods or services purchased by an entity
Performing a contractually agreed-upon task
Standing ready to perform
Acting as an agent
Granting rights to goods or services to be provided in the future
Sale of goods produced by the entity
Resale of goods purchased by an entity
Resale of rights to goods or services purchased by an entity
Performing a contractually agreed-upon task
Standing ready to perform
Acting as an agent
Granting rights to goods or services to be provided in the future
Contractors must determine whether a performance obligation is a distinct good or service. A
performance obligation will be considered distinct if both of the following conditions are met:
The customer can benefit from the good or service either on its own or together with other resources
that are readily available to the customer (that is, the good or service is capable of being distinct).
The entity’s promise to transfer the good or service to the customer is separately identifiable from
other promises.
Example 2-1
A road builder enters into a contract to deliver five miles of road in a new project to a
developer. The construction of the road requires three phases — clearing, grading, and
paving.
During each phase of the contract, the customer will benefit from the work being performed.
If the road builder defaults on the contract after the completion of the clearing, the developer
could hire another road builder to finish the building of the road without any significant
additional cost. In this case, the road builder would account for the contract as three
separate performance obligations and will track progress on each phase separately.
A performance obligation will not be considered “distinct” if the providing of the performance obligations
requires significant integration. Determining whether goods and services are distinct is a matter of
judgment.
When a good or service is not distinct, it should be combined with other promised goods or services until
an entity identifies a bundle of goods or services that are distinct. In some cases, this would result in
accounting for all the goods or services promised in a contract as a single performance obligation.
Example 2-2
A contractor enters into a contract to build a hospital for a customer. The contractor is
responsible for the overall management of the project and identifies various promised goods
and services, including engineering, site clearance, foundation, procurement, construction of
the structure, piping and wiring, installation of equipment, and finishing. The performance of
each of these services requires significant integration to produce the end product, so the
construction of the hospital will be considered one performance obligation. The builder
would track progress on the entire contract.

ACME Construction enters into a contract to sell and install elevators that it has
manufactured. ACME will deliver the elevator parts to the customer and then perform the
installation. The elevators are so unique that ACME is the only company that can install the
specialized elevators. How many performance obligations are there?
If the elevators could be installed by other contractors, how many performance obligations
would there be?
In assessing whether an contractor’s promises to transfer goods or services to the customer are
separately identifiable, the second criteria for being distinct, the objective is to determine whether the
nature of the promise, within the context of the contract, is to transfer each of those goods or services
individually or, instead, to transfer a combined item or items to which the promised goods or services are
inputs. Factors that indicate that two or more promises to transfer goods or services to a customer are
not separately identifiable include, but are not limited to, the following:
a. The entity provides a significant service of integrating goods or services with other goods or services
promised in the contract into a bundle of goods or services that represent the combined output or
outputs for which the customer has contracted. In other words, the entity is using the goods or
services as inputs to produce or deliver the combined output or outputs specified by the customer.
A combined output or outputs might include more than one phase, element, or unit.
b. One or more of the goods or services significantly modifies or customizes, or are significantly
modified or customized by, one or more of the other goods or services promised in the contract.
The goods or services are highly interdependent or highly interrelated. In other words, each of the goods
or services is significantly affected by one or more of the other goods or services in the contract. For
example, in some cases, two or more goods or services are significantly affected by each other because
the entity would not be able to fulfill its promise by transferring each of the goods or services
independently.
An additional potential performance obligation for contractors may be warranty. A warranty will be
considered a separate performance obligation if it includes additional goods and services. For example,
an HVAC contractor may include an annual maintenance checkup that includes changing air filters for a
specified period of time. Because the warranty includes additional goods and services, it would be
considered another performance obligation to the contract.
If the customer has the option to purchase a warranty separately, it is generally considered a separate
performance obligation.
If the customer does not have that option, it will be considered a separate performance obligation only if
it provides the customer with service in addition to the warranty assurance.
When assessing warranty, the entity should consider the following:
Is the warranty required by law? If so, it is not a separate performance obligation.

What is the length of the warranty coverage period? The longer the coverage, the more likely, the
warranty is a performance obligation.
What is the nature of the tasks that the entity promises to perform?
FASB ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance
Obligations and Licensing, provides additional examples of separate performance obligations and
amends the definition of performance obligations to say that performance obligations that are immaterial
to that contract do not have to be separately identified.
Construction contractors will have to evaluate all of their contracts to determine if there are multiple
performance obligations.
Step 3: Determine the transaction price

The transaction price is the amount of consideration the entity expects to receive in exchange for
transferring promised goods or services to a customer, excluding amounts collected on behalf of third
parties. An entity should use its customary business practices when determining the transaction price.
The amount of consideration may involve both fixed and variable components.
To determine the transaction price, an entity should consider the effects of the following:
Variable consideration
Constraining estimates of variable consideration
The existence of a significant financing component
Noncash considerations
Consideration payable to the customer
Variable consideration may include one or more of the following:
Discounts
Rebates
Refunds
Credits
Incentives
Bonuses and penalties (including liquidated damages)
Price concessions
If the consideration promised in a contract includes a variable amount, then an entity should estimate the
amount of consideration to which the entity will be entitled in exchange for transferring the promised
goods or services to a customer. An entity would then include in the transaction price some or all of an
amount of variable consideration only to the extent that it is probable that a significant reversal in the
amount of cumulative revenue recognized will not occur when the uncertainty associated with the
variable consideration is subsequently resolved.
To estimate variable compensation an entity may use either of the following:
1. Expected value method

a. Consider a range of possibilities using a weighted average approach. (Note: For liquidated
damages you can’t simply assume that the expected value is zero.)
2. Most likely method
a. Select the single most likely amount within a range.
Example 2-3
ACME construction enters into a contract to install 20 windows for $120,000 over 6 months.
If the project is completed early, ACME will receive a $10,000 bonus from the customer. If
ACME gets behind and completes the contract late, ACME will owe the customer a $10,000
refund. ACME uses the units of production method to track progress. Based on prior history,
20% of the time the contract is delayed, and 80% of the time the contract is finished ahead of
schedule.
Under old GAAP, the contractor would ignore the bonus and penalty situations until it
happened. The contractor would have recognized revenue of $6,000 ($120,000 ÷ 20) each
time it completed the installation of one window.
Under FASB ASC 606, the contract has both fixed and variable consideration. The contractor
needs to evaluate the likelihood of the penalty or bonus occurring. The amount of variable
consideration to be included in the transaction price is limited only to those amounts for
which it is probable that a significant reversal will not occur.
The contractor receives the bonus 80% of the time, and total contract revenue is
$130,000.
The contractor pays a penalty 20% of the time, and total contract revenue is $110,000.
If the contractor used the most likely value method, he or she could recognize revenue using
the percentage-of-completion method on a total contract price of $130,000. Each time the
contractor completed the installation of one window he or she would recognize $6,500
($130,000 ÷ 20).
Example 2-3 (continued)
If the contractor used the expected value method, he or she would recognize revenue using
the percentage-of-completion method on a weighted average contract price:
80% × $130,000 = $104,000
20% × $110,000 = $22,000
Total contract price = $126,000

In this scenario, each time the contractor completed the installation of one window, he or she
would recognize $6,300 in revenue ($126,000 ÷ 20).

Additional considerations under step 3 include the following:
If there is non-cash consideration included in the contract, the noncash portion should be included at
fair market value as of the signing of the contract. A standalone selling price may be used if fair
market value is not readily available.
If there is a difference of more than a year between payment and performance, either pre- or post-
payment, the entity should take into consideration the time value of money and impute an interest
component.
Consideration payable to a customer, such as rebates or discounts, will not be considered an
expense, but a reduction of revenue.
The transaction price should be re-assessed on a regular basis for any changes. This should be done
at least at the end of every reporting period.
Construction claims are unapproved change orders for scope and price. Under previous recognition rules
in FASB ASC 605, construction claims could only be recorded if the claim met certain criteria. In addition,
revenue could only be recorded up to the cost with no profit. Under FASB ASC 606, construction claims
are now considered variable considerations. An entity is able to recognize revenue and profit on the claim
as long as it is probable that a significant reversal of the revenue recognized on the claim will not happen
in the future. At first glance, this may appear that more claims will meet the criteria to be recognized;
however, the threshold of probable is 70% and the entity must apply constraints to the variable
consideration. Based on this, claims will most likely be more difficult to record under FASB ASC 606.
Step 4: Allocate the transaction price to the performance obligations in the contract
The transaction price is allocated to separate performance obligations in proportion to the relative
standalone selling price of the promised goods or services. It may be different than the pricing indicated
in the contract.
If a standalone selling price is not directly observable (for example, the contractor does not separately
sell certain performance obligations separately), then an entity should estimate it. The most common
methods to estimate a stand-alone selling price are the following:
Adjusted market assessment approach
– The entity may review the prices charged by other contractors in the industry to determine the
price a customer would be willing to pay for the separate performance obligation.
Expected cost plus margin approach
– The entity may calculate what it would be willing to charge for the separate performance
obligation by determining their costs and adding an appropriate margin of profit.
Residual approach
– The entity may assign the remaining contract price to a separate performance obligation when
the remaining performance obligations have observable standalone prices. The residual approach
is only used when the selling price is highly variable and uncertain.
Once the standalone prices are determined for each separate performance obligation, the total contract
price (including both fixed and variable consideration) is allocated to the performance obligations based
on their ratio to the total standalone prices for all separate performance obligations.
Example 2-4
ACME Construction has a contract to build a road for Road Runner Enterprises. The total
contract price, including variable consideration, is $10,000,000. The project has three
phases — clearing, grading, and paving. The contract states that the pricing for each phase
is one-third of the contract. The phases of the contract have the following separate
standalone values:
Clearing: $2,500,000
Grading: $4,000,000
Paving: $6,500,000
Total standalone value: $13,000,000

The allocation of the total contract price to each performance obligation would be as follows:
Clearing: $ 1,923,077 {$10,000,000 contract price × (2,500,000 ÷ 13,000,000)}
Grading: $ 3,076,923 {$10,000,000 contract price × (4,000,000 ÷ 13,000,000)}
Paving: $ 5,000,000 {$10,000,000 contract price × (6,500,000 ÷ 13,000,000)}
Total contract price = $10,000,000
Reallocation of the transaction price for changes in the standalone selling price is not permitted.

Sometimes the transaction price includes a discount or a variable amount of consideration that relates
entirely to one of the performance obligations in a contract. The ASU specifies when an entity should
allocate the discount or variable consideration to one (or some) performance obligation(s) rather than to
all of the performance obligations in the contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation
Revenue is recognized when each separate performance obligation is satisfied or when the promised
good or service is transferred to the customer. A good or service is assumed to be transferred when the
customer obtains control of that good or service.
Key point
Revenue may be recognized at a point in time or over time.
Control of an asset refers to the ability to direct the use of — and obtain substantially all of the remaining
benefits from — the asset. Control also includes the ability to prevent other entities from directing the use
of — and obtaining the benefits from — an asset. Indicators of obtaining control include when the
customer has the following:
An unconditional and enforceable obligation to pay

Legal title
Physical possession
Significant risks and rewards of ownership
Performance obligations are satisfied over time when
the customer simultaneously receives and consumes the benefit as the entity performs the task,
the performance creates or enhances an asset that the customer controls as the asset is created or
enhanced, or
the entity’s performance does not create an asset with alternative use to the entity.
When performance obligations are satisfied over time, the entity should select an appropriate method for
measuring its progress toward complete satisfaction of that performance obligation. Entities may use an
output method or input method to measure progress.
Output methods include
milestones reached,
Key point
Under FASB ASC 605, if an entity was using the output method milestones reached, it would
recognize revenue and gross profit up to the milestone reached and use the gross profit
method for the percent complete of the milestone that has not been completed. This allowed
an entity to recognize revenue and gross profit through the work performed by the entity.
Under FASB ASC 606, an entity can only recognize revenue and gross profit to the extent a
milestone has been reached. Based on this, most entities if current using the milestone
method will change to an input method such as cost incurred to a total estimated cost on the
project.
survey of performance,
appraisals of results achieved, or
units produced or delivered.
When an entity evaluates whether to apply an output method to measure its progress, the entity should
consider whether the output selected would faithfully depict the entity’s performance toward complete
satisfaction of the performance obligation.
Input methods include
resources consumed,
efforts expended or resources consumed such as costs incurred compared to total expected costs,
labor or machine hours expended compared to total labor, or
machine hours expected.
A shortcoming of input methods is that there may not be a direct relationship between an entity’s inputs
and the transfer of control of goods or services to a customer.
If a performance obligation is not satisfied over time, an entity satisfies the performance obligation at a
point in time. To determine the point in time at which a customer obtains control of a promised asset and
the entity satisfies a performance obligation, the contractor considers control of the asset, as previously
discussed.
Knowledge check
3. Which of the following is not a recognized method of allocating the transaction price to the
performance obligations in the contract?
a. Adjusted market assessment approach.
b. Expected cost plus margin approach.
c. Fair value approach.
d. Residual approach.
4. Which statement regarding recognizing revenue is not correct?
a. Revenue is recognized when each separate performance obligation is satisfied.
b. A performance obligation is satisfied when the promised good or service is transferred to the
customer.
c. A good or service is assumed to be transferred when the customer obtains control of that
good or service.
d. Revenue may be recognized only at a point in time.
Additional considerations
The remainder of this section will address other additional considerations related to contract revenue.
Retainage receivable
Retention receivables should be carefully assessed to determine whether retentions are subject to
restrictive conditions, such as fulfillment guarantees. Where retentions are subject to conditions other
than passage of time, such as fulfillment guarantees, future performance, or achievement of stated
milestones, amounts related to retention receivables would continue to be classified as a contract asset
until such time that the right to payment becomes unconditional.
Significant inefficiencies in performance – Using a cost based input method

Under FASB ASC 605, if a contractor incurred significant inefficiencies on a project the contractor would
increase the estimated total cost on the project while charging those inefficiencies to the project. Now,
under FASB ASC 606, the contractor is required to do the following:
Entity incurs significant inefficiencies in the performance on a contract

Cost determined to be a result of significant inefficiencies in performance would not be included in
the estimated cost of the project and cost incurred to date
Cost would be expensed as incurred
Costs would affect the current year financial statements dollar for dollar of the significant
inefficiencies
Uninstalled materials
Any goods that have been purchased for a project but have not yet been installed are considered
uninstalled materials. If control has not yet passed to the customer, these uninstalled material costs that
are not distinct should be considered inventory until control passes to the customer. Therefore, the
amounts should not be shown in the costs to date amount on the specific job as these costs are not
indicative of performance. If the inventory is distinct (for example, you ordered pre-fabricated windows
that were configured to only fit the skin of the building you’re working on), then those uninstalled
materials can be left in the total costs of the job.
Costs incurred that are not indicative of performance

There may also be circumstances in which the cost incurred on contract is not proportionate to the
entity's progress in satisfying the performance obligation. For example, construction entities may enter
into contracts where they procure equipment and material. The procurement alone of those products
likely would not be indicative of the entity's performance, unless the company has the right to payment
for the cost for the procurement plus a reasonable profit, such that the procurement itself represents
progress toward completion.
When a cost incurred is not proportionate to the entity's progress in satisfying the performance obligation,
the best depiction of the entity's performance may be to adjust the input method to recognize revenue only
to the extent of the cost incurred. For example, a faithful depiction of an entity's performance might be to
recognize revenue at an amount equal to the cost of a good used to satisfy a performance obligation if the
entity expects at contract inception that all of the following conditions would be met:
The good is not distinct.

The customer is expected to obtain control of the good significantly before receiving services related
to the good.
The cost of the transferred good is significant relative to the total expected costs to completely
satisfy the performance obligation.
The entity procures the good from a third party and is not significantly involved in designing and
manufacturing the good (but the entity is acting as a principal).
if it is determined that uninstalled materials meet all of the criteria, the contractor would recognize revenue
for the transfer of the goods, but only in an amount equal to the cost of those goods. If a good was
originally determined to have met the criteria and revenue was recorded equal to cost upon receipt of the
item, the contractor would determine the appropriate accounting once that item is installed in the project.
Example 2-5 illustrates how a cost not indicative of performance, television equipment, in this case, is
treated as a separate component of the contract and revenue is recorded equal to that cost.
Example 2-5 – Costs incurred that are not indicative of performance

Transaction Price: $ 2,500,000.00
Estimated Contract Cost

Labor and Overhead 1,350,000
Television Equipment 750,000
Total Estimate Contract Cost 2,100,000
Estimated Gross Profit $ 400,000
At December 31, 2020

Labor and Overhead 135,000 (10% Complete)
Total Contract Cost 885,000
Revenue Earned
Labor and Overhead 175,000 (($2.5M - $750K) * 10%)
Revenue Earned at 12/31/19 925,000
Gross profit at 12/31/19 $ 40,000
Example 2-5 – Costs incurred that are not indicative of performance
(continued)
Notes:
Transaction price is the total contract value of the project.

Estimated contract cost is the total expected cost to incur on the project. It is made up of
two cost types:
– Labor and overhead – The amount of labor and overhead anticipated to be charged
to the job through completion.
– Television equipment – The amount of television equipment (non-distinct) that will be
charged to the project at cost.
Total estimated contract cost is the total of the two cost types.
Estimated gross profit is the transaction price less the total estimated contract cost. This
is the amount expected to be profit on this project at completion.
The amounts shown as of December 31, 2019, include the following:
– Labor and overhead incurred on the project from the inception of the project through
December 31, 2019.
– Television equipment cost incurred on the project from the inception of the project
through December 31, 2019.
Contract cost is the amount of cost incurred related to the two cost types through
December 31, 2019, on the project.
Revenue earned is calculated based on the following:
– Television equipment revenue is recognized based on the cost incurred; no profit is
recognized on the television equipment. Had the television equipment been included
in the calculation of the percentage of completion, it would have overstated the
percent complete based on the performance of the contractor.
– Labor and overhead revenue is calculated based on the actual cost incurred related to
the performance of the contractor.
Gross profit is calculated based on the revenue earned of $925,000 compared to the total
contract cost of $885,000.
Example 2-6 illustrates the difference between how revenue would have been recognized based on the
old standard, FASB ASC 605, compared to the new standard, FASB ASC 606.
Example 2-6 – Recognition under FASB ASC 605 vs. FASB ASC 606
Total Contract From Inception to December 31, 2020
Total Estimated Estimated Costs of

Contract Costs of Gross Contract Revenues Estimated Costs
Description Price Revenues Profit Revenue Earned Gross Profit to Complete
FASB ASC 606
Conference System
Contract
Labor and Overhead $ 1,750,000 $ 1,350,000 $ 400,000 $ 175,000 $ 135,000 $ 40,000 $ 1,215,000
Television Equipment 750,000 750,000 – 750,000 750,000 –
Total Conference System
Contract 2,500,000 2,100,000 400,000 925,000 885,000 40,000 1,215,000
FASB ASC 605
Conference System
Contract 2,500,000 2,100,000 400,000 1,053,571 885,000 168,571 1,215,000
Impact of New Method $– $– $– $ (128,571) $– $ (128,571) $–
Notes:
The columns under “Total Contract” illustrate the detail specific to how the contract is
estimated to be at completion of the project.
The columns under “From Inception to December 31, 2019” represent the calculation
based on the percentage of completion from the inception of the project through that
date.
The Impact of New Method shows the difference between the Contract Revenue and
Gross Profit earned comparing FASB ASC 606 to FASB ASC 605. As shown, the Contract
Revenue and Gross Profit is negatively impacted in this example on the entity from
applying the new standard.
Costs incurred that do not transfer value

When an entity incurs cost that does not provide value to the customer, the entity is not allowed to
recognize revenue. These costs may include mobilization to the site, surety bonds, administrative costs
to set up a project, and so on.
Cost of these items would be removed from the cost incurred on the project and amortized over the life
of the contract.
For instance, a contractor enters into a contract that specifies that the contractor must obtain a bond
prior to the contract being started. Now let’s assume that the contractor is a road builder and has to
transfer a large amount of equipment to the jobsite. Between the bond cost and the mobilization costs,
the contractor could have 5% of its total estimated costs incurred prior to actually starting any work.
Under revenue recognition rules for FASB ASC 605, the contractor would be able to recognize 5% of the
total revenue on day one along with these costs. Under FASB ASC 606, these costs must be deferred and
amortized over time in relation to the percent complete on the project. See example 2-6.
Example 2-7 – Costs incurred that do not transfer value
Fact pattern:
The contractor entered into a $30,000,000 contract.

The estimated total costs (including mobilization and startup costs) is $25,500,000.
As of December 31, 2019, the contractor had incurred $1,000,000 of mobilization and project
startup costs in addition to incurring $3,500,000 of cost related to work performed on the
contract. This results in total costs incurred to date of $4,500,000.
The percentage complete under FASB ASC 605 = $4,500,000 / 25,500,000 = 17.65%.
The percentage complete under FASB ASC 606 = $3,500,000 (excluding mobilization and
startup costs) / $24,500,000 (total costs, less mobilization and startup costs) = 14.28%.
Amortization of mobilization and startup costs ($1,000,000 × 14.28% = 142,800).
The amortization of mobilization and startup costs would then be added to the costs to date on
the job to recognize revenue as shown subsequently.
Total Contract Price From Inception to December 31, 2020 At December 31, 2020
Cost
and Est.
Earning Billing in
in Exc. Costs
Estimated Estimated Costs of Estimated Excess and
Total Contract Costs of Gross Contract Revenues Billing to Costs to of Estimated
Description Price Revenues Profit Revenue Earned Gross Profit Date Complete Billings Earnings
FASB ASC 606
Interstate Highway
System $ 30,000,000 $ 25,500,000 $ 4,500,000 $ 4,285,647 $ 3,642,800 $ 642,847 $6,000,000 $21,857,200 $- $1,714,353
FASB ASC 605
Interstate Highway
System 30,000,000 25,500,000 4,500,000 5,294,118 4,500,000 794,118 6,000,000 21,000,000 – 705,882
Impact of New
Method $– $– $– $ (1,008,471) $ (857,200) $ (151,271) $– $ 857,200 $- $ 1,008,471
Loss contracts
At the time it becomes known to the entity that a contract will result in a loss, the entity is required to
record the entire loss. The loss is first calculated through percentage of completion. The remaining
amount of the loss that is not earned through percentage of completion is required to be accrued for as
an accrued loss on uncompleted contract.
The entity may also incur a loss at the performance obligation level. An election can be made, but not
required, to determine the provision for loss at the performance obligation level. If this election is made,
the entity would be required to record the provision for loss at the performance obligation level for the
current and future similar types of contracts that the customer’s consideration is due for goods and
services the entity will yet provide.
Contract acquisition costs
The incremental costs related to obtaining a contract are capitalized and amortized on a systematic
basis consistent with transfer of goods and services.
Contract acquisition costs may include the following:
Consulting fees
Sales commissions
As a practical expedient, an entity may expense these costs when incurred if the amortization period is
one year or less.
Disclosure
ASU No. 2014-09 significantly expands the disclosure requirements and is designed to include more
information about specific revenue contracts entered into by an entity, including performance obligations
and the transaction price.
“Under current U.S. GAAP, disclosures about revenue are limited and lack cohesion … the new
disclosure package will improve the understandability of revenue …” — Marc Siegel, FASB member
Disclosures for all entities include, but are not limited to the following, based on circumstance:
Transition method adopted

Qualitative and quantitative information about the following:
– Revenues
– Remaining performance obligations
– Activity affecting the contract balances
Disaggregation of revenue (qualitative only for non-public), some examples:
– Type of good or service
– Geographical region
– Market or type of customer
– Type of contract
– Contract duration
– Timing of transfer of goods or services
Backlog on remaining performance obligations
Revenue recognition policies
– Nature of good or services promised
– Method used, over time or at a point in time, input or output methods
– Implied and explicit contract terms
– Methods, inputs, and assumptions used for public companies on the following:
Determining the transaction price
Assess whether an estimate of variable consideration is constrained
Allocation of transaction price
Measurement of obligations for returns, refunds, and other similar obligations
– Election to use the practical expedient for not recognizing a financing component within a
contract
Significant changes in estimates
Contract costs
Incremental costs of obtaining a contract
Cost to fulfill a contract
Significant judgments
Chapter 3 further covers the required disclosures.
The completed-contract method

The second method for recognizing revenues on construction contracts is the completed-contract
method. This method should be used only if one of the following is true:
It does not vary materially from the percentage-of-completion method.

The contractor is unable to make reasonably dependable estimates.
The completed-contract method is sometimes used by contractors who primarily have short-term
contracts.
Under the completed-contract method, all revenues, costs, and profits are deferred until the contract is
completed. While the contract is still in process, an asset or liability is recorded for the difference
between the costs incurred on the contract and the billings. Once a contract is substantially complete, all
of the revenue, costs and profits on the contract are recognized.
Determining when a contract is substantially complete is a matter of judgment. Generally, a contract is

considered substantially complete when the remaining costs, as well as the potential risks on a contract,
are insignificant.
CPAs must consider the risk of issuing an unqualified opinion in cases where the contractor lacks the
ability to provide reasonably dependable estimates.
Conclusion
FASB ASC 606 will have a significant impact on the construction industry, and that impact is felt already.
As industry practice continues to develop, this course will be updated with additional guidance and
examples.
Leases
Learning objective: Recall the details in the accounting for leases in accordance
with FASB Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842).
Overview
On February 25, 2016, FASB issued ASU No. 2016-02, Leases (Topic 842). The objective of the ASU is to
increase transparency and comparability in financial reporting by requiring balance sheet recognition of
leases and note disclosure of certain information about lease arrangements. This ASU codifies the new
FASB ASC 842, Leases, and makes conforming amendments to other FASB ASC topics.
In November 2019, FASB issued ASU No. 2019-10, Financial Instruments—Credit Losses (Topic 326),
Derivatives and Hedging (Topic 815), and Leases (Topic 842), which revised the effective dates as follows:
For public business entities, ASU No. 2016-02 is effective

– for annual reporting periods beginning after December 15, 2018, and
– interim periods within those fiscal years.
For all other entities, ASU No. 2016-02 is effective
– for annual reporting periods beginning after December 15, 2020, and
– interim periods within annual periods beginning after December 15, 2021.
FASB ASC 842 applies to all leases and subleases of property, plant, and equipment; it specifically does
not apply to the following nondepreciable assets accounted for under other FASB ASC topics:
Leases of intangible assets

Leases to explore for or use nonregenerative resources such as minerals, oil, and natural gas
Leases of biological assets, such as timber
Leases of inventory
Leases of assets under construction
ASU No. 2016-02 requires that all leases be accounted for on the balance sheet (with minor exceptions).
The capitalizing of leased assets and the related liabilities will have an effect on financial ratios such as
working capital, current ratio, and debt to equity. The subsequent transfer over time of the balance sheet
accounts to the income statement will affect both net income and earnings before interest, taxes,
depreciation, and amortization (EBITDA). CPAs for contractors should consider how these changes will
affect loan covenants, bonding requirements, and multi-state taxation apportionment allocations.
In particular, CPAs for contractors should consider contacting loan officers and bonding agents ahead of
the implementation to explain how the adoption of the new rules will affect the appearance of the
financial statements. The preparation of pro forma financial statements might be beneficial.
Under FASB ASC 840, leases which met one four criteria were considered capital leases. The four criteria
were the following:
Does the title/ownership transfer to the lessee at the end of the lease term?
Is there a bargain purchase option?
Is the lease term 75% or more of the remaining economic life of the asset?
Does the present value of the sum of the lease payments exceed 90% or more of the fair value of the
underlying asset?
Under FASB ASC 842, finance leases (previously capital leases) the concern is control.
Is it a lease or a service arrangement?
A lease is a contract that conveys the right to use an asset for a period of time in exchange for
consideration. A lease involves the control of an asset. An entity would determine whether a contract
contains a lease by assessing whether there is a specifically identified asset.
The following are questions to consider when determining whether there is a lease:
Has a specific asset been identified?

Does the customer control the use of the identified asset?
Can the lessor substitute the asset?
Who bears the risk of loss?
In most cases, a lease or a rental agreement will be considered a lease. If the customer has little to no
control over the asset, then the arrangement would be considered a service arrangement and accounted
for as a rental with no balance sheet effect.
Key point
Highlights of FASB ASC 2016-02:
All leases will be recorded on the balance sheet as a right-of-use asset and a lease
liability. Potential negative effect on common ratios sureties review.
Leases will be categorized as two types — operating leases and finance leases.
There will be two methods of transferring the balance sheet costs to the income
statement depending on the nature of the underlying lease.
Lessee and lessor accounting will be different.
Adoption of the standard will initially have a negative effect on certain ratios such as working
capital and debt to equity. As such, every entity should review their loan covenants and
regulatory requirements to ensure that they are still in compliance after adopting the new
standard.
Finance or operating lease

The new lease rules are considered a “right-of-use” model where all leases will be recorded on the
balance sheet as a finance lease or an operating lease.
There is an optional election to account for leases with a term of 12 months or fewer at inception as a
rental arrangement.
In a finance lease, the customer obtains control of the underlying asset based on the following five
criteria:
1. The ownership of the asset transfers to the lessee.

2. The lease contains a purchase option reasonably certain to be exercised.
3. The lease term is for a major portion of asset’s economic life.
4. The present value of lease payments and residual value exceeds substantially all of the fair value of
the underlying asset.
5. The specialized nature of underlying asset results in no expectation of alternative use after the lease.
The criteria are similar but not identical to the classification rules for a capital lease. Under the old lease
rules, the mere existence of a bargain purchase option was enough to qualify as a capital lease. Under
the new rules, there must be a reasonable expectation that the purchase option will be exercised. The
criteria are no longer based on whether the purchase option is a bargain but whether the purchase option
will actually be exercised.
Under FASB ASC 840, or old GAAP, criteria 3 and 4 had percentages assigned to them. The new standard
removed the percentages but gave accountants the option of using the prior percentage — lease term
equal to or greater than 75% of the remaining economic life of the asset or the present value of the
minimum lease payments is equal to or greater than 90% of the assets fair market value.
An operating lease is any lease that does not qualify as a finance lease. It also includes any lease that
falls within the last 25% of the total economic life of the underlying asset. Operating leases are likely to be
leases of real estate or very long-lived assets such as airplanes, rail cars, or ships. However, all operating
leases will still be recorded on the balance sheet.
Leases between related parties will be classified based on the legally enforceable terms and conditions
of the lease.
Lease term
The lease term will include the term of the lease plus any renewal period or options for which there is a
significant economic incentive to renew. This may include renewals at a bargain rate, in which there may
be a significant lease termination penalty or if the lessor controls the renewal options. For many entities
that have historically exercised options to extend, this provision will require the lease asset and liability to
be calculated over a significantly longer term and at a significantly higher amount than previously
recorded.
The lease term and the expected exercise of options should be assessed regularly.
Recording the initial lease

Both operating and finance leases will be recorded on the balance sheet:
Dr. Right-of-use asset
Cr. Lease liability
The right-of-use asset will be recorded at the sum of
the initial lease liability,

lease payments made to the lessor at or before the lease commencement date, and
initial direct lease costs (only commissions or payment made to the prior lessee).
The right-of-use asset will be separately stated from all other assets either on the face of the balance
sheet or in the notes to the financial statements.
The lease liability will be recorded at the sum of
the present value of the remaining minimum fixed lease payments,

any variable lease payments tied to a specific index or rate (such as an escalation clause),
the exercise of the purchase option when reasonable expected to be exercised,
any amounts owed for a residual value guarantee, and
less and lease incentives received from the lessor.
The lease liability will not include
common area maintenance charges,

real estate taxes,
insurance, or
variable lease payments based on a percentage of sales or reaching a milestone. Variable lease
payments are recorded as a separate lease expense when incurred.
The lease liability will be separately stated from all other liabilities either on the face of the balance sheet
or in the notes to the financial statements.
Exhibit 2-1 Income statement recognition patterns

Finance lease Operating lease
Amortization expense N/A
Interest expense N/A
N/A Lease expense
Expense reported below EBITDA Expense reported above EBITDA
Front-loaded expense Straight-line expense
Finance leases
For a finance lease, the right-of-use asset will be amortized (not depreciated) over the useful life of the
asset using the same methods used for an entity’s fixed assets. The amortization expense will be
separately stated on the face of the income statement or in the footnotes.
When payments are made on the lease payable, the principal will be posted against the liability, and
interest expense will be recorded. Interest is always higher at the beginning of a lease, so the total coat of
the lease, amortization, and interest will be highest at the beginning of the lease and decrease as time
passes. The interest expense on the lease payable will be separately stated on the face of the income
statement or in the footnotes.
The statement of cash flows will reflect both financing activity, in the form of the repayment of the
principle, and operating activity, in the form of interest expense.
Operating leases
For an operating lease, the amortization expense and interest expense are combined into a single lease
expense that is recorded on a straight-line basis. The entity will calculate the monthly straight-line lease
expense at the beginning of the lease, but it will be composed of both interest and amortization. Because
interest expense is a known quantity, this means the amount recorded for amortization will be a
calculation (or plug).
(calculated on a straight-line basis)
The statement of cash flows will reflect only operating activity.
Example 2-8
ACME Construction has a 10-year lease on a crane with an option to extend the lease an
additional 5 years. The option is not expected to be exercised. The lease requires annual
payments of $50,000 payable at the beginning of each year. The initial direct cost related to
the lease is $15,000. The lessee’s incremental borrowing rate is 5.87%. The present value of
the remaining minimum lease payments is $342,017. The company uses straight-line
deprecation.
Initial lease entry
For both operating and financing, leases the initial entry to record the lease would be:
Dr. Right-of-use asset $407,017 ($342,017 present value + 50,000 first lease payment +
$15,000 initial direct costs)
Cr. Lease liability: $342,017 (present value)

Cr. Cash: $65,000 (first lease payment and initial direct costs)
Entry at year-end
The entry at year-end will be different depending upon whether you have a finance or
operating lease.
Example 2-8 (continued)
Finance lease
At the end of each year, the entity will record accrued interest on the lease liability and
interest expense.
Dr. Interest expense $20,076 ($342,017 lease liability balance × 5.87% incremental
borrowing rate)
Cr. Lease liability $20,076
The lessee will also record amortization of the leased asset.
Dr. Amortization expense $40,702 ($407,017 asset value ÷ 10-year life)

Cr. Right-of-use asset $40,702
Operating lease
The lessee must first calculate the straight-line lease expense using all expected lease
payments over the entire life of the lease.
The total lease expense for ACME will be $515,000 (10 payments of $50,000 + $15,000 initial
direct costs). Therefore, the annual lease expense for ACME will be $51,500 ($515,000 ÷ 10
years).
The entry to record the annual lease expense will be
Dr. Lease expense $51,500 (the calculated straight-line amount)

Cr. Lease payable $20,076 (to record the accrued interest)
Cr. Right-of-use asset $31,424 (balancing entry)
Comparison of year-end account balances:
Financing Operating
Initial asset 407,017 407,017
Initial liability 342,017 342,017
Amortization 40,702 –
Interest expense 20,076 –
Lease expense – 51,500
Asset — End of Yr1 366,315 375,593
Liability — End of Yr1 362,093 362,093
Knowledge check
5. Which statement is not correct with respect to the new FASB ASU No. 2016-02, Leases
(Topic 842)?
a. All leases go on the balance sheet (with certain exceptions).
b. Leases will be classified as either a finance lease or an operating lease.
c. Financing leases and operating leases have significantly different balance sheet impacts.
d. Financing leases and operating leases have different income statement and cash flow impacts.
6. When a lease meets one of the five criteria discussed in FASB ASC 842, it will be considered a
financing lease. Which of the following is one of the criteria?
a. No transfer of ownership.
b. Bargain purchase option exists.
c. Economic life — <25%.
d. Present value of minimum lease payments exceeds fair value.
Disclosures
The disclosures for both types of leases will be significantly expanded to include the following:
Information about nature of entity’s leases

Reconciliation of beginning and ending balance of lease liabilities
Maturity analysis of undiscounted cash flows
Information about the principle terms of the lease
Expenses related to variable payments
Existence of options to extend or terminate leases
Significant assumptions and judgments
Lease transactions with related parties
Options for lessee to purchase leased asset
Information about how it manages risk with residual value of assets
Lease maturity analysis
Additional quantitative disclosures such as lease income and components of its aggregate net investment
Lessor accounting
FASB ASC 842 provides recognition guidance for sales-type leases, direct financing leases, and operating
leases. Exhibit 2-2 summarizes the guidance.
Exhibit 2-2 Lessor accounting
Sales-type leases
At the commencement date After the commencement date

Lessor derecognizes the underlying asset and Lessor recognizes the following:
recognizes the following:
Interest income on the net investment in
Net investment in the lease (lease the lease
receivable and unguaranteed residual Certain variable lease payments
asset) Impairment
Selling profit or loss arising from the lease
Initial direct costs as an expense
Direct financing leases

Lessor derecognizes the underlying asset and Lessor recognizes the following:
recognizes the following:
Interest income on the net investment in
Net investment in the lease (lease the lease
receivable and unguaranteed residual Certain variable lease payments
asset reduced by selling profit)
Selling loss arising from the lease, if
applicable
Impairment
Operating leases

Lessor defers initial direct costs. Lessor recognizes the following:
The lease payments as income in profit or

loss over the lease term on a straight-line
basis (unless another method in more
representative of the benefit received)
Certain variable lease payments as
income in profit or loss
Indirect costs as an expense over the
lease term on the same basis as lease
income
Key presentation matters include the following:
For sales-type and direct financing leases
Statement of financial position

– Separate presentation of lease assets (that is, aggregate of lessor’s net investment in sales-type
leases and direct financing leases) from other assets
– Classified as current or noncurrent based on the same considerations as other assets
Statement of comprehensive income
– Presentation of income from leases in the statement of comprehensive income or disclosure of
income from leases in the notes with a reference to the corresponding line in the statement of
comprehensive income
– Presentation of profit or loss recognized at the commencement date in a manner appropriate to
lessor’s business model
Statement of cash flows
– Presentation with operating activities—cash receipts from leases
For operating leases
Statement of financial position

– Presentation of an underlying asset subject to an operating lease in accordance with other FASB
ASC topics
Statement of comprehensive income
– Separate presentation or disclosure of lease income
– Presentation with operating activities—cash receipts from leases
Disclosure requirements include qualitative and quantitative information for leases, significant
judgments, and amounts recognized in the financial statements, including certain specified information
and amounts.
Sale and leaseback transactions

FASB ASC 842 provides guidance for both the transfer contract and the lease in a sale and leaseback
transaction (a transaction in which a seller-lessee transfers an asset to a buyer-lessor and leases that
asset back). Determination of whether the transfer is a sale should be based on provisions of FASB ASC
606. FASB ASC 842-40-25 provides measurement guidance for a transfer that is either determined to be
a sale or determined not to be a sale.
FASB ASC 842-40 provides guidance for subsequent measurement, financial statement presentation,
and disclosures.
Leveraged lease arrangements

The legacy accounting model for leveraged leases continues to apply to those leveraged leases that
commenced before the effective date of FASB ASC 842. There is no separate accounting model for
leveraged leases that commence after the effective date of FASB ASC 842.
What to do now?
In preparation for the adoption of the new lease standard, the first step will be to prepare a summary of
all leased and rented assets including the following:
Nature of the asset

Lease start and end dates
Current method of accounting for each lease
Future method of accounting for each lease
Pro forma effect on the balance sheet
This inventory will inform the amount of preparation that will be necessary.
Summary
This chapter focused on major changes in construction accounting including revenue recognition and
accounting for leases. All contractors should determine if and how they will be affected by each of the
standards. Because of the sweeping nature of the changes, an entity should consider whether to adopt
both standards separately or together.
Practice questions (Optional)

1. What are the five-steps in the revenue recognition process?
2. What are the three methods that can be used by an entity to estimate the value of a variable
consideration? When would each of those methods be used?
3. What are the steps required to be taken when a significant inefficiency occurs in performance on a
project that uses a cost-based input method?
4. What is the proper classification for on a contractor’s financial statements for uninstalled materials
that are non-distinct and control has not passed to the customer?
5. Name a few items that are costs incurred by a contractor that do not transfer value to a customer?
How should those costs be recorded on a contractor’s financial statements?
Chapter 3
Financial Statements for the Contractor
Learning objectives
Identify the unique characteristics of the contractor financial statements — specifically, accounts
generally unique to construction contractors.
Identify the unique disclosures common to contractor financial statements.
Recall the unique supplementary information normally included in the financial statements of a
construction contractor.
Introduction
The financial statements of a contractor are the most important criteria a surety uses to determine the
capital ability of a contractor to perform profitably on a construction contract. It is important that every
person dealing with a contractor understand the unique accounts, disclosures, and schedules that are
required or requested by various users of the financial statements, but, more importantly, the surety. This
is discussed further in chapter 4, “Working With a Surety.”
Learning objective: Identify the unique characteristics of the contractor financial
statements — specifically, accounts generally unique to construction contractors.
This chapter focuses primarily on the following items:
Balance sheet — The balance sheet is a critical financial statement assessed by financial statement
users. It is analyzed to determine working capital, bonding limits for individual contracts, bond
program for the contractor, debt implications, and many more issues that affect the contractor.
Proper presentation is the first step in addressing the needs of any contractor.
Income statement — The importance of the income statement is to summarize the details provided
by the standard schedules included in the supplementary information. The detail included in the
income statement may vary based upon the amount of detail provided by the supplementary
schedules. Proper revenue recognition and presentation is critical for the contractor.
Notes to the financial statements — Due to the unique accounts presented by construction,
contractors require unique disclosures of certain information. Samples of these unique disclosures
have been provided.
Supplementary information — Many questions arise of what to include and what not to include in the
supplemental information of financial statements. The best advice that can be given is to provide the
user of the financial statements the information needed to make a well-informed decision.
Financial statements
Many construction industry disclosures are unique and are required by generally accepted accounting
principles (GAAP). These disclosures are defined by Financial Accounting Standards Board (FASB)
Accounting Standards Codification® (ASC) 606-10-50 and discussed in the AICPA Audit and Accounting
Guide Construction Contractors. These guidelines are important to properly recognize the unique
accounts that are introduced by the construction industry.
However, there may be optional disclosures that are not promulgated by the CPA’s professional literature
but may be requested or mandated by the user of the contractor’s financial statement. As mentioned in
prior chapters, it is critical that the CPA be aware of the unique requirements of the users of the
contractor’s financial statements. These users typically require information that is contained in
supplementary schedules to the financial statement.
Knowledge check
1. The uniqueness of the income statement for contractor financial statements largely is due to
a. The income statement summarizes data from supplementary information.

b. The income statement is used primarily by sureties to determine bonding.
c. The unique terminology used on the income statement.
d. The unusual formatting of the income statement.
Exercise 3-1 Group Discussion
With a partner, or in a small group, create a list of financial statement accounts that you
believe are unique or important to construction contractors.
Current assets unique to contractors

Following is a list of current assets commonly used by contractors that are unique to the construction
industry:
Accounts receivable on contracts

Retention receivables
Unbilled contract receivables
Cost and estimated earnings in excess of billings
Other deferred contract costs
Equipment and small tools specifically purchased for, or expected to be used solely on, an individual
contract
Investments in joint ventures
Contract asset (new under FASB ASC 606)
Key point
The FASB Master Glossary defines contract asset as:
An entity’s right to consideration in exchange for goods or services that the entity has
transferred to a customer when that right is conditioned on something other than the
passage of time (for example, the entity’s future performance).
Current liabilities unique to contractors

Following is a list of current liabilities commonly used by contractors that are unique to the construction
industry:
Accounts payable on contracts

Retention payables
Accrued contract costs
Billings in excess of costs and estimated earnings
Provision for anticipated losses on uncompleted contracts
Accrued expenses for contingencies, warranty, or workers’ compensation liabilities
Advance payments on contracts for mobilization or other purposes
Deferred income taxes resulting from using a method of income recognition for tax purposes
different from the method used for financial reporting purposes
Contract liability (new under FASB ASC 606)
Key point
The FASB Master Glossary defines contract liability as:
An entity’s obligation to transfer goods or services to a customer for which the entity has
received consideration (or the amount is due) from the customer.
These current assets and liabilities have a good bit of similarity and typically include amounts related to
the same contract. However, it should be mentioned that the accounting of such similar assets or
liabilities should not be offset with each other. As we will discuss later in this chapter, the reporting of
these accounts will be seen within the footnotes and different schedules. Because of the multiple
disclosures within the financial statements, it is critical to report the unique assets and liabilities at their
gross amounts and not net balances.
As previously noted, there are unique accounts that have unique names as promulgated by GAAP that
may not be commonly referred to by contractors. It is important to name the assets and liabilities using
GAAP terminology and not the common names or jargon in actual practice.
Contractor balance sheet

Contractors typically use the classified balance sheet approach. This method is preferred by most
sureties reflecting the contractor’s current assets and current liabilities on one line. As discussed in our
chapter on sureties, the working capital as defined by GAAP and the working capital as defined by a
surety may be different, but the appropriate disclosure of current assets and current liabilities on the
balance sheet is important.
Classified balance sheets are based on one’s operating cycle. The operating cycle can be difficult to
measure with precision because it is determined by contracts of varying durations. The FASB ASC
Master Glossary defines the operating cycle as
The average time intervening between the acquisition of materials or services and the final cash
realization constitutes an operating cycle.
With that being said, a contractor who normally performs contracts over an 18- to 24-month period will
have assets and liabilities associated with those contracts disclosed as current because that is the
operating cycle of that contractor. The focus is not on a calendar or one-year mentality, but, instead, the
focus is on the contract life. With that said, the predominant practice in the construction industry for
contractors whose operating cycle exceeds one year is to classify all contract-related assets and
liabilities as current under the operating cycle concept and to follow other, more specific, guidance in
classifying other assets and liabilities. Following those general rules promotes uniformity of presentation
and narrows the range of variations in practice. (Practice note – You should disclose in your financial
statements that these balances, which may extend beyond one year, are included in current assets and
liabilities on the balance sheet.)
Comparative financial statements are not required for the construction industry. However, one may want
to ask the users of the financial statements about their preference in how they would like the balance
sheet presented.
Following is the consolidated balance sheet for a contractor provided as an example and will be used for
highlighting the unique accounts and specific disclosures.
Note regarding Accounting Standards Update (ASU) No. 2014-09, Revenue

from Contracts with Customers (Topic 606)
As industry practice develops with regards to the implementation of FASB ASU No. 2014-09,
updated guidance (as appropriate) will be included in a future edition of this course.
ACME, Inc. and Subsidiaries

Consolidated balance sheet
December 31, 20X1
Assets
Current assets
1
Cash and cash equivalents (Subsidiary B portion − $225,374) $ 1,160,791
1
Per FASB ASC 810-10-45-25, a reporting entity shall present each of the following separately on the face of the
statement of financial position:
a. Assets of a consolidated variable interest entity (VIE) that can be used only to settle obligations of the
consolidated VIE
b. Liabilities of a consolidated VIE for which creditors (or beneficial interest holders) do not have recourse to
the general credit of the primary beneficiary.
Note: FASB ASC 810, Consolidation, does not provide guidance on how assets and liabilities that meet this separate
presentation criteria should be presented in the primary beneficiary’s statement of financial position. A reporting
entity that is the primary beneficiary of a variable interest entity could present each asset element that meets the
separate presentation criteria as one line item and parenthetically disclose the amount of the asset in a variable
interest entity, as presented in this example. Alternatively, the reporting entity could present an asset element in two
separate line items, one line item for the asset in a variable interest entity that meet the separate presentation
criteria and another line item for the reporting entity’s corresponding asset. There may be other acceptable
December 31, 20X1
Contracts receivable, net (Subsidiary B portion − $2,546,223) 6,404,128

Costs and estimated earnings in excess of billings on 1,004,598
uncompleted contracts (Subsidiary B portion − $533,410)
Current portion of note receivable 113,546
Prepaid expenses and other current assets (Subsidiary B portion 1,781,128
− $698,009)
Total current assets 10,464,191
Noncurrent assets
Note receivable, less current portion 127,287
Cash surrender value of officers’ life insurance 1,030,448
Goodwill, net 1,799,109
Deposits and other assets (Subsidiary B portion − $9,234) 80,151
Property and equipment, net of accumulated depreciation and
amortization (Subsidiary B portion − $1,445,209) 2,763,945
2
Deferred tax asset (Subsidiary B portion − $654) 1,837
Total noncurrent assets 5,802,777
Total assets $ 16,266,968
Liabilities and stockholders’ equity
Current liabilities
alternatives. FASB ASC 810 does not provide any requirements for separate presentation of a consolidated variable
interest entity’s revenue, expense or cash flow figures.
2
FASB ASU No. 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes, was issued in
November of 2015.
The amendments in ASU No. 2015-17 are effective for public business entities’ financial statements issued for
annual periods beginning after December 15, 2016, and interim periods within those annual periods. The
amendments are effective for all other entities’ financial statements issued for annual periods beginning after
December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. Earlier
application is permitted.
ASU No. 2015-17 applies to all entities that present a classified statement of financial position. The ASU amends
FASB ASC 740 to require that deferred tax liabilities and assets be classified as noncurrent in a classified statement
of financial position. Readers are encouraged to consult the full text of this ASU on FASB’s website at
www.fasb.org.
Accounts payable (Subsidiary B portion − $1,776,589) $ 3,173,919
Billings in excess of costs and estimated earnings on
uncompleted contracts (Subsidiary B portion − $36,714) 95,876
Line of credit 1,851,590
Accrued expenses (Subsidiary B portion − $1,343,989) 3,638,207
Accrued loss on uncompleted contracts (Subsidiary B portion −
$44,390) 105,950
Current maturities of long-term debt 1,253,602
Total current liabilities 10,119,144
Noncurrent liabilities
Long-term debt, less current maturities 2,975,142
Deferred tax liability (Subsidiary B portion − $98,965) 208,740
Total noncurrent liabilities 3,183,882
Total liabilities 13,303,026

December 31, 20X1 (continued)
Stockholders’ equity
Common stock, no par value, 100,000 shares authorized, 23,549 2,752,574
issued and outstanding
Retained earnings 85,561
Total controlling interest stockholders’ equity 2,838,135
Noncontrolling interest in subsidiary 125,807
Total stockholders’ equity 2,963,942
Total liabilities and stockholders’ equity $ 16,266,968
The accompanying notes are an integral part of these consolidated
financial statements.
Specific accounts to review for contractors
Inventory
Accounts receivable
– A surety may require an aging of receivables in the supplementary information.
– They will also want to know if retention receivables have been separately stated.
Costs and estimated earnings in excess of billings on uncompleted contracts
Contract asset
– Under FASB ASC 606, certain contract specific assets are to be categorized as contract assets.
These amounts include retainage receivable (if that retainage is not satisfied by the passing of
time only) and costs and estimated earnings in excess of billings on uncompleted contracts
(previously discussed in chapter 2). The contractor can choose to group these amounts into one
line on the balance sheet as contract assets or can leave the presentation, as was typically shown
under FASB ASC 605; however, at the very least, the balances that comprise the contract assets
must be disclosed in the financial statement footnotes.
Property, plant, and equipment
Investment in joint ventures
Accounts payable and accrued liabilities
– If subcontractor payables are involved with retention payables, this could be required based upon
using the classified balance sheet.
Billings in excess of costs and estimated earnings on uncompleted contracts
Contract liability
– Under FASB ASC 606, certain contract specific liabilities are to be categorized as contract
liabilities. These amounts include billings in excess of costs and estimated earnings on
uncompleted contracts and customer deposits. The contractor can choose to group these
amounts into one line on the balance sheet as contract liabilities or can leave the presentation as
was typically shown under FASB ASC 605; however, at the very least, the balances that comprise
the contract liabilities must be disclosed in the financial statement footnotes.
Warranty and reserves
Debt or lines of credit
Deferred income taxes
– If this contractor was a nontaxpaying entity, the income tax and distribution disclosure to the
shareholders, partners, or members could be optionally disclosed.
It is important that all amounts presented are clerically accurate and that the balances between the
financial statements and disclosures agree and, if appropriate, are properly referenced.
Contractor’s income statement

Following is the consolidated statement of income for a percentage-of-completion contractor provided
as an example and will be used for highlighting the unique accounts and specific disclosures.
Note regarding ASU No. 2014-09, Revenue from Contracts with Customers
(Topic 606)
Consolidated statement of income
for the year ended December 31, 20X1
Revenues $ 18,178,085
Cost of revenues 13,057,260
Gross profit 5,120,825
Selling, general, and administrative expenses 3,315,136
Income from operations 1,805,689
Other income (Expenses)
Rental income 55,988
Interest income 34,340
Interest expense (382,303)
Miscellaneous income, net 286,951
Total other expenses, net (5,024)
Net income before provision for income tax expense 1,800,665
Provision for income tax expense 461,789
Net income 1,338,876
Net loss attributable to noncontrolling interest in Subsidiary B 177,140
Net income attributable to controlling interest $ 1,516,016
The accompanying notes are an integral part of these consolidated financial statements.
Specific accounts to review for contractors
Contract revenues earned

– A surety will look to the supplementary information for the reconciliation between the completed
contracts, jobs in progress, and any other information to report contract revenues.
– This reconciliation should be reported on the schedule of contract revenues earned.
Cost of revenues earned
– This is the same as contract revenues earned.
– Some sureties like to see a breakdown of the cost of revenues between materials,
subcontractors, supplies, equipment, burden, and other items as a separate schedule in the
supplementary information.
Selling, general and administrative expenses
– A surety will look to the supplementary information for a detail schedule of these expenses.
Investment in joint ventures
Deferred income taxes
– If this contractor was a nontaxpaying entity, the income tax and distribution disclosure to the
shareholders, partners, or members could be optionally disclosed.
Stock- and equity-based composition
It is important that all amounts presented are clerically accurate and that the balances between the
financial statements and disclosures agree and, if appropriate, are properly referenced.
Contractors statement of changes in stockholders’ equity

Following is the consolidated statement of changes in stockholders’ equity for a percentage-of-
completion contractor provided as an example and will be used for highlighting the unique accounts and
specific disclosures
Consolidated statement of changes in stockholders’ equity
Retained Total
Common
stock shares Common earnings Noncontrolling stockholders’
outstanding stock (deficit) interest equity
Balance-
January1, 22,881 $2,529,434 $(1,430,455) $302,947 $1,401,926
20X1
Issuance of
Common 668 223,140 – – 223,140
Stock
Net Income
1,516,016 (177,140) 1,338,876
(Loss)
Balance-
December 31, 23,549 $2,752,574 $85,561 $125,807 $2,963,942
20X1
Contractor’s statement of cash flows

Following is the consolidated statement of cash flows for a percentage-of-completion contractor
provided as an example and will be used for highlighting the unique accounts and specific disclosures.
The statement of cash flows is very similar to any other industry’s cash flow statement. One should be
aware of the unique accounts reflected in the balance sheets that will have an impact on the cash flow
statement. Pay attention to the breakdown of cash flows from operations versus financing and investing
activities.
Consolidated statement of cash flows
Cash flows from operating activities

Net income including noncontrolling interests $ 1,338,876
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 969,616
Increase in cash surrender value of officers’ life insurance (243,031)
Gain on sale of property and equipment (216,377)
Provision for deferred income taxes 186,429
Provision for bad debt expense 521,895
Changes in assets and liabilities:
Contracts receivable 8,339,602
Costs and estimated earnings in excess of billings on
uncompleted contracts (62,009)
Prepaid expenses and other current assets 369,356
Deposits and other assets 51,654
Accounts payable 484,437
Billings in excess of costs and estimated earnings on
uncompleted contracts (3,600,106)
Accrued loss on uncompleted contracts (4,883,623)
Accrued expenses (696,184)
Net cash provided by operating activities 2,560,535
Cash flows from investing activities
Repayment of note receivable 90,876
Proceeds from sale of property and equipment 83,145
Purchases of property and equipment (290,300)
Net cash used in investing activities (116,279)
Cash flows from financing activities
Consolidated statement of cash flows
for the year ended December 31, 20X1 (continued)
Payments on line of credit, net (1,722,580)

Principal payments on long-term debt (1,392,257)
Principal borrowings on long-term debt 250,000
Proceeds from issuance of common stock 223,140
Net cash used in financing activities (2,641,697)
Net change in cash and cash equivalents (197,441)
Cash and cash equivalents — Beginning of year 1,358,232
Cash and cash equivalents — Ending of year $ 1,160,791

Supplemental disclosure of cash flow information
Cash payments for:
Interest $ 374,900
Income Taxes $ 201,488
Supplemental disclosure of noncash investing and financing activities
Purchase of vehicles by entering into long-term debt
$ 151,723
Specific disclosures for contractors
Learning objective: Identify the unique disclosures common to contractor financial

statements.
Exercise 3-2 Group Discussion

With a partner, or in a small group, create a list of disclosures that you believe are unique or
important to construction contractors.
Under FASB ASC 606 there are numerous changes to the required footnote disclosures. Examples of
those changes are as follows:
In the year of adoption, the contractor must disclose how they adopted FASB ASC 606. There are two
choices for non-public entities, which are full retrospective method (changes are made to all
previously reported periods, along with a cumulative adjustment to retained earnings) or modified
retrospective approach (report just the current year under FASB ASC 606 with an adjustment to
opening retained earnings). Disclosures for both methods are as follows:
– Full retrospective method –
 Effective January 1, 20X1, Company A elected to adopt the requirements of FASB ASC 606
using the full retrospective method. Prior to the adoption of FASB ASC 606, Company A
recognized revenues for construction contracts using the percentage of completion method
of accounting under FASB ASC 605. Under FASB ASC 606, revenues for construction
contracts are recognized over time. The adoption of FASB ASC resulted in a cumulative
adjustment to retained earnings of $10 million as of January 1, 20X0.
– Modified retrospective method –
 Effective January 1, 20X1, Company A elected to adopt the requirements of FASB ASC 606
using the modified retrospective method applied to those contracts that were not completed
as of January 1, 20X1. The results for reporting periods beginning after January 1, 20X1, are
presented under FASB ASC 606, whereas prior period amounts are not adjusted and continue
to be reported in accordance with Company A’s historic accounting under FASB ASC 605.
Company A recorded a net reduction to opening retained earnings of $10 million as of
January 1, 20X1, due to the cumulative impact of adopting FASB ASC 606.
Disaggregation of revenue – Under FASB ASC 606, contractors are required to disaggregate the
revenue recognized from contracts with customers into categories (such as type of service,
geographical region, type of customer, type of contract, etc.). For non-public entities, you can elect
not to apply quantitative disaggregation of revenue, however, at minimum, you must disclose revenue
disaggregated according to transfer of goods or services (for example, at a point in time and over
time) and qualitative information about how economic factors (for example, type or geographical
location of customers or type of contract) affect the nature, amount, timing, and uncertainty of
revenue and cash flows.
Disclosures for contract balances must include the following: Contract assets and contract liabilities
(including changes in those balances); the amount of revenue recognized in the current period that
was previously recognized as a contract liability; the amount of revenue recognized in the current
period that is related to performance obligations satisfied in the prior periods (note the non-public
entities can elect to disclose on the opening and closing balances of contract assets, liabilities and
receivables from contracts with customers).
Performance obligations — An entity must disclose information about its performance obligations in
contractors with customers, including a description of all of the following:
– When the entity typically satisfies its performance obligations, including when performance
obligations are satisfied in a bill-and-hold arrangement
– The significant payment terms
– The nature of the goods or services that the entity has promised to transfer goods or services
– Obligations for returns, refunds, and other similar obligations
– Types of warranties and related obligations
– The aggregate amount of the transaction price allocated to the performance obligations that are
unsatisfied as of the end of the reporting period
– An explanation of when the entity expects to recognize as revenue the amount disclosed which
the entity must disclose in either the following ways:
 On a quantitative basis using the time bands that would be most appropriate for the duration
of the remaining performance obligations
 By using qualitative information
In addition, the contractor must have qualitative disclosures of the “aggregate amount of the
transaction price allocated to the performance obligations that are unsatisfied (or partially
satisfied)” and when the entity expects to recognize that amount as revenue. Non-public entities
can choose not to disclose this information.
Significant judgements – Under FASB ASC 606 additional disclosures surrounding significant
judgements are required. Some examples of necessary information to be disclosed are as follows:
– For performance obligations satisfied at a point in time, an entity shall disclose the significant
judgments made in evaluating when a customer obtains control of promised goods or services.
– An entity must disclose information about the methods, inputs, and assumptions used for all of
the following:
 Determining the transaction price, which includes, but is not limited to, estimating variable
consideration for the effects of the time value of money, and measuring noncash
consideration.
 Assessing whether an estimate of variable consideration is constrained.
 Allocating the transaction price, including estimating standalone selling prices of promised
goods or services and allocation discounts and variable considerations to a specific part of
the contract.
 Measuring obligations for returns, refunds, and other obligations.
– Non-public election: Non-public entities must disclose the methods, inputs, and assumptions
used to assess whether an estimate of variable consideration is constrained. The other
disclosures of significant judgments are optional.
Costs to obtain or fulfill a contract need to be disclosed.
Policy decisions need to be disclosed, such as whether the entity used the practical expedients for
significant financing components and contract costs allowed by FASB ASC 606.
Following are the example disclosures that may assist the user in gaining insight to writing disclosures
contained in the financial statements of contractors. Not all required disclosures are represented.
Note regarding ASU No. 2014-09, Revenue from Contracts with Customers
(Topic 606)
Following are preliminary examples of disclosures that can be utilized under FASB ASC 606.
Note 1 — Nature of operations and significant accounting policies
Nature of operations
ACME, Inc. and Subsidiaries (“the Company”) operates under the following industries:
Subsidiary A — Provides construction, maintenance, repair, and upgrade of water and wastewater
facilities in the Southeastern United States.
Subsidiary B — Provides installation, service and operation maintenance of equipment sales of

water, waste water, and electrical control systems for commercial and residential clients in the
Southeastern United States.
Significant accounting policies

Basis of consolidation and variable interest entities
The consolidated financial statements include the accounts of ACME, Inc. and Subsidiaries and
its wholly-owned subsidiary, Subsidiary A. The Company has identified Subsidiary B as a variable
interest entity of Subsidiary A that is considered the primary beneficiary and has a controlling
financial interest in Subsidiary B. See Note 13 for additional discussion of Subsidiary B, a variable
interest entity. Amounts pertaining to the noncontrolling ownership interests held by equity
owners of Subsidiary B in the operating results and financial position of Subsidiary B are reported
as noncontrolling interests in the consolidated subsidiary. The consolidation of Subsidiary B does
not change any legal ownership and does not change the assets or liabilities and equity of ACME,
Inc. and Subsidiaries as a separate legal entity. All intercompany accounts and transactions have
been eliminated in consolidation.
Use of estimates
The preparation of the consolidated financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the consolidated financial statements and reported
amounts of revenue and expenses during the reporting period. Actual results could differ from
those estimates. Management periodically evaluates estimates used in the preparation of the
consolidated financial statements for continued reasonableness. Appropriate adjustments, if any,
to the estimates used are made prospectively based upon such periodic evaluation. It is
reasonably possible that changes may occur in the near term that would affect management’s
estimates with respect to the percentage-of-completion method, allowance for doubtful accounts
and accrued expenses.
Revisions in estimated contract profits are made in the year in which circumstances requiring the
revisions become known.
Balance sheet classifications
The Company includes in current assets and liabilities retentions receivable and payable under
construction contracts that may extend beyond one year. A one-year time period is used as
classifying all other current assets and liabilities.
Cash and cash equivalents
For purposes of reporting cash flows, the Company considers all highly liquid investments
purchased with a maturity of three months or less at acquisition as cash and cash equivalents in
the accompanying consolidated balance sheet. The Company has interest bearing deposits in
financial institutions that maintained FDIC insurance in full for all accounts and limited coverage
up to $250,000 per financial institution. The portion of the deposits in excess of this amount is not
subject to such insurance and represents a credit risk to the Company. At times, balances held at
each financial institution may exceed $250,000, which represents a credit risk to the Company. At
December 31, 20X1, there were no uninsured deposits.
Contracts receivable
Contracts receivable from construction, operation and maintenance are based on amounts billed
to customers. The Company provides an allowance for doubtful collections that is based upon a
review of outstanding receivables, historical collection information, and existing economic
conditions. Normal contracts receivable are due 30 days after issuance of the invoice. Contract
retentions are usually due 30 days after completion of the project and acceptance by the owner.
Contracts receivable past due more than 60 days are considered delinquent. Delinquent contracts
receivable are written off based on individual credit evaluation and specific circumstances of the
customer.
Unbilled receivables result from the accrual of revenue on the percentage-of-completion method
of accounting for which billings have not yet been rendered.
Property and equipment
Property and equipment is stated at cost. Depreciation is computed using the straight-line
method over the estimated useful lives of the assets that range from 3 to 15 years. Leasehold
improvements are amortized on a straight-line basis over the shorter of the estimated useful life
of the improvement or the lease term. Expenditures for repairs and maintenance are charged to
expense as incurred.
For assets sold or otherwise disposed of, the cost and related accumulated depreciation are
removed from the accounts, and any related gain or loss is reflected in income for the period.
Impairment of long-lived assets
The Company reviews long-lived assets for impairment whenever events or circumstances
indicate that the carrying value of such assets may not be fully recoverable. Impairment is
present when the sum of undiscounted estimated future cash flows expected to result from use
of the assets is less than carrying value. If impairment is present, the carrying value of the
impaired asset is reduced to its fair value. During the year ended December 31, 20X1, there was
no impairment losses recognized for long-lived assets.
Goodwill
Goodwill, which is the excess of cost over the fair value of net assets (including identifiable
intangibles) acquired in a business acquisition, is not amortized but rather assessed at least
annually for impairment or whenever events or changes in circumstances indicate that the
carrying amount of the asset might not be fully recoverable. The Company qualitatively
evaluates relevant events and circumstances to determine whether it is more likely than not
that the fair value of a reporting unit is less than it’s carrying amount. If so, the Company
quantitatively compares the fair value of the reporting unit to its carrying amount on an annual
basis to determine if there is potential goodwill impairment. If the fair value of the reporting
unit is less than it’s carrying value, an impairment loss is recorded to the extent that the
implied fair value of the goodwill is less than its carrying value. Fair values for reporting units
are determined based on discounted cash flows, market multiples or appraised values. As of
December 31, 20X1, there were no events or circumstances that indicated that goodwill
impairment exists and the Company has recorded no goodwill impairment loss during the year
ended December 31, 20X1.
Debt issuance costs
Debt issuance costs of $16,742 are presented on the balance sheet as a direct reduction from
the carrying amount of the related debt liability and are being amortized as interest expense
using the effective interest method. The debt issuance costs are being amortized over the
term of the underlying debt, which is five years. Accumulated amortization amounted to
$15,878 at December 31, 20X1. Amortization expense for the year ended December 31, 20X1,
was $3,406. The remaining unamortized amount will be expensed in the year ending December
31, 20X2.
Revenues and cost of revenues
The Company adopted FASB ASC 606 with a date of initial application of January 1, 20X0. As a
result, the Company updated its accounting policy for revenue recognition to reflect the new
standard. The Company applied FASB ASC 606 using the modified retrospective method,
applying the guidance to contracts with customers that were not substantially complete as of
January 1, 20X1. The results for reporting periods beginning after January 1, 20X1, are presented
under FASB ASC 606, whereas prior period amounts are not adjusted and continue to be reported
with the Company’s historic accounting under FASB ASC 605. For contracts that were modified
before the adoption date, the Company has not restated the contract for those modifications.
Instead, the Company reflected the aggregate effect of all modifications when identifying the
satisfied and unsatisfied performance obligations, determining the transaction price and
allocating the transaction price, if necessary. The cumulative effect of initially applying the new
revenue standard would be applied as an adjustment to the opening balance of retained earnings.
The Company has analyzed this effect and found the adoption of the new guidance did not have a
material impact on its financial statements and its recognition is consistent with the historical
accounting policies.
Under FASB ASC 606, revenue is recognized when a customer obtains control of promised goods
or services in an amount that reflects the consideration which the entity expects to receive in
exchange for those goods or services. To determine revenue recognition for arrangements that
an entity determines are within the scope of FASB ASC 606, the Company performs the following
five steps: (1) identify the contract(s) with a customer; (2) identify the performance obligations in
the contract; (3) determine the transaction price; (4) allocate the transaction price to the
performance obligations in the contract; and (5) recognize revenue when (or as) the entity
satisfies a performance obligation.
The Company only applies the five-step model to contracts when it is probable that the entity will
collect the consideration it is entitled to in exchange for the goods or services it transfers to the
customer. At contract inception, once the contract is determined to be within the scope of FASB
ASC 606, the Company assesses whether each promised good or service is distinct. The
Company then recognizes as revenue the amount of the transaction price that is allocated to the
respective performance obligation when (or as) the performance obligation is satisfied. The
Company does not collect sales, value-add and other taxes collected on behalf of third parties.
Contract revenues are primarily derived from fixed price construction contracts. The Company
has determined that these fixed-price construction projects provide a distinct service and,
therefore, qualify as one performance obligation as the promise to transfer the individual goods
or services is not separately identifiable from other promises in the contracts and, therefore, not
distinct. Revenue is recognized over time, because of the continuous transfer of control to the
customer as work is performed at the customer’s site and, therefore, the customer controls the
asset as it is being constructed. The cost-to-cost measure of progress continues to best depict
the transfer of control of assets to the customer, which occurs as costs are incurred.
Revenues from time-and-material contracts are billed to customers as work is performed. The
Company determined that time-and-material contracts cover a single performance obligation,
with transfer of control continuously as the customer simultaneously receives and consumes the
benefits. Therefore, revenue for time-and-material contracts is considered to be recognized over
time.
Cost of revenues earned include all direct material and labor costs and those indirect costs
related to contract performance, such as indirect labor, supplies, tools, repairs, and depreciation
costs. The cost of uninstalled materials or equipment is generally excluded from the recognition
of gross profit because such costs are not considered to be a measure of progress. Costs to
mobilize equipment and labor to a jobsite prior to substantive work beginning are capitalized as
incurred and amortized over the expected duration of the contract. As of December 31, 20X1, and
as of January 1, 20X1, the Company had no capitalized mobilization costs. General and
administrative costs are charged to expense as incurred. Provisions for estimated losses on
uncompleted contracts are made in the period in which such losses are determined.
Certain construction contracts include retention provisions to provide customers that the
Company will perform in accordance with the contract terms and, therefore, not considered a
financing benefit. The balances billed but not paid by customers pursuant to these provisions
generally become due upon completion and acceptance of the project by the customer. The
Company has determined that there are no financing components included in construction
contracts as of December 31, 20X1, and January 1, 20X1.
Contract assets and liabilities
The timing of revenue recognition, billings, and cash collections results in billed contracts
receivable, retainage receivable, and costs and estimated earnings in excess of billings on
uncompleted contracts (contract assets) on the accompanying balance sheet. The contract
asset, “costs and estimated earnings in excess of billings on uncompleted contracts” represents
revenues recognized in excess of amounts billed. The contract liability, “billings in excess of costs
and estimated earnings on uncompleted contracts,” represents billings in excess of revenues
recognized. The following table provides information about receivables, contract assets and
contract liabilities from contracts with customers as of December 31:
20X1 20X0
Contract retainage receivable (contract asset) $ 727,411 $654,014
Costs and estimated earnings in excess of billings

on uncompleted contracts (contract asset) 1,004,598 942,589
Billings in excess of costs and estimated earnings
on uncompleted contracts (contract liability) 95,876 3,695,982
Contract estimates
Accounting for long-term contracts involves the use of techniques to estimate total contract
revenues and costs. Transaction price for contracts may include variable considerations, which
includes increases to transaction price for approved change orders, claims, and other contract
provisions. The Company includes variable consideration in the estimated transaction price to the
extent it is probable that a significant reversal of cumulative revenue recognized will not occur or
when the uncertainty associated with the variable consideration is resolved. The estimates of
variable consideration and determination of whether to include estimated amounts in transaction
price are based largely on an assessment of the anticipated performance and all information
(historic, current and forecasted) that is reasonably available to the Company. The effect of
variable consideration on the transaction price of a performance obligation is recognized as an
adjustment to revenue on a cumulative catch-up basis.
To the extent unapproved change orders and claims reflected in transaction price are not
resolved in the Company’s favor, or to the extent other contract provisions reflected in the
transaction price are not earned, there could be reductions in or reversals of previously
recognized revenue. No adjustments on any one contract was material to the financial
statements for the year ended December 31, 20X1.
Transaction price allocated to the remaining performance obligations
As of December 31, 20X1, the Company had approximately $4,054,000 of estimated revenue
expected to be recognized in the future related to performance obligations that are unsatisfied (or
partially satisfied).
Advertising costs
Advertising costs are expensed as incurred. Total advertising costs for the year ended December
31, 20X1, was $101,655.
Income taxes
Provisions for income taxes are based on taxes payable or refundable for the current year and
deferred taxes on temporary differences between the amount of taxable income and pretax
financial income and between the tax basis of assets and liabilities and their reported amounts in
the financial statements. Deferred tax assets and liabilities are included in the consolidated
financial statements at currently enacted income tax rates applicable to the period in which the
deferred tax assets and liabilities are expected to be realized or settled. As changes in tax laws or
rate are enacted, deferred tax assets and liabilities are adjusted through the provision for income
taxes. The deferred tax assets and liabilities represent the future tax consequences of those
differences that will either be taxable or deductible when the assets and liabilities are recovered or
settled. Deferred taxes are also recognized for operating losses that are available to offset future
income. Valuation allowance are recorded for deferred tax assets when it is more likely than not
that such deferred tax assets will not be realized.
If it is probable that an uncertain tax position will result in a material liability and the amount of
the liability can be estimated, then the estimated liability is accrued. If the Company were to incur
any income tax liability in the future, interest on any income tax liability would be reported as
interest expense, and penalties on any income tax would be reported as income taxes. The
Company’s federal and state income tax returns are open for years after December 20W5. As of
December 31, 20X1, there were no uncertain tax positions.
Concentration risk
At December 31, 20X1, approximately 85% of the Company’s workforce is union-represented

subject to collective bargaining agreements of which approximately 63% are represented by
unions whose existing labor agreements will expire on various dates in 20X2. The individual
unions may limit our flexibility in dealing with our workforce. Any work stoppage or instability
within the workforce could delay our ability to satisfy our commitments under existing contracts
with our customers in the manner management anticipated when developing contract estimates
used in preparing these financial statements. This could cause severe negative impacts to the
Company, including possible penalties for delayed contract performance, strained relationships
with existing customers, impacts on our ability to obtain future contracts, and cause a loss of
revenues, any of which could adversely affect our operations.
Subsequent events
These consolidated financial statements have been updated for subsequent events occurring
through June 19, 20X2, the date these consolidated financial statements were available to be
issued.
Note 2 — Contracts receivable, net

Contracts receivable included the following at December 31, 20X1:
Completed contracts $ 3,509,785
Contracts in progress 1,948,445
Unbilled 650,845
6,109,075
Retentions:
Completed contracts 214,675
Contracts in progress 727,411
942,086
7,051,161
Allowance for doubtful accounts (647,033)
$ 6,404,128
Note 3 — Costs and estimated earnings on uncompleted contracts
The following is a summary of contracts in progress at December 31, 20X1:
Costs incurred on uncompleted contracts $ 17,755,341
Estimated net loss on uncompleted contracts (2,808,452)
14,946,889
Billings to date (14,038,167)
$ 908,722
This amount is included in the accompanying consolidated balance sheet under the following
captions at December 31, 20X1:
Costs and estimated earnings in excess of billings on $ 1,004,597

uncompleted contracts
Billings in excess of costs and estimated earnings on $ (95,875)
$ 908,722
Note 4 — Note receivable

The Company has a note receivable relating to the sale of certain assets in 20X0. The note
receivable bears interest at 6%. The note receivable calls for monthly payments of $9,602,
including interest, with the balance of all principal and unpaid interest due in December 20X3. At
December 31, 20X1, $240,833 was outstanding on the note receivable. Interest income related to
the note receivable was $15,874 for the year ended December 31, 20X1.
Future maturity of the note receivable is as follows:
Years ending December 31,
20X2 $ 113,546
20X3 127,287
$ 240,833
Note 5 — Property and equipment
20X1
Assets
Equipment $ 2,699,813
Vehicles 2,658,477
Software 1,443,485
Furniture and fixtures 1,381,370
Leasehold improvements 782,497
8,965,642
Accumulated depreciation and

amortization
Equipment $ 1,867,509
Vehicles 1,838,919
Software 998,484
Furniture and fixtures 955,518
Leasehold improvements 541,267

6,201,697
Net property and equipment $ 2,763,945
Note 6 — Financing arrangements
Line of credit
The Company has a $7,500,000 line of credit bearing interest at an annual rate equal to the bank’s
prime rate plus 1.5% (4.75% at December 31, 20X1). There was $1,851,590 outstanding at
December 31, 20X1. The line of credit is secured by the assets of the Company.
Covenants
The line of credit with the bank contains certain financial covenants, including a minimum
tangible net worth ratio, minimum debt to tangible net worth ratio and a minimum net profit, as
defined in the agreements.
Long-term debt
Long-term debt includes the following notes payable at December 31, 20X1:
Various notes payable to Lender A due in monthly

installments ranging from $264 to $18,558, including
interest, ranging from 1.90 to 6.24%, expiring at various
dates through May 20X6. The notes are secured by certain $ 2,187,163
vehicles and equipment.
Various unsecured notes payable to Lender B due in
monthly installments ranging from $704 to $4,437,
including interest at 3.25%, expiring at various dates 1,383,410
through April 20X6.
Note payable to Lender C due in monthly installments of
$4,110, including interest at 1.90%, expiring in July 20X4.
The note is secured by equipment. 410,745
Various notes payable to various financing institutions, due
in monthly installments ranging from $458 to $711,
including interest, ranging from 1.99% to 4.69%, expiring at
various dates through July 20X5. The notes are secured by 248,290
certain vehicles.
4,228,744
Current maturities of long-term debt (1,253,602)

Less unamortized debt issuance costs (864)
$ 2,975,142
Aggregate maturities
Aggregate maturities of all long-term financing arrangements are as follows:
Years ending
December 31,
20X2 $ 1,253,602
20X3 1,029,838
20X4 952,920
20X5 785,094
20X6 207,290
$ 4,228,744
Note 7 — Stock redemption agreements
The Company has stock redemption agreements with all of its shareholders. Under the terms of
the agreement, the Company is required to purchase all of the stockholder’s shares upon death,
disability, retirement, or termination. Additionally, beginning at age 63 through age 67,
shareholders are required to sell their stock back to the Company. The Company annually
establishes a per share transaction value based upon a formula established in the stockholder
agreements and approved by the board of directors. At December 31, 20X1, the Company has
outstanding stock purchase commitments with its stockholders totaling 10,383 shares at
purchase prices ranging up to $384.04 per share.
Note 8 — Retentions payable

Accounts payable includes amounts due to subcontractors of $313,090 at December 31, 20X1,
which has been retained pending the completion and customer acceptance of the contracts.
Note 9 — Leases
Key point
On February 25, 2016, FASB released Accounting Standards Update (ASU) No. 2016-02,
Leases (Topic 842). Among several changes to the lease guidance, it will require that lessees
record nearly all leases on the balance sheet. Lessors will see some changes as well, largely
made to align with the revised lessee model and FASB’s new revenue recognition guidance.
In November 2019, FASB released ASU No. 2019-10, which modified the implementation
date of the standard, as follows:
1. Public business entities: Not-for-profit entities that have issued or are conduit bond
obligors for securities that are traded, listed, or quoted on an exchange or an over-the-
counter market; and employee benefit plans that file or furnish financial statements with
or to the SEC for fiscal years beginning after December 15, 2018, including interim
periods within those fiscal years
2. All other entities for fiscal years beginning after December 15, 2019, and interim periods
within fiscal years beginning after December 15, 2020.
Key point (continued)
Because FASB ASU No. 2016-02 already is effective for all entities within (1) above (that is,
including not-for-profit conduit bond obligors), FASB retained the effective date for those
entities, including smaller reporting companies. FASB also decided, consistent with having
bucket two be at least two years after the initial effective date, to defer the effective date for
all other entities by an additional year. Therefore, FASB ASU No. 2016-02 is effective for
entities within (2) above for fiscal years beginning after December 15, 2020, and interim
periods within fiscal years beginning after December 15, 2021. Early application continues to
be allowed.
The following footnote has not incorporated the concepts of FASB ASU No. 2016-02.
The Company has various noncancelable sublease agreements with lessees to occupy space in
various operating facilities. The sublease agreements call for monthly payments ranging from
$350 to $3,900. The subleases expire at various times through November 20X3.
Total rental income amounted to $55,988 for the year ended December 31, 20X1.
Future minimum rental income is as follows:
Years ending
December 31,
20X2 $ 39,067
20X3 5,483
$ 44,550
Operating leases
The Company rents its main operating facility. Monthly rent payments are $54,789. The lease
expires in June 20X4. Rent expense related to this operating facility for the year ended December
31, 20X1, was $657,468.
In addition, the Company has various noncancelable operating leases for operating facilities.
Monthly lease payments range from $1,650 to $16,161. The leases expire at various times
through April 20X7. Rent expense related to the operating facilities for the year ended December
31, 20X1, was $1,029,073.
The Company has various noncancelable operating leases for office equipment. Monthly lease
payments range from $129 to $1,836. The leases expire at various times through November
20X4. Rent expense related to the office equipment for the year ended December 31, 20X1, was
$85,437.
Future minimum lease payments
Aggregate future minimum lease payments on all operating leases are as follows:
Years ending
December 31,
20X2 $ 1,822,951
20X3 545,756
20X4 269,589
20X5 45,748
20X6 44,271
Thereafter 19,296
$ 2,747,611
Total rent expense, including equipment rental, for the year ended December 31, 20X1, was
$2,200,710.
Note 10 — Income taxes

Significant components of the Company’s deferred income tax assets and liabilities are as
follows at December 31, 20X1:
Current Long-Term
Deferred tax asset

Other — 3,843
Net operating loss — 222,401
Valuation allowance — (222,401)
Total — 3,843
Deferred tax liability
Other — (3,150)
Book-tax depreciation — (207,596)
Total — (210,746)
Net deferred tax liability — $ (206,903)
The provision for income tax expense for the year ended December 31, 20X1, includes the
following:
Current $ 275,360
Deferred 186,429
Total provision for income tax expense $ 461,789
The Company has accumulated state taxable loss carryforwards of approximately $6,901,000 at
December 31, 20X1. These loss carryforwards expire beginning in 20X2. A valuation allowance
has been provided against the state net operating loss carryforward as it is currently uncertain
about when the losses will be used by the Company. Subsidiary A also has federal and state
operating loss carryforwards of approximately $1,263,000. These loss carryforwards will expire
in 20X3.
Note 11 — Retirement plans
Employee benefit plan

The Company sponsors a 401(k) plan (the plan) that covers substantially all nonunion employees
of the Company. Contributions to the plan totaled $272,445 for the year ended December 31,
20X1. In addition, the Company may elect to make a discretionary contribution to the plan. For the
year ended December 31, 20X1, no discretionary contributions were made to the plan.
Union sponsored pension plan

The Company participates in various multiemployer defined benefit pension plans under the
terms of collective bargaining agreements covering most of its union-represented employees.
The risks of participation in these multiemployer plans are different than single-employer plans in
the following aspects:
a. Assets contributed to the plan by a company may be used to provide benefits to

participants of other companies.
b. If a participating company discontinues contributions to a plan, other participating
employers may have to cover any unfunded liability that may exist.
c. If the Company stops participating in some of its multiemployer pension plans, the
Company may be required to pay those plans an amount based on the underfunded
status of the plan, referred to as a withdrawal liability.
Information with respect to the multiemployer plans providing pension benefits in which the
Company participates is shown in the following table.
Certified
zone
status
Name of plan, Expiration date

plan number and Improvement or of collective
employer ID rehabilitation plan Surcharge bargaining
number 20X1 pending/implemented paid agreement
Plan A, 111, 11- Yellow Yes No 4/30/20X2

1111
Plan B, 222, 22- Green No No 7/31/20X3
2222
Plan C, 333, 33- Green No No 6/30/20X5
3333
Plan D, 444, 44- Green No No 12/31/20X2
4444
Plan E, 555, 55- Green No No 12/31/20X2
5555
The zone status is based on information that the Company received from each of the plans.
Among other factors, plans in the red zone are generally less than 65% funded, plans in the yellow
zone are less than 80% funded and plans in the green zone are at least 80% funded. The
“Improvement or Rehabilitation Plan Pending/Implemented” column indicates plans for which a
financial improvement or a rehabilitation plan is either pending or has been implemented.
Contributions made are as follows:
20X1
Plan A $—
Plan B 543,121
Plan C 766,119
Plan D 231,223
Plan E —
Other Plans 93,153
$ 1,633,616
Note 12 — Commitments and contingencies
The Company, as conditions for entering into certain construction contracts, purchased surety
bonds. The bonds are guaranteed by contracts receivable of the Company.
The Company is subject to various claims and legal proceeding covering a wide range of matters
that arise in the ordinary course of its business activities. Management believes that any liability
that may ultimately result from the resolution of these matters will not have a material effect on
the financial condition or results of operations of the Company.
The Company is contingently liable to a surety company under a general indemnity agreement.
The Company agrees to indemnify the surety for any payments made on contracts of surety ship,
guarantee, or indemnity. The Company believes that all contingent liabilities will be satisfied by
their performance on the specific bonded contracts.
Certain contracts are subject to government review of cost and overhead rates as defined in
various federal cost regulations. Management of the Company believes that there are no
adjustments that would materially affect the Company’s financial position and results of
operations as a result of a review of government contracts.
The Company has a purchase commitment with a vendor whereby the Company committed to
purchase minimum amounts of office supplies used in its normal operations. Future annual
minimum purchases remaining under the purchase commitment are $120,000 for the two-year
years ending December 31, 20X3. During the year ended December 31, 20X1, total purchases
under the purchase commitment were $94,434.
Note 13 — Variable interest entity

Management analyzes the Company’s variable interests including loans, guarantees and equity
investments, to determine if the Company has any variable interests in variable interest entities.
This analysis includes both qualitative and quantitative reviews. Qualitative analysis is based on
the evaluation of the design of the entity, its organizational structure, including decision making
ability, and financial agreements. Quantitative analysis is based on forecasted net cash flows. A
reporting entity is required to consolidate a variable interest entity when the reporting entity has a
variable interest that provides it with a controlling financial interest in the variable interest entity.
The entity that consolidates a variable interest entity is referred to as the primary beneficiary of
that variable interest entity. The Company also uses qualitative and quantitative analysis to
determine if it is the primary beneficiary of variable interest entities in which the Company holds
one or more explicit or implicit variable interests.
Subsidiary B is a related party installation company that has common controlling ownership with
the Company. The Company uses the services of Subsidiary B for installation of water and waste
water equipment. The Company has determined that Subsidiary B is a variable interest entity due
to lack of sufficient at-risk equity. The Company has also determined that it is the primary
beneficiary of Subsidiary B because it has the power to direct the activities of Subsidiary B that
most significantly affect Subsidiary B’s economic performance, including establishing installation
rates, and daily management decisions for operations and the awarding of subcontracts and
determination of subcontract terms for work performed by Subsidiary B for Subsidiary A in
addition to structuring certain arrangements with customers of Subsidiary A for certain work to
be structured as separate contracts directly between the customer and Subsidiary B. Additionally,
the Company is exposed to the obligation to absorb losses of Subsidiary B and the right to receive
benefits of Subsidiary B that could potentially be significant to Subsidiary B through the
subcontracts executed by the Company with Subsidiary B and implicitly due to the common
controlling ownership. Subcontracts with Subsidiary B that do not provide positive cash flow or
sufficient profitability may expose Subsidiary A to a loss. The operations of Subsidiary B are
financed by stockholder contributions of equity. Additionally, Subsidiary A has provided necessary
financial support to Subsidiary B for operations when needed. During the year ended December
31, 20X1, there was no financial support provided to Subsidiary B that was not previously
contractually required other than the access to bonding capacity that is expected to continue in
the future.
As the Company has been determined to be the primary beneficiary of this variable interest entity,
Subsidiary B’s assets, liabilities and results of operations are included in the Company’s
consolidated financial statements after elimination of intercompany accounts and transactions.
The interests of the noncontrolling equity owners of Subsidiary B is reflected in “Noncontrolling
interest in subsidiary” and “Net loss attributable to noncontrolling interest in subsidiary” in the
accompanying consolidated balance sheet and consolidated statement of income, respectively.
The condensed summary of the carrying amount and classification of Subsidiary B’s financial
information included in the Company’s consolidated balance sheet as of December 31, 20X1, is
as follows:
Condensed balance sheet
Current assets $ 4,003,670
Noncurrent assets 1,454,443
Total assets 5,458,113
Current liabilities 3,201,682
Noncurrent liabilities 98,965
Total liabilities 3,300,647
Condensed results of operations
Revenues $ 6,574,857
Cost of revenues 3,039,483
Net income 3,535,374
The assets of Subsidiary B can be used only to settle the liabilities of Subsidiary B. Subsidiary B’s
creditors, other than it’s bonding company, do not have recourse to the general credit of the
Company and certain assets such as costs and estimated earnings in excess of billings on
uncompleted contracts can be used only to satisfy the obligations of Subsidiary B; therefore,
Subsidiary B’s assets and liabilities have been presented notationally in the Company’s
consolidated balance sheet.
Note 14 — Backlog
The following schedule shows a reconciliation of backlog representing the amount of revenue the
Company expects to realize from work to be performed on uncompleted contracts in progress at
December 31, 20X1, and from contractual agreements on which work has not yet begun.
Contract revenues on uncompleted contracts at December 15,097,685

31, 20X0
Contract adjustments 2,688,136
Contract revenues for new contracts, 20X1 4,446,338
22,232,159
Contract revenues earned, 20X1 (18,178,085)
Backlog at December 31, 20X1 $ 4,054,074
In addition, between January 1, 20X2, and June 19, 20X2, the Company entered into additional
construction contracts with revenues of $5,332,800.
Knowledge check
2. An asset deemed unique to the financial statements of a contractor may be
a. Contract assets.
b. Prepaid insurance.
c. Machinery and equipment.
d. Cash.
3. A liability deemed unique to the financial statements of a contractor may be
a. Accounts payable.
b. Accrued liabilities.
c. Provision for anticipated losses on uncompleted contracts.
d. Long-term debt.
Schedule of supplementary information
Learning objective: Recall the unique supplementary information normally included

in the financial statements of a construction contractor.
The last piece of information typically included in the set of financial statements provided by the CPA is
the supplementary schedule.
The following are two lists of supplementary information found:
Most common
1. Schedule of contract revenues earned — This schedule is used to reconcile the completed contract
schedule and contracts in progress schedule to the income statement. There are other revenue and
cost items that may not be included in the other schedules. Those revenue and cost items would be
disclosed in the schedule of contract revenues earned. Such reconciling items can include, but are
not limited to, revenue and costs from: service contracts, contracts completed in previous years,
warranty costs, and unallocated job costs.
2. Completed contract schedule — This schedule reports all the jobs that were significantly completed
during the current year. It will reflect the revenues and costs incurred in the current year and also
those revenues and costs incurred in previous years, if applicable.
3. Contracts in progress — This schedule lists those jobs that were in progress at the end of the
contractor’s year-end. It will reflect the following items for each significant job in progress:
a. Estimated contract total price
b. Estimated contract total gross profit
c. Total revenues earned to date
d. Total costs incurred to date
e. Total gross profit earned to date
f. Total billings to date
g. Cost and estimated earnings in excess of billings on uncompleted contracts
h. Billings in excess of costs and estimated earnings on uncompleted contracts
i. Revenues earned during the current fiscal year
j. Costs incurred during the current fiscal year
k. Gross profit earned during the current fiscal year
4. Schedule of selling, general, and administrative expenses — This schedule should display the individual
expenses that make up the company’s overhead for the current fiscal year.
Alternative schedules
1. Schedule of contracts receivable — The schedule of contract receivables more than likely will include
the amount of retention receivable, if any. Some sureties request an estimated date of collection of
both the contract receivable and the retention.
2. Aging of contracts and accounts receivable — Provides the surety if there are any collection issues on
any contracts.
3. Schedule of property, plant, and equipment — This schedule reflects aging of equipment and hours of
use. This may allow the surety to assess future equipment needs of the contractor. Note that,
depending on the level of detail in the footnote disclosures, this may already be disclosed in the basic
4. Schedule of long-term debt — The surety is able to observe monthly cash flow and can observe in
detail what equipment may be associated with what debt. Note that, depending on the level of detail
in the footnote disclosures, this may already be disclosed in the basic financial statements.
5. Schedule of cost of goods sold — If the cost of goods sold is not broken down on the income
statement, the surety may want to observe the breakdown of labor, materials, equipment,
subcontractor costs and job, and overhead burden allocations.
The inclusion of any of the preceding schedules is optional per GAAP. However, supplying adequate
information for the surety to assess your client’s financial situation is very important. If you do not supply
the supplemental information within your financial statements, the surety will likely obtain from the client
with or without your assistance.
Following are example supplementary schedules.

Consolidated earnings from contracts
December 31, 20X1
Gross
Revenues Cost of revenues profit (loss)
Contracts completed during the year $ 10,432,966 $ 3,128,852 $ 7,304,114
Contracts in progress at year-end 7,745,119 9,822,458 (2,077,339)
Accrued loss on uncompleted contracts — 105,950 (105,950)
$ 18,178,085 $ 13,057,260 $ 5,120,825
Consolidated contracts completed during the year ended
December 31, 20X1
From inception to For the year ending

Total contract December 31, 20X0 December 31, 20X1
Contract
type
A—fixed-
price
B—cost- Cost of Gross Cost of Gross profit Cost of Gross profit
plus-fee Revenues revenues profit Revenues revenues (loss) Revenues revenues (loss)
Subsidiary A
Contract A B $ 5,159,692 $ 3,309,198 $1,850,494 $ 2,723,477 $2,852,343 $(128,866) $ 2,436,215 $ 456,855 $1,979,360
Contract B B 3,253,691 1,468,319 1,785,372 1,540,879 961,742 579,137 1,712,812 506,577 1,206,235
Contract C A 453,090 336,232 116,858 — — — 453,090 336,232 116,858
Contract D B 439,450 315,625 123,825 — — — 439,450 315,625 123,825
Contract E A 348,964 279,672 69,292 — — — 348,964 279,672 69,292
Small 272,085 228,218 43,867 — — — 272,085 228,218 43,867
contracts
Subsidiary B
Contract A B 4,655,660 2,849,081 1,806,579 2,318,930 2,487,826 (168,896) 2,336,730 361,255 1,975,475
Contract B B 3,888,514 1,580,613 2,307,901 2,446,155 1,491,964 954,191 1,442,359 88,649 1,353,710
Contract C A 267,322 127,365 139,957 — — — 267,322 127,365 139,957
Contract D A 261,576 150,345 111,231 — — — 261,576 150,345 111,231
Contract E A 209,206 166,567 42,639 — — — 209,206 166,567 42,639
Contract F A 122,098 67,499 54,599 — — — 122,098 67,499 54,599
Contract G A 111,323 79,890 31,433 — 59,196 (59,196) 111,323 20,694 90,629
Small 1,083,865 923,368 160,497 1,064,129 900,069 164,060 19,736 23,299 (3,563)
contracts
$20,526,536 $11,881,992 $ 8,644,544 $10,093,570 $8,753,140 $1,340,430 $10,432,966 $3,128,852 $7,304,114
Consolidated contracts in progress as of
December 31, 20X1
From inception to Year ended

Total contract December 31, 20X1 At December 31, 20X1 December 31, 20X1
Contract
type Costs and Billings in
A—fixed- estimated excess of
price Estimated Estimated earnings in costs and
B—cost- Contract gross profit Cost of Gross profit Billings to costs to excess of estimated Cost of Gross profit
plus-fee price (loss) Revenues revenues (loss) date complete billings earnings Revenues revenues (Loss)
Subsidiary A
Contract A A 5,561,983 (1,816,526) 5,453,561 7,234,676 (1,781,115) 5,320,985 143,833 132,576 — 1,910,753 2,686,566 (775,813)
(In dollars)
Contract B A 2,179,077 (103,357) 1,627,779 1,704,987 (77,208) 1,305,119 577,447 322,660 — 918,722 1,055,878 (137,156)
Contract C B 1,804,030 596,800 725,379 485,413 239,966 776,500 721,817 — 51,121 656,396 428,743 227,653
Contract D A 1,442,319 550,261 798,126 493,632 304,494 782,175 398,426 15,951 — 177,396 118,618 58,778
Small 398,890 85,235 216,017 169,859 46,158 224,057 143,796 — 8,040 218,271 169,683 48,588
contracts
Subsidiary B
Contract A A 3,682,939 (2,472,475) 3,616,816 6,044,901 (2,428,085) 3,324,895 110,513 291,921 — 2,650,540 4,468,281 (1,817,741)
Contract B B 2,649,845 1,137,742 1,697,750 968,801 728,949 1,554,274 543,302 143,476 — 476,913 284,416 192,497
Contract C A 334,418 113,389 103,832 68,626 35,206 140,546 152,403 — 36,714 87,891 49,642 38,249
Contract D A 310,572 102,490 278,621 186,675 91,946 267,730 21,407 10,891 — 232,785 165,691 67,094
Contract E A 228,025 41,819 134,448 109,791 24,657 92,438 76,415 42,010 — 114,165 108,526 5,639
Small 408,865 9,134 294,560 287,980 6,580 249,448 111,751 45,112 — 301,287 286,414 14,873
contracts
(In dollars) 19,000,963 (1,755,488) 14,946,889 17,755,341 (2,808,452) 14,038,167 3,001,110 1,004,597 95,875 7,745,119 9,822,458 (2,077,339)
Summary
Of all the work one does for the construction client, there is nothing more important than the year-end
financial statements. Such statements are reviewed and evaluated to make critical decisions by its users.
Therefore, it is very important that the preparer of such financial statements to understand the proper
presentation of such financial statements in the construction industry.
Chapter 4
Working With a Surety
Learning objectives
Recall the main reasons for and types of surety bonds in the construction industry and the
advantages to the owner of such bonds.
Identify the various financial benchmarks a surety or surety agent might analyze in a contractor’s
financial statements to determine the amount of the contractor’s surety credit.
Introduction
Chapter 1 introduced you to the basics of surety bonding and how most construction contractors must work
closely with their surety. This chapter explores the relationship between contractor and surety in more detail.
Why it matters
It is important for you to understand the surety process for the following reasons:
Smaller, less sophisticated contractors may rely on you to help manage the surety
relationship. The contractor may even ask you to make a preliminary determination of
bonding capacity.
The surety company is one of the principal users of the contractor’s financial statements,
and you should be sure the financial statements meet its needs.
Audit materiality is a determination made from the user’s point of view (that is, an item is
material if it affects the decision of the user), in this case, the surety.
What is a surety bond?
Learning objective: Recall the main reasons for and types of surety bonds in the
construction industry and the advantages to the owner of such bonds.
Recall the following diagram from chapter 1.
A surety bond is a guarantee of the contractor’s performance. As the diagram suggests, if the contractor
fails to perform under the construction contract, the surety pays the owner for damages. In turn, the
contractor is obligated to reimburse the surety company for these payments to the owner. It is because
of this relationship that a surety bond functions like a credit guarantee. It is not insurance.
A surety bond premium may vary from one surety to another and depends heavily on the contractor’s
experience. Typically the premium may range from 0.5% to 2.0% of the contract amount.
There are two main reasons why it is advantageous for an owner to require a contractor to post a bond:
1. A bond ensures that the owner will receive a finished product at the negotiated price.
2. The surety’s due diligence process is designed to determine the competency of the contractor. In
effect, the surety company prequalifies the contractor by eliminating those contractors that are
unqualified to perform the work.
There are several types of surety bonds as summarized in exhibit 4-1.
Exhibit 4-1 Types of surety bonds
Bond type Description The surety’s responsibility
Bid bond States that the surety believes the If contractor is awarded the contract
contractor has the ability and but refuses to sign it, surety must pay
resources to complete the project at owner difference between the winning
the bid price. bid and the next lowest bid.
Assures that contractor will file its
performance and payment bonds if
awarded the contract.
Used by owners to prequalify
contractors.
Performance Guarantees that contractor will If contractor deviates from contract

bond complete project as specified by the terms, surety must reimburse owner
contract. for any losses.
Maintenance Guarantees against any faulty In the event of faulty workmanship or

bond workmanship or materials. materials, surety must reimburse
owner for any losses.
Usually good for one year after
construction is complete.
Payment bond Guarantees payment to If contractor fails to pay

subcontractors and suppliers. subcontractors or suppliers, surety is
required to pay.
Assures owner that project will be
free of liens from unpaid
subcontractors or suppliers.
Completion May be issued in lieu of performance If contractor fails to perform, surety

bond and payment bonds. must find another contractor to finish
the work.
Guarantees that the contractor will
perform and pay for all contracted
work.
Benefits of bonds
After analyzing the risks involved with a construction project, consider how surety bonds protect against
those risks. Owners, lenders, contractors, and subcontractors are protected. The following are reasons
for such protection:
The contractor has undergone a rigorous prequalification process and is judged capable of fulfilling
the obligations of the contract;
Contractors are more likely to complete bonded projects than nonbonded projects because the
surety company more than likely will require personal or corporate indemnity from the contractor;
Subcontractors have no need to file mechanic’s liens on a private project when a payment bond is in
place;
Bonding capacity can increase a contractors or subcontractors project opportunities;
The surety bond producer and underwriter may be able to offer technical, financial or management
assistance to a contractor; and
The surety company fulfills the contract in the event of contractor default.
The surety process

The surety and bonding credit process results in an analysis of the potential risk of contractor default.
Surety companies prequalify contractors and provide assurance to project owners with their issuance of
bonds such as the ones discussed previously. Assurance is provided by the bonding process that assists
the contractor with
timely completion;
contract fulfillment;
contract price; and
payment to certain laborers, subcontractors, and suppliers associated with the bonded project.
The surety process involves construction, surety, and owners to achieve the common goal to complete
the project. The definition of “extending credit” differs between a bank and a surety. Credit extended by a
bank is deemed a loan or financing. Typically the bank loan is collateralized by assets of the company.
For a surety the extending of credit is in the form of a pledge guarantee.
Surety insurance compared to traditional insurance
Surety Traditional
Three-party relationship Two-party relationship
Risk-transfer technique Risk-transfer technique
Protect obligee Protect insured
Surety Traditional
Regulated by state insurance commissions Regulated by state insurance commissions
No expectation of losses Calculated pooled risk
Project specific Term specific
Penal sum Policy limits
Bond agent versus surety underwriter

It is important to understand the relationship between the bond agent and the surety with the contractor.
A bond agent is essentially an independent insurance salesperson. The bond agent represents a number
of different sureties. The bond agent does not take on the amount of risk exposure of the surety. Most of
the time, the extent of loss an agent may have on a bond is their commission.
Bond agents are the point of contact with the contractor. In the past, the bond agent has served the
surety underwriter as a resource in determining the contractor’s character and reputation.
On the other hand, there is the surety. The surety is the risk taker. If the contractor fails to perform on the
previously mentioned bonds, it is the surety’s responsibility to ensure that the contract under question is
resolved and free of any issues.
What the surety looks for

The traditional “three Cs” of surety underwriting are character, capacity, and capital.
Character
Does the contractor’s past record indicate good character and responsibility in fulfilling its obligations
and contracts?
In the past, sureties have relied heavily on bond agents to answer questions regarding contractor character.
However, due to the recent performance of the surety industry, sureties are now making extra efforts to
evaluate contractors’ character themselves. They have done this by meeting with construction company
owners and discussing job issues, financial statements, and other pertinent information. Through these
meetings the surety is able to understand the contractor’s attitude toward the surety’s areas of concern.
A surety will gather information from owners for whom the contractor has worked. It may also question
suppliers and subcontractors and may review the résumés and past histories of company owners and
project managers. It is also common for the surety to make inquiries of the contractor’s outside
professionals, such as the CPA, banker, or lawyer.
Food for thought
The credibility of a contractor’s financial statements may reflect a contractor’s character. It is
usually better to fully disclose bad news as early as possible rather than wait for the surety to
discover it on its own. Financial statements that seem to make concerted attempts to
disguise bad news (for example, delay recognition of a loss) call into question their own
credibility and that of the contractor.
Value-added service
Educating the contractor regarding their knowledge about generally accepted accounting
principles (GAAP), financial statements, tax, and bonding issues is a great benefit in assisting
with the character of the contractor. The level of knowledge the contractor has about the
construction industry outside of their particular specialty is a great encouragement to
sureties.
Business planning is another valuable sign of a contractor’s character. Presenting a thoughtful business
plan at an underwriting meeting is a key way to give the surety a greater level of insight into the
contractor’s character. A simple conversation outlining the thought-out plans reflects the approach the
contractor has to his business.
Capacity
Does the construction firm have the skills, experience, knowledge, and equipment necessary to perform
the work?
A contractor’s performance history is often a good indication of production capacity. Generally, each
production phase (for example, design, field construction, and completion) is evaluated separately.
Sureties are hesitant to bond contractors working in new areas, both in terms of geography and project
type. A surety‘s focus here may be on the contractor’s key personnel, labor force, or equipment.
Value-added service
Advising and assisting the contractor with internal control systems and adequate job cost
systems is a great benefit in assisting the contractor with their capacity issues. Analyzing
contracts outside of the normal bid process and understanding if and when the contractor
can handle the contract informs the surety that the contractor has assessed the necessary
risks for themselves and the surety when taking on larger work.
Capital
Does the construction firm have the money, or access to the money, to perform the work?
Of the Cs that have been discussed, the capital assessment by sureties is probably the most important of
them all. The following is a survey performed by Grant Thornton of the most important criteria asked of
sureties when contractors are trying to obtain credit.
Criteria Respondents
Strength of balance sheet 96%
Financial statement presentation 93%
Equity 87%
History of successful projects 81%
Debt 79%
Experience in type of project 78%
Consistent profit 77%
Use of CPA with industry knowledge 74%
Expertise of management team 72%
Claims history 67%
Reputation of firm 60%
Financial statement disclosure 60%
Accounting policies 55%
Experience in geographic area 55%
Size of under or over billing 54%
Overhead expenses 37%
Contract volume 28%
Succession planning 28%
Safety record 14%
CFO has CCFP designation 3%
Based on the survey, 11 of the 20 most important criteria deal with the contractors’ financial statements.
It is these reasons why many firms that specialize in the construction industry deem the construction
industry as a high-risk client. The financial statements of a contractor are critical in the surety
assessment.
There are two additional Cs the author has deemed highly important through discussions with many
sureties and bond agents: Continuity and CPA.
Continuity
Sureties may also be interested in a contractor’s succession plan in the event a key person in the
company retires or is incapacitated. Sureties want to be assured that any potential successor has the
necessary experience and knowledge of the business. They will also want to be assured that the
company retains sufficient equity if the succession plan calls for the buyout of an owner or management
member.
Succession planning is important in any business, but in the small contractor setting it is vital. For
example, in a small company an individual contractor might serve the following positions:
President and CEO

Chief estimator
Project manager on a large job listed as work in progress
If this key individual is hospitalized or dies due to a health issue or an accidental death, what will happen
to the company? Is the spouse knowledgeable enough to operate the company? Maybe one of the
owner’s children will take over the management of the company. What, if at the time the owner became
incapacitated, the surety had extended the company $4,000,000 of bond credit. How do you think the
surety would feel in this situation?
Value-added service
Succession planning is critical in any business and the utilization of a CPA to assist in this
project is key. In any situation whereby the contractor does not have succession planning,
the CPA should highly recommend this no matter what level of service is performed by the
CPA. Continuity plans are often requested by sureties but not insisted upon. However, for
your contractor client to be in the best position with the surety, a continuity plan will only
benefit the contractor not only with the surety but also in the event the continuity plan needs
to be enforced.
CPA
More and more frequently, sureties want to work with CPAs that have experience with contractors and
have a good reputation. CPAs have a reputation with the users of financial statements. Whether a CPA
compiles, reviews, or audits one set of contractor financial statements a year or 100 sets of contractor
financial statements a year, he or she all have a reputation with the surety. The question is do you, as a
CPA, have a good reputation or a bad one?
It would be each CPA’s goal to have an excellent reputation with the surety. A few things should happen
to achieve a good reputation with the surety:
Know your contractor’s surety. Do not just know the bond agent. Every CPA should know who the
users of the financial statements are.
Communicate with the surety. At a minimum, the surety and contractor should meet once a year to
review the year-end financial statements and discuss the upcoming projects and other pertinent
bonding issues.
Understand the GAAP used in the construction industry. Congratulations!! Your first step is taking this
course!! It is often stated that sureties understand GAAP better than most CPAs do when it comes to
a contractor’s financial statements. This is only somewhat true. Sureties understand when
contractors’ financial statements do not comply with GAAP. In those instances when financial
statements differ from GAAP, an explanation should be discussed with the surety.
The things that may bring your reputation into concern with any surety follow:
Untimely financial statements: your financial statements play an important role in the surety‘s
decision-making process. You must address the scheduling of your workload for the surety with your
client.
Use of non-GAAP terms: the use of under and over billings is very common in the construction
industry; however, they are not GAAP.
Lack of disclosure of certain footnotes and supplementary information: the schedules typically
addressed as supplementary information is not a GAAP requirement. The supplemental information
is strictly for the user of the financial statements. The exclusion of information will permit the surety
to question your industry knowledge.
Disclosure that the contractor does not use the percentage of completion method: this is important.
There are times when the percentage of completion method is not appropriate, and the use of the
completed contract method is justified for a particular contractor. To the surety, it is unusual. To
rectify this, the CPA should discuss with the surety the reason why the completed contract method is
more appropriate. A simple discussion will dramatically improve your reputation with the surety; on
the other hand, a lack of follow-up on this issue will have a big negative effect.
What sort of reputation do you have with your surety?
Value-added service
Your construction clients may need your advice in picking a bonding agent. Get to know
several who are experienced and successful. Nurture that relationship. It will be helpful not
only for your existing clients, but bonding agents can be an excellent reference source for
new business.

With a partner, or in a small group, discuss the following questions.
Does your surety want an audit, review, or compilation?
What types of information do you have to submit to the surety before issuing a bond?
Which of the “five Cs” do you think is most important to the surety?
Character
Capacity
Capital
Continuity
CPA
Knowledge check
1. The three parties to a traditional bonding arrangement do not include?
a. Surety.
b. Owner.
c. Contractor.
d. Local government.
2. Which of the traditional “five Cs” of surety underwriting is the evaluation of whether the construction
firm has the skills, experience, knowledge, and equipment necessary to perform the work?
a. Character.
b. Capital.
c. Capacity.
d. CPA.
How the surety uses a contractor’s financial statements
Learning objective: Identify the various financial benchmarks a surety or surety

agent might analyze in a contractor’s financial statements to determine the
amount of the contractor’s surety credit.
The surety will evaluate each contractor thoroughly before deciding whether to bond the company. They
often ask for a lot of documentation including the following:
Audited or reviewed financial statements

Interim financial statements
Current tax returns
Accounts receivable and accounts payable aging schedules
Equipment schedules
Owner’s personal financial statements
Schedule of project profit and loss
Additional information requested may include the following:
Organization chart and résumés of key employees

A description of the accounting system used
Management policies for monitoring job performance
Business plan
References from subcontractors, suppliers, and architects
Contractor’s qualification statement (AIA)
Evidence of a line of credit
Proof of liability insurance
Summary of bid history
The first user of the financial statements is generally not the surety but a bonding agent who represents
several sureties. Different sureties have different underwriting criteria and preferences. The bonding
agent will perform the first analysis of the contractor and determine which surety is best suited for that
particular contractor.
The contractor’s financial statements are used mostly to evaluate the third of the “three Cs,” capital. The
financial statements for the three most recent years are usually required. The surety often prefers
audited financial statements, but some will accept reviewed financial statements, especially if the surety
has a long relationship with the contractor. The most recent financial statements submitted should be
within 90 to 120 days after year-end. A surety typically reads the financial statements, notes, and
supplementary schedules and applies analytical procedures that address the following:
Profitability — The contractor should be making adequate profits to allow the business to grow, even
with the occasional losing project.
Liquidity and cash management — The contractor should maintain adequate liquidity to finance
operations without having to rely totally on outside sources. Overbillings (job borrow) should be
properly managed.
Fixed assets — Fixed assets should be adequate but not excessive for the contractor’s current
operations.
Debt — Debt payments and accrued expenses should be covered by the profits being made by the
existing work program.
Equity — Equity should support the current work program and possibly fund a losing project without
being eliminated.
G&A expenses — General and administrative expenses should be appropriate for the size of the
contractor. G&A expenses that fluctuate with large changes in the contractor’s volume may indicate
that the contractor is cost conscious and willing to make tough decisions. For example, if volume
drops in half, will the contractor make the necessary cuts in overhead?
Officers’ salaries — The relative size of officers’ salaries indicates whether profits are staying in the
business or being distributed to the owners. They may be an indication of how the owner will respond
in difficult times, that is, in tough times will the owner work for free?
The surety will calculate various ratios to help address these issues. Comparisons are made to the
contractor’s prior year results and to the results of similar contractors published in the CFMA Financial
Survey Results or by the Risk Management Association. The Risk Management Association,
www.rmahq.org, is a not-for-profit organization of bank lending officers. Annually, it publishes Financial
Statement Studies, a listing of key financial ratios and other information organized by SIC code. The
ratios most often used by sureties are summarized in exhibit 4-2.
Exhibit 4-2 Example ratios used by sureties
To measure Use ratio And look for
Profitability Gross profit percentage Trends

Comparison to industry averages
Profitability Net income as a percentage of Trends

revenue
Profitability Backlog gross profit to G&A Should be greater than 50%
Profitability & Underbillings to equity Must be less than 20%

Liquidity
Liquidity Net quick Must be greater than 1:1

Current assets – (Inv + Ppd) :
Current liab – Def taxes
Liquidity Cash to equity Should be greater than 20%
Liquidity Cash to overbilling Must be greater than 1:1
Debt Total liabilities : Net worth Less than 3:1 is considered good
Debt Interest-bearing debt : Net worth 8 to 1.0
Debt Debt coverage Over 1.25
Gen. & admin. G&A revenue Comparison to industry averages

exp.
Whether ratio stays relatively constant
in slow times
Should be less than 5% (excluding
other discretionary expenses)
Officer’s salaries Officers’ salaries : Revenue Comparison to industry averages
Other ratios used by sureties include the following:
Cash balance greater than 5% of revenue

Available line of credit greater than 5% of revenue
Surety working capital at least 7.5% of revenue
Total equity greater than 10% of revenue
In addition to key ratios, the surety will also analyze other financial information, some of which is included
in the basic financial statements and some of which is not. Some of the more typical data includes the
data described in the next eight subtopics.
Accounts receivable aging

A surety analyzes the accounts receivable aging for the same reason an auditor analyzes the aging — to
determine whether the receivables are collectible.
Value-added service
The accounts receivable aging is typically analyzed by job, not by invoice or customer. To
help the surety perform its analysis, group the aging report by jobs and note which jobs are
completed and which ones are still in progress. Retentions receivable should also be
presented separately.
Marketable securities and notes receivable

The GAAP accounting and fair value disclosure requirements for marketable securities and notes
receivable are important for answering many of the questions a surety will have about these items. The
answer to some questions may not be so readily apparent, for example:
How willing is the owner to convert marketable securities to cash? Just because a security is listed
as available-for-sale does not necessarily mean the contractor is willing to sell it at any time. For
example, will the contractor take a loss on a security sale to raise cash for the business? It is also
important to know what type of investments the contractor is holding. If the investments are level 2
or 3 investments that are inherently harder to value and may be harder to sell, it could impact the
analysis of the contractor.
What transaction created the notes receivable? This information may be presented in the statement
of cash flows or notes to the financial statements. The surety is interested in the transaction.
Overbillings and job borrow

Overbillings will be analyzed on a job-by-job basis. Overbillings are usually better than underbillings, but
too much of a good thing can be a problem. Recall example 1-2: Job Borrow. That example illustrated
how overbillings may create a situation where the contractor gets so far ahead in billing on a job that it
will have to use cash on hand to finish the project. Job borrow is calculated as follows:
Job borrow = Overbillings – Total estimated gross profit
In other words, if a contractor has billed $100,000 in excess of cost and estimated profit, and the total
profit on the job is only $30,000, the contractor has, in effect, billed for $70,000 of cost it has yet to incur.
The question is, when it comes time to pay for those costs, will the contractor have the cash on hand to
do so? This could call into question if the contractor is “lapping” its jobs, whereby the excess billings from
job A are used to pay for job B and then job B billing is used to finish job A and so on. Although the
contractor could have profit from each job, if the initial money was taken out of the company and used
personally by the owner, if the job backlog slows down, the contractor may not have the capital on hand
to finish the work.
A surety will analyze job borrow and compare that amount to the amount of cash on hand. Job borrow
that is too high in relation to cash on hand is a red flag for most sureties.

A surety’s primary concern is whether the contractor has enough equipment to perform the job it has
been asked to bond. If the contractor does not currently have sufficient equipment, the surety will want to
know what plans have been made to acquire the equipment.
Sureties are also concerned about contractors that have significant underused equipment.
Example 4-1 Idle equipment

WannaBee Contractors is a small heavy construction contractor. Mr. Bee bids and wins a
contract to excavate a foundation for a building in Alaska near the Arctic Circle. The
excavation of tundra, digging through permafrost, requires a highly specialized piece of Arctic
excavation equipment. Mr. Bee rents this equipment to perform the job.
The job turns out well, and at its conclusion Mr. Bee rationalizes, “We’ve already put a lot of
money into this new equipment. For only another $30,000, we can own it. Why not?”
For some contractors the decision to purchase equipment is primarily emotional, with little
regard for economics. At best, Mr. Bee has taken $30,000 of profit from a successful job and
bought a piece of equipment that he may or may not ever use again. At worst, he enters into a
capital lease to buy the equipment. The current maturities under the capital lease become a
current liability; the equipment is long-term. Working capital and liquidity are negatively impacted.
Underused equipment may be impaired under FASB Accounting Standards Codification (ASC) 360,
Property, Plant and Equipment. Auditors and financial statement preparers should perform procedures to
ensure that all equipment is properly valued.
Finally, one question that most auditors would not normally consider is whether the contractor’s
equipment represents a hidden asset — is the fair value of the asset greater than its book value? Such a
situation will work in the contractor’s favor and may help increase the surety credit.
Value-added service
If your client has a significant amount of equipment on the balance sheet, the surety may be
interested in knowing the fair value of the equipment. This information is not required to be
disclosed in the financial statements, but it may be provided in a separate report. The insured
value of the equipment is a starting point for estimating its fair value, as this represents the
contractor’s estimate of what the equipment is worth. Third-party estimates are also
available, for example, from an auction guide or equipment dealer.
Sureties are also interested in any land carried on the contractor’s balance sheet. If that land is not used
in operations, the surety may ask about the contractor’s intentions. Is it being held as an investment? For
future expansion? For development? The surety may also be interested in the fair value of the land.
Debt
The scheduled maturity of long-term debt (a GAAP-required disclosure) is important information for
sureties because it helps them understand the future cash flow requirements of the contractor. They are
particularly interested in the amount and timing of any balloon payments.
The surety is also interested in any subordinated debt arrangements the owner has made with the
company. A situation often arises where a small contractor bids on a job that is beyond its current
bonding capacity. One way to increase the bonding capacity is for the owner to inject working capital into
the company in the form of subordinated debt. A surety may be interested to know whether the owner
has the willingness and ability to enter into that type of transaction.
Underbillings
The surety will normally analyze underbillings on a job-by-job basis. Significant or chronic underbillings is
a red flag that will raise questions. If the underbillings are merely the result of the terms of the contract or
timing (for example, the preparation of the financial statements vs. the contractor’s billing procedures),
then the underbillings are easily explained.
Unless historical results support the validity, underbillings will generally be discounted, and, if in excess of
20% of equity, completely eliminated by the surety.
Difficulty arises when the underbillings are the result of disputes or unapproved change orders. In some
cases, underbillings may represent unrecognized losses on a particular job. The underbillings could also
merely represent poor billing practices by the contractor, which the surety would want to understand
because there are potentially significant cash flow issues with this practice.
Profitability
The surety will analyze profitability on a job-by-job basis. Typically, it will separate the jobs into those that
have been completed and those in progress. It will be interested in the consistency of profit margins
between jobs and between completed and uncompleted work. It will also be interested in tracking a job’s
profitability over time. For example, if the job was originally projected to have a profit margin of 15%, is
that how the job ended up? Jobs that indicate a significant profit fade (original estimate was for $200,000
profit and the job ended up at $125,000) are sure to raise questions. As a rule of thumb, any job that
shows profit fade greater than 10% will probably be viewed negatively by the surety. The contractor
should be prepared to explain these fades and, as part of the CPA’s work in the review or audit process,
these items should be openly discussed. In addition, significant gains or fades that are deemed material
should be separately disclosed in the financial statements.

The statement of cash flows will help the surety understand the contractor’s activities during the year,
particularly those that are not portrayed in the income statement or balance sheet. For example, if the
construction company borrows heavily from the owner during the year, then pays off the debt just before
year-end, the only place that activity will be captured is in the statement of cash flows.
Practice pointer
It should be noted that different sureties request different information from contractors. For
example, one surety may request an aging of accounts receivable. Another may request a
debt service schedule and an aging of accounts receivable by job. This request may be made
during the year, but typically these requests are made subsequent to the receipt of the year-
end financial statements. If so, it is important (in this author’s opinion) that the
supplementary information requested by the surety be included in the year-end financial
reports. By doing this, you can accomplish the needs of the user of the financial statements
without any further request. The request for supplemental schedules not included in year-end
financials made of the contractor may not match the year-end financial statements due to
adjustments to the general ledger at year-end and not to the subsidiary ledgers.
Knowledge check
3. As part of the surety process, who will likely perform the first analysis of the contractor?
a. Bonding agent.
b. Lawyer.
c. Surety.
d. CPA.
4. What will cause the job borrow level to be a red flag for most sureties?
a. Job borrow that is too high in relation to cash on hand.
b. Job borrow that is low in relation to inventory on hand.
c. Job borrow that is low in relation to cash on hand.
d. The dollar value when purchased.
5. Which is a significant concern of a surety with regards to a contractor’s equipment?
a. The amount of extra equipment.
b. Whether the equipment is in “like-new” condition.
c. Location of the equipment.
d. The dollar value when purchased.
Maximizing surety credit

The surety agent, the surety company, and the contractor share a similar goal — to maximize surety
credit.
Surety credit is determined based on working capital and net worth. Typically, the maximum surety credit
for an individual project is 10 times working capital. The maximum credit for a work program is usually
10 times net worth.
The starting point for determining the amount of surety credit is the current assets as presented in
accordance with GAAP. From there, the surety will make certain adjustments to arrive at working capital
for surety credit purposes. Those adjustments are summarized in exhibit 4-3.
Exhibit 4-3 Determining working capital for surety credit
Current assets
Current Assets — GAAP-basis $ X,XXX
Subtract:
Receivables from officers, employees, owners (XXX)
50% of inventory not at jobsite (XXX)
Prepaid expenses (XX)
Add:
Cash surrender value of life insurance XX
Current Assets — Surety Credit Purposes X,XXX
Current liabilities
Current liabilities — GAAP-basis (X,XXX)
Adjusted working capital for surety credit $ XXX
Accounts and notes receivable from officers, employees, or owners — As a general rule, most sureties
will eliminate these from working capital for the purposes of determining surety credit.
Notes receivable — These may or may not be included in working capital, depending on the
creditworthiness of the payor. Sureties will evaluate these on a case-by-case basis. Jobsite material
is usually cost, not inventories.
Inventory — The surety will want to know why the contractor maintains inventory and how quickly it
turns over, that is, how soon it will be costed to a job, billed, and converted to cash. As a general rule,
100% of materials on the jobsite are included in working capital for surety credit purposes, but only
50% of other inventory is included.
Prepaid expenses — Usually not included for determining working capital for surety credit purposes.
Cash value of life insurance — For GAAP purposes this is not a current asset, but usually a surety will
include it as working capital for its purposes. However, the surety may be interested in the
creditworthiness of the insurance company.
Current liabilities — In most instances, current liabilities for GAAP purposes is used, unadjusted, for
determining surety credit. Exceptions in rare circumstances include deferred income taxes and
subordinated debt.

If you were a surety, what indicators would make you nervous about the company
applying for bonding? List five indicators.
When a surety evaluates a contractor, the surety looks for certain warning signs to minimize the surety’s
risk. Some of the risks and warnings signs for sureties include the following:
The contractor’s accounting and financial reporting system — The surety likes receiving timely
information from the contractor. The contractor’s inability to produce standard financial statements
and job profit or loss reports is not a strong sign for the surety.
Turnover of personnel — The leadership of the contractor is crucial. A contractor’s experience and
capacity within the industry relieves the surety of certain concerns. An important consideration
regarding the leadership is the contractor’s successor in the event of death or disability. A plan of
succession is important.
Changes in the contractor’s business — The change may be dealing with the type of construction
engaged in by the contractor or it could be dealing with the size of the contracts the contractor is
pursuing.
Maximized lines of credit — This warning sign informs the surety that the contractor has nowhere else
to go in the event of problems on the job. The risk of filing claims only increases that much more.
Poor estimating and project management — The evidence of varying bid spreads of significant
degrees concerns the surety that the contractor’s estimating department is inexperienced or proves
their lack of ability.
Profit fade — A continual downward trend of profit fade on jobs and diminishing gross margins is of
concern especially if the contractor does not have a contingency plan on improvement or the
contractor lacks the balance sheet strength to overcome the negative trends.
Onerous contract terms — Tight deadlines with significant penalties may put pressure on the
contractor.
Increased out-of-state work — Out-of-state work may indicate a lack of work in the home state or an
expansion of the business that may stress the existing resources and abilities of the contractor.
Increase in self-performed work — When a contractor reduces his or her use of subcontractors and
performs more work, it may be an indication of cash flow problems or poor subcontractor relations.
Case study 4-1
XYZ Contractors
The following pages present the balance sheet, income statement, and schedule of
uncompleted contracts for XYZ Contractors. Using this financial information perform or
answer the following:
1. Using the general rules of thumb presented in this chapter, calculate working capital for
surety credit purposes (assume that inventory includes general materials and supplies
that are not associated with a specific job). Based on this calculation of working capital,
what is the largest job a surety is likely to bond?
2. What additional information will the surety be likely to want on the accounts receivable?
3. What additional information will the surety be likely to want on the notes receivable?
4. Do any jobs indicate profit fade? How is the surety likely to respond?
5. Which jobs indicate large underbillings? How is the surety likely to respond?
6. Do any jobs indicate job borrow? How is the surety likely to respond?
Case study 4-1 (continued)
XYZ Contractors
Balance sheet
Assets
Current assets
Cash and cash equivalents $ 106,520
Accounts receivable, trade 1,275,000
Accounts receivable, stockholder 19,500
Note receivable, current portion 60,000
Inventory 139,730
Costs and estimated earnings in excess of billings 747,000
Prepaid expenses 46,770
Total current assets 2,394,520

Land 100,000
Building 450,000
Machinery and equipment 970,000
Automobiles 180,000
Office furniture and equipment 128,000
1,828,000
Less: accumulated depreciation (829,370)
Net property and equipment 998,630
Other assets
Land held for investment 40,000
Cash surrender value of life insurance 38,850
Note receivable, long-term 20,000
Total other assets 98,850
$ 3,492,000
XYZ Contractors
Balance sheet
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable and accrued expenses $ 1,260,880
Current portion of long-term debt 240,770
Billings in excess of costs and estimated earnings 281,940
Deferred income taxes 50,000
Total current liabilities 1,833,590
Long-term debt, net of current portion 650,410
Deferred income taxes 55,000
Total long-term liabilities 705,410
Stockholders’ equity
Common stock 50,000
Additional paid-in capital 100,000
Retained earnings 803,000
Total stockholders’ equity 953,000
$ 3,492,000
XYZ Contractors
Income statement
Earned revenues $ 7,700,000
Cost of earned revenue 7,007,000
Gross profit 693,000
General, administrative, and selling expenses 462,000
Income from operations 231,000
Other income (expense)
Interest income 9,000
Interest expense (37,000)
(28,000)
Income before taxes 203,000
Provision for income taxes (61,000)
Net income $ 142,000
XYZ Contractors
Schedule of uncompleted contracts
Original est. Billings to Costs to Est. costs to

Project Contract price profit date date complete
1 $3,000,000 $300,000 $2,370,000 $2,430,000 $ 300,000
2 800,000 64,000 250,000 575,000 125,000
3 1,500,000 180,000 73,680 100,000 1,220,000
4 2,200,000 110,000 300,000 200,000 1,890,000
5 1,750,000 150,000 1,030,000 750,000 875,000
$ 9,250,000 $804,000 $4,023,680 $4,055,000 $4,410,000
Earned
Percent Revised income to
Project complete gross profit date Underbillings Overbillings
1 89% $270,000 $240,300 $300,300
2 82% 100,000 82,000 407,000
3 8% 180,000 13,680 40,000
4 10% 110,000 10,560 $ 89,440
5 46% 125,000 57,500 222,500
$785,000 $404,040 $747,300 $311,940
Summary
This chapter provided you with additional details of the surety underwriting process. The chapter started
with an overview of the relationship among contractor, surety, and owner and the various types of surety
bonds a contractor may be required to post. The rest of the chapter described how a surety or surety
agent might analyze a contractor’s financial statements to determine the amount of its surety credit. Any
CPA who provides services to construction contractors should develop a good understanding of the
relationship between contractor and surety and how the surety uses the contractor’s financial
statements in its decision-making process.
Chapter 5
Audit Planning and Risk Assessment

Procedures
Learning objectives
Recall the considerations of the applying risk assessment procedures specifically in the audit of
construction contractors.
Recall the common three phases of contract review during audit planning.
Identify other preliminary procedures and areas of concern common to an audit of a construction
contractor.
Introduction
Auditing is a risk-driven process; that is, audit procedures are designed to reduce overall audit risk to an
acceptable level. One of the primary objectives of audit planning is to identify high-risk audit areas. From
there you can plan your audit accordingly. This chapter provides guidance primarily on the application of
certain standards. Specifically, this chapter provides guidance on the risk assessment process that
includes, among other things, obtaining an understanding of the entity and its environment, including its
internal control, and additional general auditing considerations for construction contractors.
This chapter discusses audit planning from two perspectives.
On an overall basis, some entities are riskier than others simply based on the nature of their business.
The first section of this chapter will help you identify high-risk construction contractors.
The audit of a contractor is the audit of individual contracts. The second half of this chapter will help
you identify high-risk contracts.
The nature and extent of planning activities will vary according to the size and complexity of the entity,
the key engagement team members' previous experience with the entity, and changes in circumstances
that occur during the audit engagement. Planning is not a discrete phase of an audit but rather a
continual and iterative process that often begins shortly after (or in connection with) the completion of
the previous audit and continues until the completion of the current audit engagement. Planning,
however, includes consideration of the timing of certain activities and audit procedures that need to be
completed prior to the performance of further audit procedures.
Professional skepticism
The proper mindset is arguably the most important “tool” that an auditor brings to an engagement. Your
attitude should be characterized by an appropriate level of professional skepticism, which includes a
questioning mind and a critical assessment of audit evidence. Furthermore, professional skepticism
requires an ongoing questioning of whether the information and evidence obtained suggests that a
material misstatement due to error or fraud has occurred. In exercising professional skepticism in
gathering and evaluating evidence, you should not be satisfied with less than persuasive evidence
because of a belief that management is honest.
Considerations when planning and supervising the audit
Learning objective: Recall the considerations of applying risk assessment

procedures specifically in the audit of construction contractors.
AU-C section 300,1 Planning an Audit, establishes requirements and provides guidance on the
considerations and activities applicable to planning and supervision of an audit conducted in accordance
with generally accepted auditing standards (GAAS), including the following:
The involvement of key engagement team members in planning

Preliminary engagement activities
General planning activities, including establishing an overall audit strategy that sets the scope, timing, and
direction of the audit and that guides the development of the audit plan, which may include the following:
– Developing specific procedures for high-risk audit areas
– Determining the extent of the involvement of professionals possessing specialized skills
1
All AU-C sections can be found in AICPA Professional Standards.
– Additional considerations for initial audit engagements, including performing procedures required
by AU-C section 220, Quality Control for an Engagement Conducted in Accordance With Generally
Accepted Auditing Standards
– Any necessary communications in accordance with AU-C section 210, Terms of Engagement
– Documentation considerations
Auditors communication with those charged with governance

It is critical in any audit that open communication be established with those charged with governance.
This could be with an audit committee of the board of directors for a larger sophisticated company or
with the single owner manager of a smaller company.
AU-C section 260, The Auditor’s Communication With Those Charged With Governance, notes that clear
communication of the auditor's responsibilities, the planned scope and timing of the audit, and the
expected general content of communications help establish the basis of effective two-way
communication. Matters that may also contribute to effective two-way communication include
discussion of the following:
Purpose of communications
– When the purpose is clear, the auditor and those charged with governance are in a better position
to have a mutual understanding of relevant issues and the expected actions arising from the
communication process.
Form in which communications will be made
Person(s) on the audit team and among those charged with governance who will communicate
particular matters
Auditor's expectation that communication will be two-way and that those charged with governance
will communicate with the auditor matters they consider relevant to the audit, including the following:
– Strategic decisions that may significantly affect the nature, timing, and extent of audit procedures
– The suspicion or the detection of fraud
– Concerns with the integrity or competence of senior management
Process for acting and reporting back on matters communicated by the auditor
Process for acting and reporting back on matters communicated by those charged with governance
Materiality
The concept of materiality is applied by the auditor both in planning and performing the audit; evaluating
the effect of identified misstatements on the audit and the effect of uncorrected misstatements, if any,
on the financial statements; and in forming the opinion in the auditor's report. In planning the audit, the
auditor makes judgments about the size of misstatements that will be considered material. These
judgments provide a basis for
determining the nature and extent of risk assessment procedures,

identifying and assessing the risks of material misstatement, and
determining the nature, timing, and extent of further audit procedures.
The auditor's determination of materiality is a matter of professional judgment and is affected by the
auditor's perception of the financial information needs of users of the financial statements.
When establishing the overall audit strategy, the auditor should determine materiality for the financial
statements as a whole and tolerable misstatement. If, in the specific circumstances of the entity, one or
more particular classes of transactions, account balances, or disclosures exist for which misstatements
of lesser amounts than materiality for the financial statements as a whole could reasonably be expected
to influence the economic decisions of users, then, taken on the basis of the financial statements, the
auditor also should determine the materiality level or levels to be applied to those particular classes of
transactions, account balances, or disclosures.
Once established during planning, materiality is not static throughout the audit. The auditor should revise
materiality for the financial statements as a whole (and, if applicable, the materiality level or levels for
particular classes of transactions, account balances, or disclosures) in the event of becoming aware of
information during the audit that would have caused the auditor to have determined a different amount
(or amounts) initially.
Performance materiality is considered. Performance materiality is the amount or amounts set by the
auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low
level the probability that the aggregate of uncorrected and undetected misstatements exceeds
materiality for the financial statements as a whole. If applicable, performance materiality also refers to
the amount or amounts set by the auditor at less than the materiality level or levels for particular classes
of transactions, account balances, or disclosures. Performance materiality is to be distinguished from
tolerable misstatement, which is the application of performance materiality to a particular sampling
procedure.
Key point
Financial statement level materiality is used in the planning and overall review phase of the
audit.
Tolerable misstatement is used in the application of audit procedures.
Assessing risk at the overall financial statement level

AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material
Misstatement, requires that the auditor assess audit risk at two levels: the overall financial statement
level and at the assertion level for each significant account balance and class of transaction.
The overall financial statement level assessment is often referred to as an entity level risk assessment.
The auditor evaluates the control environment overall. The auditor looks to determine at an entity level
how risks are identified and managed. These risks would include not only general business risks that all
business’ face but also risks that are unique to the industry.
Early in your risk assessment procedures of your audit, you should be alert for conditions that indicate an
increased risk of material misstatement due to errors or fraud. These conditions include the following:
Liquidity matters
– The company is undercapitalized, is relying heavily on bank loans and other credit, and is in
danger of violating loan covenants.
– The company is having difficulty obtaining surety credit.
– The company is having difficulty obtaining or maintaining financing.
– The company is showing liquidity problems.
Quality of earnings
– The company is changing significant accounting policies and assumptions to less conservative
ones.
– The company is generating profits but not cash flow.
Management characteristics
– Management’s compensation is largely tied to earnings.
– The company appears vulnerable to weakening economic conditions, and management is not
proactive in addressing changing conditions.
– There is a significant change in members of senior management or the board of directors.
Before moving on to risk assessment at the assertion level, a discussion of estimates is appropriate.
The importance of estimates to the audit of a contractor and the

considerations of the associated risk
Recall the basic contract equation introduced in chapter 2:
(Estimated total contract price – Estimated total contract costs) × Completion % = Gross profit to date
Consider how estimates affect the preceding equation? For example, total contract price may include a
performance incentive based on the completion date of the project. That completion date is an estimate.
Think of the ways an estimate can affect the basic contract equation. It can be argued that the
contractor’s ability to make proper estimates has the most significant effect on the financial statements.
Reading between the lines

Estimating is a major part of a contractor’s business. Therefore, an audit of a contractor’s
business is an audit of a contractor’s ability to estimate.
Ways in which estimates affect the basic contract equation include the following:
Estimated costs to complete – One entire component of the equation is an estimate. The estimated
costs to complete should be monitored on a consistent basis by the contract and continually revised.
However, such revisions should not be used as an end to adjust profitability on a contract.
Contract penalties or incentives – The recognition of penalties or incentives depends on whether the
amount can be reasonably estimated.
Profit from change orders – Profit on a change order can be recognized only if the amount can be
reasonably estimated.
Revenue from a claim – Revenue related to a claim can be recognized only if the amount can be
Allocation of equipment costs – Equipment charges are generally allocated to individual jobs based
on an internally developed use rate. That use rate is dependent on estimates such as the useful life of
the equipment, average idle time, and operating costs. A contractor that is not equipment-intensive
may not find justification for allocating equipment costs.
Percentage complete – A project’s percentage complete (assuming it is somewhere between 0% and
100% complete) will almost always be an estimate because the denominator (total costs, labor hours,
units-of-delivery, and so on) is usually an estimate.
The purpose of this exercise was to point out that estimates can have a significant impact on a
contractor’s financial statements – more so than on other business entities. Because of the way the
contract equation affects the financial statements (including the overbilling and underbilling accounts),
the gross profit, net income, equity, and working capital of a contractor can all be based substantially on
estimates.
Early in the audit planning process you should develop an understanding of how important estimates are
to the contractor’s overall financial statements. If management meets with project teams weekly or
monthly, that can help lower audit risk rather than management only meeting yearly to discuss the overall
position of each job at year end for financial reporting only. The following example will show how two
seemingly similar contractors actually have very different risk characteristics.

With a partner, or in a small group, consider the information in the following tables and prepare a
response to the questions posed.
Summarized financial information for the Contractors A and B follows.
Contractor A Contractor B
Job revenue $10,000,000 $10,000,000
Job cost 9,000,000 9,000,000
Gross profit 1,000,000 1,000,000
General and administrative 500,000 500,000
Earnings before taxes 500,000 500,000
Income taxes 200,000 200,000
Net income $300,000 $ 300,000
Equity $ 1,500,000 $ 1,500,000
Exercise 5-1 Group discussion (continued)
The components of earnings are as follows:
Contractor A Contractor B
Completed In progress Total Completed In progress Total
Job revenue $9,500,000 $500,000 $10,000,000 $500,000 $9,500,000 $10,000,000
Job cost 8,550,000 450,000 9,000,000 450,000 8,550,000 9,000,000
Gross profit $ 950,000 $ 50,000 $ 1,000,000 $ 50,000 $ 950,000 $ 1,000,000
What is the total gross profit for each contractor? What are the gross profit percentages for
each contractor? How are the two contractors different?
Why it matters
The analysis used in example 5-1 should be performed before you even accept the
engagement. Contractors where estimates have a significant impact on the financial
statements (such as Contractor B) will be more difficult to audit and will take more time. Your
fee estimate should reflect this.
Overall engagement risk will also affect your staffing and supervision. On a higher risk
engagement such as Contractor B, you should use your best, most experienced staff. Plan on
close supervision and a large number of partner hours.
During the planning stage of the audit, you should make some preliminary inquiries of company
management to find out the magnitude and relative importance of those items subject to estimate. For
example, do the financial statements include significant unapproved change orders? Do any unfinished
contracts have material penalties or incentives? In making the estimates, what were management’s key
assumptions or uncertainties. This process is even more important under FASB ASC 606 because this
impacts the transaction price of each job.
As soon as possible – before accepting the engagement, if you can – try to get a feel for the contractor’s
estimating skills. In general, there are two distinct types of skills:
Take-off – The take-off skill is the ability to accurately estimate the cost of a job from the plans and
specifications. This skill can be analyzed by reviewing the consistency of gross profit rates realized
during the life of a project, as well as the frequency of losses.
Production – The production skill is the ability to estimate the cost required to complete while the
project is in progress. This skill can be analyzed by comparing the gross profit rate realized when the
job is completed against that estimated when the job was in progress. It should also include a review
of the number of loss jobs that were not recognized until they were completed.

You will have to obtain historical financial statements (in particular the contracts in progress
and completed contract schedules) to analyze a contractor’s estimating skills. Inquiries of
outsiders familiar with the contractor, such as bankers or sureties, may also help you assess
the contractor’s estimating skills.
On initial engagements be sure to make inquiries and gather the information needed from the
predecessor auditor.
CPAs who service construction contractors on a regular basis typically maintain a database
that tracks the progress of all the contractor’s recent jobs. This database can then be
segregated by type of work, type of contract, location, owner, or project manager. This can
further pinpoint a contractor’s estimating skills or weaknesses.
An example of a job history report is included as appendix 5-A.
Major swings in profits on individual jobs indicate a high audit risk, particularly where jobs experience
profit fade. Profit fade, in other words, can represent late recognition of losses. A pervasive pattern of
profit fade or late recognition of losses is a red flag you should watch out for.
Finally, the state of the overall economy may increase the overall engagement risk for a contractor.
Knowledge check
1. Which item will more likely be affected by estimation?
a. Profit from change orders.
b. Cost incurred to date.
c. Amount billed to the customer.
d. Revenue on a completed contract.
2. What is another term for late recognition of losses when analyzing construction contracts?
a. Profit fade.
b. Loss avoidance.
c. Job borrow.
d. Profit gain.
Risk assessment at assertion level
In this section, the discussion will be focused on the concepts or risk assessment with specific
application to the audit areas related to the construction contractor.
As a review, this is the audit risk (AR) model equation:
AR = RMM × DR, where RMM = IR × CR
Recall the relevant definitions:
Risk of material misstatement. The risk that the financial statements are materially misstated prior to the
audit. This consists of two components, described as follows at the assertion level:
Inherent risk. The susceptibility of an assertion about a class of transaction, account balance, or
disclosure to a misstatement that could be material, either individually or when aggregated with
other misstatements, before consideration of any related controls.
Control risk. The risk that a misstatement that could occur in an assertion about a class of
transaction, account balance, or disclosure and that could be material, either individually or when
aggregated with other misstatements, will not be prevented, or detected and corrected, on a
timely basis by the entity’s internal control.
Detection risk. The risk that the procedures performed by the auditor to reduce audit risk to an acceptably
low level will not detect a misstatement that exists and that could be material, either individually or when
aggregated with other misstatements. Detection risk is comprised of analytical procedures risk and
substantive tests of details risk.
In most cases, the risk assessment for the account balance is typically performed with the related class
of transaction account. The reasons for this are twofold, as follows:
When documenting controls, in most cases the account balance and the related class of transaction
accounts share common controls. For example, the control in place to ensure sales are recorded is
also going to be, for the most part, the control that makes sure the receivable is recorded. If they are
not subject to the same control, the controls are certainly interdependent.
When determining RMM, the risks are generally interdependent, as the identical transaction is
affecting both accounts. Performing risk assessment together for the accounts is a more effective
and efficient approach.
GAAS require the auditor to perform an assertion-level risk assessment for any significant account
balance or class of transactions. Although not specifically defined, by extending other definitions used,
one could reason that if an account contains the risk of material misstatement on the IR basis, it’s likely
significant.
Detection risk is the risk that the procedures performed by the auditor to reduce AR to an acceptably low
level will not detect a misstatement that exists and that could be material, either individually or when
aggregated with other misstatements. The risk of material misstatement is the risk that the financial
statements are materially misstated prior to the audit and includes inherent risk and control risk, both at
the assertion level.
GAAS does not ordinarily refer to inherent risk and control risk separately, but rather to a combined
assessment of the risks of material misstatement. However, the auditor may make separate or
combined assessments of inherent and control risk depending on preferred audit techniques or
methodologies and practical considerations. The assessment of the risks of material misstatement may
be expressed in quantitative terms, such as in percentages or in nonquantitative terms. In any case, the
need for the auditor to make appropriate risk assessments is more important than the different
approaches by which they may be made.
Audit objectives and assertions
Practice pointer
Issued in May 2019, Statement on Auditing Standards (SAS) No. 134, Auditor Reporting and
Amendments, Including Amendments Addressing Disclosures in the Audit of Financial
Statements, significantly changes the form and content of the auditor’s report issued after
auditing a set of financial statements. The SAS also addresses the auditor’s responsibility to
form an opinion on the financial statements. The auditor reporting suite of standards will
benefit users of audited financial statements throughout the United States by placing the
auditor’s opinion at the front of the report for added visibility and providing necessary
transparency into the basis for the auditor’s opinion and the responsibilities of both entity
management and auditors.
In addition, SAS No. 134 amends AU-C section 315 with respect to assertions. Paragraph
.A133 of AU-C section 315, as amended by SAS No. 134, reads:
Assertions used by the auditor in considering the different types of potential misstatements
that may occur may fall into the following categories:
a. Assertions about classes of transactions and events, and related disclosures, for the
period under audit, such as the following
i. Occurrence. Transactions and events that have been recorded or disclosed have
occurred, and such transactions and events pertain to the entity.
ii. Completeness. All transactions and events that should have been recorded have
been recorded, and all related disclosures that should have been included in the
financial statements have been included.
iii. Accuracy. Amounts and other data relating to recorded transactions and events
have been recorded appropriately, and related disclosures have been appropriately
measured and described.
Practice pointer (continued)
iv.Cutoff. Transactions and events have been recorded in the correct accounting
period.
v. Classification. Transactions and events have been recorded in the proper accounts.
vi. Presentation. Transactions and events are appropriately aggregated or
disaggregated and clearly described, and related disclosures are relevant and
understandable in the context of the requirements of the applicable financial
reporting framework.
b. Assertions about account balances, and related disclosures, at the period end, such as
the following:
i. Existence. Assets, liabilities, and equity interests exist.
ii. Rights and obligations. The entity holds or controls the rights to assets, and liabilities
are the obligations of the entity.
iii. Completeness. All assets, liabilities, and equity interests that should have been
recorded have been recorded, and all related disclosures that should have been
included in the financial statements have been included.
iv. Accuracy, valuation and allocation. Assets, liabilities, and equity interests have been
included in the financial statements at appropriate amounts, and any resulting
valuation or allocation adjustments have been appropriately recorded, and related
disclosures have been appropriately measured and described.
v. Classification. Assets, liabilities, and equity interests have been recorded in the
proper accounts.
vi. Presentation. Assets, liabilities, and equity interests are appropriately aggregated or
disaggregated and clearly described, and related disclosures are relevant and
understandable in the context of the requirements of the applicable financial
reporting framework.
Recall that SAS No. 134 is effective for audits of financial statements for periods ending on
or after December 15, 2020. Early implementation is not permitted.
According to AU-C section 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit
in Accordance with Generally Accepted Auditing Standards, an auditor’s overall objectives in conducting
an audit of financial statements are to
a. obtain reasonable assurance about whether the financial statements as a whole are free from
material misstatement, whether due to fraud or error, thereby enabling the auditor to express an
opinion on whether the financial statements are presented fairly, in all material respects, in
accordance with an applicable financial reporting framework; and
b. report on the financial statements, and communicate as required by GAAS, in accordance with the
auditor’s findings.
To support this overall objective, auditors use assertions relevant to specific classes of transactions,
account balances at period end, and presentation and disclosure. According to AU-C section 315,
assertions used by the auditor to consider the different types of potential misstatements that may occur
fall into the following three categories and may take the following forms:
Assertions about classes of transactions and events for the period under audit, such as the following:
– Occurrence. Transactions and events that have been recorded have occurred and pertain to the
entity.
– Completeness. All transactions and events that should have been recorded have been recorded.
– Accuracy. Amounts and other data relating to recorded transactions and events have been
recorded appropriately.
– Cutoff. Transactions and events have been recorded in the correct accounting period.
– Classification. Transactions and events have been recorded in the proper accounts.
Assertions about account balances at the period end, such as the following:
– Existence. Assets, liabilities, and equity interests exist.
– Rights and obligations. The entity holds or controls the rights to assets, and liabilities are the
obligations of the entity.
– Completeness. All assets, liabilities, and equity interests that should have been recorded have
been recorded.
– Valuation and allocation. Assets, liabilities, and equity interests are included in the financial
statements at appropriate amounts, and any resulting valuation or allocation adjustments are
appropriately recorded.
Assertions about presentation and disclosure, such as the following:
– Occurrence and rights and obligations. Disclosed events, transactions, and other matters have
occurred and pertain to the entity.
– Completeness. All disclosures that should have been included in the financial statements have
been included.
– Classification and understandability. Financial information is appropriately presented and
described, and disclosures are clearly expressed.
– Accuracy and valuation. Financial and other information is disclosed fairly and in appropriate
amounts.
Exhibit 5-1, taken from the AICPA Accounting and Audit Guide Construction Contractors, illustrates how
the assertions apply to transactions during the period, account balances at the end of the period, and
account presentation and disclosure.
Exhibit 5-1 Audit assertions
Evaluating risk at the contract level
Learning objective: Recall the common three phases of contract review during
audit planning.
The major difference between auditing a contractor and other types of business entities is that for a
contractor a “balance sheet approach” is not sufficient. For the contract-related accounts you have to
test the transactions; you have to audit the contracts. When planning for the audit of a contractor, at
some point you need to review the jobs and determine which jobs represent the higher risk.
Why it matters
Think of your audit approach for accounts receivable on a commercial engagement. You
typically divide the population into two groups: individually significant items and everything
else. The individually significant items you positively confirm 100%. Take the “everything else”
pool as of an interim date and roll it forward to year-end. The individually significant accounts
you confirm as of balance sheet date. Your valuation test work is similarly modified to focus
on high-dollar and high-risk accounts.
An audit of a pool of construction projects takes a similar approach. You want to segregate
the population into high-risk and low-risk jobs. Your risk assessment will affect
the nature, timing, and extent of your audit procedures;
the staffing on the engagement;
supervision and the amount of partner involvement; and
when the work is performed (that is, high-risk areas first; not saved until the end because
no one likes surprises at the end of an audit).
A planning review of contracts in progress should be done in three stages. These stages act as a filtering
process.
Phase 1
Review the client’s unadjusted contracts-in-progress schedule as of the balance sheet date. Focus on the
percentage complete and total contract price jobs. Jobs that are either in the very early or very late
stages of completion are typically lower risk. Why? Think back to the exercise at the end of chapter 2.
Mistakes (for example in estimating costs to complete) are multiplied by the percentage complete.
Therefore, if the estimate of a 10% complete job is off by $100,000, the effect on gross profit is only
$10,000.
True, errors on jobs that are almost complete will have a greater impact on gross profit. However, when a
job is 90% or more complete, the contractor should be able to develop estimates within a fairly tight
range.
Therefore, a scan of the contracts-in-progress schedule will identify large jobs or those that fall between
25% and 90% complete that may be high-risk. These pass through the filter to phase 2.
Phase 2
The preliminary review of the contract status report should identify potential high-risk jobs. Your next
step is to sit down with the contractor and ask him or her about these jobs. In making your inquiries do
not forget the information you have accumulated in your job history database and your knowledge of the
client and the industry. Some general questions to ask include the following:
Type of project – Try to get an understanding of the relative complexity of the job and whether it is
within the contractor’s expertise. Construction complexities will affect the risk assessment of a
particular job, but you should also ask about architectural and engineering complexities. For example,
a contractor may have significant experience building office buildings, but if a building makes
extensive use of a new type of material, risk may be increased.

Keep in mind that a contractor’s expertise may be fairly narrowly defined. Be skeptical of the
contractor who says, “I’m a road builder, so I should be able to build a bridge. It’s nothing but
a road on stilts.” Any responses such as the above should be viewed with professional
skepticism as previously discussed and not accepted outright.
Timing and scheduling – Jobs that stretch out over a long time frame are generally riskier. Ask the
client about jobs that are behind schedule or that are under an accelerated schedule with the owner
pushing to get the work done. These are generally riskier, too.
Location – Contractors may take on unforeseen risks when they perform jobs outside of their normal
geographic area. Those risks are usually attributable to the contractor’s unfamiliarity with the
business conditions and practices of the local economy. The contractor may also take on the risk of
mobilizing people and supplies to a remote area.
Example 5-2 Change in location

Mainland Builders is a general contractor that specializes in building hotels. They were
contracted to build Da Kine Resort on a remote spot of the island of Kauai, Hawaii. Mainland
Builders encountered significant problems mobilizing their equipment to the jobsite. They
had to be shipped first to San Francisco, then Honolulu, and finally on to Kauai. Delays and
unexpected fees were encountered at each port.
Once on the jobsite, the equipment developed rust and other problems related to the salty air
and high humidity. Breakdowns and delays were more frequent than the company normally
encountered on its mainland projects.
Partway through construction, the builders discovered an ancient Hawaiian heiau (or temple)
and burial site close to the resort project. The local workers immediately walked off the job
and refused to work any longer. After a long delay, a kahuna (or shaman) was brought in to
bless the site, and the workers returned to the job.
These are all examples of events that could occur in an area that is unfamiliar to a
contractor. Although a lot of these events become hindsight, the discussion should be had
with the contractor to determine what they’ve done to prepare for work in a new region.
Weather – Many construction projects are executed outdoors, and weather can have a significant
impact on how the job is performed. For example, the severe weather conditions had to be taken into
consideration when the Trans-Alaska pipeline was built. Unusual weather conditions can also cause
delays or loss.
Owners – The contractor’s relationship and past experience with the owner can have an impact on
the risk of a particular project. You should also try to obtain a general understanding of the owner’s
financial position. Working with owners who are experiencing financial difficulty can make a job
riskier (for example, in getting paid on time).
Subcontractors – Try to obtain an understanding of the extent to which your client uses
subcontractors. Remember that your client will almost always be responsible to the owner for any
failure of the subcontractor to deliver the work he has contracted to perform. Your client may also be
responsible for any unpaid labor or material bills. Your client’s past experience with a subcontractor
and the subcontractor’s financial position should be evaluated.
Bid spread – Bid spread is the difference between the winning bid and the next lowest bid. A large bid
spread between your client and the next lowest bidder may indicate your client failed to consider a
significant cost or was otherwise unrealistically optimistic when bidding the job. These spreads are
typically available on all public work, but are less common to be provided on private work. As this
could provide more risk, the CPA should gain an understanding of what, if anything, the contractor
does with this information.
Proceeding on your discussions with management, you may further refine your breakdown of lower risk
and higher risk projects. The high-risk projects pass on to phase 3 of the evaluation.
Phase 3
For the projects that make it to this phase of the planning process, you will need to obtain additional
detailed information. You can get this through inquiry of the project manager or someone else who is
thoroughly familiar with the project. You might also want to perform more detailed procedures, such as
fully reading the contract and analyzing interim financial information. Some things to look for include the
following:
Profit fade – Review interim financial information for the project for signs of profit fade. This is
usually a sign that something on the job did not proceed according to plan.
Underbilling – Chronic underbilling may indicate the client has a control problem in the billing area.
Significant underbilling on a particular job may indicate an unrecognized loss.
Example 5-3 Underbilling hides an unrecognized loss

Halfway through a job, the management of Acme Builders realizes the scope of a project is
larger than it originally planned, and the project will go over budget. Costs continue to
accumulate on the project, but the progress billings are prepared as originally agreed to, with
no increase for additional costs.
The result is that Acme will build up a substantial underbilling for this job. The cause of this
underbilling is that costs are greater than expected. Management (and the auditor) should
consider whether the increase in costs will eventually be billed and collected from the client.
If not, any loss should be recognized immediately.
Type of contract – As discussed in previous chapters, cost-type contracts are generally less risky
than fixed-price contracts. However, it may sometimes be difficult to determine the reimbursable
expenses on cost-type contracts, and this should be considered when evaluating risk.
Claims – The presence or absence of significant claims related to a project will affect the risk
associated with that project.
Exhibit 5-2 provides a simple flow chart for identifying high-risk contracts.
Exhibit 5-2 Identifying high-risk contracts
Contractors and estimates
Exhibit 5-3 presents the risks associated with each of the three phases.
Exhibit 5-3 Assessing risk of individual contracts table of risk factors
Factor Lower risk Higher risk
Phase 1: Review schedule of uncompleted jobs
Percent complete 0% – 25 % > 90% 25% – 90%
Size of project Relatively small job Relatively large job
Phase 2: Make inquiries of management

Type of project Simple, routine Complex, one of a kind
Within contractor’s expertise Not within contractor’s expertise
Timing and Short-term project Long-term project

scheduling
Work is on schedule Work is falling behind
Comfortable time frame Accelerated time frame
No penalties for late completion Significant penalties for late

completion
Location Established area with past New area

successful projects
Materials and labor readily available Remote area – materials and

labor not readily available
Weather Low susceptibility to adverse High susceptibility to adverse

weather weather
Owner or investor Significant previous contact Little previous contact
Solid financial position Weak financial position
Underbilling Normal or nominal underbilling Unusual or significant

underbilling
Type of contract Cost-type, clear definition of Fixed-price

reimbursable costs
Cost-type, difficult to determine
reimbursable costs
Exhibit 5-3 Assessing risk of individual contracts table of risk factors
(continued)
Factor Lower risk Higher risk
Claims No claims Significant claims
Subcontractors Large portion of work performed by Small portion of work performed

subcontractors by subcontractors
Significant previous contact Little previous contact
Solid financial position Weak financial position
Significant subcontract agreements Significant subcontract
finalized agreements not finalized
Bid spread Tight bid results Significant variances in bid
amounts
Phase 3: Obtain detailed information
Profit fade No significant profit fade Significant profit fade
Underbilling Normal or nominal underbilling Unusual or significant
underbilling
Type of contract Cost-type, clear definition of Fixed-price
reimbursable costs
Cost-type, difficult to determine
reimbursable costs
Claims No claims Significant claims

With a partner, or in a small group, review exhibit 5-3 and consider the following question:
Which factors are of greatest concern for your clients?
Knowledge check
3. What timing and scheduling situation will cause a job generally to be riskier?
a. Short-term job.
b. Cost plus contracts.
c. Job that stretches out over a long timeframe.
d. Tight bid results.
Other areas for preliminary audit or review analysis
Learning objective: Identify other preliminary procedures and areas of concern

common to an audit of a construction contractor.
We have discussed the contract level approach for the audit and review engagements. By now you have
selected the contracts we are most concerned about and have office personnel retrieving those job files.
What about the remainder of the engagement? Let us take a look at some of the other key areas of
importance.
General and administrative expenses

Understanding a contractor’s overhead is extremely important. It assists the contractor in
determining budgets for the next fiscal year,

understanding a break-even analysis that assists in profit projections in bidding, and is
a key tool in understanding monthly cash outflow.
You should prepare a working paper that summarizes general and administrative expenses. From this
working paper an analysis is prepared, for example, using four fiscal periods, an average of the four-year
period and a current year comparison to the four-year average. The four-year average and the current
year comparison to the average allow us to develop independent expectations as required by both the
Statements on Standards for Accounting and Review Services and the Statements on Standards for
Accounting and Review Services. The four-year comparison allows us to identify trends or unusual
variances that may occur in any specific account. Unusual notations should be reviewed with the client
and follow-up work should be determined if necessary.
Additionally, four critical areas need to be identified for analyses:
Backlog gross profit. This would have been determined from the job schedule of the work in process
prepared in other working papers. The backlog gross profit is the backlog profit that is yet to be
earned (estimated gross profit on contract – gross profit earned).
Backlog gross profit to selling, general and administrative expenses. This is a critical ratio evaluated by
the surety. This allows the surety to determine the adequacy of the contractors’ workload based on
the contractor’s contracts in progress. A ratio of over one is a good indicator. A ratio of less than .5
indicates the contractor has a dire need to find more work.
Selling, general and administrative expenses as a percentage of revenue – This ratio is a good
measure for the contractor when determining what percentage of a contract amount may need to be
estimated when considering the company’s overhead burden. This ratio is always a moving target.
Simply stated, the ratio will vary dependent on the amount of work in progress the contractor has at
any given time.
Selling, general and administrative expenses as a percentage of revenue without officers’ salaries –
This ratio is calculated in the event that the officers have a significant amount of salaries. It is very
useful when owners have exuberant payroll or high bonuses. During stressful times, an owner of a
company may restrict their payroll. Such a move would make a tremendous effect on their overhead.
It is important that this not be deemed strictly for officers, but more for those salaries of owners that
would be adjusted during stressful or beneficial times.
Cost of revenue analysis

The cost of revenue analysis (CORA) is a working paper that be used in several different situations:
1. An overall review of the revenue and cost of sales analysis among all jobs
2. An overall review of the revenue and cost of sales analysis among completed jobs
3. A review of the revenue and cost of sales for individual completed contracts
Overall review among all jobs
The use of CORA among all jobs allows you to look at the overall performance of the company.
Identifying key components of costs will assist you in benchmarking the contractor’s cost of sales
among other analyses. By analyzing the key construction cost ideas, CORA allows you to focus your audit
and review efforts in those key areas.
Overall review among completed jobs

We have discussed that our approach to a contractor is neither a balance sheet nor an income statement
approach; instead, our approach should be a contract approach. The contract approach requires us to
review in-progress jobs on an individual contract risk assessment. That is, our testing or inquiries are driven
toward the contracts that reflect the most risk. However, we cannot forget about the completed contracts.
The CORA among completed jobs allows us to address the completed jobs in an analytical form. By
separating jobs in progress from completed jobs, we can observe if margins on completed jobs are less or
more than those in progress. We can determine if cost components differ from those in progress. The
analysis may require further work if you see variances between the completed and in-progress work.
Review of completed jobs at the individual contract level

For completed contracts that appear to be unusual (extremely high or low margins), a further analysis of
the cost of sale components may identify areas of further testing and inquiries for the accountant. By
establishing the benchmark from the overall company CORA analytic, one can compare the percentage
of cost component to the contract price to the completed contract with a risky margin. Again, such a
comparison will focus on the cost component area and direct further inquiry or testing.
Property and equipment analysis

A simple analytical procedure required in the fixed asset program of any audit or review program. For
example, increases in current year depreciation may be explained away due to a purchase of a forklift.
Receivable and payables analysis

The receivable and payable analysis is calculated by every surety. Primarily to determine the days in
receivables and payables but for the accountant, this ratio can be useful when looking for unrecorded
liabilities, especially for general contractors. For example, if we see a retainage receivable to retainage
payable ratio averaging around 1.5 and this ratio nearly doubles, questions need to be asked. Has the
contractor paid the subcontractors their retainage because of their outstanding work? Not likely.
Contractors work on the basis of pay when work is complete, not a minute sooner. No this should alert
the accountant that either the use of subcontractors has diminished (refer to the CORA analysis), or the
contractor has not recorded retainage payable on the subcontractors.
Gross profit gain or fade analysis

The gross profit gain or fade analysis is a required working paper in every accountant’s file. The gross
profit gain or fade analysis should be a part of the contractor client’s permanent file. This working paper
allows the accountant to review how in-progress contracts were completed in the subsequent year. This
working paper evaluates a contractor’s estimating skills whether the job is just starting out or when the
job is 75% complete. The accountant should make inquiries and follow up with testing on significant
variances from one year to the next.
Balance sheet ratios

Three critical ratios on the balance sheet that are contract driven include the following:
Underbillings to equity – Underbillings are viewed in one of three ways by sureties: poor billing
practices, unapproved change orders, or potential loss on the job in progress. Because of this a
surety believes that a ratio of underbillings to equity in excess of 20% is considered unusual. Such a
ratio indicates further review and inquiry may be necessary.
Underbillings to working capital – Because a surety‘s interpretation of underbillings is so important,
the impact of underbillings to working capital is greatly observed by sureties. The surety does not
want to make a mistake on bonding an individual contract when a large amount of working capital is
based upon underbillings.
Cash to overbillings – Overbillings are created from the art of “front loading” a contract. That is, billing
for money that you have not yet earned. A common practice usually combated by the architects and
engineers to whom a contractor must submit their billings. A surety does like to see overbillings as long
as the contractor has not spent the overbillings. That is why the accountant should run the ratio cash to
overbillings. At a minimum there should be a 1:1 ratio. A higher ratio is even better. At times the
overbillings may be less than a 1:1 ratio. When this occurs, the accountant should look to contract
receivables and determine if the overbilling has been created by a recent billing. If so, the accountant
may want to disclose this in the receivables or work-in-progress footnote.
Summary
Audit planning is performed at two general levels. First, you should assess risk at the overall entity level.
Understand the contractor’s estimating process and how significant estimates are to the financial
statements. Many CPA firms maintain a database of their contractor’s job history, which allows them to
track their contractor’s estimating experiences over time.
On a second level, you should assess risk at the relevant assertion including the individual contract level.
This chapter provided you with a methodology and a list of factors to consider when making that
assessment. The flowchart on the following page summarizes this methodology.
1. What is the difference between “take-off” estimating skill and “production” estimating skill? Which one
is more important?
2. This chapter introduced the concept of a job history report (an example is included in
appendix 5-A). How is this report generated? How can it help plan the audit?
3. Describe the three-phase process for assessing risk at the individual contract level.
Appendix 5A
JOB HISTORY REPORTS
© 2020 Association of International Certified Professional Accountants. All rights reserved. Chapter 5, A-1
© 2020 Association of International Certified Professional Accountants. All rights reserved. Chapter 5, A-2
Chapter 6
Substantive Auditing Procedures
Learning objectives
Identify the five key components of the contractor’s audit model.
Recall the common audit procedures to test each of the five key components of the contractor’s
audit model.
Introduction
As an auditor, you have probably had the experience in which you started to review a working paper, and
it soon became apparent that the person doing the work really did not know what he or she was doing.
Perhaps they blindly followed last year’s working papers, and, as a result, certain audit areas were
overlooked while others were over-audited.
Does this sound vaguely familiar?
It is easy to follow a canned audit program or the guidance in the audit and accounting guide. But to
really do a good audit, you have to understand not only what you are doing but why. This chapter will
focus on why.
Contractor’s audit model
Learning objective: Identify the five key components of the contractor’s audit
model.

With a partner, or in a small group, discuss your experience with performing substantive
procedures and why some substantive procedures are more interesting than others. Do you
have a favorite substantive procedure to perform?
Chapter 5 introduced audit planning and preliminary analytical procedures for the audit of a construction
contractor. The basic concept is that a contractor is audited at the contract, or performance obligation,
level, and an auditor applies the audit risk model to the key components of the basic contract equation.
The five key components are
1. original contract price,

2. modifications,
3. cost to date,
4. estimated costs to complete, and
5. billings.
This chapter discusses substantive procedures that are unique to contractors. When you perform these
procedures, you need to be aware of which of the key components of a contract you are testing. For
example, if you decide to perform a jobsite visit for a particular job, you need to know which components
of the equation you are testing and how your observations affect the financial statements.
The relationship between substantive auditing procedures and the key components of a contract are
listed in exhibit 6-1.
Keep in mind that determining the nature, timing, and extent of substantive procedures is a function of
the risk of a material misstatement. For example, you are not required to read all of the contractor’s
contracts. But if the risk of materially misstating the original contract amount for a given contract is
higher than acceptable, you would want to fully read that contract.
Exhibit 6-1 Substantive tests and their relationship to the financial statements
Contract or performance obligation equation components
Original Estimated
contract Costs costs to
Substantive procedure amount Modifications to date complete Billing
Read the contract
Confirmation with owner
Review unapproved
change orders
Test cost accumulation
Review cost to complete
Jobsite visit
Read the contract
Learning objective: Recall the common audit procedures to test each of the five
key components of the contractor’s audit model.
Tips for audit efficiencies

You do not have to wait until year-end to read contracts. Read them a couple of months
before year-end. Focus on the high-risk contracts that will most likely still be in progress at
balance sheet date.
Reading contracts at an interim date will help you plan the audit and distribute some
chargeable hours to a slower time of the year. It will also give you contact with your client
outside of the normal audit and tax season. If the client doesn’t maintain a work-in-process
schedule throughout the year, performing this analysis at an interim date may not be useful
because it will be harder to identify the high-risk jobs.
A contractor is audited at the contract or performance obligation level; an audit of a contractor is an audit
of individual contracts or performance obligations. Therefore, most auditors read the contracts for the
higher risk projects. Some things to look for when you are reading a contract:
Guarantees – Many contracts provide for contract guarantees, for example, that the completed power
plant will generate a specified number of kilowatt hours. For some contracts, retentions and their
ultimate realization are related to the fulfillment of these guarantees. Make sure the contractor has
given adequate consideration to the cost of fulfilling any guarantees.
Penalties and incentives – Previous chapters have commented on the penalty and incentive clauses
that are written into most contracts. When reading the contract be sure to note how the amount of
the penalties and incentives will be calculated and the event that triggers their recognition.
Cancelation and postponement provisions – Some contracts contain provisions that describe the
terms and various rights of the contractor in the event the owner cancels or postpones the project.
The most important thing for the auditor is to understand the contractor’s right and ability to recover
costs and damages if the contract is canceled or postponed.
If a contract is postponed, you should check to make sure the estimated costs to complete include any
increases in cost that may be caused by the delay.
Certain correspondence will not be maintained in the contract files. Such “correspondence files” may
contain disputes with subcontractors, suppliers, owners, and so on. It is critical this information be
subject to your review. Many unrecorded liabilities may surface as a result of your due diligence in
this area.

Be familiar with the contract before you prepare the confirmation. Understand how the
original contract price was determined and how the billings tie to the contractor’s general
ledger.
Address the confirmation to someone who is willing and able to confirm the information
requested.
The confirmation you send to the owner will ask for information about a number of items, including
original contract price,

total approved change orders,
total billings and payments,
total unpaid balance,
retainage held and whether it accrues interest,
details of any claims, back charges, or disputes,
estimated completion date, and
estimated percentage complete.
There are two types of confirmations you can prepare. You can fill in the amounts and ask the owner to
just check them to be sure they are accurate. Or you can leave the amounts blank and ask the owner to
fill them in. There are pros and cons to both methods. Fill in the amounts, and you run the risk that the
owner does the most expedient thing: signs and returns the confirmation without thoroughly checking
the information. Leave the amounts blank, and the owner may decide it is too time-consuming and not
respond to the confirmation.
The contractor may include incentives or penalties in the “Original contract amount” column of its
schedule of uncompleted contracts. It is usually best to segregate these amounts when preparing the
confirmation.
Keep in mind that the owner is likely to confirm only the approved change orders and other contract
modification. Most of the audit risk is related to unapproved change orders and modifications. Auditing
procedures for unapproved change orders will be discussed later in this chapter.
Many times the auditor asks the owner to confirm the estimated completion date or the estimated
percentage complete of the project. Do not expect these estimates to match exactly with the contractor’s
estimates. With your confirmation, you are looking only to identify significant differences or problems. If
the cost-to-cost estimate of percentage complete is 85%, but the owner says the job is only half done,
then that is a red flag. The job may be significantly over budget and may even be in a loss position. The
owner may also simply confirm the percent complete as the percent billed because, in their eyes, they
have been billed for the percent complete that the job is because the owner doesn’t see any potential
billings or costs in excess amounts. Therefore, if the confirm reflects a number different from what you
see, first determine if that amount is the percent billed before performing additional procedures.
When confirming billings and payments, many auditors separate retentions from unpaid progress
billings. Retentions are usually not collected until the job is completed and may be subject to restrictive
conditions such as fulfillment guarantees.
Remember that confirmations do not address all assertions equally well. The confirmation of billings and
payments provides a great deal of evidence about the existence assertion but very little about valuation.
In other words, the owner can acknowledge the existence of unpaid bills, but the confirmation says
nothing about whether it has the ability and intent to pay those bills.
As with other engagements, you will need to do additional work to gather evidence about the collectibility
of the receivables. With a contractor it is important to consider not just the amount the customer owes at
the balance sheet date, but the amount of the contract price yet to be billed. Remember, the owner is on
the hook for the entire contract amount, not just what is outstanding at any one point in time.
To evaluate collectibility you may need to review the financial statements or other indicators of the
owner’s financial ability to pay. In some situations it may be appropriate to make such inquiries even
though there may be no apparent indication that the receivable currently on the contractor’s balance
sheet might not be collectible.
Knowledge check
1. Which is most likely to be confirmed by the auditor directly with the owner of the project?
a. Total approved change orders.
b. The percentage of completion on the job.
c. Costs to date.
d. Unapproved change orders.
2. Which assertion does the confirmation of billings and payments with the project owner address?
a. Existence.
b. Completeness.
c. Valuation.
d. Presentation.
Unapproved change orders procedures

Identify significant unapproved change orders early in the audit. Impress upon the client the
need for owner approval or other documentation to support the recognition of revenue
related to change orders. As discussed in earlier chapters, if the unapproved change orders
are included, do these amounts include cost and profit, or just cost? And how has the
contractor differentiated between costs arising from additional work versus overruns on
work within the scope of the contract that the owner doesn’t have an obligation to pay?
If you address the issue early in the audit, you give the client time to obtain approval or gather
the necessary evidence. Nobody likes an eleventh-hour surprise.
Chapter 2 discussed the accounting for change orders, claims, and other similar contract modifications.
Essentially, the costs of such items should be recognized during the period in which they are incurred but
any related revenues can be recognized only if they are probable of collection and the amount can be
Unapproved change orders are difficult to audit because of the lack of evidence to support the probability
of collection and the estimate’s reasonableness. It is the client’s responsibility to supply sufficient
documentation. If there is no evidence to support the recognition of revenue on an unapproved change
order or claim, then it should not be recognized.
Testing for unapproved change orders involves gathering evidence to support both the cost and any
related revenue.
Procedures used to audit unapproved change orders and claims include the following:
Vouch accumulated costs to underlying invoices, time records, and other supporting documentation.
In some circumstances you may wish to confirm amounts paid to subcontractors.
Evaluate whether the costs relate to work within or outside the scope of the contract. If the costs
relate to work within the scope of a fixed-price contract, no basis for additional contract revenues
may exist, and the costs may not be recoverable.
Evaluate the nature and reasonableness of claimed damages that are attributable to customer-
caused delays, error in specifications that caused incorrect bids, or various other reasons. You may
need to obtain an opinion from the contractor’s legal counsel regarding
– the contractor’s legal right to file such a claim against the owner and
– the contractor’s likelihood of success in pursuing the claim.
Consider the likelihood of the contractor pursuing and collecting on a claim. A claim may be properly
supported but, if the contractor does not pursue it, it will never be collected. For example, a contractor
may be less likely to press for collection of a claim from a major customer.
Consider the contractor’s past success in negotiating and settling similar types of claims.
Scope changes on contracts, particularly cost-plus contracts, are often not well-documented. Large cost-
plus contracts frequently evolve through numerous starts and stops by both the contractor and the
owner. As a result, the final scope of the contract is not always clearly defined. For cost-plus contracts,
you should carefully consider which costs are reimbursable and which are not.
Testing cost accumulation

The test of cost accumulation may be performed at an interim date as a way to shift some
chargeable hours out of the tax and audit season.
At year-end coordinate the test of cost accumulation with the search for unrecorded liabilities.
Audit tests are ultimately related to audit assertions. Testing the existence and valuation assertion of the
costs to date is usually accomplished by vouching the accumulated costs to the supporting
documentation.
This is one area of the audit that usually lends itself to sampling. When using sampling, it is important
that the sample be representative of the population. This involves considering all of the contractor’s
projects, both completed and uncompleted. It also involves considering all of the different types of costs
within those contracts. Samples that consider only materials and not labor, or direct costs and not
indirect costs, are not representative samples.
Your tests of costs to date should also gather evidence to support the completeness assertion. There are
two primary tests for this:
1. Review unapplied indirect charges – You should review unapplied indirect charges, including
equipment charges. The proper accounting for indirect charges was discussed in chapter 2. Also, be
alert for costs the contractor has described as general and administrative when in fact they were job
costs. Such a misclassification will affect the gross margin on jobs that may be material to a financial
statement user.
2. Audit of contract-related liabilities – You should audit liabilities for a contractor in the same way you
audit liabilities for other business entities. Your primary concerns are completeness (usually tested
through a search for unrecorded liabilities) and cut-off.
When auditing a contractor’s liabilities there are a few things you should keep in mind that may be
different from other clients:
You may wish to confirm the terms and status of subcontracts with subcontractors.
When auditing subcontractor payments be alert for indications of claims and extras that may be
billed by the subcontractor. Also look for signs of back charges.
Older invoices and retentions may indicate defective work, failure on performance guarantees, or
other contingencies that the contractor has not properly considered.
Make note of any commitments or contingencies for future costs. Make sure these have been
properly considered by the client in estimating costs to complete.
Review estimated cost to complete

Look to post-balance-sheet date events or transactions to provide evidence about the
balance-sheet-date estimate. If the contractor’s year-end is December 31, and you do the
audit work at the end of February, nearly two months of activity will have taken place on the
jobs that were in progress at year-end. This activity may confirm or refute the assumptions
used by management to prepare their year-end estimates.
Many auditors ask their contractors to provide updated estimates at the start of field work. If
these are not prepared as a normal course of the contractor’s business, be sure to make your
request several weeks in advance of when you need them.
The authoritative guidance on auditing accounting estimates is provided by AU-C section 540, Auditing
Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures.
Accounting estimates are based on key factors and assumptions. For example, the price of materials
may be a key factor, and the contractor may assume that prices will not rise significantly during the
course of the job. When auditing the estimated cost to complete, you should focus on those key factors
and assumptions that are
Significant to the estimate,

Sensitive to variation,
Deviations from historical patterns, and
Subjective and susceptible to misstatement or bias.
AU-C section 540 describes the approaches an auditor may take to evaluate the reasonableness of an
estimate. When auditing a contractor’s estimate of costs to complete, you should use one or a
combination of the following approaches:
Review and test the process used by management to develop the estimate.
Develop an independent expectation of the estimate to corroborate the reasonableness of
management’s estimate.
Review subsequent events or transactions occurring before completion of field work.
Even if after developing your understanding of the entity and its environment, including its
internal control, you are planning a primary substantive audit approach and plan to assess
control risk at or slightly less than the maximum, you still should gain an understanding of a
contractor’s estimating process. This understanding will help you gather evidence to support
estimates of the cost to complete.
As a practical matter, most auditors use a combination of the three approaches, with an emphasis on the
first and third approaches.
The following are some of the procedures you might apply:
Identify and understand significant uncertainties – As part of understanding the client’s assumptions
you also should identify the related risks and uncertainties associated with those assumptions.
Understand internal control structure – Focus on the areas that can affect the estimate of costs to
complete: the estimating and bidding process, jobsite accounting and control, and contract costs,
including the costs of change orders, extras, and back charges.
Be aware of contractor’s history – Does the contractor have a history of making accurate estimates?
Consider maintaining a job history database for your contractor clients.
Compare actual to budget – Take the sum of accumulated costs to date plus estimated costs to
complete by budget line item. Compare this sum to the original bid and budget. Compare allocation
rates for equipment, payroll overhead, and so on, used by estimates with actual rates. Review items
with front-end loading and significant bid spreads. Investigate any unusual variances. Be aware that
most jobs do not perform as they were originally budgeted. You should always seek updates to the
budget from discussions with project managers and estimators and have their schedules revised. If
the estimated contract costs per the job schedule are the same as the original bid, very little weight
should be given to this estimate.
Review subsequent estimates, events, and transactions – You should review the post-balance-sheet
revised or updated estimates of cost to complete. Compare the balance-sheet-date estimates with
the actual costs incurred after the balance sheet date. The accountant should perform a profit/fade
analysis in this area. This will guide the accountant in understanding how original estimates compare
in the year the contract is completed.

For example, the estimated total gross profit at the balance sheet date was $10 million. Two
months later the estimate was $9.5 million.
As a practical matter, most auditors insist the contractor use the $9.5 million. This approach
preserves the credibility of the financial statements in the eyes of the users.
Compare assumptions to terms of contract – Make sure estimated costs to complete take into
consideration penalties for termination or late completion, warranties or contract guarantees, and
related items. Also check for the inclusion of actual or expected quantity or price increases.
Discussion with personnel – Make inquiries of those who are familiar with or responsible for the
project. Obtain any written reports they might prepare on the status of the job, including those
prepared before the balance sheet date. Look for significant revisions or other indications of
problems on the job.
Look for disputes and contingencies – Disputes and contingencies may have an impact on the
estimated costs to complete. Review confirmation responses, boards of directors’ minutes and
responses from attorneys for evidence of these items. Make sure they have been properly considered
in the estimate of costs to complete.
Nature of reasonable estimates and inherent hazards

In practice, contract revenues and associated costs are estimated in ways ranging from simple to
complex methods. The ability to produce reasonably dependable estimates does not depend on the
elaborateness of the contractor’s estimating process. A contractor’s estimating procedures should
provide reasonable assurance of a continuing ability to produce reasonably dependable estimates.
The ability of the contractor to estimate anticipated contract revenues and costs covers more than just
the estimating and documentation of revenues and costs. It covers the entire internal control system of
the contractor. It depends on all of the procedures and involvement of contractor personnel who are
involved in project management, cost control, administrative control, and accountability for contractors.
The auditing of the estimates looks to FASB Accounting Standards Codification® 605-35 in testing the
contractor’s estimating system: “Previous reliability of a contractor’s estimating process is usually an
indication of continuing reliability, particularly if the present circumstances are similar to those that
prevailed in the past.”
The auditor’s experience with the contractor’s ability to estimate its revenues, costs, and gross profits in
previous years can reasonably determine if a contractor’s estimating process is reliable. If significant
changes have occurred in the process and procedures, such historical reliance may not be available and
must be reviewed again. However, if the current circumstances allow the reliance on processes, then
auditors have available for them a “look-back” procedure by comparing the prior year estimated year-end
contract elements of uncompleted contracts to the final completed amounts. If the contract is not
completed, the testing is still reliable by reviewing the same uncompleted contracts with a “revised”
schedule. Such year-to-year comparisons will reveal the following:
Slightly positive or negative trends – Slight modifications from year to year would allow one to
reasonably believe that the contractor’s estimating system is reliable.
Significantly positive trend (the existence of “job gain”) – Be cautious in using typical materiality
assumptions when reviewing this trend. Variations of 5% of job gain can be substantial. Job gain can
be viewed in two different ways. One way is that the contractor has discovered ways to make
additional profit. The additional profit could be from excellent profit management, gains on material
pricing or shopping down subcontractors. However, the opposite view to job gain can look at the
estimating process negatively. How did the estimating department bid certain cost items too high?
Are there other projects missed due to estimating floating costs? Or are there certain costs not being
properly allocated to jobs.
Significantly to the negative – The phrase is called “job fade.” There are no positive indicators with this
trend. A negative trend reveals a flaw in the estimating process. Poor project management, improper
allocation methods, theft, and poor estimating are just a few examples that could lead to such
negative trends. Furthermore, consistent job fade will result in a contract being awarded projects that
do not produce enough profit for the long-term existence of the contractor.
Jobsite visits

With a partner, or in a small group, discuss your experience with job site visits. What has
been the most interesting job site you have been to? Did you witness anything unusual?

The persons performing the jobsite visit should be familiar with the contractor and the
project. They should also understand the objective of their visit. Send them to the job with an
audit program.
A jobsite visit is similar to an inventory observation in that it is a dual-purpose procedure: it gathers

information about the internal control structure and it also gathers substantive audit evidence.
The AICPA Audit and Accounting Guide Construction Contractors lists the following five objectives of a
jobsite visit:
1. To gain an understanding of the contractor’s method of operations

2. To determine that the job actually exists
3. To obtain information from field employees that may or may not corroborate with what is
represented by management
4. To obtain an understanding of those elements of internal control maintained at the job site
5. To obtain information relating to job status and problems (if any) that may be useful in other phases
of the audit
The fifth objective refers to “other phases of the audit.” Usually, those other phases have to do with the
audit of estimated costs to complete.
The contractor’s estimate of costs to complete is based on certain assumptions and uncertainties about
how the job will be completed. During the jobsite visit, the auditor should take note of existing conditions
that either confirm or are contrary to the assumptions made by management to develop its estimated
costs to complete.
Example 6-1 Jobsite visit
Acme Mudders is a plaster and drywall subcontractor. One of their jobs is the Big Condo
Project, a 20-story building. During the jobsite visit, Amanda Auditor discovers there have
been problems on the job.
One group of workers did a poor job of taping on floors one through five and as a result the
work had to be redone. “Show me,” says Amanda, and the project manager takes her to the
fifth floor. Half of the floor has been retaped, and the other half contains the original, sub-par
work. On comparison, it is obvious to Amanda that the original work is of poor quality.
“Have you fixed the problem?” asks Amanda. The project manager assures her that the
workers have been properly trained and instructed and that Acme does not plan to redo any
more work.
Acme has just finished floors six through ten. Amanda should take a tour of those floors to
see if any of the work is obviously deficient or whether it supports the project manager’s
assertion.
The primary procedures performed during a jobsite visit involve discussions with project managers,
supervisors, subcontractors, and other individuals regarding the status of the project and any significant
problems. Project managers play an important role in controlling and reporting jobsite costs. They also
are close to the facts and are more likely to get more prompt and accurate information than accounting
personnel. Meeting with the project manager also will help you develop expectations for your analytical
procedures. It is common practice for auditors to ask the project managers of significant projects to
complete a questionnaire regarding the status of their contracts. In addition, the auditor should observe
the following:
Any uninstalled materials – Remember from chapter 4 that it makes a difference to the surety
whether inventory is general supplies and materials or specific materials located at the job site. While
performing a jobsite visit, the auditor should observe jobsite inventory if the amounts are material.
Work performed to date – In some circumstances, it may be relatively easy for the auditor to observe
the work performed to date (for example, painting four floors of an eight-story building). That
information is useful in assessing the reasonableness of management’s estimate of costs to
complete.
Contractor-owned or rented equipment – Equipment is charged to projects based on hours of use.
The auditor’s observation of equipment at a job site is strong evidence to support the validity of the
charge.
Previously unidentified complexities in performing the project – Ask questions of random workers or
subcontractors to learn if there are any problems, disputes, or delays on the project.
Note that in lieu of or in addition to an in-person jobsite visit, some accounting firms are hiring drone
operators to record video of the jobsite.
In addition, the individual performing the job site visit should not be concerned with differentiating that
the job is 70% complete versus 75% complete because CPAs are not engineers. However, if the
contractor claims that the job is 80% complete and the contract is for the construction of a full office
building, yet when the CPA arrives the walls haven’t even been fully constructed, then it is reasonable for
the CPA to determine that 80% isn’t reasonable because no other trades have been into the building yet.
Knowledge check
3. When using sampling to test costs to date, which types of costs should be included?
a. Only materials costs.

b. Materials costs and labor.
c. Only subcontract costs.
d. Only subcontract labor.
4. Which is a key factor or assumption when auditing the estimated costs to complete?
a. Deviations from historical patterns.

b. Experience of the estimator.
c. Level of subcontractors used.
d. Timing of estimates.

Working with a partner, or in a small group, consider our discussion of substantive tests and
their relationship to the financial statements. Then, place a mark in the column and row of
the chart indicating where a substantive procedure is an appropriate audit procedure.
Contract equation components
Original Estimated
Read the contract
Review unapproved
change orders
Jobsite visit
Summary
This chapter discussed the substantive audit procedures that are somewhat unique to construction
contractors. The primary objective of the chapter was to explain why certain procedures are performed.
As emphasized throughout this auditing section, the audit of a contractor is the audit of individual
contracts.
The basic model we have used throughout this section is one that is based on the basic contract
equation. As an auditor, you must gather evidence to support the assertions for each key component of
the equation. This chapter explained key substantive audit procedures and illustrated how these fit into
this overall model.

1. Why should you read the contracts? What are you looking for? How do you decide which contracts to
read?
2. What is the purpose of a jobsite visit?
Chapter 7
Other Auditing Considerations
Learning objectives
Identify the basic tenets of AU-C section 240, Consideration of Fraud in a Financial Statement Audit,1
and the common characteristics of construction contractors that affect the auditor’s responsibility
under the guidance for detecting fraud.
Identify select financial statement elements unique to contractors.
Recall the key objectives when evaluating a contractor’s ability to continue as a going concern.
Introduction
So far, this course has focused exclusively on the audit of construction contracts because this is usually
the highest-risk audit area. However, there are other audit areas that may have unique considerations for
construction contractors. This chapter will discuss those areas.
1
All AU-C sections can be found in AICPA Professional Standards.
Considering fraud in a financial statement audit
Learning objective: Identify the basic tenets of AU-C section 240, Consideration of
Fraud in a Financial Statement Audit, and the common characteristics of
construction contractors that affect the auditor’s responsibility under the guidance
for detecting fraud.
As an auditor, you have a responsibility to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The auditing standards make it clear that your
responsibility extends to all material misstatements, whether caused by errors or fraud.
However, your responsibilities for detecting fraud are constrained by two factors: materiality and
reasonable assurance.
Materiality. Your responsibilities relating to fraud are considered within the context of financial
statement materiality. You are not responsible for detecting fraud per se, but rather, for detecting
any material misstatements caused by fraud. You are not responsible for detecting immaterial
misstatements caused by fraud.
Reasonable assurance. The auditing standards make it clear that you can get only reasonable
assurance that the financial statements are free of material misstatements caused by fraud. This
is a high threshold, but it is not absolute assurance.
AU-C section 240 is the definitive standard relating to the auditor’s responsibilities for detecting fraud on
an audit. The primary objective of the standard continues to be to provide you with specific guidance on
what is required for you to fulfill your responsibilities for detecting material misstatements caused by
fraud. AU-C section 240 places emphasis on professional skepticism.

With a partner, or in a small group, consider the following questions:
What type of fraud are likely to occur at construction contractors?
What types of fraud are more common with small businesses?
Have you ever encountered fraud at a construction contractor? What did you find?
Overview of AU-C section 240

AU-C section 240 categorizes frauds into two basic types: fraudulent financial reporting and
misappropriation of assets.
Fraudulent financial reporting
This occurs when management cooks the books. As defined in the guidance, these misstatements arise
from “intentional misstatements, including omissions of amounts or disclosures in financial statements
to deceive financial statement users.” Fraudulent financial reporting may include
manipulation, falsification, or alteration of accounting records or supporting documents from which

financial statements are prepared;
misrepresentation in, or intentional omission from, the financial statements of events, transactions,
or other significant information; and
intentional misapplication of accounting principles relating to amounts, classification, manner of
presentation, or disclosure.
Financial reporting fraud is most frequently perpetrated by owners and senior management. Fraudulent
financial reporting may occur when a contractor cannot make his or her loan covenants or obtain
bonding.
For example, if a contractor deliberately failed to record a legitimate payable, that would be a form of
fraudulent financial reporting.
Misappropriation of assets
Misappropriation of assets, more commonly referred to as the theft of company assets, usually involves
employees. Misappropriation can be accomplished in various ways, including embezzlement, stealing
assets, or causing an entity to pay for goods or services not received. Misappropriation of assets may be
covered up by false or misleading supporting documents or by collusion among employees or employees
and third parties outside the entity. Misappropriation of assets is most commonly committed by
employees.
Small tools on the jobsite are highly susceptible to theft, as are materials or equipment that can be easily
used personally (for example, washers and dryers or floor tile).
Bribery
Bribery may occur in construction in during the acquisition of work or during inspections. Bribery is the
hardest of the types of fraud to catch because it frequently involves cash, and the parties involved both
have reasons and motivation to keep the bribery secret.
Bribery related to the acquisition of work may sometimes be discovered by reviewing the bid spread. The
bid spread is the difference in price between the winning low bid and the next lowest bid. If the bid spread
is too narrow, it may mean that the winning contractor received insider information about the submitted
bids. Another indicator might be if the bid was submitted minutes before the close of the bid process,
and the last bid submitted was the winning bid.
Bribery may be committed by owners, senior management, or employees.
Requirements under AU-C section 240
AU-C section 240 describes what you should do to meet your responsibilities relating to material
misstatements due to fraud. Under the statement, you are required to do the following:
Maintain professional skepticism – In accordance with AU-C section 200, Overall Objectives of the
Independent Auditor and the Conduct of an Audit in Accordance With Generally Accepted Auditing
Standards, the auditor should maintain professional skepticism throughout the audit, recognizing the
possibility that a material misstatement due to fraud could exist, notwithstanding the auditor’s past
experience of the honesty and integrity of the entity’s management and those charged with
governance.
Conduct discussions among the engagement team – This discussion should include an exchange of
ideas or brainstorming among the engagement team members about how and where the entity’s
financial statements might be susceptible to material misstatement due to fraud, how management
could perpetrate and conceal fraudulent financial reporting, and how assets of the entity could be
misappropriated. The discussion should involve all members of the engagement team and should
specifically address the types of fraud that might occur at the client, how the frauds might be
perpetrated, and how they might appear in the client’s books and records.
Perform risk assessment procedures and related activities – When performing risk assessment
procedures and related activities to obtain an understanding of the entity and its environment,
including the entity’s internal control, required by section 315, the auditor should include the following
procedures to obtain information for use in identifying the risks of material misstatement due to
fraud:
– Discussions with management and others and/or those charged with governance – First and
foremost, determine if management understands where they are exposed to the risk of fraud.
Discuss with management and/or others within the entity management’s assessment of the risk
that the financial statements may be materially misstated due to fraud, including the nature,
extent, and frequency of such assessments and management’s process for identifying,
responding to, and monitoring the risks of fraud in the entity. Inquiries should also be made
regarding whether management or others have knowledge of any actual, suspected, or alleged
fraud affecting the entity. Unless all of those charged with governance are involved in managing
the entity, the auditor should have similar discussions with those charged with governance of the
entity.
– Identification of unusual or unexpected relationships – Based on analytical procedures performed
as part of risk assessment procedures, the auditor should evaluate whether unusual or
unexpected relationships that have been identified indicate risks of material misstatement due to
fraud.
– Consideration of other information – The auditor should consider whether other information
obtained by the auditor indicates risks of material misstatement due to fraud.
– The auditor should evaluate whether the information obtained from the risk assessment
procedures and related activities performed indicates that one or more fraud risk factors are
present.
Identify and assess the risks of material misstatement due to fraud – The auditor should identify and
assess the risks of material misstatement due to fraud at the financial statement level, and at the
assertion level for classes of transactions, account balances, and disclosures. The auditor’s risk
assessment should be ongoing throughout the audit, following the initial assessment. The auditor
should treat those assessed risks of material misstatement due to fraud as significant risks and,
accordingly, to the extent not already done so, the auditor should obtain an understanding of the
entity’s related controls, including control activities, relevant to such risks, including the evaluation of
whether such controls have been suitably designed and implemented to mitigate such fraud risks. It
is important to remember that the determination of whether or not a risk is significant is made on the
inherent risk basis.
Respond to the results of the assessment – AU-C section 240 requires the auditor’s response to the
risks of material misstatement due to fraud to be as follows:
– A response that has an overall effect on how the audit is conducted (for example, assignment of
personnel and supervision at a higher level)
– A response to identified risks involving the nature, timing, and extent of audit procedures at the
assertion level
– A response to address management override of controls
The tendency is to assume that these steps are performed sequentially and that you are done once the
final step has been performed. However, the guidance points out that the audit process is nonlinear and
iterative. The process of gathering, updating, and analyzing information does not end when you complete
the last step. It continues in a circular fashion until you have gathered sufficient evidence to reach your
conclusion. Exhibit 7-1 summarizes the process described in AU-C section 240.
Exhibit 7-1 The fraud risk assessment process
Applying AU-C section 240 to the audit of a construction contractor

AU-C section 240, appendix A, “Examples of Fraud Risk Factors,” provides a list of fraud risk factors –
conditions that often have been observed in circumstances when a fraud has been committed. It is
important that you become thoroughly familiar with these risk factors and be on the lookout for them
during the course of your audit. The presence of fraud risk factors may indicate that a fraud has been or
is being committed.
Keep in mind that the example fraud risk factors listed in the appendix of the AU-C section are only
examples and may be modified to fit the circumstances of your particular client. When modifying these
examples for the audit of a construction contractor, consider the following issues.
Small business auditing
When evaluating fraud, a construction contractor might consider the fraud triangle, a three-pronged
model that attempts to explain fraud. Based on observations, fraud often exhibits the following three
elements:
Incentives and pressures

Opportunity
Attitudes and rationalization
Most construction contractors are small privately-owned businesses with fraud risk factors that are
different from those in large publicly owned enterprises. Auditors of small companies usually are more
concerned with frauds relating to misappropriation of assets rather than fraudulent financial reporting.
When identifying audit risks relating to misappropriation of assets, be alert for weak internal controls that
provide fraudsters with the potential to perpetrate and conceal frauds. In a contractor, the area’s most
vulnerable to employee theft are cash, purchasing (receiving kickbacks from suppliers), and payroll
(ghost employees). Keep in mind that when you observe a situation in which a specific individual has
both access to the assets and the ability to cover it up, you have a fraud risk.
If you are concerned about possible fraudulent financial reporting, be alert for situations that may provide
management with a motivation to cook the books. For example, a contractor that is performing only
marginally may be tempted to misstate earnings or assets to deceive the bonding company or the bank.
Remember that a contractor’s financial statements depend heavily on management estimates such as costs
to complete projects in process and to recover claims and change orders. These estimates are the most
vulnerable to intentional misstatement if management is interested in deceiving financial statement users.
During the conduct of your audit be aware of the following:
Repeated difficulty obtaining records

“Hemming and hawing” – a refusal to answer questions directly
“Wheeler/dealer” attitudes in which policy and procedure are not important
Lack of internal controls

Owners and managers of small construction contractors frequently are entrepreneurs who are more
likely to give priority to the field activities of the business (that is, the actual construction) rather than to
accounting systems and internal control activities. As a result, internal control accounting and financial
reporting functions may receive less support and attention than might be warranted. As stated
previously, internal control weaknesses may provide an opportunity for employee theft.
As part of the required risk-based audit approach, after auditors identify the inherent risks of material
misstatement embodied in the relevant assertions, they then must consider the controls the client has in
place to mitigate those risks. The auditor is required to decide regarding whether the controls are
appropriately designed and in place. This is done through walkthroughs and other procedures. If the
controls are determined not to be in place or operating effectively, this finding should be evaluated to
determine if it represents a material weakness or significant deficiency. If yes, the item should be
included in the internal control letter.
Example 7-1
Fred was the bookkeeper/controller of a small ($4m) electrical contractor. The two owners of
the business were usually out in the field, working and supervising jobs. To streamline office
procedures and make sure bills got paid when they were not around, they gave Fred the
authority to sign checks that were for less than $5,000. He also was responsible for
reconciling the bank statements.
Fred had an evil twin who got in trouble with a bookie. To help his brother, Fred looked to
borrow $3,000 from his employers, but he was too embarrassed about the situation to
explain it to the owner, so he simply made out the check to himself, signed it, and posted the
debit to “employee advances.” Later, when he realized that the owners had no idea what he
had done, he reclassified the entry to miscellaneous job costs.
This was how Fred learned to steal from the company. At first it was $1,000 to $2,000 every
couple of months, with the rationale that someday he would pay it all back. Gradually, he
began writing checks to himself every two weeks with no intention of ever paying the money
back. Over a three-year period he stole more than $200,000.
In the preceding example, there were no controls to prevent the fraud from occurring. There was no
segregation of duties — Fred had ample opportunity to both perpetrate and conceal the fraud. He had
both access to the asset and the ability to cover it up, there was no oversight or other control exercised
by the owners over their employee.
Value-added service opportunities

If you identify weaknesses in internal controls during the course of your audit, suggest
control policy fixes that will help prevent fraud. Sell these recommendations to your client as
fraud prevention measures and not just some esoteric accounting policy. Some
recommendations to try:
Have bank statements sent directly to the owner-manager. The most common control weakness
in a small contractor is a lack of segregation of duties, and one of the area’s most vulnerable to
theft is cash. If your contractor has one employee who can sign checks and who also reconciles
the bank statements, recommend that your client receive all bank statements unopened, directly
from the bank before the bank accounts are reconciled. This will make it impossible for people
like Fred to make checks out to themselves without getting caught.
Enforce mandatory vacations. Perpetuating and concealing a fraud are high-maintenance
activities, which is why many frauds are discovered when the fraudster is not around to cover
his or her tracks. If someone in a position to commit a fraud knows he or she will have to turn
over duties to someone else for at least two weeks a year, the increased risk of getting
caught may serve as a successful deterrent.
Value-added service opportunities (continued)
Include “right-to-audit” clauses with major suppliers. One of the more common frauds in a
contractor (and one of the more difficult to detect) are kickback schemes where the person
responsible for approving purchases receives a gratuity from favored suppliers. “Right-to-
audit” clauses can be included in contracts with suppliers or printed on the back of all
purchase orders. Under a right-to-audit clause, the contractor reserves the right to audit the
supplier’s books at any time. Suppliers who know their records are subject to examination
generally are reluctant to make kickback payments.
Establish a code of conduct. Even small businesses should have a written code of conduct
that clearly spells out appropriate and inappropriate behavior. For example, the company
should describe acceptable and unacceptable uses of company assets and set limits on the
amount and type of gifts employees can receive from suppliers. If the company adopts
policies relating to the relationship between employees and third parties such as vendors,
those policies should be circulated to the third parties.
Establish a tip line for reporting waste, fraud, and abuse.
Safeguard controls
Construction supplies and small tools are highly susceptible to theft. Contractors should have
procedures in place to make sure that jobsites are secure and the physical access to easily stolen items
is controlled. Auditors should make inquiries and observe safeguard policies and procedures during
jobsite visits. Any weaknesses noted should be identified in the internal control letter.

Lack of internal controls is a significant concern of small businesses and specifically
small construction contractors.
Where have you seen a lack of internal controls specific to construction contractors?
What ways of preventing and detecting fraud have you encountered?
Knowledge check
1. What type of fraud occurs if a contractor deliberately failed to record a legitimate payable?
a. Fraudulent financial reporting.
b. Corruption.
c. Misappropriation of assets.
d. Embezzlement.
2. Which type of fraud are auditors of small companies usually more concerned with?
a. Misappropriation of assets.
b. Corruption.
c. Fraudulent financial reporting.
d. Embezzlement.
Workers’ compensation insurance

Workers’ compensation insurance can be an important part of a contractor’s business. The bookkeeping
for this type of insurance can be troublesome for less sophisticated clients or those with a poor
accounting staff. The consequences for failing to properly account for insurance accruals can be severe,
so this is one area you may need to focus on.
The premiums for workers’ compensation are based on payroll. Labor dollars are multiplied by a rate to
determine the total premium. At the beginning of the policy term labor dollars by type of worker are
estimated, and premiums are paid during the policy term based on this estimate of labor dollars. After
the policy expires the insurance company performs an “audit” of payroll to determine the true premium.
Adjustments are made based on this “audit” and the contractor either receives a check from the
insurance company or must pay additional amounts.
Bookkeeping problems arise when the following occur:
Insurance policy years do not coincide with the contractor’s year-end. This is usually the case.
Several policies remain open at the same time. This is usually the case.
The contractor’s bookkeeper has a poor understanding of how insurance premiums are calculated,
checks are coming and going on several different policies all at once, and the whole thing becomes
overwhelming. This may be the case. The typical response is that the bookkeeper treats insurance on
the cash basis:
– All checks written to the insurance company are expensed.
– All checks received from the insurance company are credited to expense.
At year-end the contractor needs to make an accrual to adjust the workers’ compensation expense to the
amount of labor dollars actually incurred during the period. For example, the estimated policy premiums
may have been based on an estimate that the contractor’s payroll would be $2m for the period from
August 1 to December 31. Cash paid to the insurance company is based on this estimated payroll. If the
actual payroll was $2.5m, then an accrual is necessary to properly state the expense.
An increasingly popular form of insurance is the retrospective insurance plan. Under a retrospective plan,
the contractor is basically self-insured for a portion of workers’ compensation losses. The following
diagram illustrates how a retrospective plan works and how this might compare to a guaranteed
premium plan.
Exhibit 7-2 Retrospective insurance plan
Max. Premium
Guaranteed Cost
Min. Premium
a Losses b
The contractor pays a minimum premium that is less than the amount that would be paid under a
guaranteed premium plan. The contractor is effectively self-insured for losses that range between (a) and
(b). Any losses between these two amounts come out of the contractor’s own pocket and therefore,
increase the total amount paid under the plan. At some point the amount of premium plus losses equals
then exceeds the amount the contractor would have paid under the guaranteed premium plan. For any
losses greater than (b) the contractor is insured completely.
Several things to be on the lookout for if your contractor has a retrospective insurance plan:
They are complex. Chances are the contractor does not fully understand the risks of self-insurance.
Making an accrual for one of these plans involves a lot of estimates.
If the contractor does understand the risk involved, it probably underestimated it. It sees only the
upside potential, that is, the savings it has over a guaranteed premium plan. It fails to objectively
assess its loss history and loss control efforts.
If you do come across one of these plans, talk to the insurance agent and make sure you thoroughly
understand how they work.
Value-added service opportunity

If your contractor is considering a retrospective insurance plan, make sure it consults with
you before it decides. Take some time to explain to your client how the plan works. Run some
numbers and make sure the client fully understands the risks it is assuming and how these
stack up against the potential benefits.
Knowledge check
3. What are the premiums for workers’ compensation (an important part of a contractor’s business)
based on?
a. Stated amount of coverage desired by the business.
b. Covered subcontractors.
c. Payroll.
d. Annual revenue.
Financial statement disclosures
Learning objective: Identify select financial statement elements unique to

contractors.
Most contractors include supplementary schedules with their financial statements, and these are
Earnings from contracts,

Completed contracts, and
Contracts in progress.
You should review the schedules that are included in the example financial statements in the AICPA Audit
and Accounting Guide Construction Contractors and are included in chapter 3. Note how they tie to the
basic financial statements. The earnings from contracts schedule support the income statement. The
two contracts schedules support the earnings from contracts. Under-billing and overbilling tie to the
balance sheet.
Some contractors combine their schedules of completed and uncompleted contracts. Some contractors
also include an extra column on their contract schedules to indicate accounts receivable by job.
For reasons of confidentiality, some contractors may choose not to include these three schedules as
supplementary information. Instead, this information is provided directly to the surety or banker outside
of the general-purpose financial statements. The CPA is providing assurance in audit and review
engagements even if the schedules are not included. The contract schedules are the basis for income
recognition under the percentage-of-completion method, and, therefore, must be audited and reviewed to
permit an unqualified opinion on the basic financial statements. Keep in mind that these schedules are
the basis for income recognition under the percentage-of-completion method. Even if they are not
included with the basic financial statements, you must still audit them to permit an unqualified opinion.
Backlog is another disclosure that is frequently provided by contractors. This disclosure is encouraged,
but not required. As a practical matter, the failure or inability to provide this information will raise a red
flag for many financial statement users. Backlog is usually a significant off-balance sheet risk and, as
such, should be disclosed. The example financial statements in the audit and accounting guide provide
an example backlog disclosure.
Backlog information should be presented only if a reasonably dependable determination of total revenue
and a reasonably dependable estimate of total cost under the contracts can be made.
Backlog information can derive from either signed contracts or from letters of intent. The audit and
accounting guidance for backlog is summarized in exhibit 7-3.
Exhibit 7-3 Disclosure and auditor’s responsibilities for backlog information
Disclosure Auditor’s Audit

Source requirements requirements test work
Signed contracts Disclosure Within the scope of Evaluate existence,

whose cancellation is encouraged. an auditor’s completeness, and
not expected. responsibilities. accuracy of
information.
Letters of intent. May be included Letters of intent not Auditor may obtain
within the backlog normally within the evidence to support
disclosure. scope of an audit of a existence,
If included, should be contractor’s financial completeness, and
separated from statement. accuracy of
backlog on signed information.
contracts.
FASB Accounting Standards Codification® (ASC) 275, Risks and Uncertainties, requires entities to include
financial statement disclosures about the nature of their operations and the use of estimates in the preparation
of financial statements. In practice, complying with these requirements has been relatively straightforward.
However, FASB ASC 275 also requires that, if specified criteria are met, the financial statements should include
disclosures about certain significant estimates and current vulnerability due to certain concentrations.
In practice, it sometimes can be difficult to determine when the criteria that require these additional
disclosures have been met. FASB ASC 275-10-55-15 gives examples of items that may be based on
estimates that meet the criteria; that is, they are particularly sensitive to change in the near term.
Examples of similar estimates that may be included in the financial statements of a contractor include
Construction project estimates of progress toward completion, and

Estimates of gross profit or loss accrual on construction projects.
Examples of concentrations that may meet the criteria that require disclosure include
Revenue from a particular type of construction activity,

Sources of building materials,
Construction labor subject to collective bargaining agreements, and
Construction activities limited to a particular geographic area.
Evaluating a contractor’s ability to continue as a going concern
Learning objective: Recall the key objectives when evaluating a contractor’s ability
to continue as a going concern.
In August 2014, FASB issued ASU No. 2014-15, Presentation of Financial Statements—Going Concern
(Subtopic 205-40) Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, to
address the lack of guidance in GAAP about management’s responsibility to evaluate whether there is
substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote
disclosures.
AU-C section 570, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern,
addresses the auditor's responsibilities in the audit of financial statements relating to the entity's ability
to continue as a going concern and the implications for the auditor's report.
The auditor’s objectives are as follows:
To obtain sufficient appropriate audit evidence regarding, and to conclude on, the appropriateness of
management's use of the going concern basis of accounting, when relevant, in the preparation of the
financial statements
To conclude, based on the audit evidence obtained, whether substantial doubt about the entity’s
ability to continue as a going concern for a reasonable period to time exists
To evaluate the possible financial statement effects, including the adequacy of disclosure regarding
the entity's ability to continue as a going concern for a reasonable period of time
To report in accordance with AU-C section 570
To evaluate a contractor’s ability to continue as a going concern, you look to many of the same indicators
you would for any other business, for example, profitability, cash flow from operations, and the ability to
meet debt payments.
Additionally, here is a good analytical review procedure that is unique for construction contractors. This
procedure involves the following steps:
1. Estimate the fixed overhead (SG&A) the contractor will have to cover. Determine the amount of pretax
income the contractor needs. The sum of these two is the gross profit from jobs the contractor will
need to generate in the coming year.
2. Estimate the gross profit remaining on the jobs in progress.
Note: In making this estimate, use historical gross profit percentages on completed contracts.
3. Is the gross profit remaining on jobs in progress enough to cover the gross profit needed that was
determined in step 1? If not, how much gross profit is needed from new work?
4. Using historical gross profit percentages, estimate how much volume the contractor will have to do
to make the required gross profit. Given the contractor’s past history, does this volume level seem
reasonable?
To walk through this analytical procedure, use the example financial statements for Percentage
Completion Contractors, Inc., included as appendix H in the Audit and Accounting Guide Construction
Contractors, also included in chapter 3 of this course.
Step 1: Estimate future gross profit needs
Future gross profit needs are the sum of fixed overhead and income before taxes. In 20X1 the example
company had $3,315,136 of SG&A expense. For the purposes of this example, assume that the
contractor anticipates an increase of these expenses, and in the next year they are expected to increase
to $4.1m.
Income before taxes for the last two years has averaged about $1,800,665. Say that this is an acceptable
income level necessary to maintain the business, the surety relationships, and so on.
Estimated future overhead $4,100

Required income before taxes 1,800
Gross profit required next year $5,900
Step 2: Estimate gross profit remaining on uncompleted contracts

The key to this step is to use the historical gross profit percentage earned on completed contracts. This
will flush out any tendency the contractor might have to overestimate expected gross profit while the
contract is in progress. Use the Schedule of Completed Contracts supplementary schedule:
Gross profit on completed contracts $ 8,645

Revenues from completed contracts ÷ $20,526
Historical gross profit percentage 42.1%
Next, assume that the contracts in progress will end up at the same historical gross profit percentage.
From this amount, subtract the amount of gross profit recognized to date to estimate the gross profit
remaining. Use the contracts in progress supplementary schedule:
Total contract revenues $19,000
Historical gross profit percentage × 42.1%
Estimated gross profit 7,999
Gross profit recognized from inception (2,808)
Estimated gross profit remaining $10,807
Step 3: Compare gross profit remaining to gross profit required
In this step, you determine how much gross profit is required from new work, based on the estimates
made in steps 1 and 2.
Gross profit required next year (step 1) $5,900

Estimated gross profit remaining (step 2) 10,807
Gross profit required from new work N/A
In this case, the contractor is projected to generate sufficient profit from the jobs ongoing. However, to
show an example to completion, let us assume that the amount of gross profit required from new work is
actually $3,000.
Step 4: Can the contractor generate the required new work?

Based on our assumption that the contractor needs to generate $3,000 in gross profit from new work to
cover its overhead and generate a reasonable profit, how much volume is required to generate that gross
profit?
Again, use historical gross profit rates to make that estimate.
Gross profit required from new work $3,000

Historical gross profit percentage ÷ 42.1%
Estimated volume $7,126
The contractor had volume of $18m in 20X1. For the upcoming year he has about $4m remaining on
contracts in progress at year-end. Add to this the $3m required from new work, and the total of $7m
seems well within the contractor’s capabilities. Looking at the backlog footnote, it appears that with over
$4m in signed contracts (and another $5m entered into after year-end) the contractor should have no
problem meeting the $3m required from new work.

This analytical review procedure gives you an indication of a contractor’s financial strength
and future operations. Use it on prospective clients as part of the client acceptance
procedures. Be cautious of contractors who look as if they might have problems.
The following flowchart summarizes the steps an auditor should take to evaluate a contractor’s ability to
continue as a going concern.
Exhibit 7-4 Evaluating a contractor as a going concern
Estimate gross profit Use historical gross

remaining on profit percentage
Sum of fixed
costs and income
before taxes
Yes
Required gross Does g.p. from w-i-p
profit for next year cover required g.p.?
No
Difference is required gross

profit from new work
Use historical gross
profit percentage Estimate required volume
from new work
Yes
Is estimated
Look at history,
volume likely?
existing backlog
No
May be a problem Looks good!
Knowledge check
4. To evaluate a contractor’s ability to continue as a going concern, you look to many of the same
indicators you would for any other business—for example, profitability, cash flow from operations,
and the ability to meet debt payments. Which is not one of the steps to evaluate a contractor’s ability
to continue as a going concern?
a. Estimate gross profit on remaining uncompleted contracts.
b. Estimate future gross profits needs.
c. Assess the likelihood of the contractor generating required new work.
d. Recalculate the gross profit on completed contracts.
Case study 7-1 Evaluating a contractor’s ability to continue as a going concern
1. Return to the analytical procedure used to assess going concerns outlined in the
preceding topic area “Evaluating a Contractor’s Ability to Continue as a Going Concern.”
Assume the following facts for ABC Contracting, Inc.:
Total contract revenues, 2015 $23,500
Historical contact revenues
2012 17,500
2013 19,800
2014 17,250
Historical gross profit percentage 6%
Gross profit recognized from inception 1,686
Estimated future overhead $1,100
Required income before taxes 850
What is the estimated gross profit remaining on uncompleted contracts? Why is this a
negative amount?
What is the gross profit required from new work?
Given the historical gross profit percentage of 6%, what is the required volume? Does this
seem likely?
Summary
This chapter focused on other audit areas that are unique for construction contractors. There are special
dangers of fraud in the construction industry. The accrual for workers’ compensation insurance can be
tricky and complex. The consequences of under-accrual can be severe, so this might be a high-risk area.
Pay special attention to retrospective insurance policies.
Some of the financial statement disclosure items for a contractor require special consideration, for
example, the backlog note and the supplementary schedules.
Finally, this chapter provided you with an analytical procedure to help assess the contractor’s ability to
continue as a going concern. You might also want to use this procedure during the client acceptance process.
Construction Contractors Glossary
Back charges – Billings for work performed or costs incurred by one party that, in accordance
with the agreement, should have been performed or incurred by the party to whom billed.
Owners bill back charges to general contractors, and general contractors bill back charges to
subcontractors. Examples of back charges include charges for cleanup work and charges for a
subcontractor’s use of a general contractor’s equipment.
Backlog – The amount of revenue that a contractor expects to be realized from work to be
performed on uncompleted contracts, including new contractual agreements on which work has
not begun.
Bid – A formal offer by a contractor, in accordance with specifications for a project, to do all or a
phase of the work at a certain price in accordance with the terms and conditions stated in the
offer.
Bid bond – A bond issued by a surety on behalf of a contractor that provides assurance to the
recipient of the contractor’s bid that, if the bid is accepted, the contractor will execute a contract
and provide a performance bond. Under the bond, the surety is obligated to pay the recipient of
the bid the difference between the contractor’s bid and the bid of the next lowest responsible
bidder if the bid is accepted and the contractor fails to execute a contract or to provide a
performance bond.
Bid security – Funds or a bid bond submitted with a bid as a guarantee to the recipient of the
bid that the contractor, if awarded the contract, will execute the contract in accordance with the
bidding requirements and the contract documents.
Bid shopping – A practice by which contractors, both before and after their bids are submitted,
attempt to obtain prices from potential subcontractors and material suppliers that are lower
than the contractors’ original estimates on which their bids are based, or, after a contract is
awarded, seek to induce subcontractors to reduce the subcontract price included in the bid.
Bidding requirements – The procedures and conditions for the submission of bids. The
requirements are included in documents such as the notice to bidders, advertisement for bids,
instructions to bidders, invitations to bid, and sample bid forms.
Bonding capacity – The total dollar value of construction bonds that a surety will underwrite for
a contractor, based on the surety’s predetermination of the overall volume of work that the
contractor can handle.
Bonding company – A company authorized to issue bid bonds, performance bonds, labor and
materials bonds, or other types of surety bonds.
Bonus clause – A provision in a construction contract that provides for payments to the
contractor in excess of the basic contract price as a reward for meeting or exceeding various
© 2020 Association of International Certified Professional Accountants. All rights reserved. Glossary 1
contract stipulations, such as the contract completion date or the capacity, quality, or cost of the
project.
Broker – A party that obtains and accepts responsibility as a general contractor for the overall
performance of a contract but enters into subcontracts with others for the performance of
virtually all construction work required under the contract.
Builders’ risk insurance – Insurance coverage on a construction project during construction,
including extended coverage that may be added for the contractor’s protection or required by
the contract for the customer’s protection.
Building codes – The regulations of governmental bodies specifying the construction standards
that buildings in a jurisdiction must meet.
Building permit – An official document issued by a governing body for the construction of a
specified project in accordance with drawings and specifications approved by the governing
body.
Change orders – Modifications of an original contract that effectively change the provisions of
the contract without adding new provisions. They include changes in specifications or design,
method or manner of performance, facilities, equipment, materials, site, and period for
completion of work.
Claims – Amounts in excess of the agreed contract price that a contractor seeks to collect from
customers or others for customer-caused delays, errors in specifications and designs,
unapproved change orders, or other causes of unanticipated costs.
Completed and accepted – A procedure relating to the time for closing jobs for tax purposes
under the completed-contract method of accounting that allows closing a job when construction
is physically completed and the customer has formally accepted the project as defined in the
contract.
Completion bond – A document providing assurance to the customer and the financial
institution that the contractor will complete the work under the contract and that funds will be
provided for the completion.
Construction loan – Interim financing for the development and construction of real property.
Construction management contractor – A party who enters into an agency contract with the
owner of a construction project to supervise and coordinate the construction activity on the
project, including negotiating contracts with others for all the construction work.
Contract bond – An approved form of security executed by a contractor and a surety for the
execution of the contract and all supplemental agreements, including the payment of all debts
relating to the construction of the project.
Contract cost breakdown – An itemized schedule prepared by a contractor after the receipt of a
contract showing in detail the elements and phases of the project and the cost of each element
and phase.
Contract item (pay item) – An element of work, specifically described in a contract, for which
the contract provides either a unit or lump-sum price.
Contract overrun (under run) – The amount by which the original contract price, as adjusted by
change orders, differs from the total cost of a project at completion.
Contract payment bond – The security furnished by the contractor to guarantee payment for
labor and materials obtained in the performance of the contract. (See Payment (labor and
materials) bond.)
Contract performance bond – The security furnished by the contractor to guarantee the
completion of the work on a project in accordance with the terms of the contract. (See
Performance bond.)
Critical path method (C.P.M.) – A network scheduling method that shows the sequences and
interdependencies of activities. The critical path is the sequence of activities that shows the
shortest time path for completion of the project.
Draw – The amount of progress billings on a contract that is currently available to a contractor
under a contract with a fixed payment schedule.
Escalation clause – A contract provision that provides for adjustments of the price of specific
items as conditions change (e.g., a provision that requires wage rates to be determined on the
basis of wage levels established in agreements with labor unions).
Estimate (bid function) – The amount of labor, materials, and other costs that a contractor
anticipates for a project, as summarized in the contractor’s bid proposal for the project.
Estimated cost to complete – The anticipated additional cost of materials, labor, and other
items required to complete a project at a scheduled time.
Extras (customer’s extras) – Additional work, not included in the original plan, requested of a
contractor that will be billed separately and will not alter the original contract amount.
Final acceptance – The customer’s acceptance of the project from the contractor on
certification by an architect or engineer that the project is completed in accordance with
contract requirements. The customer confirms final acceptance by making final payment under
the contract unless the time for making the final payment is otherwise stipulated.
Final inspection – The final review of the project by an architect or engineer before issuance of
the final certificate for payment.
Front-end loading – A procedure under which progress billings are accelerated in relation to
costs incurred by assigning higher values to contract portions that will be completed in the early
stages of a contract than to those portions that will be completed in the later stages so that
cash receipts from the project during the early stages will be higher than they otherwise
would be.
General contractor – A contractor who enters into a contract with the owner of a project for the
construction of the project and who takes full responsibility for its completion, although the
contractor may enter into subcontracts with others for the performance of specific parts or
phases of the project.
Incentives – (See Bonus clause and Penalty clause.)
Joint venture – An entity owned, operated, and jointly controlled by a small group of participants
as a separate and specific business or project for the mutual benefit of the participants,
including arrangements for pooling equipment, bonding, financing, and sharing skills (such as
engineering, design, and construction).
Letter agreement (letter of agreement) – A letter stating the terms of an agreement between
addressor and addressee, usually prepared for signature by the addressee as indication of
acceptance of those terms as legally binding.
Letter of intent – A letter signifying an intention to enter into a formal agreement and usually
setting forth the general terms of such an agreement.
Lien – An encumbrance that usually makes real or personal property the security for payment of
a debt or discharge of an obligation.
Liquidated damages – Construction contract clauses obligating the contractor to pay specified
daily amounts to the project owner as compensation for damages suffered by the owner
because of the contractor’s failure to complete the work within a stated time.
Loss contract – A contract on which the estimated cost to complete exceeds the contract price.
Maintenance bond – A document, given by the contractor to the owner, guaranteeing to rectify
defects in workmanship or materials for a specified time following completion of the project.
A one-year bond is normally included in the performance bond.
Mechanic’s lien – A lien on real property, created by statute in many areas, in favor of persons
supplying labor or materials for a building or structure, for the value of labor or materials
supplied by them. In some jurisdictions, a mechanic’s lien also exists for the value of
professional services. Clear title to the property cannot be obtained until the claim for the labor,
materials, or professional services is settled. Timely filing is essential to support the
encumbrance, and prescribed filing dates vary by jurisdiction.
Negotiated contract – A contract for construction developed through negotiation of plans,
specifications, terms, and conditions without competitive bidding.
Payment (labor and materials) bond – A bond executed by a contractor to protect suppliers of
labor, materials, and supplies to a construction project.
Penalty clause – A provision in a construction contract that provides for a reduction in the
amount otherwise payable under a contract to a contractor as a penalty for failure to meet
targets or schedules specified in the contract or for failure of the project to meet contract
specifications.
Performance bond – A bond issued by a surety and executed by a contractor to provide
protection against the contractor’s failure to perform a contract in accordance with its terms.
Prequalification – The written approval of an agency seeking bids on a project that authorizes a
contractor to submit a bid on the project in circumstances in which bidders are required to meet
certain standards.
Prime contract – A contract between an owner of a project and a contractor for the completion
of all or a portion of a project under which the contractor takes full responsibility for the
completion of the work.
Prime contractor – A contractor who enters into a contract with the owner of the project for the
completion of all or a portion of the project and who takes full responsibility for its completion.
(See General contractor.)
Progress (advance) billings – Amounts billed, in accordance with the provisions of a contract,
on the basis of progress to date under the contract.
Punch list – A list made near the completion of work indicating items to be furnished or work to
be performed by the contractor or subcontractor in order to complete the work as specified in
the contract.
Quantity takeoffs – An itemized list of the quantities of materials and labor required for a
project, with each item priced and extended, which is used in preparing a bid on the project.
Retentions – Amounts withheld from progress billings until final and satisfactory project
completion.
Specifications (specs) – A written description of the materials and workmanship required on a
project (as shown by related working drawings), including standard and special provisions
related to the quantities and qualities of materials to be furnished under the contract.
Stop order – A formal notification to a contractor to discontinue some or all work on a project
for reasons such as safety violations, defective materials or workmanship, or cancellation of the
contract.
Subcontract – A contract between the prime contractor and another contractor or supplier to
perform specified work or to supply specified materials in accordance with plans and
specifications for the project.
Subcontractor bond – A bond executed by a subcontractor and given to the prime contractor to
assure the subcontractor’s performance on the subcontract, including the payment for all labor
and materials required for the subcontract.
Substantial completion – The point at which the major work on a contract is completed and
only insignificant costs and potential risks remain. Revenue from a contract is recognized under
the completed-contract method when the contract is substantially completed.
Surety – (See Bonding company.)
Turnkey project – A project for which a contractor undertakes under contract to deliver a fully
operational and tested facility before being entitled to payment.
Unbalanced bid – A bid proposal under which the contract price is allocated to phases or items
in the contract on a basis other than that of cost plus overhead and profit for each bid item or
phase. A common practice is to front-end load a bid proposal to obtain working capital to
finance the project. Another form of unbalanced bid on unit-price contracts assigns higher
profits to types of work for which the quantities are most likely to be increased during the
performance of the contract.
Waiver of lien – An instrument by which the holder of a mechanic’s or materials lien against
property formally relinquishes that right.
Warranty (maintenance) period – A specified period, which is normally specified in the contract,
after the completion and acceptance of a project, during which a contractor is required to
provide maintenance construction, and for which the contractor is required to post a
maintenance bond.
Index
A G
analytical procedures ...........................................5-9 Going Concern ............................................ 7-1, 7-13,
analytical procedures risk ....................................5-9 7-15, 7-16, 7-17
audit .........................................................................5-9
Audit Risk ..................................................... 1-7, 1-11,
I
5-1, 5-8, 6-2, 6-5, 7-6
Impairment...........................................................2-30
B
J
Bid ................................................................... 1-2, 1-7,
1-8, 1-9, 1-18, 4-3, 4-6, 4-19, 5-16, 5-19, 6-9, Job Borrow ................................................ 1-19, 4-11,
6-10 4-13, 4-14, 4-17, 4-20, 5-8
Bidding ................................................ 5-16, 5-20, 6-9 Job-Site Accounting ............................................. 6-9
Job-Site Visits .............................................. 6-11, 7-8
C
L
Capacity ....................................................... 1-13, 4-1,
4-4, 4-5, 4-6, 4-10, 4-15, 4-19 Leases ............................................... 2-29, 2-30, 2-31
Capital ........................................................1-12, 1-18,
1-19, 1-21, 3-1, 3-2, 3-4, 4-5, 4-6, 4-7, 4-10, 4-11, M
4-14, 4-15, 4-17, 4-18, 4-20, 5-6, 5-22
Character .............................................. 4-5, 4-6, 4-10 Materiality............................................. 4-1, 6-10, 7-2
Claims .................................................................. 4-19 measurement ......................................................2-31
Completed-Contract Method ........................... 2-22 misstatement ........................................................ 5-9
Cost Estimates ............................................ 1-7, 1-14
O
D Overbilling ............................................................ 4-12,
Disclosures .......................................................... 2-31 5-6, 5-22, 7-11
E P
effective date ...................................................... 2-31 Percentage-of-Completion Method ................ 2-22,
Estimating...................................................... 1-7, 1-8, 7-11
1-10, 1-11, 1-13, 4-15, 4-19, 5-5, 5-8, 5-14, 5-22, Professional Skepticism ....................... 5-2, 7-2, 7-4
5-23, 6-8, 6-9, 6-10
R
F Reasonable Assurance .............................. 6-10, 7-2
FASB ........................................................... 2-29, 2-31 Revenue Recognition ........................................... 3-2
Fraud .............................................................. 5-2, 5-5, Risk Assessment ....................................... 5-9, 5-14,
7-1, 7-2, 7-4, 7-5, 7-6, 7-7, 7-8, 7-9, 7-17 5-21, 7-4, 7-5
risk of material misstatement ............................ 5-9
© 2020 Association of International Certified Professional Accountants. All rights reserved. Index-1
S U
SAS No. 99..............................................................7-2 Unapproved Change Orders .................... 4-16, 5-7,
Surety ........................................................... 1-2, 1-12, 5-22, 6-3, 6-5, 6-6, 6-13
1-17, 1-18, 1-20, 1-26, 3-1, 3-4, 3-7, 3-10, 3-34, Underbilling ................................................. 4-15, 5-6,
3-35, 4-1, 4-2, 4-3, 4-4, 4-5, 4-6, 4-7, 4-8, 4-9, 5-16, 5-18, 5-19, 7-11
4-10, 4-11, 4-13, 4-14, 4-15, 4-16, 4-17, 4-18,
4-19, 4-20, 4-25, 5-5, 5-20, 5-21, 5-22, 6-12,
W
7-11, 7-14
Surety Bond ...............................................1-17, 1-18, Warning Signs .....................................................4-19
1-20, 4-1, 4-2, 4-3, 4-4, 4-25
© 2020 Association of International Certified Professional Accountants. All rights reserved. Index-2
CONSTRUCTION CONTRACTORS:
ACCOUNTING AND AUDITING
BY JAMES WIEDEMANN, CPA; AND

ROBERT MERCADO, CPA, CCIFP
Solutions
CAAT GS-0420-0A Course Code: 733864

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Solutions
Chapter 1
Practice question solutions
1. Different types of contractors have different types of risks and different service needs. External
factors in the economy, such as interest rate fluctuations, will have a different impact on different
types of contractors.
2. Estimate costs and prepare a bid. In this phase the contractor reviews the plans and –estimates what
it will cost to perform the work. After considering a number of factors (see exhibit 1-2), the contractor
will use that estimated cost as a basis for determining mark-up and preparing a bid.
Enter into a contract. Most construction work is governed by a contract that describes the work to be
performed, the billing arrangements, and any penalty or incentive clauses, among other things.
Mobilize labor, equipment, and materials. Construction projects are performed at a site away from the
contractor’s office. Mobilization and setting up the jobsite are the first steps toward starting the job.
Manage the project. A project manager is needed to manage the day-to-day operations at the jobsite.
3. The accounting and auditing of a contractor is centered on the accounting and auditing of individual
projects. The contracts describe the requirements of each project. The type of contract affects the
risks associated with the project and the design of the contractor’s internal control structure.
4. The contractor has a contractual obligation to the owner. The surety guarantees the work will be
performed under the terms of the contract. In the event the contractor fails to perform, the surety
pays the owner for damages. The contractor is then liable to reimburse the surety. Thus, a surety
bond is more like a credit guarantee than an insurance policy.
Most projects require the contractor to obtain a performance bond from the surety. Without a surety
the contractor is severely limited as to the type of work that can be performed. The surety is also one
of the primary users of the contractor’s financial statements.
5. A contractor’s greatest financing need is working capital. Front-end loading is done with the objective
of generating the working capital necessary to finance the job.
© 2020 Association of International Certified Professional Accountants. All rights reserved. Solutions 1
Knowledge check solutions
1.
a. Correct. Subcontractors are second level contractors who enter into a contract with the general
contractor to perform a specific part or phase of a project. Specialties may include electrical,
plumbing, concrete, mechanical, carpentry, drywall, and flooring.
b. Incorrect. A construction manager enters into an agency contract with the owner to supervise
and coordinate the construction activity on the project, including negotiating contracts with
others for the work.
c. Incorrect. An architect will typically be working for the owner of the contract. The architect has
designed the project and will review the progress of the work as it is done. The architect will have
control over the progressiveness of the billings.
d. Incorrect. General (or prime) contractor who enters into a contract with the owner and who takes
full responsibility for its completion. Can engage subcontractors to perform specific parts or
phases of projects. Specialties might include housing, schools, hospitals, office buildings,
manufacturing plants, or warehouses.
2.
a. Incorrect. Preparing cost estimates and bids would be equivalent to a CPA reviewing the
potential client’s financial statements, operations, books and records, and then estimating what
it will cost to perform the audit.
b. Correct. A CPA and an audit client sign an engagement letter; a contractor and an owner sign a
contract.
c. Incorrect. Starting the job would be the equivalent to the CPA mobilizing the staff and getting
them to the client’s office along with their supplies and any necessary equipment, such as
computers.
d. Incorrect. Project management would be the equivalent to the CPA monitoring the quality of onsite
and day-to-day management which is a key in determining the success or failure of a given job.
3.
a. Incorrect. Fixed-price contracts provide for a single price for the total amount of work to be
performed on a project. The price is usually not subject to any adjustment by reason of the cost
experience of the contractor or the performance under the contract.
b. Incorrect. A cost plus contract provides for reimbursement of allowable or otherwise defined
costs incurred plus a fee that represents profit. Terms of the contract should include terms
specifying reimbursable costs, overhead recovery percentages and fees, which may be fixed or
based on a percentage of total costs.
c. Correct. Unit-price contracts provide that a contractor will perform a specific project at a fixed
price per unit of output. A unit-price contract is essentially a fixed-price contract with the only
variable being units of work performed.
d. Incorrect. Similar to a cost-plus contract, these contracts generally provide for payments to the
contractor on the basis of direct labor hours at fixed hourly rates and cost of materials or other
specified costs.
4.
a. Correct. The surety plays a critical role in the construction industry. Primarily used by general
contractors, but at times subcontractors may be required to produce a bond to the general
contractor or the owner of the project. Further, a surety ensures the timely completion of the
project in accordance with the terms of the contract.
b. Incorrect. The estimator is a critical player within the construction company and has a great
impact in the performance of the contractor for whom he works; however, the question looked at
the industry as a whole.
c. Incorrect. The project manager is a critical player within the construction company and has a
great impact in the performance of the contractor for whom he works. The project manager
manages the day-to-day administration and interaction with the client.
d. Incorrect. The general contractor is a critical player, a representative of the construction
company. The general (or prime) contractor who enters into a contract with the owner and who
takes full responsibility for its completion.
5.
a. Incorrect. A surety bond is a contract between three parties: the contractor, the surety company,
and the project owner. The project owner is a party.
b. Correct. The materials supplier works with the contractor to provide materials for the project but
is not a party to the surety bond.
c. Incorrect. A surety bond is a contract between three parties: the contractor, the surety and the
project owner. The contractor is a party.
d. Incorrect. A surety bond is a contract between three parties: the contractor, the surety and the
project owner. The surety is a party.
Chapter 2
Exercise solutions
Exercise 2-1
Because the elevators must be installed by Acme, the customer does not benefit when the parts of
the elevators are made and delivered. There is only one performance obligation on this contract.
The customer does benefit once the elevator parts are made and delivered since anyone can perform
the installation. In this case, the contract has two performance obligations.
1.
a. Correct. All revenue recognition content will reside in FASB ASC 606, Revenue from Contracts
with Customers, and other revenue guidance will be superseded.
b. Incorrect. Revenue recognition content will only reside in FASB ASC 606, Revenue from Contracts
with Customers.
c. Incorrect. Revenue recognition content only reside in both FASB ASC 606, Revenue from
Contracts with Customers, and other revenue guidance in particular industry areas of FASB ASC
900 will be superseded.
d. Incorrect. Revenue recognition content will only reside in both FASB ASC 606, Revenue from
Contracts with Customers. Guidance in FASB ASC 605, Revenue Recognition, and, in particular,
industry areas of FASB ASC 900 will be superseded.
2.
a. Incorrect. Revenue is recognized when each separate performance obligation is satisfied.
b. Incorrect. A performance obligation is satisfied when the promised good or service is transferred
to the customer.
c. Incorrect. A good or service is assumed to be transferred when the customer obtains control of
that good or service.
d. Correct. Revenue may be recognized at a point in time or over time.
3.
a. Incorrect. The entity may review the prices charged by other contractors in the industry to
determine the price a customer would be willing to pay for the separate performance obligation.
b. Incorrect. The entity may calculate what it would be willing to charge for the separate
performance obligation by determining their costs and adding an appropriate margin of profit.
c. Correct. The fair value method is not a recognized method to allocate the transaction price to the
performance obligations in a contract.
d. Incorrect. The entity may assign the remaining contract price to a separate performance
obligation when the remaining performance obligations have observable standalone prices.
4.
a. Incorrect. This is a correct statement. Revenue is recognized when each separate performance
obligation is satisfied.
b. Incorrect. This is a correct statement. A performance obligation is satisfied when the promised
good or service is transferred to the customer.
c. Incorrect. This is a correct statement. A good or service is assumed to be transferred when the
customer obtains control of that good or service.
d. Correct. This statement is incorrect. Revenue may be recognized over time or at a point in time.
5.
a. Incorrect. All leases will be recorded on the balance sheet, as a right-of-use asset and a lease
liability.
b. Incorrect. Leases under FASB ASU No. 2016-02 will be classified as either a finance lease or an
operating lease.
c. Correct. This statement is false. Financing leases and operating leases have similar balance
sheet impacts however, have different income statement and cash flow impacts.
d. Incorrect. Financing leases and operating leases have different income statement and cash flow
impacts.
6.
a. Incorrect. Transfer of ownership to the lessee is one of the criteria.
b. Incorrect. It must be reasonably certain that the purchase option will be exercised, not simply
that a bargain purchase option exists.
c. Incorrect. The 25% test is no longer one of the criteria. Now is should be shown that the lease
term is for a major portion of the asset’s economic life.
d. Correct. One of the criteria is that the present value of lease payments and residual value
exceeds substantially all of the fair value of the underlying asset.
1. The following is the five-step process to recognize revenue:

a. Identify the contract(s) with a customer.
b. Identify the performance obligations in the contract.
c. Determine the transaction price.
d. Allocate the transaction price to the performance obligations in the contract.
e. Recognize revenue when (or as) the entity satisfies a performance obligation.
2.
a. Expected value method – Should be used when there is a range of possibilities using a weighted
average approach.
b. Most likely method – Should be used when an entity can select from a single most likely amount
with in a range.
3.
a. Entity incurs significant inefficiencies in the performance on a contract.
b. Cost determined to be a result of significant inefficiencies in performance would not be included
in the estimated cost of the project and the cost incurred to date.
c. Costs would be expenses as incurred.
d. Costs would affect the current year financial statements dollar for dollar of the significant
inefficiencies.
4. Non-distinct uninstalled materials that control has not transferred to the customer should be included
in inventory on the balance sheet.
5. A few items that make up cost that do not transfer value to a customer would include mobilization.
Surety cost and administrative costs to setup a project. These costs should be capitalized on the
balance sheet and amortized over the life of the project they relate to, based on the percent complete
of the project.
Chapter 3
1.
a. Correct. The importance of the income statement is to summarize the details provided by the
standard schedules included in the supplementary information. The detail included in the income
statement may vary based upon the amount of detail provided by the supplementary schedules.
b. Incorrect. The income statement is a key financial statement for any industry; however, sureties
in the construction industry will focus more on the balance sheet and the job schedules that roll
up into the income statement.
c. Incorrect. Terminology is more prevalent on the balance sheet.
d. Incorrect. The income statement formatting is not significantly different than other industries.
2.
a. Correct. Receivables are withheld to insure the contractor completes work.
b. Incorrect. Prepaid insurance is a common asset found in most financial statements.
c. Incorrect. Machinery and equipment is a common asset in most financial statements.
d. Incorrect. Cash is a common asset across all industries.
3.
a. Incorrect. Accounts payable is a common liability for all industries.
b. Incorrect. Accrued liabilities is a common liability for all industries.
c. Correct. Due to the integral aspects of IRC Section 460, the construction contractor has unique
deferred income tax components.
d. Incorrect. Long-term debt is a common liability for most industries.
Chapter 4
Case study solution: XYZ contractors

1. Working capital for surety credit purposes would be determined as follows:
Current assets – GAAP-basis 2,394,520

Subtract:
Accounts receivable, stockholder (19,500)
50 percent of inventory, not at jobsite (69,865)
Prepaid expenses (46,770)
Add:
Cash surrender value of life insurance 38,850
Current assets, surety credit purposes 2,297,235
Current liabilities – GAAP-basis (1,833,590)
Working capital, surety credit purposes $ 463,645
The largest single job a surety is likely to bond is normally 10 times working capital for surety
purposes, in this case $4,636,450.
2. The surety will most likely request an accounts receivable aging, broken down by job and
summarized according to completed jobs, jobs in progress, and retentions.
3. The surety will want to know about the transaction that gave rise to the note receivable, the terms of
the note, and the creditworthiness of the payor.
4. Jobs 1 and 5 both show profit fade. Job 1 started out with an original estimated profit of $300,000. At
balance sheet date the estimated gross profit is $270,000, a decline of 10%. Job 5 began with an
estimated profit of $150,000, which by the balance sheet date had faded 17% to $125,000.
The surety will probably want an explanation as to what caused the profit fade in these two jobs. It
will also want to be assured that the contractor has made a good estimate of costs to complete, and
the jobs will not continue to show decreasing profit.
5. Jobs 1 and 2 indicate large underbillings. The surety will most likely want to know what caused these
underbillings. It wants to know whether these jobs will truly become billable and, if so, will the bills be
collected.
6. Job 5 indicates job borrow, since the overbillings exceed gross profit by $67,500. The surety will
compare this amount to the cash balances at balance sheet date. Job borrow that is significant
compared to cash balances is a red flag for sureties that will require explanation.
1.
a. Incorrect. A surety is normally a party to a traditional bonding arrangement and provides the
guarantee.
b. Incorrect. The owner is normally a party to a traditional bonding arrangement and is the recipient
of the guarantee.
c. Incorrect. surety contractor is normally a party to a traditional bonding arrangement and is the
party the guarantee is on behalf of.
d. Correct. The surety, owner and contractor are the usual parties in a traditional bonding
arrangement. The local government is not a part of the arrangement.
2.
a. Incorrect. Character is the “C” where the surety evaluates if the contractor’s past record indicates
good character and responsibility in fulfilling its obligations and contracts. The capacity “C”
evaluates if the construction firm has the skills, experience, knowledge, and equipment
necessary to perform the work.
b. Incorrect. Capital is the “C” that addresses the financial strength of the construction company.
c. Correct. The surety addresses the contractor’s capacity by determining if the construction firm
has the skills, experience, knowledge, and equipment necessary to perform the work.
d. Incorrect. CPAs have a reputation with the users of financial statements. The CPA is one of the
additional “C”s noted by the author.
3.
a. Correct. The first user of the financial statements is generally not the surety but a bonding agent
who represents several sureties. Different sureties have different underwriting criteria and
preferences. The bonding agent will perform the first analysis of the contractor and determine
which surety is best suited for that particular contractor.
b. Incorrect. The point at which a lawyer performs an analysis of the contractor is after a disaster
occurs. The contractor more than likely has gone into default.
c. Incorrect. The first user of the financial statements is generally a bonding agent who represents
several sureties. The bonding agent will perform the first analysis of the contractor and
determine which surety is best suited for that particular contractor.
d. Incorrect. CPAs, while potentially having a relationship with a surety, are not the first user of the
4.
a. Correct. A surety will analyze job borrow and compare that amount to cash on hand. Job borrow
that is too high in relation to cash on hand is a red flag for most sureties.
b. Incorrect. Job borrow is based upon billings on the contract and if the contractor has liquid
assets or a reasonable level of overbillings. Inventory on hand should not be included in the costs
incurred to date and should be shown outside of the contract schedule. Therefore, the inventory
has no relationship to job borrow.
c. Incorrect. A job borrow that is low in relation to cash on hand is preferred by most sureties. A
reasonable level of overbillings is usually a positive factor.
d. Incorrect. A surety will be concerned with job borrow and will analyze job borrow and compare
that amount to cash on hand.
5.
a. Correct. A surety will be concerned about the amount of idle equipment a contract has.
Underused equipment may be impaired under FASB ASC 360.
b. Incorrect. A surety would be significantly less concerned about the appearance of the equipment
as opposed to the amount of equipment.
c. Incorrect. Although a surety may be concerned that a contractor does not have the equipment on
hand, they are more likely concerned about the contractor lacking the ability to have the proper
equipment to complete the job.
d. Incorrect. The surety would not be overly concerned with the price the contractor paid for the
equipment.
Chapter 5
Exercise solution
Exercise 5-1
The total gross profit for each contractor is the same. The gross profit percentage is the same (10%)
for both completed projects and those in progress. The difference is that 95% of contractor A’s profit
is from completed projects. The results are certain; they are not subject to the estimating process
because the job is finished. On the other hand, 95% of Contractor B’s gross profits are from projects
that are still in progress and therefore still at risk.

1. “Take-off” skill is the ability to accurately estimate the cost of a job from the plans and specifications.
“Production” skill is the ability to accurately estimate cost to complete once the job is in progress.
Both skills are equally important.
2. The Job History Report is generated from a database of all the contractor’s recent jobs. This
database may be maintained by the auditor. A job history report can help you assess the contractor’s
estimating skills because it tracks the gross profit results of recent jobs through all stages of
completion. This type of report is also useful in spotting trends. For example, it can be sorted by
owner, type of project or project manager to help identify areas where the contractor has been
successful or not successful in the past.
3. Phase one involves scanning the client’s unadjusted contracts in progress schedule as of the balance
sheet date. Contracts that are relatively large or those that are between 25% and 90% complete are
considered to be possible high-risk contracts.
Phase two involves making inquiries of the client about those projects identified as possibly high-risk.
The answers to these questions (summarized in exhibit 5-1) will further refine your assessment of
those projects that are potentially high-risk.
Phase three involves further analysis of interim financial results and other information to identify
high-risk projects.
1.
a. Correct. Profit from change orders can only be recognized if the amount can be reasonably
estimated.
b. Incorrect. Cost incurred to date is a hard number based upon invoices received from vendors, payroll,
material costs and subcontract costs. There are no estimates in the costs incurred to date.
c. Incorrect. The amount billed to the customer is usually certain and not an estimate. Profit from
change orders can only be recognized if the amount can be reasonably estimated.
d. Incorrect. Revenue on a completed contract should be a known amount not subject to
estimation.
2.
a. Correct. Major swings in profits on individual jobs indicate a high audit risk, particularly where
jobs experience profit fade. A pervasive pattern of profit fade or late recognition of losses is a red
flag to watch out for.
b. Incorrect. Losses are not avoided with the late recognition of losses. Late recognition is also
known as profit fade. Major swings in profits on individual jobs indicate a high audit risk,
particularly where jobs experience profit fade.
c. Incorrect. Job borrow is when the contractor has more in overbillings than gross profit in the
jobs; therefore, the contractor has borrowed from the job. Job borrow does not deal with losses
on contracts.
d. Incorrect. Major swings in profits on individual jobs indicate a high audit risk, particularly where
jobs experience profit fade. A pervasive pattern of profit gain is a concern regarding the ability of
the contractor to estimate.
3.
a. Incorrect. Short term jobs are usually not risky from a timing and scheduling perspective. Jobs
that stretch out over a long time frame are generally riskier.
b. Incorrect. Timing and scheduling is less risky on a cost plus contract because you bill when
costs are incurred. The contractor is not subject to down time.
c. Correct. Jobs that stretch out over a long time frame are generally riskier. The auditor should
also ask the client about jobs that are behind schedule or that are under an accelerated schedule
with the owner pushing to get the work done. These are generally riskier, too.
d. Incorrect. Tight bid results commonly indicate a lesser risk.
Chapter 6
Exercise solutions
1.
Substantive tests and their relationship to the financial statements

Contract equation components
Original Estimated
Read the contract
Review unapproved change
orders
Jobsite visit

1. The audit of a contractor is an audit of individual contracts. Auditors read the contracts to understand
the contractor’s projects. A reading of the contracts gathers evidence about the reported contract
amount. When reading the contracts look for
 Guarantees,
 Penalties and incentives, and
 Cancellation and postponement provisions.
Focus your efforts on the high-risk contracts.
2. There are three objectives of a job-site visit:
 To gain an understanding of the contractor’s method of operation

 To obtain an understanding of those elements of the internal control structure maintained at the
jobsites
 To obtain information relating to job status and problems (if any) that may be useful in other
phases of the audit, such as the audit of estimated costs to complete
1.
a. Correct. The confirmation the auditor sends to the owner will ask for information about a number
of items, including the original contract price.
b. Incorrect. The auditor should stay away from confirming the percentage complete while auditing
a contractor. The person completing the confirmation may not understand or go to the effort of
having the project manager confirming the percent complete.
c. Incorrect. The costs to date would not be information that the owner of the project would
normally have to confirm. The owner could confirm total billings and payments but not the costs
to date.
d. Incorrect. Confirmations are not a feasible way to gain audit evidence over change orders that
are unapproved.
2.
a. Correct. The confirmation of billings and payments provides a great deal of evidence about the
existence assertion.
b. Incorrect. Confirming the billings may allude to the completion assertion, but the amount of
billings and payments does not determine how complete the contract may be. A contract could
possibly be completely billed out and only be 50% complete if significant problems exist.
c. Incorrect. The confirmation of billings and payments provides very little evidence about the
valuation assertion, but a great deal of evidence about the existence assertion. The owner can
acknowledge the existence of unpaid bills, but the confirmation says nothing about whether it
has the ability and intent to pay those bills.
d. Incorrect. Confirming the billing and payments does not help the auditor achieve comfort over
presentation.
3.
a. Incorrect. When using sampling, it is important that the sample be representative of the
population. This involves considering all of the different types of costs within those contracts.
Samples that consider only materials and not labor are not representative samples.
b. Correct. When using sampling, it is important that the sample considers all of the different types
of costs within those contracts. Samples should consider both material and labor for the sample
to be representative.
c. Incorrect. When using sampling, it is important that the sample be representative of the
Samples that consider only subcontractors and not labor or materials are not representative
samples.
d. Incorrect. When using sampling, it is important that the sample be representative of the
Samples that consider only subcontractors labor are not representative samples.
4.
a. Correct. When auditing the estimated cost to complete, the auditor should focus on certain key
factors and assumptions that are significant to the estimate, sensitive to variation, deviations
from historical patterns, or subjective and susceptible to misstatement or bias.
b. Incorrect. It is important to have knowledge of the experience of the estimator. Understanding
the controls in place over the bidding of the estimator is an essential audit step. However, by
utilizing the historical job schedules maintained by job, contract type, by estimator, and so on, will
reveal great historical patterns to further testing.
c. Incorrect. The presence of subcontractors as part of the cost to complete is not a key factor or
assumption. The auditor should focus on certain key factors and assumptions that are
significant to the estimate, sensitive to variation, deviations from historical patterns, or subjective
and susceptible to misstatement or bias when auditing the estimated cost to complete.
d. Incorrect. Timing of the estimates made by the contractor is not a key factor or assumption.
Chapter 7
Case study solution
1. The estimated gross profit remaining is actually a loss:
Total contract revenues $23,500
Historical gross profit percentage × 6%
Estimated gross profit 1,410
Gross profit recognized from inception 1,686
Estimated loss remaining $ (276)
The contractor may have been overly optimistic in estimating profit on uncompleted projects.
Historically, the client has only earned 6% on its jobs. If historical experience holds up, the contractor will
have to recognize losses when these jobs finish up.
The gross profit from new work is as follows:
Gross profit required next year $1,950
Plus estimated loss remaining 276
Gross profit required from new work $2,226
The estimated volume using a historical gross profit percentage of 6% is as follows:
Gross profit required from new work $ 2,226
Historical gross profit percentage ÷6%
Estimated volume $ 37,100
In this case, the estimated volume required is $37 million, which is nearly as much as the client has done
in the past two years combined. Some follow-up is required, for example, discussing the situation with
the contractor and possibly refining the estimate. There may be a valid reason that the uncompleted
contracts will end up at something higher than the 6% gross profit historically realized; or the analytical
procedure may have highlighted some real problems.
1.
a. Correct. A contractor deliberately failing to record a legitimate payable would be a form of
fraudulent financial reporting.
b. Incorrect. Corruption can happen at any size company; however, the misappropriation of assets
is more common at the small company level.
c. Incorrect. Misappropriation of assets is more commonly referred to as the theft of company
assets. This situation is a form of fraudulent financial reporting.
d. Incorrect. Embezzlement can often happen; however, the misappropriation of assets is more
common at the small company level.
2.
a. Correct. Auditors of small companies usually are more concerned with frauds relating to
misappropriation of assets, rather than fraudulent financial reporting.
b. Incorrect. Corruption results from a contractor receiving or paying kickbacks on jobs and tends
to be more of illegal acts that occur at the top of the company.
c. Incorrect. Most construction contractors are small privately-owned businesses with fraud risk
factors that are different from those in large publicly owned enterprises. Auditors of small
companies usually are more concerned with frauds relating to misappropriation of assets, rather
than fraudulent financial reporting.
d. Incorrect. Embezzlement of cash can often happen; however, the small amount of cash on hand
at a jobsite usually mitigates the issue.
3.
a. Incorrect. Workers’ compensation insurance can be an important part of a contractor’s business. The
bookkeeping for this type of insurance can be troublesome for less sophisticated clients or those
with a poor accounting staff. The premiums for workers’ compensation are based on payroll.
b. Incorrect. Workers’ compensation will have an impact on subcontractors that do not have
insurance coverage. It is critical that a contractor receive a certificate of insurance from
subcontractors that work on the contracts. If not, the contractor could face premium
adjustments for uninsured and undocumented subcontractors.
c. Correct. The premiums for workers’ compensation are based on payroll. Labor dollars are
multiplied by a rate to determine the total premium.
d. Incorrect. The premiums for workers’ compensation are based on payroll. Revenue is not a
consideration in the calculation.
4.
a. Incorrect. Estimating gross profit on remaining uncompleted contracts is the second step in
evaluating a contractor’s ability to continue as a going concern.
b. Incorrect. Estimating the future gross profits needs is the first step in evaluating a contractor’s
ability to continue as a going concern.
c. Incorrect. Assessing the likelihood of the contractor generating required new work is the fourth
step in evaluating a contractor’s ability to continue as a going concern.
d. Correct. Recalculating the gross profit on completed contracts is not one of the steps to evaluate
a contractor’s ability to continue as a going concern.
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CONSTRUCTION CONTRACTORS:

ACCOUNTING AND AUDITING

BY JAMES WIEDEMANN, CPA; AND

ISBN 978-1-119-74650-8 (paper)

Appendix 5A: Job History Reports Chapter 5, A-1

Nature of the Construction Industry

Learning objective: Recall the predominant types of construction contractors and

Construction industry overview

The construction industry is different from other industries in many ways.

Contributes a significant portion of the U.S. economy

Exhibit 1-1 Types of contractors

Contractor type Nature and scope of work

Design-build Also known as a “turnkey” contractor, they specialize in heavy

Contractor type Nature and scope of work

Subcontractors A second-level contractor who enters into a contract with the

Players in the industry

Exhibit 1-2 Players in the industry

Other contractors What type of subcontractors do we use? What is the capacity of

CPA What is their reputation in the construction industry? Does the

Players within the contractor-client relationship

Estimate the cost of the job and preparing a bid

Prepare cost estimates and bids

Preparing cost estimates and bids

the quantities and price of materials;

Entering into the contract

Starting the job

a. Preparing cost estimates and bids.

Exhibit 1-5 Characteristics unique to contractors

What makes a contractor

What makes a contractor

As a means of generating working Cash flow is a key element to managing a construction

Unique joint ventures

There are four basic types of contracts:

Exhibit 1-6 Four basic types of contract

Contract type Considerations

Unit-price Provide that a contractor will perform a specific project

Cost-type or cost-plus Provide for reimbursement of allowable or otherwise

Time and materials Similar to a cost-plus contract, these contracts

Exhibit 1-7 Types of contracts, risk, and internal control consideration

Contract type Risks Control considerations

Fixed-price or Cost overruns Emphasis on cost accumulation for each

Unit-price Unforeseen conditions Emphasis on unit costs

Poor or incomplete cost Reports should help management identify

Contract type Risks Control considerations

Cost-type or Time and cost overruns Emphasis on documentation of costs and

Time and Job management failures Emphasis on accumulation of time and

Construction projects take a long time

Change orders and other contract modifications

Exhibit 1-8 The contractor/surety/owner relationship

Managing cash flow

Completion of certain stages of the work

Example 1-2 Job borrow

Cash outflow: $(15) $(20) $(20) $(20) $(25) $(100)

Cash inflow: 25 30 30 20 15 120

Net cash flow $10 $10 $10 $0 $(10) $ 20

How the economic environment affects contractors

The state of the industry

Exercise 1-1 Group discussion

Resources for the construction industry

2. Describe the steps in the construction process.

Significant Changes – Contract Accounting

FASB ASU No. 2014-09

FASB ASU No. 2014-09 is now effective for all entities.

Core concept of ASU No. 2014-09

Construction Accounting & Auditing

Construction Accounting & Auditing