Audit Considerations for Construction Companies

Why construction audits carry disproportionate risk

Construction companies concentrate estimation risk in fewer line items than most other industries. A manufacturer with €50M revenue might have 10,000 sales transactions. A construction company with the same revenue might have 15 contracts. Each contract contains a revenue recognition judgment, a provision assessment, and a work-in-progress valuation that all depend on a single underlying estimate: total expected contract costs. If one contract estimate is wrong, it can move the financial statements by a material amount on its own.

ISA 540.15 requires heightened scrutiny of accounting estimates with high estimation uncertainty. In construction, virtually every significant balance involves estimation. Revenue depends on estimated total contract costs. Provisions depend on estimated future losses. Work-in-progress depends on estimated stage of completion. The auditor cannot treat these as routine balances tested through standard vouching and reconciliation. ISA 540.17 requires the auditor to evaluate whether the methods used by management are appropriate and whether the data underlying the estimates is reliable. That evaluation is not a box-ticking exercise on a construction engagement. It requires an auditor who understands how construction projects actually work.

The other factor that distinguishes construction from most mid-tier industries is the multi-period nature of contracts. A single contract can span two to eight reporting periods. Errors in early-period estimates compound through subsequent periods because the percentage-of-completion calculation is cumulative. An overstatement of completion in year one becomes a larger overstatement in year two unless corrected. ISA 540.A125 references this specifically: the auditor should consider whether assumptions used in prior periods remain appropriate.

For non-Big 4 firms, construction clients are common but audit methodology often doesn’t reflect the industry-specific risks. The firm’s standard audit programme may not include procedures for testing cost-to-complete estimates or challenging surveyor reports. If your firm audits construction companies and you’re using a generic programme, the procedures below fill the gaps.

The five assertions that drive construction audit risk

Revenue recognition: accuracy and cut-off (IFRS 15.B14–B19)

IFRS 15.35(c) requires revenue recognition over time when the entity’s performance creates an asset with no alternative use and the entity has an enforceable right to payment for performance completed to date. Most construction contracts satisfy both conditions. Under IFRS 15.B14, measurement then uses either an input method (cost-to-cost) or an output method (surveys of work performed).

The accuracy assertion is where the risk sits. The input method divides costs incurred to date by estimated total contract costs. Both numbers are within management’s control. Costs incurred to date can be verified against supplier invoices and payroll records. Estimated total costs cannot. That estimate is the single largest judgment in the financial statements of a construction company. ISA 540.13(a) requires the auditor to obtain an understanding of how management makes this estimate, including the data and assumptions used.

Cut-off risk is equally significant. Costs incurred near year-end may be allocated to the wrong contract or the wrong period. Subcontractor invoices received after year-end but relating to pre-year-end work must be accrued. If they aren’t, both the cost base and the completion percentage are understated, which overstates the margin recognised in the current period.

Provisions: completeness and valuation (IAS 37 and IFRS 15)

Onerous contracts under IAS 37.66 require a provision when the unavoidable costs of meeting contractual obligations exceed the economic benefits expected. In construction, this means a contract where estimated total costs exceed the contract price. The completeness assertion matters because management may not identify onerous contracts until late in the project lifecycle. The valuation assertion matters because the provision depends on the same cost-to-complete estimate that drives revenue.

A contract can move from profitable to onerous between reporting periods based on a single cost revision. A materials price increase or a subcontractor delay requiring acceleration costs can flip a contract’s profitability within weeks. ISA 540.17 requires the auditor to evaluate whether management’s process identifies these changes on a timely basis.

Work-in-progress: existence and valuation (IAS 2 and IFRS 15)

Work-in-progress on a construction company’s balance sheet represents costs incurred on contracts that have not yet been billed. Under IFRS 15, this is a contract asset (IFRS 15.107). The existence assertion is tested by tracing WIP balances to underlying cost records. The valuation assertion requires confirming that WIP is carried at the lower of cost and net realisable value (IAS 2.9), where net realisable value depends on the expected contract outcome.

If a contract is profitable, WIP is recoverable. If the contract is onerous, WIP exceeds its net realisable value and must be written down. This links directly to the onerous contract assessment. The two are not independent tests. An auditor who tests WIP valuation without considering the contract profitability assessment has missed the connection that IAS 2.28 establishes between cost and NRV. In practice, test them together: obtain the contract profitability summary first, identify any contracts with margins below 3%, and then assess whether WIP on those contracts needs writing down before testing the WIP balances on profitable contracts.

Retentions: existence and recoverability

Retentions (amounts withheld by the customer pending completion of defect liability periods) are common in construction. They appear as receivables on the balance sheet but have different recoverability characteristics than standard trade receivables. The defect liability period can run 12 to 24 months after practical completion. During that period, the customer can offset rectification costs against the retention.

Auditing retentions requires testing existence (confirming the retention balance to the contract terms and the customer’s records) and recoverability (assessing whether the client is likely to incur rectification costs that would reduce the retention). For older retentions past their release date, the auditor should inquire why they haven’t been collected. An aged retention is either a collection issue or a disputed defect. Both have financial statement implications.

The retention balance can be material in aggregate even when individual retentions are small. A company with 18 contracts retaining 5% each can accumulate €3M or more in retention receivables. If the entity has a history of defect rectification costs on completed projects, the auditor should assess whether the retention balance includes an adequate allowance for expected rectification offsets. IFRS 9.5.5 applies to the extent that the retention represents a financial asset with credit risk.

Contract modifications: occurrence and classification (IFRS 15.18–21)

IFRS 15.18 defines a contract modification as a change approved by the parties to the contract. IFRS 15.20 requires the auditor to consider whether a modification creates a separate performance obligation (new scope at standalone selling price) or is accounted for as part of the existing contract. Construction companies routinely process variation orders and change requests. Each one is potentially a contract modification under IFRS 15.

The audit risk is in classification. If a variation order adds genuinely distinct goods or services at their standalone selling price, it is a separate contract (IFRS 15.20). If not, it modifies the existing contract and requires a cumulative catch-up adjustment (IFRS 15.21(a)). Getting this wrong either overstates or understates cumulative revenue.

Test a sample of variation orders for correct classification and confirm the accounting treatment matches.

How to audit cost-to-complete estimates

The cost-to-complete estimate is where most construction audit deficiencies originate. ISA 540.18 requires the auditor to perform one of two approaches: test management’s process for making the estimate, or develop an independent estimate as a point estimate or range.

Testing management’s process means evaluating the inputs and assumptions. For a construction contract, the inputs include committed subcontractor costs (verifiable to signed contracts), uncommitted costs still to be incurred (estimated by the project manager), materials costs (partially verifiable to purchase orders, partially estimated), and labour costs (estimated based on projected hours and rates). The committed costs are testable. The uncommitted costs are judgment. Focus the audit time on the uncommitted portion.

Start with the project budget. Every construction contract has one. Obtain the original budget, the latest revised budget, and the variance analysis between them. If the budget has been revised upward multiple times during the year, the entity’s cost estimation process is reactive rather than predictive. That pattern weakens your confidence in the current estimate.

The second procedure is testing the margin consistency across a portfolio of contracts. If a construction company has 20 active contracts, all showing estimated margins between 6% and 10%, but historically delivered margins between 2% and 8%, the current estimates are collectively optimistic. ISA 540.21 requires the auditor to evaluate indicators of possible management bias. Consistent margin estimates above the historical range are such an indicator. Plot the estimated margins on a chart against historical actuals. If the current estimates cluster at the top of the historical range, the visual alone tells the story.

Where the ISA 570 going concern calculator becomes relevant: a construction company with several contracts approaching onerous status, combined with tight working capital, may trigger going concern indicators under ISA 570.A2. The link between contract profitability and entity-level viability is direct in construction. A single contract turning onerous can eliminate the entity’s working capital buffer.

Worked example: Brouwer Bouw B.V.

Client profile: Brouwer Bouw B.V. is a Dutch mid-market construction company with €62M revenue, 18 active contracts, a workforce of 140 employees plus approximately 30 subcontractors. Year-end is 31 December. The largest contract (a logistics warehouse for Janssen Transport B.V.) represents €18M of total revenue across a 30-month construction period.

1. Select contracts for detailed testing

The 18 active contracts range from €0.5M to €18M. Performance materiality is €465K (€62M revenue x 0.75%). Select all contracts individually exceeding performance materiality for detailed testing. Result: 8 contracts selected, representing €52M (84% of revenue). The remaining 10 contracts are below materiality individually but are tested analytically as a portfolio.

2. Test the largest contract (Janssen Transport warehouse, €18M)

Obtain management’s cost-to-complete estimate. Total contract price: €18M. Estimated total costs: €16.2M. Costs incurred to date: €10.9M. Management’s percentage of completion: 67.3% (cost-to-cost method). Revenue recognised to date: €12.1M. Estimated margin: 10%.

Retrospective test: at the prior year-end, management estimated costs-to-complete of €8.4M on this contract. Actual costs incurred since that date: €5.2M. Remaining estimate now: €5.3M. Total implied costs since prior year-end: €10.5M versus original estimate of €8.4M. Variance: €2.1M (25% overrun against the prior estimate). This triggers additional inquiry.

3. Test subcontractor cost accruals at year-end

Obtain the subcontractor invoice log for the Janssen contract. Identify all subcontractor work performed in December for which invoices were received after year-end. Result: four subcontractors with €380K of work performed in December, invoiced in January. Confirm that €380K is accrued in the December financial statements. If not accrued, the cost base is understated by €380K, and the completion percentage drops from 67.3% to 65.0% (€10.52M / €16.2M). Revenue recognised would decrease by approximately €420K.

4. Assess the contract portfolio for onerous contract indicators

Review the estimated margin on all 18 contracts. Two contracts show estimated margins below 2%: a residential renovation (€1.8M contract, 1.1% margin) and a public infrastructure project (€4.2M contract, 0.8% margin). At these margins, a cost overrun of €20K on the renovation or €34K on the infrastructure project tips either into loss territory. Obtain management’s assessment of whether these contracts are onerous under IAS 37.66. If management has not performed the assessment, request it.

5. Test contract modification accounting on a sample

Brouwer processed 14 variation orders during the year. Select the 5 largest by value. For each, confirm the modification is approved by both parties (IFRS 15.18) and verify the accounting treatment matches the classification (separate contract under IFRS 15.20, or modification of existing contract under IFRS 15.21). Result: 4 of 5 correctly classified. One variation order (€280K scope addition on the Janssen contract) was treated as a separate contract but does not meet the “distinct” criterion under IFRS 15.27. Propose reclassification as a contract modification with cumulative catch-up.

Practical checklist for construction engagements

1. Retrospective review on cost-to-complete estimates. Perform this before testing current-year estimates. Compare prior-year estimates to actual costs incurred. Identify contracts where actual costs exceeded estimates by more than 10%. Document the analysis and the explanation for each variance. (ISA 540.A127)
2. Test subcontractor cost accruals. Obtain the invoice log for the two months following year-end. Identify all work performed before year-end but invoiced after. Confirm accruals are recorded. Quantify the revenue impact of any unrecorded accruals. (IFRS 15.B19)
3. Screen the entire contract portfolio for onerous contract indicators. Any contract with an estimated margin below 3% warrants a detailed assessment under IAS 37.66. Document management’s assessment and your evaluation of the key assumptions.
4. Test variation orders for correct classification. Sample variation orders under IFRS 15.18–21. Confirm that modifications treated as separate contracts meet the “distinct” and “standalone selling price” criteria in IFRS 15.20.
5. Verify measurement method consistency. Confirm the method of measuring progress (input or output) is applied consistently across similar contracts and across reporting periods. A switch from cost-to-cost to survey-based measurement without justification is an indicator of earnings management. (IFRS 15.B15)
6. Assess aged retentions. For retentions older than six months past the defect liability release date, inquire about the status and assess recoverability. Aged retentions that management cannot explain require a provision assessment.

Common mistakes regulators flag

• The FRC’s 2022–23 inspection report identified that auditors of construction companies frequently accepted management’s cost-to-complete estimates without performing the retrospective comparison required by ISA 540.A127. Without this comparison, the auditor has no basis to evaluate whether management’s estimation process produces reliable results.
• The AFM flagged in its 2023 thematic review that onerous contract assessments were incomplete or absent in construction audit files. IAS 37.66 requires a provision when unavoidable costs exceed expected economic benefits. Several files reviewed contained contracts with margins below 1% but no documented assessment of whether the contract was onerous.
• The PCAOB’s 2024 inspection observations noted that cut-off testing on construction engagements was frequently insufficient. Subcontractor costs incurred before year-end but invoiced after were not accrued, resulting in understated costs and overstated revenue in the current period.

Related content

Frequently asked questions

Further reading and source references

• IFRS 15, Revenue from Contracts with Customers: paragraphs B14–B19 on measuring progress, and paragraphs 18–21 on contract modifications.
• IAS 37, Provisions, Contingent Liabilities and Contingent Assets: paragraph 66 on onerous contracts.
• ISA 540 (Revised), Auditing Accounting Estimates and Related Disclosures: the framework for testing cost-to-complete estimates.
• IAS 2, Inventories: paragraph 9 on the lower of cost and NRV for work-in-progress.
• FRC Audit Quality Inspection Report 2022–23: findings on construction audit deficiencies.
• AFM 2023 Thematic Review: findings on onerous contract assessments in construction files.