The authoritative document with reference to long term contracts is IAS 11: Construction Contracts and IAS 18: Revenue Recognition, and ISA 600 Reliance on the Work of otherV Auditor

IAS 11 Construction Contracts

A construction contract is a contract specifically negotiated for the construction of an asset or combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.

Such contracts often span more than one accounting period. This gives rise to a number of accounting and therefore auditing issues.

The auditor must examine a schedule of all the construction contracts that the enterprise is currently engaged in, and reach an opinion as to whether attributable profits and losses have been satisfactorily calculated. Furthermore the presentation of contracts in the financial statements must accord with the IAS. Although the auditor should have a working knowledge to be able to deal with many aspects of long term contracts, it may be necessary to contact external experts to seek assurance in specialist areas where the auditor has insufficient expertise himself. For example, determination of the stage of completion of a building in the course of construction.

Whilst the audit process will require verification work (e.g. examination of costing records, verification and allocation of materials, labour and overhead costs to supporting documentation, etc) the more sensitive audit issues are disclosure, recognition and measurement of profits and revenues and valuation matters.

• Contract revenue should be recognized in the accounting period in which the work is performed
• Contract costs should be recognized against the revenue to which they relate
• Expected excesses of total contract cost should be recognized immediately
• Costs which relate to future activity (contract work in progress) should be carried forward as an asset (provided they are recoverable)
• Irrecoverable amounts receivable from recognized contract revenue should be recognized as an expense.

Long-term contracts are those for which the estimated lives is longer than one accounting period. Periodic accounts artificially break down the life of company into specific periods and the need for the matching concepts to be followed makes it necessary to ascribe a proportion of the profit on a contract for each of the accounting periods that it covers. This is in conflict with the prudence concept which would require that costs be accumulated until the completion of the contract, or can be reasonably foreseen through estimates to complete. Generally, when there is conflict between the prudence concept and the matching concept the prudence concept prevails.

(a) Cost and Authorization

The cost incurred to date on a contract can be checked by routine vouching to invoices and suppliers statements.

(b) Valuation

The basis of valuation should be cost plus attributable profit less foreseeable losses and progress payments both received and receivable. It becomes necessary to determine the appropriate amount of profit that can be taken on a contract. This appropriate attributable profits is arrived as follows:

Total costs to Date x Anticipated x Allowance = Attributable

Total anticipated total profit for prudence profit

costs on the contract

This formula derives the total profit that can be taken on the contract to date. This profit after it had been worked out must be reduced by any profits taken in previous years to determine the attributable profit for the year. For the auditor, the following points must be noted:

1) Total costs are derived from the current estimated total costs for the contract

2) Total profits is derived from the contract price less total estimated costs

3) Prudence must be taken into account when determining the amount of attributable profits. By prudence in this case we mean you must take into account the likelihood of the profit figure being achieved and this is a function of

a) Time: that is the longer a contract has to run the more difficult it is to determine the profit.

b) Consider the company's ability to estimate its costs accurately.

c) Consider the nature of the contract: a fixed price contract is far more risky than one which allows costs escalation: thus a cost plus contract carries very little risk at all.

You will notice that this exercise is wholly dependant on the company estimating its future costs. This is where the auditor has to be extra careful because the directors can distort the accounts by using unrealistic estimates. Conventional, historic costs techniques are therefore inappropriate and alternative methods must be adopted. They may include:

1) Examination of the company's budgets and budgetary system. Are they a reliable basis for determining future costs or do the figures appear to be pure guess work.

2) Comparison of the costs to date on the contract with the original budget. If they relate reasonably, then it will give some confidence that the future costs are also reasonably stated.

3) Comparison of the results of previous contracts completed with the original budget to determine the company's ability at forecasting.

4) Perform detailed tests to substantiate the future costs by reference to technical data and reports from any independent personnel.

5) Review the progress of contracts in relation to any penalty clauses for late delivery. If the auditor is satisfied that the future costs are fairly stated, he should check the calculation of attributable profits, taking into account the issue of prudence on the basis of the points raised earlier on. If it becomes apparent that on completion of a contract a loss will be made, then such a loss should be charged against income in the year it is foreseen. If any profits have already been taken in the past years they should be written back along with the total loss.