An auditor is evaluating a client's revenue recognition for long-term construction contracts. The client uses the percentage-of-completion method. To test the accuracy of revenue recognized, the auditor should primarily focus on which of the following?
- ATracing progress billings to the general ledger and cash receipts.
- BPerforming analytical procedures on the overall contract profitability.
- CConfirming contract terms and conditions with the customer.
- DExamining engineering estimates of completion and comparing them to actual costs incurred.
Show answer & explanationAnswer & explanation
Correct answer: D. Examining engineering estimates of completion and comparing them to actual costs incurred.
Under the percentage-of-completion method, revenue is recognized based on the progress towards completion of the contract, which is often measured by cost-to-cost. Therefore, examining engineering estimates of completion and comparing them to actual costs incurred is crucial for assessing the accuracy of the percentage-of-completion calculation and, consequently, the revenue recognized.
Why the other options are wrong
- A. Tracing progress billings to the general ledger and cash receipts primarily tests completeness and existence of cash and receivables, not the accuracy of revenue recognized based on completion.
- B. Analytical procedures on overall profitability can identify potential misstatements but are a high-level review; more detailed testing is needed for accuracy of revenue recognized by percentage-of-completion.
- C. Confirming contract terms is important for existence, rights, and sometimes revenue recognition criteria, but not directly for the accuracy of the percentage-of-completion calculation.
Auditing Percentage-of-Completion Revenue
When auditing revenue recognized using the percentage-of-completion method, the auditor must verify the accuracy of the estimated percentage of completion and the total estimated contract costs and revenues. This method relies heavily on management's estimates and cost accounting data.
- Revenue is recognized based on progress towards completion, often measured by costs incurred to date divided by total estimated costs.
- Key audit risks include inaccurate cost estimates, fraudulent reporting of progress, and improper recognition of revenue.
- Auditors examine cost records, engineering reports, and management's estimation processes.
Memory trick: For %-of-completion, CHECK the ESTIMATES of COSTS to ensure ACCURATE revenue.