This blog is a continuation of our previous article, “Construction Accounting Challenges: FRS 115 Compliance Lessons from a Singapore Contractor’s First Audit”. If you haven’t read it yet, we recommend starting there to understand the foundational challenges SMEs face in construction accounting.

This article dives deeper into what auditors focus on during contract audits and explains why these procedures are essential for compliance with Financial Reporting Standard 115 [FRS 115]. This involves scrutinizing contracts, revenue recognition processes, and cost tracking systems—areas that are particularly complex under the cost-to-cost method [input method].

The blog also explains why auditors perform specific procedures, helping bookkeepers better prepare for audits.

Table of Contents

1. Correct Revenue Recognition Method
2. Accuracy of Cost Estimation
3. Changes in Project Scope and Variation Orders
4. Budget Preparation and Monitoring
5. Allocation of Overheads
6. Revenue Recognition vs. Progress Billing

Audit Procedure Table

Audit Focus Area	What Auditors Look For	Why It Matters	How You Can Help
Revenue Recognition Method	Use of cost-to-cost method under FRS 115 instead of the completed contract method.	Ensures revenue is recognized progressively and accurately reflects financial performance.	Align revenue recognition policies with FRS 115 standards. Educate management on progressive revenue recognition.
Accuracy of Cost Estimation	Reasonableness and accuracy of total budgeted costs. Regular updates to reflect changes in scope, material prices, or labor rates.	Accurate cost estimation prevents misstated revenue and profit recognition.	Regularly update cost estimates. Document revisions to provide a clear audit trail.
Changes in Project Scope and Variation Orders	Proper documentation and accounting for variation orders. Treatment as part of original contract or new contract under FRS 115.	Ensures financial statements reflect accurate revenue and cost figures.	Maintain detailed records of all variation orders, including approval and impact on costs and revenues.
Budget Preparation and Monitoring	Initial preparation of detailed budgets. Regular updates and inclusion of all relevant costs (e.g., overheads).	Forms the foundation for accurate cost tracking, revenue recognition, and financial reporting.	Prepare detailed budgets at project initiation. Regularly review and update budgets.
Allocation of Overheads	Inclusion of all overheads (e.g., office expenses, project management salaries) in total budgeted costs. Consistent allocation methods.	Incorrect allocation can distort project profitability and delay revenue recognition.	Use consistent overhead allocation methods. Ensure all overheads are captured in budgeted costs.
Revenue vs. Progress Billing	Alignment of revenue recognized using cost-to-cost method with progress billings. Proper accounting for discrepancies (e.g., overbilling or underbilling).	Prevents overstated or understated revenue, ensuring accurate financial reporting and compliance with FRS 115.	Maintain accurate records of unbilled revenue and overbillings. Reconcile differences regularly.
Loss-Making Contracts	Early identification of contracts expected to incur losses. Prompt recognition of such losses in financial statements.	Ensures financial performance is not misstated due to delayed recognition of losses.	Update cost estimates promptly. Communicate potential losses to management. Document assumptions clearly.

Additional Focus Areas for Consideration

Audit Focus Area	What Auditors Look For	Why It Matters	How You Can Help
Fraud Risk in Cost Tracking	Review for manipulation of revenue recognition through overstated costs or understated total costs.	Weak controls create opportunities for fraud, potentially distorting financial performance.	Implement strong internal controls. Regularly review cost tracking practices for anomalies.
Contract Terms and Performance Obligations	Assessment of contract terms to identify performance obligations and enforceable payment rights.	Proper identification ensures correct revenue recognition timing and compliance with FRS 115.	Review contracts thoroughly. Clearly define performance obligations and enforceable rights in contracts.
Unbilled Revenue and Overbilling	Proper disclosure of unbilled revenue and overbilling in financial statements. Reconciliation with contract terms.	Ensures financial transparency and compliance with accounting standards.	Maintain detailed records of unbilled revenue. Reconcile amounts regularly with contract milestones.
Subcontractor Costs and Payments	Verification of subcontractor costs and payment terms. Reconciliation with project budgets.	Ensures subcontractor costs are accurately reflected and do not distort project costs or profitability.	Track subcontractor payments and costs closely. Reconcile subcontractor invoices with project budgets.

1. Correct Revenue Recognition Method

What Auditors Look For:

• Whether the company has adopted the correct revenue recognition method under FRS 115.
• Whether the cost-to-cost method [input method] or output metho is applied, rather than the completed contract method, for long-term contracts where performance obligations are delivered progressively.

Why This Matters: If a company incorrectly uses the completed contract method, it defers revenue until a project is fully completed, which misrepresents financial performance by delaying revenue recognition and inflating profits in later periods.

Example: SC Builders Pte Ltd undertakes a 2-year project worth SGD 2 million. They use the completed contract method, recognizing revenue only in Year 2 when the project is completed.

Impact	Correct Approach
In Year 1, the company shows a loss of SGD 500,000 (due to unrecognized revenue); while in Year 2, it reports an inflated profit of SGD 1.5 million.	Under the cost-to-cost method, revenue is recognized progressively. For example, if costs incurred in Year 1 amount to SGD 1 million, and total estimated costs are SGD 2 million, the percentage of completion is 50%, and SGD 1 million of revenue should be recognized in Year 1.

Challenges Faced

Incomplete or outdated accounting policies: Companies often lack clear policies for revenue recognition, leading to non-compliance with FRS.

Management resistance: Bookkeepers and management may not fully understand why the completed contract method is inappropriate, and they may resist adjustments suggested during audits.

2. Accuracy of Cost Estimation

What Auditors Look For:

• Whether the total budgeted costs for the project are accurate and reasonable.
• Whether cost estimates are updated regularly to reflect changes in scope, material prices, or labor rates.

Why It Matters: The cost-to-cost method calculates the percentage of completion by dividing costs incurred to date by total estimated costs (Costs incurred to date ÷ Total estimated costs). If estimates are inaccurate, revenue and profit recognition will be misstated.

Example: SC Builders Pte Ltd undertakes a 2-year project worth SGD 2 million. The company underestimated the total costs for the project by SGD 300,000 due to rising material prices. The initial budget was SGD 1.5 million, but actual costs totalled SGD 1.8 million and SGD 1.2 million cost incurred to date.

Impact

Correct Approach

Overstated Percentage of Completion: The company calculated the percentage of completion as 80% (SGD 1.2 million ÷ SGD 1.5 million) instead of the correct 66.7%(SGD 1.2 million ÷ SGD 1.8 million). Premature Revenue Recognition: The company recognized SGD 1.2 million in revenue instead of the correct amount of SGD 1 million, overstating revenue by SGD 200,000.

Update Cost Estimates Regularly: Continuously revise cost estimates as new data becomes available (e.g., changes in material prices or labor costs). Recalculate Percentage of Completion: Use the updated total estimated costs to calculate the correct percentage of completion: Percentage of Completion = Costs Incurred ÷ Total Estimated Costs In this case: SGD 1.2 million ÷ SGD 1.8 million =66.7%. Recognize Revenue Accurately: Revenue should be recognized based on the updated percentage of completion: Revenue Recognized = Percentage of Completion × Total Contract Value In this case: 66.7% × SGD 2 million =SGD 1 million. Maintain Detailed Documentation: Keep records of all cost adjustments and updates to ensure accurate revenue recognition and provide a clear audit trail.

Challenge faced: Identifying Loss-Making Contracts

Auditors must identify contracts that are expected to incur losses and ensure that these losses are recognized promptly in accordance with accounting standards.

Implications of Loss-Making Projects on Financial Statements

Loss-making projects represent one of the most critical areas in construction accounting and financial reporting under FRS 115. These projects occur when the total estimated costs exceed the total contract revenue, resulting in an expected loss. FRS 115 mandates that such losses be recognized immediately in full in the financial statements, regardless of the percentage of project completion.

Failure to identify and recognize loss-making projects promptly can lead to misstated financial performance, incorrect profit margins, and potential compliance issues during audits.

3. Changes in Project Scope and Variation Orders

What Auditors Look For:

• Whether variation orders (e.g., changes in scope or contract terms) are properly accounted for under FRS 115.
• Whether variation orders are treated as part of the original contract or as a separate contract.

Why It Matters: Variation orders often result in increased costs and revenue. If these changes are not properly incorporated into the budget and revenue recognition process, financial statements may understate or overstate revenue and profits.

Example: A client of SC Builders Pte Ltd requested a variation order to add an additional floor to a building project, increasing the contract value by SGD 500,000 and adding SGD 300,000 in costs.

Impact	Correct Approach
The company failed to update the budget and revenue calculations to reflect the variation order, leading to understated revenue and costs on financial statements.	Update the total contract value and total estimated costs to include the variation, then recalculate the percentage of completion and adjust revenue recognition accordingly. [see the possible impact on above example].

Challenges Faced:

• Poor documentation: Variation orders may not be properly documented or approved, making it difficult for auditors to verify their validity.
• Impact on Revenue Recognition: Changes in scope can significantly alter the percentage of completion and revenue recognized, requiring auditors to reassess the entire contract.
• Judgment in Classification: Auditors must determine whether changes should be treated as part of the existing contract or as a new contract under FRS 115. 

4. Budget Preparation and Monitoring

What Auditors Look For:

• Whether proper budgets are prepared at the start of the project and updated regularly.
• Whether the budget includes all relevant costs, including overheads.

Example: SC Builders Pte Ltd did not prepare detailed budgets for its projects. Instead, it relied on rough estimates, leading to significant variances between budgeted and actual costs.

Impact	Correct Approach
Profitability: The cost overrun reduced gross profit margins, potentially turning the project into a loss-making one. Revenue Recognition: The inaccurate budget affected the percentage-of-completion calculation, leading to misstated revenue. Cash Flow: The additional costs strained cash reserves, requiring unplanned funds to complete the project.	Prepare Detailed Budgets: Create comprehensive budgets at the start of the project, including all costs (direct, indirect, and overheads). Regular Updates: Continuously update budgets to reflect changes in material prices, labor costs, and scope adjustments. Implement Monitoring Systems: Use robust internal controls to track costs and identify variances early.

Challenges Faced

• Weak Controls: Many organizations lack robust systems for tracking costs and managing contracts, increasing the risk of errors or fraud.
• Complex Processes: The cost-to-cost method involves multiple processes (e.g., cost allocation, budget revisions, and revenue recognition), each of which requires strong controls.
• Fraud Risk: Weak controls can create opportunities for management to manipulate revenue recognition by overstating costs incurred or underestimating total costs.

5. Allocation of Overheads

What Auditors Look For: Whether overheads (e.g., project management salaries, office expenses) are included in the total budgeted costs and allocated appropriately.

Why It Matters: Excluding overheads understates the percentage of completion, delaying revenue recognition. Inconsistent allocation methods can distort project profitability.

Example: SC Builders Pte Ltd excluded overhead costs (e.g., project management salaries and office expenses) from its project budgets. These costs totalled SGD 200,000 annually.

Impact

Correct Approach

Understated Percentage of Completion: Excluding overheads caused the percentage of completion to be understated, delaying revenue recognition. Distorted Financial Reporting: The exclusion of overheads led to incomplete and inaccurate cost tracking, misrepresenting project profitability.

Adopt a logical and consistent method to allocate overheads across all projects. Ensure that all overhead costs, such as project management salaries and office expenses, are included in the total budgeted costs. Continuously monitor and document overhead allocation to ensure accuracy and compliance with FRS 115. Train staff on the importance of including overheads in project budgets to avoid delayed revenue recognition and errors in financial reporting.

Challenges faced:

• Subjectivity: Overhead allocation methods (e.g., activity-based costing or pre-determined rates) involve significant judgment, making it difficult for auditors to assess their appropriateness.
• Inconsistencies: Inconsistent application of overhead allocation methods across projects can lead to errors in cost tracking and revenue recognition.
• Impact on Profitability: Errors in overhead allocation can distort project profitability and financial performance.

6. Revenue Recognition vs. Progress Billing [will discuss contract assets / liabilities in next blog]

What Auditors Look For:

• Whether revenue recognized under the cost-to-cost method aligns with progress billings.
• Whether discrepancies (e.g., overbilling or underbilling) are properly accounted for.

Why This Matters: Progress billings and revenue recognition often don’t align, as billings are tied to contractual milestones, while revenue is based on the percentage of completion.

Example: SC Builders Pte Ltd recognized revenue based on progress billings rather than the percentage of completion. For a project worth SGD 1 million, the company billed 60% of the contract value (SGD 600,000) in Year 1 but had only completed 40% of the work.

Impact

Correct Approach

Overstated Revenue: The company recognized SGD 600,000 in revenue, but based on the percentage of completion, revenue should have been SGD 400,000. This resulted in an overstatement of SGD 200,000 in year 1. Overstated revenue could lead to potential audit findings and non-compliance with FRS.

Revenue should be recognized based on the percentage of work completed, not the amount billed. Recalculate Percentage of Completion: Revenue must be calculated as follows: Percentage of Completion= Costs Incurred ÷ Total Estimated Costs. Revenue Recognized= Percentage of Completion × Total Contract Value. Correct Calculation: 40% × SGD 1 million = SGD 400,000(not SGD 600,000). Reconcile Progress Billings: Ensure that progress billings are reconciled with revenue recognized under the percentage-of-completion method. Any discrepancies (e.g., unbilled revenue or overbilling) must be appropriately disclosed in the financial statements.

Challenge faced:

• Timing Differences: Revenue recognition is based on the percentage of completion, while progress billings are based on contractual milestones. These two figures often do not align.
• Unbilled Revenue and Overbilling: Auditors must ensure that unbilled revenue and overbilling are properly accounted for in the financial statements.
• Complexity of Reconciliation: Reconciling these figures requires detailed analysis and a thorough understanding of the contract terms.

Conclusion

This guide highlights key areas auditors focus on when auditing contracts under the cost-to-cost method. Bookkeepers play a vital role in ensuring compliance with FRS 115, maintaining accurate records, and addressing potential issues proactively. By understanding these focus areas, bookkeepers can enhance financial reporting accuracy, streamline audits, and minimize last-minute adjustments.

In our next blog, we will discuss what FRS 115 requires for revenue recognition and why traditional methods, such as the completed contract method, no longer meet compliance standards for long-term contracts.

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Disclaimer

The information provided in this blog is for general informational purposes only and does not constitute professional advice. While we strive to ensure accuracy, the content here may not address specific circumstances or recent regulatory changes. For tailored advice and guidance, we recommend consulting your audit or accounting professional.

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