Your client recognises €14M of revenue on a single contract using percentage-of-completion. The surveyor’s estimate of physical completion is 72%. The project manager’s cost-to-complete estimate implies 68%. Finance used the project manager’s number. That four-percentage-point gap is worth €560K, and it sits entirely within the judgment of one person inside the client’s organisation. Welcome to construction auditing.
Auditing a construction company requires the auditor to address industry-specific risks concentrated in revenue recognition under IFRS 15 (percentage-of-completion estimates), provision measurement under IAS 37 (onerous contracts and retention liabilities), asset valuation for work-in-progress under IAS 2 , and contract modification accounting under IFRS 15.18 –21, with particular attention to management’s cost-to-complete estimates that drive the majority of material balances on the financial statements.
Key Takeaways
- How to challenge cost-to-complete estimates under IFRS 15 .B14–B19 and what documentation a reviewer expects
- Where the highest-risk assertions sit on a construction company’s balance sheet and income statement
- How to test percentage-of-completion revenue recognition when physical completion and cost completion diverge
- What the AFM and FRC flag most frequently in construction audit files
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, a work-in-progress valuation, and a contract modification assessment 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. The work-in-progress balance, in turn, 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 mid-tier firms, construction clients are common but audit methodology often doesn’t reflect the industry-specific risks. We’ve seen firms just SALY the PY programme and roll it forward without adding any construction-specific procedures for cost-to-complete testing or surveyor challenge. That’s how files get flagged. 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 ). You test the existence assertion 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, the variance analysis between them, and any formal change-order documentation. 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. The ciferi analytical review tool structures this comparison with dual-threshold variance analysis and flags contracts where current-year margins deviate from the historical pattern. If the current estimates cluster at the top of the historical range, the visual alone tells the story.
Where the ciferi 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.
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.
Documentation note: Record the selection basis in WP E.1.1. List all 18 contracts with contract value, costs incurred to date, estimated total costs, percentage of completion, and cumulative revenue recognised. Flag the 8 selected for substantive testing.
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.
Documentation note: Record the retrospective comparison in WP E.2.3. Document the inquiry with the project manager regarding the €2.1M variance. If the variance is explained by approved variation orders, obtain and inspect the variation documentation. If unexplained, assess the impact on the current cost-to-complete estimate and consider whether an adjustment is required under ISA 540 .A131.
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.
Documentation note: Record the accrual test in WP E.3.1. For each subcontractor invoice tested, document the period of work, the invoice date, the accrual status, and the amount. Quantify the impact of any unrecorded accruals on both costs and revenue.
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.
Documentation note: Record the margin analysis for all 18 contracts in WP E.4.1. For the two contracts with margins below 2%, document management’s onerous contract assessment, the key assumptions, and your evaluation of whether a provision is required.
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.
Documentation note: Record the variation order testing in WP E.5.1. For the misclassified variation, quantify the revenue impact of reclassification and propose an adjustment. Document the discussion with management.
Practical checklist for construction engagements
Common mistakes regulators flag
- 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
- Audit materiality glossary entry: Explains how to set materiality for a construction company where revenue concentration in a small number of contracts affects the benchmark selection.
- ISA 320 materiality calculator: Calculate overall and performance materiality for construction clients, with revenue as the recommended benchmark given profit volatility in the sector.
- How to calculate and document materiality under ISA 320 : The full ISA 320 application guide, relevant because construction companies frequently have volatile profit margins that affect benchmark selection.
Related content
Frequently asked questions
What is the biggest audit risk in a construction company?
The cost-to-complete estimate is the single largest judgment in a construction company’s financial statements. It drives revenue recognition under IFRS 15 (percentage-of-completion), provision assessment under IAS 37 (onerous contracts), and work-in-progress valuation under IAS 2 . If one contract estimate is wrong, it can move the financial statements by a material amount on its own.
How do you test cost-to-complete estimates on a construction audit?
The most effective procedure is the retrospective review under ISA 540 .A127: compare management’s cost-to-complete estimate from the prior year to actual costs incurred in the current year. If actual costs significantly exceed the estimate, the estimation process has a bias. Additionally, test margin consistency across the contract portfolio and evaluate whether uncommitted costs are supported by evidence.
When does a construction contract become onerous under IAS 37 ?
A construction contract becomes onerous under IAS 37.66 when the unavoidable costs of meeting contractual obligations exceed the economic benefits expected, meaning estimated total costs exceed the contract price. Any contract with an estimated margin below 3% warrants a detailed onerous contract assessment.
How should contract modifications be accounted for under IFRS 15 ?
IFRS 15.18 defines a contract modification as a change approved by the parties. If the modification adds genuinely distinct goods or services at 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)). Each variation order must be tested for correct classification.
What do regulators most commonly flag in construction audit files?
The FRC, AFM, and PCAOB have all flagged construction audit deficiencies including: failure to perform retrospective comparisons of cost-to-complete estimates ( ISA 540 .A127), incomplete or absent onerous contract assessments ( IAS 37.66 ), insufficient cut-off testing for subcontractor costs incurred before year-end but invoiced after, and inadequate challenge of management’s assumptions on percentage-of-completion calculations.
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.