Following on from large fines issued in recent weeks to KPMG, PwC has been fined a total of £5 million for two audits involving construction firms - Galliford Try and Kier. While it is natural to concentrate on audit failings in cases like this, they also highlight the challenges in accounting for long-term contracts.
In the case of Galliford, PwC failed to sufficiently challenge several significant management assertions about long-term contracts. The FRC did not believe that the breaches were intentional, dishonest or reckless, which shows how difficult issues involving the audits of long-term contracts can be. It was also noted that PwC has already started to implement measures to deal with the audit of long-term contracts going forward.
What is it that makes these contracts so complicated? Having to look ahead and predict how profitable a contract will be at an early stage can be challenging. The longer the contract, the greater the degree of uncertainty and the potential margin for error. Large constructing projects rarely turn out as expected, which has repercussions for the accounting involved, particularly regarding revenue recognition.
This type of contract requires the use of accrual accounting whereby revenue must be recognised before all the work is completed. This can be difficult as while there may be some interim payments agreed upon in the contract, these do not provide a definitive basis for revenue recognition. Thus, it becomes necessary to evaluate the likely outcome of a project as it progresses. Assessing costs to date can be straightforward if records are kept, however assessing the costs to complete and when completion will be are a bit more difficult.
IFRS 15 covers the rules for revenue recognition in long term contracts and was brought about because some entities were recognising revenue on an overly optimistic basis. Despite this, there is still a lack of clarity as the standard deals with long term contracts alongside other revenues and only limited examples relating to long term contracts are provided in the accompanying guidance.
So, how should revenue be assessed and recognised in long term contracts? The key to recognising revenue in these contracts is assessing progress towards meeting a performance obligation, which in turn leads to the amount recognised in the financial statements. There is a requirement that the method used for assessing progress should be applied consistently from one period to the next, to minimise opportunities for gaming. At each period end, the degree of progress should be remeasured, and revenue re-recognised.
Most commonly, the percentage of completion method is used. In such instances, we take revenue based on the percentage of progress made towards achieving final objectives. It can be difficult to objectively assess the degree of completion, and the more subjective the assessment, the greater the degree of uncertainty.
Auditors should take special care in this area, as PwC has now learnt, as with the pressures of management preferring to maximise the recognised revenue, along with the difficulty of assessing the degree of completion, long-term contacts have proved to be difficult for all.
This blog is an extract from a News Bite written by Wayne Bartlett. News Bites are an exclusive service, providing verifiable CPD for accountingcpd licence holders . Each News Bite focuses a recent news story and draws out lessons for accountants.
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