Revenue Recognition and Audit Evidence for a Construction Contract
Armenian construction company 'Ararat Build' CJSC has a fixed-price contract to construct a commercial building for 1,200 million AMD over 24 months. At the end of year 1, costs incurred are 400 million AMD, estimated total costs to complete are 800 million AMD, and progress billings to date are 350 million AMD. The company recognizes revenue using the percentage-of-completion method based on costs incurred. The auditor is concerned about the accuracy of the estimated total costs and the existence of the receivables. The company's internal control over cost estimation is weak: estimates are prepared by the project manager without formal review. The auditor has obtained the contract, cost reports, and a schedule of billings. The company refuses to provide access to the project manager for inquiry.
1. Calculate the revenue, gross profit, and contract asset/liability to be recognized at the end of year 1 under IFRS 15. Show your workings.
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Under IFRS 15, revenue is recognized over time based on progress towards complete satisfaction of the performance obligation. Progress = costs incurred to date / total estimated costs = 400 / (400+800) = 400/1200 = 33.33%. Revenue = 1,200 * 33.33% = 400 million AMD. Gross profit = revenue - costs incurred = 400 - 400 = 0 (since total expected profit is 1,200 - 1,200 = 0). Contract asset/liability: compare revenue recognized (400) with billings (350). Since revenue > billings, a contract asset of 50 million AMD is recognized (assuming no impairment). If billings exceeded revenue, it would be a contract liability. The calculation assumes the cost estimates are reliable; however, given the weak controls, the auditor should assess the reliability of the estimates.
2. Identify the key audit risks related to the revenue recognition and the contract asset, and describe the audit procedures you would perform to address them, considering the lack of access to the project manager.
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Key audit risks: (1) Accuracy of estimated total costs: if underestimated, revenue and profit are overstated. (2) Existence and valuation of contract asset: the 50 million AMD contract asset may not be recoverable. (3) Management bias in estimates. (4) Lack of access to project manager limits inquiry procedures. Audit procedures: (a) Review the contract for terms and conditions, including price adjustments and penalties. (b) Examine cost reports and invoices to verify costs incurred to date, and test a sample of costs for occurrence and accuracy. (c) Evaluate the reasonableness of estimated costs to complete by comparing to historical data, industry norms, and budgets; consider using an auditor's expert (e.g., quantity surveyor) if necessary. (d) Inspect correspondence with the customer regarding variations and claims. (e) Confirm the contract asset with the customer if possible. (f) Assess the company's ability to complete the project by reviewing financial resources. (g) Since the project manager is unavailable, perform alternative procedures: review project documentation, minutes of meetings, and communicate with other personnel; if still unable to obtain sufficient appropriate evidence, consider a modified opinion. (h) Evaluate the adequacy of disclosures regarding estimates and uncertainties.