Why Do Construction Companies Need Annual Financial Audits

Overview

Naturally, contracts are long-term, and they cover multiple reporting periods and usually rely on estimates of cost to complete, variations and claims. Large projects and extended subcontractor approaches bring more complexity.

The Importance of Audits for Construction Companies

Construction profits often rely on management estimates, so reports can be overstated and difficult for external users to assess. There is no construction-related audit threshold. The general rule applies which is audited financial statements are needed for corporate tax return submission when revenue exceeds AED 50 million, and if it is below that, the requirements generally depend on the company’s legal form and licensing authority. An independent audit provides reasonable assurance over management estimates and helps users asses if the reported profits are fair and free from material misstatements. An audit also shows what the business has earned, what’s owed, and highlights projects that may cause losses to the company.

Mainland companies are required to appoint a certified auditor to comply with the requirements of Article 27 and 54 of Federal Decree Law No. 32 of 2021, while companies in free zones follow specific auditing requirements applicable in those free zone jurisdictions. Sometimes, banks require audited accounts for granting loans and tender evaluators may also need audits for pre-qualification in the tendering process.

Key Risks in a Construction Company and How Audit identifies Them

Construction companies have long project cycles, and hence they deal with financial and operational risks. They also overly rely on the estimates and subcontractor agreements. Audit procedures like contract reviews, analytical reviews, transaction testing, reconciliations and testing of supporting documents help identify misstatements and control weaknesses. Some of the key risks are:

• Revenue recognition may not be in line with IFRS 15
• Cost-to-complete estimation may not be accurate and complete
• Variation and claims risk
• Subcontractor liability risk
• Retention and receivables
• Fraud and control risk

Besides the standard audit procedures, auditors of construction companies give attention to:

• Revenue and progress: Percentage-of-completion and certified progress are compared in order to confirm revenue is not recognized before the actual performance of work.
• Cost and loss-making contracts: Actual costs are compared with the budgets, and forecasts to complete are tested to check whether any contract has become challenging or if it needs a provision.
• Variations and claims: Variation orders and claims are cross-examined with signed approvals and related documents. Therefore, unapproved amounts are not taken as probable revenue.
• Subcontractors, retentions and leases: Subcontractor buildups are checked for completeness, retention and receivable ageing are tested for recoverability, and leased equipment is tested for correct accounting.

All these steps help identify the abovementioned risks and help construction firms in improving their project oversight and financial reporting.

Point of concern: The margins are generally steady for the many projects; there is a large amount of WIP that has not yet billed and the collection remains slow; the claims increase from year to year.