Auditing Infrastructure Construction Companies:
Key Considerations for Hong Kong Auditors
Infrastructure construction is an industry that plays a vital role in the economic development of Hong Kong. As an auditor in this vibrant city, it’s essential to understand the intricacies of auditing companies operating in this sector. In this blog post, we’ll discuss crucial aspects to consider when auditing infrastructure construction companies that adopt the Hong Kong Financial Reporting Standards (HKFRS) framework. We’ll also introduce the powerful Audit Program 3.0, which revolutionizes the way auditors approach their work.
Part 1: Revenue Recognition in Infrastructure Construction
In the infrastructure construction industry, recognizing revenue accurately and timely is crucial. The HKFRS 15 “Revenue from Contracts with Customers” provides guidance on when and how to recognize revenue. For infrastructure construction companies, revenue is typically recognized over time as performance obligations are satisfied. Key factors to consider include:
1. Identifying the contract: Ensure that the company has a legally enforceable contract with its customers, outlining the rights, obligations, and payment terms for each party.
2. Identifying performance obligations: Analyze the goods and services promised to customers and determine if they constitute separate performance obligations. This may involve assessing whether a good or service is distinct or if it’s part of a series of distinct goods or services.
3. Determining the transaction price: Examine the contract to identify the total amount the company expects to receive in exchange for satisfying its performance obligations.
4. Allocating the transaction price: Allocate the transaction price to each performance obligation based on the relative standalone selling price.
5. Recognizing revenue: Recognize revenue when the company satisfies a performance obligation by transferring control of a good or service to the customer
Illustrative Example 1: Application of HKFRS 15 - Revenue Recognition
For example, Audit Program 3.0 would include the following audit documentation on the Revenue Recognition in the Infrastructure construction industry when applying HKFRS as follows. This documentation would typically be included in the Engagement Planning Meeting Minutes in Section C of the APM:
“Revenue Recognition for an Infrastructure Construction Entity under Hong Kong Financial Reporting Standards (HKFRS)
Revenue recognition for an entity engaged in infrastructure construction primarily follows the guidance provided under HKFRS 15 “Revenue from Contracts with Customers”. HKFRS 15 establishes a five-step approach for recognizing revenue, which includes identifying the contract, identifying performance obligations, determining the transaction price, allocating the transaction price to performance obligations, and recognizing revenue when or as the entity satisfies those performance obligations.
- Identify the contract with the customer: Contracts are usually in the form of written agreements between the construction company and its customers, which can be government agencies, private entities, or public-private partnerships. The contract outlines the scope of work, project timelines, payment terms, and other relevant terms and conditions. The accounting team should maintain a proper record of all signed contracts, including any amendments or modifications.
- Identify performance obligations in the contract: Performance obligations are promises to transfer goods or services to the customer. In an infrastructure construction project, the performance obligations could be the construction of different components or phases of the project. These obligations should be distinct and separately identifiable. The accounting team can refer to the contract’s terms and project milestones to identify the distinct performance obligations.
- Determine the transaction price: The transaction price is the amount of consideration the entity expects to receive in exchange for transferring goods or services. In infrastructure construction projects, the transaction price may include fixed fees, variable fees, or a combination of both. Variable fees, such as performance bonuses, may need to be estimated based on the likelihood of the company achieving the specified performance criteria. The accounting team should maintain proper documentation of the agreed transaction prices, any changes, and assumptions used to estimate variable fees.
- Allocate the transaction price to performance obligations: The transaction price should be allocated to the identified performance obligations based on their relative standalone selling prices. The standalone selling price is the price at which the entity would sell a promised good or service separately to a customer. In the case of infrastructure construction, the allocation may be based on the estimated costs, profit margins, or other observable inputs. The accounting team should keep a record of the basis for allocation and any changes made during the contract period.
- Recognize revenue when or as the performance obligations are satisfied: For infrastructure construction projects, revenue is typically recognized over time as the entity performs its obligations. This approach is chosen when the customer simultaneously receives and consumes the benefits provided by the entity’s performance, or the entity’s performance creates or enhances an asset that the customer controls. The accounting team can refer to project progress reports, site visit records, and independent progress assessments to determine the percentage of completion and calculate the revenue to be recognized. The percentage-of-completion method is commonly used, which involves recognizing revenue based on the proportion of costs incurred to date relative to the total estimated costs of the project.
In summary, the accounting team for an infrastructure construction company should maintain proper documentation of contracts, performance obligations, transaction prices, allocation bases, and project progress. This information will help them adhere to the HKFRS 15 guidance and accurately recognize revenue in the financial statements. Regular communication with project managers and other key stakeholders is crucial to ensure that revenue recognition remains accurate and up-to-date throughout the project’s life.”
Part 2: Understanding the Design and Implementation of Internal Controls within the Revenue Recognition Business Process
Internal controls are critical in ensuring the accuracy and reliability of financial reporting. When auditing infrastructure construction companies, pay close attention to the design and implementation of internal controls related to revenue recognition. Key areas to evaluate include:
1. Segregation of duties: Assess whether there’s a proper division of responsibilities among employees involved in the revenue recognition process. This minimizes the risk of errors or fraud.
2. Authorization and approval: Verify that contracts and change orders are authorized and approved by appropriate personnel.
3. Revenue recognition policies and procedures: Review the company’s policies and procedures for recognizing revenue to ensure they’re in line with HKFRS 15 requirements.
4. Periodic review and reconciliation: Confirm that revenue transactions are periodically reviewed and reconciled to supporting documentation.
5. Monitoring and review of estimates: Examine the company’s process for reviewing and updating estimates used in the revenue recognition process, such as the percentage of completion.
By understanding the intricacies of revenue recognition and internal controls in infrastructure construction companies, auditors can provide valuable insights and support to their clients.
Illustrative Example 2: System Notes on Internal Controls in Revenue Business Process
For example, Audit Program 3.0 would include the following illustrative audit documentation when understanding the internal controls in the revenue business process of a client operating in the Infrastructure construction industry when applying HKFRS as follows. This documentation would typically be included in section C5.1 of the APM:
“ Internal Controls on Revenue Recognition
Control Activity 1: Contract Review and Approval
– Type of Control: Preventive
– Responsible Position: Accounts Manager
– Frequency: At the inception of each contract
Walkthrough:
1. The Accounts Manager reviews each new contract, including any amendments or modifications, to ensure that it complies with the company’s policies and procedures, as well as the relevant Hong Kong Financial Reporting Standards (HKFRS).
2. The Accounts Manager checks the contract for completeness and accuracy, ensuring that all required information is included, such as project scope, timelines, payment terms, and performance obligations.
3. The Accounts Manager approves the contract and forwards it to the Director for final approval.
4. The Accounts Manager maintains a record of all approved contracts and amendments, storing them in a secure location with controlled access.
Control Activity 2: Identification of Performance Obligations
– Type of Control: Preventive
– Responsible Position: Accounts Clerk
– Frequency: At the inception of each contract and whenever there are changes to the contract
Walkthrough:
1. The Accounts Clerk reviews the approved contract to identify distinct performance obligations, referring to project milestones and contract terms.
2. The Accounts Clerk documents the identified performance obligations in a project tracking system, which is updated regularly to reflect any changes in project milestones or contract terms.
3. The Accounts Manager reviews and approves the identified performance obligations to ensure they are consistent with the contract and HKFRS requirements.
Control Activity 3: Determination of Transaction Price
– Type of Control: Preventive
– Responsible Position: Accounts Clerk
– Frequency: At the inception of each contract and whenever there are changes to the contract
Walkthrough:
1. The Accounts Clerk reviews the approved contract to determine the transaction price, including fixed and variable fees.
2. The Accounts Clerk documents the transaction price, assumptions used to estimate variable fees, and any changes in the transaction price in the project tracking system.
3. The Accounts Manager reviews and approves the transaction price and related assumptions to ensure they are consistent with the contract and HKFRS requirements.
Control Activity 4: Allocation of Transaction Price to Performance Obligations
– Type of Control: Preventive
– Responsible Position: Accounts Clerk
– Frequency: At the inception of each contract and whenever there are changes to the contract
Walkthrough:
1. The Accounts Clerk allocates the transaction price to the identified performance obligations based on their relative standalone selling prices, using appropriate methods such as estimated costs or profit margins.
2. The Accounts Clerk documents the basis for allocation and any changes made during the contract period in the project tracking system.
3. The Accounts Manager reviews and approves the allocation basis to ensure it is consistent with HKFRS requirements.
Control Activity 5: Recognition of Revenue
– Type of Control: Detective
– Responsible Position: Accounts Clerk
– Frequency: Periodically, based on project progress
Walkthrough:
1. The Accounts Clerk monitors project progress, referring to progress reports, site visit records, and independent assessments.
2. The Accounts Clerk calculates the percentage of completion and the revenue to be recognized using the percentage-of-completion method.
3. The Accounts Clerk records the recognized revenue in the accounting system, ensuring that it is properly classified and recorded in the appropriate accounts.
4. The Accounts Manager reviews the recognized revenue for accuracy and completeness, ensuring that it is consistent with project progress and HKFRS requirements.
Internal Controls on Sales Receipts
Control Activity 6: Reconciliation of Sales Receipts
– Type of Control: Detective
– Responsible Position: Accounts Clerk
– Frequency: Daily
Walkthrough:
1. The Accounts Clerk retrieves a daily report of sales receipts from the accounting system.
2. The Accounts Clerk compares the daily report to the bank deposit records, ensuring that all sales receipts have been deposited and recorded correctly.
3. The Accounts Clerk investigates and resolves any discrepancies found in the reconciliation process.
4. The Accounts Manager reviews and approves the daily reconciliation of sales receipts.
Internal Controls on Sales Posting
Control Activity 7: Review and Approval of Sales Journal Entries
– Type of Control: Detective
– Responsible Position: Accounts Manager
– Frequency: Monthly
Walkthrough:
1. The Accounts Clerk prepares a monthly report of sales journal entries from the accounting system.
2. The Accounts Manager reviews the report for accuracy and completeness, ensuring that all sales transactions have been properly recorded in the appropriate accounts.
3. The Accounts Manager investigates and resolves any discrepancies found in the review process.
4. The Accounts Manager approves the monthly sales journal entries and reconciles them with the general ledger.
By implementing these internal controls, the hypothetical audit client can effectively prevent, detect, and correct misstatements in their financial statements, ensuring accurate revenue recognition, sales receipts, and sales postings in compliance with Hong Kong Financial Reporting Standards and Hong Kong Standards on Auditing.”
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In conclusion, understanding the revenue recognition process and internal controls is crucial when auditing infrastructure construction companies adopting HKFRS. By leveraging the power of Audit Program 3.0, Hong Kong auditors can streamline their work, enhance efficiency, and elevate audit quality to new heights. Experience the transformative impact of Audit Program 3.0 on your practice and watch your client relationships thrive.