The Auditors and Contractors Dilemma -06/07/2022

KPMG, a large accounting firm, is defending a £1.3 billion lawsuit by liquidators of the collapsed construction and services group, Carillion.  The liquidator’s claim the KPMG auditors’ failed to obtain proper evidence to justify Carillion recognising profits under long-term contracts.  This case highlights the difficulty in judging when it is appropriate for companies to record revenues, costs and profit for contracts extending over many years.  

If a construction company, for example, is to build a motorway or a huge stadium over several years then when should it recognise the profit? 

Options include: 

 

  1. Only recording the profit at the end of the contract when all the income and costs are known- but this might lead to bumper profits some years and very low profits in other years when no contracts are completed. 
  2. Spreading the estimated profit equally over the duration of the project- while this would avoid the peaks and troughs of option (1) the drip-feeding of profits to smooth overall performance may lead to the recognition of profits at a relatively early stage and well before all the costs and the final profit are known.
  3. Not recognising any profits until the contract has progressed beyond certain milestones and when there is greater certainty of the costs yet to be incurred to complete the project.  

 

Option 3, a compromise between 1 and 2 is the current approach used by contractors; it allows some profit to be recognised before the completion of the contract.  However, the percentage of the profit realised, which is based on costs incurred to date and future costs to be incurred, still depends on some estimates.  It still involves assumptions.  And directors under pressure to report improving profits may be optimistic about future outcomes.  Their judgement could be compromised.  They may present evidence in a biased way to the external auditors whose main role is to report if a company’s annual financial statement is true and fair with no material errors or omissions.  

While external auditors are expected to challenge and question the reporting of financial events and transactions, and collect relevant evidence, there is a limit to their expertise and knowledge of a company’s business and the evidence available.  How can an external auditor be expected to know when a contract will be completed, what resources will be needed and what future costs a contractor will incur?  Auditors are not soothsayers.  Auditors are not time-travellers.  And so this conundrum of when to recognise profits continues, as will the case of some companies recognising too much profit too early, until all parties acknowledge the most prudent time to recognise profit to avoid further scandals is when the contract is completed.  

Auditing Team 

Finance, Accounting and Economics Department 

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