Financial Accounting - Contract Account

Contracts are undertaken to customer’s requirements, which is generally of constructional. For example, construction of buildings, ships, Bridges, Roads, etc. In all the above cases, contract account is opened. A unique number is allotted to each contract and a separate account is maintained for each individual contract.

Features of Contract Accounting

Following are the important features of a contract accounting −

• Direct Costs − Direct cost is the main proportion of expenses in a contract account. However, indirect nature of expenses is also treated as direct expenses in a contract account.

• Indirect Costs − Proportion of the indirect cost is very low in a contract accounting such as expenses related to the head office in case of various contracts.

• Cost Control − Cost control is the main challenge in a contract account especially in the large scale contracts. For example, control over the material cost, labor cost, loss, damages, etc. are difficult to regulate.

• Surplus Material − After completion of the constructional project, if any material such as cement, iron and steel, marbles, etc. is remained unused, is known as surplus material. Surplus materials are normally disposed of to get back the invested amount.

Types of Contract

There are three types of contracts, as depicted in the following figure.

Recording of Costs, Value, and Profit on Contract

Recording of each contract will be done as under −

Material

Cost of “Material” will be debited from the contract account in the following manners −

• Direct purchase
• Supplied from stores
• Transfer from other project/contract

Contract account will be credited −

• Material returned to stores
• Sale proceed of surplus material

Amount will be transferred to Profit & Loss account −

• Profit or Loss on sale of surplus of material

• Damaged, Lost, or stolen material (except normal wastage of material that will be charged directly to concerned contract account).

Labor

Labor or wages directly charged to concerned contract account and outstanding wages should be debited from the contract account.

Direct Expenses

In addition to material and labor, all other expenses, which are directly attributable to the specific contract account are called direct expenses and will be debited from the contract account.

Plant and Machinery

Following are the two methods for charging value of Plant & machinery to a contract account −

Indirect Expenses

The expenses, which cannot be directly charged to such contract are known as indirect expenses.

On the basis of some percentage, these expenses may be distributed among several contracts. For example, charges of supervisor, engineer, administrative expenses etc.

Sub Contract

When a main or prime contractor assigns some specific work to another contractor as part of the main contract called as sub contract. Sub-contractors are paid by the main contractor. Sub-contractors normally do some specialized work, in which they are specialized. Charges paid to the sub-contractor will be shown in the debit side of the contract account.

Extra Work Charges

Any additional works in addition to the main contract, done by contractor as per the requirement of the Contractee, may be charged to same contract account. However, in case where volume of the extra work is not substantial; so, the amount received in lieu of that extra work should be added to the contract price.

In case where extra work is of substantial amount, a separate contract account should be prepared, as explained above.

Recording of Value and Profit on Contracts

Certification of Work Done

During the period of contract, Contractee has to pay sums of amount to contractor especially where a contractor is engaged in a big and long term contract. This amount is paid on the basis of certification of work done by surveyors or architects on behalf of the Contractee, who certified the value of the work done by the contractor.

Usually, some percentage of the certified amounts is paid by Contractee and the balance amount called as “retention money.” The retention amount remains with the Contractee until the work is completed to safeguard and keep in favorable position. Completed work, which is not certified is called “uncertified work.”

Following accounting procedure should be followed after getting certificate −

a) Contractee personal A/cDr

To Contract A/c

Note −

• 1. Above entry will be done with certified value

• 2. Balance amount in personal account will represent retention money as debtors.

b) Contractee personal A/cDr

Retention Money A/cDr

To Contract A/c

c) Under this method, any amount received from the Contractee till the completion of contract will be crediting to Contractee’s personal account debiting cash/bank. Amount so received will represent advance received from Contractee and will be shown as (work in progress less advance received) in the Balance sheet.

Profit on Incomplete Contract

Actual ascertainment of the cost is possible only after fully completion of the contract. Therefore, it is not possible to know the profit or loss on contract till it is completed.

However, following principles are adopted to estimate profit on uncompleted contracts −

• No profit is ascertained and transferred to profit and loss account where work is completed up to 25% of the total contract.

• In case where contract is completed from 33.33% to approximately 75%, one-third amount of the notional profit may retain to suspense account as a provision for future loss and balance; two third is transferred to the profit and loss account. Sometime notional profit is further reduced in the ratio of the cash received and the work certified, the formula is −

  $$\small Notional\:Profit \times \frac{2}{3} \times \frac{Cash\:Received}{Work\:Certified}$$

• In case where a contract is almost completed, proportion of an estimated profit is transferred to the profit & loss account by one of the most popular formula as given below −

  $$\small Estimated\:Profit \times \frac{Work\:Certified}{Contract\:Price}$$

Note − In case of any loss that should be transferred to Profit & Loss account.

Work in Progress

Uncompleted contracts at the end of the financial year, which are known as work-inprogress will be accounted as −

• Work-in-progress will be shown at the asset side of the Balance sheet on the account of expenses incurred the un-completed contracts.

• Value of the work-in-progress will be inclusive of Profit.

• Cash received from the Contractee will be deducted from the value of work-inprogress.

• Contractee will be treated as a debtor only after completion of the contract.

• Contractee will not be shown as creditor on account of cash received from him.

• Cost of plant and material at the site will be shown separately as “Plant at site” and “Material at site” on the asset side of the Balance sheet.

Illustration

Please prepare a Contract Account, Contractee Account and Extract of Balance sheet from the following information as received from M/s “Solid Building Contractor’ for the period 01-04-2013 to 31-03-2014.

Solution

M/s Solid Building Contractor

Contract Account

(For the period 01-04-2013 to 31-03-2014)

Contractee Account

Balance-Sheet

(As on 31-03-2014)

Modern Approach on Profit on Uncompleted Record

Following are the two methods of calculating the profits on uncompleted contracts −

• Where profit is ascertained only after completion of the contract or after substantially completion of the contract is called ‘completion contract method.’

• Under the second approach, it is ascertained at the end of each and every accounting period on percentage basis, which comes before completion of the entire contract.

Work-in-Progress

Work-in-progress means total expenditure incurred up to the end of financial or accounting year known as work-in-progress account.

Following example is described for better understanding −

Illustration

Please evaluate the profit of the period by using both of the given methods −

• Percentage of completion method and
• The completed contract method.

Please also find the value of work-in-progress in the Balance sheet by assuming, the contractor received Rs. 460,000 on completion of the first stage.

Solutions −

On the Basis of Percentage of Completion Method −

Balance Sheet

On the Basis of Completion Contract Method −

No profit will be ascertained before the completion of contract −

Balance Sheet

Cost Plus Contract

In some cases, it is not possible in advance to know the exact cost of contracts; therefore, cost plus contract clause need to be applied, in which the value of contract is ascertain by adding certain percentage of the profit in cost.

Escalation Clause

An Escalation clause is applied to cover up the changes in price due to change in prices of the raw material or change in utilization of the production capacity. Escalation clause safeguards both the contractor and the contractee against any unfavorable change in the cost or the price.

Target Costing

Under this method of a contract, contractee gives target of the production with target of the expenditure. Contractor cannot increase the cost of contract without increasing the production. It means, expenditure is fixed with the target of the production.