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The contract account is a system of cost accounting used by contractors engaged in construction and building works, where it is common for a firm to be engaged in execution of many separate contracts at the same time, and which can continue over a long period (many years). The contract accounts make it possible to allocate most of the expenditure incurred directly to the individual contracts, thus making it very easy to prepare, within the framework of financial accounts, a separate account which will disclose the profit or loss on each contract.
The contract accounts take care of such businesses whose nature of work does not conform to a financial year’s calculation of profits, based on the duration of period required to complete the job. Assume that a firm of contractors has only one contract in progress, which is construction of a large stadium complex which might take three years to complete. In this instance, the actual profit or loss on this type of contract can only be correctly calculated on the completion of the contract.
However, if the company has been formed especially for this contract, the owners may not want to wait for three years before profit could be calculated and dividend paid. Therefore, an attempt is made to calculate yearly profits.
In contract accounts, it is important that a firm should keep a close check on the costs incurred on each contract, and eventually on the profit actually realized. This is more so important where the contract will extend more than one accounting period its imperative that annual account be prepared to determine the yearly profit or loss on the contract.
The Nigeria Accounting Standards Board defines construction contract as the execution of building and civil engineering projects, mechanical and electrical engineering installations and other fabrications normally evidenced by an agreement between two or more parties.
The standard classifies the construction contract as:
- Short-term construction contract
- Long-term construction contract
The short-term construction contract are those contracts that are expected to be completed within 12 months, while the long-term construction contracts are those contracts that are expected to take more than 12 months to complete.
Methods of Revenue Recognition
Revenue recognition means the process of accounting for and inclusion of revenue from a contract in financial statement. In contract account, revenue is deemed realized at the point where the portion of the work responsible for generating the revenue has been performed.
There are two main methods of recognizing revenue under contract account as follows:
- Completed contract method
- Percentage of completion method
Completed Contract Method
This is a method used for long-term contracts (i.e. a contract that will take more than 12 months to complete), particularly in situations where there are no dependable estimates or where there are uncertainties which make accurate forecast impossible. Under this method, revenue from a contract is recognized only when the contract is completed. Thus, all costs incurred on a contract and billing there from are accumulated until the contract is completed. No interim charges and credits are made to the profit and loss account.
This method has a major problem of subjecting the periodic revenue from long-term contract to distortion. Revenue earned before the completion of the contract is not reflected in the accounts of a business, even if operations on a contract are uniform throughout the contract period.
Percentage of Completion Method
This method apportions revenue from a contract to each accounting period involved in the execution of a contract on the basis of the proportion of the contract executed during the period to total value of the contract. Under this method costs that are incurred on a contract are accumulated in an asset account. It is usual to ascertain the proportion of revenue to be included in a period account in relation to the work done through one of the following two methods:
- The percentage of estimated total revenue that the cost incurred to data bears to the estimated total costs.
- The percentage of total contract value that the engineering and architectural work done to date bears to the engineering and architectural estimate of the whole contract.
This method attempts to match revenue with incurred cost in the accounting period.
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Determination of Profit Realized on a Contract
Some contracts may take several years to complete, during which time a firm (contractor) may receive some payment on account of the work done. It is usual for firms to determine the amount of profit realized and pay dividends to their owners.
In small contract, payment for the job executed may be paid in one lump sum after the work is completed, while in the case of large contracts, there is usually an agreement between the parties to provide for the payment in stages.
This is the part of a contract work to which a certificate has been issued by a project architect or engineer as an evidence that such part of the contract has been satisfactorily completed.
These are the accumulated certifiable costs which relate to a contract that is yet to be completed. The progress payments received and receivable on such contract are deducted from them.
This is the retained part of the cash payment made to a contractor on the value of the work certified. The money is retained as a penalty in case the contract is not completed by a stated date or against claim for faulty workmanship etc. the retention money is later paid on satisfactory completion of the whole contract. For example, where an engineer issue a certificate for N100,000 as value of work completed, and the contractor is to be paid subject to deduction of say 10 per cent as retention money, then the contractor will receive N90,000 on the certificate issued.
Profit on work certified
The profit on a contract is determined by deducting the cost required to complete the work from the contract price. Thus the profit to be taken to work certified is the contract value of the work completed less the cost of the work completed. For example if a contract that is worth N200,000 is certified as 40 per cent complete, then the value of the completed work is N2,000,000 x 40% = N80,000.
Assume the total cost of the contract is to be N150,000, the cost of the work completed should be about N150,000 x 40% = N60,000.
Therefore the profit made would be N(80,000 – 60,000) = N20,000.
Account Entries of Contract Work
A contract account should be debited with all expenditure directly incurred on the contract, and debited with such proportion of the indirect expenditure that can conveniently be apportioned to it.
The direct expenses will consist of the materials, labour, plant and equipment purchased specially for a particular contract and any other expenditure which are incurred on the contract site wholly for the purpose of the contract.
The indirect expenditure will normally be small and in relation to direct charges, and will include administrative expenses office salaries, directors remuneration, audit fees, postages, telephone, stationery and so on. these expenditures are apportioned to various contracts using some arbitrary basis, such as a percentage on prime cost, or labour cost or the use of time occupied on a contract etc. the contract account is credited with the contract price at the completion of the contract. The balance on the account thus represents the ultimate profit or loss.
Methods of Book-keeping
Where the contract has fairly advanced but is impossible to estimate future expenditure to complete the contract.
- Debit the contract account with all expenditure to date.
- Credit and carry down the value of plant and equipment and unused materials at the end of the accounting period.
- Credit and carry down work-in-progress at cost plus the proportion of profit taken to date.
- Debit the contract account and credit the firm profit and loss account with the proportion of profit taken in the accounting year.