In contract costing, businesses often work on long-term projects like construction, shipbuilding, or infrastructure development. These contracts may span several years, so it becomes essential to determine and report profits accurately throughout the life of the contract. The profit determination on completed and uncompleted contracts varies based on the stage of completion and the accounting principles adopted.
Profit on Completed Contracts:
When a contract is fully completed within an accounting period, it is straightforward to determine the profit or loss. The total revenue from the contract is compared with the total cost incurred, and the difference represents the profit or loss.
Steps to Calculate Profit on Completed Contracts:
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Determine Contract Revenue:
The total value agreed upon in the contract or the amount certified by the contractee (client) is considered.
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Calculate Total Costs Incurred:
Include direct costs (materials, labor, expenses) and overheads allocated to the contract.
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Account for Retention Money:
Often, a portion of the contract value is retained by the client (known as retention money) to ensure contract fulfillment. Though this amount is withheld temporarily, it is still part of the total contract revenue.
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Determine the Profit or Loss:
Subtract the total cost from the contract revenue to calculate the profit or loss on the contract.
Formula:
Profit/Loss = Contract Revenue − Total Costs Incurred
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Transfer Profit to the Profit and Loss Account:
The entire profit or loss is recognized in the current period since the contract is completed.
Profit on Uncompleted Contracts
For contracts that are still in progress at the end of the accounting period, only a portion of the profit is recognized. The profit calculation depends on the stage of completion and the percentage of work certified by an independent surveyor or architect.
Key Terms in Uncompleted Contracts:
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Work Certified:
The value of work done and certified by the client or surveyor.
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Work Uncertified:
The value of work completed but not yet certified.
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Notional Profit:
The difference between the value of work certified and the cost of that work. It represents the profit that might be realized if the contract were completed at the current stage.
Methods for Determining Profit on Uncompleted Contracts:
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Percentage of Completion Method:
The profit is recognized based on the percentage of the contract completed. This method matches revenue with costs over the contract duration.
Steps:
- Determine the percentage of completion (based on work certified and contract value).
- Calculate the notional profit (Work Certified – Cost of Work Certified).
- Recognize profit proportionately using the formula:
Recognized Profit = Notional Profit × {Contract Value / Work Certified}
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Proportion of Cash Received Method:
The recognized profit is calculated based on the proportion of cash received from the client compared to the total contract value.
Formula:
Recognized Profit = Notional Profit × {Work Certified / Cash Received}
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Profit Based on Estimated Completion:
In this approach, the profit is determined based on estimated costs to complete the contract. The notional profit is adjusted based on expected future costs.
Formula:
Recognized Profit = Notional Profit × {Work Certified / Total Contract Value} × {Estimated Costs Incurred / Total Estimated Costs}
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Prudence Concept:
The prudence principle in accounting suggests recognizing only a portion of the estimated profit on uncompleted contracts to avoid overstating profits. A common practice is to recognize:
- One-third of the notional profit when less than 25% of the contract is completed.
- Two-thirds of the notional profit when 25%-50% of the contract is completed.
- The entire notional profit if more than 50% of the contract is completed.
Example:
Assume a contract value of ₹10,00,000, and the following details for an uncompleted contract:
- Work certified: ₹5,00,000
- Cash received: ₹4,00,000
- Costs incurred: ₹3,50,000
- Total estimated costs: ₹7,00,000
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Percentage of Completion Method:
- Percentage of completion = (₹5,00,000 / ₹10,00,000) × 100 = 50%
- Notional Profit = ₹5,00,000 – ₹3,50,000 = ₹1,50,000
- Recognized Profit = ₹1,50,000 × 50% = ₹75,000
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Proportion of Cash Received Method:
Recognized Profit = ₹1,50,000 × (₹4,00,000 / ₹5,00,000) = ₹1,20,000
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Profit Based on Estimated Completion:
Recognized Profit = ₹1,50,000 × (₹5,00,000 / ₹10,00,000) × (₹3,50,000 / ₹7,00,000) = ₹37,500
Factors Influencing Profit Recognition in Uncompleted Contracts:
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Stage of Completion:
The higher the stage of completion, the more profit can be recognized.
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Prudence and Conservatism:
Accountants often opt for a conservative approach to avoid overestimating profits.
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Contract Conditions:
Retention clauses, penalties, and bonus payments can impact profit recognition.
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Risk and Uncertainty:
Delays, price changes, and unforeseen expenses may lead to lower recognized profits.