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 −

a) Contract account will be debited with the full value of Plant & Machinery −
Contract A/cDr(With full value)
To Plant & Machinery A/c(With Full Value)
Contract account will be credited with the depreciated value of Plant & Machinery at the
end of the contract −
Plant & Machinery A/cDr(with Depreciated Value)
To Contract A/c

b) Contract account will be debited with hourly rate of Depreciation −

This is much better and scientific approach as compared to the first method. On the basis of
time, contract will be debited with hourly rate of depreciation.
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 −
NotionalProfit×23×CashReceivedWorkCertifiedNotionalProfit×23×CashRe
ceivedWorkCertified
• 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 −
EstimatedProfit×WorkCertifiedContractPriceEstimatedProfit×WorkCertifie
dContractPrice
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.
 Particulars Amount

Contract Price 18,000,000

Material Issued to contract 3,060,000

Wages & Salary 4,800,000

Plant used for Contract 900,000

Other Miscellaneous Expenses 300,000

Cartage paid on Material 60,000

Loss of Plant at site 180,000

Plant returned to store on 31-03-2014 120,000

Loss of Material at site 150,000

Material in hand at site on 31-03-2014 138,000

Cash received 80% of work certified 7,680,000

Uncertified work 60,000

Depreciation on Plant 15%

Profit transferred to Profit & loss account 23rd23rd

Solution
M/s Solid Building Contractor
Contract Account
(For the period 01-04-2013 to 31-03-2014)

Particulars Amount Particulars Amount

To Material 3,060,000 By Material at site 138,000

To Wages & Salary 4,800,000 By Profit & Loss A/c

To Plant 900,000 Material Lost150,000

To Cartage 60,000 Plant Lost180,000

To Misc. Expenses 300,000 -----------

To Notional Profit c/d 1,620,000 By Plant return to store120,000

Less: Dep.18000

-----------

By Plant at site600,000 330,000

 Less: Dep.90,000

-----------

By Work In progress A/c

Work certified9,600,000

Work uncertified60,000

----------- 102,000

510,000

9,660,000

Total 107,400,000 Total 107,400,000

To Profit & Loss A/c 864,000 By Notional Profit b/d 1,620,000

1,620,000×23×451,620,000×23×45

To Work in Progress A/c (Reserve)

756,000

Total 1,620,000 Total 1,620,000

Contractee Account

Particulars Amount Particulars Amount

To Balance c/d 7,680,000 By Cash Received 7,680,000

Total 7,680,000 Total 7,680,000

Balance-Sheet
(As on 31-03-2014)

Particulars Amount Particulars Amount

 Profit & Loss A/c864,000 Plant720,000

Less: Loss of330,000 Less: Dep. 15%108,000

Plant & Material----------- ------------

Material at site

Work-in-progress

Work Certified9,600,000 612,000

534,000 Uncertified work60,000 138,000

------------

9,660,000

Less: Reserve756,000

------------

8,904,000

Less: Cash Received7,680,000

------------

1,224,000

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.

Stages Estimates Actual Cost Contract

Price
Original Revised
(Rs.) (Rs.)

Certified 345,000 368,000 356,500 460,000

Completed but not certified 115,000 126,500 120,750 172,500
Completed 75% 115,000 126,500 95,450 149,500
Completed 25% 230,000 276,000 71,300 345,000
Incomplete 138,000 172,500 -- 161,000

943,000 1,069,500 644,000 1,288,000

Solutions −
On the Basis of Percentage of Completion Method −

Stages Actual % of Balance estimates Total Rs. Contract Profit or

Cost completion (Rs.) Price Loss

1 356,500 356,500 460,000 103,500

2 120,750 120,750 172,500 51,750
3 95,450 127,075 149,500 --
4 71,300 25% 278,300 345,000 --
5 -- 75% 172,500 161,000 (11,500)
31,625
100%
207,000
172,500
 644,000 411,125 1,055,125 1,288,000 143,750

Balance Sheet

Particulars Amount Particulars Amount

Advances 460,000 787,750

Work in Progress
(Actual cost + Profit) 644,000 + 143,750

On the Basis of Completion Contract Method −

No profit will be ascertained before the completion of contract −
Balance Sheet

Particulars Amount Particulars Amount

Advances 460,000 Work in Progress 644,000

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.