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Financial Accounting for Construction Contracts

A contract is a big job requiring considerable length of time to complete and
comprising activities to be done outside the factory promises, viz. construction
of a dam or school building, laying down railway lines, etc. Since each contract
involves considerable resources both in terms of men and materials, it is
necessary to devise an appropriate accounting system to ascertain the cost and
profit made on each contract separately.

Profit on incomplete contracts: At the end of an accounting period it
may be found that certain contract have been completed while others are still in
process and will be completed in the coming years. The total profits made on
completed contract say be safely taken to the credit of the profit and loss
account. But the same cannot be done in case of incomplete contracts. These
contracts are still in process, and there are possibilities of profits being
turned into to losses on account of heavy rise in prices of materials and labor
and losses on account of other unforeseen contingencies. At the same time it
does not also seem desire able to consider the profits only on completed
contracts and ignore completely incomplete ones because this may result in heavy
fluctuations in the figure of profit from year to year. A year in which a large
number of contracts have been completed will show an abnormal high figure for
profit while reserve may be the case in the year in which a large number of
contracts remain incomplete. Therefore, profits on incomplete contracts should
be considered, of course, after providing adequate sums for meeting unknown
contingencies.

There are no hard and fast rules for the calculation of the figures for
profit to be taken to the credit of profit and loss account. However, the
following rules may be followed:

(a) Profit should be considered in respect of work certified only,
work uncertified should always be valued at cost.

(b) No profit should be taken into consideration if the amount of work
certified is less than 1/4 of the contract price because in such cases it is not
possible to foresee the future clearly.

(c) If the amount of work certified is 1/4 or more but less than1/2 of
the contract price, 1/3 of the profit disclosed, as reduced but the percentage
of cash received from the contractee, should be taken to the profit and loss
account. The balance should be allowed to remain as a reserve.

(d) If the amount of work certified is very much near completion, if
possible the total cost of completing the contract should be estimated The
estimated total profit on the contract then can be calculated by deducting the
total estimated cost from the contract price. The profit and loss should be
credited with that proportion of total estimated profit on cash basis, which the
work certified bears to the total contract price.

(f) The whole of loss, if any, should be transferred to the profit and
loss account.

Cost Plus Contracts: In certain contracts the contractee agrees to pay
to the contractor the cost price (usually prime cost) of the work done on the
contract plus an agreed percentage thereof by way of overhead expenses and
profit. Such contracts are known as cost-plus contracts. The system of cost plus
contract costing is employed in cases where it is very difficult for the
contractor to quote the contract price because there has been no precedent which
he may take as basis. It is also employed where the work to be done is not fixed
at the time of placing order for the contract. The method is generally used
where government happens to be the contractee. The method suffers from the
following disadvantages:

There is no incentive to the contractor to eliminate waste and economies the
cost of completing the contract. On the other hand, he is tempted to increase
the cost because greater the cost, the greater will be his share of profit. In
case of this system the amount of overheads recovered and profit made depends
upon the value of materials used, which is subject to considerable price
fluctuations. The agreed fixed percentage may, therefore, prove to be either too
excessive or too low for covering overheads and profit.

Escalation Clause: Escalation clause is usually provided in the
contract as a safeguard against any likely changes in the prices of utilization
of material and labor. The clause provides that in case prices of items of raw
materials, labor, etc. specified in the contract, change during the execution of
the contract, beyond a specified limit over the price prevailing at the time of
signing the agreement, the contract price will be suitably adjusted. The term of
the contract specify the procedure for calculating such adjustment in order to
avoid all future disputes. Thus, such a clause safeguards the interests of both
the contractor and contractee in case of fluctuations in the price of materials
and labor, etc.

Work in Progress: At the end of the accounting period a contract may
still be in progress. The term work in progress refers to the work done so for
in respect of the contract, which is still incomplete. It consists of the
following:

(1) Working Certified: It refers to the work approved by the
contractee. In case of contracts it is the useful practice for the contractor to
get the work approved from time to time from the contractee. This is helpful to
the contractor in two ways; first in case the contractee finds the work not up
to specifications, he may ask the contractor to take corrective actions in time.
Second, in contract accounts it is useful practice to have a system of progress
payments, i.e., the contractee agrees to pay a certain percentage of the work
certified (say, 80 or 90 percent). This is advantageous to the contractor since
he gets immediate liquid funds.

(2) Work Uncertified: It refers to the work which has been done by the
contractor but not so far approved by the contractee.

Work certified generally includes some profit element also while work
uncertified is always valued at cost to the contractor.

Sub Contracts: The contractor may entrust some portion of the work to
be done under the contract to a sub-contractor. Usually work of a specialized
nature, i.e., steel work, special flooring, etc., is done by sub-contractors,
who are responsible to the main contractor. The cost of such sub-contracts is a
direct charge against the contract for which the work has been done.

Special financial and management accounting
is required to maintain the records of construction contracts.