A contract is a large job that requires a considerable amount of time to complete and encompasses activities that must be performed outside of the factory’s promises, viz. construction of a dam or school building, laying of railways, etc. Since each contract involves considerable resources both in terms of men and materials, it is necessary to have an appropriate accounting system in place to determine the cost and profits made on each separate contract.
Benefit from incomplete contracts: At the end of an accounting period, certain contracts may be found to have been completed while others are still in process and will be completed in the next few years. The total profits made on the completed contract must be safely credited to the profit and loss account. But the same cannot be done in case of incomplete contracts. These contracts are still pending and there are possibilities that the benefits will turn into losses due to a sharp rise in the prices of materials and labor and losses due to other unforeseen contingencies. At the same time, you also don’t seem to want to be able to consider earnings only on completed contracts and ignore completely incomplete ones because this can result in sharp fluctuations in the earnings figure from year to year. A year in which a large number of contracts have been completed will show an abnormally high profit figure, while the reserve may be the case in the year in which a large number of contracts remain incomplete. Therefore, earnings from incomplete contracts should of course be considered after providing adequate sums to deal with unknown contingencies.
There are no hard and fast rules for calculating the profit figures that must be credited to the profit and loss account. However, the following rules can be followed:
(For) Earnings should be considered with respect to certified work only, uncertified work should always be valued at cost.
(B) No benefit should be taken into consideration if the quantity of certified work is less than 1/4 of the contract price because in such cases it is not possible to clearly foresee the future.
(vs) If the quantity of certified work is 1/4 or more but less than 1/2 of the contract price, 1/3 of the disclosed profit, as reduced but the percentage of cash received from the contractor, should be carried to profit and loss. bill. The balance should be allowed to remain as a reserve.
(D) If the quantity of certified work is very close to completion, if possible, the total cost of completing the contract should be estimated. The total estimated profit on the contract can be calculated by deducting the total estimated cost from the contract price. The profit and loss must be credited with the proportion of the total estimated profit in cash, that the certified work entails on the total price of the contract.
(me) The entire loss, if any, must be transferred to the profit and loss account.
Cost Plus Contracts: In certain contracts, the contractor agrees to pay the contractor the cost price (usually the principal cost) of the work performed on the contract plus an agreed percentage of the contract for general expenses and profits. These contracts are known as additional cost contracts. The costing plus contract costing system is used in cases where it is very difficult for the contractor to quote the contract price because there has been no precedent to take as a basis. It is also used when the work to be done is not fixed at the time of placing the contract order. The method is generally used when the government is the contractor. The method suffers from the following disadvantages:
There is no incentive for the contractor to eliminate waste and save the cost of completing the contract. On the other hand, you are tempted to increase the cost because the higher the cost, the greater your share of the profit. In the case of this system, the amount of overhead recovered and the profit made depend on the value of the materials used, which are subject to considerable price fluctuations. Therefore, the agreed fixed percentage may be too high or too low to cover overhead and profits.
Escalation clause: The escalation clause is generally provided in the contract as a safeguard against any probable change in the prices of use of material and labor. The clause establishes that in the case of prices of articles of raw materials, labor, etc. specified in the contract, change during the execution of the contract, beyond a specified limit on the price in force at the time of signing the contract, the contract price will be adjusted appropriately. The contract term specifies the procedure for calculating such adjustment in order to avoid all future disputes. Therefore, this clause safeguards the interests of both the contractor and the contractor in the event 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 work performed against the contract, which is still incomplete. It consists of the following:
(1) Job certificate: Refers to work approved by the contractor. In the case of contracts, it is a useful practice for the contractor to obtain approval of the work from time to time from the contractor. This is useful to the contractor in two ways; First, in case the contractor finds that the work does not meet the specifications, he can ask the contractor to take corrective action in time. Second, in contract accounts it is a useful practice to have a progressive payment system, that is, the contractor agrees to pay a certain percentage of the certified work (say, 80 or 90 percent). This is advantageous for the contractor, as he obtains immediate liquid funds.
(2) Non-certified work: Refers to work that has been performed by the contractor but has not been approved by the contractor so far.
Certified work generally includes some element of benefit as well, while non-certified work is always valued at cost to the contractor.
Subcontracts: The contractor may entrust a part of the work to be carried out under the contract to a subcontractor. Generally, jobs of a specialized nature, that is, steel work, special floors, etc., are performed by subcontractors, who are responsible to the main contractor. The cost of such subcontracts is a direct charge against the contract for which the work has been performed.