A contract is a large piece of work that takes considerable time to complete and comprises activities to be performed outside of factory promises, viz. construction of a dam or school building, laying of railway tracks, etc. Since each contract involves considerable resources both in terms of men and materials, it is necessary to devise an appropriate accounting system to determine the cost and profit obtained on each contract separately.
Gain on incomplete contracts: At the end of an accounting period, it may be found that certain contracts 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 say will be safely taken to the profit and loss account credit. But the same cannot be done in case of incomplete contracts. These contracts are still in process and there is a possibility that the gains will turn into losses due to a sharp increase in the prices of materials and labor and losses due to other unforeseen contingencies. At the same time, it also does not seem desirable to be able to consider earnings only on completed contracts and ignore completely incomplete ones because this can result in strong 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 a year in which a large number of contracts remain incomplete. Therefore, profits from incomplete contracts must, of course, be considered after providing adequate sums to meet unknown contingencies.
There are no hard and fast rules for calculating profit figures to be credited to the profit and loss account. However, the following rules can be followed:
(on) Profit should be considered only with respect to certified work, non-certified work should always be valued at cost.
(B) The benefit should not be taken into account 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.
(against) If the amount of certified work is 1/4 or more but less than 1/2 of the contract price, 1/3 of the disclosed profit, less the percentage of cash received from the contractor, must be taken to the profit and loss account. bill. The balance must be allowed to remain as a reserve.
(D) If the amount of certified work is very close to completion, the full cost of completing the contract should be estimated if possible. The total estimated contract profit can be calculated by subtracting 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 has with 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 owner agrees to pay the contractor the cost price (generally the principal cost) of the work performed on the contract plus an agreed percentage thereof for overhead and profit. Such contracts are known as cost-plus contracts. The cost plus contract cost system is used in cases where it is very difficult for the contractor to quote the contract price because there has been no precedent on which to base it. It is also used when the work to be done is not fixed at the time the contract order is placed. 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, he is tempted to increase the cost because the higher the cost, the greater his share of the profit. In the case of this system, the amount of overhead recovered and the profit made depends on the value of the materials used, which is subject to considerable price fluctuations. Therefore, the agreed fixed percentage may be too high or too low to cover overhead and profit.
Escalation clause: The escalation clause is usually provided in the contract as a safeguard against any likely changes in the prices for the use of materials and labor. The clause establishes that in the event that the prices of the items 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 agreement, the contract price will be adjusted accordingly. The contract term specifies the procedure for calculating such an adjustment in order to avoid all future disputes. Thus, such a clause safeguards the interests of both the contractor and the contractor 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 work done for the contract, which is still incomplete. It consists of the following:
(1) Job certificate: Refers to the work approved by the contractor. In the case of contracts, it is useful practice for the contractor to obtain approval of the work from time to time by the contractor. This is helpful to the contractor in two ways; First, in case the contractor finds that the work does not meet the specifications, he can request the contractor to take corrective measures in time. Second, it is a useful practice in contract accounts 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.
(two) Uncertified work: Refers to work that has been performed by the contractor but has not yet been approved by the contractor.
Certified work generally includes some element of profit, while non-certified work is always valued at cost to the contractor.
Subcontracts: The contractor may entrust a subcontractor with a part of the work to be performed under the contract. Generally, work of a specialized nature, ie steel work, special flooring, etc., is 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.