CONTRACT ACCOUNTS

WEEK 4                                                                                                            DATE______________

TOPIC: CONTRACT ACCOUNTS

CONTENTS:

• Definition of contract account

• Reasons for contract account

• Types of construction contract

• Methods of recognizing revenue under contract account

• Preparation of contract accounts

SUB-TOPIC 1:

Meaning of contract account

This is a system of cost accounting used by contractors engaged in construction and building works where it is common for a firm to be engaged in execution of many separate contracts at the same time an which can continue over a long period of time (many years).

Features of contract

i.the cost that is direct and is large

ii.it is site based

iii.it is undertaken to customer’s special requirement

iv.it is of relatively of long duration

v. there is low indirect cost

Reasons for contract account

1. To find the profit on each contract

2. To ascertain the level of contract execution

3. To take care of such businesses whose nature of work does not conform to a financial year’s calculation of profit.

Construction contract

Construction contracts can be defined as the execution of building and civil engineering projects, mechanical and electrical engineering installations and other fabrications usually evidenced by an agreement between two or more parties (i.e. contractor and customer).

Types of construction contract

1. Short term construction contract

2. Long term construction contract

Short term construction contract: This refers to a contract which is expected to be started and completed within an accounting period.

Long term contract: it is a contract entered into for manufacture or building of a single substantial entity or the provision of a service where the time taken to manufacture, build or provide is such that a substantial proportion of all such contract work will extend for a period exceeding one year.

A contract account is a financial statement that summarizes all information related to work performed and payments received from a project under a construction contract. There are several reasons why a company might need to track its performance on a project using a contract account, including:

• To accurately report revenues and costs associated with the work being done under the contract;

• To keep track of performance milestones and ongoing project costs;

• To ensure that payments received from the client are properly allocated to the work being completed under the contract.

There are several different types of construction contracts that may be used in a project, including fixed-price, cost-plus, and time-and-materials contracts. In a fixed-price contract, the client agrees to pay a specific price for the agreed-upon scope of work, regardless of any changes or additions that may be required during the course of the project. Under a cost-plus contract, on the other hand, the company is reimbursed for all costs incurred in performing the work, and also receives a percentage of the project budget as profit. Finally, in a time-and-materials contract, the company is paid based on the number of hours worked and the cost of materials used for each task performed.

There are several different methods that can be used to recognize revenue under a construction contract, including the completed contract method, the percentage of completion method, and the adjusted-retained earnings method. Under the completed contract method, revenue is recorded once all work under the contract has been completed and delivered to the client. The percentage of completion method is based on estimates of costs incurred and revenues earned over the course of a project, while the adjusted-retained earnings method takes into account any changes to project estimates and the costs of outstanding work orders. In order to prepare contract accounts for a construction project, companies will typically use a combination of these different methods depending on the specifics of the project and the accounting standards that apply.

Terminologies:

1. Revenue recognition: This is the process for accounting for revenue in the financial statements when it has been earned.

2. Contract work in progress: This is the accumulated certifiable cost relating to contract that is yet to be completed.

3. Mobilization fees: This is the amount advanced by employer to a contractor to enable construction work to start.

4. Contract certification: This is a process by which the project’s architect or engineer issues a certificate to evidence the value of work done on a construction contract as at a particular date.

5. Retention monies: There is frequently a contract clause that entitles the customer to withhold payment of a proportion of the contract value (10%) for a specified period after the end of the contract.

SUB –TOPIC 2

Methods of revenue recognition

Revenue recognition means the process of accounting for and inclusion of revenue from a contract in financial statement. In contract account, revenue is deemed realized at the point where the portion of the work responsible for generating the revenue has been performed.

There are two main methods of recognizing revenue under contract account as follows

1. Completed contract method

b .Percentage of completion method

COMPLETED CONTRACT METHOD

This is a method used for short-term contracts i.e a contract that will take more than 12 months to complete.

Accounting entries

1. DR: contract account with all the expenses applicable to that particular contract

b.CR:             contract account, debit personal account of customers with contract price

c.find profit or loss on contract and transfer to profit and loss account on contract account

d.when the customer pays ,credit his personal and debit bank

Example

On 1 July 2005, the consortium builders were engaged to construct a stretch of 2 km road at a contract price of N100, 000.The contract was tagged contract No.6 by the company. During the year, the company incurred the following expenditure on the contract:

N

The equipment purchased has an estimated useful life of four years and the company adopts straight line method of depreciation in providing for depreciation on all its assets.

You are required to prepare a Contract account for contract No 6 for the years ended June ,2006

CONSORTIUM OF BUILDERS

CONTRACT NO.6

Depreciation calculation:

Cost of equipment =N45, 000

Estimated useful life =4 years

Scrap value   =nil

4

Evaluation:

1. Define contract account

2. Mention five features of contract

3. State two types of construction contract

4. What are two methods of revenue recognition in contract account?

Sub-topic 1:

Percentage of completion method

Under this method, profit is recognized based on the degree of work done. It is applicable where cost of completion can be calculated with a degree of certainty.

Calculating profit under percentage of completion method

The traditional method of calculating notional profit would be used as follow:

Profit to be taken =2/3 x cash received                        x            notional profit

Evaluation:

1. Define percentage of completion method of recognizing contract revenue

Sub- Topic 3

Example 1:

As a precaution this amount is further reduced according to the progress payments made. The only profit taken is that obtained by taking a fraction.

Progress payment received

Value of architect’s certificates

Thus if N9, 000 had been received, the profit actually credited would be

9,000       x        2,000    =N1, 500

12,000

CONTRACT

Evaluation: practice question 8 of the essential financial accounting page374

GENERAL EVALUATION

Objective Test:

Use the information below to answer the questions that follow:

If a contract that is worth N200, 000 is certified as 40 per cent complete. The total cost of the contract is N150, 000.

4. The part of the final price of a contract which are withheld when paying a contractor when a contract has not been completed a.kick back money  b.contract price c.retention money    d.mobilisation money

5. The justification for taking two-third off the profit on an uncompleted contract before payment is affected is (A)to evidence a satisfactory performance of job on the part on which it is issued bidon because it is required by the law c.to calculate the portion of profit to be recognized on the contract d.to delay payment of money to the contractor

6. The completed method of recognizing revenue is mostly adopted in situation a.money involved in a contract is huge b. where there are no dependable estimates of the amount of costs that will complete the contract c. where the contract will be completed within a very short period

d.when it is agreed to by all the parties in a contract site

7. The purpose of issuance of certificate on the part of a contract before payment is effected is a.to evidence a satisfactory performance of job on the part on which it is issued

b.done because it is required by the law

c.to calculate the portion of profit to be recognized on the contract d.to delay payment of money to the contractor

Under the percentage of completion method, revenue is only recognized when a fraction of the work has been completed.

Revenue recognition
The revenue for a contract is recognized as work is completed and the associated risks and rewards are transferred to the customer.
Contract work in progress
Any work that has been started on a contract, but has not yet been completed, is recorded as contract work in progress.
Mobilization fees
These are fees charged by contractors to mobilize their resources to begin work on a project.
Contract certification
This is the process of verifying that the contractor has met all the requirements specified in the contract.
Retention monies
These are payments made to contractors as an incentive to keep them working until the project is completed.

Essay

1. Write a short note on the following
   • Revenue recognition
   • contract work in progress
   • mobilization fees
   • contract certification
   • retention monies