Accounting for Profit Making Construction Contracts


Accounting treatment

Where outcome of the contract can be estimated reliably and the total revenues are likely to exceed total costs, contract revenue and costs (and hence profit) are to be recognized in the income statement on the basis of Stage of Completion of the contract (also known as Percentage of Completion Method).

Example 1 - Construction Contract Accounting using Value Based Approach

ABC Builders LTD is a construction firm. It enters into a 2 year contract for the construction of a building for one of its customers. ABC Builders LTD estimates stage of completion on the basis of value of work completed. Following information is available in respect of the contract at the end of first year:

$
Total Contract Price2,000,000
Total Expected Costs1,200,000
Costs incurred to Date800,000
Value of work certified as complete 1,000,000
Amount billed to customer900,000
Progress payments received from customer700,000

Step 1 - Determine Expected Outcome of the Contract

As the total contract revenue ($2m) exceeds total expected contract costs ($1.2m), the contract is expected to be profitable. Therefore costs and revenue be accounted for using stage of completion method.

Total Profit under the contract is expected to be $800,000.

Step 2 - Calculate the Stage of Completion

Stage of completion may be calculated as follows:

Stage of Completion % = [ $1,000,000 / $2,000,000] x 100 = 50 %

Step 3 - Determine the amounts to be recognized in Income Statement for Profit, Revenue and Cost

When stage of completion is calculated using value based method, revenue to be recognized is equal to the value of work certified as complete. Profit is calculated based on the percentage of completion of the contract whereas cost recognized in the income statement is the balancing amount arrived by calculating the difference between revenue and profit.

$
Revenue(Value of work Certified)1,000,000
Profit(800,000 x 50%)400,000
Cost(Balancing Amount: [1,000,0000 - 400,000])(600,000)

Step 4 - Calculate amounts to be recognized in the Balance Sheet for Gross Amounts due to/ from Customers and Trade Receivables

Trade Receivables are calculated finding the difference between amount billed to the customer for progress payments and the amount of progress payments received from the customer.

Trade Receivable of ABC Builders LTD should therefore be calculated as follows:

Trade Receivable = 900,000 (Amount Billed) - 700,000 (Amount Received) = $200,000

Gross Amount due from Customers is calculated by deducting the amount billed to customer (along with any losses recognized) from the sum of profit recognized and costs incurred to date.

Gross Amount due from Customers of ABC Builder LTD must therefore be calculated as follows:

Gross Amount due from Customer = 400,000 (Profit) + 800,000 (Cost Incurred) - 900,000 (Amount Billed) = $ 300,000

Step 5 - Prepare Extracts of Financial Statements in respect of Construction Contracts

ABC Builders LTD
Income Statement (Extracts for the Year 1)
$
Revenue1,000,000
Cost(600,000)
Profit400,000


ABC Builders LTD
Balance Sheet (Extracts at the end of the Year 1)
Current Assets$
Trade Receivables200,000
Gross Amount due from Customers300,000

Step 6 - Prepare Construction Contract Control Account

Although not a part of the double entry system, control accounts may be useful to confirm the overall accuracy of accounting entries relating to construction contracts. ABC Builders LTD's control account would appear as follows:

Contract Control Account
Debit$Credit$
Revenue Recognized1,000,000Cost Recognized600,000
Costs Incurred800,000Amount Received from customer700,000
Trade Receivable200,000
Amount due from customer300,000
1,800,0001,800,000

Example 2 - Construction Contract Accounting using Cost Based Approach

ABC Builders LTD is a construction firm. It enters into a 2 year contract for the construction of a building for one of its customers. ABC Builders LTD estimates stage of completion on percentage of cost basis. Following information is available in respect of the contract at the end of first year:

$
Total Contract Price2,000,000
Total Expected Costs1,200,000
Costs incurred to Date800,000
Amount billed to customer900,000
Progress payments received from customer700,000

Step 1 - Determine Expected Outcome of the Contract

As total contract revenue ($2m) exceeds total expected contract costs ($1.2m), the contract is expected to be profitable. Therefore costs and revenue be accounted for using stage of completion method.

Total Profit under the contract is expected to be $800,000.

Step 2 - Calculate the Stage of Completion

Stage of completion should be calculated as follows:

Stage of Completion % = [ $800,000 / $1,200,000] x 100 = 66.67 %

Step 3 - Determine the amounts to be recognized in Income Statement for Profit, Revenue and Cost

When stage of completion is calculated using cost based approach, Cost recognized in the income statement is the contract cost incurred to date. Profit is calculated based on the percentage of completion of the contract whereas Revenue recognized in the income statement is the balancing amount arrived by adding cost and profit.

$
Cost(Cost incurred during the year)800,000
Profit(800,000 x 66.67%)533,333
Revenue(Balancing Amount: [800,0000 - 533,333])1,333,333

Step 4 - Calculate amounts to be recognized in the Balance Sheet for Gross Amounts due to/ from Customers and Trade Receivables

of ABC Builders LTD should be calculated as follows:>

Trade Receivable = 900,000 (Amount Billed) - 700,000 (Amount Received) = $200,000

Gross Amount due from Customers of ABC Builder LTD must be calculated as follows:

Gross Amount due from Customer = 533,333 (Profit) + 800,000 (Cost Incurred) - 900,000 (Amount Billed) = $ 433,333

Step 5 - Prepare Extracts of Financial Statements in respect of Construction Contracts

ABC Builders LTD
Income Statement (Extracts for the Year 1)
$
Revenue1,333,333
Cost(800,000)
Profit533,333


ABC Builders LTD
Balance Sheet (Extracts at the end of the Year 1)
Current Assets$
Trade Receivables200,000
Gross Amount due from Customers433,333

Step 6 - Prepare Construction Contract Control Account

ABC Builders LTD's control account would appear as follows:

Contract Control Account
Debit$Credit$
Revenue Recognized1,333,333Cost Recognized800,000
Costs Incurred800,000Amount Received from customer700,000
Trade Receivable200,000
Amount due from customer433,333
2,133,3332,133,333