# 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 Price 2,000,000 Total Expected Costs 1,200,000 Costs incurred to Date 800,000 Value of work certified as complete 1,000,000 Amount billed to customer 900,000 Progress payments received from customer 700,000

### 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 LTDIncome Statement (Extracts for the Year 1) \$ Revenue 1,000,000 Cost (600,000) Profit 400,000

 ABC Builders LTDBalance Sheet (Extracts at the end of the Year 1) Current Assets \$ Trade Receivables 200,000 Gross Amount due from Customers 300,000

### 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 Recognized 1,000,000 Cost Recognized 600,000 Costs Incurred 800,000 Amount Received from customer 700,000 Trade Receivable 200,000 Amount due from customer 300,000 1,800,000 1,800,000

### 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 Price 2,000,000 Total Expected Costs 1,200,000 Costs incurred to Date 800,000 Amount billed to customer 900,000 Progress payments received from customer 700,000

### 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 LTDIncome Statement (Extracts for the Year 1) \$ Revenue 1,333,333 Cost (800,000) Profit 533,333

 ABC Builders LTDBalance Sheet (Extracts at the end of the Year 1) Current Assets \$ Trade Receivables 200,000 Gross Amount due from Customers 433,333

### Step 6 - Prepare Construction Contract Control Account

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

 Contract Control Account Debit \$ Credit \$ Revenue Recognized 1,333,333 Cost Recognized 800,000 Costs Incurred 800,000 Amount Received from customer 700,000 Trade Receivable 200,000 Amount due from customer 433,333 2,133,333 2,133,333