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 LTD - Income Statement (Extracts for the Year 1) | |
|---|---|
|
|
$ |
|
Revenue |
1,000,000 |
|
Cost |
(600,000) |
|
Profit |
400,000 |
| ABC Builders LTD - Balance 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
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) | |
|---|---|
|
|
$ |
|
Revenue |
1,333,333 |
|
Cost |
(800,000) |
|
Profit |
533,333 |
| ABC Builders LTD - Balance 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 |