Chapter 3

Contract Accounts
 Contract Accounts

3.1 Financial statements and the business cycle

The span of production differs between businesses, and some fit into the normal pattern
of annual financial statements more easily than others. A farmer's financial statements are
usually admirably suited to the yearly pattern, as the goods they produce are in
accordance with the seasons, and therefore repeat themselves annually. With a firm
whose production span is a day or two, the annual financial statements are also quite
suitable.

On the other hand, there are businesses whose work does not fit neatly with a
financial year's calculation of profits. Assume that a firm of contractors has only one
contract in progress, the construction of a large oil refinery complex which is expected to
take five years to complete. Until it is completed, the actual profit or loss on the contract
cannot be accurately stated — too many things could happen that would affect the final
profit or loss over the five years of the contract. However, if the company was formed
solely for the purpose of undertaking this contract, the shareholders would not want to
wait for five years before the profit could be calculated and dividends paid. As a result,
an attempt must be made to calculate profits earned to date at the end of each financial
year. Some companies will have more than one contract under way at a time, each at a
different stage, in which case the profit earned to date on each contract must be calculated.

3.2 Contract accounts

When a company starts a long-term contract, an account is opened for it. It is, in fact, a
form of trading account. As an example, if a company has a contract to construct a new
college building, it may be called Contract 71, in which case an account for ‘Contract 71’
would be opened. All expenditure traceable to the contract is charged to the account. This
is far easier than apportioning expenses to specific products manufactured in a factory, as
any expenditure on the contract site will be expenses of the contract, e.g. wages for the
manual workers, rental of telephone lines, hire of machinery, wages for the timekeepers,
clerks.

3.3 Certification of work done

When a building is being constructed, the contractor is paid on the basis of architects'
certificates. In the case of an engineering contract, it is on the basis of an engineer's
certificate. The architect, or engineer, will visit the site at regular intervals and will issue
a certificate stating his or her estimate of the value of the work done, in terms of the total
contract price (the sale price of the whole contract). For example, a certificate may be
issued for £90,000 which represents the proportion of the total contract amount which he
or she believes has been completed.

Normally, the terms governing the contract will contain a clause concerning
`retention money'. This is the amount, usually stated as a percentage, which will be
retained, i.e. held back, in case the contract is not completed by a stated date, or in case

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there are claims made for faulty workmanship, etc. A 10% retention in this case would
lead to £81,000 being payable by the organisation for whom the contract was being
performed.

3.4 Allocation of overheads

Any administration overhead expenses that are not directly traceable to individual
contract sites may be split between the contracts using an appropriate base, such as the
overall contract amount or the labour cost to date. Of course, if there were only one
contract then all the overhead expenses would quite rightly be chargeable against it. On
the other hand, if there are 20 contracts, any apportionment will be arbitrary. No one can
perfectly apportion the administration overhead expenses of, for example, the managing
director's salary, the cost of advertising to give the business the right ‘image’, or the costs
of running the accounting system for the whole company, and these are only a few of
such difficult to apportion expenses.
Similar to the effects of apportioning overheads in departmental accounts, as
covered in Chapter 38 of Business Accounting 1, the allocation of overheads to
individual contracts may sometimes produce misleading results. It is, therefore, far better
for the administrative overhead expenses which are obviously not chargeable to a
contract to be omitted from the contract accounts. The surplus left on each contract
account would, therefore, represent the ‘contribution’ of each contract to administrative
overhead expenses and, thus, to profit.
Let's look at a worked example.

3.5 A worked example of a contract account

In many cases, contracts will start and finish in the same financial period. In such cases,
there is no need to estimate profits and losses at the period end. However, when a
contract extends into one or more periods after it started, it is known as a ‘long-term
contract’ and an appropriate estimate of profits or losses must be made so that appropriate
entries can be made in the financial statements. In Exhibit 3.1, Contract 44 extends into a
second accounting period.
This example shows how profit or loss may be calculated for inclusion in
financial statements prepared for internal purposes. As you will later learn, when
financial statements are prepared for publication, a more complex approach to the
calculation of profit or loss must be used.

Exhibit 3.1
Contract 44 is for a school which is being built for the Blankshire County Council. By the
end of the construction company's financial year, the following items have been charged
to the contract account:

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 Contract Accounts

The entries concerning expenditure traceable direct to the contract are relatively simple.
These are charged to the contract account. These can be seen in the contract account
shown below.
Architects' certificates have been received during the year amounting to £147,000.
It is assumed that the certificates relate to all work done up to the year end. A retention of
10% is to be made, and the Blankshire County Council has paid £132,300 so far. The
£147,000 has been credited to a holding account called an Architects' Certificates
Account and debited to the Blankshire County Council Account.
The total of the Architects' Certificates Account now needs to be transferred to the
Contract 44 account. It is, after all, the 'sale' price of the work done so far, and the
contract account is a type of trading account. The £132,300 received has been debited to
the bank and credited to Blankshire County Council Account, which now shows a
balance of £14,700 representing the retention money.
The cost of the materials on the site at the end of the period is not included in the
value of the architects' certificates and is, therefore, carried forward to the next period at
cost. The value of the plant at the end of the year is also carried forward. In this case the
value of the cost of the plant not yet used is £14,000. This means that £20,000 has been
debited for the plant and £14,000 credited thus, effectively, charging £6,000 for
depreciation. Assume that the unused materials cost £8,000.
The Contract 44 account will appear as follows:

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 Contract Accounts

3.6 Profit estimation

In order to estimate the profit or loss on Contract 44, more information is needed
beyond the values shown in the contract account. The contract is only part-completed,
and costly snags may crop up which would dissipate any potential profit earned, or
problems may have developed already, such as subsidence which has remained unnoticed
as yet. It is not possible to identify all known factors of this type. To minimise the risk of
profits being overstated or losses understated, the concept of prudence is applied and the
profit is reduced according to an ‘appropriate’ modifier.

A custom developed over many years of multiplying the profit shown on the
contract account by two-thirds and then multiplying the result by the proportion of work
certified for which

Cash had been received. While the current and far more complex IAS 11 and IAS
18 rules must be adopted in practice when preparing financial statements for publication,
the previous, simpler approach is an excellent example of the prudence concept and is
still used in examinations. You will, therefore, need to learn how to apply it.

It is relatively straightforward to apply, as shown in the following example:

For example: the apparent profit earned to date on Contract 44 is £14,000 (see Activity
3.2)

On the basis of the £8,400 profit calculated above, the Contract 44 account can now be
completed

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 Contract Accounts

Profit and Loss

Profit from contract £
Contract 43 ?
Contract 44 8,400
Contract 45 ?

3.7 Anticipated losses

In the above case, there was an apparent profit earned to date of £14,000 but we only
recognise £8,400 in the financial statements. If instead of revealing such a profit, the
contract account had shown a loss, all the loss would be recognised now. Thus, if the loss
were £9,000, that would be the amount transferred to profit and loss. This is in
accordance with the concept of prudence.

As is the case with valuation of inventory it is not always the case that an engineer
or architect will certify the work done on the last day of the financial year. He or she may
call several days before or after the year end. The cost of any work done but not certified
at the year end is carried down at cost as a balance to the next period when certification
will take place.

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 Contract Accounts

So far, we have considered how the various figures to be included in the financial
statements prepared for internal use may be calculated. When financial statements are
prepared for external use, i.e. for publication, the more complex IAS 11/IAS 18 approach
must be adopted.

You may not need to know the current accounting standard rules relating to long-term
contracts. It depends upon which examinations you are studying for. If you do, Section
3.8 provides an introduction to the rules contained in IAS 11 (Construction Conracts) and
IAS 18 (Revenue) but you will need to consult the relevant International accounting
standards or a more advanced textbook on the subject before tackling your examinations.

3.8 Long-term contracts and accounting standards

Long-term contracts should be assessed on a contract by contract basis. They should be

reflected in profit and loss by recording turnover and related costs as contract activity
progresses. Turnover should be ascertained in a manner appropriate to the stage of
completion of the contract, the business and the industry in which it operates. Where the
outcome of a contract can be assessed with reasonable accuracy, profit should be
recognised (so far as prudence permits) as the difference between recognised turnover
and related costs. Any foreseeable losses identified should be immediately recognised.
The amount of long-term contracts, at costs incurred, net of amounts transferred to cost of
sales, after deducting foreseeable losses and payments on account not matched with
turnover should be classified as ‘long-term contract balances’ and disclosed separately
within the balance sheet heading of ‘inventory’. The balance sheet note should disclose
separately the balances of ‘net cost less foreseeable losses’ and ‘applicable payments on
account’.

Profit recognition
There are two definitions relevant to any consideration of long-term contracts:
those of ‘attributable profit’ and ‘foreseeable losses’.

Attributable profit is that part of total profit currently estimated to arise over the
duration of the contract, after allowing for estimated remedial and maintenance costs and
increases in costs (so far as not recoverable under the terms of the contract), that fairly
reflects the profit attributable to that part of the work performed at the accounting date.
There can be no attributable profit until the outcome of the contract can be assessed with
reasonable certainty.

Foreseeable losses are those losses estimated to arise over the duration of the
contract, after allowing for estimated remedial and maintenance costs and increases in
costs (so far as not recoverable under the terms of the contract), whether or not work has
commenced, and irrespective of both the proportion of work completed and profits
expected on other contracts.

A contract's outcome must be capable of being assessed with reasonable certainty

before any profit should be recognised. This leaves it entirely too individual judgement as

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to when to start recognising profit on a long-term contract. One company may recognise
profit after the first six months, while another may wait until a year has passed. As a
result, inter-company comparability is impaired. However, the standards do assist in
inter-company comparison from one year to the next as they require consistent
application of the method of ascertaining attributable profit both within the business, and
from year to year.

Clearly, future costs must be estimated in arriving at a figure for attributable profit
or foreseeable losses. Unfortunately, no two people are likely to arrive independently at
exactly the same amount. Thus, the profits or losses recognised are likely to vary
considerably from one company to another and intercompany comparability is further
impaired.

Turnover valuation
Turnover should be ascertained in a manner suitable to the industry and the
specific contracts concerned. The valuation of work carried out may be used to derive a
value for turnover and profit then calculated; or profit should be regarded as earned in
relation to the amount of work performed to date. These two approaches often produce
different results, but the profit recognised needs to reflect the proportion of the work
carried out and to take into account any known inequalities of profitability in the various
stages of a contract. Consequently, when there is a work certified value, this should be
used as the turnover value and the costs incurred in achieving that turnover charged to
cost of sales.

Where no work certified figure exists, costs to date as a proportion of total

expected costs should be applied to the contract value in order to determine the figure for
turnover. Where the work certified value is not available for all work completed, a
combination of the two approaches would be appropriate. One further point regarding
turnover concerns settlements of claims against the purchaser arising from circumstances
not foreseen in the contract: these should only be incorporated when there is sufficient
evidence that payment will be received.

Complexity
The standards relevant to this topic are extremely complex and it is beyond the
scope of this book, where this topic is being introduced rather than developed in detail, to
extend coverage to the level of complexity that would be required in order to cover the
rules adequately.

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