How to calculate profit and loss on contracts?
The procedure for the determination of profit or loss on contracts under different circumstances may be given as follows:
1. Profit on Completed Contracts:
In case of contracts completed during the accounting year, the full contract price, whether payable in lump sum on the completion of the contract or payable by installments, shall be debited to the Contractee’s Personal Account and credited to the Contract Account.
The difference between the total of the two sides of Contract Account shall be transferred to Profit and Loss Account of the contractor by way of profit or loss. Sometimes, under the terms of the agreement, the contractor undertakes to rectify the defects, if any, in the contract work which may arise during a specified period (known as Maintenance Period after the date of the completion of the contract.
The amount of profit or loss on contracts in such a case should be ascertained only after making a sufficient provision for the cost of maintenance expected to be incurred during the maintenance period.
2. Profit on Incomplete Contracts:
As a general rule, profits on incomplete contracts should not be taken credit for. A number of arguments are given against the calculation of profits on incomplete contracts. Firstly, the anticipation of profits is against general accounting principles. Secondly, the true profit on a contract cannot be ascertained until a contract is finished since a contract which appears to be profitable in its early stages may finally result into a loss on account of unexpected losses. Lastly, income tax will be paid on profits at an earlier date than would otherwise be necessary.
But, it is counter-argued that by including profit on incomplete contracts in the Profit and Loss Account, undue fluctuations in the profits and dividends paid can be avoided. Secondly, some contracts may take several years to complete and if profits are calculated on such contracts on completion, it shall appear that the entire amount of profit has been earned in one year, which is not correct. Therefore, profits on incomplete contracts should be calculated very cautiously and only a portion of it may be credited to Profit and Loss Account.
The computation of profit on incomplete contracts has two aspects:
(a) Computation of Notional Profit at the End of the Accounting Period on Incomplete Contract.
For this purpose, the value of Certified Work and cost of Uncertified Work at the end of the accounting period is credited to the Contract Account. The amount of notional profit shall be:
(b) Computation of the Proportion of the Notional Profit to be Transferred to Profit and Loss Account.
The entire amount of notional profit at the end of the accounting period is not transferred to Profit and Loss Account. In view of the future uncertainties involved in contract work, only a portion of the notional profit is transferred to Profit and Loss Account and the remaining portion is kept by way of a provision to cover future contingencies. The following principles are generally followed for the purpose of ascertaining the proportion of notional profit to be transferred to Profit and Loss Account.
(i) Incomplete Contracts with Little Progress:
These are the contracts which have just commenced or where only a small portion of the contract (as a general rule, less than — ) has been finished. In case of such contracts, it is not prudent to take credit for any profit made thereon, since it is impossible to see the future position of such contracts clearly. The entire amount of notional profit on such contracts is kept by way of provision for contingencies and is transferred to the credit of Work-in-Progress Account so as to bring it down to its actual cost.
(ii) Incomplete Contracts with Appreciable Progress:
A contract is generally said to have made appreciable progress if at least 1/4 of the contract has been completed. The proportion of the notional profit to be transferred to Profit and Loss Account in respect of such contracts is computed as follows:
(a) When work certified is 1/4 or more than 1/4 but less than 1/2 of the contract price, the amount of profit to be transferred to profit and loss account should be:
(b) When work certified is 1/2 or more than 1/2 of the contract price, but the contract is not nearing completion, the profit to be transferred to Profit and Loss Account should be:
(iii) Incomplete Contracts Nearing Completion:
These are the contracts which are nearing completion. and the future costs to be incurred on their completion can reasonably be estimated. The amount of profit to be transferred to Profit and Loss Account, in this case, shall be ascertained on the basis of estimated profit. Estimated Profit, in case of contract nearing completion, is the difference between the contract price and the total estimated cost of contract on completion and can be ascertained as follows:
The calculation of the Estimated Cost of Contract on Completion shall be calculated as follows:
Moreover, only a proportion of the estimated profit is to be transferred to profit and Loss Account, leaving the balance to guard against future contingencies. The proportion of estimated profit to be transferred to Profit and Loss Account can be calculated by any of the following formulae:
Loss on Incomplete Contracts:
When an incomplete contract reveals a loss, the whole of the amount of such loss must be charged to the Profit and Loss Account of the accounting year.