A contract is a large job that requires considerable time to complete and comprises activities to be performed outside of factory promises viz. construction of a dam or school building, laying of railways, etc. Since each contract involves considerable resources both in terms of men and materials, it is necessary to devise an appropriate accounting system to determine the cost and profit earned on each separate contract.

Gain on incomplete contracts: At the end of an accounting period, certain contracts may be found to have been completed while others are still in the works and will be completed in the next few years. The total profit made on the completed contract says that it will be safely taken to the credit of the profit and loss account. But the same cannot be done in case of incomplete contracts. These contracts are still in process and there are possibilities that the profits will turn into losses due to a sharp increase in the prices of materials and labor and losses due to other unforeseen contingencies. At the same time, it also does not seem desirable to be able to consider earnings only on completed contracts and ignore completely incomplete ones because this can result in strong fluctuations in the earnings figure from year to year. A year in which a large number of contracts have been completed will show an abnormally high profit figure, whereas the reserve may be the case in the year in which a large number of contracts remain incomplete. Therefore, the gains from incomplete contracts must, of course, be considered after adequate sums have been provided to meet unknown contingencies.

There are no hard and fast rules for calculating the profit figures that should be credited to the profit and loss account. However, the following rules can be followed:

(has) Profit must be considered only with respect to certified work, non-certified work must always be valued at cost.

(b) The benefit should not be taken into account if the amount of certified work is less than 1/4 of the contract price because in such cases it is not possible to clearly foresee the future.

(against) If the amount of certified work is 1/4 or more but less than 1/2 of the contract price, 1/3 of the disclosed profit, less the percentage of cash received from the contractor, should be recognized in the profit and loss account. bill. The balance must be allowed to remain as a reserve.

(d) If the amount of certified work is very close to completion, if possible, the full cost of completing the contract should be estimated. The estimated total profit of the contract can be calculated by subtracting the estimated total cost from the contract price. The gain and loss must be credited with the proportion of the estimated total cash gain that the certified work has with the total contract price.

(me) The entire loss, if any, must be transferred to the profit and loss account.

Cost Plus contracts: In certain contracts, the employer agrees to pay the contractor the cost price (generally the principal cost) of the work performed on the contract plus an agreed percentage thereof for overhead and profit. Such contracts are known as cost plus contracts. The cost plus contract cost system is used in cases where it is very difficult for the contractor to quote the contract price because there has been no precedent on which to base it. It is also used when the work to be done is not fixed at the time of placing the order for the contract. The method is generally used when the government is the contracting party. The method suffers from the following disadvantages:

There is no incentive for the contractor to eliminate waste and save the cost of completing the contract. On the other hand, he is tempted to increase the cost because the higher the cost, the greater his share of the profit. In the case of this system, the amount of overhead recovered and the profits made depend on the value of the materials used, which is subject to considerable price fluctuations. Therefore, the agreed fixed percentage may be too high or too low to cover overhead and profit.

Escalation clause: The escalation clause is generally provided in the contract as a safeguard against any probable changes in labor and material utilization prices. The clause establishes that in the event that the prices of the articles of raw materials, labor, etc. specified in the contract, change during the performance of the contract, beyond a specified limit on the price in force at the time of signing the agreement, the contract price will be adjusted accordingly. The contract term specifies the procedure for calculating such adjustment in order to avoid all future disputes. Thus, such a clause safeguards the interests of both the contractor and the contractor in case of fluctuations in the price of materials and labor, etc.

Work in progress: At the end of the accounting period, a contract may still be in progress. The term work in progress refers to work performed for the contract, which is still incomplete. It consists of the following:

(1) Job certificate: It refers to the work approved by the contractor. In the case of contracts, it is a useful practice for the contractor to obtain approval of the work from time to time by the contractor. This is helpful to the contractor in two ways; First, in case the contractor finds that the work is out of specification, he can request the contractor to take corrective action in time. Second, in contract accounts it is a useful practice to have a progressive payment system, ie the contractor agrees to pay a certain percentage of the certified work (say 80 or 90 percent). This is advantageous for the contractor since he obtains immediate liquid funds.

(two) Uncertified work: This refers to work that has been carried out by the contractor but has not yet been approved by the contractor.

Certified work generally includes some element of profit, while non-certified work is always valued at cost to the contractor.

Subcontracts: The contractor may entrust a subcontractor with a part of the work to be carried out under the contract. Usually, work of a specialized nature, ie steel work, special flooring, etc., is performed by subcontractors, who are accountable to the main contractor. The cost of such subcontracts is a direct charge against the contract for which the work has been performed.