by An incomplete contract refers to a contract that is still under execution and not yet fully completed by the end of an accounting period. In such cases, work may be partially done, and costs incurred and revenues earned must be accounted for accordingly. Since the contract spans multiple periods, only a reasonable portion of the profit is recognized based on the work certified and cost incurred. This method ensures fair reporting of financial results, avoiding the overstatement or understatement of profits. Incomplete contracts are common in construction, engineering, and infrastructure projects that involve long durations.
Principles of Incomplete Contract:
- Prudence Principle
The principle of prudence emphasizes that profits should not be overstated and that only reasonable profits should be recognized from incomplete contracts. Since the work is not yet fully finished, uncertainties may arise due to cost overruns, disputes, or delays. Therefore, profit should be recognized only to the extent it is certain and realizable. Any expected loss, however, should be provided for in full. This principle protects the business from showing inflated profits that might later be reversed, thus ensuring more realistic financial reporting and minimized future risk exposure.
- Percentage of Completion Method
Under this principle, revenue and profit are recognized in proportion to the percentage of the contract work completed. This allows for progressive income recognition rather than waiting until the contract is fully finished. The method uses either work certified or cost incurred as a base to determine the extent of completion. The stage of completion guides the amount of profit to be transferred to the Profit & Loss Account. This principle ensures the matching of income with the period in which the related costs are incurred, promoting transparency and fairness in reporting.
- Realization Principle
According to this principle, income is recognized only when it is realized or realizable. In the context of incomplete contracts, profit should be recognized only on work that has been certified by the client’s engineer or architect, as this represents work officially acknowledged and billed. Work uncertified should be valued at cost without recognizing any profit. This approach ensures that revenues are not prematurely booked. It is a conservative accounting principle that safeguards the integrity of financial statements and avoids recognizing income from work that may not yet result in payment.
- Cost Matching Principle
This principle ensures that costs incurred are matched with the revenue recognized during a specific accounting period. When recognizing a portion of the contract profit, only the costs directly related to the certified work should be considered. This avoids misrepresentation of financial performance and aligns with accrual-based accounting. By applying this principle, businesses can provide a more accurate picture of profitability and financial health over the duration of long-term contracts. It helps prevent both underreporting and overreporting of profits in any accounting period.
- Conservatism in Valuation
Incomplete contracts often include elements like work uncertified, retention money, and unbilled revenues, which are inherently uncertain. Therefore, valuation should be done conservatively. Work uncertified should be shown at cost only, retention money should be recorded as a receivable only when reasonably assured, and escalation claims should not be included unless accepted. This principle encourages businesses to be cautious in recognizing income and assets, thereby protecting stakeholders from misleading financial information and helping maintain the financial stability of the business in the long run.
- Provision for Contingencies
Due to the long-term nature of contracts, various uncertainties can arise—such as changes in material costs, labor disputes, climatic issues, or policy changes. The principle of providing for contingencies involves retaining a portion of the notional or estimated profit until the contract is complete. This reserve acts as a safety margin against unforeseen circumstances. The retained profit appears in the balance sheet under work-in-progress and is not transferred to the Profit & Loss Account until the contract is fully completed and final results are known.
