Profit on Incomplete Contracts

In contract costing, especially in long-term projects, contracts may span several accounting periods. In such cases, it becomes necessary to calculate and recognize a portion of the profit earned from contracts that are incomplete at the end of the financial year. This practice follows the matching principle of accounting, ensuring that revenues and related expenses are recognized in the same period.

Recognizing profit on incomplete contracts is vital for reflecting the true financial position and operational performance of a business, particularly in industries like construction, shipbuilding, or infrastructure development where contracts are typically long-term and high-value.

Purpose of Calculating Profit on Incomplete Contracts:

• To report realistic financial results.

• To match cost and revenue within the accounting period.

• To avoid overstating or understating profits.

• To provide timely financial data to management, shareholders, and creditors.

Since incomplete contracts are not fully billed or paid, only a reasonable and prudent portion of the profit is recognized. This ensures that revenue recognition is not aggressive and reflects actual performance.

Basis of Profit Recognition:

Profit on incomplete contracts can be estimated using two key profit figures:

• Notional Profit = Work Certified – Cost of Work Certified

• Estimated Profit = Contract Price – (Cost Incurred to Date + Estimated Cost to Complete)

Depending on the level of completion of the contract, either notional or estimated profit is used.

Stages of Completion and Treatment:

The stage of completion determines how much profit should be recognized. General accounting practice includes:

a. Less than 25% Complete

• No profit is recognized.

• The contract is still in its early stages.

• All costs are carried forward as work-in-progress.

b. 25% to 50% Complete

• Recognize 1/3 of Notional Profit, adjusted for cash received.

Formula:

Profit to P&L = 1/3 × Notional Profit × (Cash Received / Work Certified)

c. 50% to 90% Complete

• Recognize 2/3 of Notional Profit, adjusted for cash received.

Formula:

Profit to P&L = 2/3 × Notional Profit × (Cash Received / Work Certified)

d. 90% or More (Near Completion)

• Use Estimated Profit as basis.

• Recognize a prudent portion of the estimated profit.

Formula:

Profit to P&L = Estimated Profit × (Work Certified / Contract Price) × (Cash Received / Work Certified)

Or simply:

Profit to P&L = Estimated Profit × % of Completion × Cash Ratio

These formulas help balance the amount of profit to be recognized while considering the risk associated with incomplete work.

Profit Transfer to Profit and Loss Account:

Only the calculated share of profit is transferred to the Profit & Loss account. The remainder is retained as reserve against contingencies or shown under Work-in-Progress in the Balance Sheet. This provides a cushion for future losses, cost overruns, or disputes.

Presentation in Financial Statements:

• Balance Sheet:

  • Work-in-progress is shown as an asset.

  • Retention money receivable is also included under current assets.

  • Any reserve or deferred profit is shown separately.

• Profit & Loss Account:

  • Only the calculated share of profit is credited.

  • Costs of contract and other related expenses are debited.