Profit on incomplete contracts

18th July 2021 0 By indiafreenotes

(a) If a contract has not advanced to a sufficiently high stage, no credit for profit should be taken. Generally, no credit is taken unless the contract is at least one-fourth complete.

(b) In case the contract is 1/4 but less than 1/2 complete, one-third of the profit disclosed as reduced to the percentage of cash paid by the contractee should be transferred to the Profit and Loss Account, the balance being treated as a provision.

(c) In case the contract is one-half or more complete, two-thirds of profit (disclosed by the Contract Account) as reduced to the percentages of cash paid by contractee should be transferred to the P&L A/c, the remaining profit being treated as a provision.

(d) The whole of the loss, if any, should be transferred to the P&L A/c.

The following are the rules or principles to be followed in relation to profit on incomplete contracts:

(a) When work-certified is less than 25% of contract price- No profit should be transferred to P & L A/c. The entire notional profit is kept in reserve for contingencies.

(b) When work certified is 25% or more but less than 50% of the contract- 1/3rd of the notional profit, subject to the ratio of cash received to work certified, and is transferred to P & L A/c.

Profit credit to P& L a/c = Notional Profit*(Cash received/Work Certified) *1/3

(c) When work certified is 50% or more of the contract price- 2/3rd of the notional profit is transferred to P & L A/c, after reducing it further in the ratio of cash received to work certified.

Profit credit to P&L a/c = Notional Profit*(Cash received/Work Certified) *2/3

When a Contract is Nearing Completion:

Contracts on the verge of completion or nearing completion are dealt with in a different manner.

Escalation Clause:

When a contract is negotiated, ‘escalation clause’ may be included if the contract is likely to take some length of time. In periods of inflation and also when the economy is unstable, the contractor may feel that protection is needed against rise in material prices and wages rates.

The clause may provide for compensation to the contractor if the escalation in costs is more than an agreed limit. In such cases the contract price is increased to the agreed extent after calculating the exact amount of compensation. It can be credited to the contract account in case of incomplete contracts along with the work certified and uncertified.

Cost plus Contracts:

Estimating the costs exactly may prove difficult in some cases. Violent fluctuations in material prices and unexpected changes in wage rates may make quoting for a contract a hazardous task. The contractor may desire to make a specific rate of profit. In such circumstances, cost plus contracts are generally accepted.

Advantages of Cost-plus Contract:

(1) The contractor is sure of making desired profit, irrespective of cost fluctuations.

(2) It insures the contractor from price fluctuations.

(3) The contractee knows definitely the profit to be earned by the contractor.

(4) Contractee pays on the basis of cost rather than arbitrary price quoted.

Disadvantages:

(1) There is premium or incentive for inefficiency because the contractor has no incentive to control or reduce costs.

(2) The contractor has the scope to inflate his costs and consequently his profits also.

(3) The burden of justifying each cost falls on the shoulders of the contractor.

(4) In contractee’s anxiety to minimise the costs, quality may be sacrificed. Generally, cost plus contracts are more popular with government organisations.