Contract Account – SS3 Book Keeping Lesson Note (Second Term)

A contract account is a cost account kept by a contractor to record the costs and revenue of each building or construction contract and to find its profit.

Behavioural objectives

By the end of the lesson, students should be able to:

1. Define contract account.
2. State the features of a contract and the reasons for keeping a contract account.
3. Distinguish between short-term and long-term construction contracts.
4. Explain the common terms used in contract accounts.
5. Prepare a simple contract account and calculate notional profit.

What is a contract account?

A contract account is a system of cost accounting used by contractors engaged in construction and building works.

• Many contracts: a firm often executes several separate contracts at the same time.
• Long duration: each contract can continue for many years.
• Separate account: each contract has its own account, so its profit or loss can be found.

What are the features of a contract?

A contract has five main features: large direct costs, a site base, special customer requirements, long duration and low indirect costs.

1. Large direct costs: materials, wages and plant make up most of the cost.
2. Site-based: the work is done on the customer’s site, such as a road or a block of flats.
3. Special requirements: the work is done to the customer’s own specification.
4. Long duration: the work often lasts more than one year.
5. Low indirect costs: most costs can be charged straight to the contract.

Why is a contract account kept?

A contract account is kept to find profit, measure progress and deal with work that does not fit one financial year.

1. Profit: to find the profit of each contract.
2. Progress: to ascertain the level of contract execution.
3. Financial year: to take care of businesses whose work does not conform to a financial year’s calculation of profit.

What is a construction contract?

A construction contract is the execution of building and civil engineering projects, mechanical and electrical engineering installations and other fabrications.

• Agreement: it is usually evidenced by an agreement between two or more parties.
• Contractor: the firm that carries out the work.
• Contractee (customer or employer): the person or body that orders and pays for the work.

What are the types of construction contract?

There are two types of construction contract: short-term and long-term.

• Short-term construction contract: a contract expected to start and finish within one accounting period.
• Long-term construction contract: a contract for building a single substantial entity, or providing a service, where a substantial part of the work extends beyond one year.

What are the terminologies in contract accounts?

Contract accounts use five key terms: revenue recognition, contract work in progress, mobilisation fees, contract certification and retention monies.

1. Revenue recognition: the process of accounting for revenue in the financial statements when it has been earned.
2. Contract work in progress: the accumulated certifiable cost relating to a contract that is yet to be completed.
3. Mobilisation fees: the amount advanced by the employer to a contractor to enable construction work to start.
4. Contract certification: the process by which the project’s architect or engineer issues a certificate to evidence the value of work done as at a particular date.
5. Retention monies: the part of the contract value (for example 10%) that the customer withholds for a specified period after the contract ends, as the contract clause allows.

What is the difference between work certified and work uncertified?

Work certified is work the architect or engineer has approved, and work uncertified is work done but not yet approved.

How is a contract account prepared?

A contract account records all costs on the debit side and the value of work and closing assets on the credit side.

What items appear on the debit side?

• Materials: materials bought or sent to the site.
• Wages: wages of workers on the site.
• Plant: machinery sent to the site, at cost.
• Direct expenses: other costs charged straight to the contract.
• Subcontractors: payments to other firms for part of the work.

What items appear on the credit side?

• Materials returned: materials sent back to the store or supplier.
• Materials on site: unused materials at the end of the period.
• Plant on site: plant at the end of the period, at its value after depreciation.
• Work certified: value of work approved by the architect or engineer.
• Work uncertified: cost of work done but not yet certified.

How is notional profit found?

Notional profit is the balancing figure on the contract account before any adjustment for prudence.

1. Add up all the debit items to get the total cost.
2. Add up the credit items: materials and plant on site, work certified and work uncertified.
3. Subtract the total cost from the total credits.
4. The difference is the notional profit (a negative result is a loss).

Worked example

• Contract price: N10,000,000.
• Costs: materials N2,500,000, wages N1,800,000, plant N1,000,000, direct expenses N300,000.
• At year end: materials on site N200,000, plant on site N700,000.
• Work certified: N6,000,000. Work uncertified (at cost): N400,000.
• Cash received: N5,400,000.

How much profit is taken for an unfinished contract?

Only part of the notional profit is taken on an unfinished contract, to follow the prudence concept.

• Less than one quarter complete: no profit is taken.
• One quarter to one half complete: 1/3 × notional profit × (cash received ÷ work certified).
• More than one half complete: 2/3 × notional profit × (cash received ÷ work certified).
• Expected loss: the whole loss is recorded at once.

In the example, work certified is 60% of the price, so more than one half is complete.

1. Cash received ÷ work certified = 5,400,000 ÷ 6,000,000 = 0.9.
2. Profit taken = 2/3 × 1,700,000 × 0.9 = N1,020,000.
3. Profit not yet taken = 1,700,000 − 1,020,000 = N680,000, carried forward.

Evaluation

1. Define contract account.
2. State three features of a contract.
3. Distinguish between short-term and long-term construction contracts.
4. Explain retention monies and mobilisation fees.
5. Define notional profit and state how it is found.

Classwork: answer the evaluation questions above.

Assignment

List the features of a contract, state the reasons for keeping a contract account, and explain contract certification.

Teaching methods and materials

Instructional techniques

• Identification
• Explanation
• Questions and answers
• Demonstration
• Videos from source

Instructional materials

• Videos
• Loudspeaker
• Textbook
• Pictures

To close the lesson, the teacher commends the students positively.