Introduction to accounting for long-term contracts/contract costing

Accounting rules require organisations to produce annual accounts. They are not normally permitted to produce accounts for periods in excess of this. It is also recognised that the revenue for this period is matched with the expenditure incurred in generating that revenue.

For most companies this causes no major difficulties or problems as the goods produced take a relatively short period of time to complete, certainly well within a 12 month period. It follows, therefore, that the revenue from such work and the cost incurred in producing the goods can be easily ascertained. Thus the company can report quite accurate profits for the work undertaken in this same 12 month period.

However, many companies undertake work that is not completed within 12 months. Consider a building company or a business involved in shipbuilding. The construction of a major bridge or tunnel can take many years to complete, for example, the Channel Tunnel linking England and France.

Difficulties arise in such circumstances at financial year ends. A business needs to report annual profits or losses. How can it do this accurately when work is still incomplete, total costs are not known with any accuracy and it is possible unforeseen costs may arise? A tunnelling company may suddenly find that during construction unstable ground conditions are encountered. Bad weather may seriously delay completion. It is not uncommon for costs to exceed original estimates.

As a matter of good accounting practice, costs as they arise should be monitored against estimates. Any major departure should be investigated and controlled. Material costs may be getting excessive — this could be due to theft, receipt of damaged goods or failure to take advantage of discounts that may be on offer. On a large building site it is difficult to monitor the activities or attendance of the construction workers — systems must be put in place to control this.

In more complex examples, where contracts do span more than one accounting year, a number of considerations arise in ascertaining the profit to be taken on given contracts for particular years. The rules or principles are not matters that have to be dealt with in paper B2 (Cost Accounting Systems). These are dealt with in later stage papers. The general rules and procedures are generally covered in SSAP 9.

In paper B2, by way of introduction, there is only a requirement to produce contract accounts for contracts that are completed within a 12 month period. The assumption is also made in such situations that all costs are known with a reasonable degree of accuracy.

Contract accounts

A contract account takes the normal `T' account format. The account is credited with the value of the contract — this is usually agreed between the customer and the contractor at the start of the contract and is in principle a fixed amount.

All costs arising during completion of the contract are debited to the contract. These will include direct materials bought specifically for the work or residual materials transferred from other sites. They will also include the direct labour costs of individuals employed on construction. Any plant or equipment bought for the work or transferred from other sites will also be charged to the account. Additionally Head Office expenses and/or indirect overheads will be charged to the contract at some agreed rate. At the end of the contract consideration must be given to any costs that need accruing for (e.g., outstanding wages). It is also normal to credit the contract with any residual materials that can be transferred elsewhere and with the `written down' value of any plant and equipment that has any remaining useful life.

Notes to the contract account

All costs have been charged to the debit side of the account including items transferred from other contracts (see table below). The charge for head office costs based on the contract price has also been debited to the account and a provision has been made for the unpaid wages (£3,100) — note that this item is carried forward into the next accounting period as a credit balance.

The contract has been credited with the agreed contract price and with both the unused materials and net book value of usable plant and equipment. It may be assumed in this case that the unused materials and plant and machinery have some value — it may be the case that the material and plant have no further use.

The actual contract price agreed has been shown in this case as a single receipt. In reality the amount agreed would be paid in stages or instalments as the work progressed. Further, it is likely that the customer would also hold back a small percentage of these instalments. These would be held back as a form of insurance against unsatisfactory or faulty work. These items would not have to be accounted for in Contract Accounts at B2 level.

These matters would, however, be examined in higher level papers.

Example

AB Construction Ltd., have recently completed Contract KL99. This contract was to build a small footbridge for a City Council. The following information has been extracted from the records of the company:

(*) These values will be the written down value of the plant.

Head office costs and other overheads are charged to the contract at 8% of the agreed contract price.

Required

Produce the ledger account for Contract KL99 clearly showing the profit arising on completion. You may assume that the contract was completed within an accounting year.

Other considerations

All the costs charged are shown as totals for the period, but in reality these would be a whole series of smaller amounts for each cost element, being charged to the account as they arise over time.