Contract Costing: Profit Recognition on a Partly Completed Contract
Sunrise Constructions has a contract with a price of ₹60,00,000, expected to take 18 months; it began on 1 April 2024. At 31 March 2025 the following were recorded: work certified ₹36,00,000; cash received from the client ₹32,40,000, being 90% of work certified, the balance being retention; materials purchased ₹18,00,000, of which materials costing ₹2,00,000 were still at site; wages paid ₹12,00,000, with ₹40,000 earned but unpaid; site overheads ₹3,00,000; plant sent to site costing ₹8,00,000, to be depreciated at 25% per annum. No work remains uncertified. The accountant wants to credit the full difference between value certified and cost incurred to profit, arguing that cash has been received. The managing director is uneasy because the contract is only partly complete.
1. Compute the cost of work certified, the notional profit and the percentage of completion.
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| Cost of work certified | ₹ |
|---|---|
| Materials consumed (18,00,000 − 2,00,000 stock at site) | 16,00,000 |
| Wages (12,00,000 paid + 40,000 outstanding) | 12,40,000 |
| Site overheads | 3,00,000 |
| Depreciation on plant (25% × 8,00,000) | 2,00,000 |
| Total cost of work certified | 33,40,000 |
Notional profit = value of work certified − cost of work certified = ₹36,00,000 − ₹33,40,000 = ₹2,60,000.
Percentage of completion = ₹36,00,000 / ₹60,00,000 = 60%.
The plant is not charged to the contract in full; only the depreciation representing the portion of its life consumed is a contract cost. Materials still at site and wages not yet paid are excluded from cost because they have not been consumed in the work certified.
2. Decide how much profit may be taken to the statement of profit or loss, and compute the work in progress.
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Completion is 60%, which lies between 50% and 90%, so the standard formula applies:
Profit to P&L = 2/3 × Notional profit × Cash received / Work certified
= 2/3 × ₹2,60,000 × (₹32,40,000 / ₹36,00,000) = 2/3 × ₹2,60,000 × 0.90 = ₹1,56,000
Work in progress:
- Work certified: ₹36,00,000
- Less cash received: ₹32,40,000
- Less profit recognised: ₹1,56,000
- WIP = ₹2,04,000
Check: cost of work done ₹33,40,000 + retained profit (₹2,60,000 − ₹1,56,000 = ₹1,04,000) − cash received ₹32,40,000 = ₹2,04,000.
The retention of ₹3,60,000 remains a receivable; the ₹1,04,000 unearned profit is held back as a reserve against future costs and uncertainties.
3. Criticise the accountant's proposal, and state what would change if only 30% of the contract had been certified.
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Criticism: cash received is not evidence of profit. The ₹32,40,000 includes retention and relates to work whose remaining costs, defects liability and completion risks are still ahead. Crediting the whole ₹2,60,000 would overstate profit and distributable reserves, and would be inconsistent with prudence. The formula recognises only the earned portion (₹1,56,000) and defers the rest.
If only 30% were certified: completion would be below 50%, so no profit would be credited to the statement of profit or loss. Work in progress would be carried at cost less cash received, and if the contract showed an expected overall loss, the full anticipated loss would be provided immediately. This illustrates the principle that profit is recognised only when the outcome can be measured reliably, while foreseeable losses are recognised at once.