Profit Recognition on an Incomplete Construction Contract
Buildwell Contractors has a contract with a price of ₹50,00,000. At the end of the year, work certified is ₹30,00,000 and cash received is ₹24,00,000, the retention being 20%. Costs incurred to date are: materials ₹8,00,000, wages ₹6,00,000, plant depreciation ₹2,00,000, direct expenses ₹1,50,000 and overheads ₹1,50,000. Materials worth ₹50,000 are still at site. Work uncertified is ₹1,00,000. Estimated further cost to complete is ₹12,00,000. The site engineer wants to recognise profit in proportion to work certified because the contract is already 60% complete and the estimated total profit is ₹19,50,000. The finance manager is more conservative and points out that cash collection is only 80% of certified work and that a penalty clause for delay may be invoked.
1. Compute the notional profit and the profit to be transferred to the profit and loss account using the standard conservative formula.
Read the worked answer
Cost of work done to date
| Item | ₹ |
|---|---|
| Materials consumed (8,00,000 − 50,000) | 7,50,000 |
| Wages | 6,00,000 |
| Plant depreciation | 2,00,000 |
| Direct expenses | 1,50,000 |
| Overheads | 1,50,000 |
| Total | 18,50,000 |
Value of work done = work certified ₹30,00,000 + work uncertified ₹1,00,000 = ₹31,00,000.
Notional profit = ₹31,00,000 − ₹18,50,000 = ₹12,50,000.
Completion = ₹30,00,000 ÷ ₹50,00,000 = 60%. Cash received ÷ work certified = ₹24,00,000 ÷ ₹30,00,000 = 80%. Since completion is between 50% and 90%, use:
Profit to P&L = Notional profit × cash received/work certified × 2/3 = ₹12,50,000 × 80% × 2/3 = ₹6,66,667 (approx.).
The balance of ₹5,83,333 is retained as a reserve against future costs and uncertainty.
2. Evaluate the site engineer’s proposal to recognise ₹11,70,000 of profit (60% of estimated total profit).
Read the worked answer
The engineer’s figure is ₹19,50,000 × 60% = ₹11,70,000. It is more aggressive than the standard notional-profit method for three reasons.
- Cash realisation: Only 80% of certified work has been received. The unpaid 20% includes retention, which is not a default but is not cash either. Recognising profit on the full certified value ignores this.
- Uncertified work: ₹1,00,000 of work is not yet certified. It may be rejected or remeasured. The engineer’s calculation effectively gives value to it through the 60% completion ratio without a separate check.
- Future cost estimate: The ₹12,00,000 further cost is an estimate. If it rises, the ₹19,50,000 total profit falls. The standard formula deliberately recognises only part of the notional profit until the contract is near completion.
A more conservative approach also asks whether the penalty clause is probable. If it is, a provision should be made before transferring any profit. The engineer’s method may be acceptable only when the contract is near completion and costs are reliably known; at 60% completion it is too optimistic.
3. If cash received were only ₹15,00,000 and a penalty of ₹1,00,000 were probable, recompute the profit to be transferred.
Read the worked answer
Cash received ÷ work certified = ₹15,00,000 ÷ ₹30,00,000 = 50%.
Profit before penalty = ₹12,50,000 × 50% × 2/3 = ₹4,16,667.
Because the penalty is probable and can be estimated, create a provision:
Profit to P&L = ₹4,16,667 − ₹1,00,000 = ₹3,16,667.
The penalty is a foreseeable loss relating to the contract, so it should be charged in the current period rather than waiting until the penalty is actually imposed. If the penalty were only a possible obligation, it would be disclosed as a contingent liability instead of provided for.