Financial Aspects of Contract
Accounting Methods
The main theme of contractor’s accounting system centers around the determination of income and expense from each of its construction projects i.e., to say each contract is treated as a separate profit center.
The cash method and the accrual method are two basic accounting procedures. Under the cash method, income is taken into account only when cash is actually received, and expense is taken into account only when cash is actually expended.
The cash method is simple and straight forward form of income recognition and no attempt is made to match revenues with the accompanying expenses.
The accrual method is the second basic accounting procedure. Under these method, income is taken into account in the fiscal period during which it is earned, regardless of whether payment is actually received.
Accounting for long term contracts:
The tax reform act of 1986 mandates that one of three methods of accounting must be applied by contractors to their long term construction contractors. These are called the percentage of completion method, the percentage of completion- capitalized cost method, and the completed contract method.
Percentage of completion method:
The percentage of completion method recognizes job income from long term contracts as the work advances. Thus, the profit is distributed and the taxes are paid over the fiscal year during which the construction is under way. This method has a advantage of recognizing project income periodically on a current basis rather than regularly as contractors are completed.
Completed contract Method:
The completed contract method of accounting recognizes project income only when the contract is completed. What actually constitutes completion of a contract for income- reporting purposes has been subject to varying interpretation by the courts. Under the completed contract method, project costs are accumulated during construction using extended period cost capitalization. The scope of contract costs that must be capitalized includes not only the costs directly related to the contracts but also indirect costs attributable to the project. Costs such as general and administrative expenses and interest expense relate to the performance of the contract are included.
These financial statements serve many important functions with respect to external agencies. Bankers, surety and insurance companies, equipment dealers, credit –reporting agencies, and clients are concerned with the contractor’s financial status and profit experience. Stock holders, Partners, and others with a proprietary interest use the statements to obtain information concerning the company’s financial condition and the status of their investment. Two financial statements of particular importance are the income statements and the balance sheet.
Financial Reports:
Budget:
It helps management to plan and control the effective and efficient application of all the resources of the company and it usually covers monetary units such as rupees, estimates the performance potential of the responsibility center.
Cost Reports:
Cost reports focus on cost data that aids management in controlling cost and taking other related decisions and they also cover products, services, jobs, programmes, divisions, departments, projects.
Profit and loss account:
It is an activity statement that shows details and result of the company’s profit related activities for a period of time.
Cash flow statement:
It is an activity statement that shows the details of company’s activities involving cash during a period of time.
The income statement
The income statement is an abstract of the nature and the amounts of the company’s income and expense for a given period of time, usually a quarter or full fiscal year.
The balance sheet:
A balance sheet presents a summary of the assets, liabilities, and net worth of the company at a particular time. The basic balance sheet equation may be stated as follows:
Assets = Liabilities + Net worth
The balance sheet presents in analytical form all company-owned property, or interests in property, and the balancing claims of stockholder or others against this property.
Financial Ratios:
Liquidity ratios:
these measures reveal a company’s ability meet its financial obligations.
Activity ratios:
these ratios indicate the level of investment turnover or how well the company is using its working capital and other assets.
Profitability Ratios:
These values relate company profits to various parameters such as contract volume or total assets.
Leverage Ratios:
These ratios compare company debt with other financial measures such as total assets or net worth.
Accounting Methods
The main theme of contractor’s accounting system centers around the determination of income and expense from each of its construction projects i.e., to say each contract is treated as a separate profit center.
The cash method and the accrual method are two basic accounting procedures. Under the cash method, income is taken into account only when cash is actually received, and expense is taken into account only when cash is actually expended.
The cash method is simple and straight forward form of income recognition and no attempt is made to match revenues with the accompanying expenses.
The accrual method is the second basic accounting procedure. Under these method, income is taken into account in the fiscal period during which it is earned, regardless of whether payment is actually received.
Accounting for long term contracts:
The tax reform act of 1986 mandates that one of three methods of accounting must be applied by contractors to their long term construction contractors. These are called the percentage of completion method, the percentage of completion- capitalized cost method, and the completed contract method.
Percentage of completion method:
The percentage of completion method recognizes job income from long term contracts as the work advances. Thus, the profit is distributed and the taxes are paid over the fiscal year during which the construction is under way. This method has a advantage of recognizing project income periodically on a current basis rather than regularly as contractors are completed.
Completed contract Method:
The completed contract method of accounting recognizes project income only when the contract is completed. What actually constitutes completion of a contract for income- reporting purposes has been subject to varying interpretation by the courts. Under the completed contract method, project costs are accumulated during construction using extended period cost capitalization. The scope of contract costs that must be capitalized includes not only the costs directly related to the contracts but also indirect costs attributable to the project. Costs such as general and administrative expenses and interest expense relate to the performance of the contract are included.
These financial statements serve many important functions with respect to external agencies. Bankers, surety and insurance companies, equipment dealers, credit –reporting agencies, and clients are concerned with the contractor’s financial status and profit experience. Stock holders, Partners, and others with a proprietary interest use the statements to obtain information concerning the company’s financial condition and the status of their investment. Two financial statements of particular importance are the income statements and the balance sheet.
Financial Reports:
Budget:
It helps management to plan and control the effective and efficient application of all the resources of the company and it usually covers monetary units such as rupees, estimates the performance potential of the responsibility center.
Cost Reports:
Cost reports focus on cost data that aids management in controlling cost and taking other related decisions and they also cover products, services, jobs, programmes, divisions, departments, projects.
Profit and loss account:
It is an activity statement that shows details and result of the company’s profit related activities for a period of time.
Cash flow statement:
It is an activity statement that shows the details of company’s activities involving cash during a period of time.
The income statement
The income statement is an abstract of the nature and the amounts of the company’s income and expense for a given period of time, usually a quarter or full fiscal year.
The balance sheet:
A balance sheet presents a summary of the assets, liabilities, and net worth of the company at a particular time. The basic balance sheet equation may be stated as follows:
Assets = Liabilities + Net worth
The balance sheet presents in analytical form all company-owned property, or interests in property, and the balancing claims of stockholder or others against this property.
Financial Ratios:
Liquidity ratios:
these measures reveal a company’s ability meet its financial obligations.
Activity ratios:
these ratios indicate the level of investment turnover or how well the company is using its working capital and other assets.
Profitability Ratios:
These values relate company profits to various parameters such as contract volume or total assets.
Leverage Ratios:
These ratios compare company debt with other financial measures such as total assets or net worth.
