When construction contracts are signed, there is a lot of uncertainty regarding profits or losses. The circumstances often take unexpected turns that turn a well thought out and a well-planned contract into a loss-making one.
While such situations can sometimes be avoided, but at others, you need to account for the losses incurred and then mitigate the negative impacts. You can seek professional consultancy for this purpose and carry out accounting treatment for the analysis.
Income statements are highly reflective if the costs become lost for a construction project. So the data from the income statement and balance sheet is extracted for the first year of a construction contract to get a clear picture of the losses and then control them for the coming period of the contract. The process is accounting treatment.
This article will introduce you to the steps involved in the accounting treatment of a loss-making construction contract.
Steps for an accounting of a loss-making construction contract
If there is a chance of losses in a construction contract, you can analyze the income statement to recognize the losses. For any construction project, dealing with cost escalation or losses is an inevitable circumstance. For this reason, you need to get in touch with a professional construction quantum expert to save your construction project.
If you want to carry our accounting treatment for your construction contract, which on the path of loss-making, you may continue to read for the steps:
Determine the Expected Outcome of the Contract
You take up accounting treatment for a contract when it begins to cause you loss. When the costs exceed the expected revenue threshold, you expect losses. In such a scenario, you need to measure or calculate the whole expense with the inclusion of the cost to enter the territory of losses.
You must charge the whole loss amount as expenditure in the 1st year, use the stage of completion method for an accounting of contract costs and revenues. In this way, you will determine the expected outcome of the construction contract you are dealing with.
Determine Profit, Revenue, and Cost
After determining the expected outcomes of your construction contract, you can move on to determining the amounts of profit, revenue, and cost, as reflected in the income statement. The loss in the income statement will tell the entire expected loss. Similarly, the information on costs will tell you the complete cost incurred during the first year of your construction contract.
Calculate Gross Amounts due to/ from Customers and Trade Receivables
In the third step, you will have to calculate the values for Gross Amounts from the balance sheets. The gross amounts will be calculated as they are due to or from trade receivable and customers. You can make the calculations for a hypothetical company XYZ LTD as follows;
Trade Receivable = 90000 (Amount Billed) – 70000 (Amount Received) = $20000
The Gross Amount due from Customers of XYZ LTD measured as follows:
Gross Amount = -50,000 (Loss) + 150,000 (Cost Incurred) – 90,000 (Amount Billed) = $10,000
After calculating gross amounts due to pay or receive from customers or trade partners, you have to prepare extracts. The extracts will come from Financial Statements in respect of Construction Contracts.
For the first year, if the revenue reflected by the income statement is 1,000,000, the cost is 1.500.000, the net loss will be 500,000. Extracts at the end of the year will be as follows then:
Trade receivables: 200,000
Gross due amount to be paid by customers: 100,000
Prepare Construction Contract Control Account
The accounting treatment of a loss-making contract will end at the fifth step to prepare a control account for the contract. A hypothetical company, XYZ LTD’s account, will look something as follows:
- A Debit vs. Credit table
- Debit column entailing revenue recognized and costs incurred.
- The credit column enlisting a)cost recognized, b)the amount received from the customer, c) trade receivable, and d) amount that is due to be received from the customer.
With hypothetical data, the table the values will be as follows:
Revenue recognized: 1,000,000
Costs incurred: 1,500,000
Net Debit: 2,500,000
Cost recognized: 1,500,000
The amount received from your customer: 700,000
Trade receivable: 200,000
Amount due from contract customer: 100,000
Net Credit: 2,500,000
Is our construction contract going in losses?
Well, no one can predict the force majeure, so such circumstances are very frequent in case of long contracts that span over the years. While you cannot completely avoid the cost escalation and losses in the contract, you can mitigate the losses and keep the project going. For this reason, you need the help of a construction consultant throughout the construction process and carry out the accounting treatment of your contract.
Make sure you hire only the best professionals for both cases.