To understand the purpose of a contract, it is necessary to show the differences between a contract Job and a non-contract Job.
A non-contract Job begins with transactions being recorded against a Job. The cost of these transactions is automatically posted to the balance sheet in the Work-In-Progress General Ledger account (WIP GL account). Those transactions are then used to generate an invoice for the customer which reflects the revenue and COGS in the income statement. Depending on the nature and duration of the Job, this cycle can continue multiple times within a Job.
This process works for situations where the transactions that have been processed onto the Job are used as the basis for the invoice that is generated to the customer. At the same time, it works well where the generated invoice can be posted directly to revenue in the profit and loss.
However, there are several situations where the transactions recorded against a Job do not form the basis for the invoice or where the invoice raised is not necessarily allowed to be reflected as income in the income statement. In these scenarios, contracts within Eralis Job should be used.
The process for a contract Job follows a very different structure and there is more separation between various processes. The invoice process is no longer tied to the Job lines that have been entered onto the Job. Instead, invoicing is now linked to a set of defined invoice phases. Invoices can be processed as available, and at this stage the work may or may not have been done on the Job. The value of the invoice is posted to a deferred revenue account in the balance sheet and does not show up income inside the income statement.
Transactions are also recorded against the Job, which can be done before or after the invoice has been raised. Since there is no direct association between the invoice and the transaction, they can occur in any order. The cost of the transaction that is recorded against the Job is posted directly to the balance sheet, as is standard with Eralis Job. At this stage, both the invoice value and Job costs are sitting in the WIP balance sheet.
Revenue Recognition Process
A revenue recognition process can then be carried out, which posts the revenue and expenses to the income statement. The Job lines that have been incurred are used as the basis for the recognition of costs, while the value of the recognition is controlled by the user.
The contract processing also has an optional process which allows the company to adjust the recognized revenue and expenses based on a point in time assessment of what will be required to complete the Job.
Based on the previous illustrations, the purpose of the Contract module is to allow the company with to separate the invoice function from the work that is being carried out. This allows the company to raise an invoice to a customer based on a pre-determined factor, other that the work that has been carried out. This could be achieving a milestone in the project, or raising an invoice for an initial deposit. The Contract module also allows the company to control how and when revenue is reflected in the income statement to comply with accounting rules on revenue recognition. Again, the revenue recognition is not tied to invoicing that may or may not have been carried out on the Job, but rather based on the work that has been done on the Job. This allows the revenue and associated cost of the work, to be recognized at the same time.
When to Use Contracts
Having reviewed the purpose of contracts, we can now address the question as to when contracts should be used in Job processing:
- The ability to raise an invoice to a customer is controlled not by the work carried out, but instead is based on achieving an outcome. For example, in a construction job, the invoice milestones may state:
- 20% of the contract value can be invoiced when the foundation is laid.
- 20% of the contract value can be invoiced when the external walls are standing, etc.
In this type of situation, the value and cost of work required to achieve the various milestones is not relevant to the invoice process. The only factors involved in raising the invoice is meeting the criteria outlined in the contract.
- When there is a need or agreement to pre-bill a Job, or where the company requires a deposit before starting work on a Job. In this situation, accounting requirements dictate that the value of the deposit cannot be reflected as revenue inside the income statement. As a result, billing must be done from the contract to post the revenue portion to a deferred revenue account in the balance sheet.
- When the company needs to be able to control the recognition of revenue inside the income statement, unrelated to the invoicing that has been carried out. This allows the company to maintain consistency in their income statement where there may be lengthy periods between work being carried out and the invoice being raised.
- Contract invoicing is not specifically intended for fixed price Jobs.
There are four business processes that are associated with a contract, three of which are mandatory:
- Contract Invoice Process – This process creates a Service Type A/R invoice to the customer on the Master Job, with revenue posted to a Deferred Income account in the balance sheet.
- Process Contract Line – This is a revenue recognition process which moves the determined revenue values out of the balance deferred income account and into the income statement revenue account. At the same time, it moves the cost of the work out of the balance sheet WIP to the income statement revenue accounts.
- Contract Completion – This process compares the revenue recognized in the income statement to the revenue posted in Deferred Revenue and passes an adjustment to balance the two values. This adjustment balances the deferred income account for the contract to zero with the income statement reflecting the invoiced value of the contract. The Contract Completion process should only be run once the contract has been completed and no further processing is required.
- Estimated Cost to Complete – This process is optional. This process allows the company to post adjustments to recognized revenue or expenses based on a point-in-time assessment of what will be required to complete the Job. Once this assessment has been made, the system will provide a recommendation of adjustment to be posted to the income statement in order to reflect the state of the contract. Since the recommendations are based on a point-in-time assessment of the contract, the system will post these adjustments as reversing journals. This allows the company to make another assessment at a later stage and provide adjustment recommendations based on the new assessment. The Estimated Cost to Complete process allows the company to factor the implications of unplanned costs that may arise against their income statement as they become aware of them to meet accounting reporting requirements.