July 23, 2022

Proper Accounting for Change Orders Makes All the Difference

If there’s any aspect of the construction business that gives you mixed feelings, it’s probably the humble — or in some cases not-so-humble — change order. On the one hand, the circumstances that give rise to change orders tend to be disruptive and often cause confusion or even conflict between contractors and project owners.

On the other hand, a change order can generate more revenue from a job and, if expenses are kept in line, lead to a greater profit when all is said and done. One often-overlooked aspect of change-order management is proper accounting. When you know the numbers, you’ll have a much clearer picture of the situation.

Are we doing this right?

Customers can sometimes change their minds after signing a contract, but before work is completed. To keep projects on schedule, it’s not unusual for contractors to begin out-of-scope work before a change order is approved. But failure to properly track and account for the costs and revenue associated with this work can have a negative impact on your financial statements.

Suppose, for example, that you record costs attributable to a change order in total incurred job costs to date, without making a corresponding adjustment to the total contract price and total estimated contract costs. To a lender or surety, this might indicate excessive underbillings.

In other cases, profit fade can occur if you’re overly optimistic about your chances of receiving change-order revenue. If you increase the total contract price based on out-of-scope work but are unable to secure change-order approval, your profit could fade as the job progresses. This can also shake the confidence of financial statement users.

How to categorize?

Without proper tracking procedures, you might inadvertently forget to charge customers for change orders in accordance with the contract terms. Change orders generally fall into three categories.

First, there are approved change orders. For this category, it’s appropriate to adjust incurred costs, total estimated costs and the total contract price. Depending on the contract’s change-order provisions, this may increase your construction business’s estimated gross profits.

Second, you might wind up with an unpriced change order. If the parties agree on the scope of work but leave pricing negotiations for later, the accounting treatment depends on the probability that you’ll recover your costs. If doing so is improbable, change-order costs are treated as costs of contract performance in the period during which they’re incurred. Therefore, the contract price remains unadjusted, and your estimated gross profit will decrease.

If you probably will recover the costs through a contract price adjustment, you can generally either:

  • Defer the costs until you and the owner have agreed on the change in contract price, or
  • Treat them as costs of contract performance in the period incurred and increase the contract price to the extent of the costs incurred (resulting in no change in estimated gross profit).

To determine whether recovery is probable, consider your background knowledge of the owner, as well as your experience negotiating similar change orders. If it’s probable that the contract price will be increased by an amount that exceeds the costs incurred (increasing estimated gross profit), you might recognize increased revenue — provided realization of that revenue is “assured beyond a reasonable doubt.”

Finally, there are unapproved change orders. These should be treated as claims. It’s appropriate to recognize additional contract revenue only if, under guidance provided in the accounting rules, it’s probable that a claim will generate such revenue and the amount can be reliably estimated.

Who can help?

For the purposes of this article, we’ve assumed you’re using the percentage-of-completion accounting method. Whatever you approach you use, tracking and reporting change orders can be complex. Your CPA can help assess your change-order process and help you improve the accuracy and usefulness of your financial statements.

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