Change orders are a mixed blessing. On the one hand, they present the opportunity to make more money on a construction project because of the additional or more complex work involved. On the other, if they’re mishandled, change orders can lead to conflicts, confusion and even lost money should a change go unpaid.
One place to specifically mishandle change orders is on the accounting side. If a revision to a job isn’t recorded in a timely and accurate fashion, bad results may soon follow. Let’s look at some of the risks involved.
It’s not unusual for contractors to begin out-of-scope work before a change order is approved. But failure to properly account for the costs and revenues associated with this work can have a negative impact on a construction business’s financial statements.
Suppose, for example, that a contractor records 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 surety or lender, this may indicate excessive underbillings.
Profit fade can occur if contractors are overly optimistic about their chances of receiving change order revenue. If a contractor increases the total contract price based on out-of-scope work but is unable to secure change order approval, profits may fade as the job progresses, shaking the confidence of sureties and lenders.
Categories of Change
Generally, change orders fall into one of three categories: 1) approved, 2) unpriced (approved as to scope but not price) and 3) unapproved.
Approved change orders are usually the easiest to deal with — a telling reminder of why it’s important to have a solid process for dealing with project changes. From an accounting perspective, it’s appropriate to adjust incurred costs, total estimated costs and the total contract price. Depending on the contract’s change-order provisions, doing so may increase the construction business’s estimated gross profits.
Unpriced change orders are much trickier to handle. If the parties agree on the scope of work but leave negotiations on price for later, the accounting treatment depends on the probability that the contractor will recover its costs. If it’s not probable, change order costs are treated as costs of contract performance in the period during which they’re incurred and the contract price is not adjusted. As a result, the contractor’s estimated gross profit decreases.
If it’s probable that the costs will be recovered through a contract price adjustment, the construction business has two choices:
- Defer the costs until the parties have agreed on the change in contract price.
- 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, a contractor should consider its past experience in negotiating change orders and other factors.
If it’s probable that the contract price will be increased by an amount that exceeds the costs incurred (increasing estimated gross profit), the contractor may recognize increased revenues, provided realization of those revenues is assured beyond a reasonable doubt.
Last, 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.
It’s important to anticipate the possibility of change orders in your contracts. It’s also important to have the proper paperwork and chain-of-approvals in place should a job change arise. But don’t forget the critical role that the home office plays in change orders. By ensuring that changes are properly accounted for, you’ll keep your construction company’s financial statements — and financial standing — in optimal shape.
We welcome the opportunity to put our construction industry expertise to work for you. To learn more about how our firm can help advance your success, please contact Dave Wolfenden at (302) 254-8240.