How to Account for Contract Change Orders
- Feb 17, 2023
While last-minute changes to contracts can be frustrating, they sometimes present an opportunity to boost profits if managed correctly. Here are a few ways that construction companies who enter into long-term contracts with clients can more efficiently track change orders, account for them properly and use them to enhance their bottom line.
How Contract Change Orders Occur
Change orders occur when clients make alterations to a project after signing a contract but before work on the project has been completed. Contractors will typically begin out-of-scope work before a change order is approved to keep their projects on schedule. But contractors must be careful to properly account for the costs and revenue associated with this work, or it could negatively impact the business's financial statements.
For example, suppose a contractor records the costs attributable to a change order in the total incurred job costs to date, but does not correspondingly adjust the total estimated contract costs and total contract price. This could indicate excessive under-billings to a lender or surety. On the other hand, if a contractor increases the amount of the contract price to reflect out-of-scope work but can't secure a change order approval, profit fade may occur as the job progresses, which can rattle the confidence of financial statement users.
Accounting for Change Orders
It's crucial to have proper tracking procedures in place so that contractors remember to charge clients for change orders according to their agreement's terms. Change orders fall into three general categories:
- Approved change orders. For approved change orders, it's appropriate to adjust the incurred costs, the total estimated costs and the total contract price, which may increase the company's estimated gross profits, depending on the contract's change-order provisions.
- Unapproved change orders. Unapproved change orders should be accounted for as claims. However, if it's probable that a claim will generate revenue and the amount of the claim can be estimated reliably, it may be recognized as additional contract revenue.
- Unpriced. If the parties have agreed on the scope of work but have yet to negotiate a price, the accounting treatment will depend on the probability that the contractor will recover its costs.
If it's not probable the contractor will recover its costs, change-order costs are treated as contract performance costs during the period they're incurred without adjusting the contract price. The contractor's estimated gross profit decreases as a result.
If it is probable that the contractor will recover its costs through a contract price adjustment, the contractor may:
- Defer these costs until the parties have agreed on a change in the contract price; or
- Treat them as contract performance costs in the period incurred and increase the price to the extent of the costs incurred (to result in no change in estimated gross profit)
Contractors should consider their past experiences negotiating change orders, among other factors, to determine whether recovery is probable. The contractor may recognize increased revenue if it's likely that the contract price will be increased by an amount that exceeds the costs incurred, provided that the realization of that revenue is "assured beyond a reasonable doubt."
Record Income from Change Orders Carefully
Accounting for change orders is critical in preparing your financial statements and sets the stage for the relationships you'll have with banks and bonding companies. It's important not to be overly aggressive in attempting to record income related to unapproved change orders. By taking a more conservative approach and only including income from approved change orders in your financial statements, you're more likely to exceed your bonding company's expectations, enhancing their confidence in your construction firm and positioning yourself as an attractive candidate for bonding support when larger jobs become available.
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Donald N. Hoffman
Donald Hoffman is Partner-in-Charge of the firm's Maryland office. His expertise includes accounting, tax planning, business consulting, strategic planning, business succession, buy/sell agreements, and estate planning.
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