Contractors: Substantiating Change Orders Is Critical to Financial Health
When can a construction contractor recognize pending change orders in its financial statements? To answer that question, the contractor should select accounting policies and procedures in accordance with generally accepted accounting principles (GAAP) and maintain sound internal controls over the process of evaluating and recording change orders.
Unapproved change orders are a recurring situation in the construction industry and can lead to significant issues for contractors if not accounted for properly. Improperly recording unapproved change orders and the contractor's inability to substantiate them may result in large under billings and profit fades, causing concern to sureties and banks. As a result, the contractor's ability to bid on larger jobs and maintain financing could potentially be adversely affected.
A contractor's ability to adhere to its internal accounting policies and properly maintain files and records is crucial. Doing so will allow the contractor to evaluate change orders in a timely manner so they can be properly reflected in the financial statements and will allow the contractor to take corrective action as needed with its customer.
How to properly account for change orders in financial statements
In order to understand when it is appropriate to recognize pending change orders in its financial statements, a contractor needs to maintain a working knowledge and understanding of Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 605 "Revenue Recognition - Construction-Type and Production-Type Contracts."
Change orders are modifications of an original contract that effectively change the scope of the contract without adding new provisions. Initiation of the change order can be from the contractor or the customer, and will include changes in specification or design, manner or method of performance or other modifications. There are three main types of change orders: approved change orders, unpriced change orders, and unapproved change orders. Accounting for them depends on the characteristics and underlying circumstances in which they occur.
Approved change orders
Approved change orders regarding the scope and price of the work are approved by both parties. This will result in a change in contract price and total estimated costs to reflect the amounts approved by the customer and the contractor.
Unpriced change orders
Unpriced change orders define the work to be performed, but the price (adjustment to contract price) is to be negotiated at a later time. For all unpriced change orders, recovery should be deemed probable if the future event or events necessary for recovery are likely to occur. Factors to consider in evaluating whether recovery is probable include the following:
- Obtaining the customer's written approval of the scope of the change order;
- Separate documentation for change order costs that are identifiable and reasonable; and
- Contractor's favorable experience in negotiating change orders.
The contractor should follow the guidelines below when accounting for unpriced change orders under the percentage-of-completion method of accounting:
- Costs attributable to unpriced change orders are treated as costs of contract performance in the period in which the costs are incurred if it is not probable that the costs will be recovered through a change in contract price. This would result in no change in contract price and a decrease in estimated gross profit.
- If it is probable that the costs will be recovered through a change in contract price, the costs may be deferred until the parties have agreed on the change in contract price. Alternatively, the costs associated with the unapproved change order may be treated as costs of contract performance in the period in which they were incurred, and contract revenue shall be recognized to the extent of costs incurred. This will result in an increase in contract price for the costs incurred associated with the unpriced change order and no change in estimated gross profit.
- If it is probable that the contract price will be increased by an amount in excess of the costs incurred attributable to the change order and the amount in excess can be reliably estimated, the original contract price shall also be adjusted for that amount when the costs are recognized as costs of contract performance if its realization is probable. This will result in an increase of contract price in excess of the costs incurred associated with the unpriced change order and an increase in estimated gross profit. However, since the substantiation of the amount of future revenue is difficult, revenue in excess of the costs attributable to unpriced change orders shall only be recorded in circumstances in which realization is assured beyond a reasonable doubt.
Unapproved change orders
Change orders unapproved as to both scope and price should be evaluated as a claim. The recognition of additional revenue relating to claims is appropriate only if it is probable that the claim will result in additional contract revenue and if the amount can be reliably estimated. The satisfaction of those two requirements is contingent upon the existence of all of the following conditions:
- The contract or other evidence provides a legal basis for the claim; or a legal opinion has been obtained, stating that under the circumstances there is a reasonable basis to support the claim.
- Additional costs are caused by circumstances that were unforeseen at the contract date and are not the result of deficiencies in the contractor's performance.
- Costs associated with the claim are identifiable or otherwise determinable and are reasonable in view of the work performed.
- The evidence supporting the claim is objective and verifiable, not based on management's feel for the situation or on unsupported representation.
The evaluation and recognition of change orders in a contractor's financial statements should be in accordance with GAAP and in accordance with the contractor's internal policies and procedures. Proper accounting will ensure revenues and expenses are not misstated, thereby enabling contractors to maintain a favorable reputation among banks and sureties – a necessity for realizing success and profit on future projects.
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This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.