No matter how much preparation and planning goes into a project, there is always the chance that critical changes will arise and bring on complications. As a result of these changes, contractors often find themselves encountering change orders. It has been said that the only thing that is certain in life is change, and with the COVID-19 crisis, we find ourselves facing changes every day.

A construction change order can be initiated by either the contractor or project owner and may encompass changes in specification or design, manner or method of performance, or other modifications. On more complex, larger scale projects, change orders can significantly add to the final financial results of a contract’s performance.

While contractors are familiar with project changes, they must properly account for these changes to protect their financial reporting credibility.

While the accounting rules have changed for privately held companies due to the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers, effective for private companies in 2019, the basic concepts related to the theory behind recording change orders and claims have remained relatively intact.

Accounting for Change Orders

Accounting for approved change orders on a financial statement is fairly simple, but it can get a bit challenging when dealing with accounting for unapproved change orders and claims. It is important to note that accounting for change orders depends on the underlying circumstances, which may differ for each change order depending on the customer, the contract, and the nature of the change as articulated in ASC 606-10-25-11.

Unapproved change orders are heavily scrutinized by banks and surety firms, which often take a conservative view on adjusting the contract price until such changes are agreed to in writing. The unapproved change orders will be removed from the contract price if a contractor’s bank or surety firm does not fully understand the specific facts and circumstances that resulted in the changes to a contractor’s estimated gross profit on a job. Therefore, assets will be removed from working capital and result in a decreased equity position. This can impact banking financial ratios, prequalification approvals, and surety program capacity and lead to credibility and potentially damaging credit underwriting issues down the road.

In order to understand the accounting rules behind change orders and claims, contractors and their financial advisors must maintain a working knowledge of ASC Topic 606, with specific emphasis on paragraphs 32-5 through 32-13, which addresses contract modifications, estimating variable consideration, and any constraints per se on the variable consideration.

Let’s review a summary of the basic concepts of accounting for approved change orders, unpriced change orders, and unapproved change orders:

Approved Change Orders

In an approved change order, both parties approve the scope and price of the work. The work-in-progress (WIP) schedule will be impacted by an adjustment to the contract price and total estimated costs to reflect the amounts approved by the customer. Work performed relating to a change order that has been approved but not billed on the contract will most likely yield underbillings on the WIP schedule. Under ASC Topic 606, approved change orders that are deemed to be a continuation of a contract will be accounted for on a similar basis to historical accounting requirements; however, if a change order is deemed to be “distinct” from the initial contract, then a new “contract” line would be established for the change order for percentage of completion purposes.

Approved & Unpriced Change Orders

An unpriced change order defines the work to be performed, but the price (i.e., the adjustment to the contract price) is negotiated at a later time.

For all unpriced change orders, recovery should be deemed probable if the events necessary for recovery are likely to occur and the contractor has experience in the conversion to priced and approved change orders. Factors to consider in evaluating whether recovery is probable include:

• The customer’s written approval of the scope of the change order
• Separate documentation for change order costs that are identifiable and reasonable
• The entity’s favorable experience in negotiating change orders
• The impact of COVID-19 on converting change orders in a distressed economy

Should an approved and unpriced change order meet these factors, the contractor can recognize revenue for the change in the contract price based on the guidance for variable consideration. All gross profit related to the changes in scope should be recognized once the change order is approved in writing. Additionally, all final accounting should be in the same form as priced approved, priced change orders under ASC Topic 606.

Unapproved & Unpriced Change Orders

In an unapproved change order, costs are being incurred on work that has not been approved in either scope or price. Depending on the circumstances, an unapproved change order that adjusts contract price and gross profit requires a detailed examination to determine if the amount is recoverable. This will most likely result in an underbilling on the WIP schedule.

Accounting for unpriced change orders and unapproved change orders depend on the characteristics and underlying circumstances in which they occur. Here are some recommended approaches to accounting for these items under the percentage-of-completion method (PCM):

• Costs attributable to unpriced change orders should be treated as costs of contract performance for the period in which the costs are incurred.
• If it is not probable that the costs will be recovered through a change in the contract price, then the contract value and profit will drop as the company is recognizing unplanned costs without corresponding revenue. As a result, these unapproved changes will not show up as underbillings.
• The contract value and profit will change if it is likely that the costs will be recovered through a change in the contract price. Underbillings related to the change order will likely be reflected.
• Costs attributable to unapproved change orders and claims should be treated as costs of contract performance for the period in which the costs are incurred.

If it is likely that the contract price will be adjusted by an amount that exceeds the costs attributable to the unapproved change order, then the contract price should only be adjusted to the costs to be recognized and profit recognition should be deferred until the outcome is fully resolved, subject to the accounting rules in ASC Topic 606.