This article was originally published in the September/October 2020 issue of CFMA Building Profits.
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, large-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, pre-qualification approvals and surety program capacity and lead to credibility and potentially lethal 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 Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Subtopic 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 mere 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, a new “contract” line would be established for the change order for the percentage of completion purposes.
Approved and 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 and 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.
Accounting for Construction Claims
If not properly addressed, unapproved change orders can become formal construction claims, which have a number of common causes as defined below:
- Delays in construction or completion of the contract
- Delays in the delivery and supply of materials
- Delays due to poor or unforeseen weather conditions
- Delays due to poor construction management and oversight of the project
- Difficult job site conditions or access not predicted during the estimating phase
- Owner-requested changes that do not receive approval, but the work is completed regardless
- Poor plan designs and inaccurate architectural and engineering drawings
The two most common methods for change order accounting, under ASC 606-10-32-8, are the expected value method and the most likely amount method. Both methods address the estimates for variable consideration.
Expected Value Method
The “Expected Value Method” estimates variable consideration based on the sum of probability-weighted amounts in a range of possible consideration amounts. This method may be appropriate when an entity has a large number of contracts with similar characteristics or the range of possible outcomes in any one contract is wide (i.e. generally there are more than two possible outcomes).
Most Likely Amount Method
The “Most Likely Amount Method” estimates the variable consideration based on the single most likely amount in a range of possible consideration amounts. This method may be appropriate if the estimate of variable consideration has only two possible outcomes. For example, an entity is entitled to all of variable consideration upon achieving a performance milestone or none if the performance milestone is not achieved. Whichever method is used, the resulting adjustment in contract price is subject to a constraint, as defined in ASC Topic 606-10-32-11. This allows the construction firm to include the variable consideration in the contract price only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the change order or claim is resolved.
Recognizing Additional Claim Revenue
As one of the most difficult areas in construction accounting, recognizing additional revenue related to claims is only appropriate when it is highly probable that the claim will result in additional contract revenue and the amount can be reliably estimated.
All of the following conditions must exist for a claim to be recorded on contractor’s financial statements:
- 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.
- The 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.
- The additional costs identified for the claim are determinable and reasonable in view of the work performed.
- The actual documentation and evidence supporting the claim are objective and verifiable.
The contract price should not be recorded if any of these conditions do not exist. Even though the initial costs of the claim should still be recorded. Instead, the details should be disclosed in the footnotes and contain enough information to allow the financial statement user to determine what financial credit should be given to the contractor related to the final outcome of the claim.
Lastly, the most important and most conservative approach for recording construction claims is to simply report an increase in contract price when payment is received related to the claim (i.e. the cash basis of accounting). As a result of COVID-19, it is likely that two things may be more common with financial reporting of unapproved change orders and claims:
- Contractors may be more aggressive on recording unapproved change orders and claims, even if the facts and circumstances are a bit light for formal recording.
- Contractors will be faced with more disputes as project owners struggle with financing to determine what is part of the contract vs. what is outside the scope of the contract.
Given the cost control motive of the project owner vs. the profit motive of the contractor, the risk of construction claims and disputes are an industry norm and, as noted above, will likely become more common as we see the impact of COVID-19 on the construction industry and economy.
Contractors and their clients should ensure that the original contract provides provisions to address the associated risks of change orders and claims to avoid the risk of additional expenses, strain on cash flow, project lien issues or completion time for a potentially longer project. Timely submission, review and approval of all change orders are also critical to a favorable outcome for all contract parties; the longer an issue is not addressed, the more likely a dispute and potential litigation may occur.
The best way to avoid construction claims is to implement systems and controls that address construction issues upfront. By following common steps one can help successfully mitigate the likelihood of project claims:
- Have a qualified legal expert perform a detailed review of all contract terms and conditions before a contract is executed
- Hire reputable contractors and consultants
- Consider a process to eliminate the possibility of accepting unusually low bids
- Implement effective job planning and management to avoid disputes
- Engage legal counsel with an expertise in construction litigation
- Resolve disputes early on in the project to avoid costly post-construction litigation
The Bottom Line
A contractor that fails to accurately record unapproved change orders and claims can create significant financial reporting problems leading to serious underwriting issues with banks and surety firms that provide credit products to contractors.
When a change order is unpriced or otherwise unapproved, careful evaluation of the specific facts and circumstances is required prior to including it in a contract price.
The contractor is unable to substantiate unapproved change orders when they are improperly recorded. This can result in large underbillings and profit fade which is a concern for banks and surety firms. As a result, this could affect the contractor’s ability to bid on larger jobs or additional work while maintaining proper financing.
It is crucial for contractors to adhere to internal accounting policies and properly maintain files and records. This gives them the ability to evaluate change orders in a timely manner, properly reflect them in the financial statements and take corrective action as needed.