In construction, change is constant. On average, more than one-third of projects will have at least one major change along the way, according to a study of more than 12,000 projects by the Independent Project Analysis group.
Although change orders can be a hassle when it comes to a project’s budget and schedule, properly accounting for them can mean the difference between a profit and a loss.
Meticulous, timely accounting is critical to change order management. It is incumbent on construction companies to forecast the cost and revenue impacts — even if the contractor and client are still negotiating price.
Change orders and best practices
By definition, a change order is an agreement between the parties of a construction contract to alter the project’s scope of work, price, or both.
Ideally, a contractor and client would agree to a change order’s terms — meaning scope of work and price — and put the changes in writing. In reality, most contracts require work to begin as soon as the contractor or client authorizes work to begin, even if the price is yet to be determined. Sometimes, all it takes is a handshake agreement.
Even if there’s no written agreement in hand, best practices dictate contractors should formally account for a change order as soon as the superintendent or client authorizes the work. The company will need to estimate the total project costs. And once work begins, the contractor needs to track all material and manpower costs along the way carefully.
Accounting for change orders
Determining how to account for a change order depends on the status of the order’s approval. Change orders usually fall under one of three categories:
- Approved: This means all parties approved the contract changes, including scope and price, in writing. This is the ideal scenario. To account for an approved change order, the contractor would enter any associated costs and then adjust the overall contract value accordingly.
- Unpriced: This is when both parties have agreed on the scope of the changes but will determine price later. Accounting for unpriced change orders can get tricky. Best practices recommend a conservative accounting approach, in which the contractor would calculate a weighted cost estimate based on the probability of whether the company will recoup costs:
- If recovering costs is likely, the contractor can either calculate the estimated revenue and include that amount in the overall contract costs or defer costs until all parties reach an agreement.
- If recovering costs are unlikely, the contractor will treat the change as a performance cost. The overall contract price would not change, though, so the company’s estimated profits would decrease.
- Unapproved: This means the contractor and client have not put the terms of the change order in writing but may have a verbal or implied agreement. Contractors should treat unapproved change orders as claims they need to resolve. The contractor should only recognize additional revenue if the customer will likely approve payment and if the contractor can reliably estimate the costs.
How to adjust revenues
It’s important to stay on top of the latest accounting standards when adjusting revenues for change orders. The Financial Accounting Standards Board worked with the International Accounting Standards Board in 2019 to update its generally accepted accounting principles, or GAAP, to establish a five-step process for how to recognize revenue:
- Identify the contract with the customer.
- Identify the performance obligations contained in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue as each performance obligation is met.
Stay ahead of change orders
Change orders may be an inevitable reality of construction, but being prepared can help make them less unpleasant. You may even be able to avoid them altogether. Here are some tips:
- Budget for contingencies to cushion the impact of potential change orders.
- Build a change order process into the contract.
- Emphasize communication, collaboration, and transparency with the client and other trades on the project.
- If a change order does arise, identify costs and work with the client to agree on changes to the project budget.
- Get the changes in writing.
Properly accounting for change orders can involve extra legwork, but it’s important to protect your company’s profits. If your construction firm needs help navigating the process or implementing change order management practices, our team of industry experts can guide you along the way.