Even though last-minute updates to contracts can be challenging for businesses, they provide a chance to increase profits—but they must be handled in accordance with appropriate accounting rules. However, with a strategic workflow in place, they don’t have to derail progress towards completing contract agreements.
Common contract issues
One of the most common issues with contracts is that customers change their mind about the scope of a project after they’ve signed the contract—but before any work has been completed. When this happens, schedules can be delayed.
To keep a project on schedule, contractors may start proceeding with the new scope of work. However, if new costs and revenue projections aren’t accounted for in the project budget, this decision can negatively impact their financial statements.
For example, if a contractor attributes costs to a change order for the total incurred job costs to date and they don’t make a corresponding adjustment to the total contract price and total estimated contract costs. To a lender or surety, this may indicate excessive underbillings.
Similarly, profit fade can take place if contractors overestimate change order revenue. If a contractor increases the total contract price from projected out-of-scope work but ultimately doesn’t secure the necessary change order approval, profits may be lost as the job moves forward. This can also decrease financial statement users’ confidence in the accuracy of documents.
Types of change orders
While there are many types of contracts, change orders can be divided into three general categories:
1. Approved change orders: For approved change orders, it’s acceptable to update incurred costs, total estimated costs and the total price for the contract. Depending on the change-order provisions, these updates may increase a business’s estimated gross profits.
2. Unpriced change order: When parties agree to a scope of work within a contract but have yet to finalize price negotiations, the accounting treatment depends on the probability that costs will be recovered. If recouping costs isn’t probable, change order costs are handled as costs of contract performance during the period they’re incurred. As a result, the contract price isn’t adjusted and the contractor’s estimated gross profit decreases.
However, cost recovery is probable because of a contract price adjustment, the contractor can either:
- Defer costs until the time at which parties come to an agreement on a new contract price, or
- Handle them as costs of contract performance in the period incurred and increase the contract price to the extent of the costs incurred, resulting in no change in estimated gross profit
Assessing the probability of cost recovery is a complex calculation. Contractors should weigh their past experience in negotiating change orders along with other factors, such as client needs, times, and scope of work. If it’s probable that the contract price will be greater than the costs incurred (increasing estimated gross profit), the contractor may recognize increased revenue — provided realization of that revenue is “assured beyond a reasonable doubt.”
3. Unapproved changed costs: Unapproved changed costs must be handled as claims. Businesses should recognize additional contract revenue only when it’s probably that a claim will generate such revenue and the amount can be reliably estimated. Moreover, accounting rules should be strictly followed in these situations.
Smolin can help
Accounting for change orders can be confusing. Contact us for help handling your company’s change order procedures and improving the accuracy and transparency of your financial statements.