Change Orders and Claims:
When To Record The Revenue

Claims and change orders are a part of life in construction contract accounting. Whether your company is a large general contractor or a subcontractor, claims or change orders are likely to have an impact on your bottom line. These contract revisions impact revenues and expenses not only from an operations perspective, but also in administrative costs incurred to manage them. Because of this, it is important to understand the accounting for these contract revisions. A thorough knowledge of claims and change order accounting will streamline the administrative process and maximize the effectiveness of your records and financial information.

While most contractors have a good system in place for handling claims and change orders, there may be times that the accounting for such events is not clear. It is important that changes from the original contract are accounted for in accordance with Generally Accepted Accounting Principles (GAAP). GAAP gives guidance under the AICPA Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type Contracts, relating to these issues. The following explanation of this standard aims to make the accounting for claims and change orders more easily understood.

Change Orders

A change order is simply a modification of an original contract between a contractor and an owner, or a general contractor and a subcontractor. Change orders include changes in: specifications or design, method or manner of performance, facilities, equipment, materials, site, and period for completion of work.

When both parties agree on the contract adjustment in scope and in price, contract price and costs should be adjusted to reflect such approved change orders. When it is probable that costs incurred will not be recovered through a change in the contract price, costs relating to unpriced change orders should be treated as costs of contract performance in the period in which the costs are incurred.

If cost recovery is probable , then the costs should either be 1) deferred (excluded from the cost of contract performance) until the parties have agreed on the change in contract price, or 2) treated as costs of contract performance in the period incurred and revenue recognized to the extent of the costs incurred. However, to recognize revenue on unapproved change orders in excess of costs incurred (i.e., recognize profit on the unapproved change order), the adjustment to the contract price needs to be probable and reliably estimable. In the case that change orders are in dispute or are unapproved in both scope and price, then they should be evaluated as claims.

Claims

In the case of a claim (an amount in excess of the agreed contract price), the contractor typically seeks to collect from owners or others for owner-caused delays, errors in specifications or designs, unapproved change orders, or other causes of unanticipated costs.

Under SOP 81-1, a claim is only recognized if it is probable that it will result in additional contract revenues, and the amount to be collected can be reliably estimated. If your claim meets all of the following conditions, it passes the probable collection and reliably estimated tests:

• 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 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.
• 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 representations.

If the above conditions are met then claim revenue may be recognized, but only to extent of the contract costs incurred. Thus, no profit is recognized on ongoing claims.

Contract accounting typically relies heavily on accurate estimates and becomes more complicated with any departure from the original contract. A thorough understanding of the accounting for claims and change orders is essential for both proper GAAP accounting as well as maximizing administrative efficiencies.

For more information, please contact Rhett Ennis, Senior Staff Accountant in the Construction & Real Estate Group at (425) 454-7990 or rennis@bpcpa.com.