new jobs this week On EmploymentCrossing

830

jobs added today on EmploymentCrossing

38

job type count

On EmploymentCrossing

Healthcare Jobs(342,151)
Blue-collar Jobs(272,661)
Managerial Jobs(204,989)
Retail Jobs(174,607)
Sales Jobs(161,029)
Nursing Jobs(142,882)
Information Technology Jobs(128,503)

Trusting in Over-Optimistic Change Orders and Claims Can Be Hazardous to Your Financial Health: Accounting for Change Orders and Claims in the Construction Industry

22 Views      
What do you think about this article? Rate it using the stars above and let us know what you think in the comments below.
Trusting in over-optimistic change orders and claims can lead to significant problems in the construction industry. Companies that continually realize less profit from jobs than they originally estimate can see their ability to bid on larger jobs hindered due to bonding issues and their financial stability potentially adversely affected.

Because of the risks associated with them, change orders can be dangerous areas for contractors. When a change order is unpriced or otherwise unapproved, careful evaluation of the specific facts and circumstances is required prior to inclusion of the change order in estimated contract revenues.

For example, if a contractor has to use more yards of concrete or a different machine on a particular job, it will likely have to do a change order, and often the change order will not be fully approved by the customer. Subsequently, documentation of change orders is very important because when the construction company is audited, the auditor will need to evaluate the propriety and the collectibility of unapproved change orders that are the basis for significant additional contract revenues. (For example, an original contract of $1 million may be treated as $1.1 million if the auditor can verify that the change orders are recoverable.)



The auditor may be able to confirm the amounts of unapproved change orders with customers; however, if confirmation is not possible, the auditor will need to obtain evidence to evaluate the likelihood of settlement on satisfactory terms and the collectibility of the recorded amounts. The auditor also needs to consider how the contractor has historically collected on its unapproved change orders.

If historically the contractor does not get the ultimate approval for a change order, or if it is approved for an amount less than what is expected by management, the auditor needs to consider this when determining the reasonableness of current and pending change orders. For unapproved or unpriced change orders, the construction company typically hasn't obtained written authorizations from a customer representative as of the audit fieldwork, which means that these other forms of documentation will be necessary to support the change order to the auditor.

From an accounting perspective, the additional $100,000 of revenue (and related assets) that the contractor puts on its books needs to be solid. However, many times the construction company is too optimistic, saying, "Don't worry, we'll get it." They assume they'll get it, but historically construction change orders aren't always as "good as gold." Often, considerably less than what was expected is realized, and the company incurs a profit fade on the job.

The bonding companies (sureties) that back construction companies don't like to see profit fades — the reduction of the estimated gross profit over the life of a contract. Subsequently, the bonding company may reduce the amount of the bond it's willing to issue for the construction contractor.

For example, a company's working capital (current assets minus liabilities) may be $1 million. The bonding company may bond the construction company for 10 times its working capital or $10 million. That means the construction company can bid jobs up to the $10 million bonding capacity.

If, because of the contractor's history of having profit fades, the bonding company identifies assets that it does not consider recoverable, it subtracts or discounts them from the balance sheet, limiting the surety's bonding capacity and the construction company's ability to bid higher-priced jobs.

Another pitfall for contractors who don't document change orders is having more time spent on their audits, which can result in adjustments to the books, higher costs, and longer time frames to complete financial statements, resulting in less-timely financial information for the contractor's bank and surety.

The following is an overview of the accounting principles of change orders and claims based on the criteria of Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts.

Change Orders

Change orders are modifications of an original contract that effectively change the provisions of the contract without adding new provisions. They may be initiated by either the contractor or the customer.

They include changes in:
  • specifications

  • design

  • method or manner of performance

  • facilities

  • equipment

  • materials

  • sites

  • period for completion of the work

There are three types of change orders:
  1. Approved: The change order is priced, and both parties have approved the scope and price.

  2. Unpriced: The work to be performed is defined, but the adjustment to the contract price is to be negotiated later.

  3. Unapproved as to both scope and price.

Accounting for change orders depends on these characteristics and the underlying circumstances in which they occur.
  1. Approved change order: Contract revenue and costs should be adjusted to reflect change orders approved by the customer and the contractor regarding both scope and price.

  2. Unpriced change order:

    1. Under the completed-contract method, costs attributable to unpriced change orders should be deferred as contract costs if it is probable that aggregate contract costs, including costs attributable to change orders, will be recovered from contract revenues. Some of the factors to consider in evaluating whether recovery is probable are the customer's written approval of the scope of the change order, separate documentation for change order costs that are identifiable and reasonable, and the entity's favorable experience in negotiating change orders.

    2. Under the percentage-of-completion method:

      1. Costs attributable to unpriced change orders should be treated as costs of contract performance in 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 (no change in contract revenue and percentage complete while costs are incurred and recognized).

      2. If it is probable that the costs will be recovered through a change in the contract price, the costs should be deferred as an asset (excluded from the cost of contract performance) until the parties have agreed on the change in contract price, or alternatively, they should be treated as costs of contract performance in the period in which they are incurred, and contract revenue should be recognized to the extent of the costs incurred.

      3. If it is probable that the contract price will be adjusted by an amount that exceeds the costs attributable to the change order and the amount of the excess can be reliably estimated, the original contract price should also be adjusted for that amount when the costs are recognized as costs of contract performance if its realization is probable. However, since the substantiation of the amount of future revenue is difficult, revenue in excess of the costs attributable to unpriced change orders should only be recorded in circumstances in which realization is assured beyond a reasonable doubt, such as circumstances in which an entity's historical experience provides such assurance or in which an entity has received a bona fide pricing offer from a customer and records only the amount of the offer as revenue.

  3. If change orders are in dispute or are unapproved regarding both scope and price, they should be evaluated as claims.

Claims

Claims are amounts in excess of the agreed-upon contract price (or amounts not included in the original contract price) that a contractor seeks to collect from customers or others for customer-caused delays, errors in specifications and design, contract terminations, change orders in dispute or unapproved as to both scope and price, or other causes of unanticipated additional costs.

Recognition of amounts of additional contract revenue relating to claims is appropriate only if it is probable that the claim will result in additional contract revenue and if the amount can be reliably estimated.

Those two requirements are satisfied by the existence of all of the following conditions:
  • 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. (Work must be outside the scope of the original contract. If the customer has rejected the claim, it would be helpful to have a trial date set by the courts. If legal proceedings are not complete, the contractor should obtain representation from counsel that there is a reasonable basis for the claim. If a reasonable basis for the claim does not exist, it is unnecessary to go any further.)

  • 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. (Work must be outside the scope of the original contract.)

  • Costs associated with the claim are identifiable or otherwise determinable and are reasonable in view of the work performed. (They must have underlying invoices, time records, and similar documentation.)

  • The evidence supporting the claim is objective and verifiable, not based on management's "feel" for the situation or on unsupported representations. (There must be a history of positive results of resolving similar unapproved/disputed change orders in the past.)

If the foregoing requirements are met, revenue from a claim should be recorded only to the extent that contract costs relating to the claim have been incurred. The amounts recorded, if material, should be disclosed in the notes to the financial statements. Costs attributable to claims should be treated as costs of contract performance as incurred.

However, a practice such as recording revenues from claims only when the amounts have been received or awarded may be used. If that practice is followed, the amounts should be disclosed in the notes to the financial statements.

If the four requirements are not met or if those requirements are met but the claim exceeds the recorded contract costs, a contingent asset should be disclosed in accordance with FASB Statement No. 5, paragraph 17.

About the Author

Mark E. Noble, CPA, is the audit manager at Pease & Associates, a Cleveland, Ohio, accounting firm. He can be reached at mnoble@peasecpa.com or 216-348-0600.

Noble graduated magna cum laude with a Bachelor of Business Administration in Accounting degree from the University of Toledo in 1989 and has had 16 years of public accounting experience, all at Pease & Associates and its predecessor firm, serving construction-industry clients throughout this time. He is a member of the Ohio Society of Certified Public Accountants and the American Institute of Certified Public Accountants; he has been a CPA since 1992.

As a member of CPAmerica, Noble has participated in CPAmerica-sponsored peer reviews. He is also a former member of the Surety Association of Ohio (SAO) and the Construction Financial Management Association (CFMA).
If this article has helped you in some way, will you say thanks by sharing it through a share, like, a link, or an email to someone you think would appreciate the reference.

Popular tags:

 contracts  methods  management  accounting  customers  construction company


What I liked about the service is that it had such a comprehensive collection of jobs! I was using a number of sites previously and this took up so much time, but in joining EmploymentCrossing, I was able to stop going from site to site and was able to find everything I needed on EmploymentCrossing.
John Elstner - Baltimore, MD
  • All we do is research jobs.
  • Our team of researchers, programmers, and analysts find you jobs from over 1,000 career pages and other sources
  • Our members get more interviews and jobs than people who use "public job boards"
Shoot for the moon. Even if you miss it, you will land among the stars.
EmploymentCrossing - #1 Job Aggregation and Private Job-Opening Research Service — The Most Quality Jobs Anywhere
EmploymentCrossing is the first job consolidation service in the employment industry to seek to include every job that exists in the world.
Copyright © 2024 EmploymentCrossing - All rights reserved. 168