As you know, change orders are an inherent part of the construction industry. Alterations to the original design, specifications, execution methods or scope of a job can impact the budget and timeline. And when not discussed and documented properly, they can lead to nonpayment for additional work and legal disputes.
That’s why establishing a standard, comprehensive change order management process is critical to the financial well-being and operational stability of every construction business.
Approved vs. unapproved
Approved change orders, whereby the contractor and project owner formally agree on the additional work and price — and put that agreement in writing — are relatively straightforward to account for in billing and financial reporting.
On the other hand, unapproved change orders call for careful evaluation and documentation until formal approval is obtained. As you may have learned the hard way, a verbal agreement and handshake don’t always guarantee payment.
What’s more, waiting for approval documents before entering change orders into your accounting system could prevent your company from accurately tracking project costs. This may compromise financial reporting, which can in turn negatively impact creditworthiness and internal financial management.
Effective measures
Fortunately, there are a variety of measures that can help you more effectively manage and account for change orders — both approved and unapproved. Here are some to consider:
Review contracts and plans to clarify scope. For every project, or perhaps those of high value or complexity, ask your attorney to review the contract and revise or eliminate clauses that may lead to additional work. During preconstruction, you and your project manager should also review the building plans and clear up any vague or dubious specs or job scope. Both measures will help resolve ambiguities and catch errors or omissions that could lead to contentious change orders later in the job.
Establish formal submittal and approval procedures. Ensure the language of each contract specifies change order procedures, including how costs will be calculated and how the project schedule will be adjusted. Emphasize the need for written documentation and approval. Many construction businesses attach a change order form template and a payment schedule to contracts or project documents.
Keep organized project records. Maintaining thorough documentation empowers your team to evaluate change orders promptly, accurately reflect them in financial statements and take corrective actions when needed. Make sure the documents objectively support why additional work is needed. Any facts or specs mentioned should be verifiable and consistent with the work already performed.
Communicate effectively with all stakeholders. It’s obviously important to maintain an open dialogue with project owners, designers, subcontractors and other partners throughout a job. But this is especially true when a change order arises. After all, no one wants to be the last to know. Raise the issue as soon as possible, discussing the likely impact on costs, productivity, scheduling, and resources such as labor, materials and equipment.
Adjust accounting based on likeliness of approval. Generally, you don’t want to start work on a change order until you have a signed approval in hand. In such cases, the accounting approach usually involves adding costs associated with the change order to the total project costs and increasing the total contract value by the additional amount charged.
However, as you may have experienced, real-world circumstances sometimes force you to move forward on an unapproved change order. If such a change order will likely be approved, you could add the costs to a special asset account until approval is obtained. Another option is to conditionally add the cost to the total project costs and increase the anticipated job revenue by the same amount.
If you believe a change order is unlikely to be approved, you may choose to add the associated costs to the job’s direct costs. Again, careful documentation of the work performed and costs incurred will be imperative, as you may need to undertake legal action down the line.
A business imperative
To be clear, the optimal accounting treatment for each change order will depend on the facts and circumstances involved. We’d be happy to help you properly account for your construction company’s change orders, as well as assist you in improving your change order management procedures.
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