Construction Change Orders: Revenue Recognition, Disputed Claims, and PCM Impact

A contractor performs $80,000 of additional work on a project because the owner requested a scope change verbally. The change order is not signed. The owner disputes the amount. The contractor has incurred real costs (labor, materials, subcontractors) that are sitting in job cost records with no corresponding revenue. On the WIP schedule, those costs drive the percentage of completion higher, which under the percentage-of-completion method (PCM) would recognize revenue proportionally, but the revenue side of the calculation depends on the total contract price, which is now in dispute. The treatment of change orders is one of the most judgment-intensive areas in construction accounting, and it has direct consequences for the tax return, the bonding program, and the financial statements.

How does an approved change order affect the books?

When the owner or GC formally approves a change order (signed by both parties, specifying the revised scope, price, and timeline), the accounting is straightforward:

Contract price adjustment. The total contract price increases (for additive change orders) or decreases (for deductive change orders) by the change order amount. On the WIP schedule, the “total contract price” column is updated.

Estimated cost adjustment. The total estimated costs are revised to include the cost of the additional (or reduced) work. If the change order adds $50,000 to the contract price and the estimated cost of the additional work is $40,000, the estimated gross profit on the contract increases by $10,000.

PCM recalculation. The percentage of completion is recalculated using the updated contract price and estimated costs. The cost-to-cost formula (costs incurred to date divided by total estimated costs) may produce a different completion percentage, which changes the cumulative revenue recognized. The difference between the newly calculated cumulative revenue and the revenue previously recognized is the current-period revenue adjustment.

How should pending (unapproved) change orders be treated?

A pending change order is one where the work has been performed (or is being performed) but the owner has not formally approved the revised price. This is common on construction projects where the pace of work outstrips the administrative approval process.

Conservative treatment (recommended for most contractors):

• Include the additional costs in the WIP schedule (they are real costs that have been incurred).
• Do not include the unapproved revenue in the total contract price.
• Effect: the project’s apparent profitability decreases (costs are up, revenue is unchanged), and the percentage of completion may increase (costs incurred are a larger share of total costs if total estimated costs were revised upward). This is conservative because it does not recognize revenue that has not been contractually established.

Aggressive treatment:

• Include both the additional costs and the anticipated change order revenue in the WIP schedule.
• Effect: the project’s apparent profitability is maintained at the original margin (the revenue increase offsets the cost increase, assuming the change order carries a similar margin to the original contract).

The IRS does not prescribe a specific treatment for pending change orders, but it does require consistency. A contractor who includes unapproved change order revenue on some projects and excludes it on others is cherry-picking, which the IRS can challenge.

For bonding purposes, the surety generally prefers the conservative treatment because it produces a lower-risk financial picture. A contractor who inflates reported revenue with unapproved change orders and then fails to collect the change order amount will show a profit fade (revenue recognized in prior periods that is reversed when the change order is denied), which undermines the surety’s confidence in the WIP schedule.

How are disputed claims handled?

A claim is different from a change order. A change order modifies the contract by agreement. A claim asserts entitlement to additional compensation that the other party has not agreed to: delay damages, differing site conditions, acceleration costs, or additional work performed without authorization.

Revenue recognition. Claims are excluded from the contract price until resolved. Under both GAAP (ASC 606) and tax accounting, the contractor does not recognize revenue from claims until: (1) the claim is legally enforceable (based on contract terms, applicable law, or course of dealing), (2) the amount is determinable, and (3) the collection is probable. These conditions are rarely met before the claim is settled through negotiation, mediation, arbitration, or litigation.

Cost recognition. The costs associated with the claim (additional labor, materials, delay costs) are included in the WIP schedule as costs incurred. These costs increase the percentage of completion without a corresponding increase in the contract price, which depresses the project’s reported profitability.

Tax treatment. For PCM contractors, claim costs are included in the cumulative cost-to-date figure for the percentage-of-completion calculation. Claim revenue is excluded from the total contract price until settled. When the claim is settled, the settlement amount is added to the contract price, and the PCM calculation is revised going forward (not retroactively). The look-back method under IRC 460(b) will adjust for the over- or under-recognition of revenue over the life of the contract when the contract is completed.

Backcharges. A backcharge is the reverse: the owner or GC charges the contractor for costs incurred to correct defective work or complete work the contractor failed to perform. Backcharges reduce the amount the contractor collects and may reduce the contract price. The contractor should accrue the backcharge liability when the claim is probable and estimable.

What documentation is needed for change orders?

Written authorization before work begins. The single most important practice. A written change order (or at least a written directive from the owner or architect) authorizing the scope change should exist before the contractor begins the additional work. Without written authorization, the contractor’s claim for additional compensation rests on oral agreements, custom and practice, or constructive change theories, all of which are harder to prove and easier to dispute.

Cost tracking by change order. Each change order should be tracked as a separate cost code (or sub-code) within the job costing system. This allows the contractor to demonstrate the actual cost of the change order work, which supports both the change order negotiation and the WIP schedule accuracy.

Time and materials documentation. For change orders priced on a time-and-materials basis (rather than a fixed price), the contractor must maintain daily records: labor hours by worker and trade, material quantities and unit costs, equipment usage hours and rates, and subcontractor invoices. The owner or GC should sign daily T&M tickets confirming the hours and materials.

Correspondence. All correspondence related to the change order (emails, letters, RFIs, meeting minutes) should be preserved. The correspondence establishes the timeline, the scope of the change, the parties’ positions, and the basis for the pricing.

What are the common change order mistakes?

Performing work without written authorization. The contractor assumes the owner will approve the change order after the fact. The owner disputes the amount (or denies the change order entirely), and the contractor has incurred costs with no contractual basis for recovery.

Failing to adjust the WIP schedule. The contractor treats the change order as a separate item rather than adjusting the total contract price and estimated costs on the WIP schedule. This produces an inaccurate completion percentage and misallocates revenue between reporting periods.

Including unapproved revenue inconsistently. Including unapproved change order revenue on profitable projects (to maintain the margin) while excluding it on unprofitable projects (to defer the loss). This inconsistency is a red flag for auditors, sureties, and the IRS.

Not tracking change order costs separately. Lumping change order costs into the original contract’s cost codes, which makes it impossible to determine the actual cost (and profitability) of the change order work. If the change order is disputed, the contractor cannot demonstrate the cost of the additional work.

Ignoring the impact on retainage. Change orders increase the total contract price, which increases the retainage base. A $100,000 change order with 10% retainage adds $10,000 to the retainage balance, which is additional cash the contractor does not receive until project completion.

What should I do next?

If your company does not require written change orders before work begins, implement that policy on the next project. If your WIP schedule does not separately identify pending change orders and disputed claims, add that disclosure. If your job costing system does not track change order costs in separate cost codes, set up the structure before the next change order.

• Construction job costing, the cost tracking system where change order costs are captured and the WIP schedule is produced
• Construction retainage, how change orders increase the retainage balance and affect cash flow
• Construction contractor tax deductions, the PCM and completed-contract methods that determine when change order revenue is taxable
• Construction insurance and bonding, how the WIP schedule (including change orders) drives bonding capacity
• IRS accuracy-related penalty, reasonable cause defense for PCM errors related to change order treatment

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.