Why Change Orders Are the Most Dangerous Line Item on Your WIP
Every experienced contractor knows that change orders are where margins are made or lost. The original contract sets the baseline, but change orders determine whether a project finishes at 18% gross margin or 8%. What most contractors do not fully appreciate is how the accounting treatment of change orders can distort their financial picture long before the project closes.
The core problem is timing. Work is performed, costs are incurred, and billing requests are submitted, but the owner has not yet approved the change order. The project manager is confident the change will be approved because the work was clearly outside the original scope. So the question becomes: do you include that change order revenue in your WIP calculation?
The answer you give to that question determines whether your financial statements reflect reality or a version of reality you hope will eventually come true. And the gap between those two things is where contractors get into serious trouble.
What Does ASC 606 Actually Require for Change Order Recognition?
ASC 606 (Revenue from Contracts with Customers) replaced the older percentage-of-completion guidance and brought more rigorous requirements to variable consideration, which is the category that includes change orders, claims, and incentive fees.
The Variable Consideration Framework
Under ASC 606, a change order is a form of variable consideration because the total transaction price of the contract is uncertain until the change order is resolved. The standard requires contractors to estimate the amount of variable consideration and include it in the transaction price only to the extent that it is probable that a significant reversal of cumulative revenue recognized will not occur.
In practical terms, this means you need to evaluate two things. First, what is your best estimate of the amount you will ultimately receive for the change order? Second, is it probable (meaning more likely than not, a threshold above 50%) that you will actually receive that amount without a significant downward adjustment?
If both conditions are met, you can include the estimated change order revenue in your transaction price and recognize it through your percentage-of-completion calculation. If either condition is not met, you must exclude the change order revenue from your calculation, even though you may have already incurred the costs.
The Critical Distinction: Probable Versus Possible
This is where most contractors and even some CPAs get the standard wrong. Probable under ASC 606 is a higher bar than many people think. It is not enough that the change order is legitimate, that the work was clearly extra, or that the project manager believes the owner will eventually approve it. You must have sufficient evidence that the owner acknowledges the scope change and that the pricing is within a range that will likely be accepted.
Evidence that supports probable recognition includes written acknowledgment from the owner that the work is outside the original scope, a signed directive to proceed with the work, historical experience with this owner approving similar changes, or the existence of a contractual clause that clearly entitles you to additional compensation for the type of work performed.
Evidence that undermines probable recognition includes owner silence or pushback on the scope change, a history of this owner negotiating change orders down by 30% or more, absence of a written change directive, or contractual ambiguity about whether the work is truly extra or within the original scope.
The Three-Bucket Classification System
Every pending change order on every project should be classified into one of three buckets. This classification drives the accounting treatment and must be reviewed monthly.
Bucket One: Approved Change Orders
An approved change order has been signed by both parties with an agreed price. There is no uncertainty. The approved amount is added to the revised contract value, the associated costs are included in the estimated cost at completion, and the WIP calculation proceeds normally.
This is the easy bucket. The problem is that too many contractors have too few change orders in this bucket because they are slow to get signatures, even when the owner has verbally agreed to the price.
Bucket Two: Probable but Unapproved
The work has been performed or directed, the contractor has strong evidence that the change will be approved, and the estimated amount meets the ASC 606 probable threshold. The estimated change order amount is included in the transaction price, subject to the constraint that a significant reversal is not probable.
This bucket requires judgment, and that judgment must be documented. For each change order in this category, your file should include the basis for concluding that approval is probable, the estimated amount and how it was determined, any constraint applied to the estimate, and the costs incurred to date on the change order work.
Bucket Three: Not Probable
The change order is pending, disputed, or lacks sufficient evidence to conclude that approval is probable. This bucket gets the most conservative treatment: the costs incurred on the change order work are included in your costs to date (because you actually spent the money), but no corresponding revenue is recognized.
This is the bucket that hurts. Including costs without revenue reduces your percentage-of-completion margin on the entire job. But it is the honest treatment, and it prevents the far worse outcome of recognizing revenue you never collect.
How a Single Unapproved Change Order Distorts Your Entire WIP
Let us walk through a specific example to illustrate the magnitude of this issue.
The Setup
You are the GC on a $1.5 million commercial renovation. Your original estimated cost is $1.17 million, giving you an estimated gross margin of 22%. The project is 60% complete based on costs incurred ($702,000 of $1.17 million).
During the project, the owner requests additional structural work. You submit a change order for $200,000, with estimated costs of $160,000. You have incurred $80,000 of those costs so far. The owner has not yet approved the change order. They are not disputing the scope, but they are pushing back on the price and have not signed anything.
Scenario A: You Book the Change Order Revenue
If you include the $200,000 change order in your revised contract value, the job looks like this. Revised contract value is $1.7 million. Revised estimated cost is $1.33 million ($1.17M plus $160K). Costs to date are $782,000 ($702K plus $80K). Percent complete is 58.8%. Earned revenue is $999,600. Estimated gross margin is 21.8%.
The job looks healthy. Margin is holding near the original estimate. Your WIP tells a comfortable story.
Scenario B: You Exclude the Change Order Revenue
If you exclude the change order revenue but include the costs (the correct treatment when approval is not probable), the numbers shift dramatically. Contract value stays at $1.5 million. Estimated cost becomes $1.33 million ($1.17M plus $160K in change order costs you will incur regardless). Costs to date are $782,000. Percent complete is 58.8%. Earned revenue is $882,000. Estimated gross margin is 11.3%.
The margin has dropped from 22% to 11.3%. Same project, same work, same costs. The only difference is whether you are counting revenue you have not been authorized to collect.
What Happens If the Change Order Is Denied or Reduced?
If the owner ultimately approves the change order at $200,000, Scenario A was correct and no adjustment is needed. But if the owner negotiates it down to $120,000, or denies it entirely, Scenario A requires a revenue reversal that hits your income statement as a loss. Your surety sees a job that was supposedly at 22% margin suddenly drop to 14% or worse, which is the textbook definition of profit fade. Your credibility with the surety takes a hit that extends beyond this one project.
Scenario B, while more painful in the short term, protects you. If the change order is ultimately approved, you recognize the additional revenue when the uncertainty is resolved, and the job margin improves. If it is denied, you have already absorbed the cost impact and there is no surprise.
How Change Orders Affect Your Bonding Capacity
Sureties perform what is called fade analysis on your WIP. They compare the original estimated margin on each job to the current estimated margin, looking for jobs where profitability is deteriorating. Profit fade is one of the strongest negative signals in surety underwriting because it suggests either poor estimating, poor project management, or aggressive accounting.
When you book unapproved change order revenue and the change order is later denied or reduced, the resulting profit fade is sudden and large. The surety sees a job that was tracking at a healthy margin collapse in a single reporting period. That pattern, especially if it appears on multiple jobs, can lead to reduced bonding capacity, higher bond premiums, or a request for additional indemnity.
Conversely, when you take the conservative approach and exclude unapproved change order revenue, your WIP shows stable or improving margins over time as change orders are resolved. Sureties read this pattern as disciplined accounting and reliable project management. It builds credibility that translates directly into bonding capacity.
What Should Your Change Order Log Include?
Every project should maintain a change order log that is reviewed as part of the monthly WIP process. The log should track each change order with the following information.
Change order number and description. What is the scope change and why is it extra?
Date submitted to the owner. How long has this been pending?
Estimated value. What is your proposed price for the change order work?
Costs incurred to date. How much have you already spent on this change order scope?
Estimated cost to complete. How much more will it cost to finish the change order work?
Owner response status. Has the owner acknowledged receipt, requested negotiation, disputed the scope, or gone silent?
ASC 606 classification. Which bucket: approved, probable, or not probable?
Recognition treatment. Is the revenue included in the WIP calculation or excluded?
Supporting documentation. What evidence exists to support the classification? Change directives, correspondence, RFIs, meeting minutes.
This log serves dual purposes. It is your accounting documentation for ASC 606 compliance, and it is your project management tool for ensuring change orders do not languish unresolved.
How Long Should You Wait Before Writing Off a Denied Change Order?
There is no bright-line rule, but a practical framework helps. If the owner has explicitly denied the change order in writing and you do not intend to pursue it through dispute resolution, write off the revenue (if any was recognized) immediately. If the owner has denied it but you are pursuing it through mediation, arbitration, or litigation, reclassify it as a claim and evaluate whether the claim meets the recognition criteria under ASC 606 (which are generally more stringent than change order recognition criteria).
For change orders that have been pending for more than 90 days without any positive movement from the owner, critically reassess the probability of approval. Passage of time without resolution is generally a negative indicator, not a neutral one. Owners who intend to approve change orders typically do so within 30 to 60 days.
The Counterintuitive Truth About Conservative Change Order Accounting
Here is the insight that separates contractors who build sustainable, bondable businesses from contractors who lurch from one cash crisis to the next: conservative change order accounting does not reduce your profit. It reduces your reported profit in the current period, but it does not change the actual economics of the project. If the change order is ultimately approved, you will recognize the revenue when the uncertainty resolves. Your cumulative profit over the life of the project is identical.
What conservative accounting does reduce is your risk. The risk of reporting phantom margins that evaporate. The risk of borrowing against inflated receivables. The risk of a surety downgrade triggered by sudden profit fade. The risk of making bonuses based on margins that were never real.
The contractors who get this right treat their change order accounting as a competitive advantage. Their WIP schedules are trusted by sureties, lenders, and potential acquirers. Their reported margins are reliable. When they tell a surety that a job is tracking at 18% margin, the surety believes them because they have a track record of conservative, accurate reporting.
That credibility is worth more than the short-term comfort of inflated revenue on a single project. It compounds over years into higher bonding capacity, lower borrowing costs, and the ability to pursue the projects that build real enterprise value.