In the world of mergers and acquisitions (M&A), accurate financial reporting is essential. In particular, revenue and cost recognition can significantly impact a company’s valuation. For construction, and some engineering, technology, and manufacturing companies, this becomes even more critical due to the project-based nature of the work that can span multiple months or years. Failing to properly recognize and match revenue and costs in the correct period can lead to skewed financials, which in turn overstate or understate a company’s margins, revenue, and enterprise value.
One way to address the issue of out-of-period revenue for companies with longer-term projects is the Percentage-of-Completion (POC) method. This method ensures that revenue is matched with costs in the correct accounting periods, providing a more accurate representation of a company’s financial position in accordance with GAAP (Generally Accepted Accounting Principles).
A buyer or seller’s level of sophistication can vary and having the right team to guide you through the complexities of POC can be the difference between closing and not closing. Whether you are a private equity fund, venture capital fund, search fund, unfunded sponsor, or anyone else, understanding what POC is and why a business should or should not utilize the method is instrumental.
The POC method is an accounting technique designed to recognize revenue in sync with the progress of work performed during a project. Unlike the cash-basis of accounting, which records revenue when payments are received, or the milestone method, which recognizes revenue at specific project milestones, the POC method aligns revenue and expenses across the life of the project.
Under the POC method, companies recognize revenue based on the percentage of the project that has been completed during the reporting period. If, for example, a construction company completes 40% of a project in a given month, it will recognize 40% of the total revenue for the project in that period.
The key goal of POC is to match revenue with expenses. So, if the company incurs costs for materials and labor to complete 40% of the project in April, the Company should recognize the revenue associated with that portion of work in the same month. The POC method aligns with accrual-basis accounting, which ensures that financial statements reflect the true economic activity of the company, regardless of when payments are actually made.
While POC sounds straightforward, it involves several key steps and considerations. GAAP provides flexibility in the way POC can be calculated, which is crucial because different industries and companies may have varying operational structures.
For example, let’s consider a construction project with a $2 million contract.
To calculate the percentage of completion for April, divide the actual costs ($400,000) by the initial cost estimate ($1 million), resulting in 40% completion.
Then, multiply the total revenue of $2 million by 40%, which gives you $800,000 of revenue to recognize in April.
This approach is known as the cost-to-cost method, one of the most common methods used for POC calculations. It is considered an input method because it is based on the actual inputs (costs) incurred during the period. Other metrics can also be used as inputs, such as labor hours or machine hours, which provide further detail on the work completed during the period.
There is also an output method, where the percentage-of-completion is calculated based on units of work completed, such as the number of miles of roadway paved or units of a product manufactured. While this method is less common for smaller companies, it is still acceptable under GAAP.
The input method and output method for the same project may drive different results or margins so the method chosen should most accurately reflect the economic reality of project and business.
Many lower and middle-market companies, especially in the construction and highly engineered manufacturing sectors, do not properly utilize the POC method. Instead, they may recognize revenue only when they bill customers, or at specific project milestones that do not always align with the true transfer of control to the customer. However, these approaches can create several risks, particularly when it comes time for an M&A transaction:
While the POC method is likely the most accurate way to recognize revenue and costs for long-term projects, there are complexities. In addition to tracking actual costs and labor hours, companies must determine whether they are dealing with one performance obligation or multiple obligations within each contract.
For example, in construction, certain components of a project may benefit the customer before the entire project is completed which would require the distinct performance obligation to be accounted for separately based on an allocated portion of the overall contract amount.
Moreover, POC calculations can be affected by factors such as contract language, product customization, and whether goods have an alternate use. Another complexity is whether the company has a right to payment upon cancellation of a contract. These considerations can add layers of complexity for accounting teams, especially when it comes to preparing financial statements for an M&A transaction.
One of the unique benefits of the POC method in financial due diligence is the ability to make hindsight adjustments. When a project is completed, final revenue and costs become known, and diligence providers can adjust past financial reports to better reflect the actual outcomes of the project. This can be especially valuable for improving EBITDA accuracy during due diligence.
Hindsight adjustments allow diligence providers to "recast" revenue for closed jobs by applying the final margin to previous estimates, which helps eliminate the variability in margins during the life of each project. Hindsight adjustments for open jobs are based on management assertions of expected margin for the project which presents a risk as estimates often change. The risk of bias exists in any open projects that still require management’s estimates. Changes in estimates can meaningfully change a hindsight adjustment positively or negatively.
The comparison between actual results and estimates can reveal whether management consistently employs a conservative, aggressive, or uniform approach to estimating costs and margins.
For construction and manufacturing companies, this process can be crucial for accurately representing historical earnings.
However, hindsight adjustments are only possible if the company has been accurately tracking costs at the project level. Without accurate data to inform these adjustments, companies risk missing out on an opportunity to improve the accuracy of their financial statements. Although a hindsight adjustment may not be possible for all jobs, hiring a qualified diligence provider may allow for other ways to mitigate the risk.
For companies in industries like construction or highly engineered manufacturing, making the switch to the POC accounting method before a sale can be a game-changer. Not only does it provide a more accurate financial picture, but it also gives an M&A advisor a clearer understanding of the company's true value.
Switching to POC provides a more robust, GAAP-compliant set of financial statements that can minimize the risk of disputes during due diligence. If you are considering buying or selling a business in the near future, considering the impact of POC accounting could be the difference in driving a successful transaction.
Accurate revenue recognition is vital for any business, especially those involved in long-term projects like construction and manufacturing. The Percentage-of-Completion method provides a standardized way to align revenue with costs, ensuring that financial statements accurately reflect the progress of a project.
For businesses or investors planning to enter an M&A transaction, considering the impact of POC can reduce valuation risks, improve EBITDA accuracy, and help you strengthen your position. By ensuring accounting practices are up to GAAP standards, you can make the most of your M&A opportunity—both for the short-term and for future growth.
Whether you are a private equity fund, venture capital fund, search fund, unfunded sponsor, or anyone else, advance preparation is always essential if you are planning to buy or sell and hoping to get the best deal possible.
If a company is costing at the job level or already using percentage-of-completion, conducting POC analysis for M&A preparation is both doable and very valuable. That said, we have seen instances where business owners tried to do their own POC analyses with incorrect or inconsistent results. Working with an M&A or accounting advisor who knows your industry, you can get the help you need now to implement POC accounting. Then, when it is time to entertain an M&A deal, you will be prepared with quality financials.
Percent-of-completion is just one of many factors that affects the ease and outcome of M&A deals. Episodes in our podcast series The Transaction Abstract help prospective sellers and buyers learn directly from industry experts what you can do to prepare for and navigate the process to realize your best deal.