The Percentage of Completion (POC) method in accounting often carries a veil of mystery and apprehension for potential investors of project-based businesses. It is a crucial yet complex part of financial reporting in the construction and industrial sectors, in which projects often extend over long periods.

POC accounting relies on significant estimates made by management to determine the timing of revenue recognition. This flexibility opens the door to potential manipulation, underscoring the importance of approaching POC financials with a high degree of diligence and caution.

Understanding Percentage of Completion

For most businesses, revenue is recognized when a product is sold and transferred to a customer. However, this approach is impractical for project-based businesses, especially those with projects that span months or years.

Instead, POC accounting requires managers to estimate monthly revenues by determining the total contracted revenue and calculating the percentage of completion based on costs incurred relative to the total estimated costs of the project. The goal is to align revenues as closely as possible with expenses.

However, estimating total project costs often involves significant judgment, presenting opportunities for shifting revenue recognition across periods. This complexity is compounded when dealing with hundreds or thousands of projects at a time, each estimated by different project managers who may bring their own biases to the determination of POC.

Real-World Application and Challenges

Analysis can be performed to present the financials of any closed project more precisely. However, it’s crucial to understand management’s tendencies or biases to better analyze ongoing projects. Monthly fluctuations in POC revenues do not always stem from management bias; for instance, a large-scale construction project could face unexpected delays and cost overruns. Early revenue and margin recognition might be reversed if the total project costs exceed initial estimates. As most of the construction and engineering jobs are contracted based on a fixed price bid, these total estimated cost projections are key to maintaining margin throughout the project.

Commonly, revenue recognition is manipulated for beneficial timing related to tax obligations, commission payouts, or other economic reasons. This might lead managers to use conservative estimates early in the project, with a “true up” of revenue occurring towards the project’s completion. For investors, the challenge lies in evaluating recent months which might reflect more closed projects with significant revenue recognition.

Another driver of elevating margins throughout a project tends to be change orders. Projects are often engaged for an initial scope, which expands as the job progresses. The initial project may be won with a margin expectation of 15%, but as change orders are proposed and approved, these incremental tasks may be negotiated at 20% margins, as the business has the advantage of already being in the door and best equipped to perform the additional work. These change orders are extremely prevalent in construction and engineering and can lead to elevated margins as the job progresses.

Hindsight Is 20/20 (Closed Jobs)

In financial diligence, knowing the final total costs of all closed projects allows for a retrospective adjustment of when revenue should have been recognized based on the costs incurred each month and the actual project completion costs. This comparison can reveal whether management consistently employs a conservative, aggressive, or uniform approach to estimating costs and margins.

Hindsight Example

The example above shows a project where management assumed a conservative margin at the onset of the project. In period one, management conservatively assumed they would make 5% on a $1,000 contract, or would incur total costs of $950. Further, during period one, the company incurred costs of $95 or 10% of the total costs. As a result, management recorded 10% of the total contracted revenue, or $100 ($1,000 * 10%).

Period 1 Revenues

Similarly, in period five, management increased their estimated margin to 8.6% as the project got closer to completion and was confident it would generate greater margins. As it incurred $640 of expenses through period five, they therefore should have recognized 70% or $700 of revenues. Since $500 of revenues were recognized through period four, an incremental $200 was recognized in period five.

Period 5 Revenues

Ultimately, in period six, management closed the project at a margin of 20%. As a result, they recognized all remaining revenues on the contract, $300. This resulted in a period six margin of 47%, as they recognized all the margin that had been held back throughout the project.

Chart 1: Reported Margin vs Hindsight Margin

Chart 2: Reported Revenue vs Hindsight Revenue

In diligence, by looking back at the specific costs, it can be determined exactly how conservative each month was, and revenues can be adjusted to the periods they relate. The methodology used to recast the revenue is based on the ultimate total costs of $800 and 20% mark-up. Therefore, instead of recognizing variable margins each month, the job will have a consistent margin each month, and revenue will be recognized ratably with when expenses are incurred.

As the job initially was projected to have total costs of $50 and an 5% mark-up, the initial periods for revenue were understated while the final period was overstated. The adjustment with perfect hindsight would be to increase revenues for each of the first five periods and decrease revenues in the final period.

Projecting Margin Expansion (Open Jobs)

While the above recasting solves the issue for any closed project, there remains risk that bias exists in any open projects that still require management’s estimates. Diligence providers can recast those projects as well. However, instead of adjusting to known amounts for total costs, historical performance can be used as the estimate.

Total costs or total project margins can be used based on historical averages of margins for specific project types, size, historical margins for specific customers, margin that was used for the initial project bid, or any other relevant metrics that would limit management’s judgement. These methodologies can be applied using various mechanics, which may include marking up jobs to a final expected margin (based on historical performance by categories noted above) or marking up jobs based on the stage of the project (i.e., 25% complete, 50% complete, 75% complete) and a historical average growth in margin over the project lifecycle.

Diligence is often thought of as process that buyers engage in. However, diligence is also important for sellers as they prepare to present their business to the market. Sellers should get ahead of any issues, remove any perception of bias, and establish their understanding and expertise over the business and its finances.

Revenue Recognition (ASC 606 vs. ASC 605 vs. IFRS)

ASC 606 prescribes revenue recognition for long-term projects to be over time which aligns with the percentage-of-completion methodology and supersedes ASC 605. While both standards are generally consistent for POC accounting, ASC 606 requires separating performance obligations and assignment transaction prices for each. In construction or engineering type jobs, which are usually interdependent, this typically results in one performance obligation, so there’s no change from ASC 605 to ASC 606.

Under ASC 605, companies could use the completed contract method, recognizing revenue only when a project was fully complete. This was intended to be utilized when reliable estimates could not be made, on very short jobs, or when there was a risk the project wouldn’t be completed. This method leads to recognizing all revenue at the end of a project, which may differ significantly from POC accounting over longer term projects. Although ASC 606 allows for completed contract recognition in certain cases, it’s primarily reserved for circumstances when a project may not be completed. In practice, construction and engineering businesses use the completed contract methodology as a practical expedient for smaller or short-term jobs when they don’t have the resources required to track projects on a POC basis.

Like ASC 606, IFRS allows for percentage-of-completion method of accounting, but recognition under the completed contract method is effectively banned with exceptions for jobs with uncertainty of being completed.

Net Working Capital Implications

POC accounting along with billing terms outlined in the contract lead to “billings in excess of costs” (liability) and “costs in excess of billings” (assets) on the balance sheet. It is important for investors to keep in mind that any recasting of revenue will also have an impact on the calculation of net working capital, as the timing of revenue interplays with the determination of under-billings or billings in excess.

If a conservative job is recast, the project would have more revenue upfront and higher percentages complete. This likely would trigger opportunities to bill revenue at these earlier stages, thus resulting in incremental accounts receivable, which a DSO could be applied to in determining the NWC impact. However, if the contract is on a fixed billing cadence, the recognition of revenue upfront would result in an increase in costs in excess of billings which would accumulate month to month. Refer below for a hypothetical example of the NWC impact from the hindsight analysis. There are three examples of how NWC may be impacted:

1. DSO 30 Days –If the business maintained a DSO of 30 days, then any amounts billed in a period would generally be collected in the following period. So, any revenue adjustment would be expected to have a corresponding NWC for one month.
2. DSO 60 Days –If the business maintained a DSO of 60 days, then any amounts billed in a period would generally be collected in two months. So, any revenue adjustment would be expected to remain in NWC for two months.
3. Fixed –If the business had fixed billings at the end of the project, then any amounts earned in prior periods would build up in NWC until the billing occurs at the completion of the project.

One unique characteristic of construction contracts is retainage. Retainage is a portion of each invoice (typically 5-10%) that is not paid by customers but rather held until acceptance of the completed project or specific milestones This is further complicated by any retainage held and due to subcontractors. Retainage can cause extended DSO and DPO terms in analyzing metrics of the business.

The billings in excess, costs in excess, and retainage may play a role in indebtedness negotiations depending on the contract structures, billing terms, and more. These are key areas of diligence on the sell-side and buy-side which drive meaningful value.

Other Deal Considerations

Construction and engineering deals tend to have employee bases which may be tied to a union, group pension plans, workers compensation claims, self-insurance, and more. These human capital heavy businesses can often be complex while maintaining unsophisticated accounting, which can further complicate diligence. The basis of the accounting, contract terms, scheduled salary escalations, funding status, and so forth are focus areas in diligence.

It is common for businesses to have multiple entities or joint ventures which have been entered for strategic purposes. For example, businesses may engage in joint ventures to create a small business or minority-owned business by partnering strategically. The entity may be recorded on the equity method of accounting, but it is important to evaluate the financials, work-in-progress schedule of jobs, cash flow, and more. In addition, the business may subcontract services to an intercompany entity or joint venture which are performed on POC accounting. The elimination of these jobs and proper assessment of the activity is important in diligence.

Legislative Implications, Market Trends, and Opportunities

Recent legislative developments, such as increased infrastructure spending growth in manufacturing plant construction and increasing demand for electricity, have brought the POC method into the spotlight. This projected spending is translating to a growing backlog and pipeline for engineering and construction services firms.

Financial buyers that historically shied away from the sector are becoming more interested in acquiring firms that will benefit from these mega spending trends. Understanding and properly analyzing the historical and projected performance of these firms, much of which involves projecting existing backlog and pipeline to future revenue and EBITDA, requires an understanding and application of POC analysis.

In addition to investors in the sector, lenders must also be prepared to apply POC analysis to properly gauge debt capacity at closing of a transaction and to set covenants for future periods. Working with experienced due diligence providers, and in cooperation with management, banks and direct lenders can play a significant role in the continued high level of M&A activity in the sector.

The engineering and construction services sectors remain highly fragmented, and opportunities remain for investors to acquire solid, well-managed firms at reasonable multiples. Understanding the fundamentals of how these firms bid, win, and manage projects is critical to finding and acquiring winning platforms. An experienced due diligence provider that understands the impacts of POC accounting and can apply that experience to help guide investors will be critical as these mega trends continue.

Conclusion

Investors historically were often wary of businesses that utilize POC accounting, particularly those that are founder-owned or in the middle market, due to the complexities and potential for financial obfuscation associated with this accounting method.

However, with detailed diligence and expert financial practices, companies can navigate the complexities of this method, turning potential risks into opportunities for growth and success.