How To Assess Percentage-of-Completion Risk in a Contract-Based Deal Environment

Construction and contract-based businesses typically operate in fragmented industries, making them popular acquisition targets since they are well-suited for a buy-and-build strategy. Despite interest rate pressures, deal activity for these businesses remains strong as investors seek quality assets that can benefit from anticipated infrastructure spending and U.S. housing supply dynamics. In the past year alone, KSM’s Transaction Advisory Services Group has worked on more than 20 contract-based transactions in the automation, construction, and industrial services industries.

One of the more complex topics for buyers and sellers in these industries relates to revenue recognition under Accounting Standards Codification (ASC) Topic 606, which governs how companies, including those in construction, should recognize revenue from contracts. Understanding how revenue is recognized using this method can directly affect the perceived value of a business, making it a pivotal consideration in both acquisitions and sales. While ASC 606 is the technical guidance and prevailing standard, the term percentage-of-completion is still widely used, and we will continue to reference POC throughout this article.

What Is the Percentage-of-Completion Method of Accounting?

Under POC, revenue is recognized over time, typically based on the ratio of costs incurred to total estimated costs at the completion of the contract, or the cost-to-cost input method. Under this method, management estimates the total costs that will be incurred to complete a project. Project completion is then measured based on the total costs incurred as of the measurement date as summarized in Figure 1. Companies may have a dozen or hundreds of projects, all of which must be estimated under POC. Management will estimate completeness, and revenue earned, on all in-progress contracts on its work-in-progress (WIP) schedule.

Revenue Recognition Considerations for Contract-Based Businesses

Revenue recognition under the POC method can be volatile as it is dependent upon management’s estimate of final contract margins. To assess normalized earnings potential and quality of revenues, a lookback analysis can be performed on completed projects, and management’s estimated margins on ongoing projects can be assessed for reasonableness.

Performing a Lookback Analysis on Completed Projects

A lookback analysis aims to recast revenues based on final project gross margin, which removes the impact of changes in project estimates over the life of the project. In Figure 1, the company’s estimated cost perfectly aligned with how the contract performed, and no updates were made to the contract amount or cost. In practice, contract amounts and cost estimates will change as a project progresses. Contractors often maintain conservative gross margin estimates early in a project and increase estimated gross margins as projects near completion, effectively deferring profit toward the end of a contract.

Figure 2 shows the impact to earnings caused by the change in estimated contract cost. Management estimated $850,000 in total costs in FY23 and FY24. In FY25, the project was completed with only $750,000 of costs incurred. Because the company had been recognizing revenues assuming a 15% margin in FY23 and FY24, the company would then record a 58% margin in FY25 when the project is completed. Without any adjustments, revenues would be overstated in FY25 and understated in FY23 and FY24, which would net to zero over the life of the project but create a timing difference between periods.

The inverse impact will also hold true if profitability decreases over the life of the project as shown in Figure 3.

Without any adjustments, revenues would be understated in FY25 and overstated in FY23 and FY24, netting to zero over the life of the project but creating a timing difference between periods.

Ongoing Project Analysis for Revenue Accuracy

While a lookback analysis quantifies the earnings impact on completed contracts, a buyer should also assess the reasonableness of management’s estimated margins on in-progress projects. One of the largest POC risks in M&A is that revenues have been accelerated due to overly optimistic gross margin assumptions on the current WIP schedule. Projected gross margins should be compared to historical gross margins to assess the reasonableness of management’s estimates. The lookback analysis can also inform the buyer of management’s historical accuracy and level of conservatism in project estimation.

With all else equal, higher projected gross margins relative to historical margins increase the risk of a future profit fade. In addition to overall gross margin trends, significant contracts or contracts with outlier gross margins can also be assessed. Particular attention should be paid to movement in projected gross margins as a target approaches an M&A transaction.

Additional EBITDA Considerations in POC Accounting

All of the above considerations will need to be analyzed for dozens or hundreds of contracts for each company. Sellers should ensure that buyers have the ability to quantify revenues and costs by job for each month to ensure a smooth closing process.

Net Working Capital Considerations in POC Transactions

In addition to understanding the impact of POC on earnings, buyers also need to consider the unique balance sheet items within net working capital. While there can be general alignment on the treatment of these accounts, agreeing to the specific treatment of POC accounts is critical to minimizing transaction risk and increasing the certainty of closing.

Costs in Excess and Billings in Excess: Costs in excess of billings (contract assets) and billings in excess of costs (contract liabilities) represent the balance sheet impact of POC revenue recognition. Generally accepted accounting principles dictate that these balances are recorded as current assets and current liabilities. Because these items are included in definitional net working capital, buyers and sellers should be aware of, and agree to, the treatment within the purchase agreement.

Retainage Receivables and Retainage Payables: Retainage receivables and retainage payables are common in POC businesses. Buyers should be aware of retainage agreements with customers and vendors and align on the treatment within the purchase agreement.

Other Net Working Capital Items: Other balance sheet items that can be unique to POC businesses include accrued warranties, deferred revenues, and accrued compensation tied to longer-term contracts. As with any net working capital item, understanding the proper accounting treatment and aligning on the net working capital approach early in the acquisition process is key.

Additional Deal Considerations

Contracted Backlog: Forward revenue visibility is paramount in contract-based businesses. Buyers can utilize percentage-of-completion schedules to assess the backlog at different periods and compare how the backlog ultimately converts to revenues.

Installation and Service Mix: Installation and service revenues typically have different gross margins and predictability. Understanding revenue mix and how a target is accounting for each offering is key in determining future value.

End Market and Customer Considerations: Does a company contract directly with its end user, or is it primarily a subcontractor? Assessing concentration at the general contractor and end-user levels is key to assessing risk in contract-based targets.

Successfully Navigating Risks in Contract-Based Transactions

Contract-based businesses have unique value drivers, making it critical to work with an experienced team to increase the certainty of closing. KSM’s Transaction Advisory Services Group has extensive experience assessing the complexities of deals involving contract-based businesses. Our team has served as both the buy-side and sell-side advisor for percentage-of-completion transactions involving targets with revenues between $10 million and $500 million, which has given us a deep understanding of the deal dynamics.

Are you preparing to buy or sell a contract-based business? Contact us for help with your next deal.