The Importance of Percentage-of-Completion Revenue Recognition in M&A Transactions

Introduction

In mergers and acquisitions (M&A), accurate revenue recognition is crucial for assessing a target company's financial health. One of the most significant methods in industries such as construction, engineering, and long-term service contracts is the percentage-of-completion (POC) method. This approach ensures that revenue is recognized progressively as work is completed, rather than waiting until a project is fully finished.

This article explores the importance of POC revenue recognition in M&A, its impact on valuation, and a numerical example to illustrate its financial implications.

Why POC Matters in M&A Transactions

1. More Accurate Valuation

The POC method provides a realistic financial picture by matching revenues with expenses incurred over time. This ensures that financial statements accurately reflect a company’s performance, which is essential when negotiating an M&A deal.

For example, if a target company is engaged in a $10 million, three-year contract, recognizing revenue progressively rather than at completion provides a clearer view of its financial health.

2. Avoiding Revenue Distortions

Companies that recognize revenue only upon project completion may experience erratic financial statements, with some years showing exceptionally high revenue and others appearing unprofitable. The POC method smooths revenue recognition, preventing misleading fluctuations.

3. Risk Assessment and Liabilities

In an M&A transaction, buyers must evaluate potential contractual risks such as cost overruns and project delays. The POC method allows buyers to assess the percentage of work completed and determine if profit margins are sustainable. This reduces post-acquisition surprises.

4. Regulatory and Compliance Considerations

Accounting standards such as IFRS 15 (International Financial Reporting Standards) and ASC 606 (Accounting Standards Codification) emphasize the importance of recognizing revenue when performance obligations are met. Adhering to these guidelines ensures that financial reports comply with regulatory requirements, reducing legal risks in M&A deals.

5. Impact on Purchase Price and Deal Structuring

Since revenue recognition affects EBITDA and valuation multiples, it directly impacts the purchase price. A company using POC may demonstrate steady revenue growth, leading to a higher valuation compared to one using the completed-contract method.

Numerical Example: The Impact of POC on Revenue Recognition in M&A

Consider a construction company involved in a $10 million contract that will take three years to complete. Assume the estimated total cost is $7 million, with yearly costs and completion rates as follows:

Key Observations:

• Without POC, no revenue would be recognized until year 3, making years 1 and 2 appear unprofitable.
• With POC, revenue and profit are recognized proportionally to the project’s progress, providing a steady financial outlook for potential buyers.
• A buyer considering this company in year 2 would see $2.14M in cumulative profit, making it more attractive than if revenue were deferred entirely.

Key Takeaways

• The percentage-of-completion method ensures revenue is recognized progressively, offering a clearer financial picture.
• It helps avoid misleading revenue spikes or dips that can distort valuation.
• Buyers can better assess risks and contractual obligations before finalizing a deal.
• Proper POC accounting ensures compliance with global financial reporting standards.
• It influences EBITDA and deal pricing, making it crucial for fair negotiations.

In M&A transactions, understanding how a target company recognizes revenue under long-term contracts is essential. The POC method provides transparency, reduces financial uncertainty, and helps buyers make informed decisions.

How POC Affects Business Valuation in M&A

? Impact on EBITDA and Valuation Multiples

The POC method stabilizes EBITDA across multiple years, making the company’s financials more predictable and increasing its valuation multiples. Buyers often use EV/EBITDA ratios to price deals, and consistent earnings result in higher valuations.

? Cash Flow Analysis and Working Capital Adjustments

Buyers must analyze whether reported profits under POC align with actual cash flows. If revenue recognition is ahead of cash collection, the target company may require working capital adjustments in deal negotiations.

? Risk Mitigation in Due Diligence

POC highlights cost overruns, delays, and underperformance risks before deal completion. This transparency reduces post-acquisition surprises and ensures buyers pay a fair price based on actual project performance rather than expected revenue.

Conclusion: Why POC Matters in M&A

• Percentage-of-completion revenue recognition provides a more accurate, transparent financial picture, ensuring that a target company’s revenue reflects actual progress on projects.
• M&A buyers benefit from more stable EBITDA, leading to better valuation assessments and deal structuring.
• POC reduces financial risk by exposing project overruns and allowing proper due diligence.
• Regulatory compliance with IFRS 15 and ASC 606 is critical, as improper revenue recognition can cause legal and financial issues post-acquisition.
• Ultimately, POC ensures fairer deal pricing and reduces valuation uncertainties, making it a crucial factor in M&A decision-making.

By understanding how revenue is recognized, buyers can make informed investment decisions and avoid costly mistakes.

Frequently Asked Questions (FAQ)

1. Why is percentage-of-completion revenue recognition important in M&A transactions?

POC provides a realistic and stable financial outlook by recognizing revenue based on contract progress, making it easier for buyers to assess the target company’s true value.

2. How does POC impact business valuation?

Since EBITDA and revenue affect valuation multiples, POC stabilizes earnings, making a company more attractive to investors and potentially increasing its valuation.

3. What industries use the percentage-of-completion method?

Industries such as construction, engineering, software development, aerospace, and long-term service contracts commonly use POC revenue recognition.

4. What risks does POC accounting reveal in an M&A deal?

POC helps buyers identify cost overruns, project delays, and revenue discrepancies before completing a transaction, reducing financial and operational risks.

5. How does POC differ from the completed-contract method?

• POC: Revenue is recognized as the project progresses.
• Completed-Contract: Revenue is recognized only when the project is finished, which can cause financial distortions.

6. Can improper POC accounting affect an M&A deal?

Yes. Overstating project progress can lead to inflated revenue, misleading buyers. Inaccurate POC accounting can result in financial restatements or legal disputes post-acquisition.