Percentage-of-Completion Accounting: Simple Formula, Complex Due Diligence
Part One of a Two-Part Series on Percentage-Of-Completion Accounting and Transaction Diligence
-
September 23, 2026
-
Capital continues to flow into infrastructure, specialty contracting, engineering and other project-based sectors, driven by public infrastructure investment, domestic manufacturing expansion, power and grid demand and the rapid build-out of data centers. That momentum is contributing to transactions involving project-based businesses, many of which share an important accounting characteristic: They recognize revenue over time based on progress toward completing individual projects.
This method of revenue recognition is commonly known as percentage-of-completion (“POC”) accounting. It can provide a more accurate view of a project-based company’s performance than recognizing revenue only when a project is billed or completed. But the apparent precision of the calculation can be misleading. Reported revenue and earnings depend not only on work already performed, but also on management’s current expectations about the cost, revenue and profitability of projects that may not be completed for months or even years.
This is the heart of the diligence challenge. POC results depend heavily on estimates, which require management judgment and can change as project conditions evolve. For transaction participants, the central question is not whether a company applies the correct accounting policy. It is whether reported results are supported by reliable project-level information, disciplined forecasting and timely communication between operations and finance.
The Formula Is Simple; the Inputs Are Not
Under ASC 606,1 the revenue recognition standard, a company recognizes revenue as it satisfies a performance obligation. When that obligation is satisfied over time, revenue is recognized as the work is performed rather than at a single point.
Progress can be measured using output methods, such as milestones achieved or units delivered, or input methods, such as labor hours or costs incurred. In our transaction experience, the cost-to-cost input method is the most common approach among construction, engineering and specialty contracting businesses. Under this method, the percentage of completion is calculated by comparing costs incurred to date with the latest estimate of total costs to complete the project, then applying that percentage to estimated project revenue:
The formula is simple. The difficulty is that two of its three inputs, estimated total costs and estimated project revenue, can change throughout the life of a project. The reliability of the accounting is therefore tied directly to the quality of the company’s project management, estimating and financial reporting processes. The following areas deserve particular attention.
Actual costs incurred: Costs must be captured on the correct project and in the correct period. Incorrect labor coding, unmatched purchase orders, slow subcontractor invoicing, centrally purchased materials and delayed reporting from the field can all create incomplete cost capture. When costs have been incurred operationally but have not yet entered the accounting system, a project can appear further along and more profitable than it is. Cutoff matters as a result, because accrued subcontractor costs, unprocessed invoices, payroll timing and material receipts all affect reported revenue and gross profit.
Estimated costs to complete: Estimating the remaining cost of a project requires an informed view of labor productivity, material requirements, subcontractor performance, scheduling, rework and customer delays.
Project managers often carry much of this responsibility, and practices vary. Some estimators are naturally conservative, others are slow to acknowledge emerging overruns and some forecasts sit unchanged for months even as conditions shift. On large projects or those nearing completion, a small change in estimated costs can meaningfully move cumulative revenue and gross profit.
Estimated project revenue: Contract values can change because of approved or pending change orders, claims, incentives, penalties and revisions in scope. Unapproved change orders and claims warrant particular scrutiny. A company may have a commercial basis for expecting additional compensation, but recognition depends on the contract terms, the status of negotiations and whether the amount is unlikely to reverse. Weak communication among the project management, sales, legal and finance teams can cause changes to be captured late or inconsistently, and optimistic assumptions can accelerate revenue and earnings before the underlying economics support them.
Each of these inputs can create a gap between reported performance and actual project economics. In a transaction, those accounting assumptions quickly become valuation assumptions.
Why the Controls Behind the Numbers Matter
Reliable POC accounting takes more than a technically correct calculation. It requires an operating model capable of producing timely, supportable estimates—and that is where reported margins can look more dependable than they are.
Effective diligence looks past the schedules to the processes behind them: how frequently forecasts are updated, whether formal project reviews take place, how finance and operations share responsibility for estimates, how costs and change orders are tracked, whether project and accounting systems are integrated, and whether management incentives reward accuracy or optimism. Companies with disciplined project controls and strong finance-operations collaboration are better positioned to identify emerging risks and reflect them in forecasts promptly. Where those controls are weak, unfavorable developments tend to surface late, through margin fade, unexpected true-ups or weak cash conversion.
The objective is not to eliminate changes in estimates. In a project-based business, that would be unrealistic. It is to determine whether the company incorporates new information consistently, transparently and on a timely basis.
Why POC Matters in a Transaction
In a transaction, POC accounting can affect not only reported earnings, but also working capital, cash flow and the value attributed to backlog. Diligence should therefore connect the accounting conclusions to the underlying project economics. Attention must be paid to the following areas.
Quality of earnings: Changes in estimates are normal, and not every true-up requires an EBITDA adjustment. However, recurring late-stage write-downs, unusually favorable early project margins, inconsistent forecasting practices or significant year-end adjustments may indicate that interim results do not reliably reflect underlying performance. When they appear, a buyer may revise normalized EBITDA, apply greater sensitivity to backlog margins or seek additional protection in the purchase agreement.
Project-level lookback analysis: One of the most useful POC diligence procedures is a project-level lookback analysis, which compares margins forecast during a project with the economics ultimately realized. The analysis can identify whether management tends to recognize margin aggressively early in a project, whether cost overruns are incorporated promptly, or whether estimates are systematically conservative.
Looking at these patterns across project managers, customers, contract types, end markets or service offerings can help distinguish normal project variability from recurring forecasting bias. This is particularly important when recent earnings depend heavily on estimates for projects that have not yet been completed.
Working capital and cash flow: Revenue recognition and billing are separate processes. Underbillings, overbillings, retainage and delayed change order approvals can create meaningful differences between reported EBITDA and cash generation and may affect the working capital mechanism or other transaction adjustments.
Underbillings and overbillings also require careful consideration in the transaction working capital mechanism. Because these balances can fluctuate materially based on project mix, billing milestones, mobilization payments and the timing of change orders, a simple historical average may not always produce an appropriate working capital target. Diligence should consider whether the balances reflect the ordinary operating requirements of the business or unusual project timing, future funding requirements or performance obligations that will transfer to the buyer.
Backlog and project risk: Backlog can be an important indicator of future revenue, but it is not inherently equivalent to future earnings or cash flow. Its value depends on the contractual status of the underlying work, expected margins and the company’s ability to execute projects at forecasted economics.
A large, reported backlog may be attractive, but diligence should consider the contractual status of the work, cancellation provisions, expected margins, project timing, customer funding, capacity constraints and the company’s historical ability to convert backlog into revenue and profit.
Preparing for a transaction: Companies contemplating a sale or recapitalization should address POC issues before buyer diligence begins. Management should reconcile project schedules to the general ledger, refresh significant project forecasts, resolve stale change orders and prepare project-level analyses explaining historical margin movements. Doing so can help buyers distinguish normal estimating variability from issues that may affect earnings quality or valuation.
The Bottom Line
POC accounting is intended to align revenue recognition with the economics of project execution. When supported by reliable data, disciplined controls and effective collaboration between finance and operations, it can provide a meaningful view of performance. But reported revenue and gross profit remain dependent on estimates of cost, progress and contractual value, each of which can change as a project evolves.
Inaccurate or delayed estimates tend to reveal themselves through margin fade, unexpected true-ups, working capital volatility or weak cash conversion. Effective diligence identifies those patterns before they become surprises and helps transaction participants develop a clearer view of earnings quality, project risk and sustainable value.
The next article in this series will examine how buyers can test forecast reliability and what historical project accuracy reveals about earnings quality and transaction value.
Footnotes:
1: FASB ASC 606 (Financial Accounting Standards Board).
Related Insights
Related Information
Published
September 23, 2026
Key Contacts
Senior Managing Director