Across the diverse firms that make up the business and professional services (BPS) industry, the percentage of completion (POC) method of accounting is commonly utilized for revenue recognition. Unfortunately, there are many variables affecting the calculation – which in turn can have significant implications to a project’s estimated profitability prior to completion and the valuation of a business during the company sale. Long-term projects can thus pose a particular challenge when accounting for revenue.
This article, the first in a two-part series on POC, will explore accounting best practices. Part two will discuss implications of POC in the context of a business sale.
Background: Cost-to-cost vs. units-of-delivery calculation methods
Under the POC method, revenue is recognized as a function of project price multiplied by the percentage of work completed. There are two general POC calculation methods: cost-to-cost and units-of-delivery.
Cost-to-Cost – Revenue is recognized in relation to actual costs incurred to date relative to total estimated costs. It is based on input costs such as labour hours and machine hours. This method is most accurate if the project accountant regularly reviews and revises the total estimated project cost to ensure the most up-to-date cost information is applied in the recognition of revenue. If cost information is not correct, there is a risk that the appropriate gross profit will not be reflected.
Units-of-Delivery – Revenue is recognized based on the percentage of units produced or delivered to the buyer to the total number of units to be produced or delivered under the terms of the contract with a buyer. This method could lead to changing gross margins over the project as costs are not correlated back to the revenue recognition.
Both methods of POC involve a significant level of estimation of cost to complete a project. Estimates to complete are highly subjective, could be biased, and actual results may differ from estimated results. As the project progresses, updates to estimates may occur. Therefore, they can affect recognized revenue to date and lead to large swings in the period of change. Specifically, the financial results from one period to another may be misleading when the change in estimate causes a higher or lower reported gross profit for a project across accounting periods.
Best practices: Better estimating POC
Below are some best practices to enable management to understand where they are in a project and to be in the best position to estimate the costs required to complete the project:
Benchmarking against previous projects
The hindsight achieved from previous experience can assist in not only developing an initial budget or estimate for a project but also in being able to identify and anticipate roadblocks or delays on a timely basis and incorporate those lessons learned into future estimates. The ability to look back on previously completed projects is only effective if the information relating to those projects is appropriately captured and stored. There are many software programs and systems available that have modules to assist with estimation and project management, which may reduce the likelihood of calculation errors and can represent a central repository for all decision makers to access.
Monthly accountability meetings
Those involved in any long-term projects will agree that an initial estimate can be well-generated and supported; however, there are often surprises and contingencies that pop up along the way that may change those initial assumptions and estimates. Having monthly accountability meetings is key in ensuring that the lines of communication remain open between finance and project management. Such meetings are meant to be a deep dive into the progress and status of the project. While many firms claim to hold such meetings, the key factors that distinguish between an effective and ineffective meeting include (but are not limited to) the following:
- Discussing progress on a disaggregated level – having meaningful information available at an appropriate level of detail will make decisions on the estimated cost to complete more effective. Similarly, understanding the relationship between types of costs and assumptions will provide for more meaningful updates to the estimate.
- Accountability and other motivating factors – It is important to remember that project managers are not accountants and therefore may not be looking at their projects in the same way that finance is. They may be comfortable that the project is on track overall but not necessarily particular on accuracy of the percentage completed at a given point in time. It is common to see situations where a component of a project has come in under budget; however, a project manager may hold on to the cost savings as a buffer in the event that other areas fall behind (even if there is no indication of that happening). This could be either due to conservatism or for reasons relating to performance evaluation or bonus. It is important to therefore ensure that all parties are on the same page and understand the reasoning in order to obtain accurate results on a timely basis. Furthermore, being able to distinguish when a cost overrun or savings are permanent vs. a function of timing is also important in deciding whether a revision to the cost out of the complete estimate is required.
- Maintaining notes from these meetings, including changes made to estimated amounts and why – This will assist the team to know and understand the rationale behind changes in assumptions and assist in the overall evaluation process of the project upon completion. Having an overall understanding of the project and what it entails will also assist finance in being able to ask the right questions of project managers and evaluate changes being made to estimates throughout the project’s progression.
It is a good practice to debrief the overall project once completed. This serves to assess and validate:
- Were the projects that were used as a benchmark for the initial estimate appropriate? If not, is it due to the amount of time that has elapsed or are there other factors that have made the projects incomparable?
- What went well or wrong and were the causes something that should have been pre-empted? Being able to go back to the monthly meeting notes and assumptions made will assist in determining whether the team understood the reason for the over/under on the project and distinguish whether it was a function of the quantum of the impact or whether it was missed altogether.
Finally, it is important to document notes from the debrief. Not only will this serve as a learning point for future projects, but it will also enable the company to identify patterns or weaknesses across multiple projects and better understand the root cause of those weaknesses.
Bringing it all together
Overall, POC accounting involves a significant amount of estimation, specifically in establishing the cost to complete, which in turn drives the percentage of completion of a project at a particular point in time. There are many variables that impact this calculation which not only affects the overall profitability of a project, but can have significant implications on the valuation of a business. Using some of the best practices above will assist a company in having better information available to avoid significant swings in project results and provide a more accurate picture of the status and progression of the project.