Project-based businesses exhibit unique risks during financial due diligence. Due to the long-term nature of their fixed-fee projects and contracts, revenues and expenses extend across multiple years and accounting periods, which can make it more challenging to assess earnings before interest, taxes, depreciation, and amortization (EBITDA) for any given period.
U.S. GAAP requires compliance with Accounting Standards Codification (ASC) 606, which may include “over-time” revenue recognition as performance obligations are satisfied. Accounting teams have historically addressed this primarily through percentage of completion (POC) accounting and cost-to-cost estimate-based methodologies. However, many companies going through a sale in lower middle-market merger and acquisition (M&A) transactions are unaudited, and accounting policy adoption is inconsistent across these deals.
Revenue Recognition in Financial Due Diligence
Below are three common revenue recognition situations we see in transactions:
- Full monthly adoption of POC accounting. Companies with high-functioning accounting departments produce robust work-in-process (WIP)/contract asset and liability schedules with project-level revenue, cost, estimates to complete, and billing updates on a weekly or monthly basis. In these situations, diligence teams can perform standard industry diligence procedures such as lookback analysis using hindsight on closed jobs and evaluating the latest gross margin estimates and gain/fade analysis on open jobs to analyze profit assumptions. Diligence includes a combination of validation and evaluation of management’s estimates and project assumptions.
- Annual adoption of POC accounting. For lower middle-market companies, it is more common to not have full monthly adoption and instead perform these types of procedures only on an annual basis. Often, this aligns with compliance for an annual audit or review, and project estimates are generated more on a one-time basis than for an ongoing management of the business. In these situations, monthly reported revenues are on a cash, invoice/billings, or milestone basis, but may have little correlation with earned revenues and when work was performed. This is typically evidenced by large adjustments made in the month of December. In this situation, it is necessary for diligence teams to have a recast monthly view of revenue and margin to arrive at monthly, trailing twelve-month (TTM) EBITDA, and net working capital.
- No adoption of POC accounting. For unaudited companies, no POC or over-time accounting may exist. Even though long-term, fixed-fee projects are performed, records may be maintained only on a cash, invoice/billings, or milestone basis, causing monthly and annual revenue and margin volatility that is unrelated to underlying project economics. In these situations, diligence teams may need to reconstruct a POC-style model using available job data. Priority should be given to larger and/or longer duration projects, and then smaller jobs can be included as data quality allows. Work is performed to clearly bridge from reported EBITDA to adjusted EBITDA and red flags are identified (such as incomplete cost data, unbilled revenue, deferred revenue, and loss-prone projects).
Situations 2 and 3 above tend to be the most common in lower middle-market transactions. Significant diligence effort is required to develop a normalized view of project-level margins and earnings. These situations also carry higher inherent transaction risk, transaction costs, and the need for post-close investment in procedures and systems. They can also influence business valuation due to confidence in the visibility and sustainability of future earnings.
Net Working Capital Adjustments
For companies that are not consistently applying full POC estimates on a monthly basis, their net working capital balances and trends may also be misleading. Adjustments may be required to contract asset and liability balances. In this way, the income statement and balance sheet should be evaluated together. It is important for diligence teams to analyze and adjust these net working capital positions to obtain a view on the magnitude and seasonality of net working capital.
Additional Diligence Considerations
Revenue recognition is often a starting point, but a quality of earnings analysis for an architecture and engineering (A&E) firm should also connect project accounting to the underlying factors that drive profitability and financial results. In practice, this means understanding how backlog, staffing, contract terms, project management discipline, and client concentration affect both historical earnings and the sustainability of future performance. Additional diligence procedures typically focus on backlog conversion, project margin gain/fade, labor, utilization and multiplier trends, contract mix, and project/market/client concentration.
Quality of Earnings (QoE) Considerations
The QoE should incorporate the results of these operating analyses. Potential adjustments may arise from project estimate changes recorded outside the period in which the underlying performance occurred, temporary use of contract labor, owner or management compensation, nonrecurring severance or recruiting costs, transaction-related expenses, and unusual or nonrecurring legal expenses. However, proposed add-backs should be evaluated against facts and circumstances. For example, adding back elevated contract labor may not be appropriate if the firm lacks the internal capacity required to execute its backlog. Similarly, a favorable margin adjustment may require additional support from fee levels, labor availability, and project mix.
Revenue expectations should be tested from the project level upward. Diligence teams can compare projected revenue to existing backlog and expected awards, analyze conversion trends, and comment on planned hiring and utilization assumptions. This analysis helps distinguish growth supported by contracted work and demonstrated execution from growth that depends primarily on pipeline, price increases, or improvements in project performance and gross margins that have not yet been achieved.
How Forvis Mazars Can Help
The above highlights different accounting methods and other potential EBITDA adjustments, but there are additional scenarios and nuances within each transaction. There is no single diligence approach for long-duration, fixed-fee, project-based businesses. This is why identifying common situations early can help teams tailor procedures and streamline due diligence process execution.
At Forvis Mazars, our dedicated transaction advisory professionals have completed due diligence engagements on billions of dollars in transactions across a wide range of industries. Whether you’re a private equity group or a corporation, our due diligence can help you better execute the deal. For more information, please reach out to a professional at Forvis Mazars.