Having reliable and accurate financial statements is vital to getting construction surety bonds such as bid bonds, performance bonds and payment bonds. Below are some of the commonly presented financial statements and how surety bond companies view each one.
Before we talk about the scope of financial statements that contractors need, let us discuss the methods of preparing these statements and why it is important.
Cash Method of Accounting
The cash method of accounting records income when it is received and expenses when they are paid. It does not account for accounts receivable or accounts payable. In many ways, it is tracked like a bank statement. Cash goes in and cash goes out. Because it is very simple, it is the preferred method by many small and new contractors. The cash method can also have some tax advantages by delaying the recognition of income. Unfortunately, the cash method is also considered the least reliable by surety bond underwriters and other creditors. Construction contracts are often long, and the cash method does not provide a reliable representation of the contractor’s business. Most surety bonds companies will give very little bond credit based off cash based financial statements.
Accrual Method Accounting
Accrual accounting recognizes revenues when they are earned and expenses when they are incurred, regardless of when the cash is received or paid. Because of this, accrual-based accounting provides a much more accurate representation for surety bond underwriters and other lenders. The Accrual Method will show accounts receivable and accounts payable. Simple Accrual Method is also the minimal standard for most surety bond underwriters.
Completed Contract Method
The Completed Contract Method of construction accounting recognizes both revenue and costs in the period during which the contract was competed. This can be an advantage to the contractor by deferring taxable income into another period. This can also create a tax nightmare if multiple projects finish in the same period. The biggest issue for a contractor needing surety bonds is that it once again does not give an accurate picture of the construction company to surety bond underwriters and other lenders. Construction projects regularly span more than one year, or accounting period and the completed contract method does not accurately match revenue and expenses to when they are incurred.
Percentage of Completion Method
The percentage of completion method is the most accurate way for contractors to account for construction projects. From a surety bond underwriting standpoint, it presents no major downsides. The method provides a way to account for billing imbalances through underbillings and overbillings. It also gives contractors and surety bond underwriters a means of determining the how much of project is complete, what amount of revenue has been earned and an estimate of remaining costs and profits. The Percentage of Completion Method is a must for contractors seeking large Construction Surety Bonds or large amounts of bond capacity.
Now that we have discussed the different means of construction financial accounting, we can transition to the Scope of financials statements, how they are viewed by surety bond underwriters and what level is required for bonding.
Internally Prepared Financial Statements
Every contractor needs to be able to generate internally prepared financial statements regardless of the size of your company. Failure to do so will not only make it difficult to get surety bond credit, but it also puts the viability of your company in jeopardy. Construction companies often fail when they run out of cash. This can be caused my many reasons from slow collections to bad estimating. However, without good internal systems, a contract may not know until it is too late.
A quality internal financial statement should still be prepared on percentage of completion basis. It should include overbillings and underbillings. It should also accurately present depreciation along with updated short-term and long-term debt. Additionally, the contractor needs to have accurate Work in Progress and Completed Contract Schedules. The most common mistakes we see from internally prepared statements are in these areas. Unfortunately, some contractors choose cheap accounting software that is not really geared towards the construction industry. Even new contractors should opt for systems that accurately track their work. Failure to have good internal systems is one of the leading causes of performance bond claims and contractor failure.
For contract’s wanting large surety programs, the surety bond company typically wants to see internal financial statements on at the end of each quarter during the company’s operating year. Mid-size contractors typically only need to provide two internal statements. One of these at the company’s midyear point and another at year end. Additional internal financial statements may be needed if the contractor decides to bid a big or unusual project in between these periods.
Startup contractors or those needing a small bond may be able to get bonded on internal statements alone. This depends on the size of the project and the quality of the statements. Usually this only applies to bonds of less than $1,500,000. The statement qualify also matters. Good quality statements with schedules go along way. Additionally, if a contractor is relying on internal statements, they may be asked to verify their assets such as providing bank statements to prove cash balances.
Filed tax returns can be useful for obtaining small construction bonds. Typically, the surety bond companies who accept tax returns can use them to provide contract bonds on projects up to $1,500,000. There is a catch, however. Most of the surety bond companies who accept tax returns, require that these returns be completed on an accrual basis. I find that not many small contractors do this. Additionally, a contractor is limiting their options by relying on this method. Only a small number of surety bond companies will use tax returns. Even those bond companies that use tax returns may have underwriters who are unfamiliar with reading them. You significantly limit the options for your construction bonds if you go this route.
A Compiled Financial Statement (Compilation)
Compiled financial statements are prepared by an outside accountant. However, the accountant does not review or audit the information and a Compilation gives no assurances. From a practical standpoint, the quality of these statements really depends on the accountant you are working with. I have seen Compilations that are nothing more than the contractor’s internally prepared information that the accountant put their name on. For the most part, these statements are not worth spending money on for surety bond purposes. On the other hand, I have seen compiled statements that are very detailed and included job schedules and notes. These types of compilations may be suitable for small bonds up to $2 million or $3 million depending on the surety bond company. They are also great for interim reporting purposes. A potential problem with even quality Compilations is that you are limiting your bond capacity. For example, a contractor may be able to qualify for a single $2 million performance bond with a good quality compilation statement. However, soon after that contractor discovers that they need another $2 million performance bond for another project. Unfortunately, they will likely have to upgrade to a Reviewed Financial Statement. Now they have had to pay for two statements and wasted time. Consider your future surety needs before deciding to get a Compiled Financial Statement.
A Reviewed Financial Statement (Review)
A Review is conducted by Certified Professional Accountant. The CPA reviews a contractor’s financial statements and make limited assurances that they are presented fairly and accurately according to Generally Accepted Accounting Principals (GAAP). A review typically involves analytical procedures and should be done by a CPA specializing in the field of construction. Reviews for contractors should contain the CPA’s cover letter, a balance sheet, income statement, statement of cash flows, job schedules, overhead schedules, and quality notes to the financial statements. For surety bond purposes, a Reviewed financial statement can go a very long way. Many contractors can qualify for up to $50 million or more in surety bond capacity with a good quality Review. The Review only needs to be done once a year on the company’s year end financial statement. A Review will be more expensive than a Compilation but less than and Audit.
An Audited Financial Statement (Audit)
An Audited Financial Statement involves a CPA (auditor) attesting to the accuracy of a company’s financial statements and giving assurances that they comply with GAAP. An Audit goes beyond a Review by testing internal controls, performing risk assessment, substantiated procedures and giving more assurances. Audits are required for publicly trades companies and good construction companies often want audits on their organization even when they are not required. From a construction surety bond standpoint, audits are required for large contractors. Contractors with revenues exceeding $100 million need audit and many with even smaller levels of revenue.
The CPA Matters
Construction CPAs are a must for contractors looking for contract surety bonds. Surety bond underwriters look at lots of financial statements and they can tell a good one from a bad one. Contractors should not assume that because somebody has the CPA designation, that they know construction. A poor-quality Review is no better than a compilation and the same goes for an Audit. Paying money to the wrong CPA will be a waste of time and money. I have had contractors spend good on a financial statement only to be told that it is poor quality and does not help them.
Timing is Important
Another reason it is important to use a construction-oriented CPA is that they understand that timing is important to lenders and surety bond companies. Minimizing taxes is important to all businesses. However, working with a CPA who prioritizes tax filings is a mistake for contractors. Surety bond companies, banks and other lenders expect to have the CPA prepared year end statement within four months of the company’s year-end. Often, this can be extended by one or two months, but contractors may find themselves cut off from credit by doing so. Good construction CPAs understand this and will get your statements timely.
Quality financial statements are vital for contractors who need construction surety bonds. Having the right statements will make getting surety bonds easier and it may prevent your business from failure. We have seen a lot of good construction companies go out of business because they do not have a good understanding of their financial position. MG Surety Bonds can help you decide what financial statements you need for the surety bond program you desire. Contact us anytime!