financial statements

Secrets of Bonding #74: Twofers

A Basic Question

 Talk to the experts, and you may get different answers to this extremely basic question: “What is the maximum potential loss for the surety on a Performance and Payment Bond?”

If you have experience producing surety bonds, you know that a 100% Performance Bond (equal in amount to the contract) is priced based on the contract amount. If the bond rate is 2.5% of the contract amount on a $100,000 project, the Performance Bond cost would be $2,500.

How much would it be for a Performance and Payment Bond? It seems logical that if you add to the exposure, you must charge more – but the cost is the same. Surety rules typically say that the Payment bond is provided at no additional charge. Is this because the surety is being generous, or is the exposure amount not actually increased?!

Surety Practices

We have established that bonding companies do not charge twice as much for a P&P bond.

When it comes to the use of the contractors bonding capacity, they use “1 x” here too.  For the contract in our example, $100,000 of capacity is consumed by the P&P bond, not $200,000.

Combined Bond Forms

Look up New Jersey law “N.J.S.A. 2A:44-147” and you will find it stipulates a combined Performance and Payment Bond form for public work in the Garden State. The penal sum (maximum dollar value of the bond) is stated once in support of a two-headed obligation. This may lead the reader to conclude that the single bond penalty is shared by the surety’s two legal obligations. That would justify not making an additional charge when including a Payment obligation with the Performance Bond.

Bond Specifications

On public work, such a federal, state and municipal contracts, the bonding requirement may indicate “100% Performance Bond and 100% Payment Bond” or “100% Performance and Payment Bond.” In the context of this article, the implications may be obvious, but it appears contract officers use them interchangeably.

Federal contract officers, on other other hand, can be quite specific on this point and expect the surety to assume a 200% exposure for the 1 x bond fee.

Federal bond forms require a separate instrument for Performance and another one for Payment, each with its own penal sum.  The Surety may attach them both as a single document and even give them one bond number.  But the government clearly is buying a guarantee with a combined value of 200%.

Twofers

The reality is that, despite the pricing methods and handling procedures used by sureties, the bonding company IS responsible for 200% if they issue two instruments each stating a 100%  obligation. This is the twofer that sureties willingly offer. You can have Performance only, or get Performance and Payment, twofer the price of one!

The Irony

Surprisingly, obligees may not position themselves to obtain maximum value and protection from the bonds they buy, and sureties may give away coverage rather than charge for it.

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Secrets of Bonding #48: Sleuthing the Accounting Method

In Secret #47 we talked about the four accounting methods for contractor’s financial statements and which ones are accepted by bonding companies and banks. Since they are not all accepted by sureties, it is important for agents to recognize when an unacceptable accounting method has been used.  It’s a deal killer!

Depending on the level of presentation, sometimes it is up to the reader to recognize which method has been used.  If the financial statement (FS) is an Audit, everything is laid out and explained including the accounting method (normally stated in note one at the back of the document.)

On a Review FS, notes are normally included but they may be less informative.

With a Compilation typically there are no notes.

So how is the reader to recognize if an unacceptable accounting method has been used?  In addition to an explanatory note (which may be absent), there are elements that can be identified on the Balance Sheet.  They are the clues that will tip off the informed reader to know the accounting method.  Let’s get to sleuthing!

Cash Method

This is a very simplified accounting presentation. Personally, I think of it as the “cigar box” method of accounting.  It only takes into consideration what’s actually in the cigar box.  Cash is shown, but money owed to or owed by the company is not.  If there are no accounts receivable and/or accounts payable on the balance sheet, it may indicate the Cash Method.

Accrual Method

From its name you can guess that under this method, accrued assets and liabilities are included. Therefore you will see accounts receivable (A/R) and/or payable (A/P) on the balance sheet.

Percentage of Completion

This is a more sophisticated method that includes entries to reconcile the current status of billings on incomplete contracts.  The tell-tale clue will be balance sheet entries for (asset) “Costs and Estimated Earnings in Excess of Billings on Contracts in Progress” and (liability) “Billings in Excess of Costs and Estimated Earnings on Contracts in Progress.”

Completed Contract Method

This method recognizes all the revenues and profits associated with a contract only after it has been completed.  Billings issued and costs incurred are recorded on the balance sheet during the life of the project, but they do not shift to the income statement until completion of the contract. It is not normally used for financial reporting because it does not show a clear picture of current operations.

On the balance sheet, look for “Progress Billings” or “Billings on Contract.” On the profit and loss statement, no revenues, expenses or profits will be shown until the year of contract completion.

Summary

The accountant’s cover letter will not state the accounting method.  Look at note #1 for this disclosure.  If there are no notes, use your new sleuthing skills.

  • If there are no A/R or A/P it may be the Cash method and therefore unacceptable.
  • If you have A/R and A/P but no “Costs and Estimated Earnings in Excess of Billings” or “Billings in Excess of Costs,” it is the Accrual Method: OK!
  • If you do see all four or some combination of them (maybe 3), it is the Percentage of Completion Method: Even better!
  • Completed Contract is hard to detect because it resembles the PCM.  Rely on Note #1 for clarification.  The surety may accept this FS if additional documentation is provided.

Happy Sleuthing!


A special note from the author: Steve Golia

I am an Independent Broker and Surety Bond Specialist. If you wish to co-broker bond business, together we will deliver the best in bonding expertise for your clients.  I have a broad range of markets available and often can solve problems even when others have failed.

Call me now (856-304-7348) or email: Steven.Golia@gmail.com

 

Secrets of Bonding #47: Compilation, Review, Audit?

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Brokers protected.  Contractors welcomed.

When it comes to Bid and Performance Bonds everyone knows that financial statement numbers are important.  But before surety underwriters get to them, they evaluate the method of financial presentation, its quality and credibility.

  • Is a CPA needed or can a PA or Tax Preparer be used?
  • Audits are expensive.  Can contractors avoid the cost?
  • Are there times when you can’t you use the same accounting method for tax and financial reporting?

There are a number of variables to consider.  Let’s go over what to use and when.

Accounting Professionals

A CPA is a Certified Public Accountant. These people are the premiere accounting professionals.  Bonding companies expect contractors to have a CPA prepared fiscal year-end (FYE) financial statement if individual bonds will be in the range of $1 million or more.

Below a CPA is a PA, Public Accountant, and then there are bookkeepers and tax preparers. Accounting professionals with lower credentials should only be used by contractors with small bond needs.

Accounting Methods

There are four accounting methods.  Any can be used for tax purposes, but banks and bonding companies are more selective.

  1. Accrual Method – probably the most common for construction companies.  May be acceptable for all bonding situations.
  2. Percentage of Completion – more sophisticated than Accrual.  Often used by larger contractors.
  3. Completed Contract – used by contractors that have multi-year projects such as road and bridge builders.
  4. Cash Method – acceptable for tax purposes, but not for financial reporting to banks or sureties.

Financial Presentation

The presentation can vary greatly. This too, is an important element. Surety underwriters expect to make a number of financial evaluations.  If the presentation is inadequate, they will not have info they need (schedules, notes and other elements).you-decide

Audit – the accountant’s cover letter states an “unqualified opinion” meaning they vouch for the accuracy of the report without reservation.  This is the most expensive presentation and is required when bonds and bank credit are in high amounts ($2 – 5 million and above).

Review – This report includes some “review” and verification by the preparer, but less than an Audit. Review reports are required by bonding companies starting with projects around $1 million.

Compilation – This is merely a typing job by the accounting firm, using the numbers provided by the client.  They make no verifications with outsiders and may not even double check the arithmetic. Normally this is acceptable for clients needing bonds below $1 million.

QuickBooks – Financial Statements produced from the client’s computer may be adequate for small bonding lines, or to provide a mid-year update.  “Internal” financial statements are not used as primary underwriting info for sizable obligations.

Learn a little more about accounting methods: http://www.inc.com/encyclopedia/accounting-methods.html

The experts at Bonding Pros can help Insurance Agents and Contractors when tough bonding situations arise. We have the markets and the know-how to succeed even when others have failed.

Give us a call today!  856-304-7348

Not available in all states including Idaho.

Secrets of Bonding #45: Backpedaling and How to Avoid It

Sureties commonly rely on a variety of elements when deciding if they will provide bid and performance bonds for contractors. Because Sureties are required to fully back their bonds with a dedicated asset, their underwriting process may be the most thorough. When a Surety issues a bid or performance bond on a federal or private project, all relevant underwriting factors are considered, including the applicant’s financial condition.

In most bonding scenarios, the applicant for the bonds is a construction company – typically a corporation or LLC. An important element of the financial evaluation is the company’s financial statement.

Why so much emphasis on this one document? The financial statement is considered a report card on the quality of management. It shows a range of important indicators. To name a few:

  1. How strong a financial commitment the owners made to the company (capitalization)
  2. The amount of revenues management has acquired in the previous operating cycle
  3. The extent to which construction contracts were realistically estimated and successfully managed
  4. The management and efficient use of overhead dollars
  5. Tax planning
  6. Adequacy of cash flow
  7. Liquidity
  8. Profitability
  9. Reliance on banks and other creditors to finance operations
  10. Collectability of receivables

The analyst’s favorite financial statement date is the company’s fiscal year-end (FYE), which is “tax day.” They prefer this date for two reasons.

  • Underwriters need to make a periodic review to monitor the applicant’s financial status, so an annual review on the FYE is perfect.
  • The tax day numbers will be realistic and conservatively presented – to minimize the tax exposure. This conservative approach is ideal for the bond underwriters who hope to make a realistic analysis of the applicant.  For most companies tax day is December 31st.

So where does the backpedaling come in?

Company managers will rely on their Certified Public Accountant for financial advice, especially tax planning. Limiting taxes is a popular goal, but at what price? Lower taxes may be the result of lower pre-tax profits. Lower profits mean less financial growth and possibly an inadequate net worth. (See Secret #3: Taxes)Why should stockholders continue to support a company that fails in its primary mission: Producing a profit?

Obviously these issues are a great concern to surety underwriters, who want successful, well-managed companies as clients. If tax avoidance is aggressively pursued, it is not unlikely that bonding capacity will be compromised. The surety may limit their support or even terminate the relationship if financial performance is weak. Once the financial document is carved in stone, company management may face an entire year of backpedaling  “We showed poor results because…” until the next FYE report can show better numbers.

The problem is not uncommon, and the solution is simple if executed properly. Avoid backpedaling by having a draft financial statement initially produced by the CPA. The document will be marked “For Discussion Purposes” and discussion is exactly what’s needed. A review by the underwriter will determine if any elements of the report are detrimental for bonding purposes. Plans for the coming year can be discussed and bonding capacity evaluated.

If the financial statement does not support the desired amount of surety capacity, now is the time to make adjustments before the final version is produced. Backpedaling is avoided!

With some planning and open dialogue agents can help their contractors avoid the missteps that prevent companies from realizing their full bonding and financial potential.

Agents, for your clients with a 12/31 year-end, NOW is the time to act.


A special note from the author: Steve Golia

I am an Independent Broker and Surety Bond Specialist. If you wish to co-broker bond business, together we will deliver the best in bonding expertise for your clients.  I have a broad range of markets available and often can solve problems even when others have failed.

Call me now (856-304-7348) or email: Steven.Golia@gmail.com

 

Secrets of Bonding #14: Financial Statements – Timing

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Secrets of Bonding is brought to you by Bonding Pros

Need a bond?  Talk to the Pros!  856-304-7348  www.BondingPros.com

Brokers protected.  Contractors welcomed.

When it comes to financial statements, no news is bad news.  Let’s talk about the timely delivery of annual financial statements.

Many construction companies have a 12/31 fiscal year-end (FYE).  This means their most important Financial Statement (FS) are based on this date each year.

By the end of March, bond underwriters and bankers are expecting to see the financial statements for the FYE.  90 days after the date is normally the time allowed for this info.  Beginning on April 1st (or 90 after the FYE, whenever that is), the contractor enters the tap dancing zone.

Q. “When will we see the 12/31 FS?”

A. “There is a slight delay due to…” (choose one)

  • My CPA was ill and got a late start
  • Our software crashed and it delayed the accounting process
  • The dog ate it

While it’s true there are outside or uncontrollable factors, sometimes contractors intentionally hold back the info.  One example we’re seen involves loan covenants.  The company may have fallen out of compliance with their lender and now is attempting to obtain a waiver from the bank.  Having such a waiver will enable the CPA to comment that the FYE non-compliance has been resolved.  That sounds a lot better!

Here is the downside: We have seen construction clients hold back the FS for 10 months in some cases.  Obviously the delay itself can become an even bigger problem.  At some point underwriters say to themselves “If the FS was good, the contractor would want us to see it…”

So the point is that timely financial reporting is beneficial to bonds and banking.  It shows that the company is well organized and professional.  There is no hiding from the financials.  If there are issues, prepare an intelligent explanation,  describe the corrective actions management is taking and provide projections for the current year.

Producing financial info on time is as important as the numbers themselves!

The experts at Bonding Pros can help insurance agents and contractors when tough bonding situations arise. We have the markets and the know-how to succeed even when others have failed.

Give us a call today!  856-304-7348

Not available in all states including Idaho.