To determine if a contractor is financially capable of performing the construction projects it wants to undertake, the surety performs an analysis on the business financial statements. Financial statements are the cornerstone of the bond approval process.
The proper presentation of these financials is of paramount importance to maintaining adequate surety credit. Sureties want the contractor’s financial statement to be compliant with generally accepted accounting principles, or GAAP. For construction, that means the financials must be prepared using the percentage-of-completion method of accounting.
Many contractors measure a successful year by the size of their gross revenues or net income. On the other hand, the bond underwriter judges financial performance by the strength of the contractor’s balance sheet. Contractors are often frustrated by this disconnect because they are not trained to understand the various elements of the balance sheet and what they mean. While contractors are not expected to be experts on cost accounting, they should have at least a basic understanding of how their financial statements will affect their bond viability and capacity.
Cash Vs. Accrual
In today’s “fast and easy” world, cash-based accounting is very attractive. Not only is it inexpensive, it is fast and simple. Unfortunately, it does not apply to the construction business. It is never used for obtaining bonds because cash accounting simply records cash as it comes in and expenses when they are paid out. To defer tax liability, revenues from a long duration job are often not recognized until the tax year in which the job is fully completed.
Accrual accounting takes into consideration a contractor’s incurred revenues and expenses, (i.e., accounts receivable and payables). The percentage-of-completion method is an advanced version of accrual accounting that matches revenues and expenses for each individual job as they are incurred. It also accounts for overbillings and underbillings of work in progress, which can significantly affect the financial results. It requires the contractor to have an accurate and up-to-date job costing system that can be readily incorporated into the financial statements. Think of it as keeping a separate balance sheet and income statement for each job. Unless the percentage-of-completion method is used, surety underwriters are unable to properly analyze a contractor’s financial statements.
How Accurate Does It Need To Be?
There are three different levels of financial statements: compiled, reviewed and audited. Only a duly licensed CPA can legally prepare these financial statements.
- CPA compiled provides almost no assurance. It simply takes the contractor’s data and presents it in a standard format;
- CPA review provides a very good level of assurance. The CPA verifies the contractor’s books and records and makes necessary adjusting entries; and
- CPA audit provides the highest level of assurance. The CPA verifies both the contractor’s books and records as well as its customers’ and vendors’ records.
While each contractor’s particular situation is different, most will need to obtain a review, at least at some point, to maximize bonding capacity. Compilations, while inexpensive, are not generally acceptable for establishing bonding, especially for large contracts (over $500,000). Sureties typically only require an audit from very large or “jumbo”-sized contractors.
Other types of financial statements are:
- Internally prepared: financials prepared either in-house by the contractor or a hired bookkeeper. These financials, if accrual-based, can be used for smaller bonds requests.
- Tax returns: never used for bond underwriting purposes.
Selecting a Qualified CPA
By now, it should be apparent that the quality of a contractor’s financial statement is a make or break issue. The quality and accuracy of any financial statement is only as good as the preparer. So finding the right CPA is huge. There are literally hundreds of CPAs in every metro area. Lots of CPAs specialize in tax accounting while only a small few focus on construction contractors. These construction-oriented CPAs service a small, but vital niche within the accounting field. The best resource for seeking a qualified CPA will be from a professional bond agent. Seasoned bonding agents and construction CPAs tend to be actively involved in industry trade associations, such as their local surety association or the local chapter of the Construction Financial Management Association.
The Cost Factor
Providing CPA-prepared, GAAP financial statements is a major overhead expense, but is vital to optimizing bonding capacity. Contractors should avoid the temptation to skimp on financial statement preparation in an effort to save money. Whatever short-term savings there may be, it is more costly in the long run to use substandard financials. One of the main reasons for contractors to have difficulties in getting bonds is the lack of quality financial statements. Poor quality financials can also result in extra underwriting conditions such as higher premium rate, collateral and even funds control.
What Do the Numbers Mean?
In today’s surety market, underwriters are paying close attention to the contractor’s working capital (current assets minus current liabilities) and equity (total assets less total liabilities). The general rule of thumb is a contractor must maintain working capital of at least 10 percent of its total backlog (cost to complete). Understanding this basic formula enables the contractor to manage their backlog accordingly. If the contractor’s backlog becomes too large in relation to its working capital, bond capacity can be jeopardized. Here are some strategies designed to maintain adequate working capital and equity:
- Keep the money. Keep as much money in the company as possible from year to year. Large distributions to the owner can result in a weak or negative equity position for the company. It’s always better for a contractor to keep its own money in the company than have to give it to the bonding company as collateral.
- Avoid excess debt. Pay off bank lines quickly and keep low balances to maximize working capital. Excessive debt is the bane of working capital and equity.
- Let it go. Don’t take on extra work that could cause bond line to become tapped out.
- Pay to play. The construction economy is cyclical in nature, so there may be times when it makes sense to load up on work. If the balance sheet won’t support the resulting backlog, a capital infusion is necessary. A long-term loan to the company from the owner is an effective way to inject capital for bonding purposes. If the note is subordinated to the surety, this can add working capital and equity without creating debt.
Once a contractor gains a basic understanding of how its particular financial position affects its bond capacity, it is better prepared to effectively manage financials and backlog. Every contractor should review the business plan and then develop a financial strategy to maximize working capital and equity. With assistance from a CPA and bonding agent, a contractor can map out a successful strategy for maintaining adequate bonding levels.