Month: February 2014

Secrets of Bonding #53: Funds Control vs. Tripartite Agreements

Steve Golia1 Comment

You may have heard these terms used in connection with Performance and Payment Bonds.  The concepts are similar in some ways, but have different purposes.  Let’s talk about them and how they can help you as a surety bond producer.

Funds Control

Also called Funds Administration or Escrow, it is a procedure that always originates at the request of the surety.  The contractor applying for the bond (the Principal) is receiving a “conditional” approval.  The underwriters are confident there is sufficient expertise, labor, equipment, etc. to perform the bonded contract, but the contractor has some financial issues.  The underwriter is willing to bond the performance obligation, but has reservations regarding the handling of money and payment of bills (the Payment Bond exposure).  Funds Control can provide a level of protection for the surety by taking the money handling responsibilities away from the contractor.

Normal contract, the project owner (Obligee on the bond), is required to pay the contract funds to the Principal.  This is usually in monthly payments, each for the work recently performed.

With Funds Control, the money handling is taken away from the contractor and moved to a party chosen by the surety and empowered by the Principal.  The surety will require that the contractor execute a letter of instructions directing the obligee to pay the Funds Administrator instead of them.  The administrator becomes the paymaster on the project paying all suppliers of labor and material, and paying the principal, too.  This procedure eliminates most of the risk of claim on the Payment Bond.   (#Why not 100%?)

There are companies that are professional Fund Administrators.  They may be well known to the surety and handle a series of contracts with them.  A dedicated bank account is opened for the contract, and checks are issued each month which are then distributed by the principal to the vendors.  In some cases, the surety may perform the Funds Administration in house.

Tripartite Agreements

This arrangement also involves the contract funds being redirected to a third party, instead of being paid to the contractor.  And similar to Funds Administration, the point is for the Tripartite Administrator to be the paymaster on the contract.

The primary difference between the concepts is that there is no bond when a Tripartite Agreement is used – it is in lieu of a P&P bond and actually only replaces the Payment Bond.

  • Funds Control is required by the surety providing the P&P bond.
  • A Tripartite Agreement is stipulated by the obligee in lieu of bond.

Review federal regulations regarding Tripartite Agreements: A tripartite escrow agreement.  http://www.acquisition.gov/far/html/Subpart%2028_1.html

“The prime contractor establishes an escrow account in a federally insured financial institution and enters into a tripartite escrow agreement with the financial institution, as escrow agent, and all of the suppliers of labor and material. The escrow agreement shall establish the terms of payment under the contract and of resolution of disputes among the parties. The Government makes payments to the contractor’s escrow account, and the escrow agent distributes the payments in accordance with the agreement, or triggers the disputes resolution procedures if required.”

This procedure may be used for contracts between $30,000 and $150,000. The Performance Bond may be waived at the contracting officer’s discretion.

Conclusion

These procedures have different implications.  Let’s examine them.

FC= Funds Control

TA= Tripartite Agreement

The Obligee:

  • FC – They are getting Payment protection and a Performance Bond. The surety will monitor the project and step in to keep things on track (and prevent a claim or default) if necessary. In the event of failure, the surety completes the project.
  • TA – Even unbondable contractors can be awarded work. A TA may be less expensive than a bond with FC. Limitation: There may be no Performance guarantee.

The Principal:

  • Both processes result in the contractor successfully obtaining the project but with no handling of the project funds.
  • TA – No need for personal or company indemnity.  No collateral for the surety. Financial reporting, legal fees and other expenses may be less.  Limitations: Federal only permits TA on small contracts.  Fails to build a track record of “performing under bond”

Subs and Suppliers:

  • Under both procedures they are paid by a professional intermediary, which may be more dependable and faster.
  • FC – They can make a claim against the Payment Bond
  • TA – Limitation: No opportunity to claim against a surety bond if they are unpaid, or not fully paid.  What is their recourse?

Agent and surety:

  • TA – No Bond!  (Beans for supper again?)
  • FC – A normal P&P Bond is issued

# If the principal fails to list any subs or suppliers during the set-up process, they will not be under the protection of the funds administrator.  However, they WILL still have the right to make a claim against the payment bond!

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it! Call us with your next one. 

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

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Secrets of Bonding #52: “It’s Only a Maintenance Bond”

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Maintenance Bonds can be troublesome, even though you could say the risk on them is relatively low.  So what’s the deal on these?

A Maintenance Bond normally follows a Performance and Payment (P&P) Bond that guarantees a construction contract.  In many cases the Performance Bond may also cover defective materials and workmanship for some time period after acceptance of the work.  This is referred to as a maintenance period, and the bond that may specifically cover it carries the same name.

There are times when the obligee (party protected by the bond) wants two years of maintenance.  If that is longer than the performance bond provides, a separate maintenance bond is needed.  There are also cases in which no maintenance period is automatically provided by the P&P bond, so there must be a maintenance bond if the protection is desired.

Why is the Risk Relatively Low on a Maintenance Bond?

Assume “Surety A” provided a P&P bond on a contract.  They already faced the risk of the project not being performed properly.  Having now passed that exposure, it is a small step to guarantee the materials and workmanship that went into the project.  For this reason, a Maintenance Bond following a P&P Bond issued by the same surety, may be much less expensive than the related P&P Bond, and would be freely given.

Sometimes They Play Hard to Get

There are a couple of factors that can make these bonds difficult to obtain.

  • No P&P Bond – If no P&P bond was issued, the underwriter will be justifiably suspicious if a maintenance bond is requested.  Perhaps the obligee regrets not having obtained a P&P bond or was unwilling to spend the money for one.  Now they want a cheap alternative that can still cover the entire project.  Maybe they observed a suspected defect in the work and belatedly want the protection of a surety bond.
  • Different sureties – If Surety A wrote the P&P bond, Surety B will obviously ask why “A” is not also handling the maintenance bond.  Maybe “A” knows there was a problem on the contract and they want to run away from it while they can.  The only good candidate for the maintenance bond is the surety that got paid on the P&P bond.
  • Low percentage maintenance obligation – often the maintenance bond is issued for less than 100% of the contract amount.  It may be for 20%.  You have a low dollar amount, but it still covers the entire project.  This is an unappealing situation for the surety.  But it is one they will tolerate If they already reaped the benefit of issuing the P&P bond.
  • Low rates – Maintenance bond rates are normally lower than P&P bond rates because… (*why do you think?) This makes them less rewarding for the surety.
  • Difficult guarantees – Some maintenance bonds cover efficient or successful operations instead of the normal “defective materials and workmanship.”  This is a far more difficult guarantee for the surety to provide.  Many are unwilling to provide such bonds.

Solutions

The only alternative to a bond may be a “cash” type alternative such as a Standby Irrevocable Letter of Credit issued by a commercial bank. The client may not think this is a great solution, and there will be no commission for the agent, but there are not many options at this point.

One consolation is that maintenance bonds are often written for a small percentage of the contract amount.  So cash in lieu of bonds may be feasible.

Maintenance bond rates may be lower than P&P bonds because the work is already in place and has been accepted by the architect and / or owner.

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

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Secrets of Bonding #51: Writing Bonds to Your Uncle

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Sam, that is…

There are lots of federal bonds.  It’s a unique corner of the surety world with special requirements and mandatory bond forms.  Here is a general overview and some specific comments on Performance Bonds for federal contracts.

With so many federal forms for specific situations there’s bound to be some strange ones: Adulterated Butter Bond, Opium Smoking Bond and the Tobacco Tube Manufacturers Strengthening Bond to name a few!

The general categories are:

  • Official Bonds covering the actions of people in office
  • Immigrant Bonds covering foreign persons in the U.S.
  • Excise Bonds cover taxation
  • Customs Bonds relating to import and export

In addition to all the various small bonds, there are the Performance and Payment Bonds which often are for millions of dollars covering contracts for construction and services. Let’s talk about these.

For construction, the federal forms are Bid Bond #24, Performance Bond #25 and Payment Bond #25A.

Some unique aspects to note:

  • If issued by a corporate surety, they must appear on the current version of Circular 570 (T-List) for an amount sufficient to cover the bond in question.  You can refer to the current list here: http://www.fms.treas.gov/c570/c570.html
  • The use of 24, 25 and 25A is mandatory on contracts offered directly by a branch of the federal government. Projects that include federal funding, but are offered by a local non-federal entity, are governed by whatever bonding requirements they designate.
  • On Bid Bonds, the “Date Bond Executed” and “Bid Date” are not required to be identical, but the execution date cannot be after the bid date.
  • Federal bids bonds are normally for 20% of the proposal amount.
  • On the #24 Bid Bond, it is not necessary to fill in a dollar amount for the penal sum of the bid bond – as long as the Percent of Bid Price (such as 20%) has been indicated.  It is also not necessary or correct for the surety to indicate their T-List limit in the Penal Sum area or in the signing area “Surety A.”  The correct dollar amount of responsibility is automatically calculated based on the proposed contract amount.  Entering a dollar figure is only necessary if the surety wishes to cap the bid bond amount by setting a maximum value.  (Refer to Secret #8.  Call if you don’t have it. (856) 304-7348.
  • On 25 and 25A, it is not necessary to enter a dollar amount in the signing area “Surety A” unless there is a co-surety on the bond.  Liability Limit in the Surety A section is not asking for the T-list amount.
  • Federal bonds are always made out to the United States of America.  They do not name the actual governmental agency.
  • In the current edition, the nature of the work is listed on the Bid Bond, but not on the Performance or Payment Bond.  Only the contract number is indicated.
  • You can download the current edition of these Standard Forms here: http://www.gsa.gov/portal/forms/type/SF  That’s important because a bond can be rejected by the C.O. if an obsolete version of SFs are used.
  • In the current edition (2004), the form 24 Bid Bond says “Pervious edition is usable.”  Which, despite the poor spelling, means older versions are OK, same with the form 25A Payment bond.  Be sure to always read the printed details on the form which indicate the expiration date and other important facts.
  • Another “Ooops!” from Uncle: There is no typable field provided on the form to enter a bond number.  You need to do this manually. “Perviously” the form was not even typable.  Small steps!

There you have it.  Federal Bond forms are different, but that doesn’t mean we can’t still be friends.

Readers please note: These posts are for your entertainment and enjoyment.  We do not assume responsibility for your correct execution of bonds, nor are we responsible to any third parties.

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

(Don’t miss our next exciting article.  Click the “Follow” button at the top right.)

Secrets of Bonding #50: Don’t Cross that Line (of Authority)

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Bonding Lines of Authority are always in play when it comes to surety bonds.  However, they are available (or unavailable) in varying degrees to underwriters, agents, and contractor accounts.  Let’s look at where they come from, how they work, and how to get one – and keep it!

Origin of Underwriting Authority

It did not start “a long time ago in a galaxy far, far away….”  In fact, you could argue that it does not even start in the home office of the surety. The ability and the authority to make underwriting decisions on Bid and Performance Bonds is often the result of a negotiation with the surety’s reinsurers who share in the risk / rewards of the underwriting.  The reinsurance treaty provides underwriting guidelines and specific limits of capacity.  Letters of Underwriting Authority are derived from this.

Surety Branch Offices

The highest level of decision-making authority is held in the home office of the surety.  Lesser amounts are then delegated to branch office managers, their respective surety department managers, bond supervisors, and underwriters. The authority we have described thus far consists of general decision making authority; it is not “account specific.”

When individual accounts are approved for ongoing surety support, senior underwriters may choose to delegate a portion of their authority to other underwriters to help process the day-to-day bond requests more efficiently. These are the people you are likely to get on the phone when you call the surety’s office. Call them “line” underwriters for a different reason – they are directly in the line of fire with the surety’s agents and contractors.

This client specific authority has a normal set of underwriting criteria (i.e. no overseas contracts, excessive bid spreads, etc.) plus maximum dollar values for a single bond/contract and for aggregate capacity.  Call us at 856-304-7348 if you don’t have Secrets # 9 & 38 which cover aggregate capacity. There is also an expiration date which is normally a few months after the clients next FYE (*what’s that?) Such lines of authority are referred to as Bond Lines.

Agencies

The surety underwriter may in turn delegate some portion of the bond line to the agent.  This is a major step because it is being transferred to a person who is not a direct employee of the surety – and therefore less responsible to the surety for their actions.  Keep in mind, this decision-making is serious business. The underwriters are literally the custodians and guardians of the surety’s assets.  A Performance or Payment Bond claim can cost millions for the surety.

Agency authority may be issued to a specific person rather than the agency itself.  This assures a level of accountability and facilitates a periodic underwriting audit.

Don’t Cross That Line (of Authority)

Picture the chain of authority from the reinsurers down to the line underwriter and maybe the agent, too.  Each level of authority is granted based on confidence in the honesty, knowledge and dependability of the recipient.  When line underwriters miss-handle a situation, they must answer to the department manager.  That manager also has to answer to a higher up.  Each person’s individual credibility is at stake.

Over the years I have had a number of occasions when violations of authority occurred below me, it’s always an unpleasant situation (understatement!)  These were not bad people; in fact they may have had good intentions. So how do violations of authority occur?

  1. Failure to know or follow the details of the authority.
  2. Riders, documents or bonds not covered by the line are issued.
  3. Failure to note the expiration of the line.
  4. A bond is issued as an interim measure with the intention of bringing in another surety.
  5. “It’s only a bid bond and they probably won’t be low.”

Whatever the reason, underwriting authority is dependent on the trustworthiness and professionalism of the recipient.  When this is shattered, when that line is crossed, senior underwriters will never forget!

If you receive a Letter of Authority, be conscientious and conservative when exercising it.  Print out a copy and refer to the details before acting.  Also consider double checking with the person above you before making a final decision.  Just because you have the authority, it doesn’t mean you must decide on your own.

A line of authority can be a great asset, but you if you cross it, you may lose it!

*FYE = Fiscal Year-End.

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it! Call us with your next one. 

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

Don’t want to miss our next exciting article?  Click the “Follow” link in the upper right corner.

Secrets of Bonding #49: Bid with a Check?

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In Secret # 8 we talked about Bid Bonds.  Bid specifications often provide alternative forms of security to accompany the contractor’s proposal. Cash, a Certified Check, or a Bid Bond may be permitted.

Let’s take a look at the implications of each and when to use them, or not!

First, a quick primer on bids:

When contractors submit a proposal on bonded public work, bid security must be included.  The security assures the bidders sincerity.  They will accept the contract if offered or pay a penalty for walking away.

The contract then requires a Performance and Payment Bond or other form of acceptable security equal to the contract amount.

Typical options for Bid Security are Cash, Certified Check, or Bid Bond

Cash is King, but not when it comes to bid security.  Bid security amounts are usually thousands of dollars so this method is not realistic for many contractors.

Certified Checks are similar to cash.  This means the contractor must estimate the maximum proposal amount and arrange for a check payable to the obligee.  Initially, the bid percentage is known but not the bid dollar amount.  The specifications require security for amounts ranging from 5-20% of the proposal amount.  However the actual proposal amount is often not compiled until close to bid time when all the vendor prices have been received and negotiated.  To use a check, the contractor must estimate an amount sufficiently high so it is adequate to cover the bid figure when it is finally known.

Third choice, a Bid Bond issued by the surety.  The advantage of it is that the bidder’s money is not tied up (as compared to cash or a check). As a precaution on public work, obligees hold the bid security of the second and third bidders until the contract is awarded – which could take weeks.  Their bid security is tied up and the likelihood is that they will not win the contract.

Looking at the three options, a bid bond is the preferred choice. However, a bid bond is not always available when needed. When this happens, the bidder may still have the option to use cash or a check.

Normally there is no requirement to use a bid bond specifically.  The bidder also has the latitude to use one surety for the bid bond and a different one for the P&P bond (although many sureties dislike following someone else’s bid bond.)

Why would a bid bond not be available?

1.  The contractor does not have a surety.
2.  Short notice: Not enough time for the surety to make an underwriting decision.
3.  Short notice 2: The surety has approved the bid bond but there is not enough time to issue.
4.  Bid bond declination: The surety considered the project but will not support it.
5.  Bid bond declination 2: The surety wants to support the project but they are unable to due to their lack of credentials, their insufficient capacity, licensing issues, or other problems on the surety’s part.
6.  When contractors are changing bonding agents or sureties, there could be a gap in service where the new surety is not ready.

In all these cases, the contractor can decide to bid with a check. However, there may be a downside to consider. Let’s look at each of the six scenarios described above.

Risks of Bidding with a Check

1.  No surety: The contractor could forfeit the bid check if they are awarded the project but are unable to bond the ensuing contract.
2.  Short notice: The risk here is the same as #1.  Forfeiture could be the result if no bonding can be arranged for the contract.
3.  Short notice 2: This is one situation where the check may be a reasonable alternative assuming the surety has provided a written approval to bond the contract.
4.  Bid bond declination: This is a particularly troubling situation because the effort to arrange a Performance Bond faces two obstacles:

  • Time: Contract awards demand the issuance of the P&P bond by a specified date.  There could be insufficient time to set up a new surety relationship.
  • The new surety, which hardly knows the contractor, is being asked to bond a project the incumbent surety declined.  The incumbent was willing to lose the account over this project. Can the new underwriters be confident they are making a better decision than those who know the account well?

5.  Bid bond declination 2: This example isn’t as onerous as #4. The problem is that the surety wants to bond the project but can’t.  The new underwriters will be less hesitant than in #4. (So why don’t they just issue a bid bond to help the client get to the next step with another surety?  See answer below.)  If a check is used, a surety must be arranged to prevent forfeiture.
6.  Changing sureties: Handle the same as the short notice situations.

Conclusion

While its true bidding with a check is usually an option, it places the contractors funds at risk unless there is a verifiable means to bond the contract upon award.

Don’t advise your client to consider using a check unless the path forward is confirmed in writing.

Answer to #5: The surety would not want to issue the bid bond if they can’t provide the performance bond.  They make their money on performance bonds which are the main product of the surety operation.  Second reason, if no performance bond is arranged by the client, the bid bond could go into claim.  There is little for the surety to gain in this situation.

Note to our agents and other readers: We are not offering legal advice and do not assume to have covered all possible situations in this article.  When these scenarios arise, talk to your client, their attorney, the surety and feel free to call us for specific advice based on the unique circumstances.

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it! Call us with your next one. 

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

Don’t want to miss our next exciting article?  Click the “Follow” link in the upper right corner.

Secrets of Bonding #48: Sleuthing the Accounting Method

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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!

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

P.S. Check out our upcoming Free CE schedule here!

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

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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.

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

P.S. Check out our upcoming Free CE schedule here!

Follow this BLOG in the upper right hand corner for more cool bond stuff…

Secrets of Bonding #46: Turn IRON into GOLD

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When contractors apply for Performance Bonds, the underwriting review always includes a financial analysis along with other elements.

Two key components of the financial analysis are Working Capital (WC) and Net Worth (NW).  WC is a measure of short term financial strength.  NW is the ultimate value of the company upon liquidation.

The inspiration for this article came from a new bond account we recently reviewed.  The company is a trade contractor, the kind that normally performs their own work rather than subcontracting. This means their financial statements should show appropriate levels of labor, plant, and equipment.

In this case, the Profit and Loss Statement (P&L) showed sales in excess of $10 million, not a small company. The Balance Sheet showed an acceptable amount of WC, but NW was low – resulting in some weak ratios.

Another element caught our attention: On the Balance Sheet, the net value of the equipment asset was only $65,000! This made us wonder how a company could perform $10 million in sales with so little in physical resources.

There could be a couple of explanations:

  1. They could be subcontracting most of their work.  This is unlikely, however, because they themselves are subcontractors. Typically there is not enough profit to share between two firms. A review of this company’s P&L statement did not indicate extensive subcontracting.
  2. They could be renting almost everything (instead of owning).  This doesn’t sound like a practical approach with sales as high as $10 million, and the P&L did not show high rental expenses.
  3. The equipment could be substantially depreciated resulting in a low net value on the Balance Sheet.  This did turn out to be the scenario in their case.

Let’s talk more about #3. But first off, what is depreciation?

IRS definition: http://www.irs.gov/Businesses/Small-Businesses-%26-Self-Employed/A-Brief-Overview-of-Depreciation

It says in part, “Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.”

This means when a $100,000 backhoe is purchased, its value as an asset on the Balance Sheet goes down each year as the depreciation progresses.  Bear in mind, this is an accounting entry.  It is not an indication of the current market value of the asset.

Eventually, the asset is depreciated to zero. However, even if it is valueless on the Balance Sheet, it may still be out on a job site working and producing revenues.  It may still have a market value. So therein lies the Gold.

Assets such as heavy equipment (referred to as “Iron”), may have value that is not reflected on the Balance Sheet. So the question is: How to recapture that value and help the bond worthiness of the account?

One way is with a professional appraisal.  Even if the backhoe is depreciated to zero, if the current market value is $25,000, that represents NW that can be added to the financial ratios.

Imagine the effect for the company in question.  Upon further review, we determined that the cost of their equipment was nearly $2 million.  They had a lot of it and it was older so depreciation had reduced the net value on the Balance Sheet to $65,000.  However the current market value was actually $500,000!

Q. Based on these facts, what value should the bond underwriters use for the equipment:  $65,000, $2,000,000, $500,000 or some other amount?

A. If you’ve been following along, that’s where the appraised value comes in.  You need an independent determination of current market value that recognizes the amount of cash these assets could bring.  If well maintained, they have a value higher than that shown on the Balance Sheet. ($500,000)

How else can the value be determined?  The client could provide a copy of their equipment floater as evidence of current value.  You could also get an informal appraisal from their equipment dealer.  Any of these options are better that living with the unrealistically low value shown on the Balance Sheet.

Going back to our example, if the backhoe’s market value is currently $25,000, give that info to the underwriter.  The newly found net worth for all such assets can be added to the bonding analysis.  You turned the Iron into Gold, a POT of Gold!  It can totally transform the ratios and the client’s ability to qualify for the bonds they desire.

Consider this technique for companies with a sizable fleet of mature equipment, especially when their Net Worth is less than desired for bonding purposes.  This analysis can also help strengthen the banking relationship.

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

P.S. Check out our upcoming Free CE schedule here!

Follow this BLOG in the upper right hand corner for more cool bond stuff…

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

Steve GoliaLeave a comment

Sureties commonly rely on a variety of elements when deciding if they will provide surety bonds for contractors. 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. Management of overhead expenses
  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.” We 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 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, 60 days prior to your client’s fiscal year-end is the time to act. Get the ball rolling!
  • Contractors, tell your accountant a draft fiscal year-end statement will be needed for discussion with the bonding company.

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.  856-304-7348

First Indemnity of America Ins. Co.

Secrets of Bonding #44: The One Good Thing About Bad Credit

Steve GoliaLeave a comment

When it comes to Bid and Performance Bonds for contractors, low scoring business and personal credit reports are one of the most common reasons for bond declinations.  After a series of rejections, the client may be discouraged. But there is one good thing about low credit scores:

Compared to other problems, this may be one of the easiest to correct.

Step one in solving a credit score problem is knowing you have one. Credit bureaus are legally required to furnish the report free of charge if requested by the subject. The bond applicant should obtain their own credit report and seek help to interpret the data if necessary.  D&B reports can be accessed by visiting: https://iupdate.dnb.com

Understanding Why the Credit Score Is Low

How are credit scores determined?  The key factors:

  • Payment history, timeliness of payments – slow payments, collection accounts and write-offs lower the score
  • Total amount owed – excessive use of credit produces bad ratios
  • Length of credit history – short history has little credibility
  • New credit sought – multiple credit applications may indicate a cash flow problem
  • Types of credit used – may indicate a distressed applicant
  • Suits, liens and judgments

Dealing With the Problem  1) Verify Content

  • Obtain the credit report and review it for accuracy.  I’m not the only Steve Golia in the world.  It is more common than you think for reports to contain unrelated info and errors. There could also be good credit data that is missing. Send corrections to the credit bureaus in writing.
  • The payment history includes trade reporting by vendors. Companies can furnish the names of their most frequent vendors to include them in the report.  Companies may also voluntarily supply financial information, and other elements that may strengthen the report.  Discuss this with the credit bureau.
  • Suits, liens and judgments: Even if resolved / settled these may still appear open on the report.  Send the reporting agency proof of resolution.
  • After all this, follow up by ordering a subsequent report to confirm the corrections / adjustments have been made.

Dealing With the Problem  2) Long Term Credit Management

  • Be conservative when opening new credit relationships.  “Open a credit account with us today and save 10% on this purchase!”  Just the act of applying for credit can be viewed as an indication of financial problems and can lower the score.
  • Don’t assume closing existing credit accounts will improve the report, and it will not remove those designated as “collection” accounts.
  • Set up reminders for payment and pay on time.
  • Reduce total debt.
  • Pay off debt instead of moving it around.

Summary

Surety underwriters decline bond accounts for many reasons: Poor financial results, a lack of related experience or bad credit are some examples.

The One Good Thing – Contractors are not able to change history, but an erroneous credit report is easy to correct if the problem is detected and acted upon.

Get our FASTAPP for contract bonds up to $500,000 Click!

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

P.S. Check out our upcoming Free CE schedule here!

Follow this BLOG in the upper right hand corner for more cool bond stuff…