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
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