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Secrets of Bonding #48: Sleuthing the Accounting Method

Steve GoliaLeave a comment

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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Secrets of Bonding #31: When Receivables are Not Receivable

Steve GoliaLeave a comment

Surety bond underwriting involves many elements, and financial analysis is always one of them.  In this newsletter, let’s look at a single element, an important one, and how you can influence the effect it has on bonding decisions.

Accounts Receivable “A/R” are the funds owed by outside parties to the company for work it has performed.  This is a Current Asset and is part of Net Worth.   Active contractors always have such money due them.  The number can be significant for firms in a growth mode.  Problem: Sometimes bond underwriters discount, or disallow part of this figure, thus reducing the applicants recognized financial strength and bond worthiness.   Why does this happen and how can you influence the outcome?

One reason for such assets to be disallowed is the age of the individual receivable on the fiscal year-end (FYE) financial statement date.   In order to be conservative, A/Rs that are 90 days old or more “over 90” are assumed to be uncollectable, and therefore are disallowed.  (Key word: Assumed)

Same with receivables arising from change orders that are unapproved or in dispute.  Projects with performance problems may have all payments held up by the owner, and therefore related A/Rs may be disallowed.  In fact, receivables may be discounted if there is a dramatic increase over historic levels, even if there is no apparent reason to doubt the collectability of the funds.

When A/Rs are disallowed the Working Capital calculation suffers as well as the ratio analysis.

This can reduce or eliminate the contractors bonding line.

Here are some possible cures. 

Retainages – A/Rs over 90 days old may be acceptable if they are actually Retainage which is slightly different from a true “trade receivable.” Identify if any of the A/Rs are actually Retainages.  They should be separated from the A/R analysis and “allowed.”

Over 90s – Older A/Rs are allowable if they were subsequently collected (no matter how old they became.)  Ask the client or accountant for an update regarding the collection of year-end receivables.  All collected items are included in the financial strength analysis.  The underwriter should be updated if they are eventually collected at a future date.   The client will be penalized for a disallowed A/Rs for 12-15 months after the fiscal date.  Updating the file when funds come in could help achieve a bond approval any time during this period.

Change Orders – The same concept applies to COs no longer in dispute or project issues that are resolved.  All A/Rs that are ultimately collected are allowed, regardless of how late they occur.

Payment Bond – If our client is a subcontractor, there may be a Payment Bond “above them” available for claim.  An over 90 A/R might be allowed based on the existence of this safety net.

Caution: If an aged schedule of year-end A/Rs is produced at a subsequent date, items that were not over 90 at FYE (but remain open) may now may be old and therefore disallowed!  It works both ways.

Conclusion

The financial analysis associated with surety bond underwriting is primarily focused on the fiscal year-end financial condition of the company.  These numbers drive the bond line until the next FS is issued – normally about 15 months.

The receivable collection is an ongoing process that warrants interpretation and monitoring because of its changing nature.

Call us with you next Contract, Site or Subdivision Bond.

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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