financial statements

Working Capital Magic!

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Working Capital: It is a key element for contractors when they apply for Bid and Performance Bonds.  Too low, and the bond or entire account may be rejected by the bonding company.  Primarily, this number is calculated once a year on the fiscal year-end financial statement.  If the Working Capital (WC) comes out low, you’re STUCK with it all year… or are you?  Are there ways to “poof!” magically find more working capital on an existing financial statement?  Why yes!

Here are three ways contractors and their insurance  / bonding agents may overcome a WC deficiency:

  1. Stockholder loan: The owner can Subordinate an existing loan to the surety.  This means the owner / creditor will not demand that the company / debtor repay funds the company has borrowed.  The Subordination removes the stockholder loan from current liabilities, thereby increasing WC.
  2. Underbillings: Accrual Method financial statements do not include the current asset called Costs and Estimated Earnings in Excess of Billings, or for short: Underbillings.  If a net Underbilling Asset is calculated, it will directly increase the WC analysis.
  3. Bank line of credit: Many analysts will add available bank credit to the WC analysis.

Note: All three of these ideas can be applied to the recent fiscal year-end statement.  You don’t have to wait for a new statement to use them!

Bonus Poof!

How to immediately increase the Net Worth (NW) analysis: Fixed assets, such as heavy equipment, are depreciated each year resulting in their declining value on the Balance Sheet. The carrying value of the asset may eventually be less than the actual “street value” of the machine.  This lost net worth can be re-captured by finding the current appraisal value.  For big and old companies, this can give a major boost to the NW calculation – and therefore the bonding.

We hope you find these four tips helpful.   They can literally improve the analysis of an existing financial statement.

Do ALL bonding companies want you to know these secrets?  Hmmmm…  We do!  FIA is a bonding company (carrier) that has served contractors and their agents since 1979.  We are flexible and creative surety bond experts.  Call us for Bid and Performance Bonds.  Call us for Site and Subdivision Bonds – our specialty!

Steve Golia, Marketing Mgr.  856-304-7348

FIA Surety / First Indemnity of America Insurance Company, Morris Plains, NJ

It’s SO HOT!

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Record heat is being recorded in many parts of the country.  But what else is hot?

  1. Floyd Mayweather – Hot earner made $7.6 million per minute for his fight with Connor McGregor
  2. Stephen Curry – Hot contract, NBA’s first for over $200 million
  3. Timothy Berners – Lee (never heard of him?) Inventor of the world-wide web and creator of the first web site. He changed everything. Very hot.
  4. Surety Bonds by FIA Surety!
  5. Bill and Melinda Gates – Hot philanthropists donated $4.78 Billion in 2017. (Don’t worry, they kept some for themselves.)

What was that number 4, Surety Bonds?! Come on!  How can they be hot?

Glad you asked:

Surety bonds are a special area of the business.  They are unique and difficult, an opportunity and sometimes an obstacle.  But they are always a chance to shine: A path to greater success for you and your clients.  All you need… is a way to get there.

What if the surety underwriters were cooperative and production oriented?

Wouldn’t THAT be hot?

You need to ask yourself

  • Do my underwriters promise a same day response?
  • Do they help me find a way to write the business?
  • Are they open to a wide range of underwriting situations?
  • Are they Problem Solvers?

If not, you need to heat up your surety bond production.  Find out why agents bring their contract surety, site and subdivision bonds to us.

We’re flexible and creative.  THAT’S HOT!

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision and Contract Surety 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.

Secrets of Bonding: #163: Financial Statement Fraud!

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You know the old adage, “Financial statements don’t kill people, people kill people.”

While it’s true there can be misrepresentation and deception in a financial statement (FS), the document is not inherently bad, it is the poor intentions of the preparer or company that is to blame.

As credit analysts, we always review and rely on FSs when underwriting surety bonds. We know there may be attempts to mislead our judgement or even downright deception. But the need to evaluate the financial report is unavoidable. It is considered a valuable “report card on the quality of management.”

There are three levels of financial presentation by Certified Public Accounts (CPAs):

Compilation – a properly organized report where the numbers have not been verified or evaluated by the CPA

Review – includes some checking “Review” of key elements

Audit – is the highest level and includes the CPA’s statement that they have checked and believe the numbers are correct

The reader of the FS is entitled to certain expectations: A candid and complete presentation that informs the reader. Are they entitled to more than that? Does the reader sometimes expect too much?

Let’s consider what the FS actually says, and what it doesn’t… 

The Balance Sheet

This shows assets and liabilities. It describes the dollars in the company (assets) and who owns them (liabilities and stockholder’s equity). You know many of the normal entries: Cash, accounts receivable, accounts payable, inventory, bank debt, the net worth / stockholder’s equity section, etc.

The balance sheet always has a date, such as 12/31/2017. It shows the status of these accounts on the one day. Credit analysts calculate the Working Capital aka Net Quick (NQ) which is considered a measure of short term financial strength. You find the NQ by subtracting current liabilities from current assets. When the bond underwriter has the NQ number, it can then be incorporated in the decision making.

“What size bonds will be approved for this applicant?”  “How much total capacity can they be allocated?” The NQ figure becomes a benchmark that is used for the remainder of the year.

For many analysts, this one number carries a huge importance for the following 12-15 months.

Let’s move forward one day in time, to 1/1/2018. “Happy New Year!” and let’s check the bank account. Some money has come in! The accounts receivable and cash have changed. Other elements are also different and so, if we calculate the NQ based on the 1/1 balance sheet, the NQ will probably be different from 12/31. Again, that’s because the balance sheet shows the state of these accounts on ONE DAY. It is always changing!

The reality is that the working capital number is only correct for one day, then it is subject to revision. This is not to say the number is not important or relevant. And certainly decision-makers must have annual benchmarks and a method for their determinations. It is very important, but so are other elements.

Financial Statement Fraud

The most common FS fraud is not committed against us by others. It is the self-deception we commit by over relying on these “one-day numbers.” To do so is to miss the big picture!

Underwriters love to see a big cash account sitting on that top line (of the balance sheet). But that’s a one-day number. Isn’t it even more important to determine the average funds on deposit for the prior six months or year? Many analysts fail to ask for this.

Accounts Receivable and Payable – here is another key area where the “one-day number” can easily be given a historical perspective. Aged schedules of A/R and A/P are easy to obtain and they give a view over more than one day. These documents are not automatically included in FSs, and underwriters may fail to ask for them.

Another example: A broader understanding of the banking relationship is accomplished by looking beyond the balance sheet bank debt.  A reference letter can reveal if the client has bounced checks, broken loan covenants or defaulted.

Conclusion

As readers of these documents and analysts, let’s not cheat ourselves by over relying on the balance sheet or thinking it is more than a one-day snapshot. It should be scrutinized and viewed in harmony with other key underwriting factors such as mid-year financial reports and supporting documents.

In this manner underwriters can make realistic, well-informed decisions.

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.

Secrets of Bonding #160: Deep in the Weeds with Set Aside Letters

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In this article we will peel back the onion on Set Aside Letters (SAL) issued by banks in connection with construction loans.  What are they, when they are useful for bonding companies and when are they not?

Here is the essence of such documents:

“The agreement covering the project will provide that the funds in said impound account are … to be disbursed for payment of the (Name of Project) mentioned above and only after (Bank) has satisfied itself that the work paid for has actually been performed… In the event (Borrower) fails to complete the project described herein… all funds remaining in said impound account shall be immediately available to Surety to complete and pay the costs of said project, and in such event, (Borrower) waives any claim or interest in the remaining funds. Surety shall not in any way be obligated to repay said funds so used to (Bank).

This is an irrevocable commitment of funds which is not subject to recall or offset by (Bank).”

Pretty interesting!  This letter / agreement keeps the loan in play to fund the completion of the project  – even if the borrower (bank customer) fails / defaults.

When Are Set Aside Letters Used?

These documents are a common underwriting tool when a Site or Subdivision Bond is issued by a surety. If the bond applicant (who is also the developer and borrower) is relying on a construction loan to fund the bonded work, the SAL protects the surety by providing funds for the completion of the work in the event of a default.

What a great idea.  So why don’t we use these on everything?  Let’s look at another example.

Commercial Projects

The project owner hires a bonded contractor and a bank loan will fund the project.  The bank needs a guarantee that the asset / project (which backs the loan) will be built as intended.  A Performance and Payment Bond accomplishes this and assures there will be no Mechanics Liens against the property for unpaid bills.  These two aspects benefit the project owner and the lender.  Keep in mind, in a borrower default situation, the bank becomes the new owner of the property.

It is common for the bank to stipulate that a bonded contractor be used, and they may want to be a named beneficiary on the P&P bond – accomplished by issuing a Dual Obligee Rider.  In turn, should the underwriter require a SAL from the lender?

On Commercial projects, the normal practice is to NOT obtain a SAL from the lender.  Why not?  Why is this different?

Choose one:

a. The bank is a secured lender

b. The bank can subrogate against the borrower’s assets

c. The Dual Obligee Rider serves a purpose similar to the SAL

a. and b. are true, but the answer is c.

Welcome to the Weeds

We’re going in now. The Dual Obligee Rider adds the lender as a beneficiary with all the rights and obligations of the obligee named on the bond (the project owner).  And what are they?  Obviously they are entitled to make a performance claim and have the project delivered as indicated in the contract.

The named obligee also has obligations, one of the most primary is to PAY the builder. Important: The obligee is prohibited from making a performance claim if they have failed to pay the contractor.

Therefore, when the bank is included under a Dual Obligee Rider, they accept the benefits and obligations.  If the borrower defaults, the lender cannot make a bond claim unless they continue to pay the construction loan to the surety.  (Now the bank owns the project and the surety has become the contractor.)

Summary

Is this starting to make sense?  When a borrower defaults on a commercial project, a lender included by Dual Obligee Rider cannot make a claim unless they continue to pay the project funds to the surety.

Deeper Weeds

On Site and Subdivision there is a unique risk – the lender can take a free ride on the surety by having the bonding company pay out of pocket to complete the project.

Site and Sub-D bonds have the local municipality as obligee, not the bank.  The bank doesn’t want a Dual Obligee Rider because they automatically receive a financial benefit if the municipality makes a bond claim to demand completion of the project.  If the borrower has defaulted, the bank has the opportunity to withhold the balance of the loan (the borrower is gone), and watch the surety pay to complete a project they now own.  And they were not even the bond claimant…

This is the risk sureties avoid on Site and Subdivision Bonds by requiring the SAL that keeps the loan in play, even if the bond applicant / borrower has failed.

Admittedly, this is a pretty obscure subject, but also interesting to us “bond nerds.”  It never hurts to understand how things fit together.  These skills help us solve your complicated bond opportunities.  Take advantage of our expertise when the next one pops up.

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 #157: Bid Bond Quiz

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Is there anything less interesting than a bid bond?

They may not seem too exciting, but the lowly bid bond is an integral part of our surety business.  For contractors, they are often the key to acquiring new revenues.  If you don’t think they are important, watch what happens when a client is waiting for one that never arrives.

As surety underwriters, we spend a great deal of effort assuring these documents are accurate, delivered on time, and we track the outcome on each one.

Everybody knows about bid bonds, right?!  OK let’s see if you do…

True or False:

  1. If you decide to not use a bid bond you ordered, you have to send it back to the surety within 48 hours
  2. They have an expiration date
  3. A bid bond precedes every performance bond
  4. The surety can cancel the bid bond
  5. The dollar value of the bid bond equals the amount of the proposal it accompanies
  6. The surety must know the exact dollar value of the bid bond before they will issue it
  7. The premium for them must be paid in advance
  8. They remain active for up to six months
  9. It is better to use a check for security than a bid bond
  10. The same surety that issues the bid bond must issue the performance bond

OK team, how’d you do?  # of True______? # of False____?

They are all False!

  1. An unused bid bond has no value but it makes a great liner for your bird cage
  2. Never has an expiration date
  3. Some contracts are negotiated (no bid bond) or may require a surety capacity letter instead
  4. Like a performance bond, these surety instruments cannot be cancelled
  5. Most often the penal sum of the bid bond equals a percentage (10-20%) of the proposal amount
  6. Most bid bond amounts are expressed as a percentage of the proposal amount, not a dollar amount, to protect the confidentiality of the proposers bid. In such cases the exact dollar value is unknown in advance.
  7. Sureties are entitled to charge for them, but usually don’t
  8. Although not stated, most sureties consider them void after 90 days
  9. Wrong! If the performance bond is not produced, the check can be forfeited
  10. Nope! Two different sureties can be used, even if a “Consent of Surety” was issued with the bid bond.

Bonus Question: If the bid is rejected because the surety’s credentials are found to be inadequate, can this result in a bid bond claim?

Answer: Theoretically, it should not. If the bond is declared inadequate, how can it be sufficient for a claim?

When flexibility and aggressive underwriting are needed, give us a call.  Find out what you missing when it comes to surety bonds.  

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 #123: Who Was Edward Aloysius Murphy, Jr. (& Why Contractors Should Care)

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(January 11, 1918 – July 17, 1990) An American aerospace engineer who worked on safety-critical systems for the U.S. Air Force. He is best known for his namesake Murphy’s Law, which  states, “Anything that can go wrong will go wrong.”  Murphy regarded the law as crystallizing a key principle of defensive design, in which one should always assume worst-case scenarios.Murphys_Law

Keeping Major Murphy’s principle in mind, what are the critical steps contractors can take to get their projects off on the right foot, and bring them to a successful conclusion – while keeping Murphy’s Law out of the equation?

The first key to having a successful contract is to have a contract. It sounds obvious, but contractors are sometimes induced to start work, or perform change orders / additions to contracts, without an executed document in hand.  Maybe the project owner is in a rush, “We need for you to start right away so we can be completed on time.  We’ll do the paperwork later.”

The contractor wants to maintain good will.  They proceed in the hope that their responsiveness will pay off – and sometimes it does.  There are also times when the contractor incurs costs that are never reimbursed because the contract is not executed.  There could be engineering problems, governmental interference or lack of funding. There are any number of reasons for things to go wrong (as our hero indicated.) And for the contractor, they are all bad.

murphyslaw

On the other hand, let’s say there is no problem with the contract.  The paperwork is signed, the work proceeds, is paid for, and the contract is completed with a profit in hand. Is that the end?

No, not quite. Just like there is paperwork to get into the project, there is more to get out of it.  The contractor should obtain written acceptance of the work by the job owner (obligee.) 

  • This important document establishes a completion date for the contract and concludes a portion of the liability that is attached to all open contracts.
  • It will close the Performance and Payment bond if there was one. Closing the file restores the contractors bonding capacity. 
  • It may also be beneficial with lenders.
  • If nothing else, a written acceptance may be a defense when the project owner attempts to call back the contractor at a later date or claim the work was not satisfactory.

Edward_MurphyThese simple procedures are basic, good business practices. Contractors who win work competitively, and are paid under a lump sum contract, already face significant risks.  It is important to have the correct paperwork in hand when starting, modifying, and ending construction projects. 

Major Murphy learned this important lesson the hard way – but you don’t have to! 

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision and Contract Surety 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.

Secrets of Bonding #113: Your 1st Bond – Choose Door #1 or 2?

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Every week we get inquiries regarding clients who need their very first bond.  This is a great question and one we love to answer.  It is particularly gratifying to give a new client their first bond – of many!

There are different paths forward depending on the circumstances.  Each door has different aspects.  Let’s go over them.

Door Number 1:open_door3

Use this door for contracts (federal and all others) up to about $350,000.  This is the fastest / easiest program with the first bond approval coming over in about 1 day!  Only a one page application is needed – no financial statements.  The program is predicated on the work being simple and normal for the contractor, and personal credit reports of owners and spouses must be acceptable.

This door is perfect for companies that are not pursuing contracts in excess of $350,000.  Other applicants can also use it as a quick way to start while completing the application process for higher amounts.

As with all the doors, there is no charge to get pre-qualified for bonding!

Door Number 2:

This is for contracts up to about $500,000.  Similar to Door Number 1, but now add “in house” company financial statements and / or tax returns. A longer questionnaire is needed, and supporting documents such as resumes, references and personal financial statements may be required.

Door Number 3:open_door1

For contracts in the $500,000-1,000,000 range, plan on a CPA prepared Compilation statement.  This is the lowest level (least expensive) CPA financial report.  It is needed once per year.

Door Number 4:

Contracts over $1 million may require an annual CPA Review financial report.

Number 5:open_door5

For large contracts in excess of $10 million, a CPA Audit may be required by the underwriters.

It makes sense that as the obligations become larger, higher quality, more complete information is needed.

Is there some flexibility?  Sure!  It may not seem so, but underwriters are motivated to be flexible and find ways to write the business.  After all, no bonds = no revenues.  They must find ways to say yes.

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.

Secrets of Bonding #111: WIP Quiz

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 When it comes to Bid and Performance Bonds, nothing may be required more often than financial statements and WIP schedules (Work In Process aka Work On Hand).  For mood music, click here.australian-whip

The WIP schedule could be required monthly for active bidders.  Certainly, the construction company management team monitors this critical info.  It tells the tale of how things are going, and where they’re headed. Profitability is revealed.  It is a preview of the upcoming Profit and Loss section in the next financial statement.  Poor results on the WIP schedule equal low Gross Profits on the next P&L – and maybe a net loss.

Let’s look at a couple of examples and see if you can spot what’s going on.  For the sake of illustration, we’ll use an abbreviated format.

On each of the following WIP schedules, compare the expected profit upon completion to the original profit estimate.

Joe Shmoe Construction

Project

Current/Revised Contract Amount

Original Gross Profit Percentage

Billed to Date

Costs to Date (Including change orders)

Revised Remaining Costs to Complete

1001

$1,000,000

10%

$700,000

$602,000

$202,000

Is the current profit projection more or less than originally expected?

  1. More
  2. Less
  3. Exactly right

 

Global Construction and Gutter Cleaning

Project

Current/Revised Contract Amount

Original Gross Profit Percentage

Billed to Date

Costs to Date (Including change orders)

Revised Remaining Costs to Complete

4321

$1,000,000

10%

$700,000

$602,000

$410,000

Is the current profit projection more or less than originally expected?

  1. More
  2. Less
  3. Exactly right

 

Dummenhappie Contracting

Project

Current/Revised Contract Amount

Original Gross Profit Percentage

Billed to Date

Costs to Date (Including change orders)

Revised Remaining Costs to Complete

007

$1,000,000

10%

$700,000

$630,000

$270,000

Is the current profit projection more or less than originally expected?

  1. More
  2. Less
  3. Exactly right

 

Got your answers?  Let’s go over these:

Joe Shmoe originally projected $100,000 profit (10% of $1,000,000).  Now it has nearly doubled! (602,000+202,000=804,000.   1,000,000-804,000=196,000)  “a. More”

Global starts with the same numbers (to help illustrate our point), but the costs are different.

(602,000+410,000=1,012,000   1,000,000-1,012,000= -12,000)  Not only has the profit margin slipped, it exceeds the contract amount resulting in a projected overall loss. “b. Less”

And finally Dummenhappie.  This one is amazing!  They are about ¾ of the way through the project (actually 70%), and right on target profit wise. The expected profits and total costs are exactly as predicted before they started the work.

(630,000+270,000=900,000   1,000,000-900,000=100,000)  “c. Exactly right”

Think about that. This answer “Exactly right” means prior to actually starting the project, they accurately predicted the exact number of labor hours.  Do you think the reality of the project might be somewhat different from the prediction?  Maybe they will hit unexpected obstacles and things will go slower (higher labor costs).  Or they may find more efficient ways to perform the work as it progresses (lower labor costs).  The cost of material purchases can also vary.  Get the point? It’s hard it imagine any project in which the costs can be perfectly predicted in advance.

indy-whipSo what’s going on here if Dummenhappie isn’t brilliantenluckie?  Our assumption is that the contractor has failed to RE-estimate the remaining costs to complete.  They are still relying on the original estimate – not analyzing the actual “costs to complete” during the life of the project.

Relying solely on the original cost estimate is a dangerous and weak practice.  The contractor may be unpleasantly surprised if unanticipated costs (such as labor inefficiency) have eroded the profit margin.  The worst part: They won’t know about it until the end, when it’s too late to make a correction!

Surety underwriters will detect if the remaining costs are not being reevaluated.  It reflects poorly on the contractor’s management practices.  It also means their profit projections may be totally unreliable.

The solution is to keep accurate records of the labor and material costs that go into each job, and periodically reevaluate (re-estimate) the remaining costs to complete. 

You can have a lot of fun with WIPS!  We’ve just touched on one part in this article. The analyst must not only review the profit trend, but also the method of calculation to confirm that accounting procedures are appropriate.

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.

Secrets of Bonding #74: Twofers

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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. fia_surety_logo

 

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417
Visit us: www.fiagroup.com
We are currently licensed in: NJ, PA, DE, MD, VA, NC, SC, WV, TN, FL, GA, AL, OK, TX

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
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Morris Plains, NJ 07950
Office: 973-541-3417

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