Performance bonding in the construction industry. (bonding working capital)by Dufek, Thomas N.
There are problems inherent in construction performance bonding, currently exacerbated by today's economy. Underwriters are concerned about liquidity and not GAAP. Contractors can structure their financials to work to the best possible advantage when dealing with underwriters.
The economic downturn of the 1990's carries new concerns for all businesses. Banking and other credit relationships are strained by new levels of credit consciousness. The same banks who were hungry and more aggressive in the late 1980's are now taking a conservative, credit-wary position when viewing all potential borrowers. For those familiar with the construction industry, it comes as no surprise that one result has been the infliction of additional burdens unique to this field.
As the commercial building and major improvement markets continue to shrink and housing starts languish, construction contractors, large and small, are attempting to find work wherever they can. They are bidding for jobs in areas and for customers with whom they have not previously done business. They may include governmental units, educational institutions, and other non-commercial entities. Considering the economy, prospective customers want to gain a level of confidence that contracts will be completed. The result is the requirement for contractor performance bonds becoming more and more common.
Obtaining a Surety Bond
To the construction contractor, of great importance is the development and preservation of relationships between construction contractors and the sureties providing performance bonds, including how and what financial information should be provided. There are a number of common pitfalls that contractors may encounter when attempting to obtain new performance bonds or when increasing or changing existing relationships with a surety. However, guidance in the form of planning techniques can be employed to overcome many of the problems confronted in the underwriting process.
Before looking at the problems and the possible solutions related to performance bonding, important unique aspects of the industry must be understood. As part of the underwriting process for bonding, insurance carriers typically request audited financial statements from the construction contractors.
A contractor seeking to engage an auditor to satisfy a bonding company's needs may wish pursue the auditor's depth of knowledge of construction industry reporting requirements and exposure to bonding companies. Moreover, the underwriters for the bonding companies often seek assurance that a customer's independent CPA has significant experience in the industry.
In addition to the basic financial statements reported on by a CPA firm, underwriters expect to find schedules of contracts in progress and completed contracts and a reconciliation of the income and the costs of these contracts to the current year's income statement. These schedules should be in a format that follows the industry norm and conforms to the AICPA Industry Audit Guide for Construction Contractors.
Certain balance sheet accounts are unique to the construction industry-- costs in excess of billings on uncompleted contracts (an asset) or billings in excess of costs (a liability). Using the percentage of completion method, costs in excess of billings result when the billings on uncompleted contracts are less than the income earned to date. These underbillings result in increased assets. Conversely, where billings are greater than the income earned on uncompleted contracts, a liability, billings in excess of costs, results. Examples of presentations and formats for these accounts, statements and schedules are included in Exhibits A through D. These examples provide some of the basics for the financial reporting on a construction contractor.
Many bonding companies request other specific information as supplementary data. A timely and detailed response can provide many answers to bonding agent's questions and increase the likelihood of a positive reaction to a request for bonding.
The absence of the appropriate and sufficient information in the financial statements will give rise to skepticism and, at the very least, additional questions from the survey. As a result the TABULAR DATA OMITTED bonding agent will be seriously inhibited in his or her attempt to convince the insurance carrier that the reward outweighs the risk of providing performance bonds for the contractor.
For many reasons the construction contractor must maintain an appropriate cost accounting system. Its records must adequately reflect job costs, the very heart of the business, and the essential ingredient in preparing accurate financial statements. The contractor, who may be preoccupied with daily operations, cash flow needs, and selling new work is often unable to dedicate the time or may lack the necessary skills to determine accurate cost data for each job completed or job in progress.
A controlled job cost system, often viewed as an accounting luxury in the past, has become a necessity for proper financial statement presentation and control of costs. Without controlled job cost information, accurate reporting on a basis acceptable to a bonding company becomes a burdensome chore.
The contractor who attaches importance to providing a surety with appropriate financial data in a timely fashion reaps the benefit of obtaining performance and bid bonds with much less difficulty than one who postpones the task. For the contractor who believes that a major portion of future work will require bonding, information gathering must be as important a priority as any other business building effort.
Bonding companies, especially in this economic climate, want to deal with contractors who are conscious of, and responsive to, financial reporting requirements. This responsiveness may seem an onerous task at the outset, but becomes more simplified as the ritual is performed on a regular basis. A member of the internal accounting or bookkeeping staff who understands bonding requirements can usually handle the detail work. This relieves both the owner and the CPA of the more mundane aspects of compliance. In addition to the obvious benefits to operating management, timely internally prepared financial data can provide a very useful tool to the bonding agent in convincing an underwriter and insurance carrier to issue a performance bond.
Required Financial Information
Bonding companies generally require, at least quarterly, schedules of aged accounts receivable, contracts completed, work in process, and new contracts obtained since the last reporting period. While internally prepared financial statements are acceptable quarterly, the surety may routinely request for a semi-annual review and year end audit, or in the case of the smaller contractors an annual review by a CPA.
Other information generally required by the surety includes personal financial statements for all principals--a compilation is usually sufficient--and documents describing banking relationships and details of agreements related to business succession and estate planning. The underwriter will be looking for the following:
* Does the contractor have any other liabilities or commitments?
* Are personal guarantees provided to banks?
* Are various key ratios reflected in the contractors' financial statements in compliance with covenants contained in agreements with banks or other creditors?
Also of concern to the underwriter is the contractor's ability to continue performance in the event of retirement, disability, or death of a principal or key employee. The absence of basic documents such as wills and shareholders' agreements can raise concerns about the continuity of the business. Their presence adds a further dimension to the surety's confidence level, providing the appearance and comfort of sound management and a concern for the business' survival by its principals.
The underwriting process begins upon receipt of financial information.
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Bonding Working Capital
Bonding companies have developed their own definition of the components of working capital on a contractor's balance sheet and depending upon the surety, that definition may vary slightly. For example, most underwriters will remove receivables from related parties and those trade accounts receivables over ninety days old from working capital. Inventory may be only partially included depending on the type of stock in trade, nature of the contractor, and preference of the surety. Prepaid expenses and other current assets are normally excluded. Many bonding companies will increase working capital by the net cash surrender value of officers' life insurance policies owned by the corporation.
The analytical process will generally include the underwriter contacting the principals of the construction contracting company, their internal accounting personnel, and perhaps a CPA. Then inquiries may include the means for repayment of related party transactions, the collectibility of accounts receivable, the adequacy of any allowance for doubtful accounts, and questions about the type, value, and turnover of inventory. If amounts due to officers appear on the balance sheet, the underwriter may seek subordination of this debt to the bonding company. The sureties generally frown upon intercompany transactions and loans to and from officers that are carried on the balance sheet from year to year. The ability to collect, or intent to repay such balances, is frequently called into question and is another means by which the surety may choose to reduce the contractor's bonding working capital.
When a CPA reviews or audits a construction contractor's financial statements, the contractor should be made aware that the implementation of a few planned moves on his or her part can enhance the value of those financials in the eyes of the bonding company. Following are some examples:
1. Maximize Cash at Year End. A substantial cash balance is the first number on the balance sheet and creates a positive first impression for the underwriter.
2. Borrow Against Cash Values. The client should consider borrowing against the cash surrender value of officers' life insurance to increase the cash and its working capital position, in the event that the surety does not add back cash surrender value.
3. Convert Old Accounts Receivable to Notes. Accounts receivable older than ninety days should be carefully reviewed. If management knows they will be collected in the forthcoming accounting period, conversion to formal notes can provide evidence as to the current nature of the obligation. The notes should mature within twelve months of the balance sheet date and, when possible, bear interest at a reasonable rate. This enables the underwriter to consider the notes as current assets instead of removing them as uncollectible accounts receivable.
4. Eliminate Related Party Items. To the extent possible, intercompany and other related party transactions should be reduced or, where possible, eliminated prior to the financial statement date.
5. Properly Structure Asset Financing. Fixed assets should be acquired with loans whose repayment terms approximate the useful lives of the assets. This is preferable to paying cash and using a current asset to fund something that will also benefit future periods.
6. Identify Liquid Assets. Any current asset that will convert to cash quickly should be segregated and clearly defined, for example, a significant tax refund. These items should not be lumped with other current assets, because the bonding companies generally do not include them in working capital. Liquid assets should be clearly segregated within the current asset section and labeled with a title that clearly denotes their current nature.
While some of the planning may seem basic, if overlooked the bonding working capital could be significantly decreased. A common rule of thumb among bonding companies is to grant performance bonds in an amount equal to ten times bonding working capital. Therefore, every dollar effectively turned into working capital through proper planning can be very valuable to your client.
Not a Cure All
All the compliance and planning, however, are not a panacea. The construction industry is in difficult economic times and the outlook, especially in the Northeast, is dismal at best. Bbonding companies are more concerned than ever with the contractor's ability to complete jobs and survive in this economic environment. How then do contractors and their CPA's work together to demonstrate to the surety the ability of the contractor to perform?
Begin by using some of the planning techniques described above, present the most positive financial picture possible, and improve cash flow and properly finance assets. These moves will place the contractor in a better light with the surety from the financial aspect. From the performance viewpoint, a contractor new to the bonding marketplace needs to start small. The only way a surety recognizes the ability to perform is by seeing historical performance. The contractor will not obtain bonding for large jobs in the absence of satisfactorily completing smaller ones. Historical performance cannot be overemphasized when entering the bonding arena.
The bonding environment, much like that of banking and other credit grantors, is more cautious than it has been in many years. Although this has created some new hurdles in obtaining performance bonds, the educated contractor who has shown an ability to perform and who recognizes the importance of timely reporting and properly prepared financial statements that show a sound financial position, will succeed in obtaining bonds.
Thomas N. Dufek, CPA, is a partner in Kilgannon, Furey & Dufek in Babylon, NY. Mr. Dufek is a member of the NYSSCPA and is active in the Construction Financial Management Association.
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