If a CPA provides the accounting service for a construction contractor or subcontractor, chances are the client has needed a surety bond. Many contractors entertain mainly federal or public works projects, all requiring bonds.
For some 85 years, by law, the contractor, when awarded a contract, has been required to provide bid, performance and payment bonds as security to federal or public owners to protect taxpayer dollars. Often the prime general contractor will require bonds from its subcontractors.
The 3 Cs of suretyship — character, capacity and capital — have been a constant over the years in evaluating contractors. The surety relies heavily on the CPA when assessing a contractor’s capital and determining the amount of bond credit that can be provided. Here are suggestions for a contractor’s CPA to help the bonding company in its evaluation:
We can agree that the CPA, the surety company and the banker benefit from the success of our mutual contractor client. We should work as a team on behalf of that client. Just as the financial wherewithal of the client depends, in a major way, on the surety credit that the bonding company is able to offer, the surety also must rely on the CPA financial statement and the internal accounting that the contractor produces. The quality of the information provided is critical so as not to raise unnecessary questions — the more information, the better. Detailed information will often allow the surety underwriter to enhance the bond credit. It also can aid the bank in determining the credit line it is willing to offer.
CPA and internal financial reporting
Contractors rightfully want to know what their company’s bond limit is at any time. But to make that decision, the bonding company depends on current information from the CPA and the contractor’s internal recordkeeping.
Unless otherwise specified, the CPA reviews the contractor’s financials and prepares a statement once a year.
An accurate internally prepared financial statement is critical to gauging the contractor’s profitability and net worth, and the CPA can help the contractor improve its internal paper. For example, when in-house financial statements use a different method of reporting revenue (i.e., cash basis) than a CPA’s year-end statement using the accrual or percentage-of-completion method, or its hybrid, the surety is forced to make analyses akin to comparing apples to oranges. In this position, the surety underwriter will err on the side of conservatism, which might negatively impact the amount of surety credit offered. When internal accounting accurately reconciles to the CPA’s report, the underwriter has no need to guess.
Prompt CPA statements are important. The norm once was that a CPA review could be produced three months after the year’s end. Each year it seems to take longer. The longer it takes, the more the bonding company must rely on the contractor’s in-house, year-end statement — which does not carry the authority of a CPA review. This lowers the amount of bond credit the contractor can qualify for.
It behooves the contractor to supply their CPA the information it needs in a timely manner. If a contractor’s tardiness is hampering the CPA’s ability to provide a financial report, a discussion with the client by the CPA and the surety should take place.
Surety underwriters look for assets that can be turned into cash in 90 days, and trade account receivables typically make up a fair amount of current assets. Unless there is information to the contrary, the underwriter will disallow receivables that are 90 days or older (not including retention). That reduces the amount of working capital and net worth and therefore, typically reduces the amount of available bond credit. Absent a receivable aging schedule, a note from the CPA discussing receivables can allow the underwriter to maximize the amount of assets from which the working capital or net quick assets can be determined. Also, knowing the amount of receivables that were collected after year end is beneficial to the analysis.
Reducing the client’s tax liability is a function of a CPA’s service. But when the client is a contractor with bonding needs, however, mitigating a substantial amount of tax liability might negatively impact the balance sheet and income statement, thereby reducing the surety credit the bond company is willing to offer — and thus limit what the contractor can bid for. Some newer contractor companies don’t realize they can report taxes on one method (i.e., cash) but report the financial statements on the accrual or percentage-of-completion (or the hybrid) method.
With exception of some very large firms and/or publicly traded entities, most of Old Republic Surety’s contractor clients are Sub-S corporations or LLCs (pass-through entities as respects tax liability). The surety underwriter will attempt to drill down on the tax liability that the owners of the company might incur, because ultimately payment toward the liability will come from the company. This information is typically not reflected on the CPA-reviewed statement, other than in the form of member draws or stockholder distributions. As such, the underwriter will attempt to evaluate the financials as if the company were, in fact, a C-Corp relative to tax liability. The underwriter will err on the side of conservatism in its determination of possible tax liabilities and adjust the financial analysis to incorporate the possible tax expenses. The actual taxable income and tax burden that is passed through to the owners of the business may be significantly less than what the underwriter calculates. This issue alone can impact the analysis of net profit and working capital, and sometimes that results in reduced surety capacity. The bond companies don’t want our mutual client to pay Uncle Sam more than necessary, but a balance between mitigating tax liability and maintaining the balance sheet should be considered.
One way to alleviate the possible misunderstanding of this is for the CPA to elaborate on taxes and distributions in the notes included in the financial statement. Some CPA firms will outline in the notes tax calculations that would be made if the clients were a C-Corp, including current and deferred tax liability, and sometimes the note goes further to outline the amount of tax liability that is included within the distributions or member draws apart from non-tax-related distributions. This helps to keep the underwriter from guessing and ultimately benefits the contractor. Knowledge of quarterly estimates that the contractor may pay is also a valuable piece of information for the underwriter to be aware of while analyzing tax liability.
The contractor should provide the surety with a completed contract list and a work-in-progress (WIP) schedule. The surety underwriter uses them to evaluate the projects and look at any increase or decrease in contract price, differences in profit trend, cost in excess and billings in excess and then try to determine what projects are bonded.
However, often we receive a contractor’s internally prepared WIP schedule that identifies projects by name, but the CPA reports WIP projects by job number, or vice versa. WIP schedules are unnecessarily confusing when it’s unclear which project name and job number match. They need to be identified and reported consistently, or errors might be made that will, at the very least, create unnecessary questions. The same request should be made to our contractor accounts and, once again, this exercise is ultimately for the benefit of our mutual client.
It’s about our mutual benefit
The above suggestions are not intended to make the surety underwriter’s job easier, or to create additional work for the accountant, but rather to encourage teamwork with the CPA and contractor. When reporting is accurate, clear, consistent and timely, the surety can make better informed decisions and ultimately provide exceptional support to our mutual customer.
Jeff Draper is Bond Manager for Old Republic Surety's Portland, OR branch.