Florida Institute of CPAs - Are You Unsure About Surety?

With the construction industry in the middle of a downturn, many contractors are having financial difficulties. Although there was an abundance of construction work in 2006 and 2007, there now are fewer projects because it’s more difficult for project owners to find financing. This has resulted in much less construction work than in previous years. Public works is one of the few areas where construction projects are still beginning.

The ability to bid on and perform construction projects for government jobs often requires the ability to provide a surety bond to the project’s owner. Because of the lack of construction projects in other areas, public works jobs are becoming more competitive to bid. Private commercial jobs also often require the contractor to provide a surety bond. The ability to provide surety bonds for construction projects is becoming a key competitive advantage to contractors.

What Is a Surety Bond?
When a contractor fails to pay a subcontractor, supplier or employee on a private job, the unpaid party often has a right to file a lien against the owner’s property. The property can generally not be transferred without the satisfaction of the lien. Public-owned construction projects cannot have a lien placed against them, so surety bonds often are required.

Many private jobs also require the contractor to provide a bond to protect the owner. A surety bond is a guarantee by a surety company to the owner of a construction project to pay to finish a job, or to pay any unpaid laborers, subcontractors or suppliers on the project.

If a contractor fails to complete a job, or leaves employees, subcontractors or suppliers unpaid, the surety steps in to pay the them or hires a contractor to finish the project. The company that provides the surety bond to the owner then must pay the surety back for any costs the surety company incurs.

How Does a Contractor Qualify to Bond Work?
Surety bonds are a credit relationship. Surety underwriters evaluate contractor risk and work for the surety company. Surety agents sell surety bonds to contractors for the surety company. Contractors provide surety agents detailed company and financial information which they, in turn, supply to sureties in a process that’s similar to applying for a bank loan. This process, called pre-qualifying, generally is much more involved than in banking credit relationships. The intended result is for the contractor to become qualified to bond a certain amount of work (called an aggregate bond line) and a certain job size (called single job limit).

What Information Does a Surety Want To See?
Financial statements and tax returns are among the information that sureties review in their evaluation. Financial statements generally should be audited or reviewed, and prepared on a percent complete long-term contract basis under Generally Accepted Accounting Principles (GAAP). Other Comprehensive Basis of Accounting (OCBOA) statements are not useful to sureties.

Small contractors sometimes can use compiled financial statements, but this usually results in a very low aggregate bond and single job bond line. Audited statements provide additional assurance that usually makes a difference in the size of bond lines a contractor is assigned. Governmental agencies often require audited statements in order to become qualified to bid their work.

Sureties are sophisticated users of financial statements and look for financial and nonfinancial disclosure beyond what GAAP requires. Job schedules for all completed and uncompleted jobs that reconcile to the revenues and direct costs shown on the income statement should be included in supplemental information to the financial statements. Other financial statement disclosures expected by sureties include:

Disclosure of book tax accounting differences and tax deferrals for flow through entities
Subsequent year distributions to flow through entity owners
Disclosure of outstanding surety bonds
Gross profit backlog information on uncompleted and signed but not started jobs as of the financial statement report date
Disclosures of accounts receivable and payable, and retained accounts receivable and payable, by completed and uncompleted jobs
Supplementary consolidating schedules
Disclosure of succession plan and buy sell information

In addition to a company’s financial statements and income tax returns, sureties generally require a great deal of other information. Some of that information includes periodic interim internally prepared financial statements; the owners’ personal financial statements; ageing schedules of accounts receivable and payable; equipment schedules; owner and key person resumes; copies of banking agreements and notes; and personal and corporate indemnity agreements.

How Do Sureties Calculate Bonding Capacity?
Financial strength usually is more important to a surety than the results of a contractor’s operations. The most important determinants of bonding capacity are found on a contractor’s balance sheet.

One key financial indicator is adjusted working capital, which a surety calculates by subtracting current liabilities from current assets with adjustments. Adjustments may be made to remove assets such as inventory, related party receivables, and prepaid expenses from the total. Noncurrent cash value of life insurance may be added to the adjusted total. The aggregate bond line usually is some multiple of the adjusted working capital. The multiple value depends on the risk associated with the contractor.

Another key financial indicator sureties use is the ratio of total liabilities to equity. Most sureties have a ceiling on the amount of debt and other liabilities a contractor has for a given amount of equity.

How Can Contractors Improve Their Bonding Capacity?
Best of class contractors have good internal controls and pay attention to their businesses. Since business capital drives bonding, contractors should pay attention to the amount and character of their working capital. Contractors whose working capital is deteriorating often seek to increase their bonding capacity by injecting their business with more capital. Contributing cash to the company as equity increases their adjusted working capital and equity. Sometimes stepping up a financial statement engagement from a review to an audit also has an effect on the bonding line. Being familiar with a client’s or company’s surety agent and underwriter and communicating with them periodically also is very beneficial to the surety relationship.

Surety relationships are becoming increasingly important in the current economic times. Because of increased competition for work, and because many contractors are experiencing financial difficulties, the ability to provide surety bonds for construction projects has become very important to contractors.

John Reed, CPA is a construction and real estate principal with LarsonAllen LLP in Fort Myers. He is chair of the FICPA Construction Industry Conference Committee and a member of the association’s Editorial Committee.