A Flight to Quality: Proper Financial Statements are the Key to Surety Bonding in Any Market
By Jeffrey P. Deldin CPCU, AFSB, Executive Vice President, World Insurance Associates LLC
As the surety bonding market continues to tighten, many contractors are feeling the effects in their programs. Rates are increasing, underwriting conditions are tightening, and managing these programs are becoming increasingly harder. Although the surety underwriting philosophy has not changed (The 3Cs – Character, Capacity, Credit), surety companies are being required by their underwriting guidelines and resinurers to make sound financial judgments on their existing clients and new prospective accounts. One major requirement is for the contractor to obtain properly completed financial statements that include all the necessary schedules and cost information. In order for your company to keep up-to-date with this underwriting requirement, below is some information on what the surety companies are looking for.
First, there are three types of financial statements – Compilation, Review and Audit.
- Compilation is the lowest form of financial statement assurance, as the CPA is not obligated to make inquiries.
- Review of a quality statement provides a much higher degree of assurance but less than a full audit. A review consists of the CPA making inquiries of management and tests of the financial numbers, which enable the CPA to express a limited assurance that there will be no material changes in the financial statement.
- Audit provides the highest degree of financial assurance as the CPA applies extensive tests and analytical procedures to the numbers and management. Most sureties in today’s market will require a quality financial statement review as they provide some financial assurance at a moderate cost to the contractor.
Compilation quality statements are much less expensive and are still considered acceptable to a surety company with additional background information. However, compilation quality statements will limit the contractor’s ability to bid larger jobs ($750k & higher) and carry larger aggregate work programs. The surety companies will always prefer an audit as they provide the most financial assurance. Audits are mostly for contractors who do large single jobs ($10,000,000 & higher) and/or carry substantial backlogs. The cost of an audit is much higher than a review due to the increase amount of work the CPA has to perform. The question to ask yourself when considering what degree of financial statement to obtain is; how much bonding do I want? If you want to grow your bonding program to large multi-million-dollar projects, or handle large amounts of work at one time, a review or audit quality financial statement is recommended.
Second, all surety companies require that the contractor’s financial statement be prepared using “percentage of completion accounting” or POC. POC accounting recognizes revenue and cost throughout the life of each contract giving the surety company an accurate picture of the contractor’s financial position. In addition, using POC accounting on year end and interim financial statements allows the surety to accurately review a contractor’s sales, gross profits, receivables, underbillings, payables, and overbillings as it relates to each project.
Third, in each year-end and interim financial statement the surety company requires the financial statement to include work schedules for open and completed jobs as well as cost breakdown schedules for direct and overhead expenses. The work schedules allow the surety underwriter to accurately analyze each open and closed project that the contractor has on hand. The work schedules should properly “tie into” the financial statement’s balance sheet and profit and loss statement so the underwriter can see on how gross profit was derived, what projects are overbilled or under billed, and if there are any jobs with gross profit fades. Finally, the cost breakdown schedules allow the underwriter to review what costs were incurred throughout the specific time period, and provides the surety with a better understanding of how the contractor is operating.
What does all this mean to you and how can your company use the above information to your benefit? If you have a company that relies heavily on surety bonding, or want to grow in the public bonding sector, obtaining review or audit quality statements using percentage of completion accounting that include the necessary work schedules and cost breakdowns is essential. The investment your company makes into this area will benefit your firm by being able to obtain higher bonding capacity, lower rates, and an overall ease of maintaining your bonding program in any type of market, soft or hard. More importantly the investment will have an equitable return to your company by allowing your firm to better compete in today’s hard marketplace.