A contractor’s bonding capacity is the highest amount of surety credit a bonding company will allow for the contractor. Typically, bonding capacity is given in terms of the largest single-project dollar amount a surety company would issue, and also the maximum total amount of bonding a contractor holds at any given time.
So what determines the amount of bonding capacity a surety company is willing to grant a contractor? The most influential factor in arriving at this decision is the manner in which the contractor’s financial statement is presented. It is a given that the financial statements should adhere to generally accepted accounting principles (GAAP). Let’s examine three important characteristics that pertain to financial statement presentation and how it affects bond capacity.
Cash-Based vs Accrual-Based Accounting
For many businesses, cash-based accounting is utilized because it is cost-effective, faster, and easier. Unfortunately, this type of accounting is not an option for contractors. This is primarily due to the fact that revenue from longer jobs is frequently not recognized until the job is completed entirely, which can roll over into the next year.
Accrual-based accounting is a more complete and accurate way of bookkeeping when the contractor’s accounts receivable and accounts payable are taken into account. This method also has the advantage of allocating revenues and expenses for jobs as they are actually incurred. Work-in-progress jobs often have over billings and under billings, which can dramatically affect the financial picture. Surety companies are unable to get an accurate assessment of a contractor’s financial situation unless accrual-based accounting is used.
Accuracy of the Financial Statements
There are three different levels of assurance when referring to financial statements that are prepared by a CPA: compiled, reviewed, and audited. Compiled financial statements are the contractor’s numbers presented in the standard financial statement format with no obvious errors. This level of assurance may not be enough to secure bonding. A review provides more value to a surety company, as with these financial statements the CPA has performed inquiries and analytical procedures. An audit is the highest level of assurance required for the purposes of bonding. In an audit, the CPA will perform procedures beyond inquiries and analytical procedures, including observation, testing, and confirmation of financial data.
What Can Be Interpreted from the Numbers?
The surety underwriters who determine the bonding capacity from a contractor’s financial statements focus on the available working capital and equity. Working capital is calculated by deducting current liabilities from current assets, and equity equals total assets less total liabilities. An often-cited metric for working capital is that it must be 5-10% of the contractor’s total backlog, or cost to complete current projects. Therefore, it is obligatory for the contractor to understand and abide by this benchmark so their bond capacity is not threatened.
A contractor’s financial statement preparation and presentation is one of the largest factors in determining how large of a bonding capacity the surety company will grant. Choosing the right method of accounting (accrual-based), ensuring the financial statements are at the level required and prepared by a CPA, and keeping the numbers in line with the surety company expectations are all important considerations when discussing bonding capacity.
Please feel free to contact us at Klein Hall CPAs if you have any questions regarding this matter.