The Significance of Financial Statements for Surety Bonds
No matter what your surety bond requirements are, financial statements will always be required to qualify for contract surety bonding. Your company’s financial statement is the main source of information about how successful you operate, your ability to withstand overall changes in economic conditions and how well you are positioned for future growth.
A surety bond guarantees that a contractual obligation will be fulfilled. In the construction industry, the surety bond typically guarantees that a construction project will be completed according to the terms and conditions of the contract. The financial statement will give the surety company a good indication as to whether a contractor has the financial strength to complete the bonded contracts that it proposes to enter into.
Financial statements – The basics
You may want to skip this section if you are familiar with financial statements, but if not this is worth reading. A basic financial statement is made up of three distinct components. They are the balance sheet, income statement and the notes to the financial statement.
The balance sheet
The balance sheet is a snapshot, representing the state of a company’s finances at a particular moment in time. The balance sheet should be compared with those of previous periods to give a sense of the trends that are playing out over a longer period. It should also be compared with those of other businesses in the same industry, to see how the company’s finances matches up to its peers.
A balance sheet is a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity. These three balance sheet segments give its reader an idea as to what the company owns and owes, and gives a numeric value of what the company is worth if it were to liquidate all of its assets and pay all of its debts.
The balance sheet adheres to the following formula: Assets = Liabilities + Shareholders’ Equity.
Assets, liabilities and shareholders’ equity are each comprised of several smaller accounts that break down the specifics of a company’s finances. These accounts vary by industry, however there are common components that readers and users of financial statements will come across.
Within the assets segment, accounts are listed from top to bottom in order of their liquidity, that is, the ease with which they can be converted into cash. They are divided into current assets, those which can be converted to cash in one year or less; and non-current or long-term assets, which are not easily converted into cash and thus aren’t considered assets that can finance direct costs of operations.
Liabilities are the money that a company owes to outside parties, from bills it has to pay suppliers to debt it has incurred to purchase assets or taxes that are owed to the government. Current liabilities are those that are due within one year and are listed in order of their due date. Long-term liabilities are due at any point after one year.
Shareholders’ equity is the money attributable to a business’ owners. It is also known as “net assets,” since it is equivalent to the total assets of a company minus its liabilities.
In most smaller privately owned companies, shareholders equity is made up of Retained earnings, capital surplus and shareholders loans that are not to be repaid within a specified period of time.
Retained earnings are the net earnings a company reinvests in the business. Net income left in the business will increase retained earnings while dividends distributed to shareholders will decrease retained earnings.
Capital surplus represents the amount shareholders have invested in excess of the “common stock” or “preferred stock” accounts in order to help capitalize a company in need of cash.
For the purposes of bonding, shareholders can agree not to withdraw their loans to the company allowing these liabilities to be counted as equity.
An income statement is a financial statement that reports a company’s financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period.
Unlike the balance sheet, which covers one moment in time, the income statement provides performance information about a time period. It begins with sales and works down to net income. The income statement is divided into two parts: operating and non-operating. The operating portion of the income statement discloses information about revenues and expenses that are a direct result of regular business operations.
A contractor’s Gross Profit can be found in this section. The non-operating section discloses revenue and expense information about activities that are not directly tied to a company’s regular operations. The expenses in this section are also known as Overhead.
Notes to the Financial Statement
The notes to the financial statements provide additional information about the accounts found in the balance sheet and income statement. Details important for readers of financial statements are summarized separately for the sake of clarity because these notes can be quite long, and if they were included, they would cloud the data reported in the financial statements.
Notes are used to break down inventory and asset categories while outlining depreciation that has been incurred. They are used to clarify terms of debt repayment including term and interest schedules. Notes may provide additional information used to clarify a point. This can include further details about items used as reference, a clarification of any applicable policies, a variety of required disclosures, or adjustments made to certain values.
Basis of Presentation
You may have heard that your financial statements must be prepared on a review engagement basis in order to qualify for bonding. What exactly does this mean?
There are three types of financial statements prepared by a Chartered Professional Accountant and they each provide different levels of detail and analysis.
The most thoroughly verified statement is the CPA Audit. The objective of an audit engagement is to enable the independent professional public accountant to issue an opinion on the fairness of the client’s financial statements. An audit is meant to provide “reasonable assurance” that the financial statements are free of material misstatement and are in accordance with Canadian accounting standards for not-for-profit organizations.
Auditors use a variety of methods to determine if the financial statements are free of material misstatement, including study and evaluation of internal controls, inspection of documents, physical counts of assets, making enquiries inside and outside the company, and other procedures that support the Canadian generally accepted auditing standards for not-for-profit organizations.
A Review Engagement
While an audit is meant to give some assurance that the financial statements are free of material misstatements, a review engagement is only meant to ascertain whether or not the financial statements are believable or plausible.
A review provides limited assurance that the financial statements conform to generally accepted accounting principles. This type of assurance is known as negative assurance. This means that as the professional accountant is only providing assurance that nothing has come to their attention that would indicate the financial information is not presented in accordance with Canadian accounting standards for not-for-profit organizations.
An audit, on the other hand enables a positive assurance allowing the accountant to state in their auditor’s report that the financial statements are in accordance with Canadian accounting standards for not-for-profit organizations.
The Review Engagement is the most typical requirement a surety will have to establish a performance bond facility for a contractor. Especially if the limits required exceed $1,000,000.
Notice to Reader
A notice to reader or compilation is simply a compiling of information into financial statements, based on information provided by their client. No assurance is provided. Therefore a compilation is only appropriate where users do not need assurance that the financial information conforms in all respects to Canadian accounting standards for not-for-profit organizations.
Why is it important?
The basis of financial statement presentation is important because a contractor’s financial statements provide users with the information necessary to make economic decisions. Surety companies use these statements to make assessments about the contractor’s potential and future risks, while providing a basis for setting surety bond capacity limits and determining premiums. For smaller companies getting their first surety bond facility, a Notice to Reader statement may be acceptable for their first year doing bonded work but eventually the minimum standard is a review engagement.
Important Financial Information Derived from a Financial Statement
Some of the key metrics bond companies derive from these statements to make their judgements are:
- Working capital – current assets less current liabilities
- Net worth – owners’ investment in the contractor
- Debt to Equity – measure of the contractor’s financial leverage
- Coverage ratios – measure of a contractor’s ability to meet its obligations
- Contract/revenue backlog – amount and quality of the contractor’s uncompleted work
Construction – Oriented CPA
Time and time again we are asked by small contractors if they actually need a construction-oriented CPA and the answer is always yes!
A construction-oriented certified public accountant (CPA) stays up to date in accounting and tax matters having to do with a contractor and imparts sound financial, tax and management counsel to the contractor.
For small contractors, surety bonding will grow to become an important part of his/her business and their ability to obtain performance bonds and bid bonds will make the difference between getting jobs or not. In turn, obtaining surety credit is greatly facilitated by having properly prepared financial statements and by making sound business decisions with the advice of a construction-oriented CPA.
A good construction-oriented CPA usually knows the surety companies and the surety bond producers, as well as the banks that are friendly to contractors. This familiarity and trust brings an additional level of credibility to the contractor’s table and, invariably, turns into more surety and/or bank credit.