In this article, we’ll explain how to understand the importance of year-end statements for contractors.
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What Are Year-End Financial Statements?
Every business owner needs to prepare year-end statements for many purposes including tax purposes, bonding capacity, banking requirements, among other reasons. Some businesses may be looking to attract potential investors, to secure financing for capital purchases, or may need to meet regulatory requirements to put together a CPA statement. A year-end financial statement typically consists of:
- A balance sheet providing a snapshot of the business’s assets, liabilities, and any stockholder’s equity at a particular point in time
- A profit & loss statement showing revenues and expenses for the year and the net income after subtracting expenses from revenues
- A cash flow statement measuring the cash generated by the business
These statements can be generated at any point in time, showing a company’s financial performance during that period. Some companies generate monthly internal financial statements, some report performance on a quarterly basis, and nearly all generate financial statements after closing their books out at the end of each calendar or fiscal year. This discussion focuses on financial statements prepared by contractors at the end of a calendar year.
There is one additional component commonly included in a comprehensive year-end financial statement for a construction contractor—a Work in Progress (WIP) report. When reviewed in conjunction with the balance sheet, it is used to show a contractor’s current and future workload and the current billing and cost status of each project.
Why Are Year-End Financial Statements So Important in the Construction Industry?
It’s common for project owners to require the contractors they hire to purchase certain surety bonds, such as:
- Bid bonds,
- Performance bonds,
- Payment bonds,
- Maintenance bonds,
- Supply bonds,
- Subdivision bonds,
- Site improvement bonds, and more.
Multiple bonds may be required for a large project, and some contractors often are working on multiple projects simultaneously. Every contractor must be prepared to demonstrate sufficient bonding capacity to support their projected workload in the coming months. Surety companies ask for financial statements as the basis for assessing contractors’ equity, working capital and liquidity, the key factors determining their bonding capacity. The financial information is the contractor and surety’s way of “keeping score” to ensure that goals and targets are hit, as well as measuring the capital base and cashflow available to make payroll, subcontractors, pay financing costs, among other items.
What Is Bonding Capacity?
Bonding capacity is similar to the credit limit established by banks. It’s the maximum amount a surety is willing to guarantee for a contractor for a single bond and in the aggregate for multiple bonds. For example, a surety might establish a single bond limit of $3,000,000, with an aggregate limit of $6 million for all bonded work at one time. For any contractor, especially those performing public work or working for certain GCs requiring bonding, the higher the bonding capacity, the better it is for growing the business.
How Do Sureties Determine Bonding Capacity?
Reviewing year-end financial statements can tell a surety a lot about a contractor’s financial stability, construction experience, and accounting practices. They look at such things as the contractor’s equity, working capital, and debt and the amount and type of work performed to determine the contractor’s ability to complete jobs successfully and avoid bond claims.
Sureties typically adjust certain numbers when reviewing year-end financial statements to determine bonding capacity. For example, the surety may remove accounts receivable over 90 days in their working capital calculations, unless there is a valid explanation for delayed receipt of payments or if it is retainage. They may only consider 50% of inventory as part of working capital. (As a reminder, working capital is equal to current assets minus current liabilities). There are other adjustments the construction accountants preparing year-end financial statements for contractors are certainly aware of.
What’s Involved in Preparing Year-End Financial Statements?
Large construction companies may have the in-house accounting talent to prepare periodic internal financial statements that support a surety’s bonding capacity determination. It’s common for contractors of all sizes to engage the services of a certified public accountant (CPA) to prepare their financial statements at year-end. There are several types of year-end statements, distinguished by who prepares them and how reliable they are considered.
- Audited statements have been reviewed, though not necessarily prepared, by an auditor, usually a CPA. The auditor verifies the contractor’s books and records as well as the records of its clients and vendors. We typically see CPA audited statements for contractors seeking in excess of $75-100 million aggregate bonding capacity.
- Reviewed statements provide some assurance they were prepared according to GAAP—generally accepted accounting practices. We typically see CPA Reviewed financials for contractors looking to achieve bonded aggregates in the $3 million to $75 million range.
- Compiled statements are prepared by an outside accountant, who may or may not be a CPA, but the accountant does not verify the information provided by the client. They provide no assurance of accuracy because they are only as reliable as the information provided by the contractor. We typically utilize these statements for contractors looking to achieve a bonded aggregate of $1 million to $3 million.
- Company-prepared statements are prepared internally with no review or input from an outside accountant and are used primarily for the company’s own analysis and decision-making. These can be fine for periodic internal updates, however, for year-end financial statements, any contractors that are serious about achieving $2-3 million+ in bonding capacity should look to do a CPA Compilation or Review.
Many sureties require CPA-reviewed financial statements for the determination of bonding capacity in excess of $3 million.
Another issue that comes into play in the preparation of year-end financial statements for construction companies is the accounting methods used, which may include:
- The cash method recognizes revenues and expenses at the time they are received or paid. This is the simplest of the various accounting methods, but it is typically not the most favorable in terms of bonding purposes as it does not include accounts receivable or accounts payable. It is common for most contractors to report their taxes on the cash basis and their bonding financial statements on the percentage of completion basis (POC basis) – see below.
- The accrual method recognizes accounts receivable when they are billed, not when the payments are received.
- The percentage of completion (POC) method is the method favored by most contractors and surety companies. It calculates the percentage of a completed project based on an estimate of the cost incurred to date, compared to the total estimated project cost. It provides the most accurate reporting metrics to-date and is best for both contractors and the bonding company in keeping an accurate pulse on results.
- The completed contract method (CCM) recognizes profits on a project only after project completion.
Accurate and timely construction record-keeping is essential to the preparation of reliable, accurate year-end financial statements. The resulting bonding capacity determination should be generous enough to support the current level of business and allow room for company growth.
Our surety bond professionals will gladly discuss with you the year-end and periodic internal financial statements you will need to provide and offer consultation on best practices to facilitate growth in your bonding program. Please call or reach out to one of our experts today!