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Financial Statements: A Basic Overview, Surety’s Expectations and the Importance of a Qualified CPA
Financial statements provide an overview of a business’ financial position, performance and changes in the financial position at a particular point in time or throughout a specified reporting period. With regard to surety underwriting, financial statements are a key component in determining a contractor’s single job and aggregate bonding capabilities.
The four main components to a financial statement and their general purpose are as follows:
- Balance Sheet
Provides a company’s assets, liabilities and equity position at a particular point in time
(i.e. as of 12/31/2008)
- Income Statement (often referred to as a Profit & Loss Statement) Reports the revenue/sales/income, expenses and profits of a company over a period of time (i.e. for the period 1/01/2008-12/31/2008)
- Statement of Cash Flows Provides details regarding the cash flow activities of a company over a period of time with regard to operating, investments and financing activities
- Statement of Retained Earnings Explains the changes in a company’s retained earnings (portion of net income undistributed by the company to its owners or shareholders)
A Simple Overview of some Construction Based Accounting Methods:
- Cash Basis Cash basis accounting simply acknowledges for income/revenues and expenditures only as they have been physically received or paid. Be advised that cash basis accounting is not useful to the surety underwriting process.
- Accrual Basis Accrual basis accounting recognizes income/revenues and expenditures as they are physically received or paid as well as those that have been billed thus, represents accounts receivable and payables, as well.
- Percentage of Completion The percentage of completion method of accounting is generally utilized by construction contractors and is an accrual based accounting method which includes the recognition of income/profit on projects which are not complete as of the period in which the financial statement is being reported.
- Completed Contracts The completed contracts method of accounting is similarly utilized by construction contractors and is an accrual based accounting system which only includes the recognition of income/profit on projects that have been completed prior to the ending period in which the financial statement is being reported.
Internally Generated Financial Statements v. CPA Prepared Financials:
- In-house Financial Statement On a typical basis, company’s maintain an in-house accounting software program such as Quickbooks, American Contractor, Timerline and Peachtree to reconcile bank statements, track receivables and payables, manage equipment costs and depreciation, administer job costs and billings, facilitate payroll, etc. In essence, they assist in managing the overall finances of the organization. For surety underwriting purposes, internal financials are useful for limited surety bond programs for contractors. On a typical basis, it is beneficial to provide the Bonding Company financial statements for a minimum of two to three consecutive fiscal year-end periods. In addition, there is only the need of supplying a balance sheet & profit and loss statement, generated on the accrual basis, as the statement of cash flows and retained earnings are not fundamental to the underwriting process on in-house financial statements.
- CPA prepared Financials CPA is the acronym for Certified Public Accountant. A CPA is an individual who has passed the necessary examination and have met all state mandated educational and experience requirements needed for the preparation of financial statements. They adhere to the applicable generally accepted accounting principles (GAAP) when preparing, presenting and reporting financial statements on behalf of their clients.
CPA Financial Presentations:
Contractor Bond Programs and the Surety’s Expectations with regard to Financial Statement Presentation
- Compilation The most basic financial statement in which a CPA prepares is a compilation. In essence, the CPA gains familiarity with the business and industry in which the company for which he/she is preparing the compilation operates. In addition, they gain an understanding of the manner and methods the company utilizes to gather their financial information. The CPA then arranges this information into a financial statement format and interprets the financial on a minor level to determine that it is free from any obvious material misstatement. Nonetheless, a compilation does not provide any form of CPA assurance of the information contained in the financial statement.
With regard to a reviewed financial statement, the CPA will perform inquiries and analytical procedures as a means of determining that it is presented in compliance with GAAP (generally accepted accounting principles) and includes all disclosures required by GAAP. The process of going through the CPA inquiry process is indicative that a company has the ability to procure the necessary backup documentation needed by the CPA to generate the financial statement. Although a reviewed financial statement does provide some assurance from the CPA, it does not require them to understand a company’s internal controls or test their accounting records.
CPA audited financial statements have similar characteristics to a review however, they provide the highest level of assurance that they are presented according to GAAP and are a great deal more in depth than a compilation or a review. The audit process requires a CPA to gain and document a broad understanding of the clients business, internal controls and accounting procedures. In addition, the CPA will make inquiries, perform analytical procedures and test the company’s accounting procedures.
Contractors looking to secure, maintain or grow their surety bond capacity on a single job and/or aggregate basis should be aware of their surety bond agent and underwriters needs or requirements pertaining to their corporate financial statement presentation. On a generalized basis, financials that are generated on an internal basis, without the assistance or review by a CPA, typically do not provide a tremendous amount of negotiating power when presented to a surety underwriter, unless it is being provided on a quarterly, semiannual or interim basis of having a qualified CPA generated financial. Generally speaking, internally prepared financials often limit the single job and aggregate bonding capabilities of a contractor until CPA financials are prepared. It is important to mention that should in-house financials be an only option for a contractor, it is important that it be presented on an accrual basis. Cash basis statements and those prepared for tax purposes are not generally useful to the surety underwriting process.
In broad underwriting terms, should a contractor wish to secure bonding on projects larger than $250,000, CPA compiled financials are of great assistance to the underwriting process. In addition, as a contractors bond needs grow, the requirement of a reviewed financial typically is set forth when pursuing projects in excess of $500,000 - $1 million however, underwriting procedures from surety to surety differ and exceptions are made under certain circumstances. CPA reviewed financials presented on the percentage of completion basis are preferred by bond agents and surety underwriters. Audited financial statements are generally prepared by large contractors for many purposes, inclusive of their bond needs. An audited financial statement is not typically required unless the single or aggregate bonding limits of a contractor are substantially large.
Should you have additional questions regarding contractor related financial statements, please feel free to contact The Bond Exchange. Our agents are experienced with the surety underwriting process and the expectations of the bonding company with regard to the financial statement a contractor should generate to maximize their bonding capacity. Upon request, we would be happy to supply a list of CPA's familiar with generating construction related financial statements.