Accounting and Financial Reporting
Accounting and financial reporting involves the representation of transactions and other past events, in the form of dollar amounts. Users of financial statements have needs for these types of information, and these needs vary depending on whether the users are internal (management), or external (grantors, creditors, vendors, or customers).
Surety bond underwriters are usually one of the most critical types of external users of construction financial reports and many aspects of the surety underwriting process have a direct bearing on contractor reporting as it has developed over the years. It is, however, the contractor's responsibility to ensure that the company's financial statements accurately reflect the financial position and operating results of the company, and includes all disclosures necessary to make the financial statements meaningful to the contractors surety. Proper presentation of a contractor's financial position is key to the process.
The type of engagement a Certified Public Accountant, (CPA), performs is driven by the interests and needs of its recipients. Audited financial statements are preferred by the surety but Review quality statements are generally acceptable for the small to mid size contractor. Compiled statements provide no assurance and is NOT acceptable to the surety when doing the annual report.
The quality of the CPA, and the degree of involvement with the financial statements is critical to obtaining the optimum level of surety bonding. It is important that a contractor seek a CPA who knows the construction industry and the peculiarities of construction accounting and financial reporting.
Audited Financial Statements provide the highest level of CPA assurance that the financial statements are fairly stated and free of material misstatements. This high level of assurance is attributable to the extensive standards CPA's performing audits must abide by, including a comprehensive review of reporting procedures and testing which includes outside verification of balances with owners, clients and suppliers. These stringent auditing standards provide CPAs with a foundation to form their opinion on whether the financial statements are fairly presented, in all material respects, according to generally accepted accounting principals, (GAAP).
The CPAs’ opinion is communicated in a signed report, (The Auditors' Report), which accompanys the company’s financial statements. The auditors’ report must disclose any material deviations from GAAP within the financial statements or other significant matters they believe should be emphasized.
Review Financial Statements include analytical procedures designed to determine whether the amounts and other information presented in the financial statements appear to be reasonable and sufficient for the CPA to express limited assurance and that there are no material modifications that need to be made to the financial statements to conform to GAAP. They are significantly less in scope than an audit, the object of which is to express an opinion.
Compilation Statements, in contrast to Audits and Reviews, provide no assurances or opinions as to its accuracy or compliance with standard GAAP accounting procedures. This limited engagement generally has the CPA taking the companies internal financial data and formatting it into a properly structured set of financial statements. While often used as part of a mid year report, a compilation is NOT an acceptable end of the year report for the surety.
Methods of Recognizing Income
It is important to note that contractors frequently use different methods of reporting income for financial statements purposes than they do for tax reporting purposes and while Cash based statements are not in conformity with GAAP or for statement purposes, they may be an acceptable means of reporting income for tax purposes.
Percentage of Completion...Most users, especially sureties and bankers, expect the use of the percentage of completion method of recognizing income because under this method, revenue, costs and gross profit are recognized in the earned accounting period throughout the duration of the contract. To use the percentage of completion, a contractor must be able to provide reasonably dependable estimates of revenue, costs and progress toward completion.
In computing the percentage of completion for a project, the most commonly used industry practice is to compute the percentage by dividing the total costs incurred to date by the total estimated contract costs. This method is referred to as the "costs to costs" method for measuring the percentage of completion. The computed percentage, (costs incurred to date divided by total estimated costs), is multiplied by the contract amount to obtain the total revenue to be recognized. When the revenue is recognized, the costs incurred to date that have contributed to contract completion are deducted to arrive at the gross profit to date for the project.
Completed Contract...Some smaller contractors and contractors that perform smaller short-term contracts, recognize income only when the contract is complete. This form of accounting is generally acceptable when the contractor has many short-term contracts and there is no material distortion from one accounting period to the next, i.e. revenues and expenses are both recorded in the periods when economic performance takes place. The percentage of completion method remains, however, the preferred by the American Institute of Certified Public Accountants, (AICPA). Percentage of Completion is also the method favored by most sureties, because it focuses on the most current economic activity of the contractor.
Cash...Income is sometimes recognized on a cash, accrual (billing), or some other hybrid basis and none of these are acceptable for financial statements that are prepared in accordance with General Accepted Accounting Principals (GAAP). This is because they do not yield a proper matching of accounting and expenses.
Supplemental Schedules (Annual Report)
General Accepted Accounting Principals, (GAAP), require several basic financial reports (balance sheet, statement of earnings, etc.), however sureties generally require several additional schedules in order to help them assess the financial strength and management controls of the company. These include:
-An Aging Schedule of Accounts Receivable
-Notes Payable Schedule
-Reconcillation of Contract Revenue and Costs
-Schedule of Contracts in Progress
-Schedule of Completed Contracts
-Schedule of Direct Costs
-Schedule detailing Unallocated Indirect Costs
-Schedule of General and Administrative expenses
As bonds are written, the surety will continue to evaluate and trend the overall performance and financial condition of the contractor. Several years ago, this entailed an annual review to establish specific surety lines of credit without much interim reporting. Today, given the complexities and perils of the construction industry, that is no longer the case.
It is now customary for sureties to receive quarterly financial statements and detailed work-in-progress (WIP), reports that enable the surety to track job profitability and cash flow. These may not have to be prepared by the CPA but they should always be timely filed and of the same quality and detail that you would get from the CPA.
A contract cost retrieval system that validates the financial status of any project on a timely basis is a basic requirement for a well managed construction company and conversely, the failure of the contractor to supply this information on a timely basis reflects adversely on financial management. Providing this information should not place any additional administrative burden on the contractor.