Proper accounting and financial reporting are essential for contractors who are moving beyond their first year or two of being in business. If you currently have a construction surety bond program that isn’t meeting your needs, you can improve it through better accounting and reporting practices. We can help you achieve this and secure the best surety terms and conditions for your business.
Most contractors start with “Fast Bond” programs, which don’t require financial reporting of any sort; they can be underwritten solely based on personal credit scores. However, as a company evolves and grows, it needs good accounting procedures and high-quality financial reports so that its surety agent can obtain a more sophisticated bond program with lower rates and increased capacity.
Starting Out: Accounting for Tax Purposes
At this phase, the main goal for new companies is to produce a profit and loss statement (P&L) or income statement for the company’s annual tax returns. Bookkeeping or accounting through accounting software like QuickBooks is common when a new company starts.
QuickBooks can also create a balance sheet and other standard reports, like an account receivables schedule and an account payable schedule. However, most brand-new contractors are only concerned about paying their taxes, so they’re primarily concerned about that income statement. These are often processed on what is called a cash-basis of accounting—at least initially.
Please Note: While there are many accounting software options available, QuickBooks is a popular and versatile program with other functionalities for business owners, therefore we’ll use it as our primary example throughout this article. We are not affiliated, showing preference, or promoting the company in any way.
What is Cash-Basis Accounting?
Cash-basis accounting is a method of accounting in which income and expenses are recorded when they are actually received or paid rather than when they are incurred. This means that revenue is recognized when cash is received, and expenses are recognized when cash is paid out.
Contractors, in particular, often use cash-basis accounting when they are just starting out because it is easy to understand and requires less time and resources to maintain. Overall, cash-basis accounting is a practical and efficient method for smaller businesses to manage their taxes and financial records. It provides a clear and accurate representation of a business’s financial health and helps companies make informed decisions about their operations and growth.
Introducing Accrual Accounting
Accrual accounting is a method where revenues and expenses are recorded when they are earned, regardless of when the cash is actually received or paid out. This means that transactions are recorded when they occur, not when the money changes hands.
Differentiating Between Cash-Basis and Accrual Accounting
The main difference between accrual and cash-basis accounting lies in the timing of transactions recorded. Accrual accounting provides a more accurate representation of a company’s financial position by matching revenues with expenses in the same accounting period, regardless of when the cash transactions occur. This method better indicates the company’s profitability and financial health over a specific period.
Grow (and Get Surety Bonds) with Accrual Accounting
As contractors grow and want to obtain surety bonds, surety companies will say, “Look, the cash statements are fine for taxes. However, we need to see your financial statements based on an accrual method of accounting.”
The accrual method helps surety agents understand the company’s current cash positions and can allow the underwriters to look into the future by comparing the difference between the accounts receivables (the money coming into the company) and the accounts payables (the money going out).
Transitioning from cash basis to accrual accounting may seem daunting initially, but it’s a significant step towards improving your financial reporting. Thankfully, within QuickBooks, it’s pretty easy to make that adjustment by toggling between cash and accrual.
As a contractor, making this simple adjustment within QuickBooks is a clear sign of your business’s growth and progress. Recognizing that the statements you’ve been producing on a cash basis are not suitable for surety underwriters is a crucial part of your business growth journey.
The Gold Standard in Construction Accounting
To refine the growth process further, a contractor can develop a work-in-progress schedule. In construction accounting, a work-in-progress schedule is a detailed report that tracks the financial progress of ongoing projects. It is typically handled outside of QuickBooks or your accounting software, often in Excel.
A work-in-progress schedule is even more sophisticated in predicting future cash flows because it captures underbilling and overbilling by recognizing revenue through a percentage of completion method.
This is the gold standard of construction accounting, as it allows them to accurately assess the financial health of their projects and make informed decisions based on the data provided. A work-in-progress schedule is key for contractors looking to become more sophisticated in their financial reporting processes.
CPA Statements and Surety Bonds
A contractor that has been in business for a couple of years and can now produce accrual or percentage completion-based financial statements, including income statements and balance sheets, on an annual or quarterly basis is ahead of the game. That’s better than most of their competition, especially for companies within the first three years of operation.
The next step, though, or the biggest hurdle they’ll encounter if they’re pursuing bonded projects, is that surety underwriters will then ask for CPA-prepared statements, especially if they’re pursuing bonded jobs that exceed 1.5 million dollars in size. The statements we just discussed are handled internally, called “internal statements.”
The next level is to engage a CPA who can provide “assurance services.” Within that definition of assurance services, you have three levels of engagement: audits, reviews and compilation statements.
Audited Statements
Audited statements are for the major players, such as contractors producing revenue above $50 million each year. They are often required by the Department of Transportation (DOT) or public municipalities that expect to work with large, sophisticated contractors. For example, the SEC requires all publicly traded companies to have audited statements.
Reviewed Statements
The next stage down are reviewed statements. This is the bread and butter of financial reporting from a surety perspective. Almost all contractors that generate between five million to 50 million dollars in revenue, if they’re pursuing bonded work, should be obtaining reviewed statements.
Compilation Statements
The last level of engagement includes compilation statements. This is a stair step from internal to reviewed statements. The CPA does not provide any genuine assurance at this level but helps the contractor structure their statements in accordance with Generally Accepted Accounting Principles (GAAP).
The Benefits of CPA-Prepared Statements for Contractors
Moving from internal statements to CPA-prepared statements presents many challenges for contractors.
Often, the biggest objection is the financial implication. Even the lowest level—compilation statements—typically range between $7,500 and $10,000 each year. Reviewed statements can range between $10,000 and $20,000. That is a significant financial burden for something that many people think is just an added accounting service that has nothing to do with their ability to build roads or schools.
However, CPA-prepared statements are beneficial for more than just surety bonds.
Benefit 1: Keep Track of Your Financial Growth
CPA-prepared statements are issued under the Generally Accepted Accounting Principles (GAAP) standards. This standardizes reports, so you can quickly look at financial statements from one year to the next and see changes in your financial metrics, and know that is being driven by your operations or changes in your financial position, not because of changes in how an internal bookkeeper is processing items in your accounting software.
Benefit 2: Remove Your Job Size Limitations
Engaging a CPA for prepared statements is a significant step towards expanding your business’s operational capabilities. While a surety underwriter may require these statements for jobs over 1.5 million dollars, the benefits are substantial. In exchange for this third-party level of assurance, your bond program rates can decrease, and your overall capacity can increase. This opens new opportunities for your business’s growth and success.
Your level of financial reporting will no longer restrict your job sizes and aggregate program sizes. They will be more dictated by your financial metrics and ratios, like your working capital and debt-to-equity ratios.
Benefit 3: Get Access to Lines of Credit
Your bank will also have similar expectations or requirements. The right set of financial statements helps banks reduce debt costs and/or increase accessibility to lines of credit.
Benefit 4: Construction-Oriented Expert Consultations
A construction-oriented CPA will have other clients with similar challenges and goals in your trade. They can provide expert consultation on improving your internal controls, risk management, and potentially even IT issues, such as deciding which accounting software to use.
Benefit 5: Create a Growth Strategy
Construction-focused CPAs can also examine growth strategies with you and help you identify projects to increase your company’s success. Advice from a CPA living and breathing the financial metrics of the construction industry can be extremely valuable and well outweigh any cost of that annually prepared statement.
Benefit 6: Prepare for the Next Step
As your company matures through its lifecycle, there will be an exit plan, whether you will pass your company down to your kids or key employees or sell to a third party. Your ability to produce GAAP statements can be extremely important from a valuation perspective and is instrumental in the sale or transition of your company.
How to Obtain CPA-Prepared Statements
Step 1: Find a CPA That Offers Assurance Services
Not every CPA provides assurance services. A tax accountant may not be able to provide reviewed statements. Therefore, the first step is determining which accounting firms can and are willing to provide statements for you.
Step 2: Find a Construction-Oriented CPA
Next, look for CPAs who focus on construction. They can help with your unique financial statements and improve bookkeeping practices, ensuring that your percentage of completion accounting provides the right ratios and metrics.
Step 3: Schedule in Advance
Scheduling is sometimes a concern because most contractors use a calendar fiscal year that ends on 12/31 and CPAs are busy during tax season.
Reaching out to a CPA in March and asking for reviewed statements will not get you much of a response. Do yourself a favor, and don’t wait until the last minute to start. The goal is to develop a relationship and engagement over the summer or fall of that preceding year.
Construction Surety Bonds for Successful Contractors
Contractors need to take a series of steps to improve the terms and conditions of their bond program. They want to move from a cash-basis to produce accrual-based internal statements, ideally with a work-in-progress schedule that ties in the percentage completion method of revenue recognition.
They need to be able to engage a CPA firm to provide compilation, reviewed or audited statements annually. Once that major hurdle has been crossed, the door is opened to obtaining surety bonds of the size and cost structure necessary for successful contractors.
Improve Your Construction Bonds with Evergreen Surety
Since opening the doors to our Colorado office, Evergreen Surety has become a trusted name in commercial and construction bonds. We support your company’s unique needs by getting to know every facet of your company. Then, by working with a wide variety of surety carriers, I can quickly help you find the best surety bond program with reliable results.
Call our office today at 303-520-0249 to get started!
