As explained in our last Surety Corner, providing accurate and timely interim financial reporting is a key factor in successfully growing your bonding facility.
The surety company wants to know throughout the year how your company is performing financially. When the results are positive this can lead to increased surety support. However, from experience, bond companies know that the internal financial reports are not always accurate and so the sureties often request a corresponding work in progress or work on hand report to allow for a deeper analysis of the financial report.
This report is produced at the same date as your financial statements and requires for each job the contractor input estimated costs remaining, costs incurred to date, total revised revenues to date and total billings to date. Using these numbers, the underwriter will be able to get a completion percentage for each job based on costs which they can then use to calculate the earned revenue. By comparing earned revenue to the actual amount billed, the underwriter can determine if the contractor is under or over billed and check to see if this is reflected on the financial statement.
What is an ‘under billing’?
When using the percentage of completion method of revenue recognition, there will be times where a contractor is underbilled on some of their projects. This means they’ve incurred expenses, but not yet billed the project owner. There can be a multitude of reasons for this including disputes regarding billings but for this example we will assume it is a timing issue and the billings are collectible. If so, and the contractor is not recording a provision for work in progress, then they are understating their interim profitability.
Under billings example:
- Contract value: $1 million
- Costs incurred to date: $350,000
- Costs remaining: $350,000
- Expected gross profit: $300,000
- Percentage of completion: Costs incurred to date/total expected costs = $350,000/$700,000 = 50%
- Profit earned to date: Expected gross profit * % of completion: $300,000 * 50% = $150,000
- Billings to date: $400,000
In this scenario the contractor has incurred costs to date of $350,000 and earned $150,000 in profit. As such, the total revenue to date on the project should be $500,000. However, the contractor has only billed $400,000. If an under billing provision isn’t taken then the contractor is understating their profitability by $100,000.
What is an ‘over billing’?
The opposite of being under billed is being over billed. This commonly means that the contractor has front loaded the billings on a project. If a provision for over billings isn’t made on the financial statements then they could be overstating their profit.
Over billings example:
Using the same figures in the above example, we know that the contractor has incurred costs to date of $350,000 and earned $150,000 in profit. As such, the total revenue to date on the project should be $500,000. However, the contractor has already billed the client for $700,000. If the contractor just records the revenue of $700,000 without an overbilling provision of $200,000 then they are overstating their profit.
Looking back at the XYZ Contracting example cited in earlier columns, the surety company wants to confirm that the six months interim profits of $300,000 on $1.5 million in sales are in fact accurate before agreeing to increase bonding limits off the additional profits.
After a thorough review of the work in progress report prepared by XYZ Contracting, the surety does in fact determine that XYZ is overbilled by $150,000. This results in the surety adjusting the interim working capital position of XYZ from $800,000 to $650,000.
However, despite the adjustment, the adjusted working capital position of $650,000 is deemed sufficient to increase XYZ’s bonding limit from $10 million to $12 million and the surety now agrees to issue the performance and labour and material payment bonds for the new $6.8 million contract.
The importance of interim reporting
Surety underwriters sometimes have little else to rely on except for financials. Although it can be a real challenge staying up to date with reporting while running a busy construction company, good quality interim financial statements produced on time can make a real impact on your relationship with the bond company. If your company is doing well, take the time to set things up right so that reporting becomes a simpler part of running your business.
Character plus relationships and trust
In two weeks time, our final part of this series will be focused on character plus relationships and trust. This last component is arguably the most important part of the surety relationship. You can consider this section to be the “I’m a man or woman of my word” component and we will break this down from a few different angles.
Jamie Collum is the vice-president of construction for FCA Insurance. He has delivered numerous seminars and presentations on construction bonding and general industry updates in Ontario to various construction associations over the years. Andrew Cartwright is the vice-president of surety for FCA Insurance. With over 10 years of experience as an RVP of a large national surety company, Cartwright uses his expertise to help FCAs clients manage and build their surety capacity.
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