Surety bonds are arguably one of the most important aspects of a construction business. Without these bonds, contractors are unable to make bids, secure new business or continue work on projects. While the construction companies know the value surety bonds have, they often make broad guesses regarding assurance, which could negatively impact them financially.
The majority of surety companies today are divisions of large insurance companies because both traditional insurance and surety bonds are designed to mitigate risk through transfer mechanisms regulated by state insurance departments. However, traditional insurance is only designed to compensate the insured against unforeseen adverse events. Premiums for these types of products are determined based on aggregate premiums earned versus expected losses.
Surety bonds operate on a completely different model because they are designed to prevent a loss. Surety bond companies or divisions prequalify contractors based on their financial position and expertise in the field. As a result, these bonds are underwritten with essentially no expectation for a loss if the company has a good reputation and history. In these scenarios, the fee associated with surety bonds is just for prequalification services.
The four basic types of bonds used by construction companies are:
- Bid bond—Ensures that the bidder of a contract will enter into a contract and furnish the required payment and performance bonds if awarded the contract
- Payment bond—Ensures that suppliers and subcontractors are paid for work performed under the contract
- Performance bond—Ensures that a contract will be completed in accordance under the terms and conditions of the contract
- Ancillary bond—Ensures requirements that are integral to the contract are performed, which are not performance based
Construction companies need to make sure they are obtaining the right level of assurances in order to save their company from financial hardship if there is a problem. The premium structure for surety bonds can be simple if a company has certified financial records. CPAs are legally obligated to provide their clients with objective counsel as it relates to financial record keeping, auditing and tax advice. One of the most important roles they play is preparing financial statements for lending institutions and surety bond companies. Surety bond companies are more likely to award bonds when a construction company's financial statements have been reviewed and audited. Sureties rely on certain elements in the contractor's financial statement, such as:
- CPA opinion page—Discloses whether the statements were prepared according to audit, review or compilation standards as set forth by the AICPA Audit Guide for Construction Contractors
- Balance sheet—Shows the assets, liabilities and net worth of the business as of the date of the statement
- Income statement—Measures how the business is performing
- Statement of cash flow—Discloses the cash movements from operating, investing and financing activities
Sureties may also request other schedules and information, such as:
- Accounts receivable and payable schedules
- Schedule—Shows the financial performance of each contract and provide insight
- Management letter—Conveys the CPA's findings and recommendations about the contractor's business
Sureties use the contractor's reviewed and audited financial statements to support the amount of bond to award to the contractor. Sureties review the balance sheet, income statement and statement of cash flows to understand the performance of the contractor and his solvency.
The notes to the financial statements are used by sureties to gain comfort over the contractor's ability to sustain current jobs and understand disclosure of specific transactions. Other information is used to determine the level of bond award. Additionally, sureties often require financial statements to be performed in accordance with generally accepted accounting principles (GAAP) and to be comparative, which present multiple years' financial data.
Understand the requirements from your bonding company to ensure your company's financial statements are fully prepared. Not doing so can be costly to your business.