How Different Accounting Methods Impact Your Bonding

By Brady Cox

Let’s discuss four accounting methods for contractor’s financial statements and which ones are accepted by bonding companies and banks. Since they are not all accepted by sureties, it is important for contractors to recognize when an unacceptable accounting method has been used.  It’s a deal killer!

Depending on the level of presentation, sometimes it is up to the reader to recognize which method has been used.  When a CPA prepares or assists in preparing financial statements, they are required by professional standards to issue a report on those financial statements. This report can be one of three types of presentation:  audited, reviewed or compiled.

Audited Financial Statements are the product of a CPA’s highest level of assurance services. In an audit, the CPA performs all of the steps indicated below regarding compiled or reviewed statements, but also performs verification and substantiation procedures. If the financial statement (FS) is audited, everything is laid out and explained, including the accounting method (normally stated in note one at the back of the document).

Reviewed Financial Statements require that the CPA perform inquiry and analytical procedures in addition to the procedures described below for a compilation. Upon completion, a report is issued stating that a review has been performed in accordance with professional standards. On a reviewed FS, notes are normally included, but they may be less informative.

Compiled Financial Statements typically have no notes, thus this type of statement represents the most basic level of service provided with respect to financial statements. In a compilation, the CPA must comply with certain basic requirements applicable accounting principles.

Most small businesses will have either compiled or reviewed statements, which lack the documentation and assurance that comes with a full-blown audit. So how is the reader to recognize if an unacceptable accounting method has been used?  In addition to an explanatory note (which may be absent), there are elements that can be identified on the balance sheet.  They are the clues that will tip off the informed reader about the accounting method.

Cash Method

This is a very simplified accounting presentation. Personally, I think of it as the “cigar box” method of accounting; it only takes into consideration what’s actually in the cigar box.  Cash is shown, but money owed to or owed by the company is not.  If there are no accounts receivable and/or accounts payable on the balance sheet, it may indicate the Cash Method.

Accrual Method

From its name you can guess that under this method, accrued assets and liabilities are included. Therefore you will see accounts receivable (A/R) and/or payable (A/P) on the balance sheet.

Percentage of Completion

This is a more sophisticated method that includes entries to reconcile the current status of billings on incomplete contracts.  The telltale clue will be balance sheet entries for “Costs and Estimated Earnings in Excess of Billings on Contracts in Progress” (asset) and  “Billings in Excess of Costs and Estimated Earnings on Contracts in Progress” (liability).

Completed Contract Method

This method recognizes all the revenues and profits associated with a contract only after it has been completed.  Billings issued and costs incurred are recorded on the balance sheet during the life of the project, but they do not shift to the income statement until completion of the contract. This method is not normally used for financial reporting because it does not show a clear picture of current operations.

On the balance sheet, look for “Progress Billings” or “Billings on Contract.” On the profit and loss statement, no revenues, expenses or profits will be shown until the year of contract completion.

Summary

The accountant’s cover letter will not state the accounting method.  Look at note #1 for this disclosure.  If there are no notes, this is probably not a good quality statement anyway.

• If there are no A/R or A/P it may be the Cash Method and therefore unacceptable.
• If you have A/R and A/P but no “Costs and Estimated Earnings in Excess of Billings” or “Billings in Excess of Costs,” it is the Accrual Method: OK but not optimal!
• If you do see all four or some combination of them (maybe three of the four), it is the Percentage of Completion Method: even better!
• Completed Contract is hard to detect because it resembles the PCM.  Rely on Note #1 for clarification.  The surety may accept this FS if additional documentation is provided.

Brady K. Cox is a Principle with the Baldwin-Cox Agency, LLC. in Dallas, TX.  The agency was founded in 1990, and has always focused on providing construction bonds to contractors. Today the Baldwin-Cox Agency,LLC  is one of the largest bond producers within all of North Texas.

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