In the construction Industry something is needed to insure the project will be complete within time, within budget and with specifications requirements.
The surety bond guarantees that one of the primary parties will fulfill an obligation to an obligee, which in most cases is the completion of contract work as detailed in the contract drawings and specifications within the time frame designated by the owner.
To guarantee that the designated work will be completed by the contractor, owners will request contractors to submit some guarantee to do finish job, this is a type of surety bond known as a bid bond. Many times the owner will also accepted a bank check for a certain percentage of the bid price at the time of bid in place of a bid bond.
A surety bond is a three-way agreement involving a surety company, a project owner, and a contractor.
When a surety company issues a bond to a contractor, it is transferring risk from Owner to Supplier or like Owner to G.C. and G.C. to subcontractor and subcontractor to supplier or G.C. to supplier.
If the Contractor fails to perform the job to the satisfaction of the owner, then the surety will be asked by the owner to perform the work so that it is satisfactory to the owner by paying the original contractor to finish the work or hiring an outside contractor to take the place of the original contractor to complete the work. The cost incurred by the surety will be charged to the original contractor. If the contractor cannot be paid legal actions could very well be taken.
Types Of Bonds:
In Construction or any field there are many bond for giving surety of work.
In Construction there are three types of bond which are used today.
Bid Bond: Guarantees the fulfillment of an offer or bid if it is accepted
Performance Bond: Surety bond issued by an insurance company or a bank to guarantee satisfactory completion of a project by a contractor.
Payment Bond: Bond executed in connection with a contract to assure payment as required by statute of all persons supplying labor and material in the execution of the work provided for in the contract.
Benefits Of Bonds:
Provide capable & qualified contractors – Bonding Company will only issue bonds to contractors who have minimum risk involved with them. As an impartial third party, the surety prequalifies the contractor to verify that the contractor is capable and qualified.
Assure project completion – If contractor fail to do the work in timely manner or per specification then Owner is given assurance from the surety to finish the job on time and given amount. . A capable contractor is less likely to default on a project. However, there are many things that can cause contractors default, and in that event, the surety bond offers protections against financial loss.
Offer financial security -Owner is assured that the project will be completed to their satisfaction and the original contract amount.
Technical, managerial, or financial assistance -If the contractor requests help, the surety may offer technical, managerial, or financial assistance. This can help the project move forward and significantly reduce the likelihood of default.
Reduce risk of liens filed by subcontractors, laborers, & suppliers -Surety bonds relieve the private project owners from risk of liens filed by unpaid subcontractors and suppliers. In the absence of liens, the transition from construction to permanent financing is much smoother.
Protect taxpayer dollars for public projects
Smoother transition from construction to permanent financing
Lower costs-When subcontractors and suppliers know they are protected by a payment bond, they may present lower quotes since they no longer have to absorb the risk of nonpayment.
How Do Surety Companies Evaluate the Contractor?
Before issuing a surety bond to the contractor, the Surety Company will look for the following items:
Good References and reputation
Financial strength of the Company.
Bank relationship – Credit and debit.
Experience related to contract requirements- It includes education and field experience to prospective projects
Ability to obtain equipment to perform the work
Ability to hire necessary employees to perform the work
Work in progress. -Projects that are in-hand and are currently in progress.
Management capability. – How the contractor will be able to manage their company and its projects.
Geographic area in which the company operates.
Financial Data consideration:
Surety Company will look at financial reports of the company to determine whether they will be providing surety bonds to the contractor or not. They will review:
Quality of financial statements
Type of accounting method used to recognize revenues earned
Influences the amount of credibility underwriters assign to the reported data (financial statements).
Usually pronounces the entire examination and statement to have been prepared and presented in agreement with GAAP. (preferred by surety underwriters)
Quality of Financial Statement:
Compilation- Accountant provides no assurance regarding the numbers presented in client’s financial statement.
No detailed examination of the figures in the statement
Review- Accountant provides a more than routine examination of numbers.
Assurance exists that there are no misrepresentations
Audit- Accountant applies industry accepted auditing procedures including verification of relevant items in the statements.
Accountant certifies that financial statement is presented in accordance with GAAP.
* Only when a statement is prepared under the audit does a surety consider the evaluation of the contractor’s financial structure complete
Type of Accounting Method :
The Accounting method used by the contractor is significant to underwriters because it indicates how the accountant has recognized the contractor’s income.
Cash Basis-income taken into account when received
Straight Accrual-income taken into account when earned
Percentage of Completion-income recognized as work progresses
Completed Contract-income reported in the year contract was completed
Underwriters prefer not to see cash basis or straight accrual statements.
Percentage of Completion method gives the most accurate picture of financial position because income is recognized in proportion to cost incurred.
Recommended by American Institute of Certified Public Accountants
Surety underwriters review issues related to the contractor’s financial statement and perform data analysis. For example, if a particular contractor has failed to make a profit in recent years, they will have a rather difficult time in preserving a relationship with a surety company.
Sufficient working capital
Notes accompanying the financial statement
Ratio and trend analysis
Qualifications of the CPA preparing the statement
Surety’s also strongly consider backlog that the company has and also the contractor’s costs related to completing any current projects. What this reveals to the surety company is whether the contractor has the ability to cover overhead expenses for the planned project for which they wish to bid. This is one of the leading issues of the surety and the project owner.
Sureties use ratios to analyze the company’s finances
Focus analysis in five areas:
Liquidity-Current Assets/Current Liabilities
Operations-Effectiveness of management
Leverage-Level of debt pressure
Coverage-Ability to service debt
Specific expense items-Relate expense items to net sales
Ratios are compared to the contractor’s historical values and against industry averages.
Profit and Growth Analysis:
To analyze company profitability, sureties review the schedule of current and completed projects
Sureties also closely scrutinize the profit trends of the company and management’s commitment to corporate growth
A strong banking relationship is a part of a solid financial history for a contractor.
Surety companies want to see contractors with a strong banking relationship, but mainly with sufficient working capital to support work programs without bank borrowing.
In addition to the above mentioned items which are evaluated by the surety company before issuing a bond, sureties also check the contractor’s credit rating by gathering information from such sources as Dun and Bradstreet and Robert Morris Associates reports, suppliers, other contractors, and the contractor’s bank.
From the above sources, the surety is able to gain access to information such as: present/ average bank balances, credit established with the contractor’s bank, total experience in the industry, length of business relationships with various parties.
Even after all the information is provided to the surety, there is no guarantee it will result in approval.
The bond will be approved only if the surety is confident the contractor is qualified to perform the contract successfully and has the financial capacity to withstand the numerous risks involved in the construction business.