Your Numbers Are Telling the Bonding Company a Story. Here’s How to Understand it.
Are your financials telling the bonding company a story you don’t even know?
In this episode, Wade Carpenter and Stephen Brown break down exactly how your WIP schedule, over/under billings, stored materials, job losses, and accounting method all shape your bond credit.
Using real contractor scenarios, they show you what underwriters see, and how to take control of your numbers before you send anything out the door.
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Topics covered on this episode include:
- 00:00 Bonding Denial Wakeup
- 00:15 Why WIP Matters
- 02:07 WIP Schedule Basics
- 02:43 Simple Job Example
- 03:30 Cash vs Accrual Impact
- 04:41 Overbilling Scenario
- 07:54 Underbilling Reality
- 08:58 Stored Materials Trap
- 10:35 Loss Jobs Must Accrue
- 13:09 Change Orders Timing
- 14:32 Cost Overruns and Swings
- 15:57 Smell Test and Credibility
- 17:40 Manipulation and Mis-Coding
- 20:04 Hidden Payables Surprise
- 23:00 Equipment Depreciation Hit
- 24:02 Checklist Before Submitting
- 24:43 Timely Books Win Bonds
- 27:41 Listener Questions and Wrap
LINKS
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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com
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TRANSCRIPT
[00:00:00]
Wade Carpenter: You’re busy, you’re making money, then the bonding company says your financials don’t support the job you want. What are they seeing that you’re missing?
Today, Stephen and I walk through how your numbers can tell that story. You’re not gonna wanna miss this one.
This is the Contractor Success Forum. I’m Wade Carpenter with Carpenter Company CPAs, alongside Stephen Brown with McDaniel-Whitley Bonding & Insurance.
Stephen, we both have clients that don’t understand how their WIP affects them, and I know my thoughts on this are born out of a couple of frustrations with some owners that don’t understand the importance of how to present these numbers.
I realize work in progress can be very confusing, but what’s your take on this?
Stephen Brown: Wade, the Work In Progress report is the key to unleashing bond credit. Because if it’s done properly and it ties in with your balance sheet and income statement it gets you more bonds. That’s just a fact. But more importantly, it lets the bonding company know that you’re tracking your jobs appropriately.
And we’ve talked before [00:01:00] about construction accounting is different. There’s percentage of completion accounting format that has over and under billings that show up as assets and liabilities. And your WIP, if it is consistent and it’s conservative in its estimates of the profits and it’s thorough and it ties in neatly with the balance sheet and income statement, then the bonding company knows you’ve got a good set of books and you’re on top of things.
That’s it in a nutshell.
Wade Carpenter: Okay. If anybody’s listening to this on the podcast, you may wanna check this out on YouTube. We got some visuals today, and I think that might help tell the story.
But again, this is born out of about four or five different scenarios with people trying to get bonds recently. And I know, Stephen, you and I had one in particular that just, you can’t send financials to a bonding company that you don’t understand how they’re going to affect you.
Whether you have a cash-based statement, accrual-based [00:02:00] statement, or trying to do your own WIP. Sometimes people are trying to manipulate things, and that’s where a lot of this is coming from.
So let me just kinda kick this off. And Stephen, hopefully you’ll tell me if we’re not making sense here.
But essentially, what are we trying to do with a WIP schedule, Stephen?
Stephen Brown: I think you got it here. How far along are you in the projects? How much have you completed? How much have you billed? How much is left to be done to complete the project?
Wade Carpenter: Yeah. You can manipulate the things one way or another, whether you intend to or not. If you’re not collecting the cash, you’re waiting on receivables or retainage.
A lot of this the intention today is to show you how these all fit together. So what I was wanting to do today is walk through a fictional contractor and start with, what’s happening.
I’m gonna show these things a couple of different ways, but let’s just say we had two contracts.
and I’m just… for simplicity we’re gonna build on this [00:03:00] example. But the second job, we had a million-dollar job. We estimate it’s gonna cost us $800,000. We’ve got $400,000 in it to date, so we’re exactly 50% done.
That means we’ve earned half of that million dollars, and lo and behold, we’ve billed exactly $500,000. So there is no over and under-billing, and we’re basically going to be recognizing $100,000 gross profit.
Stephen Brown: Okay
Wade Carpenter: Pretty simple, That track
Stephen Brown: Yeah
Wade Carpenter: If we start looking at it and again, I’m not gonna try to…
Hopefully you can see all this. But you can see on a cash basis, we haven’t collected the extra receivables. So you can see the revenue is different because what’s come in and what’s gone out is different. Our cash may be the same, but we’re not picking up the same thing with retainage and Accounts receivable.
I’m not gonna get in the differences in the calculations, but the working capital ratio that Stephen looks at, how much [00:04:00] working capital we have, it’s very different for a cash versus accrual versus percentage completion in this case because we’re exactly billed where we should be, which almost would never happen in the real world.
These affect these main ratios that the bonding company are looking at. Your gross profitability up here plus, your debt to equity and those kind of ratios.
So you see what we’re talking about here, Stephen? Is this distracting for everybody?
Okay. So like I said, I want to build on these scenarios a little bit.
And, right now there’s not really any difference in this scenario between accrual and percentage of completion. So are we okay to move on to the next one?
Stephen Brown: Sure
Wade Carpenter: Okay. So let’s say we had that same thing, just keeping it very simple, same contract. We’re still 50%, our costs in there are 400,000, but we’ve now billed $700,000 on that job because we could. That means we’re overbilled by 200,000.
Remember, our gross profit is [00:05:00] only still 100,000 because we’ve only earned half of that, 500. So does that make sense?
I think sometimes it’s a little easier to see it here, but in this case, our revenue is changed.
In accrual billing, we would show, $390,000 of profit in this scenario, but it was overstated by $200,000.
I’m not going to go through the mechanic because I think, I’m not trying to overcomplicate this, but we have to back down by that $200,000 in revenue as well as we’re going to have this overbilling on our liabilities.
So in this case, our working capital is not the same. Instead of 1.13 million, which really is overstated by that 200,000 when we put the overbilling in there, that brings us down to 930.
And so you see that’s tanking our current ratio. That’s still a pretty healthy current ratio in this case, but, a lot of times that will tank your debt to equity and your your working capital. [00:06:00] So Does this follow so far?
Stephen Brown: Absolutely
Wade Carpenter: Any questions? Again, what we’re trying to get at is like what is it doing to our ratios?
We’re trying to give a true picture to the bonding company, and this is the biggest thing I see, whether people give a reviewed financial statement or an in-house. When it comes from us it’s our reputation.
And even though, we may be doing some in-house stuff for contractors, they need to understand when you’re sending this to the bonding company, you don’t send it blind.
And if you do have these things going on, you need to be able to know, explain it.
Stephen, I don’t know if you have any comments on, it’s like you have surprises, but if you can explain it, Does that make it easier for you?
Stephen Brown: It certainly does, Wade, because so many people don’t understand the difference between, these columns that you showed, the cash basis, the accrual, and the percentage of completion and how it affects, these numbers.
But in real world construction, you’re gonna [00:07:00] overbill and you’re gonna underbill.
Keeping it on an absolute cash basis becomes more and more difficult to do. And then you’re gonna have years where you have huge profits, and then the next year their profits aren’t as great, and you wanna level out your taxes. So the percentage of completion format allows you to do that. IRS lets you do that.
And so many of my customers it just takes a while to grasp that.
And that’s why, again, I always preach you need a construction-oriented CPA to do this for you. But again the WIP Wade, tells a story, and most bond underwriters understand the implications.
You can explain things, and they’re comfortable with it, and they give you credit for it. But, in a little bit too, we’re gonna look at your backlog gross profit or gross losses that you’re showing on your WIP.
Wade Carpenter: Yeah. You led into the next one that, probably the more likely scenario, you can only bill at a certain point in the [00:08:00] month.
Okay you do this, the work and, you know, through the end of the month, and then you bill on the 20th of the month and you get paid. That’s more like the same, again, same scenario. We got $400,000 in, but we’ve only billed 300,000.
In the case of… we’ve still got the same gross profit, but we’re underbilled by 200. If we’re looking at our ratios again, we would’ve been showing a net loss if we’re just strictly going by accrual basis.
whereas it would be $190,000 net income, our working capital, current ratio, all that stuff looks so much better because traditional accounting can’t pick that up until we can are recognizing this.
I hope this is making sense, but as far as, these build on each other and so I’m hoping that these scenarios are making sense to everybody.
So we good to move on to another one s-since you’re, so let’s talk about another one that I see.
A lot of times, like a [00:09:00] pipeline contract or whatever, that maybe they’ve got a whole bunch of money tied up in things like stored materials.
And if anybody’s ever done a pay app you’ve probably seen that stored material’s at the top of the AIA billing part.
But a lot of people don’t understand how that affects it, and there’s a lot of, truly, there’s a lot of CPA firms, even the large CPA firms, that don’t know how this calculation is supposed to work.
So again, let me show you the same scenario, the same job. We’re still estimating $200,000 gross profit on it, and now we’ve got $520,000 on it.
But we had bought $120,000 worth of pipe that’s sitting on the job that’s not installed yet, so we can’t recognize the profit on that.
The GAAP says that. That’s how the AIA billings G702s work. And so what we’re doing is we back out that 120 from the 520, and it still puts us at 400,000 of costs, so we’re 50% complete.
50% of that million dollars [00:10:00] is 500,000, and then we get to add in the cost of the stored materials. So 500 plus the 620 gives us 620 earned. We still only received or got gross profit on that.
And again, I’m assuming, just to make it simpler, that our build is the exact same, so that our…
Stephen Brown: Yeah.
Thank you for doing that.
Wade Carpenter: And again I don’t think I need to go through the way this is affecting unless you want me to. because there’s a lot of scenarios that, you know anything we can, but again, the revenue in this case, it does affect our working capital and those kind of things. So let’s take the situation where we got a job that we’re expecting to lose money now.
Now this particular job, things went wrong. Got bad weather. We had people out there longer than we needed to. We got equipment rental. Now we’re expecting the cost to be 1.1 million when we’re all said and done.
And let’s just say, just again, easy math, we’re 50% done of [00:11:00] that $1.1 million, but now we’re expecting to lose a million dollars. And if you go through the calculation of
Stephen Brown: We’re expecting to lose 100,000
Wade Carpenter: Yeah, exactly. If you go through the percentage completion, you would’ve just said, “Okay, we’re 500,000 earned on the 1 million.” We would be overbilled by $20,000. But what generally accepted accounting principles say is we have to recognize that loss as soon as it’s recognized or as soon as we see that’s gonna happen.
Stephen Brown: Okay.
Wade Carpenter: Is that making sense?
Stephen Brown: As soon as it’s incurred or as soon as you know it’s gonna–
Wade Carpenter: As soon as you know it’s going to happen, you’re supposed to recognize. And there’s a lot of people… And again, the large firm I left before I went out on my own 20-something years ago, they did not understand that. The calculation, even though they understood, like, you’re trying to get the same you know, recognizing the gross loss here in this, it’s a component of cost. And again, that’s a nuance.
But, [00:12:00] that in particular does affect your working capital because… I know I don’t have all the detail here, but, normally you would’ve recognized 800,000. We backed off 20,000 overbillings that would’ve been calculated, but we also have to accrue a liability of the other 50, so that tanks our working capital to 730. It’s more conservative that way.
And we’ll get to, if we have time the look back and how the bonding companies will look at it over time if things are, you turned it in last year, and you said you’re gonna make all this profit, but everything tanked, and you got a history of that.
I don’t know if you wanna speak to that real quick, but if you got a history of jobs tanking and what you or the underwriter might do there.
Stephen Brown: Yeah. Do you have a series of jobs that are tanking or one or two? And what’s causing it? Did you have a an estimator that put out a a long series of bad bids? Did you have profit bid spreads on a [00:13:00] lot of your projects and you felt you were comfortable doing them at the numbers that you bid it, but those numbers weren’t accurate to begin with.
Wade Carpenter: Okay. Some of these things are things that we see all the time, and when people are turning things in, let’s just say we supposed to be getting a change order. Now our estimated costs have gone up and our costs have gone up to date, but we don’t have that contract yet or the change order signed yet.
We really can’t recognize that until it’s been signed. You don’t really have a change order in place, but you’ve already done the work. This is the kind of thing where, again, I’m not gonna spend a lot of time walking through the mechanics of it, but it would change how much you’re underbilled in this case and the gross profit.
Had we recognized the extra revenue on that change order, it wouldn’t look so out of whack. So these are the kind of things that, Stephen might be asking the question like, ” Why does this one look so bad?” I got a change order that’s coming. Do you have it yet? These are the kind of things that you want to [00:14:00] make sure that you get documented, especially before your end of year.
A lot of times, like if you’re doing a review or an audit, we will look at okay, we got change orders, things that have been done since the release date of the statement I would say. We can adjust our our contract amount and the estimated costs for anything we’ve known since up to the date of, and the date of the statement.
So these are the kind of things that people don’t think about when they’re putting these WIP schedules together. Are we still good?
Stephen Brown: Yes
Wade Carpenter: Let’s take another one situation here where.
So let’s just say costs went through the roof. The estimate goes… again, there are different spins on this, but now we think the cost is gonna jump to $900,000.
That changes our gross profit. That changes, Again, I’m trying to keep it so that the earning billing and all that stuff is simplistic so we don’t have over/under billings.
But, when a profit does change, then that does [00:15:00] affect our working capital and everything.
Things like that are gonna happen in construction, and what we’re trying to get at is, thinking through this before we turn anything into the bonding company.
If something did go up mid-job, being able to explain it, right? Especially if it’s a job that they’re bonding they probably wanna know what’s going on with this.
Again, some of these other ones, Maybe I don’t know that I want to get too deep into the details on this stuff, but if we have some of the changing things, maybe we have one that that’s like, comes in and all of a sudden blows up our overbilling.
Maybe we got a mobilization or something, deposit or something like that. But one of these things just really overwhelms the WIP schedule. What does that do to our ratios and everything?
Again, there’s probably some other examples that I want to give here, when these big swings happen, that’s when people are gonna be asking questions.
Would you agree?
Stephen Brown: Absolutely
Wade Carpenter: This is another one which I got a couple of different [00:16:00] scenarios, and there was one that… it was a new client for us, and it was actually one of Stephen’s, and I’m not gonna name names, but it follows this pattern. But they did not really know where they were on the job.
There was a difference in terminology, let’s just say. They said they had billed the whole job or whatever, or they thought they’d billed the whole job. They said, “We’ve done it.” They hadn’t billed all of it. And in the case of this, it blew the overbilling up.
In the case that Stephen and I were working, it was a $1.3 million change that– this is the kind of thing that I looked at it before it even got to Stephen, and I’m like, “Okay, there is no way possible this is going to be right,” ‘ because we didn’t have the receivables… and I think if you bounce it off your bonding agent beforehand, or a CPA that understands what they’re doing with this, before you just send something blindly out the door.
That’s the point, Stephen. I don’t know if you have any comments there, but it’s just this smell test, it’s like you and I think instinctively can [00:17:00] say, ” There’s no possible way that can be right.”
Stephen Brown: Yeah. And, bonding companies realize that. And here’s the thing. When a set of financial statements, old ones do not make sense based on the current ones that do make sense, that are done by a good construction-oriented CPA, that are done on a percentage of completion basis, that tell a story then not only do they understand it, but they forgive it and move on, and you’re back in the driver’s seat.
In fact, they probably have more confidence in you than they did before
Wade Carpenter: I think the point I’m trying to make is that, you don’t send stuff blindly. And just having somebody else look at it. There’s other parts like these… I don’t necessarily need to walk through all these, but people will cut their estimates to show more profit, and they’re trying to manipulate the WIP schedule.
And I get it, we see that all the time, and we’ll get to that when we talk about the revision stuff or [00:18:00] they really do not have a good handle on the estimated cost to complete.
From my standpoint, which I don’t know if you see the same thing, Stephen, that’s one of the hardest things I have to try to get a WIP schedule out of somebody that’s never done these things.
They don’t know where they are. A lot of times, they have never had really good cost records, and they don’t have things up to date. And if they don’t have a good handle on it, they think they’re doing better than they are.
I think, number one, like in this scenario, that estimate is cut. And at the end of the year, you said “okay, it was gonna make all this money,” and then we come up with your estimates are cut. Oh, it’s not gonna cost so much. They’re gonna ask some questions, wouldn’t you think?
Stephen Brown: Absolutely
Wade Carpenter: Again, I’m not gonna walk through all The implications, but it is affecting your working capital, your equity, and your ability. So other things we see all the time, which I’ve had several contractors do this, but they will start looking at it and it’s like, “Oh, okay you just coded the cost [00:19:00] to the wrong job.”
Okay you told me, It’s like all of a sudden they’re trying to manipulate the schedules, and I get it again, but when things suddenly shift, this is another thing where you start seeing okay, this doesn’t smell right.
It’s probably the wrong term for it, but you know what I’m saying, Stephen, right?
Things suddenly shift and okay, these started going wrong, but no, I don’t wanna show the bonding company that. So they start moving money around, and then that ends up taking another job down the road, right? Okay
Stephen Brown: it just,
Wade Carpenter: You’re just agreeing with me, Stephen. You
Stephen Brown: more complicated and harder to track, but it has to be tracked, and it does come out. Why not just do it the right way, and take some numbers that you’re comfortable with always as being how to operate your business.
Wade Carpenter: Well, I hope I’m not getting too technical with these today, which, like I said, I’m trying not to get too deep into the scenarios, that kind of stuff.
Stephen Brown: All right
Wade Carpenter: again, all of them. There’s [00:20:00] various different ways they play out, and we don’t need to walk through all these. But, it’s just, one of the things I don’t have in here is the fact that I really should put a slide in here for it.
But a lot of people don’t understand that, okay we got a bunch of payables at the end of the year.
I’m not gonna give that to my accountant because I don’t want to pick up the costs. And while it makes sense that if you got revenue and then you’re gonna pick up, on an accrual basis you take off you don’t have all that cost in there, so your cost owner is high, you’re gonna show a bigger profit.
On percentage of completion basis, if those costs are on a profitable job, going back to that first scenario, if we bump up our cost to complete, we’re gonna bump up our profit. So it’s counterintuitive, but that actually helps our statement.
We may end up having more payables but we are either gonna adjust it with over/under billings and it’s going to help the revenue and it’s also gonna help the working [00:21:00] capital and the equity.
Does that make sense, or did I lose everybody on that one, Stephen?
Basically, if you have more costs on a job and it’s counterintuitive that if you put that payable on there, it’s going to add to the cost of it and would bring down your profit. But on a percentage of completion is if that payable is on a profitable job, it bumps up your percentage of completion.
You’re going to be bumping up your revenue. You’re going to be bumping up, your under-billing or lowering your overbilling.
So believe it or not, instead of trying to hide your costs from your accountant putting that right payables in there would actually help your working capital.
It helps your equity and helps your profitability. So I know that doesn’t sound right, and I don’t have a good example. I probably could build for you.
Stephen Brown: I understand that perfectly, and please don’t try to outsmart your accountant. Just let them do their job. You can argue with them. They’re there to help you not only do it the right way, but set things up where you’re comfortable all along with what you’re [00:22:00] reporting and how it’s being reported.
You never know what bonding company underwriters are gonna come in and how they’re gonna look at the numbers they see and how they interpret it.
Sometimes when an underwriter doesn’t have faith in the numbers or something stands out as wonky and we’re in a meeting with the contractor and the contractor tries to cover it up or explain it in a way that just doesn’t ring true, then that’s when the bonding relationship starts to falter.
So everybody is pulling with the same set of oars
Wade Carpenter: Well, They should be. But if you hide a payable from somebody and they turn it in June from last year, I mean, I don’t wanna spend a whole lot of other time, but there was a couple of things that I’d love to spend more time on the ratios and how they are affecting.
But, the look back, you know, maybe we could do another episode on that because showing how this is what it showed last year, this is what show this year, and how that can start to erode the confidence in your bonding company or your ability to bid.
Make [00:23:00] sense?
But there was one other scenario that I guess it was In one particular case, this happens all the time too, but heavier equipment guys, the guys that have heavy LI or hundreds of thousands of dollars in equipment, typically they’re gonna write that off upfront.
And if they’ve never had formal financial statements their tax return’s showing they’ve done Section 179, they’ve accelerated all the depreciation on it, there’s no equity left in it.
Even though the bonding company is really looking for the working capital, that does also play into the equity situation.
And in a particular case that we were just start working with, it was a $770,000 adjustment because they had never put it on financial statement book basis.
And again, these are the kind of things that I think people really need to think about. And if you’ve just got a tax accountant that’s been doing your books and then you’re trying to go get bonded, then these are the kind of the lessons that I was [00:24:00] hoping to make some sense today
So again, I know we’ve gone a little longer than I wanted to on this one, but, before you send anything to your bond agent, again, I know that’s one of the first ones there. WIP, does it tie to the general ledger? You guys are looking at that Stephen?
Do these things on here, I mean, they resonate that what you would look at versus, I know sometimes you’re based on what you’re given, and you may not have all this information. And so having the full information, I think, goes a long way to being able to explain it to an underwriter, right?
Stephen Brown: Absolutely. I think these five items are spot on, Wade
Wade Carpenter: Okay. I hope I didn’t go over people’s head too bad today. Any, takeaways from today, Stephen, or any other final questions or thoughts?
Stephen Brown: There’s so many moving parts to a financial statement that can get confusing. But if you understand that you can always get in trouble by not paying your taxes, getting too cute and not paying your taxes.
So there’s the tax [00:25:00] issues that affect your bonding. And also from a bonding standpoint, they want to be able to know that you are, that you’re never penalized for taking advantage of the benefits of percentage of completion accounting and what it will do for you.
It needs to be done correctly because if it’s done correctly you understand it, the bonding company understands it, and everyone on your accounting team understands it. From your bookkeepers they understand the importance of cost coding correctly, getting the proper information in, and then presenting it as accurately as possible.
And another thing that we didn’t discuss today is just the power of timely financial information. How long does it take you to close out the end of the month in your accounting system with relatively accurate information?
And the faster you can do that and turn it around, the more accurate your information is for you and for the bonding company. So it’s a win-win.
Wade Carpenter: I appreciate [00:26:00] that, and also, I see it myself in that. There’s a lot of people out there that they just hire a monthly bookkeeper, and all of a sudden they need to get something bonded or whatever, or they give it to the CPA that’s overworked and it takes them six months to get this out the door.
The ability to do that when your in-house bookkeeping is not facilitated where you can’t actually spit out a WIP report and know what you’re doing.
And that’s where, I really like to think that a lot of the underwriters that know us, a lot of times they’ll take a statement from us that, even if they don’t have a reviewed financial statement from somebody else, an interim, when they’ve got confidence in the numbers.
And that’s what it’s all about today, is having confidence in the numbers. But for our owners out there that are listening to this, understanding it is also the key to a healthy business.
So that was what I hope I did today, and I hope I didn’t confuse everybody else with a bunch of numbers.
Stephen Brown: I’d like to know the questions our [00:27:00] listeners have from today’s podcast. We understand, Wade, how this affects this and this, but why is this happening? Why did you put it in that category? Where do you decide how to post this and what’s best for the contractor? What’s the best set of books for a particular contractor?
And remember, everything’s fine if all you do is one project, and it’s when you have multiple projects going on that you have to track, when you have over and under billings, when you have change orders. And as your company grows, it’s inevitable you’ll have all of those things, and they just need to be accounted for.
It’s nothing to fear, but it’s something to embrace, and it’s a good thing.
Wade Carpenter: Thank you for that. If our listeners do have any thoughts on that or questions and you want us to go into deeper dive on any of this stuff later, we’d just love to see that in the comments below.
If you’re listening on Spotify or any of these other Apple engines, whatever maybe check out the visuals that we had on the screen, on YouTube.
If you’re still [00:28:00] with us, we appreciate you hanging out with us for yet another episode.
We do this every single week. We really appreciate it if you’d like, share, subscribe. It really helps the channel out, and we will see you on the next show.