Understanding Percentage of Completion Method for Surety Bonding in Construction

Surety bonding is a critical part of construction projects, ensuring that contractors fulfill their contractual obligations. For underwriters, it is essential to assess the financial health and progress of contractors when bonding them for construction projects. One of the most effective accounting methods to evaluate this is the percentage of completion (PoC) method.

In this blog, we’ll break down what the PoC method is, why it’s important, and how to calculate it in a way that helps underwriters make informed decisions when bonding contractors.

What is the Percentage of Completion Method?

The percentage of completion (PoC) method is an accounting technique used to recognize revenue and expenses on long-term contracts as they progress. Instead of waiting until the entire project is completed to recognize income (like the completed-contract method), contractors report income and expenses proportional to the work completed during a specific period.

This method provides a more accurate view of a contractor’s financial performance and is particularly valuable for underwriting purposes, as it allows sureties to track project progress and identify potential risks in real-time.

Why is the PoC Method Important for Surety Bond Underwriters?

Underwriters need to ensure that contractors are financially stable and capable of completing their projects. By using the PoC method, underwriters can:

• Monitor cash flow: Contractors need to demonstrate positive cash flow throughout the project.
• Evaluate progress: The PoC method helps underwriters ensure that a contractor’s revenue recognition is aligned with the actual progress on the project.
• Identify risks: If the work completed does not align with the revenue reported, it could indicate project delays, cost overruns, or mismanagement.

This method helps surety underwriters decide whether to issue a bond, extend it, or intervene in the case of potential defaults.

How to Calculate the Percentage of Completion

Let’s walk through a simplified example to make it clear.

Example: Calculating PoC for a Construction Project

A contractor is building a $1,000,000 office building. The contract is expected to take two years to complete. So far, the contractor has incurred $300,000 in costs out of the total estimated $800,000 in costs required to complete the project.

To calculate the percentage of completion and recognize the correct revenue, the following steps are taken:

1. Determine the Percentage of Completion:

Percentage?of?Completion = Total?Incurred Costs/Total Estimated Costs Estimated? Percentage?of?Completion=300,000/800,000=37.5%

So, 37.5% of the project is considered complete.

2. Calculate Revenue to be Recognized:

Revenue?Recognized = Total?Contract?Value×Percentage?of?Completion

Revenue Recognized = 1,000,000 x 0.375 = $375,000

At this stage, the contractor can recognize $375,000 of revenue based on the work completed.

1. Calculate Gross Profit to be Recognized:

To calculate the profit earned to date:

Estimated Gross Profit = Total Contract Value-Total Estimated Costs

Estimated Gross Profit = 1,000,000 - 800,000 = $200,000

Gross Profit Recognized = estimated Gross Profit X Percentage of Completion

Gross Profit Recognized = 200,000 x.0375 = $75,000

Therefore, the contractor has earned $75,000 in gross profit so far.

What Does This Mean for the Underwriter?

For surety bond underwriters, this calculation allows you to see that, with 37.5% of the project complete, the contractor has incurred $300,000 in costs, recognized $375,000 in revenue, and earned $75,000 in profit. This level of visibility helps you:

• Track progress: You can see that the contractor is on track with their costs relative to the work completed.
• Monitor financial stability: By comparing these figures over time, you can spot potential issues like cost overruns or delays.
• Assess bond risk: If costs rise disproportionately to work completion, you can adjust your risk assessment accordingly.

Potential Risks and Red Flags

While the PoC method gives a clear view of progress, underwriters should be vigilant about certain risks:

• Overbilling: Contractors may bill ahead of actual work completion, creating a cash flow buffer. While not inherently problematic, consistent overbilling can indicate a contractor is experiencing cash flow problems.
• Underbilling: This could mean that contractors are falling behind on work, which can be a red flag for delays.
• Cost Overruns: If actual costs incurred significantly exceed the estimates, it could mean poor project management or unexpected complications, which pose risks to the bond.

Conclusion

The Percentage of Completion method is a valuable tool for surety underwriters when bonding contractors. It provides a transparent, real-time view of project progress, helping you to monitor financial health and mitigate risks. By understanding and calculating PoC, you can make better-informed decisions that protect both your interests and the contractor’s ability to complete their projects successfully.

Understanding these concepts helps underwriters be more confident in assessing the contractor’s ability to deliver on a bond, leading to more informed and safer decisions in the surety bonding process.

At Payless Taxes, we work exclusively with contractors and provide bookkeeping solutions for them to get accurate financials with percentage of method completion. For more information, you can contact [email protected]