When a building or a home is being constructed, a huge amount of money is involved, specifically if the project is big. Although contractors are bound by contracts in the case that they do not complete the work, there are many instances when they can just quit and leave the work hanging. This is a huge disadvantage to the owners of the house or the building, because they lose money with every delay, while the contractor gets off without any consequences.
This is the main reason why performance bonds exist. Beyond the contract, these are normally required to provide a bit more assurance to the owner that these contractors and subcontractors do not just abandon projects. There is a specific amount of money, a bond, that is used to guarantee that they will accomplish the work for the price they bet on in the first place.
The term performance bond might be misleading because it is actually a performance guarantee, which is then attributed to the non-performance of the contract it is linked with. On the other hand, a bond must be paid regardless of the contract signed by both parties.
Performance bonds became necessary due to the Miller Act, requiring public building constructions worth more than $100,000 to be guaranteed. In private projects, it is also commonly seen as used by general contractors who ask for performance bonds from their sub-contractors.
The owner of the building or the project manager uses these performance bonds to weed out contractors who are bidding too low or who might end up lacking the resources to finish the job. In the past, some contractors submitted bids that are actually unreasonable and then once they win the contract, either change their price or simply drop the contract. The performance bond will lock them to the price they originally stated in their bid as well.
Contractors have to apply for a performance bond with companies who offer them. They will have to undergo a check, specifically looking at their finances. This bond is submitted along with the bid, otherwise, their bid is not considered valid.
The cost can vary, depending on the amount of the full contract. For bigger projects, it is about 1%, but smaller contracts might be higher, at 3%. Other factors that affect the price can be the state where the contractor is based, as well as the specialization or the line of work.
When applying for a performance bond, the personal credit rating of the contractor will be checked, although the financials of the business is much more important. Financial strength is one of the top considerations of bond companies, ensuring that the contractor gets the lowest rates possible. To prove the good financial standing of the company, contractors can submit their balance sheet, cash flow statement and income statement, along with other documents.
Working with your CPA is a good idea to be able to present the financials well and acquire a good rate. While it is possible to get a performance bond with personal financial statements or tax returns, they might be then limited to smaller construction contracts, like $350,000 and below. While it might cost the contractor some money to hire a CPA to apply for a performance bond, it might be preferred by the bond company and it might give the contractor a higher chance of winning the contract.
There are different accounting methods that can be used when applying for a performance bond.
Percentage of Completion
This is the preferred method of bond companies and is also appropriate for bigger construction contracts
This method is the simplest and least expensive but is not as in-depth because it only looks at the money available in the bank. It misses out on the payables and receivables, which can be a bigger part of the contractor’s assets.
This is a simple step that can be used for medium-sized contracts. In this method, the expenses for the project are matched with the income from the same project.
Completed Contract Method
This method is best used only by small contractors, as it reports the income from a contract and deducting the project-related costs during the year of the project completion.
Although performance bonds will cost the contractor some money, it is the surest way for them to win contracts. Because they weed out unserious or incapable contractors, the work goes much easier and the projects get completed on time.