Performance Bonds are important for many commercial and industrial contractors. They can present sizable obligations to complete work. Learn how to properly account for performance bonds in a company financial statement.
Performance Bonds guarantee the completion of a project according to the contract terms and price. Should the principal contractor not be able to fulfill the obligation, a claim can be made on the bond. Should a performance bond claim occur, the surety bond company has the right to step into the principal’s shoes and complete the contract. The surety has legal rights to seek reimbursement from the principal of any amounts paid under the indemnity agreement.
Given this setup, some may be tempted to treat performance bond obligations as liabilities on the balance sheet. However, this would be incorrect under GAAP Percentage of Completion Accounting.
Under standard accounting practices, performance bonds do not show up on the balance sheet at all. They are treated as a “Contingent Liability”. A contingent liability is one that may occur based on future events. Contingent Liabilities fall into one of two categories. Those that are probable and those that are possible but improbable.
If a Contingent Liability is probable and the loss can be measured, it would show up on the balance sheet as a liability and on the income statement as an expense.
If a Contingent Liability is improbable, it does not show up on the balance sheet or income statement. Instead, it is disclosed in the notes to the financial statement.
Based on the accounting rules above, performance bonds are an improbable contingent liability. Therefore, they do not need to be shown on a balance sheet or an income statement. The proper way to account for performance bond obligations is by disclosing the contingent liability in the notes section of the financial statements. These notes are generally vague. An example might be:
“The company, as a condition of entering into some of their contracts, had outstanding performance bonds for the period.”
I have also seen CPAs disclose the amounts and the underlying indemnity. For example:
“The company regularly enters into contracts secured by performance bonds. At the end of the accounting period, the company had $1,000,000 in performance bonds outstanding. The bonds are secured by substantially all assets of the company and the shareholders personally.”
Both examples are correct, and it is usually at the CPA’s discretion of how much information to disclose when creating notes about performance bonds.
Most contractors view performance bonds as a job cost. They account for the premium paid on these bonds in the job cost. Therefore, the cost is included in the total job cost on a contractor’s work-in-progress report.
In my opinion, this is the correct way to account for performance bond costs.
Alternatively, some contractors prefer to count performance bond premiums as an overhead expense. In such cases, the money paid for performance bonds will show up on a contractor’s General and Administrative Expenses Schedule at the end of the financial statements.
Accounting for performance bonds is very easy. As long as no losses are expected, they only need to be disclosed in the notes to the financial statement and no accounting entries are necessary. The expense for the performance bond premium can either be included in the job cost or put into G&A expenses. It is always a good idea to use an experience construction CPA to prepare your financial statements to make sure they are accurate and recorded correctly. You may also contact the performance bond experts at Axcess Surety anytime for all your questions and needs.
Axcess Surety is the premier provider of surety bonds nationally. We work individuals and businesses across the country to provide the best surety bond programs at the best price.
