Chapter 5

Question 1

What is meant when one goes bond for another?

Answer 1

Going bond means to guarantee the performance of another

Question 2

Bonding involves the extension of credit to the principal. Discuss the three factors relating to the principal which form the basis of credit appraisal.

Answer 2

3 C’s!
(i) Character - review of company’s management performance. (i.e. to ensure pays bills promptly, good business reputation)
(ii) Capacity - assessment of principal’s ability based on past history. (i.e. experience and labour pool necessary to do the job)
(iii) Capital - assessment of principal’s financial capability. When large amounts are involved, the financial resources constitute the most important factor in determining whether the principal can obtain a surety guarantee.

Question 3

State two benefits of suretyship.

Answer 3

• agreeing to provide a surety bond indicates to the principal that the surety is confident in the principal’s ability to carry out the required task.
• guarantee that the surety will perform the contract should the principal default serves to provide obligees with the confidence needed to undertake various projects.

Question 4

Summarize the characteristics common to all surety bonds.

Answer 4

(1) Three party contract - Principal, Obligee, Surety
(2) Principal liable to surety - promise made to obligee and not to principal.
- secondary obligation arising out of default
of principal.
- surety’s duty to pay arises immediately upon default of principal.
(3) No losses expected - prequalification of bond applicants
designed to remove risk.
(4) Of indeterminate length and non-cancellable
- terminate only when principal’s obligations have been fulfilled.
(5) Statutory or Non-statutory in form
Statutory bond - required by municipal ordinance or federal or
provincial regulation or statute (i.e. licence and permit bonds)
Non-statutory bond - not required by law but made necessary as a part of agreement between principal and obligee (i.e. construction trade
bonds)
(6) Bond limit (penalty)
- amount of credit given to the principal by the surety.
(7) Bond Premium
- more appropriately described as a service fee.
(8) Written Contract
-surety contract must be provided in writing and executed under seal of the surety and, unless operating as an individual, the principal.

Question 5

Contracts of suretyship are not insurance contracts. Provide three examples to support this statement.

Answer 5

Insurance policies:
- are two party agreements, while surety is three;
- anticipate losses occurring, surety doesnt anticipate losses;
- payment of losses is made directly to the insured and insurer is not required to be reimbursed by the insured;
- the premium charged is based on current underwriting costs and future
claims expenses;
- additional limits of insurance can routinely be added by the payment of an
additional premium;
- are issued for specific periods of time and are cancellable by the insurer
during the policy period;
- an oral agreement is just as binding on the parties to the contract as is a written agreement.

Question 6

Identify three risks common to owners when undertaking a construction project without the protection of bonds.

Answer 6

Three risks common to owners when undertaking a construction project:
(i) the inability or refusal of the successful bidder to enter into the contract;
(ii) the failure of the contractor to complete the project at the contract price;
(iii) the inability of the contractor to pay sub-contractors and suppliers.

Question 7

State four factors considered by the general contractor when deciding whether subcontractors should be bonded.

Answer 7

Factors considered by general contractor:
(i) the terms of the contract;
(ii) the relationship between the contractor and subtrade;
(iii) the value of the subcontract;
(iv) the subtrade’s price in relation to other bidders;
(v) whether the general contractor wishes to pay the costs of the bonds rather than assume the risks associated with not doing so.

Question 8

The construction industry makes use of a number of different types of contract bonds. These include:

Answer 8

Bid Bond
Performance Bond
Labor and Material Payment Bond
Maintenance Bond

Question 9

Discuss the guarantee(s) provided by a Bid Bond

Answer 9

Guarantees:
-the principal can and will enter into a contract to perform the work at the tendered price; and
- the principal can and will provide whatever security is specified to ensure performance of the contract.

Question 10

Discuss the guarantee(s) provided by a Performance Bond

Answer 10

Guarantees:
-the actual performance of the contract in accordance with its specified terms and conditions.
-that faulty work will be corrected and defective materials replaced for a period of one year after completion of performance.

Question 11

Discuss the guarantee(s) provided by Labour and Material Payment Bond

Answer 11

Guarantees that the subtrades and suppliers will be paid for the work and materials that enter into the project.

Question 12

Discuss the guarantee(s) provided by a Maintenance Bond

Answer 12

Guarantees that the principal will fulfill the warranty obligations stated in the contract.

Question 12

Discuss the bond limit or penalty normally provided on each type of bond.

Answer 12

(i) Bid Bond
- a specific dollar amount equivalent to the percentage required as a penalty; or
-a percentage of the contract price with a maximum dollar amount specified.
(ii) Performance Bond
-50 or 100% of contract price
(iii) Labor and Material Payment Bond
-same limits as Performance Bond
(iv) Maintenance Bond
-limit required by obligee as per terms of contract

Question 12

Discuss common reasons for defaulting under bid and performance bonds.

Answer 12

(i) Bid Bond
-error in judgment;
-mistakes in arithmetic.
(ii) Performance Bond
(a) Involuntary default
-insolvency
-incompetence
-bank’s refusal to grant additional extension of credit
-delays resulting from modifications to the contract; failure to receive materials and equipment when needed; bad weather; labour disputes
-failure of major subcontractors when no bonding in place
(b) Voluntary default
-improper estimate of the contract costs
-cash flow problems

Question 13

Discuss how claims under bid and
performance bonds are handled.

Answer 13

(i) Bid Bonds Before a claim can be made, the principal must have rejected the obligee’s offer in writing. The amount then paid by the bond is based on the following costs:
-amount needed to compensate the owner for delay and additional costs should the project need to be re-tendered;
-the difference between the defaulting contractor’s bid and the amount for which the work is subsequently contracted.

(ii) Performance Bond The following procedures must be followed before there is any payment under the bond:
-surety must be notified by the obligee within a specified time limit;
-obligee must satisfy the surety that a default has occurred;
-obligee must show that the terms of the contract between the obligee and the principal have been observed.
Options available to the surety in the event of default of the contractor include:
-completion of the contract with existing or replacement contractor
-obtain a bid(s) for submission to the obligee for completion of the contract

Question 14

The information contained in the contractor’s financial statement will be key in determining the level of bonding the contractor can expect to obtain. Identify the three main items of information of most interest to surety underwriters when reviewing the contractor’s financial statement.

Answer 14

Working capital, net worth, profitability

Question 15

If there is a problem in interpreting the financial statements of contractors, surety underwriters agree that it lies in the method used to report income earned on work in progress. Briefly discuss the reporting methods used and state which method provides a more accurate accounting of the contractors current financial position.

Answer 15

Completed contract method: the financial statement does not show the job profit or loss until the project is completed or near completion. Advantage to the principal is that taxes can be deferred until project is substantially completed.

Percentage of completion method: the earnings from the work completed are calculated as a percentage of the total contract price. Profit or loss is recognized on a current basis … allows for a reasonable estimate of the amounts needed to complete the job.

This method is the more preferred accounting for work in progress.

Question 16

Contractors must provide their own guarantees before surety underwriters will agree to issue a bond on their behalf. Identify three forms such guarantees might take.

Answer 16

Indemnity agreements
Third party indemnities
Collateral security
Subordination agreements

Question 17

Surety

Answer 17

state of being sure, certain and secure

Question 18

Suretyship

Answer 18

the guarantee of performance made by one person or entity for another

Question 19

Surety Bond

Answer 19

an undertaking by one party (the surety) to become accountable to another party (the obligee) for the performance of an obligation or undertaking by a third party (the principal). It is a promise to provide credit, if and when needed, to ensure the faithful performance of an obligation.

Question 20

Obligee

Answer 20

The party to whom someone else is obligated under a contract
or
the party to whom the bond is given

Question 21

Principal

Answer 21

the person primarily liable

Question 22

Penalty

Answer 22

the amount of credit given to the principal by the surety
or
the amount which the surety is prepared to pay in the event the principal should default

Question 23

Statutory Bond

Answer 23

one that is required by a municipal ordinance, or federal or provincial regulation or statue

Question 24

Non-Statutory Bond

Answer 24

not required by law but flows from the contract or agreement between the parties

Question 25

Contract Bond

Answer 25

guarantees the fulfilment of certain obligations required under public and private contracts

Question 26

Consent of Surety

Answer 26

a letter assuring the owner that if the principal is the successful bidder, the surety will issue such other bonds as are specified to ensure the performance of the contract

Question 27

Working Capital

Answer 27

the amount of funds available to pay continuing business operating expenses until payment is received for work being undertaken by the contractor

Question 28

Net Worth

Answer 28

the amount of money remaining after all assets have been liquidated and all liabilities cleared

Question 29

Licence

Answer 29

issued by a regulatory body such as government in order to set rules and regulations to safeguard the public

Question 30

Permit

Answer 30

Fulfils same general function as a licence, except that they are usually required as prerequisites to performing special functions incidental to the operation of the business

Question 31

Discuss the three types of guarantees provided by licence and permit bonds

Answer 31

(1) Compliance guarantees:
Guarantee that principals will comply with those laws that affect them.
(2) Financial guarantees:
Require the surety company to protect the government body that granted the licence or permit against monetary damages resulting from the failure of licencees to comply with statutes, regulations, ordinances or codes which control their activities.
(3) Indemnity guarantees:
Extend the provisions contained in the bonds providing “financial guarantees” to third parties sustaining financial damages.
(4) Good faith guarantees:
Guarantee that principals will perform in good faith.
(5) Credit guarantees:
Usually required when principals sell property of others. Guarantees that principals will conduct their business affairs in accordance with the best interests of their creditors and will provide an honest accounting of all funds in their possession.

Question 32

Completed contract method

Answer 32

the job profit or loss is not recognized on the financial statement until the project is completed or near completion

*distorts the financial position of the contractor
Advantage is it allows the contractor to defer paying taxes on profits until the project is substantially completed

Question 33

Percentage of completion method

Answer 33

preferred accounting method for work in progress.
The earnings from the work completed are calculated as a percentage of the total contract price. profit or loss is recognized on a current basis and, as such, allows for a reasonable estimate of the amounts needed to complete the job

Significant advantage of this method is that it will generally reveal over and under billing on jobs

Question 34

What should a work in progress report include

Answer 34

Contract Description and Location
Contract Amount
Percentage Completed to Date
Amount Billed to Date
Estimated Cost to Complete
Estimated Date of Completion