Any contractor planning on doing public works projects will require the services of a surety to provide performance and payment bonds. When meeting with your local performance bond underwriter you may hear the term “profit fade”. So what is profit fade? Lets start by reviewing some accounting terms. The surety industry (as well as the IRS) will require a contractor at some point to report its financial statements using the percentage of completion method. This method of financial reporting requires a contractor to report the profit on a project throughout the project’s life time. For instance, if a project has an estimated profit of $100,000 at completion and the project is 75% complete at the date of the financial statement reporting, the contractor would recognize $75,000 of profit on that project. If the project were 35% complete, the contractor would recognize $35k in profit. Back to the original question, what is profit fade?
Profit fade is, in a nutshell the over estimation of profit on an uncompleted job. In the example in the previous paragraph, the job with the $100k profit at 75% complete was completed in the the next reporting period, however, the profit on the project ended at $90,000. The profit on the job faded from $100k to $90k. While the project still made a profit, the profit was less than what was reported in the earlier reporting cycle.
Back to the original example, in the original accounting period the contractor recognized $75k of profit on the project. That means $75k of profit made it to the profit and loss statement, but that was not an accurate profit estimate. In reality, on that first accounting period, only $67.5k of profit should have been recognized so the profit of the company was inflated by $7.5k. That also means the net worth and working capital were over inflated by that same amount. Lets assume that this was just one of a doze open contractors and none of the other projects suffered from profit fade. It that case, no surety underwriter would even bring the subject up. In all likelihood, the contractor has some jobs that made more money at completion than estimated along the way in which case the contractor actually under reported profit.
But what if there was profit fade on many jobs? What of the contractor had say 10 open jobs, and for the sake of argument, all were showing $100,000 profit. Again to keep it simple, all were 75% complete period and 9 of them closed out with a profit of $90k. In this example, the contractor would have overstated the profit on its P&L by over $67k. This could be a significant number. Additionally, if the contractor were using the same percentage of completion method for its taxes, the contractor would have paid tax on $67k in income that was not actually earned.
The surety bond underwriters will penalize a contractor for consistently overstating profits. Overly optimistic profit estimates will result in the underwriters making their own internal adjustments. Profit fade also shows a potential breakdown between estimating and project management. If you are reading this post, you know that construction is not an exact science and that profit fluctuations are going to occur through the life of almost any project. Profit fade is only an issue of it happens with regularity and enough severity that an accurate profit estimation would have changed the underwriters perception of the risk.
Have any questions about the performance bond underwriting process?
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