Budgets & Reserve Contributions

Washington State ChapterCOMMUNITY

ASSOCIATIONSINSTITUTE

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Budgets & Reserve Contributions

Catherine Kuhn, CPAKen Harer, Attorney

[email protected] [email protected] 425-641-4808

Topics Today:

Accounting Basics- Balance Sheet & Income Statement

Cash vs. Accrual Accounting Reserve Study Basics Statute Requirements

Budgets Reserves

Audit Requirements Related to Reserves Reserve Funding Plans Assumptions about inflation & earnings Interest and borrowing of reserves

Who Are You?• Old Act Condominiums (created <1990)• New Act Condominiums (created >1990)• Mixed Use Condominiums• Homeowner’s Associations (Planned Unit

Developments)• Association Managers

You?:By Total Budget Size:

• $100K or less• $100K to $250K• $250K to $500K• Over $500K

Accounting BasicsBalance Sheet

Financial Position at a Point in Time (e.g. Dec 31, 2012)

– Assets (What you OWN)– Liabilities (What you OWE)– Members’ Equity (Net Worth, Fund

Balance, Retained Earnings)

“Accounting Equation”Assets MINUS Liabilities EQUALS Members’ EquityAssets EQUAL Liabilities PLUS Members’ Equity (Balance!)

Balance Sheet ~ Assets

• Cash (Operating & Reserve)

• Accounts Receivable (Cash Yet to be Received)Typically Past Due Assessments (billing 1st of the month)Allowance for Bad Debt “contra” (offset) account

• Other Owner Receivables (Water billings, bill-backs)• Prepaid Insurance (Ins Premium Paid in Advance of Use)

Balance Sheet ~ Liabilities

• Accounts Payable – Expenses to be paid

• Prepaid Assessments – Assessments that are paid in before they are owed to the Association

• “Due between Funds” - Can be an asset or a liability depending on the Fund (discuss later)

Members’ Equity (Fund Balance)

What you OWN (Assets) less What you OWE (Liabilities)

• Two Types of Equity:• Operating• Reserves

Sample Fund Balance Sheet

Income Statement

“Statement of Revenues & Expenses”Results over a period of time

• Assessments Revenue - Should be total budgeted assessments for the year (accrual basis) Some allocated to operations, some to reserves

• Interest income (operating and reserve) • Expenses – We all know what that is! • “Net Income” Revenue Minus Expenses (Hopefully positive or

$0!) • Reserve Net Income can be positive or negative --- OKAY

Sample Income Statement

Cash vs. Accrual

• Cash– Checkbook Accounting – Recorded when PAID

• Accrual – Matches Income with Expense as incurred- Recorded when Incurred

Cash vs Accrual

• Revenue (Assessments)

Accrual records assessments at the beginning of the month based on budgetCash records assessments as collected

• Expenses• Accrual- Landscaper performs work in January- expense recorded in January Income

Statement• Cash- Landscaper performs work in January and billed/ paid in February- Expense

recorded in Feb

Is Accrual Required??

• GAAP is “Accrual” “Generally Accepted Accounting Principles”

Old Act Condos:No mention of GAAP, we recommend GAAP

New Act Condos:GAAP required- Resale Certificate Implications

HOA Act:GAAP not required – Our preference is GAAP

Accounting Basics

• QUESTIONS ????

Reserve Study Basics

• Long term financial planning tool• Provides information to include in annual

budget for major maintenance expenses• 30 year projection of expenses• Calculates steady contributions over 30 years

Core Information from Studies

• Fully Funded Balance Calculation• Cash Flow Contribution calculation

• Funding Plans• Baseline Funding – never run out of money• Full Funding – Build over 30 years to be

100% funded• Consultant’s Recommended Funding

Reserve Study Basics

• QUESTIONS ????

Progression of Laws

• 1990 reserves mentioned

• 2008 required for condos• 2012 required for HOAs• 2012 budget disclosure

required

Requirement to Fund Reserves

• CAI National Policy on Funding• Statutory Requirement to Fund

• Neither requires funding• Belief that Boards know best how to fund for

future expenses

New(er) Statutory Requirements

• Applies to New Act Condos and HOAs• Budgets proposed to owners now must include

information on status of reserves. • Key concept: 1) Current savings, 2)

Recommended by consultant, 3) Proposed Budget

• Goal is to keep membership informed.• Complex Statute requires specific information be

submitted to owners at budget time.

What if You Don’t Comply?• There is no penalty for failure to have a reserve

study Owners can petition to have included in next year’s budgetSome Associations need not have Studies

• Statute is silent on penalty for failure to disclose reserve information during budget

• Risk is that the budget would be found invalid, so any increase from prior budget would not be collectible from delinquent owners.

Risk During Collections if New Budget Process Not Followed

• Risk during collections if the new Budget Process is not followed

• Same risk as before that Board does not comply with law requiring Reserve study

• New difference is that the Budget section of New Act Condo and HOA laws were revised without same exceptions in law.

Questions?

• Law & Risk

SPECIFIC REQUIREMENTS OF 2012 LAW FOR ASSOCIATION BUDGETS

• HOAs and Condos formed after July 1, 1990

• Committee’s intent was all condos, but code reviser at legislature did not know that

Requirements of 64.34.308(4) and 64.38.025

• Well intended legislation, with a goal of fully informing owners about:

• 1 – How they are currently doing on saving for future needs, and what happens over the next 5 years.

• 2 – What the professional is recommending and how that looks.

• 3 - What the proposed budget includes and what that will do over 5 years.

Requirements of 64.34.308(4) and 64.38.025

• (a) State current, recommended, and proposed reserve contribution rates, and Funding Plan used by the professional to make the recommendation.

• (b) State if additional funding will be required, when it is due, and what it would be for. (Example: special assessment of $100,000 to replace the roof in 2015). Show amount per unit per year and month for those expenses

Requirements of 64.34.308(4) and 64.38.025

• (c) State if the association will run out of money in the next 30 years at its CURRENT contribution rate.This is a YES or NO question

• (d) If the answer to (c) is “YES”, then attach a spreadsheet showing for all 30 years when it is short, and by how much.

• These are not easy calculations to do.

Requirements of 64.34.308(4) and 64.38.025

• (e) State the projected year end:Reserve Account Balance per the Study

Reserve Account Balance per Budget, & The Percent Fully Funded as of the Reserve

Study date• (f) Estimated Year End Balance for the next 5

years at RECOMMENDED contribution rate, and CURRENT rate, &

• PERCENT FULLY FUNDED each of those years

Requirements of 64.34.308(4) and 64.38.025

• (g) Estimated Year End Balance the next 5 years at the BUDGETED contribution rate, the FULLY FUNDED BALANCE for each of the next 5 years, and the

PERCENT FUNDED each of the next 5 years at the BUDGETED contribution rate

• Intent is to show how the Current, Recommended, and BUDGETED contribution rates compare over time

We provided three samples of forms that three providers have created to try and respond to the new law

Questions on statutory requirement for budget?

Unplanned Reserve Expenses• Building related expenses are OK,

even if not planned, or not included in the reserve study

• Borrowing from reserves for unrelated expenses triggers notice requirement to owners and a repayment plan to restore balances within two years.

Failing to Fund Planned Reserves

• Is failing to fund for lack of money the same as borrowing from Reserves?

CPA Audits and your Reserves

• Budget – relation to Reserve Study• Missing Budgeted Reserve Deposits• “Due Between Funds”• “Transfer Between Funds”• Operating vs. Reserve Expenses• Controls- Reserves• Audit Reports – Required Disclosures

What if Budget NOT = Reserve Study?

• Does your association budget’sreserve contribution MATCH the RS annual contribution recommendation?

What happens if your annual budget contributions don’t match the study?

Is there an accounting “issue” if it doesn’t?

What if Budget NOT = Res Study?

• There is NO accounting (books) issue if your annual budget does not match the RS

• There IS a possible audit report disclosure issue if the annual budget contribution doesn’t match the study

What if we MISS budgeted reserve deposits?

• GAAP: Requires that the budgeted reserve allocation (contribution) be shown as the “revenue” on the reserves Income Statement, regardless if “paid” into the fund or not. (ie “accrual method”)

GAAP: If not paid to reserves, it will show as a “payable” to reserves or a “Due Between Funds”.

Due Between Funds

• When one fund owes another fund money• Can be a result of ~

• Reserve deposits not made• Expenses not paid out of right fund• Wrong amounts – either deposited or paid• Wrong coding of expense• Monies borrowed• Interest not properly posted• Accounting errors (e.g. journal entries)

What if we don’t pay back the missed Reserve Deposit?• GAAP- Considered a “transfer between

funds” and a “permanent transfer” is made from the reserve fund to the operating fund.

Transfer Between Funds

• When one fund moves assets from one fund to another

• Can be a result of:• Moving cash permanently between funds• “Forgiving” loans• “Forgiving” amounts Due Between Funds

Due Between Funds vs. Transfer - GAAP

• How to determine for GAAP? True Receivable and Payable?• Intention to repay?

• Documented plans to repay?• New Reserve Study?

• Ability to repay?• Enough operating cash/fund?

Due Between Funds vs. Transfer ~ IRS• Form 1120-H

• No impact

• Form 1120• May fail the tests ~

• Strict segregation of cash• Use of monies as intended

• May not be qualified to file form 1120 if large

Due Between Funds or Transfers

Questions?? Due to Reserves, transfers, missed deposits~

Operating vs Reserve Expenses

Is it a Reserve Expense?GAAP: Major repair or replacementIndustry Standard: • Major repair/replacement not an annual event• Extends the life of common area component• Included in the reserve study• Board determination

Is it a Reserve Expense?

• RCW: “Infrequent and significant nature make them impractical to be included in the annual budget”

• IRS: Must be “capital” in nature

Ops versus Res Expense? Why important?• Reserve Study will not be accurate if

operating and reserve expenses are not segregated and improper expenses are taken out of reserve cash

• Operating Income Statement analysis of Budget to Actual will be inaccurate

• For IRS purposes, very important to segregate operating and reserve expenses

Controls – Reserves

• Funding in accordance with the budget• Does your Board know when reserve deposits are

missed?• Reserve expenses

• Operating or Reserve expense?• Paid from correct fund?• Approvals?

Controls- Reserves

• Funding in agreement with Reserve Study• Spending in agreement with Reserve Study

Changes in either not funding or not spending according to the Reserve Study can significantly impact future cash flow projections.

Controls on Reserve Activity

• BOARD MINUTES – Very Important!

• Nature and amount of reserve expenses• Decisions to repay reserves, payment plans• Decisions to transfer funds (instead of repay)• Why the budget does not match the RS• Why reserve deposits are missed/plans --

Questions? Operating/Res Exp and Controls:

Audit Reports and Reserve Disclosures• Footnotes to the Audited Statements:

Requirements to accumulate funds (statutes), including FHA (RCW: no funding requirement) FHA requirement that 10% of op budget go to reserves

Funding Policy Reserve allocation for the year (Income Statement) Reserve Study status

Reserve Study annual allocation – compared to budget

Required (Unaudited) Supplementary Information (RSI)• Estimates of current or future costs of major

repairs and replacements for all existing components (ie, Reserve Study)

• Components, useful lives• Funds accumulated (ie Reserve Fund Equity)

C&C adds: “Percent Funded”

New RS Requirements:RCW 1/1/12

• Certain required disclosures now in the annual BUDGET document • Most of our 12/31/12 audit clients did NOT

have this disclosure in their 2013 budgets

• Internal Control Report “comment” if not included in Budget document

Questions? Audit/Internal Control Disclosures?

Investment Options for Reserves

• CAI best practices from 2001• Statutes silent on investments• Federally insured investments

no loss of principal possible. • Laddered investments• Investment Portfolio Management

Budgeting for Inflation and Income on Reserve Balances

• Over 30 years these two components cause substantial shifts in estimated contributions

• Can you earn more than inflation?• Who makes estimate of these for your

reserve study and your budgets?

How this affects budgets and needs

Contributions increase at 5%

Funding Plans - options

• 1 - Baseline Funding – Saving at steady rate so that you don’t run out of money for 30 years

• 2 - Full Funding – Saving at steady rate so that you are 100% fully funded at end of 30 years Difference may be increased contribution of 13%

• 3 – Threshold Funding – More than Baseline• 4 – Planned Special Assessments as needed• 5 – Defer repairs and maintenance

Fully Funded at end of 30 years

Becoming Fully Funded – 30 years

What Funding Plan should you use?

• Depends on specifics of each communityAge of building and timing of future repairs Circumstances of owners now and in futureRisk toleranceAbility of owner to pay on short noticeAbility of owners to invest funds and earn more

• One thing all providers agree on: More money in reserves means fewer special assessments.

Risks of no Study, or of not funding, per Study recommendation• Boards must act with reasonable and ordinary care• Statutes could be used to define that standard of care• Primary risk is no money for necessary repair• Secondary risk is owners can’t or won’t pay if you

special assess for repairs• Disclosure to owners/buyers can reduce risk.

Resource: hoacpa.com

Resource: condolaw.net

Question & Answer Session

Thank you!

Ken Harer, AttorneyCatherine Kuhn, CPA

Condominium Law Group, PLLCCagianut & Company, CPA

[email protected] [email protected] 425-641-4808

CAI and the Washington State Chapter of CAI

Working Together to Serve You

National CAIcaionline.org

(888) 224-4321

Washington State CAIwscai.org

(425) 778-6378