Pulse Exclusives (120)
Over the years almost every manager is going to ultimately deal with at least one board member that “goes rogue.” The effect on the Board of Directors, and even in the entire Association, can be devastating. These people can seemingly pop out of nowhere and all of a sudden you've got a problem to deal with. A rogue board member is generally disruptive to meetings and can damage the effectiveness and efficiency of the board. If left unchecked, this damage can spread to the entire Association.
Most of the reserve studies performed by our company occur in states that have adopted statutes establishing reserve study requirements. Since most Associations will try to comply with state statutes, it makes sense that more reserve studies are performed in states that have such statutes. However, acceptance of a reserve fund as being a good business practice is also widespread throughout the country, so it’s reasonable to expect that a significant percentage of Associations would still opt to perform a reserve study for that reason alone.
A few weeks ago I was working in a state where there are no reserve study statutes. I had forgotten that in this particular state, the general consensus is that a reserve study is more of a nuisance than anything else. It's not that the Associations in this state don't budget for reserve projects; they do. They just don’t have a formal reserve study prepared. This means they don't have a formal maintenance plan and really have no idea how well-prepared they are for future expenditures.
So what is the potential impact of the lack of a formal reserve study? It's a known fact that at least some level of inflation is still with us, costs are increasing, and common area components are deteriorating. My experience observing Associations trapped in this scenario is that they typically choose to simply defer major expenditures until funds can be accumulated. The danger of this approach is that the cost may grow exponentially until the deterioration reaches a tipping point, requiring complete replacement of components instead of simply performing major repairs. The deferral approach generally results in much higher costs overall. For example, painting siding is a relatively minor cost when compared to complete replacement of the siding itself. However, complete replacement of siding is the likely result if scheduled painting maintenance activities are not performed.
Consider how the reserve situation may look from a prospective purchaser's point of view. A knowledgeable prospective purchaser will want to see a well-funded reserve fund as well as a reserve study to back it up, so s/he can have some idea of what the future may hold in store. Unfortunately, only a small percentage of prospective purchasers are savvy enough to request and understand this information. But those who are informed would be inclined to gravitate towards Associations that do have a reserve plan and have set aside funds for future major repairs and replacements.
It is the Association's responsibility to make sure that funds are available for Association operations. When it comes to the operating budget, this is a somewhat easier task, as budget items repeat annually and each year serves as a potential benchmark for what the next year should look like.
The reserve fund, on the other hand, can look completely different from year to year. In the early years, an Association may accumulate funds without making any expenditures at all. It is simply accumulating funds for known future expenditures. It becomes somewhat more difficult to budget for these types of expenditures. The reserve study is the tool that allows an Association to create this budget.
I have heard the argument that it is a waste to accumulate funds when no money is needed on an immediate basis. However, when one considers this advance funding as an equitable funding approach, it takes on a whole different perspective. Setting aside the appropriate funds even when expenditures will not be needed until years in the future simply means that those individuals who are “using up” the common area components are also paying for them. (The flip side of this argument, of course, is thatadvance funding places a burden on struggling current owners who may not even be members of the Association when that large expenditure, such as roof replacement, is actually required. Why not let the new buyer pay for that roof?)
Large reserve projects have to be planned for several years in advance if Associations wish to avoid a large special assessment. Ironically, in my discussions with several Association management individuals in this particular state, I discovered that even though the managers may recommend preparation of a reserve study, boards of directors simply don't want to take this action. It appears that their attitude is that what they don't know, won't hurt them.
Repairs on homeowners’ association common area property may range from almost inconsequential to major projects. The decision that management has to reach is who should perform the work. Many minor repairs can and should be performed by your on-site staff. Large and complex projects should generally never be performed by anyone other than competent licensed contractors with experience in the type of work being performed. It's those “in-between jobs” that actually cause the anguish in making the decision between on-site staff versus outside contractor.
Reserves: No Standards for Calculations or Reporting
Written by Bill ChaffeeAfter more than two decades of review and re-calculating numbers in reserve studies, it is conclusive that there is a range of different financial results being produced by reserve study companies.
At the end of the recent CAI National Conference, the Reserve Shop Talk session was attended by some of the largest reserve study company principals. The subject of setting industry standards on calculations and reporting was introduced. It was stated that many reserve study companies produce much differing report presentations while also producing different calculation results (using a variety of different undisclosed formulas for calculations).
While one attendee disagreed, others agreed. This may display a lack of and need for standardization of calculations and reporting. Different reserve study company reports should have the same resulting numbers if using identical data. This may be a logical approach for the reserve study industry, but there was no interest in pursuing this direction. This raises questions (and is the basis of confusion for property managers and HOA Board of Directors) when changing reserve study companies? “How did our reserve position change so much?” Whether it be positively or negatively.
For the purposes of illustrating this point, let’s review the various formulas and calculation results of one area of reserve reporting, 100% Funded. It probably it is not generally known, but there are currently four different methods for calculating 100% Funded:
• Current Cost – Straight Line
• Future Cost – Straight Line
• Current Cost – Future Cost – Straight Line
• Future Cost – Time Valued
The following shows how these methods are calculated (assumes a current cost of $10,000, estimated useful life of 4 years, 3.00% inflation and the reserve item has been in service for one year):
Current Cost–Straight Line:
The current cost-straight line method is the easiest and the most straight forward to understand of all the methods. This method does not take into consideration inflation. It is a simple calculation that if a reserve item has a current cost of $10,000 and a four year estimated useful life, then at the end of each year the 100% Funded amounts would be by year: 1) $2,500, 2) $5,000, 3) $7,500 and 4) $10,000. Calculated as: $10,000 / 4 = $2,500 per year.
Future Cost–Straight Line:
This calculation is the same as Current Cost-Straight Line except instead of using the current cost the future cost is calculated and divided by four years. The future cost is calculated with the following formula (this formula takes into account the reserve item has been in place for one year and will be replaced or maintained in three years):
( Cost * ( ( 1 + Inflation Rate ) ^ 3 ) ) / Useful Life = $10,927.27
The future cost is divided by the estimated useful life of four years ($10,927.27 / 4 = $2,731.82) calculating the 100% Funded amounts would be by year: 1) $2,731.82, 2) $5,463.64, 3) $8,195.45 and 4) $10,927.
Current Cost-Future Cost-Straight Line:
Some States Civil Codes have been interpreted that the existing cycle of a reserve item should be calculated on a current cost-straight line calculation and the future recurring cycles on a future cost-straight line calculation. The 100% Funded amounts would be presented as above for the existing cycle (current cost-straight line) and the recurring cycles (future cost-straight line).
Future Cost-Time Value:
The future cost-time value calculates each year’s 100% Funded as a progression from year to year which more fairly represents the compounding of the inflation rate. The current cost of $10,000 compounded for one year at 3.00% equals $10,300. This future cost is divided by the estimated useful life of four years and multiplied times two years to calculate $5,150 as 100% Funded at the end of year two. The following year calculation is then repeated using the previous year future cost of $10,300 which is compounded for one year, $10,609. This is divided by the estimated useful life of four years and multiplied times three years to calculate $10,609 as 100% Funded at the end of year three. This calculation would continue for the ongoing existence into the future of the reserve item.
This method most accurately calculates the 100% Funded amount of a reserve item taking into account inflation compounded annually as opposed to any straight line calculation.
Note: the above methods utilize the current cost taking into account that the reserve item has been in service for one year
The matrix below presents the different balances of the 100% Funded calculation methods.
The variances of the straight line methods exist on their own and are materially different when compared based on the percentage differences with the future cost-time valued method.
It is obvious why the 100% Funded calculation can vary from reserve study to reserve study due to different methods. Usually it is not disclosed in the reserve study what method was used which adds additional confusion to property managers and HOA Board of Directors for first understanding their current reserve study and then when comparing results to a previous reserve study.
There is currently no documentation or guidance on these calculations from CAI (Community Association Institute), APRA (Association of Professional Reserve Analysts, AICPA (American Institute of Certified Public Accountants), FHA (Federal Housing Administration, or any individual state Civil Codes or regulations.
This examines just one area of reserve study calculations. Other calculations need to be addressed in the same manner while addressing reserve study formulas and calculations. Reserve study reports also need to be addressed in the same manner as the above in order to set standards for consistency and understanding for the benefit of all property managers and HOA Board of Directors.
A community’s roads, parking lots, and driveways are one of their most expensive assets. Asphalt pavement has an anticipated life expectancy of 25 to 27 years. The actual duration of the pavement surface is directly related to how well it is designed (in terms of release of storm water and traffic load design), constructed (installed per design specifications), and maintained (ongoing maintenance). Assuming that the first two components were completed correctly, the ongoing maintenance will play an exclusive role in the overall life.
Why audits happen for Homeowner Associations
Most audits come through referrals or projects. The IRS does not conduct many random audits.
The Community Association business is a people business. My many years of experience in the industry as a management professional have brought me into contact with a number of great people, some of whom have become friends. But, as in any large group of people, there will always be those who are difficult.
Reserves: Beyond the Reserve Study...Reserve Study vs. Reserve Management Plan
Written by Bill ChaffeeReserve Studies of some type have been done for over half a century now for many common-interest-developments. Prior to that, in some situations, maybe an abacus or pencil and paper process was attempted. The studies became simpler to do and more efficient to produce when spreadsheets came to life in the 80’s. The first version of professional cash management of reserve funds for owner associations and resorts was introduced in 1983. And surprisingly, the first cash flows projections weren’t presented until 1989.
In the 60’s, when a common-interest-development property was in the planning stages, some proactive State’s Departments of Real Estate required documentation for budgeting and disclosure purposes as to the amount potential owners would be paying for operating and maintaining the property. As we know them today, “maintenance fees” for the daily operations and reserves for the long-term maintenance and replacement of the physical common areas. Originally, the Reserve Study report was intended to be an independent (arms-length, third party) opinion at a specific point in time regarding the condition of the property, common areas and the individual assets or reserve items that made up the property. This would be similar to the concept of a CPA’s audit opinion on the financial position of a company.
Furthermore, the study accounted for the balance of existing reserve funds and calculated how much would be needed from the owners to pay for reserve items that would require maintenance or replacement in the future. The conclusions and the report were basically done with no involvement from the association’s board of directors, management, or any other advisors.
In the 90’s, Reserve Studies started to change noticeably. With dramatic changes in the economy, many boards of directors and management personnel became more involved in the end product report with participation on the assumptions used for inflation, interest earned, annual contribution increases, or the occasional “we are not raising the dues” no matter what the report says input from board members. The professional Reserve Study preparer was primarily relied upon for estimated lives, costs and the approximate timing of when maintenance or replacement would be needed next. This of course was questioned by many boards of directors as to, “how can we extend the lives of the reserve items”, or “even change the assumptions so we do not have to raise dues”. In many situations globally, this is still the case today.
So what is changing? And is the static reserve study metamorphosing into a dynamic, “living-breathing” process and a valuable financial planning tool for the future? The fact is, the world is a different place than it was 50 years ago and today there is a dramatic difference between the original Reserve Study and the developing Reserve Management Plan.
Where a Reserve Study is basically an independent report done once every few years, a Reserve Management Plan incorporates not only the involvement of the board of directors and management, it also incorporates cutting edge technology, real-time analysis, access and expertise from various other professionals.
A Reserve Study is what a professional reserve study preparer’s opinion is, where the Reserve Management Plan is an ongoing collaboration of what the intent, or plan is, of the board of directors and management today, tomorrow and into the future.
In other words, a Reserve Study is a snapshot or the view from 20,000 feet while the Reserve Management Plan starts at ground level, allows one to get off the ground safely and fly confidently at a cruising altitude with more end user intent, detail and useful managerial information.
The first thing the board of directors and management must determine is what is the end purpose the report? Is it purely for internal purposes, is it being required by a lender for the association to borrow money, for individual owners trying to meet refinance requirements, or owners trying to sell to potential buyers? This will determine if an independent Reserve Study is needed or a collaborated Reserve Management Plan.
In the summary narrative of the report it should disclose that it is an independent (arms-length, third party) opinion, or a collaboration with the board of directors, management, or any other advisors. It should continue to state the scope, intent, and how the data was originated. Also, the method used for calculating the current and projected year’s owner’s contributions, and that these calculated contributions provide a plan to assure that reserve funds will be available when needed in the future.
Where a Reserve Study might be considered one dimensional, a Reserve Management Plan can extend to including other useful managerial information:
- How reserve funds can be invested to maximize the return on investment
- Calculating individual owner contributions based on unit type or location by size, percentages, entitlements, weeks or points (timeshare/vacation ownership)
- Financial planning for underfunded owner associations that need to borrow money, special assessments, or a combination of both
- Different tracking methods that fit the desired intent and timing of reserve fund expenditures
- Documentation and compliance of the American Disability Act (ADA)
One of the biggest challenges for reserve (funds and items) analysis and reporting has been for the timeshare/vacation ownership industry. Typically, two-thirds of the total replacement/maintenance costs for a property are related to the unit interiors with common area items being the balance. Pre-planning of these types of property is extremely important for reserve consultants or the exercise can turn into “a runaway train”. Unless there is some type of understanding of what the board of directors and management are expecting, the odds are very slim that the end report will meet expectations.
Reserve consultants, management, or other advisors are the first line of education for owner associations and board of directors. The services available should be explained along with the mechanics of a Reserve Study and a Reserve Management Plan and their differences. Also, that the end services and report costs to the owner association will vary based upon what has been requested and agreed upon.
You do get what you pay for. If the board of directors is just trying to meet some requirement, then they will go with the least expensive option. But a conscientious board of directors will consider what managerial information they need to make proper decisions in the interest of all the owners.
Years ago I was managing a 500+ unit condo association in California that was approximately 25 years old and had almost nothing in reserves. When I took over the Association management, it was clear to me that assessments had been too low for too long. These were relatively low-end units and therefore attractive to what are commonly known as the entry and exit housing market: young families making their first home purchase and elderly individuals on fixed income. Therein lay the strong motivation to keep assessments as low as possible for as long as possible.
More...
Understanding CPA Service Levels - Compilation, Review and Audit
Written by Gary PorterThe By-laws, CC&R's or other controlling documents of most community associations delineate the requirement for preparation of financial statements of the Association. In addition, several states have minimum financial statement requirements.
The first level of financial reporting is performed by the association or its management company as monthly “interim” (meaning not year-end) financial statements for the association. The purpose of these financial statements is to provide the board of directors and management with the necessary financial tools to evaluate financial performance, primarily budgetary performance. This is known as managerial accounting, and is completely separate from external financial reporting. Financial statements prepared for this purpose are generally considered to be for internal use only.
If a secondary level of financial reporting exists, it generally applies to the association’s year-end financial statements only, and is performed in addition to the financial statements prepared for internal use. This generally means that that an independent CPA will be associated with the year-end financial statements of the association. The purpose of these financial statements is not just for management use, but is for external financial reporting, to the members of the association and others. While some association governing documents contain wording vague in this area, and simply refer to distribution of “year-end financial statements,” others are quite specific in requiring financial statements “prepared by an independent CPA,” or even more specific in defining the level of financial statement services as either compilation, review, or audit. In some states there are regulatory requirements that may take precedence over the governing documents to require a compilation, review, or audit.
Certified Public Accountants (CPAs) are licensed by their respective State Board of Accountancy, and must abide by the rules and regulatory requirements of their respective state. In addition, the CPA must comply with the requirements of any other state’s Board of Accountancy in which they practice. As a general rule, a CPA may preform service for an association in any state, so long as services are not performed within that state. So, if a management company in Texas manages an association in California, and the financial services are performed by the CPA in Texas, that CPA needs to comply only with the Texas Board of Accountancy. If that same engagement required the Texas CPA to travel to California to complete the engagement, then the CPA must either be licensed in California or register to practice in California and agree to be bound by California Board of accountancy rules. Almost all states have “signed on” to the CPA Portablity Act, which allows CPAs to cross state lines to perform services, mostly by simply registering with the state in which they wish to perform services. Each state’s requirements are different in this regard, but relatively uniform.
In addition, the CPA must comply with AICPA (American Institute of Certified Public Accountants) professional standards on performance of services. It is AICPA that established the service levels of compilation, review, and audit, and has created the standards of performance for each of these levels of service.
The CPA must also comply with generally accepted accounting principles (GAAP), which are established by the Financial Accounting Standards Board (FASB). The FASB codification of accounting standards is a codification created in 2009 to assemble in a single location all standards for GAAP, and it combined what were previously a number of different sets of standards into a single set of standards. These standards have generally evolved through official pronouncements of various national bodies or through common industry usage.
Lastly, the CPA must comply with any state specific requirements related to the industry. As an example, the state of Nevada requires that year-end financial statements produced by the independent CPA must contain a budget to actual comparison of the operating and reserve funds. There is rarely any continuing conflict between the regulatory requirements of a state and generally accepted accounting principles.
Under generally accepted accounting principles today, CPA's may render three levels of service with respect to an association's financial statements. These levels are known as compilation, review or audit, and these services may only be performed by a licensed Certified Public Accountant.
A brief summary of each of these levels of service is described below.
COMPILATION - The CPA compiles information in the form of financial statements. Such information is specifically the representation of management of the association. The CPA takes little responsibility for these statements, is required to perform very few procedures, and gives no assurance as to compliance with generally accepted accounting principles (GAAP). The CPA is not required to be independent of the associations, but must disclose if he or she is not independent.
REVIEW - The CPA performs limited procedures, consisting primarily of inquiries and analytical procedures; and provides negative assurance to the Association that financial statements are properly prepared in accordance with (GAAP). This level of service requires familiarity with the industry by the CPA and that the CPA be independent with respect to the association.
AUDIT - The CPA performs an examination of the financial statements, and issues a positive statement as to their compliance with GAAP. Extensive procedures are performed. This level of service requires more extensive industry knowledge by the CPA, and that the CPA be independent with respect to the association.
The table below compares various aspects of these three levels of service for association financial statements.
|
Criteria |
Compilation |
Review |
Audit |
|
Level of Assurance as to GAAP |
No assurance |
Limited assurance |
Positive statement as fairly presented in presented in accordance with GAAP |
|
Knowledge of industry |
Knowledge of accounting principles applicable to the industry and under- standing of the client’s business |
Knowledge of accounting principles applicable to the industry and under- standing of the client’s business |
Knowledge of accounting principles applicable to the industry and under- standing of the client’s business |
|
Procedures required |
Assemble in the form of financial statements – no inquiry or other procedures required unless information provided by client is questionable |
Inquiry and analytical procedures required |
Inquiry and analytical procedures required, plus substantive tests of balances |
|
Independence requirement |
CPA not required to be Independent, but must disclose any lack of independence |
CPA required to be independent |
CPA required to be independent |
|
Cost of engagement |
Least |
More |
Most |
|
Service required? |
If required by association governing documents or state statutes |
If required by association governing documents or state statutes |
If required by association governing documents or state statutes |
We often get the following questions from associations, board members and community managers: If we obtain a judgment against an owner, will it negatively impact their credit score? Can we report the judgment to one of the credit bureaus? Will the credit bureaus find out about the judgment?
IRS Exemption Letters Will Not Automatically Be Retroactive For Slow Filing 501(c)s
Written by John Knobelsdorf IINew 2013 IRS Position Revokes Policy From 1962 and Imposes 27-Month Deadline For Filing Exemption Applications Seeking Retroactive Recognition Of Exemption
How Do You Explain Revenue Ruling 70-604 To Your Members?
Written by Gary PorterI receive more questions on Revenue Ruling 70-604 than on all other tax issues combined. And, one of the questions that continually arise is “How do we inform and educate our members that they can vote on this important ruling?”
I recommend putting some descriptive wording on the ballot so that the members have a basic understanding of the Revenue Ruling. An example of such wording follows.
Revenue Ruling 70-604 is a tax ruling only. The purpose of this ruling is to allow a homeowners association to avoid taxation on any excess member income (as defined in the Internal Revenue Code) that may inadvertently arise in a given tax year. The ruling states that the members of the Association meet to make the election. The ruling applies to any excess member income. The ruling allows two options only; (1) refund the excess member income to the members or (2) apply the excess to the following year’s assessments.
The Board of Directors has determined that it is impractical to attempt to refund the excess member income because of the administrative issues involved and the fact that the excess member income may be needed as working capital to pay for continuing Association operating expenses. Therefore the Board of Directors request that you approve an election under Revenue Ruling 70-604 to apply any excess member income to the following year’s assessments. This does not mean that the assessments for next year will be reduced, as the budget has already been prepared and approved. Since expenses typically rise year-to-year, it is probable that any excess member income will be absorbed by an increase in expenditures.
Your failure to approve this election may mean that the Association will be subject to additional federal income taxes for the current year which will cause a rise in assessments for all members.
My advice to the Association and the governing board is that the ballot be drafted with only a single option, which is to apply the excess member income for the following year's assessments, and that a yes or no vote be what is presented to the members. The wording above explains why the Board of Directors is presented only a single option. To be silent on this issue and explain both options would force members to make a decision which could result in a majority of members voting to refund any excess member income. This creates a difficult situation for the board as that excess in income may represent working capital that is necessary to operate on a continuing basis. Without adequate working capital, the board would be forced to either borrow funds on an expensive short-term basis or to make a special assessment of members for working capital.
For the hundreds of associations with whom I have discussed this issue in the past you will probably recall that I have stated that, in my opinion, on which I have received verbal concurrence from the national office of IRS, that Revenue Ruling 70-604 as drafted, requiring approval of the members, is generally in conflict with the governing documents of most associations and with state law. To the best of my knowledge, statutes in all states vest the authority to make financial decisions regarding the disbursement of Association funds in the hands of the elected board of directors. The general membership normally does not have authority to make such a determination. Therefore state law is generally in conflict with Revenue Ruling 70-604.
So how do you resolve this apparent conflict? In my opinion it is relatively simple, although it requires little work. First of all go ahead and have the membership approve the election at the annual meeting, or in any other meeting or format in which a valid membership vote occurs. Second, have the Board of Directors meet and ratify the election approved by the membership. By handling the Revenue Ruling 70-604 approval process in this manner, you first meet the requirements of the IRS and second meet the requirements of state law. Can you skip the member approval and simply have the Board of Directors make the election? In my opinion, yes you can. However, to do so is to invite a challenge by the IRS. And that is a battle that you don't need to fight. It is so simple to get the member approval to make the election that it is best to simply get member approval and avoid a potential fight with the IRS.
