The new Association director is often thrust into the job with little idea of what his or her duties and responsibilities are, other than the conceptual knowledge that s/he is obligated to serve in the best interest of the Association. Unless s/he has been an active member of CAI (which is not likely if s/he is a first-time director), s/he is not even aware of the educational resources that are available for guidance in learning what a director's responsibilities are. Further, many directors serve only a one-year term and therefore have little incentive to go through the effort of getting the education necessary for performing their job, since their term will be completed before they can even begin to learn everything they should know.
The purpose of this article is to attempt to provide guidance to the director on his or her financial responsibilities. The most important rule with respect to financial transactions is that they should be well-documented. While the Association may produce monthly financial statements and an annual budget, it is also important to document, (preferably in the minutes of the Board of Directors) the following types of financial decisions:
1. Authorization for new bank accounts
2. Authorization of changes in signers of bank accounts
3. Approval of transfers of cash between accounts
4. Authorization for purchases of major equipment, or major expenditures
5. Approval of the annual budget
6. Acceptance of monthly treasurer's report
7. Acceptance of monthly interim financial statements from the management company
8. Approval of the annual audit or review report and tax return
9. Authorization for an officer of the Association to sign the annual income tax returns
10. Documentation of board actions and responses with respect to the accountant's management letter that accompanies the annual audit report
11. Collection actions(authorization to lien member property, authorization to foreclose on member property)
12. Documentation of board decisions regarding insurance coverage
13. Adoption of a conflict of interest policy
14. Authorization of contract for preparation of a reserve study
15. Authorization of reserve expenditures
16. Adoption of reserve policies
17. Adoption of Revenue Ruling 70-604 Election (This election should be made annually and should preferably be made at the annual membership meeting, then ratified at a Board of Directors meeting.)
Accounting is a complex, technical subject in which very few people have an active interest. However, the impact of financial transactions is something that permeates every aspect of our lives, and certainly that of a community association. While no individual can be given a complete accounting education in a short enough period of time to enable them to gain a complete understanding during their term of office, there are certain things that the director can and should do on a procedural basis that would allow him or her to adequately exercise the oversight of financial responsibilities of the members of the Board of Directors of an Association.
The director needs complete financial information in order to perform an adequate review of transactions. Accordingly, the monthly financial reporting package for a community Association should generally include the following documents:
1. Monthly financial statements
a. Balance Sheet on an accrual basis
b. Income Statement on an accrual basis with budget-to-actual comparisons ( The income statement should include both current month and year-to-date amounts.)
2. General Ledger
3. Cash Disbursements Journal
4. Aged Assessments Receivable Listing
5. Copies of all bank reconciliations
6. Copies of all bank statements
7. Copies of paid invoices
While the above list may seem like overkill to some, these documents should be distributed to the board members prior to the Board meeting so that they have an adequate opportunity to review them and be ready at the time of the meeting to either approve the reports or ask the necessary questions. It is not reasonable to expect even a CPA to be given a set of financial statements during a Board meeting and on the spot, have to review, understand, and approve the financial statements and, by inference, the underlying transactions.
For the director to competently review this financial package, he must have a basic understanding of each of the documents.
The balance sheet is a statement that reflects the financial status of the Association at a specific point in time (generally month-end or year-end). Common components of a balance sheet are:
Assets
Cash - Petty cash on hand or in checking accounts, savings accounts, or other types of accounts with a financial institution
Assessments Receivable - Amounts owed by members to the Association as of the date of the financial report
Fixed Assets - Property acquired by the Association with a useful life greater than one year and of significant cost
Prepaid Expenses - Payments of expenses in the current period that will benefit more than one period, such as insurance, which is often paid in a single payment for an annual premium
Liabilities
Accounts Payable - Expenses incurred, but not yet paid
Prepaid Assessments - Dues/assessments paid in advance
Income Taxes Payable - Income taxes due for the current year and any prior years
Fund Balances
Operating Fund - Accumulated earnings or losses of the Association from the current and prior years.
Replacement Fund - Amount set aside for future repairs and replacements (this balance should have an equal amount of cash set aside to accumulate for major expenses).
The income statement reflects, for a period of time, the income and expense activities of the Association. A preferred format would reflect both the current month’s and year-to-date budgeted and actual activities. Revenues generally consist of member assessments, fines, vending machine, parking, or other income and interest income. Expenses would include operating maintenance costs, utilities, management company fees, and other administrative and operating fees. Amounts transferred to reserves are generally reflected as an expense of the operating budget, unless financial statements are prepared on a fund basis.
The general ledger is a document which underlies the financial statements and summarizes all activity by account. For instance, if three different checks during the month were written for repairs, they would be grouped into the repairs expense account (even though the checks were not in sequential order). The total of those three checks would represent the current month’s total repair expense, which should agree with the income statement. This document can be used by the director to research questions such as "what is in utility or repair expense this month?", and "why is it so high compared to prior months or prior years?" The general ledger should provide sufficient detail for you to find the answer to that question.
The cash disbursements journal is simply a listing of checks in numerical order for the current month, listing the date, payee, and amount.
The other reports are self-explanatory.
The procedures that the director might employ in analyzing these documents should consist of:
1. Examine the balance sheet and compare it against prior periods to see that cash balances and assessments receivable balances appear reasonable. Note if there are any significant fluctuations between restricted reserves in the current period versus prior periods.
2. Examine the bank reconciliations and see that they agree to the amounts reflected as cash on the balance sheet. Investigate any differences. Also, make sure they agree with the bank statements. The bank reconciliation should begin with cash per bank and reconcile down to cash per financial statements and general ledger. The reconciling items will generally consist of deposits in transit and outstanding checks. Investigate and question any large or old outstanding checks.
3. Review the bank statements to ascertain that all interest income has been recorded in the financial statements.
4. Make sure that all bank accounts are recorded in the general ledger of the Association.
5. Examine the aged assessments receivable listing and compare it to the balance sheet. The total of assessments receivable should agree with the balance sheet.
6. Review the aged assessments receivable listing and question any assessments receivable that are more than 30 days old. The Association should adopt a strict collection policy that would consist of assessment of late charges, warning letters, filing of a lien, and ultimately foreclosing on member property for non-payment of assessments. There should be no exceptions to these rules, especially for directors of the Association.
7. Review the income statement comparison of budgeted to actual activity both for the current month and the year-to-date, and question any significant variations.
8. For any questioned income or expense items, trace the account to the general ledger and review the detail for that account.
9. Review the cash disbursements journal for the month and challenge the propriety of all expenses. For instance, if any checks are written to any director of the Association, find out why. If the management company is being paid more than their contractual fee, find out why.
It will take some time for the director to perform all of the above procedures, but it will provide you with insight as to the financial transactions of the Association, and a greater understanding of how your Association operates. While this may seem like too much work to be done on a monthly basis, you as a director have an obligation to the members of the Association to safeguard the assets of the Association. Only through diligence and a step-by-step procedural review of transactions can this be done.
Revenue Ruling 70-604 states that “a meeting is held each year by the stockholder-owners of the corporation at which they decide what is to be done with any excess assessments...”.
This wording is generally interpreted literally to mean that only the members can make the election. The board of directors cannot make the election. This interpretation places the election approval process directly in conflict with state law (for at least every state in which I have researched this issue), which prescribes that only the board of directors may make decisions regarding disposition of association funds; the members cannot do so. That’s why directors were chosen to represent them.
Associations continually tell me that they can’t get a quorum of members to make a legal vote, or that they have difficulty getting the members to approve an election under Revenue Ruling 70-604. The follow-up question is, “Can’t we just have the Board of Directors make the election?”
The answer is probably yes, but that depends on how much risk you want to take or how much money you want to spend fighting the IRS on this issue. An argument made out of context to the IRS that “the board must make the election because only they have the authority to do so” is a losing one. (If you don’t believe me, just ask any IRS agent.)
The IRS interprets this Ruling very literally to mean that the stockholder-owners must make the decision, because that’s what the Ruling says. The IRS is bound by the Internal Revenue Code and Federal Court cases, but is not bound by state law, non-judicial precedent, or any other precedent except those of their own making. The IRS must follow its own Revenue Rulings whenever they apply to a given situation.
The IRS doesn’t care what state law stipulates, or who has the actual authority to make a decision regarding the disposition of association funds. They only care what their Ruling says, and it says “stockholder-owners,” not directors. However, the phrase as stated by the IRS makes sense ONLY if the members have the authority to determine the disposition of association funds.
It takes only a subtle change in interpretation to change the face of the argument entirely. When working under Revenue Ruling 70-604, pay careful attention to the subtleties of phrasing: “A meeting is held each year by the stockholder-owners of the corporation at which they decide what is to be done with any excess assessments . . .” The phrase “they decide” clearly implies that the stockholder-owners have the authority to make the decision. In fact, they don’t. The IRS was simply unaware of this aspect of association governance at the time the Ruling was issued.
I discussed this issue several years ago with the national office of the IRS, and they conceded that their only interpretation was a literal one, meaning the members had to make the election. I suggested an alternate interpretation: “A meeting is held each year by the individuals in the association who have the authority to make the decision (the board of directors) at which they decide what is to be done with any excess assessments...”. The IRS agreed that my interpretation had merit because the Ruling has no basis if the individuals making the election do not also have the authority to determine the disposition of association funds.
Winning an argument with the IRS isn’t done by telling them that their Revenue Ruling is wrong. Winning the argument is done by showing them how their Revenue Ruling really conforms to the facts. The board makes the election because they are empowered to do so, and that’s what the Revenue Ruling says (in substance, not literally).
Having now discussed the issues, what is an association to do? Well, do you want to comply with what the IRS requires and have the members make the election, or would you prefer to fight them and have the board of directors make the election?
The fact is, you can take a simple action to satisfy both state law and IRS requirements.
I recommend to clients that the members make the election, usually at the annual meeting, although any legal vote of the members will suffice. Then, have the Board ratify that election at their first meeting after the annual meeting. That way, you’re covered no matter how you interpret the ruling.
It’s getting to be that time of year again when associations are thinking about year-end procedures, one of which is making the annual election under Revenue Ruling 70-604.
I have been asked a number of times what those numbers mean. “70” signifies the year in which the ruling was issued (1970), and “604” simply represents the numerical sequence of the ruling for that year. This was ruling number 604 issued in 1970.
As a CPA, I receive more questions about the application of Revenue Ruling 70-604 than on all other tax issues combined. Several of my articles on the subject of Revenue Ruling 70-604 are posted in various places on the web, so I routinely get “found” and questions are routed in my direction. One question I receive over and over is “when do we make the election?”
While Revenue Ruling 70-604 is one of our most powerful tax planning tools for associations filing Form 1120, it also is the one most subject to interpretation. One reason for this is that the Ruling itself is so brief - only two paragraphs in length. The absence of internal definitions within the Ruling means that readers have to interpret it and make their own definitions for almost all critical issues within the scope of the Ruling, including the timing of the election.
Because so many areas of this Ruling are subject to interpretation, many years ago I contacted Mr. Ransom (who drafted Revenue Ruling 70-604) at the Internal Revenue Service (IRS) National Office, to discuss this and other matters. When I pointed out the ambiguity in the Ruling with respect to the timing of the election, Mr. Ransom stated that he felt that there was no ambiguity, as the matter was purposely worded so that the Ruling would be flexible. I specifically asked Mr. Ransom if an association could make their election after their fiscal year had ended, and he affirmed that they could. He agreed that the only limitation on the timing of the election is that the election must be made before the tax return is filed, and must be made on a timely filed return.
I also asked Mr. Ransom if it was possible for an association to make an election before the fiscal year had ended. He agreed that it would be possible to make the election in this manner, since the Ruling was purposely drafted to be flexible by stating that “any” excess could be carried over from one year to the subsequent year. That means that one does not have to state a specific amount that would be carried over from one year to the next, nor does one even have to know if there will be any excess.
There is no downside risk to making an election under Revenue Ruling 70-604. If an association does not have an excess of membership income over membership expenses, the election will simply not apply to that year. It would be the same as if no election had been made. If an association files Form 1120-H instead of Form 1120, then no election is needed, so again, the election will simply not apply to that year.
November 11, 1918 sparked the origins of Armistice Day. It was on that date that the Armistice (truce) was signed by the Allies and the Germans, ending the four years of conflict of World War I. This day began not only with the laying down of arms, but also with much celebration of the promised peace in the form of blowing of whistles, impromptu parades, and closing of places of business. Demonstrations were made all over the world. In November of 1919, President Woodrow Wilson issued his Armistice Day proclamation. The last paragraph set the tone for future observances: “To us in America, the reflections of Armistice Day will be filled with solemn pride in the heroism of those who died in the country’s service and with gratitude for the victory, both because of the thing from which it has freed us and because of the opportunity it has given America to show her sympathy with peace and justice in the councils of the nation.” In 1927 Congress issued a resolution requesting President Calvin Coolidge to issue a proclamation calling upon officials to display the Flag of the United States on all government buildings on November 11, and inviting the people to observe the day in schools and churches. But it was not until 1938 that Congress passed a bill stating that each November 11 “shall be dedicated to the cause of world peace and ...hereafter celebrated and known as Armistice Day.” That same year President Franklin D. Roosevelt signed a bill making the day a legal holiday in the District of Columbia. For 16 years the United States formally observed Armistice Day, with ceremonies at the Tomb of the Unknown Soldier, where the Chief Executive or his representative placed a wreath. In many communities, the American Legion was in charge of the observance, which included parades and religious services. After World War II, there were many new veterans who had little or no association with World War I. Leaders of veterans’ groups decided to make November 11 the day to honor all who had fought in various American wars, not just in World War I. On November 11, 1953 the town of Emporia, Kansas held a Veterans’ Day observance instead of an Armistice Day program. This was so well-received that a bill was introduced into the House to officially change the name of the holiday to Veterans’ Day. After this bill passed, its author wrote to all state governors and asked for their approval and cooperation in observing the changed holiday. The name was officially changed to Veterans’ Day by an Act of Congress on May 24, 1954. In October 1954, President Eisenhower recognized the change of name to Veterans’ Day in honor of the servicemen of all America’s wars, and called on all citizens to observe the day by remembering the sacrifices of all those who fought so gallantly to gain an enduring peace. While some wars have been very unpopular, that emotion is based on political positions and should not ever reflect on the nation’s warriors that fight the battles. Our service men and women serve the political class, and don’t make the decisions of what battles to fight. They simply “do or die,” and deserve the appreciation of all citizens for the sacrifices they make.
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