Association Accounting and Budgets

When it comes to the association’s finances, how can boards be assured they’re handling things properly? Where should the board begin when creating budgets? What are the reporting requirements and rules for handling association funds? What are the proper accounting methods? How can an association be assured they don’t become the victims of theft or fraud when it comes to their funds? We spoke with Linda Strussione, CPA of Owens and Strussione PC in Shelby Township, Michigan to answer these questions and enlighten readers on other important accounting topics.

There are two different accounting methods, accrual and cash. Which is the best one for associations? According to Linda Strussione, accrual works best for associations. She explained the reason for this is that it follows the American Institute of Certified Public Accountant’s (AICPA’s) requirement that at least the annual report at the end of the year be on an accrual basis. Accrual basis accounting is the technically correct method because it recognizes income in the year it was supposed to be collected,

whether it’s collected or not. Accrual basis accounting also recognizes expenses in the fiscal year in which they occur, whether they are paid or not. This method gives the association a true picture of what the income and expenses were for in a particular fiscal year. The other method is called cash basis accounting but only recognizes income and expenses when they actually happen, therefore, assessments are not recognized until collected and expenses are not recognized until paid.

Strussione said there is, in fact, a professional requirement for how the accounting is done. In Michigan, if an accountant is doing audits or reviews, they are required to follow the American Institute of Certified Public Accountants (AICPA) guidelines. This mandates that reports be done on an accrual basis.

When creating the association’s budget, of course it makes sense to categorize expenses. What is the best way to categorize these, and how detailed should the categories be?

Strussione explained that there are certain categories that are commonly used, and within those are sub-categories, which break the main category into greater detail. The first category associations typically list is the “Administrative” section. Within that section there will be sub- groupings such as office, legal, professional, accounting, paper, postage, etc. The second category that would appear on a typical association budget is “Operating Expenses” — which includes things such as utilities and rubbish removal. The third category seen on a typical budget is “Repairs & Maintenance.” This category can be as detailed as needed, and include anything having to do with interior or exterior maintenance and repairs. “Sometimes the more detailed the better,” said Strussione. If an association has a clubhouse, they can have a fourth category of expenses for that. “We recommend they keep that separate so they know exactly how much the clubhouse is costing,” she said. After this, Strussione recommends having a category for “Reserve Expenses.” This is where the association predicts what their reserve withdrawal expenses will be used for during that year. The last category would be “Insurance & Taxes.” These are the main categories Strussione recommends for boards creating budgets. Those main categories can be expanded further using sub-categories. Strussione again stressed that “the more detailed, the better.”

The operating fund is the portion of your association dues dedicated to be used for monthly accounting of income and expenses. At the end of the year, the operating fund is like retained earnings in the business world. It’s the accumulated net profit and losses of all the operating years of the Association. The goal as a non-profit association is to bring the operating fund close to zero.

The advantage of having detailed sub-categories is that they allow an association to see exactly what expenses they are estimating every year. “For example, in the Repairs and Maintenance category, you could have something like cement, or window replacement. You’re going to have large ticket items that go through the operating expenses, but they don’t necessarily occur every year,” she said. The Repairs and Maintenance category is sometimes 80% of the total budget. The more detailed the budget is, the more you will see what you are paying for. “You’re always going to have some fixed expenses, but you’re going to have variable costs that come up,” said Strussione.

How often should the budget be analyzed and by whom? The budget is the responsibility of the board of directors. There is usually a lot of support from the association’s manager or management company, but the board is ultimately responsible. Strussione recommended reviewing the budget 3-6 months prior to the end of the association’s fiscal year, but she also said that you should look at it throughout the year. “If they’re gathering data and trying to figure out what they need to do for the next calendar or fiscal year, or if they’re expecting their expenses to go up or down, or determine what major expenditures may be incurred in the next fiscal year, I recommend they look at their budget at least three times a year,” she said. An association will finalize its budget for the upcoming year toward the end of their current year. Then Strussione also recommended that the association review the budget 4-6 months after the start of the new year to compare actual expenses to their projections.

Does the association’s accountant typically review the budget prior to its being approved by the board? “We typically see it after,” she said. Although, sometimes boards will consult with their accountants prior to approving their budgets to see if they have any recommendations. “It’s a good idea,” she said, “because your auditors sometimes catch mistakes that the board makes.”

What are an association’s annual reporting requirements for financial statements? According to Strussione, under the AICPA rules, the association’s accountant is required to follow the Codification Code for financial statement presentations for condominium associations. These mandated methods were formerly guidelines, but starting in 2009, they were placed under the AICPA Codification Code. “If you are a CPA and you belong to the AICPA, you are mandated to report using the Codification Code,” she said. She warned if you use a CPA firm that is not familiar with ac- counting for common interest realty associations (CIRA), their reporting will most-likely not conform to the rules on financial statement presentation for a condominium association. Associations are required to report as a non-profit therefore having separate columns for operating funds vs. the replacement funds.

Unlike a budget, which is the board of directors’ projection of income and expenses for the fiscal year, the financial statements are the actual reports of the association’s income and expenses. The board and manager should analyze this report when preparing the budget for the next year and look for items they think may be variable in the upcoming year. For example, if the association knows that water rates will be going up in their city or municipality, they should incorporate the increase into their up- coming budget. Another variable expense is insurance. Additionally, the association should do a physical inspection of their property to see if there are any big projects that may need to be tackled in the upcoming year. “They should do physical inspection reports,” said Strussione. “You need to pay attention to that and see if they need to be incorporated into the budget.”

What types of tax returns does an association file? The two types of tax returns a condominium association is allowed to file, on the federal level, are Form 1120, which is the tax return for corporations, including condominium associations, or Form 1120-H, which is the tax return man- dated for homeowners associations (HOAs) and which can also be used by condominium associations.

The calculation of income for both of these types of returns is the same. For each you must separate the membership income from non-membership income, because membership income is not subject to tax. The membership income is the income received from all regular members, such as assessments and late charges. The taxable income is the non-membership income. This would include things like income from clubhouse rental, interest income, dividends and capital gains.

The calculation for the expenses is the same on both types of returns as well. You can deduct a percentage of your management fees, accounting fees and administrative costs.

So what are the differences between filing the 1120 versus the 1120- H? “The difference is that on Form 1120, the net taxable income is subject to a corporate tax rate of 21 percent. Also, if there is a net-operating loss, associations can carry forward that loss for up to 20 years. For Form 1120-H, the taxable income calculation is the same, but the tax rate is a 30 percent flat tax after a $100 allowed deduction and there is no net taxable loss carry forward allowed,” said Strussione.

In Michigan, as well as some other states, if associations file Form 1120-H, they do not need to also file a corporate state tax return. While this seems like an incentive to file the 1120-H, Strussione said there is no advantage to doing this. “When you look at it, Michigan state tax is only 6 percent. So you’re better off filing the federal at 21 percent and the state at 6 percent — it’s only 27 percent, and you get the loss carry forward versus if you file the 1120-H, you pay a flat 30 percent,” she said. She also said this would be a state-by-state decision, since every state has a differ- ent way of calculating their state taxes as well as different tax percentages.

So why would anyone ever file the 1120-H? Certain associations that are true HOAs are mandated by the government to file the 1120-H. So condominium associations can choose to file the 1120 rather than the 1120-H, but HOAs do not have this choice. “In the eyes of the IRS, if you’re a condominium association, on an annual election basis, you get to elect which of the two forms you file,” she said. Some local municipalities also requires the Association to file a Corporate Income Tax.

Each fiscal year a condominium association has excess assessments over expenses, a net profit, or excess expenses over assessments, a net loss. The Internal Revenue Rule 70-604 states that if there are excess assessments over expenses these monies must be re- turned to the co-owners or applied to the following year’s assessments in order for them not to be taxable to the corporation.

A condominium association is subject to tax under the Federal IRS rules even though it is incorporated as a non-profit in the State of Michigan. A meeting should be held each year where a responsible party, board of directors, or vote by election decides whether to have any excess paid back to themselves or to have the excess applied against the following year’s assessments. To apply to the next year, Strussione suggests that they prepare the subsequent year’s budget and add an income line “carry forward from IRS Rev-Rule 70-604” for a line item amount. Then, in order to not throw off the budget, include a separate expense line called “contingent expenses” for the same amount. This amount is, at best, an estimate, as the actual amount is usually not known at the time of budget preparation. She also suggests that the board of directors make the vote and document the board of directors’ minutes stating that they have elected to carry forward any excess assessments per IRS Rev-Rule 70-604. “For our condominium association tax clients, we include a separate line on the attachment page to the Form 1120-Corporate Tax Return stating that ‘per IRS Rev- Rule 70-604 the excess will be carried forward,’ and we show the calculation,” Strussione explained.

The IRS code section does not state who must make the election. Our firm contacted the IRS in 2017 and documented that it doesn’t matter who makes the election as long as it is a party responsible to make decisions for the corporation. Therefore, the board of directors can make the election and avoid having to take it to all residents for a vote.

A Peer Review is a process by which a qualified CPA firm re- views the operational procedures of another CPA firm to ensure that those procedures meet certain standards. The program is intend- ed to help the public understand the oversight of firms and gauge the ability of a CPA firm to provide certain services at an expert level. Peer reviews are required of all firms that are members of the American Institute of CPAs, and all Michigan firms that perform audits, reviews or compilations relied upon by third parties. Most CPA firms undergo a Peer Review of their accounting and auditing practice at least once every three years. Owens & Strussione PC has had peer reviews every three years since 1992 and has always received the highest grading level.

There was an amendment to the Michigan Condominium Act that affects the requirements for community association audits. The new State of Michigan requirements are in effect for associations with fiscal years starting after January 14, 2014. The change affects all condominium associations of co-owners with annual revenues greater than $20,000. The amendment specifies that these associations need to have an audit or re- view of their records and financial statements performed by a certified public accountant (CPA) on an annual basis. In the past, associations could do a compilation of their records. This is no longer allowed because it is mandated that an audit or review is needed.

Such associations have an option to opt-out of these audit and review requirements, but they must do it on an annual basis. In order to opt-out, they need to have a majority vote of all the membership, which is all co-owners, declaring that they want to opt out. The majority vote needs be repeated on an annual basis, and done in accordance with the association’s bylaws.

“If they don’t have an election to opt-out, then they need to have an audit or review engagement performed,” said Strussione. If an association successfully votes to opt-out of the audit or review requirement, they can then do a compilation and tax return. Strussione said that this amendment is the biggest change in the State of Michigan’s condominium association accounting law in over 30 years.

How can associations protect themselves from fraud? The most common scenario of theft of association funds occurs when an association allows their bookkeeper to physically make deposits of the association’s money and also approve invoices and pay bills. “There is no division of duty,” said Strussione. “That is the biggest threat of fraud to an association.

Another common threat is when a board allows for only one signer on a bank account. “They just allow one board member to be the signer on a reserve savings, certificate of deposit, or checking account, without requiring two signatures,” said Strussione. This gives the signer the opportunity to commit fraud. “With a second signer on a bank account you would need to have two people in cahoots together if you’re paying fictitious bills. It could happen, but it’s less likely if you have more than one signer on the bank account,” she said. Strussione recommended having either two board members as signers, or a board member and someone from the association’s management company.

What are some of the warning signs that theft or fraud is occurring? One warning sign is when a board member who is the only signer on the bank account is having the association’s bank statements mailed direct- ly to their home. “That is a fraud indicator right there,” said Strussione. “They’re controlling the bank account as the only signer and no one else is privy to those bank statements. That’s your biggest problem right there.” Another indicator is if you have board members that have altered their lifestyle. “You see them purchasing or living beyond their means,” she said. She also warns about board members who express they have financial concerns of their own or for a family member. A person experiencing a desperate financial situation could be a potential threat for committing fraud against the association.

Strussione said that the most important thing to look for in a certified public accounting firm is if they are a member of the Michigan Association

of Certified Public Accountants (MICPA) and the AICPA. If the firm is a member of the AICPA, they are mandated to belong to the Peer Review Program. Therefore, association needs to find out if the CPA firm is a part of the AICPA, and if they are, that the CPA firm is having their mandated Peer Reviews done every three years. Also, what types of reports are they getting on these Peer Reviews?

If an association is bringing someone in to perform an audit, Strussione strongly recommended asking if they are in compliance with the AICPA’s Peer Review Program. Linda also said that you should ask to see a copy of their latest Peer Review acceptance letter. Strussione stressed that, in Michigan, CPAs are not allowed to be performing audits or reviews unless they’re part of the Peer Review Program.

She explained further what the AICPA’s Peer Review program consists of. Based on the size of the firm, they can either self-select another CPA firm to come and perform the peer review, or they can turn their re- cords in to the state to do the peer review. Small companies, such as those with one CPA, are allowed to submit their own records to the State of Michigan and the state performs the Peer Review. Medium or large sized firms need to have an outside accounting firm come in and audit their records to make sure the CPA firm is complying with the AICPA’s rules. Firms are reviewed on how they prepare financial statements, how they audit, how they document their work papers, if they’re keeping up with the standards of the AICPA, if they’re complying with the government’s rules on how to do financial statements for condominium associations, and more. “It’s a really big thing,” she said.

Strussione also recommended asking about the firm’s expertise in working with condominium associations. Find out if they are preparing financials using the Codification Code for Common Interest Realty Associations (CIRA). Ask what position they take in preparing a financial statement. Do they take the position of filing Form 1120 for a corporation and take advantage of the lower income tax rates and net operating loss rules, or do they file a simple 1120-H Homeowner Association Tax Return subject to a higher tax rate? What are the qualifications of the people who will be doing the association’s audit? What continuing education classes do the firm’s accountants take to keep up their CPA licenses? Are any of those classes taken for government reporting, or working with condominium and homeowner associations? What type of continuing education keeps them up-to-date with condominium associations? “These are all pretty important questions,” said Strussione.

The cost for accounting services will vary based on several factors, such as if an association has a lot of reserve activity, if they’re bringing in monthly dues versus annual dues, and the size of the association in terms of the number of cash receipts and cash disbursements per month. “Those items are what indicates to a CPA firm what to charge an association,” said Strussione.

She also said the majority of associations are billed on a fixed fee. “They pay one price to do the job,” she said. Other associations, however, are billed per diem because the activity in their situation varies from year to year. Some years they are billed more, and some less, based on what is going on. “Some of the condos are so complex that CPAs just charge by the hour to do the job,” she said. The hourly bills should have detail out- lining how many hours of staff time and how many hours of partner time are included in the billing.

One last bit of advice Strussione gives is not to select a firm solely based on price. “You need to see if people are really checking your re- cords,” she said.