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 John A. Grady, CPA, of Bogush & Grady, CPA’s in Rhinebeck, New York, to answer these questions and enlighten readers on other important accounting topics.
There are two different accounting methods — cash and accrual. Which is the best one for associations? According to Grady, association financial statements should be prepared on the accrual basis of accounting, to be in conformity with the Generally Accepted Accounting Principles (GAAP). He said that the reason for this is that it presents a more accurate picture of the financial statements for the association. Grady explained that the cash basis of accounting only recognizes revenue when the money is received, rather than when earned. Likewise, expenses are recognized when paid, rather than when the obligation is incurred.
But the accrual basis of accounting records revenues to the association (such as common charges) when the amounts are due, regardless of when they are actually received from unit owners. “Expenses of the association are likewise recorded when incurred for goods and services rendered to the association, and not when actually paid,” Grady noted. This method gives the association a complete picture of the association’s financial position.
Grady explained, “The cash basis of accounting can easily be misleading and/or manipulated by the timing of cash receipts and disbursements. For example, on the cash basis of accounting unpaid bills wouldn’t be accounted for. This could have a significant impact on their financial position and budget to actual comparisons.”
The American Institute of Certified Professional Accountants (AICPA) provides guidance on accounting for a community association, also known as a Common Interest Realty Association (CIRA). The AICPA reinforces the GAAP requirements of accrual basis financial statements and requires that information of future major repairs and re- placements on common elements be presented to supplement the basic financial statements. “Such information, although not a part of the basic financial statements, is required by the Financial Accounting Standards Board, who considers it to be an essential part of financial reporting for placing the basic financial statements in an appropriate operational, economic or historical context,” he stated.
According to Grady, associations should generally strive to have a zero-based budget, as long as reserve contributions are taken into account. “Zero-based budgeting is a way of budgeting where your income minus your expenses equals zero,” he stated. Furthermore, when creating the association’s budget, it makes sense to categorize expenses. What is the best way to categorize these expenses, and how detailed should the categories be?
Grady explained that there are certain categories that are commonly used, and within those are sub-categories which break the main category into greater detail. One of the main categories that associations typically list is the “Administrative” section. Within that section there may be sub-groupings such as office, paper, postage, etc. Another category that would appear on a typical association budget is “Utilities”— which includes things such as rubbish removal. A typical association budget would also include a category for “Repairs & Maintenance.” This category can be as detailed as needed and can include anything having to do with interior or exterior maintenance and repairs. Other typical categories include “Professional Fees” and “Management Fees.” If an association has a clubhouse, they may have a category of expenses specifically for that. Other categories may include insurance, taxes, lawn care, snow removal, etc. Grady also recommended that associations have a reserve contribution category, where the association determines its planned savings for its reserves, “that is a calculation based on a reserve study, rather than a guess or plug to balance the budget.”
In all, the categories should be detailed enough for the board to monitor the financial position of the association, but not so detailed that every expense has its own line item. “This is a matter of preference and relevance,” Grady noted. The advantage of having detailed sub-categories is that they allow an association to see exactly what expenses they are estimating every year.
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.
Grady recommended reviewing the budget several months prior to the end of the association’s fiscal year and comparing historical trends for the normal operational expenses, and perhaps extrapolating out the remainder of the year. “With this data, the main operating expenses should be easily derived. It is important to be mindful of large unexpected expenses in prior periods being analyzed, as well as any increases in contractual obligations for the upcoming year.” he said. An association will finalize its budget for the upcoming year toward the end of their current year. Some expenses may be more uncertain, so it may prove worthwhile to contact certain vendors for pricing.
Does the association’s CPA firm typically review the budget prior to it being approved by the board? Grady said that the association’s CPA firm does not usually review the budget. “We don’t have the day to day involvement needed for proper budget review,” he noted.
It’s the fund that accounts for all of the association’s operating revenue and expenses. “The operating fund encompasses all of the normal, reoccurring annual day-to-day expenses necessary to run the association,” Grady said.
What are an association’s annual reporting requirements for financial statements? According to Grady, under the AICPA rules, the association’s CPA firm is required to follow the GAAP for financial statement presentations for community associations. He warned that if you use a CPA firm that is not familiar with accounting for a CIRA, their reporting will most likely not conform with the rules on financial statement presentation for a community association.
Unlike a budget, which is the board of director’s projection for revenue and expenses for the fiscal year, the financial statement is the actual report of the association’s revenue 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 of municipality, they should incorporate the increase into their up- coming budget. Another potential variable expense is insurance.
According to Grady, financial statements with budget to actual com- parisons should be prepared monthly and reviewed by the board and management. Any significant variances should be discussed and researched. Furthermore, in New York, most offering plans require an annual audit of the financial statements.
In New York, associations are generally taxed as corporations and make an annual election to file either Form 1120-H (IRC Section 528) or the standard Form 1120 (IRC Section 277). According to Grady, if an association elects to use Form 1120-H and be taxed under IRC Section 528, it must allocate its income and expenses between its exempt function activities and its activities for the production of gross income (or nonexempt function activities). “It is not taxed on its exempt function activities, but is taxed at the rate of 30% on its net nonexempt function income,” he explained. Form 1120-H is a relatively simple form to prepare but has certain qualification requirements and a higher tax rate for most associations than the alternative Form 1120.
On the other hand, Form 1120 is extremely complex. Under IRC Section 277, an association must allocate its income and expenses between membership and nonmembership; and, by making certain tax elections, only its net nonmembership income is taxed at regular corporate tax rates. “While it will normally result in a lower tax rate than Form 1120-H, its complexity and the lack of specific rulings in several areas create a much higher tax exposure risk when using that form,” Grady stated. “The ultimate decision is the association’s, not the accountant’s.”
IRS Revenue Rule 70-604 is used by associations filing Form 1120. Grady explained: “It allows associations to remove any excess membership assessments from taxable income by recharacterizing them as a return of capital. Under the revenue ruling, associations may make an annual election to exempt or defer net membership income from taxation. They may either apply the excess of member- ship income over membership expenses to the following year’s assessments or refund the excess of membership income over membership expenses to the association’s members.”
According to Grady, there are several key differences between an audit, a review, and a compilation. Essentially, a compilation requires the auditor to simply present financial statements based on the representations made by management, with no effort to verify this information.
In a review engagement, the auditor conducts analytical procedures and makes inquiries to ascertain whether the information contained with- in the financial statements is correct. The result is a limited level of assurance that the financial statements being presented do not require any material modifications.
In an audit engagement, the auditor must corroborate the ending balances in the client’s accounts and disclosures. This calls for the examination of source documents, third party confirmations, physical inspections, tests of internal controls and other procedures as needed.
How can associations protect themselves from fraud? One common scenario of theft of association funds can occur when a self-managed association allows their bookkeeper to physically make deposits of the association’s money and also approve invoices, pay bills and sign checks. “For example, a check written to a vendor you never heard of, or accounts receivable written off without board approval,” Grady stated. In essence, associations should not allow only one person to have full control of the association’s money. “The board should also understand the management company’s internal controls and segregation of duties. The more segregation of duties, the lower the risk of fraud,” he said.
Grady advised that, in order to help prevent fraud, the board should be certain to review monthly financial statements. The documents that the board should review monthly include a balance sheet, a statement of revenues and expenses, a budget to actual comparison, the accounts receivable list, the accounts payable list, the list of checks written during the month, bank reconciliations and bank statements. “The more eyes the better when looking for anything that doesn’t seem just right,” Grady said.
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 directly to their home. Grady said that other signs may include unexplained trans- actions on the bank statements, bank statements that are not or cannot be reconciled, the absence of monthly reports, and resistance to having an audit.
Grady said that the most important thing to look for in a certified public accounting firm is if they are a member of the AICPA. If the firm is a member of the AICPA, they’re mandated to belong to the Peer Review Program. The association needs to find out if the firm is a part of the AICPA and, if they are, if the CPA firm is having their mandated peer reviews done every three years. Once that is confirmed, the association should then look at the reports the firm is getting on their peer reviews.
If an association is bringing someone in to perform an audit, Grady strongly recommended asking if they are in compliance with the AICPA’s Peer Review Program. He said that the association should also ask to see a copy of their latest peer review acceptance letter. Grady stressed that, in New York, CPAs are not allowed to be performing audits or reviews un- less they are part of the Peer Review Program.
When it comes to peer reviews, CPA firms are reviewed on how they prepare financial statements, how they audit and review, how they focus their work papers, if they’re keeping up with the standards of the AICPA and the rules on how to do financial statements for community associations, and more.
Grady also recommended asking about the firm’s expertise in working with community associations. Does the CPA firm prepare financials using the guidelines for a CIRA? What are the qualifications of the CPA firm’s staff who will be doing the association’s audit? Which continuing education classes do the firm’s accountants take to maintain 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?
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, the size of the association in terms of the number of cash receipts and cash disbursements per month, the number of units in the association and whether they are legally organized as a condominium association or a homeowner association.
Typically, Grady said that most associations are billed on a fixed fee. This means the association would pay one price for the audit or review, one price to have their federal and state corporate tax returns prepared, etc. An association may not be billed on a fixed fee if an unexpected circumstance were to arise, which would then require a new fee estimate to be negotiated.