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 be- come the victims of theft or fraud when it comes to their funds? We spoke with Michael P. Mullen, CPA, who is the owner of Michael P. Mullen, CPA, PLLC, of Minneapolis, Minnesota, 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 Mullen, the accrual basis of accounting would be best, if implemented properly. It follows 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. Mullen explained that the cash basis of accounting only recognizes revenue when the money is received and expenses when the money is paid. But the accrual basis of accounting recognizes revenue when earned (when assessments are made) and expenses when incurred (when the service has been performed). Also, the accrual basis accounting recognizes revenue in the year it was supposed to be collected, whether it’s collected or not. This method gives the association a true picture of what the revenue and expenses were for a particular fiscal year.
Mullen said this is, in fact, a professional requirement for how the financial statements for an audit or review must be presented by a CPA firm. In Minnesota, if a Certified Public Accountant (CPA) is performing audits or reviews, they are required to follow the professional standards as set forth by the American Institute of Certified Public Accountants (AICPA) and be enrolled in the Peer Review program. This mandates that reports be done on an accrual basis.
When creating the association’s operating fund budget, of course it makes sense to categorize expenses. The objective of the association is to have a zero-based operating fund budget (revenues = expenses). What is the best way to categorize these expenses, and how detailed should the categories be?
Mullen 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 will 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 electricity, gas, water/sewer, etc. 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 common area maintenance and repairs. “Sometimes it’s better to be very detailed,” Mullen said. Other typical categories include “Professional Fees” and “Management Fees.” If an association has a clubhouse that they rent for events, for example, they can have a category of expenses specifically for that. “An association should keep the clubhouse as a separate category, so the association knows the exact costs pertaining to that common element,” Mullen recommended. Other categories include insurance, taxes, lawn care, snow removal, etc. Lastly, Minnesota state statute requires that associations have a separate category for reserve expenses. This is where the association records their reserve expenses, also referred to by the AICPA as the major future repair and replacement costs, for Common Interest Realty Associations (CIRAs). These are the main categories Mullen recommends for boards creating budgets.
The advantage of having detailed sub-categories is that they allow an association to see the exact costs compared to the budget each month. “For example, in the Repairs & Maintenance category, you would not record an expense for something like major siding, roof or asphalt repair or replacement, because those would go in the reserve category. You’re not going to have big ticket items that go through the operating expenses, because they don’t necessarily occur every year,” Mullen explained. 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, such as management fees, but you are going to have variable costs that come up,” he said. Mullen also noted that associations should not make too many categories so as to make it impractical, and that it largely depends on the size of the association.
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, but the board is ultimately responsible. Mullen recommended reviewing the budget to actual comparison each month. “They should be gathering data and trying to figure out what assessment level they need for the next fiscal year. An association will usually finalize its budget for the upcoming year toward the end of their current year.
Does the association’s CPA firm typically review the budget prior to it being approved by the board? “We typically see it after it’s approved,” Mullen said. Although, sometimes boards will consult with their CPA firm prior to approving their budgets, to see if they have any recommendations. “It’s generally a good idea,” he said, “because your auditors pro- vide a second set of eyes.”
It’s the fund that accounts for all of the association’s operating revenue and expenses. Your operating fund balance, at the end of the year, is like the retained earnings in the business world (a for- profit entity). It’s the net of the profits and losses for all the operating years since the association’s inception.that the reserve account will never fall into a deficit position or below a set minimum amount.
What are an association’s annual reporting requirements for financial statements? According to Mullen, under the AICPA rules, the association’s CPA firm is required to follow GAAP for financial statement presentations for community associations. He warned that if you use a CPA firm that is not familiar with accounting for CIRAs, 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 internal financial statements consist of the balance sheet and statement of revenues and expenses. The board and manager should analyze these reports 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 upcoming budget.
Minnesota statutes require that the association maintain an adequate reserve fund and that those monies be kept separate from operating fund monies activity. Additionally, associations are required to reevaluate the adequacy of their reserve funds at least once every three years. “They should also do a physical inspection of the property each year,” Mullen said. “This is important to make sure that the correct amount designated towards major future repair and replacement expenses are incorporated into the reserve portion of the budget.”
As mentioned earlier, associations in Minnesota are required to reevaluate their reserves at least once every three years. But are there any other requirements when it comes to reserves for associations in Minnesota?
According to Mullen, there are several other requirements. In general, replacement reserves must be included in the annual budget, and the amount allocated should be enough to reasonably replace the association’s aging components over their estimated remaining useful lives and their estimated future replacement costs. The exception to this is that associations are not required by, Minnesota law, to annually fund reserves for components that, at that time, are estimated to last longer than 30 years.
Mullen noted that associations are also required to keep their reserves separate from their operating account, and that the re- serves may not be used for operating expenses. An association can, however, use their reserves as security when seeking a loan.
Lastly, if the association finds itself with surplus funds after providing for common expenses and its budgeted reserves, it can either credit it to reserves or use it to reduce future assessments for the unit owners. This is typically determined by the board, unless the association’s declaration addresses it.
What types of tax returns can an association file? With rare exceptions, there are two types of federal tax returns a CIRA can choose from: Form 1120 (regular corporation), or Form 1120-H (homeowner association). “The calculation of income for both of these types of returns are basically the same. One difference is that laundry income is taxable on the 1120-H, but not on the 1120,” Mullen explained.
For Form 1120, the association must separate the membership income from nonmembership income, because membership income is not subject to tax under Internal Revenue Code (IRC) 277. The membership income is the income received from the members, such as assessments and late charges. The taxable income is the portion received from nonmembers, such as interest income, dividends and capital gains.
Meanwhile, for Form 1120-H, the association must separate the exempt function income from nonexempt function income, because exempt function income is not subject to tax under Internal Revenue Code (IRC) 528. The exempt function income is the income received from the members, such as assessments and late charges. The taxable income is the portion received from nonmembers, such as interest income, dividends and capital gains.
According to Mullen, the calculation for the expenses is the same on both types of returns. “An association can allocate expenses that relate to the taxable income, thus creating a deduction,” he stated. Examples of this includes management fees, accounting, audits, tax preparation, insurance and administrative expenses.
So what are the differences between filing the 1120 versus the 1120- H? “One of the biggest differences is that on Form 1120, the net taxable income is subject to a flat tax rate of 21% (IRS rule change effective beginning in 2018), while Form 1120-H has a flat tax rate of 30%, after a $100 specific deduction,” said Mullen.
In Minnesota, as well as certain other states, associations still need to file a state tax return, and depending on which type of federal return is selected, it dictates which state form is required. Minnesota’s tax rate is 9.8% regardless of which form is filed, Mullen noted.
A word of caution should be taken into consideration when filing as a regular corporation (Form 1120) where there is a net membership income. Mullen explained that that excess can be exempt or deferred under the Internal Revenue Rule 70-604, which states that if there are excess assessments over expenses, the excess should either be refunded to the members (not recommended) or applied to the following year’s assessments (recommended). The election must be made by the membership and before the tax return is filed.
Since June 1, 1994, Minnesota law requires community associations to have an independent CPA perform a review, at a minimum, of their financial statements at the end of the fiscal year. Many associations elect to to have a higher level of service, which is an audit. However, Mullen noted, an association can waive the review requirement if at least 30% of the association’s voting interest elects to do so.
This vote to opt out of the review, though, needs to take place within 60 days after the end of the fiscal year, through a meeting of unit owners or by mailing a ballot. Furthermore, if the association votes to waive the review, the waiver only counts towards the fiscal year that was voted upon, and not additional years as well. If a review does occur, every member of the association must receive the reviewed financial statements within 180 days of that fiscal year’s end.
According to Mullen, Minnesota law requires a review to be per- formed by a CPA who is licensed according to the AICPA requirements. The CPA must also be independent of the association and cannot be a member of the association, or employed by the association’s declarant or those affiliated with the declarant.
According to Mullen, an audit is the highest level of financial statement service that only a CPA can perform. It provides the expression of an opinion as to whether the financial statements are fairly presented in all material respects. The work preformed includes, but is not limited to: the inspection of invoices, canceled checks, bank statements and the general ledger to determine that transactions were properly recorded — that monies were properly collected and deposited and that checks to vendors were supported by an invoice. “We evaluate the internal control structure of the association to determine whether weaknesses exist. In an audit, we also perform all of the procedures that are part of a review engagement,” Mullen explained.
A review, Mullen noted, is the second highest level of financial statement service that, again, only a CPA can perform. It provides limited assurance as to whether the financial statements require any material modification. The work performed includes, but is not limited to: analytical procedures such as comparing current year actual revenue and expense balances to the budgeted amounts, comparing current year actual to prior year actual, and analyzing material fluctuations to determine if the explanation is reasonable. “We reconcile account balances to the corresponding subsidiary ledger, but we do not look into the detail as this would be an audit procedure,” he said.
In summary, an audit requires many more procedures than a review. An audit also provides an opinion versus a limited level of assurance and, as a result, audits cost more than reviews. “Most associations will have an audit every three years, at a minimum,” Mullen said. Associations may also elect to have an audit instead of a review in the event that any of the following situations occur during the year:
• Documents require audit
• Change in management company
• Turnover from developer
• Significant change of board members
• Large insurance claim
• Large reserve expenses
• Special assessment
• Association has a loan payable
• Association has investments that fluctuate on market value
• Association sold property
How can associations protect themselves from fraud? The most common scenario of theft of association funds occurs when a self-managed association allows their treasurer to physically make deposits of the association’s money and also approves invoices, pay bills, signs checks, reconciles the bank statements and prepares financial statements. “There are no segregation of duties in that scenario,” said Mullen. “That’s the biggest threat of fraud to a self-managed association.”
Another common threat is when a board allows for only one signer on a bank account. Most management companies pay all of the bills for the association, since that is what they are hired to do. Mullen suggests boards set a dollar amount threshold based on the size of their budget so that all non-contractual or extraordinary invoices needing to be paid, that exceed that amount, require two signatures — one from the management company, and one from the board. Just allowing one board member to be the signer on a reserve savings, certificate of deposit, or checking ac- count, without requiring two signatures, gives the signer the opportunity to commit fraud. “With a second signer on a bank account, you would need to have the collusion of two individuals in order to commit fraud, like paying fictitious bills, for example. It could happen, but it’s less likely if you have more than one signer on the bank account,” he said. Mullen 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 or a management company, who is the only signer on the bank account, prevents online access to the bank statements. “That is a fraud indicator,” Mullen said. “They’re con- trolling 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 more than usual, or living beyond their means,” he said. He also warns about board members who express they have financial concerns of their own, or for a family member. A per- son experiencing a desperate financial situation could be a potential threat for committing fraud against the association.
Mullen said that the most important thing to look for in a Certified Public Accounting firm is if they are a member of the Minnesota Society of Certified Public Accountants and the AICPA. If the firm is a member of the AICPA and they perform audits or reviews, they’re mandated to belong to the Peer Review Program. So the association needs to find out if the 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, Mullen strongly recommended asking if they are in compliance with the AICPA’s Peer Review Program. He said further that you should ask to see a copy of their latest Peer Review acceptance letter. Mullen stressed that, in Minnesota, CPAs are not allowed to perform audits or reviews unless they are part of the Peer Review Program.
Firms are reviewed on how they prepare financial statements, how they audit and review, how they focus their work papers, if they’re keep- ing up with the standards of the AICPA, and the rules on how to do financial statements for community associations, and more. “Those are very important things to consider,” he said.
Mullen also recommended asking about the firm’s expertise in work- ing with community associations. Find out if they are preparing financials using the guidelines for a CIRA. What are the qualifications of the CPA firm’s staff that 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 condominium and homeowner associations? What type of continuing education keeps them up to date with condominium associations? “These are all very important questions to consider,” Mullen said.
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. “Those items are what indicates to a CPA firm what to charge an association,” Mullen explained.
He also said the majority of associations are billed on an agreed upon fixed fee listed in the engagement letter. “They pay one fee for an audit and a lesser fee if a review is selected. Fees typically include preparation of the association’s federal and state corporate tax returns,” he said.
One last piece of advice Mullen gives is not to select a firm based solely on price. “Instead, look to a CPA firm that is a specialist who understands the unique and complex financial, accounting, and tax issues facing community associations today,” he said.