Association Accounting & 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 be- come the victims of theft or fraud when it comes to their funds? We spoke with Brad L. Schneider, CPA, Certified Fraud Examiner, and President of Condo CPA, Inc., in Elmhurst, IL, to answer these questions and en- lighten readers on other important accounting topics.

Finances are, of course, crucial to the survival of an association, and boards therefore want assurance that everything is running properly. Associations with management companies generally have their account- ing functions taken care of by that management company. Self-managed associations may outsource their accounting functions to increase the amount of resources available to them. That way, they do not just rely on the abilities of their treasurer.

Schneider explained that each situation comes with its own issues and methods of setting up and verifying internal controls. In the case of a management company, the board will need to look into the reputation of that management company and its internal controls before turning over finances and future collections. The treasurer, or even another board member, in a self-managed association should have access to bank statements, whether online or in the form of hard copies. If accounting functions are outsourced, treasurers should see to it that they receive accurate and timely reports of income, expenses, cash and investments. A second signer can be utilized for all checks. It is imperative for the self-managed association where the treasurer is handling the finances, he said. “In any case, the association should make sure that they have a copy of the fidelity bond coverage of either the management company or the accounting firm, and they should make sure that anyone who has access to the funds is covered by the fidelity bond. And they should keep a copy in their file,” Schneider said.

The three different accounting methods are modified cash basis (the most prevalent, according to Schneider), cash basis, and accrual. Modified cash basis accounting records expenses on the cash basis and income on the accrual basis. Assessments and other charges are recorded when billed rather than when paid. If income is done on the accrual basis, as recommended by Schneider, the amounts receivable from the unit owners show up on the balance sheet. This allows associations to compare the receivable listing at the end of the month to the balance on the balance sheet. If those two numbers do not match up, certain items may be out of balance. The budget should also match what is being billed, Schneider said. Accounts written off during the year will appear as bad debts. “This method can work for most associations unless the association is getting behind in pay- ing bills. Then this method becomes dangerous. If an association is running into financial difficulties or is running low on cash, and invoices to be paid are not being paid when due, the accrual method must be used,” Schneider explained.

Accrual basis accounting records income when billed and records expenses when incurred, rather than received or paid. Schneider stated that accrual is usually the most accurate method when done properly, and it is also the most time-consuming for the management accounting staff. Management companies may need to hire additional staff, making accrual more of a rarity in Illinois. Accrual is best for associations experiencing difficulty with getting bills paid in a timely manner because the balance sheet lists the total amounts due to the vendors. Schneider recommended modified cash basis for associations that do not have this issue, as it creates unnecessary complexity.

The third method, cash accounting, records bills when they are paid and records amounts due from owners, along with other revenue items, when they are received. Schneider noted that this method is simplistic and can be good for small associations. “The problem with this method is that, sometimes, no one is reconciling the books to the receivables system. When we audit buildings on the cash basis, many times when we convert it to the accrual basis, the accounts receivable do not reconcile,”
Schneider said. This forces the accountants to inquire into any units writ- ten off during the year, as they will not show up on financial statements until converted to the accrual basis. Schneider explained that some association boards will want to see income on the cash basis so that they can use the statement of revenues and expenses as a cash flow statement. Income should be converted to the cash basis with a monthly entry, but the accounts receivable from the owners, along with the assessments and bad debts, must first be reconciled to ensure their accuracy. Since some avoid reconciling the books each month, Schneider discouraged cash basis accounting.

Schneider stated that the American Institute of Certified Public Accountants (AICPA) does not require monthly financial statements from the management company. However, he strongly recommended that the board receive monthly or at least quarterly financial statements for small associations. For associations that hire independent accounting firms for the year end, they must have a schedule included in the supple- mental information relating to the reserves, based on either a formal or informal reserve study. “If a basis of accounting is used that is not accrual based accounting, we are required to state the basis in ‘the auditor’s opinion or the independent accountant’s opinion (for compilations and reviews),’” Schneider said. He further explained that accountants, in this case, will say that they audited or reviewed the financial statements on the cash basis. The accountants state if the statements present fairly or that they were not aware of any material modifications based on the cash basis, Schneider said.

Associations often begin the budgeting process in July. Schneider stated that the process should begin no later than November in order for a budget to be passed in December.

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

Schneider explained that categorization depends on the type of association, be it a condo, co-op, or other. He noted that many management companies already have expense groupings set up, and budget worksheets can also suggest groupings. Associations should ultimately strive for categories that make the most sense to them. Schneider recommended that special facilities be grouped separately (i.e. garage, pool, clubhouse, or other major cost and income centers); items such as laundry, however, may be too small for their own category. Associations should always have a category for reserves.

With regard to detail, the categories should strike a balance between too detailed and not detailed enough. The categories should not be burdensome to the association. “A good indication that the budget is too detailed is when you have a lot of categories that are small amounts,” Schneider said. Sub-categories are an option as well, with their advantage being the ability to track items in greater detail when there are questions relating to management decisions.

How often should the budget be analyzed and by whom? Schneider said that the manager or treasurer of an association should first draw up a preliminary budget based on the input of the board and its plans for the upcoming year. Association managers should have a supervisor review the budget for any mistakes and provide information on how similar associations have handled their budgets. The budget then goes to the finance committee or board for their comments, according to Schneider, and then it returns to the board for review. Finally, the budget is presented to the owners prior to the board of directors passing the budget at an official meeting. Schneider further noted that accountants typically are not consulted on the budget prior to its approval by the board; however, an accountant can provide helpful suggestions to incorporate into an association’s budget.

Once passed, Schneider recommended that the budget be reviewed monthly. He explained, “For instance, if it is a prolonged winter, the amount budgeted for gas may not be enough. If it is bad enough to put the association in financial straits, the board will need to consider passing either a special assessment or amending the budget mid-year and increasing the assessments or passing an energy assessment.”

• Administrative
• Repairs and Maintenance
• Payroll
• Utilities
• Building
• Operating/Contractual Expenses
• Reserves (including, according to Schneider, Reserve Transfers/ Reserve Assessments)
  Special Assessments*

* “By definition, these are un-budgeted assessments in the year they are created. However, if it is an on-going special assessment over a period of years, then it can be included in the reserve section of the budget,” Schneider said.

What are an association’s annual reporting requirements for financial statements? Schneider said, “According to the Illinois Condominium Property Act, the board must supply to all unit owners an itemized ac- counting of the common expenses for the preceding year actually incurred or paid, together with an indication of which portions were for reserves, capital expenditures or repairs or payment of real estate taxes, and with a tabulation of the amounts collected pursuant to the budget or assessment and showing the net excess or deficit of income over expenditures plus re- serves.” He noted that an association’s declaration may have a stricter pol- icy that requires an annual audit. It can also provide a date by which the annual accounting must be disseminated. Association funds must not be commingled with those of other associations, the management company, or even reserve funds, he said. Schneider recommended that associations review their financial statements on a monthly basis. Smaller associations might review on a quarterly basis, although their bank accounts should still be reconciled monthly.

The Prudent Man Rule typically dictates how reserves might be in- vested: reserve funds should be placed in safe, insured investments, including money market funds, money market accounts, certificates of de- posit, or treasury bills. Investing in mutual funds to take advantage of the stock market are frowned upon, Schneider said.

According to Schneider, the financial statement and the budget differ mainly on one thing: perspective. While the budget predicts for the com- ing year, the financial statements report what has happened in the past. Statements that are a “budget to actual comparison” are a hybrid of both, with both historical and prospective columns.

Variable expenses, such as electricity, are those expenses that change according to usage. Electricity use tends to change from month to month, so the expenses too will vary. Some expenses are part variable and part fixed. Elevator contracts are fixed, but certain parts or services related to the elevator may not be covered under contract and are, therefore, variable, Schneider explained.

“The operating fund is where the activity of the association occurs to maintain the daily operations. It will not include capital re- placement projects,” Schneider said.

What types of tax returns does an association file? Tax returns differ based on the type of entity, and associations rarely qualify as true tax exempt organizations under the Internal Revenue Code section 501C. “There are the rare occasions where an association may qualify as a 501C4 Social Welfare organization or as a Social Club, 501C7. Cooperatives will need to file the 1120-C as well as the IL-1120. Condominiums, HOAs, and town home associations will generally be able to file as either a regular corporation (1120) or a homeowners association (1120-H),” Schneider said. Deciding which form to file happens annually.

The 1120-H form taxes net income of non-assessment or membership fees from owners. Under this form, many associations have no net taxable income due to extremely low interest rates at the present moment. Provided that there is any tax due, the tax rate is a flat 30% in addition to the Illinois taxes of approximately 9.5%. Schneider explained that the 1120-H requires that an association be residential, obtain at least 60% of its revenue from membership dues or assessments, and have 90% of its expenses going to manage, maintain, care for, acquire, or build the association property. “Non-exempt income, such as user fees for the laundry facility, or income other than assessments, such as interest income, is taxed net of directly related expenses,” Schneider said.

The 1120 form, Schneider said, is much more complex. This form is for a normal corporation and is modified by Section 277 of the Internal Revenue Code, stating that member losses cannot offset non-member in- come gains. This particular form taxes net non-member income and member income. Member income can be carried over to the next year, provided that elections are successfully completed. The IRS requires that this is a one year election passed by the unit owners. “If the 1120 is filed and there is tax, the first $50,000 of taxable income is taxed at 15% along with the approximately 9.5% Illinois tax. At the present time, we recommend the filing of the 1120-H form since there are less issues upon IRS audit and, since the interest rates are presently very low, most associations end up with no net taxable income,” Schneider said.

“A compilation is a financial statement where the outside accountant prepares financial statements based on the management company’s records or the treasurers’ records for self-managed associations,” Schneider explained. The format and level of disclosure of compilations can vary greatly in Illinois because CPA firms are not required to adhere to Peer Review quality standards. Compilations do not require that the underlying numbers be looked into. If the CPA firm is licensed in Illinois, it is required to adhere to quality re- view standards mandated by the American Institute of CPAs. If the firm or partners are “registered” in Illinois, Schneider said, they are not required to follow Peer Review standards. Schneider said that, because of the lack of requirements in Illinois for compilations, the quality of the financial statements and the work product of the accountant varies greatly. He said it is essential that the firm selected is a member of the AICPA Peer Review Program. Compilations can, however, serve as viable alternatives to audits when an association feels comfortable with its level of financial control. Compilations are often the only level of service affordable for a smaller association.

The Illinois Condominium Property Act does not require audits, although some Illinois declarations do call for annual audits. Schneider noted that this is rare and that an association, by law, may opt out of an audit at any point in time, assuming it is not required by their declaration. The cost per unit of an audit is negligible in a larger association, and it can be a good way to increase oversight of the financial operations of the association. “According to the Association of Certified Fraud Examiners, oversight can greatly reduce the opportunity, and thus the incidents, of fraud,” Schneider said. An audit can also be provided to prospective unit owners to give them an idea of the association’s financial condition.

How can associations protect themselves from fraud? The best way to avoid fraud, according to Schneider, is to examine the internal controls set up by the management company (or the board if the association is self- managed). Solid internal controls and segregation of duties can do much to prevent fraud. The treasurer, or even another board member, should have access to original bank statements or online check copies. Cash disbursements should be compared to check copies on a spot basis. Schneider reiterated that annual audits can also discourage fraud.

Warning signs for theft or fraud can include a bank balance on the books that does not reconcile with the bank records. Unit owner receivables increasing at the same time as unit owners stating that their accounts are incorrect and that payments are missing can be another sign. Keep on the look out for expenses that were not authorized or approved yet that still show up on financial statements, for dropping bank account balances while costs increase at an abnormal rate, or for vendors who refuse to bid on jobs or complain that they had to pay extra to bid. Schneider further recommended to look for income that had been on previous financial statements and is now missing.

Associations should periodically check for items of income that are not part of the typical monthly assessment bill to determine if they are reason- able (i.e. laundry income, health club memberships, antenna income, etc.). Checks made out to cash, credit card companies, or hardware/other house accounts without back-up attached to the paid bill copy can also serve as red flags for fraud. Accounts where the management company is not a signer and no records have been turned over to the management company are also suspect. Associations should keep in mind that QuickBooks al- lows changes to payment dates and the payees and therefore is susceptible to fraud. Schneider said, “In order for a fraud to happen, the three legs of the fraud triangle must be in place: opportunity, need, and rationalization.”

When selecting an accounting firm, Schneider recommended, first of all, that a firm has consistently received reviews of good quality from the AICPA and has a solid reputation in the industry. Associations should look to the experience of a firm’s staff, the number of associations with which they work, and the availability of the firm’s partners to answer questions in a timely manner. Firms should expose themselves to continuing education relating to the community association industry and stay in- formed of current topics and issues. As Schneider said, some questions an association should ask of accounting firms include, “Do they participate in Community Associations Institute (CAI) locally and at the national level for educational updates? Do they participate in CPA society educational opportunities relating to your association? Are they well known by newspaper, magazine, and public speaking engagements to give advice to associations?”

Billings are based on the time spent by staff members at a CPA firm; a multiple of the staff members’ hourly rate will be calculated to produce an hourly billing rate for whatever service is provided to an association. Schneider stated that many firms charge a flat fee for auditing, accounting, or tax work for community associations since those associations work on a fixed budget or assessment. Note that unforeseen circumstances can increase the cost of a firm’s services. “Although the fee is important, so is the quality of the service,” Schneider said.