Financial Management, Adhering to a Budget and Financial Warning Signs

Financial management is perhaps one of the most critical facets of a homeowners association. Financial transactions factor into day-to-day interactions in an HOA, with residents paying dues and vendors providing goods and services. The complexities of an HOA, however, demand a business-like approach to financial matters in order to provide a well-functioning environment for all involved. Budgets, therefore, become essential to success.

How does an association diagram a budget? What can the association do to limit surprises in a budget? How do reserve studies factor in? What are the different types of budgets? Creating a sound budget and adhering to it for the fiscal year for the association is very important. Thomas Engblom, CMCA, AMS, CPM, PCAM, PhD, provided us with an explanation of the budget process.

According to Engblom, “A budget is a roadmap that provides an estimate of a community’s revenue, expenses and reserves. It provides an avenue for a community to plan activities, goals, maintenance, repairs, reserves, determine assessments, and minimize the unexpected.” While the necessity of an association budget may seem clear, the process itself can be quite complex. Engblom stated that an association should first consider the legal requirements for a budget in their state. Refer to state statutes as well as the governing documents of your association as your guidelines. “Every community association must have a budget. It is required at various levels of the law and in the governing documents,” Engblom said. He added that local laws may require a budget, whether for insurance, emergency, life safety, etc. All associations must conform to IRS rules, and mortgage institutions may set requirements that a community will need to meet as well. Additionally, budgets mandate the procedures to determine the applicable requirement for reserves.

Once the legal necessity of a budget has been established, how must your association proceed? From there, your association may take into account the needs and desires of homeowners. What services do they require on a daily, weekly, monthly and yearly basis? Which do they expect? Engblom also noted that associations should not simply aim for a net profit or loss. Don’t simply set a budget including all known expenses (i.e. routine maintenance, electricity, water, etc.). The budget will also need to account for and include unexpected expenses. If, for example, a natural disaster occurs, your association will need to be prepared. Ideally, a budget will limit the impact of financial surprises. Within a budget there is a chart of accounts, which is an organized list of the numbers of the association, categorized showing each item being budgeted for. This is detailed in the previous chapter on association accounting under the heading “Preparing and Organizing Budgets.”

When is the budget due? This depends on the association and is generally contained within the bylaws. Typically, budgets are done either by calendar year or fiscal year. Most do them by calendar year, Engblom noted. The association’s manager typically puts the budget together. A budget committee, headed by the board treasurer, can be formed by board resolution to come up with the nuances in the budget. This is an ongoing, standing committee. Engblom again underscored that an association should not just budget for money it expects or does not have. As an example, Engblom said, “You shouldn’t necessarily be budgeting for fines and late fees.” If income is not expected, don’t budget as if it is.

There are two components of a budget: revenue and expenses.

•    Revenue: assessments (which Engblom noted is the only component of value that an association has), excluding miscellaneous income of  late fees, fines, move ins and move outs, etc.
•    Expenses: operating expenses (i.e.: maintenance, utilities, administrative, management, insurance, copying, printing, Internet, etc.)

Furthermore, two components are affiliated with each budget line as to whether it is mandatory or discretionary. Mandatory expenses are things such as insurance and utilities. These are expenses the association is obligated to cover, as opposed to discretionary items such as pool furniture, a community newsletter or the expectation of an individual unit owner.

There are also two types of budgets:

•    Zero base: In this type of budget  all line items are set to zero. Therefore, all line items must be justified, rather than assuming a base line from the prior year. This assures that every line item is necessary and reduces the fluff within the budget. This zero base approach requires every line item to be calculated accordingly (i.e. utilities) based on usage.
•    Historical trend: In this type of budget an association uses the historical data from budgets past, then reviews  its past history to determine what the increase or decrease in expenses will be for the next year. As an example, Engblom said, “To increase the percentage, you can look at two years ago. You spent 17%, and then this year you spent 19%. So you know to increase 2% again for the next year.” Typically the budget has numerous line items that have inaccurate numbers in those accounts.

There are three (3) types of accounting methods to be used within a budget as follows:

1.    Cash method. Using this method, the association will collect money and pay it out as invoices are received. A great comparison would be one’s personal checkbook.
2.    Accrual is based on when income is earned (or billed), and when expense are incurred. Income and expenses are accounted for outside of when the actual cash comes in or goes out.
3.    Modified cash, also know as modified accrual, is the most complicated method for accounting, but also the best. It records income and expense on a cash basis with some on an accrual basis.

As mentioned earlier, the association can take into account the needs of the homeowners. Budget line items are determined to be either mandatory or discretionary. Mandatory line items are a need or an obligation, such as water, insurance, or taxes. Discretionary line items are a desire or expectation, such as a pool, playground, or golf course. The discretionary items can be ranked based on the desires of the homeowners, but mandatory items must always be budgeted for.

Reserve studies themselves are detailed in another chapter, but here is an overview of the studies and how they are utilized within the framework of budget creation. Once revenue and expenses are established, the association has the so-called bottom line of the budget. Engblom advised that reserves are taken out at this point. Reserve studies serve as a resource for capital expenditures that would be in the the future of the association. The reserve study consists of two components including a physical inspection and a financial inspection. “Reserve funds are set aside for the future, for replacement of major components of an association,” Engblom said, “and reserve studies should be updated every three to five years.” They may be required by a state statute, regulations, mortgagees, or the association’s own governing documents. The Federal Housing Administration suggests setting aside 10% of the total budget for reserves.

Funding for reserves consist of four aspect as follows:
1.    Statutory — Required by state or federal agencies.
2.    Fund Safety — Maintain in FDIC insured accounts.
3.    Liquidity — Don’t have all funds in certificate. Have some cash on hand for emergencies.
4.    Yield — The return on investments.

Reserve studies generally include capital improvements and major improvements. Capital improvements include existing entities that must be replaced, such as a roofs, siding or playground equipment. Reserve studies set money aside for the future, anticipating that something will need to be replaced or repaired. Engblom noted that the amount of money set aside can be judged from the useful life of the structure in question. As an example, “A roof has a 30 year useful life, but because of weather or the like, it may need to be replaced sooner or later. Reserve studies plan for putting aside money for these sort of things,” Engblom said.

Major improvements, on the other hand, include the addition of something new to the association, such as a clubhouse, pool, or golf course. These improvements  are not being maintained, as with a capital improvement, but rather they are being constructed for the first time.

Engblom pointed out some of the benefits of using a reserve study: meets legal and fiduciary professional requirements, provides for planned replacement of major components, minimizes the need for special assessments, enhances the resale value of units, equalizes new and old,  reduces personal liability from financial mismanagement, prioritizes a business plan for repairs, acts as a communication tool for the owners, can reveal maintenance issues that you haven’t seen, saves planning time, reveals unbudgeted items.

He also mentioned some of the drawbacks of a reserve study: underfunding resulting in the need for a bank loan, deferred maintenance, overfunding, board member liability and possible loss of directors & officers liability insurance.

In relation to a budget, a reserve study can most importantly determine what has not yet been budgeted for. It can provide an association with a more thorough road map for the what-if scenarios and help secure an association’s future.

In addition, having control of your financial reports will provide a means of best practices for procedures relating to accounts receivable or accounts payable. In the global aspect for the association it can help discourage dishonest behavior within the association that may result in embezzlement, fraud or theft.

Extra money goes into reserves.