Accounting for Bond Investments

Auditing condo and homeowner associations is a very rewarding activity for us.  Between Doug and me, we have many years of experience auditing HOA’s and condominium associations.  For the most part, our role is helping the board and the manager create better, more accountable processes so that the owners can feel comfortable knowing their assessments are working hard for them.

There are several areas however, that toss a wrinkle into the audit process.  And it all revolves around the reserve – specifically having enough on hand or not having enough.  When there is enough in the reserve, the quest becomes making that reserve work more effectively for the association by having it take on perceptively more risk.  When there isn’t enough the owners have to agree to a special assessment and oftentimes bank loans to fund the projects.

Both have their accounting complexity and both have add complexity to the audit.  Today we are going to discuss the accounting and audit issues around having sufficient reserves to allow for some greater returns than money market savings.

The first foray into reserve investing is typically bonds.  These are likely long-term bonds with interest of 3% to 5%.  And the accounting complexity begins almost immediately.

Lets say you buy a $1,000 bond that pays 5% interest.  It had an original maturity of 20 years and matures in 10 years.  And lets say you paid $1,020 for it.  How should you record this transaction?

The simple answer is not the correct one.  It would be so simple to record it as

Bond investment     $1,020
Cash                                         $1,020

And then you record the $50 received each year by recording

Cash                         $50
Interest                             $50

Finally 10 years down the road you get $1,000 and turn in the bond but what happens with the $20 extra you paid?  It would be a loss on the redemption.

Cash                         $1,000
Bond investment                 $1,020
Loss on redemption   $20

But that is not the way GAAP works.  Since you know the price you will receive in the future you need to get rid of the difference between what you paid and what you will receive. You do this by amortizing the difference, the premium or discount, over the remaining life of the bond in your possession.

So, in this case, the easiest thing to do is amortize $2 every year on this bond to reduce the additional $20 you paid.

Interest                 $2
Bond investment        $2

By taking this step you will eliminate any gain or loss at the time of the bond redemption, assuming you hold it until it matures.

This seems simple and straightforward right?  And it is, until you get to 10, 20 or 30 bonds and then trying to keep it all straight becomes an accounting headache.  Then someone needs to manage the spreadsheet to make sure that the premiums and discounts are allocated correctly and guess what, no one really has that expertise.

There is a cost to seeking a higher return on your reserve fund.  Your accounting becomes more complex and because of that, your reporting and ultimately your auditing costs start to increase.  There are disclosure requirements for your financial statement and the auditor has to test the investments and then make sure the right information is gathered to put in the notes.  Having investments, even investments as straightforward as bonds, can easily increase your compliance costs by $1,000 or more.  You need to take that into consideration as you move away from CD’s and money market accounts into other investments.

Taking on additional risk in your reserve fund needs to be thought through.  These investments are not guaranteed by the FDIC or NCUA.  You could be locked into a low return and, if you are investing in non-US government securities, you might even lose your investment because of default.  This doesn’t mean to avoid investing but it does require a board to think about this clearly.  And most importantly, understand that your accounting, and the audit you rely upon, will increase in cost and complexity as you invest more.

Have a great day.  If you would like to discuss this further or would like information on how to work with us at C.O.R.E. please head to our website for more information and to contact us.  We are here to be of service to you.



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