The Contract, Control and Your Condo Accounting

Theoretical question: Does an HOA or condominium association ever try to enhance its accumulated assets?  Or, is the association’s sole purpose to breakeven, that is cover its expenses over the long-term so that unit owners do not have to continually reach deep to pay bills?

I follow the later theory.  When you think about the association and its reason to exist, you will be hit by the fact that it budgets for breakeven and it attempts to accumulate assets only in sufficient amounts to satisfy potential future claims.  Specifically, the operating assessment is designed to cover all of an association’s expenses and the reserve assessment to accumulate assets to deal with the inevitable problems of owning things.  Over the life of the co-owned assets, the reserve should have only enough in the fund to pay for the expected future repair and replacement value of the shared assets.

What does this mean to an association and the upcoming changes under ASC 606?  You will likely not have a statement of revenue, expenses and changes in fund balances that means a great deal.  I say this because as we move towards the control principle of revenue recognition, it is highly likely that assessments (revenue) will only be recognized as a specific expense is recognized.

Under ASC 606, your budget should not only be a bunch of numbers, it should also be a bunch of performance expectations.  Thus, for every expense items, such as landscaping or management, you will want to identify when you believe you have “gotten what you paid for”, so you can recognize the revenue.  And some of you will even say, “This isn’t a problem, we have a contract.”

Thus, today’s exercise.  Do your contracts actually spell out performance obligations so that you can easily determine when the provider delivers and your association has met a performance obligation to those with whom you contract (the Owners)?  I think you are going to be both surprised and horrified as to how little thought goes into most contracts and how your management and board can identify if and when revenue should be recognized in your Association financial statement.

We obviously read a ton of contracts.  We produce them as well – an audit engagement letter for instance is a contract.  So, taking the audit ELA as our first example, lets walk through this to determine when and how an association will likely have to address revenue recognition.

In 2020, you prepare a budget and your budget calls for $5,000 for your annual audit of the 2019 year end.  Your auditor sends you the retainer agreement in January 2020 for $2,500.  The entry, done properly, would be

• Prepaid expense – audit              $2,500
  • Accounts Payable                                $2,500

You also bill your owners for the audit.  Sometimes this is done through an annual budget process but in this particular case, the owners all agreed that bills would be split up and charged to the owners as they come in.  The 50 owners each receive their bill for $50.  How do you recognize it?

This is where the new ASC comes into play.  There are 5 steps you will need to go through to determine how you recognize revenue going forward:

1. Identify the contract.  In this case, the owners agreed (contracted) to have a specific service performed and to pay the charge.  So, it appears we have a contract.  And, by the way, contracts are very liberally identified.  So if it looks like an agreement, it is likely a contract, even if it is not in writing.
2. Identify the performance obligations.  You need to first understand that we are talking about the performance obligations that your customer, i.e. the owners, expect.  In this particular case, the owners expect the completed and issued audit report.
3. Determine the transaction price.  In this specific instance, the price charged to the owners is identical to the price charged from the vendor so the completed audit report has a price of $5,000.
4. Allocate the transaction price to the performance obligation. Since there is only one performance obligation (completed audit report) and the transaction price is for the completed audit report, the price per performance obligation is $5,000.
5. Recognize revenue when (or as) the entity satisfies the performance obligation.

In our particular example, the invoice sent in by the vendor is for a retainer so the invoice to the owners is for the retainer – that is, the billing to the owners is not yet earned.  Thus, the entry is

• Owner receivable                 $2,500
  • Unearned revenue                       $2,500

Notice that the charge to the owners sits in unearned revenue.  Since the performance obligation, that is the completed audit report, has not been presented, the revenue is not recognized.  When the audit report is completed and issued, the auditor sends in their final bill for $2,500;

• Audit expense                           $5,000
  • Prepaid expense – Audit                $2,500
  • Accounts payable                            $2,500

And, since the audit is done, that is, the performance obligation has been met, you would record the revenue;

• Unearned revenue                     $2,500
• Owner receivable                       $2,500
  • Revenues                                            $5,000

This isn’t so bad right?  True, but I set you up with the easiest one first.  In this instance, the Association billed the owners directly for the costs.  But what happens when the audit is but one component of a $500,000 budget assessment?

You guessed it.  It is quite possible that your association is going to create, during its budgetary process, specific performance obligations for each of those contracts and, potentially pass those same performance obligations to the owners through your budgeting.

So, the more detailed your budget is, the greater the possibility that you are creating multiple performance obligations which require your assessments (the transaction price) to be allocated over those performance obligations.  And it is very unlikely that your auditor, those nice ladies and gentlemen looking out for your financial well-being, are going to accept the mere passage of time as a performance obligation.

ASC 606 is not something to ignore and hope your financial management team can figure out on the fly.  We talk with these managers and they either show incredible contempt for the change in how revenues are recognized or are thinking they can safely ignore it because their boards are not paying attention.  The one thing they are not doing is planning for this change.  You, as a board, need to start having this conversation, ESPECIALLY if you are obligated to issue financial statements prepared in accordance with accounting principles generally accepted in the United States of America.

Next up, looking at how ASC 606 performance obligations and assessments might work for you.