Category: Accounting

Accounting Standards

~ C.O.R.E. Beliefs ~ Leave a comment

One of the big issues we face, as auditors, is an entity following an accounting standard for its financial statements.  Which begs the question, what is an accounting standard?

The best way to look at it is that an accounting standard is the expectation of how transactions should be recorded and disclosed in financial statements.   For generally accepted accounting principles, also called GAAP, this way of recording and reporting transactions is presented in the Accounting Standards Codification, or ASC’s.

Why should anyone care?  That is the question we are struggling with this week.  It seems that there are some, even in professional accounting, who are unsure why GAAP should be followed.  I have shared with you some of our more interesting conversation with clients and their management but we have similar discussions within the profession.

The simplest answer is, eliminating confusion.

GAAP, with all its faults, is just what it says it is, generally accepted.  This doesn’t mean universally accepted but it does mean that most of us agree that transactions should be recorded and reported a particular way.  By agreeing, up front, on how transactions should be completed, we get rid of the guesswork and the uncertainty of everyone deciding on their own.

Yes, this is all wonderfully theoretical but the vast majority of small businesses, non-profits and HOA’s don’t care about GAAP, is the argument we hear.  No doubt.  But the people who put their money into it should.

On a simple level, you are approach by a friend, a contractor lets say.  He wants you to be a guarantor on a project.  It seems he can’t get bonding.  You agree but only if you look at his financial statements so you know what you might be getting into.

He hands you a single piece of paper.  On it it says,

Cash        $500,000
A/R       $2,500,000
Profits                 $3,000,000

Are you ready to sign on the dotted line to guarantee this upcoming project?  If so, please write me immediately because I have an investment idea for you!

Of course you are not going to accept it.  Not because you question the numbers, per se, but because you don’t understand how they came into being.  In short, this is confusing isn’t it?

What would you like to know?  How about how he decides to recognize his income?  Perhaps how he elects to record expenses?  Does he have any debts that are not on the books?

You are interested in his accounting principles.  Now, if you happen to know how most (not all) contractors do accounting, you could ask something like,

Other contractors I know record revenues based on how much of the work is completed, is that how you record it?  I have read several other financial statements from contractors and they all have some amount of construction costs, how do you record costs?

If everyone could pick and choose the policy they want to follow we don’t have standards.  You would not have an ability to compare one company against another in the exact same industry – you would not even be able to follow a single company from year-to-year.  Accounting standards enable you to do this.

Look, we know GAAP can be complex.  But in all fairness, your entity is complex.  If you are a retailer of candy bars and you sell for cash only, you have very simple accounting.  If you take money today for work that will be done over the next three years, you created complexity.  And if you do work today and allow people to pay you over the next three years but only in relationship to how effective your work is, you created a nightmare.

As a reader, you should want to know how an entity records and reports transactions.  You should want to feel comfortable that a lot of other similar entities are doing the same thing.  In short, you want to feel good that the financial statements you are looking at are, in fact, generally accepted.

If you don’t like GAAP, then don’t play with other people’s money.   Don’t ask lenders, don’t ask investors, don’t ask me.  If you are the only person who relies upon how you do the accounting do it any damn way you please.  I mean, lets be honest, you won’t even look at a financial statement.  You will log into your bank to see how much cash you have and make all your decisions based on that.

But if you expect others to put their faith in you, then embrace GAAP.  Ensure you prepare financial statements for them to read that comply with the standards the accounting profession has provided.  The standards don’t exist to make your life miserable, they exist to help you get the funding you need.  Overwhelm your reader with good, actionable information and they will return the love.  They may not give you money, but they will likely do what they can to help you succeed.

Because honesty and integrity are still rewarded in this world, even if it often doesn’t seem like it.

Have a great weekend.  And if you are looking for an auditor or CPA firm to review your financial statements, or just help you make sure your financial statements are useful to your readers, feel free to get more information and contact us through our website.  We are here to help you rely upon your management, even if that is you.

 

Thoughts on Accounting and Reserve Funds

~ C.O.R.E. Beliefs ~ Leave a comment

This weekend Doug and I were discussing the soon-to-be-required ASU 2014-09 and ASC 606 and how it applies to Common Interest Realty Association’s (CIRA).  As we look at this more closely, it is highly likely that something is going to have to change in order for Property Owner Association financial statements to comply with GAAP.

There may be a considerable problem with our current POA financial presentation that we, as a community of professionals, need to address. Specifically, how do we treat the receipt of resources paid to the Association for future activity in the Reserve Fund?

To review the 5 steps as they pertain to a reserve fund transaction as spelled out in ASU 2014-09 and ASC 606:

  1. Identify the contract. The POA passes a motion (resolution) which states that all owners must contribute a certain sum of money. The owners agree (or fail to disagree in sufficient numbers). This likely creates the contract under 2014-09.
  2. Identify the performance obligations. The purpose of the charge is to amass sufficient assets for future repairs and renovations. Thus, the reserve study, which is the underlying documentation calling for the expenditure of funds, creates the performance obligations. The POA could either call each discrete item its own performance obligation or bundle the annual expected disbursements into specific performance obligation groups. The grouping approach is allowed under 2014-09.
  3. Determine the transaction price. The transaction price would be the sum total of the performance obligations as spelled out in the reserve study.
  4. Allocate the transaction price to the performance obligations. Since each performance obligation already has an agreed-upon price, no further steps are warranted unless the POA receives information calling the transaction price into question.
  5. Recognize the revenue when performance obligations are satisfied. And here is the problem.

Currently, GAAP treats the request for reserve funding as revenue when billed (received). It bases this on the premise that, while the income is, in theory, unearned, there is no right to request a refund and the funds are owned and controlled by the POA. Since the funds do not ever need to be refunded ASC 605 states that the most appropriate treatment is income.

But ASC 606 and ASU 2014-09 have the new performance obligation. If the performance obligation is in fact the future expenditure of resources in line with the reserve study, then this is no longer revenue but deferred revenues. It doesn’t matter if there is no right of refund anymore. These resources can only be taken into income when the reserve project is authorized and expenditures arise.

It would likely be incorrect to argue that the performance obligation is the mere demand for funds. An association is not allowed to amass assets without some rational basis – like the reserve study. Even if the reserve study is management’s, or the boards, best guest (meaning they don’t hire an independent expert to plan the amassing of reserve funds) the point of the accumulation is to pay it out at some future time: i.e. specific performance obligations.

This assumes, by the way, that the correct treatment of reserve transaction is, in fact, through the income statement. Since there is no profit motive, that is, the goal of the accumulation of reserve funds is to have sufficient assets on hand to address specific items without the expectation of additional accumulation of profits, it is possible that this is some sort of transaction other than revenue. This would imply that the transaction is a liability or an equity transaction, in that the accumulated assets are claims by other, currently unidentified contract members and participants receive the future benefit, but in the long-run since there is no real profit motive, the reserve breaks even.

The accumulation of assets is to ensure sufficient (hopefully) resources to address a future commitment to repair and renovate the property as called for in the reserve study. The problem, of course, is that the POA does not have title to the specific assets for which the funds are being accumulated. This amount is being taken in trust. Thus, the only “items of revenue” in the reserve fund would be the investment earnings and direct expenses, including any agreed-upon management fee, incurred directly by the fund. The payment of a reserve project would be recorded against the trust corpus and accumulated earnings – i.e. the liability account.

So, it is very possible that this new ASC will require a complete rethinking of how POA’s account for reserve funds. If the profession agrees that a POA is subject to ASC 606 for the contractual obligations then reserve funds will likely need to be treated as unearned until the performance obligation is satisfied. Or, if the profession believes that the transaction is not subject to ASC 606, then ASC 972 will need to be clarified to address how such funds are to be recorded. The contribution of those resources can be treated as temporarily restricted contributions in line with NPO accounting but this would necessitate the transition to NPO reporting and away from fund reporting. This will further necessitate an update to 972 to explicitly require this type of accounting. ASU 2014-09 calls into question how reserves will be treated moving forward and ASC 972 appears to be silent on the application of the ASU and the ultimate reporting of claims against assets accumulated for the future repairs and renovation of common property.

Welcome to Monday.  If you are looking for a firm which focuses on audits and reviews of Property Owner Associations and other types of organizations, feel free to get more information about us from our website.  We look forward to the opportunity to be of service to you.

 

Management’s Representation

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We are often asked, “Why do I have to sign this letter?”  The letter being referred to is the management representation letter.  As to the why, because you as management, the owner, the board, are making specific assertions that we, the independent accountant’s are relying upon.

An important part of management’s representation is the concept of materiality.  The representation letter typically includes this paragraph, “Certain representations in this letter are described as being limited to matters that are material. Items are considered material, regardless of size, if they involve an omission or misstatement of accounting
information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement.”

In this section you are agreeing to the concept that the dollar value alone is not necessarily indicative of materiality.  I will use a real-world example (one we are currently facing) to explain:  Way back in November 2013, an association approved a special assessment.  Interest was to start December 1, 2013 if the full amount of the special assessment wasn’t paid by November 30.  Unpaid interest earned was about $3,500.  The manager did not accrue the interest for those who hadn’t paid by December 31.    Was it material?  Dollar-wise probably not.  But had it been known that over 30% of owners had not paid their first payment – which would have been obvious had the accrued interest been included – it is quite probably that a reasonable person’s judgement may have been changed.

So what are some of the specific representations you are making?  Regarding the financial statements, you represent:

  • You understand that you are responsible for the preparation and fair presentation of the financial statements.  This is true even if you entrust the preparation of the financial statement to the outside accountant.
  • You acknowledge your responsibility to design, implement and maintain an internal control system and you have fulfilled this responsibility.  This is a big issue; go back to the example above, obviously the control system to ensure that all relevant information was provided in the financial statement was not working properly.
  • You acknowledge your responsibility to design, implement and maintain an internal control system to prevent and detect fraud.  Fraud, by the way, is not just about people stealing it is also about ensuring the financial statements are not intentionally misleading.
  • Related party relationships and transactions have been accounted for and are disclosed.  This could be as simple as renting the building from an LLC owned by the majority shareholder or as complex as contracting with a company where the controller is a silent partner.  You are stating that these types of transactions have been fully documented and are properly disclosed to a reader of the financial statements.
  • Any important events that happened after the balance sheet date are accounted for and/or disclosed.  This means, if you decide to pay a large bonus to key employees after the year-end, at a minimum it needs to be fully disclosed and more likely properly accrued since the bonus no doubt stems from the profit of the year.

These are by no means all the things you are representing regarding the financial statements.  But you get the idea; you have the primary responsibility for all the financial information and making sure it gets in the financial statement.  You can and should bring it up to your accountant (or whoever is preparing the financial statement) if you have the slightest concern that it is something that should be included.

When is that you ask?  The fact it is on your mind means it should probably be disclosed.  The old saying, “When in doubt, let it out.” definitely applies to your financial statements.  Don’t try to suppress bad news or fluff up the good.  You, as management and the board (if it exists) have an obligation to ensure the truth is provided so that the reader can make an informed decision.

If you need help with preparing financial statements or designing an effective internal control system, feel free to contact us through our website.  We have worked with many large and small businesses, non-profits, and associations as auditor and also consultants.  We are here to be of service to you.

The Dilemma of the Review Engagement

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GAAP can be incredibly complex.  A review engagement under SSARS requires the independent accountant perform analytical tests to determine if GAAP is being complied with.   A review is not an Audit.  It is “substantially less in scope than an audit…” which is a fancy way of saying that the reviewer is not looking deeply into the financial statements.  This means that some complex GAAP issues can be overlooked during a review because the analytic procedure may not discover the problem.

Case in point:

Alpha Condo Association was faced with a dilemma.  The 20 unit complex had substantial leaking through the roof last winter.  Sadly the roof was at its end of life and was going to cost $200,000 to tear-off and replace and also upgrade their elevator and HVAC system.  The association had only $50,000 in their reserve fund.

No, I am not going to rant about the lack of foresight by the board.  My other blog is addressing that issue.  What I am going to discuss is how things can go sideways and it might take years to discover.

Back to the issue at hand.  The board votes to have a special assessment for $10,000 per unit to deal with the problem.  The owners approve the special assessment 13 to 7.  Here is where things go wrong.

The board apparently provided owners two payment options.  Full payment within 30 days or payment over 10 years with interest.  The resolution which passed stated the interest rate charged was going to be equal to the interest rate on any bank loans taken out.

Five owners paid the $10K within 30 days.  The remainder took the payment option and the board borrowed $200,000 from the bank to do the work.

Apparently the board decided that, to make things easier, they would include the interest due from the owners in the initial assessment.  So, instead of their special assessment being $10K, it was $16,000.  Yes, that’s right.  The bank’s interest rate times the ten years for the repayment term of the special assessment.  The actual interest ended up being about 9.6%.

Ignore, for the moment, the fact that this does not calculate out to 6.0% interest, the real problem is that the management company recorded a receivable of $290,000 and special assessment revenue of $290,000.  The special assessment of $200,000 and the interest charge of $90,000.

The financial statements were reviewed by several different independent CPA’s (not us) over the years which reported the financial statements were prepared according to GAAP.

No they weren’t.  The original entry was incorrect by treating the interest as special assessment revenue.

Today’s missive is not about GAAP per se, it is about the inherent risk of a reviewed financial statement.

I am not trying to defend the fact that the CPA’s overlooked the problem.  In hindsight it is obvious that the $90,000 was not “earned” as special assessment but it was rather unearned interest on the special assessment receivable.  Now, almost a decade past the original special assessment we are performing the review and we stumbled across this matter.

Of course, like any good story there is lots of murkiness.  Like the fact that the unit owners voted to pass on having a review in the year of the special assessment as well as the two years after.  It wasn’t until 3 years after the transaction that the CPA was asked to review the financial statements.  And sadly, this issue was overlooked.

Again, this isn’t about GAAP; directly.  This is about the fact that the owners decided against spending money on an assurance service.  That’s right, hiring a CPA to perform an attest function on your financial statements is a means to ensure that what you are being told in those statements is prepared according to the rules everyone agreed to.

Most state condominium laws require at least a review of the association’s financial statements.  The law also typically requires that the financial statements be prepared according to GAAP.  But the law also typically gives boards and/or owners the right to waive compliance with the attest of the financial statements.

The owners agreed to waive the preparation of the financial statements for three straight years.  For three straight years the presumption is everyone was cool with how the accounting was done.  Finally a review is done and, because the reviewing CPA missed the original transaction, they want the CPA’s head on a platter.  Talk about shooting the messenger.

If you, as a non-profit board, as a business owner, as an investor, take a pass on hiring an independent CPA to perform an attest service, don’t blame the CPA when things don’t go right.  And, if you think saving money by having a review instead of a very painful (and valuable but costly) audit performed is a great idea, don’t be surprised when things are not working like you were lead to believe.  After all, the accountants’ report clearly states that a review is substantially less in scope than an audit… buyer beware.

No one likes to make mistakes but it happens.  As professionals we are ok with being held accountable for our work.  But when you elect to take the cheap route and things are wrong, don’t go looking to blame the professionals when it suddenly comes to bite you in the butt.

We haven’t worked out yet how we are going to handle this.  It is a problem to be sure – on several levels.  But the point is, don’t skimp on an audit if you want reasonable assurance that the financial statements are prepared correctly; and don’t skimp on a review if you are not involved in the day-to-day operation of the entity.  Neither service will catch everything that might be wrong but, what doesn’t get told in a financial statement is often worse than what is in there.

Have a great day.