Category: Audit and Review

Accounting for Bond Investments

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

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.

 

 

The Possible

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

There are times when I think we do not spend enough time thinking about the possible.  What I mean to say is, we are almost always fixated on the probable, or most likely to happen, outcome.  This is as true in accounting and auditing as it is in life itself.

One important aspect of our role as auditor though, is to consider the possible.  For instance, theft of company assets.  When we look at how assets are controlled, from their purchase to their ultimate disposal, we are looking for possible holes in that system.  Who approves a bad debt write-off, who can set the selling price of a piece of equipment that is no longer in use; the issues which concern is are possibilities.

If we focused solely on the probable, we would potentially miss a warning sign.  Is it probable that the purchasing agent is receiving a kick-back from a vendor for steering business their way?  Maybe not.  But what controls, what business process reduces the possibility?

It is one of the things that concerns us regarding condo and HOA audits.  As the association’s independent auditor, we are first and foremost concerned with the financial statement and the fact that it is materially correct.  But when you think about what provides a materially correct financial statement, it is all the controls and safeguards of the manager – who is charged with the board with carrying out the daily activity of the association.

This is the main reason we spend so much energy on understanding how the community manager does the job.  Who has access to a checking account, who initiates the transaction, who approves it?  These points reduce or increase the risk of misuse of the association’s assets. There are far too many stories about trusting a system that really did not provide any safeguards and addressing that possibility is the responsibility of the auditor.

For instance, what if employee A of the community manager could initiate a transaction for say, yard maintenance.  Employee A contacts the maintenance company, negotiates the price and sets the contract.  Employee A then reviews their work and approves payment.  Finally Employee A can write the check and have someone else sign.

This seems harmless doesn’t it?  After all, employee A can’t sign the check so the asset is safeguarded right?  Not at all.  Employee A could have created a fact maintenance transaction, set up a fake company, approved the work and, because everything was signed off on, the check is cut.  To employee A.

Is it probably this happens in any particular association?  No.  But this scenario could result in this possible outcome.  And the auditor should know that and make appropriate comment.

Community Managers will argue that this couldn’t happen.  They are, however, arguing that it is not probable because they believe they know their employees.  The fact that it could happen though is what we are concerned with when we try to determine the risks of weak internal controls.  Boards need to be made aware that the risk exists so they can take steps, if they feel it necessary, to eliminate, or at least reduce, the risk of it happening.

As a director, make sure your auditor works to understand how the community manager is operating and how it impacts your association.  Press them on their thoughts on what risks might exist to the assets of your association.  Your auditor should have a good grasp of the fundamentals of the control system and can give you some good points to consider.  And if they can’t, it may be time to switch auditors.  C.O.R.E. is here to help you, the board, rely upon your manager.  We do this by looking at the managers controls and how they impact your association.  Feel free to contact us to schedule a conversation about how we can be of service to your association.

Have a great weekend.

 

Dad, What do you do?

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

Brendan and I have been going to the gym 2-3 times a week and lifting weights.  He is starting to learn how to control free weights and he is enjoying charting his progress.  The other day, while we were between sets, he asked me, “What do you do as an accountant?”

One of those exciting moments every parent of a pre-teen lives for!

So I explain to him that I am an auditor, which is not really an accountant but a scientist.  He seemed puzzled but I pressed on.

“Do you remember learning about the scientific process?” I asked, he replied yes and then started to explain that you first set a hypothesis, test the hypothesis, and then draw a conclusion from your test.

I told him that is what makes an auditor a scientist.  We follow the exact same pattern.

Whenever an auditor begins work, we start by creating a hypothesis.  We changed it around a bit to state we test assertions but in reality we create the hypothesis about management’s assertions.  Ok, that is a little wonkish so perhaps an example.

The books show that the company has $100,000 in a bank account.  Management has made several assertions:

  • That the $100K Exists
  • That the Company has a Right to the money
  • That the $100K is Complete and all transactions are recorded
  • That it is actually Valued at $100K
  • That it is actually Classified as a bank account
  • And that management Cutoff all transactions on the right date

Six assertions on one little bank account but any one of them being an incorrect assertion possibly means that the $100K isn’t really.  So, as an auditor/scientist, the first thing we do is form the hypothesis; and our hypothesis is always a negative.  For instance, some of the hypotheses for this bank account could be

  • There really isn’t a bank account with $100K in it (it doesn’t Exist)
  • The bank account is in the name of another business (There is no Right to it).
  • Management failed to get checks signed and mailed by year end (The transactions are not Complete)
  • The account is in Peso’s in a Mexican bank (the Value is not $100K dollars but 100K Pesos)
  • The account is an investment account (it is not Classified correctly)
  • Management recorded deposits that were actually received later (they didn’t get a good Cutoff)

We create these hypothesis and then test them.  For a bank account, we have a ready-made solution – the bank confirmation.  We send out a letter to the bank and ask them to say they agree, or confirm, managements assertions.  The bank writes back and says, “Yes, there is $100K in the bank, it is actually in US Dollars and it is a demand deposit business checking account in the Company’s name.

One confirmation and poof, four assertions are taken care of.  Our hypotheses were disproven and we can safely say that, as far as those assertions go, management was correct.  As a matter of fact, one of the best forms of evidence for an auditor is when a third party can provide evidence that a transaction exists.  We can confirm a lot and prefer it whenever possible as it can help us with more than one assertion – other tests typically only go after one assertion at a time – which means we can spend hours trying to prove the remaining assertions.

Oh yes, by the way, I lost him at the six assertions – he is only 13 after all.  And, to be honest, he is far more curious about the times we catch people making poor choices and how we deal with it.

I told him to read my blogs.  No, he prefers Star War’s books.  But someday he will.  In the meantime, I hope you begin to have an appreciation of what steps we take as auditors to ensure that management is recording transactions to your books accurately.

An audit is designed to prove that the financial statements being presented are fair and accurate.  Management makes those six assertions on every account and ever dollar reported.  So, the next time you are meeting with your auditor, ask him about management assertions and how they design their hypothesis.  If nothing else, it is a great way to find out if they pay attention to their checklists!

Have a great day.  If you are looking for a firm to perform a review or audit of your financial statements, we would love the opportunity to be of service to you.  Go to our website, look us over and then click the Get a Quote tab.  We are a little wonkish but love to get the job done right and on budget.

 

The Importance of Independence

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

Yesterday, Doug and I discussed taking on a new client.  It is not an HOA or condo but a for-profit business.  Yes, even though we focus primarily on HOA audits and condominiums, we do the for-profit financial statement attest as well.  It is with for-profit businesses that our focus on remaining independent really helps.

With HOA’s and condo audits, the boards typically change every few years so we are pretty confident that we can remain independent.  The one class of client we will never do any work for is community management companies – as we firmly believe that this would impair our independence.  We are, after all, passing judgement on their work as it relates to their associations and we believe nothing impairs independence better than taking money from the watchdog.

The biggest independence issue with for-profit companies is that we typically do work for both the owner/shareholders and then perform the attest service on the business.  In most cases, this isn’t a big problem but occasionally, like the engagement we are evaluating now, the two may end up at odds.

Obviously this client does not want a review of its financial statements for its own benefit – although I think it is smart for every business to prepare financial statements and have them reviewed by an independent CPA.  In this case, they have bank covenants that require a reviewed financial statement.  And our independence issue is that we both have social contact with several of the shareholders and actually enjoy their friendship – which, by the way, is what provided us the opportunity to propose our review service.

The ethics rules don’t prohibit a CPA from being friendly with shareholders and management – I mean, lets face it, accountant’s are not the most likeable people on the planet so to deny us the few close friends we MAY be able to conjure would be cruel.  But we look at the independence issue a little deeper.  Is a friendship more important than our objectivity?

It is easy to say that “No, I would never let my friendship get in the way of doing my job!”  But when push comes to shove, are you willing to speak objectively about your friend’s job performance?  Do you have such a strong enough moral compass that you can deal with the glares and whispers from people you both know who have heard one side of the story, because yours has to remain silent?

Perhaps an example will help.

Last year we were performing a review engagement and during the engagement found that the controller had taken an incorrect stance on a certain transaction.  Her stance led to the understatement of liabilities by about $5.0 Million.  with that additional debt recorded, the company would have blown through their loan covenants and probably been put in special assets.

We called the controller on it.  She fought back and said that we could issue our report with an “Except for” paragraph if we wanted but she was not willing to book the liability.  Our friendship, a very strong personal relationship was on the line and all we had to do was go along with the non-recording of the transaction and issue a modified review report.

Doug and I discussed it and agreed that the most appropriate response was to inform the board of the controllers decision, our understanding of the transaction and that we were not willing to allow the financial statements to be issued without the liability being booked.

This is one of the reasons, by the way, that I took the chance to start C.O.R.E. Services with Doug.  He agreed that, if push came to shove, it was far better to be fired by a client for keeping our integrity than cave in – because once we cave we can never regain our original position.

So yes, when you select your CPA for attest services, those pesky audits and reviews, pick one who is willing to stand up for what is right – and not just because the rules say so – but because in the end you want someone of the highest moral principal you can find standing behind your financial statements.

Have a great weekend.  And as always, if you are looking for a CPA to perform an audit or review, check our website and schedule a conversation with us.  I think you will be glad you did.