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.

 

 

Why GAAP matters

Sadly I am not allowed to say too much about today’s meeting as the board was in executive session but the gist of the other accountant’s opinion is that economic reality doesn’t matter only the legal form of a transaction.

Really?

When pressed about how that could possibly be the case since contractors obviously have earned a certain amount of revenue based upon an economic theory, the reply was, “Well you can’t confuse for profit with non-profit.”

Really?

When asked how, when a contract shows the total amount due or, if you elect you can pay a sum each month over XXX number of months and it includes interest at Y%, this someone does not create a sum certain for accounting purposes,  there is not somehow some understanding that the sum certain is a receivable, the replay was, “The contract says it is revenue only upon the payment of the monthly amount.”

Really?

The board naturally is confused.  Rightly so.  Two professionals, two different opinions, one type of transaction.

Except that one professional has a position backed up by research on the application of GAAP and how the Accounting Standards Codifications call for the transactions to be recorded.  The other is an opinion based upon his 30+ years of experience so he doesn’t need to know GAAP.

Honestly, if I were the board I would fire us both.  Me for yelling at a dumbass accountant who thinks that if he appeases his fired client he will continue to reap referrals and the other accountant for being a dumbass and trying to provide accounting 101 lessons.

I was wrong to lose my temper.  At the end of the day the treatment we selected is appropriate and consistent with GAAP.  But there was almost $2,500 of billing listening to a lecture of how debits are on the left and credits are on the right.  I was infuriated not for myself but the fact that these board members have owned and run businesses, sat on boards and really do understand the basics of accounting theory.  They paid $2,500 to listen to a self-proclaimed expert prattle on how form matters over substance.

Each person in the room understands that Enron happened.  That WorldCom cost them and their friends dearly.  When no matter how you cut it, you can’t incur an expense without the expectation that there exists a pool of resources to pay the attendant liability. And one expects their financial statements to reflect the reality of that situation.

GAAP exists for a reason.  GAAP doesn’t reflect – or rather should not reflect – the mere form of a transaction.  GAAP reflects economic reality.  And it does matter.  Because the next time you go to buy a home and you look at the books and it shows zero receivable from the owners and a bank liability of any amount, please understand, you are likely facing a special assessment only no one wants you to know.  And, had those books been properly kept on GAAP, you would have known the problem exists.  You probably still would have bought but at least you won’t be able to say (with a straight face) that you weren’t warned.  Which is the whole point of a financial statement anyways – to help you make better investing decisions.

So, GAAP is GAAP.  If you are bothered by the fact that your accounting is complex, look to the reality of your transaction as it is likely complex.  The further you get from doing work and billing for it, the more complex you make accounting in addressing your transactions.  Don’t blame the accountants… We are simply the messengers.

What did I say?

I guess I stepped in it today.

On my other blog for CORE, I wrote today about independence, you know that little section of rules which constrain the CPA from essentially reporting on their own work.

  • Yes, I know that it is done;
  • Yes, I know it is done all the time;
  • Yes, it is a literal interpretation;
  • No, I don’t think you should try and paper it over.

Two reports require the CPA to be independent of the client and management: Audit and Review.  No one is forcing the CPA firm to perform an audit or a review.  If you want to be part of management, I say GO FOR IT!  Help management get their act together.  Help them adjust their books and, more importantly, know when they need to debit this and credit that.  Help them, but don’t come back and then claim your independence isn’t impaired.

Impairment of independence isn’t just a factual matter.  Yes, you can create lots of paper which says that Ms. Whatshername, the a/p clerk, understands what you are doing on her behalf and she is ok with you making that journal entry for her.  But when you are brought in to re-enter the entire accounts payable because Ms. Whatshername didn’t enter anything and the controller was fired so there is no one to check your work… don’t push your luck.

The appearance of impairment is even more important for those reviews and audits.  You are dealing with the integrity of the profession when you ignore what some other person might think about your independence, or lack of it.  If it looks to an innocent person that you are doing the work of management, well, guess what?  You are.

To paraphrase a letter which went from an association to the owners of a condominium:

  • Management way back when got it wrong
  • New management starting in 20XX got it even more wrong
  • New management denied their work was wrong consistently from then until now
  • New management denied it was wrong even after being beat over the head with it
  • Board hired independent CPA to redo management’s work
  • Independent CPA recalculated the numbers, resulting in a major change
  • The CPA says their work is correct
  • And, you can rely upon the CPA for this because they are trustworthy

Sorry, but that wonderful letter praising the CPA now means the CPA probably is no longer independent as to the financial statement audit.

Their work was awesome.  Totally correct.  Nailed it to within $0.02 for every owner.  Told the attorney and the board they were right and said so in a letter to the owners.  they were worth every dime they were paid to fix the mess.

But their independence is now impaired.  There is no one, not management, not the board, definitely not the attorney, who is going to take responsibility for the CPA’s work.  The CPA owns it.  They said so.  Under the rules, both of the AICPA and common sense, they are no longer independent of the client.

No independence no audit.

I get it, it is my interpretation.  Well… Not really.  It is 20 odd years of practicing in this area and reading hundreds of ethics interpretations.  It is having to struggle with deciding when we cross a line and are no longer looked at by Tommy Banker or Amanda Bonding Agent as separate from management.  When the question is, “Are you getting paid to help management or to report on them?”; it does become a little more clear.

Attest firms MUST err on the side of caution.  The big 4 don’t, the next 8 don’t.  Their failures don’t give the rest of us license to slide down that wonderful chute into impairment hell.  Take the road less traveled but best for your client.  Have integrity to admit your lack of independence when it exists.

Make the right call.  Help management or report on them.  If you can’t tell the difference, well, you probably shouldn’t be playing this game.

 

A Focus on Cash Flow

At a recent board and owner meeting, I was asked about cash basis of accounting being a better reflection of activity than GAAP.  This owner was an observer at a prior board meeting where I discussed this issue with the board so I think she wanted me to go on record in front of others.

GAAP, for all its flaws, is superior to the cash basis of accounting when it comes to reporting outside of management.  While I agree that GAAP can include requirements that are complex and perhaps outside the competency of management, that doesn’t mean that GAAP is inappropriate: It means that management is likely over its head.

Since this was a condominium association, I asked the board if management told them how much money owners had not paid for the reporting period.  The answer – Yes.  But it wasn’t included in the financial statements.  Management prepared a report showing how much money was collected and spent during the month, and then provided a separate statement with

  • How much owners hadn’t paid
  • How much in vendor invoices came in but were not paid yet

Also known as accounts payable and accounts receivable. The concern I have is not that they were doing this on a monthly basis but rather that management decided that this was an appropriate year-end reporting model as well.  This was the mistake.

Management could have made essentially three journal entries to ensure that the books and records accrued non-cash activity:

  • Record the due but unpaid assessments
  • Record the due but unpaid vendor invoices
  • Adjust the insurance for the amount that is considered prepaid

There is absolutely nothing wrong with keeping a set of management books and a set of financial reporting books.  It is, in fact, encouraged since decision-makers have different information needs.  Keeping separate books should not entail a great deal of work either.  Most software today is sophisticated enough to easily track cash in and cash out while at the same time tracking the amounts which have not been converted to cash.  The excuse that it is too much work is just that; an excuse.

But I would go further.  The board should receive a GAAP based balance sheet and statement of operations for each meeting.  But, management should also create special reports, or dashboards, for the various members of the board.  The treasurer is mostly worried about current cash receipts and disbursements.  The president, on the other hand, may be worried about reserve project expenditures in relationship to the reserve study.  It is most appropriate, indeed it should be considered essential, to give the information to decision-makers which is most appropriate for their particular needs.

GAAP fills a need for external reporting.  It is as complicated as the entity makes itself out to be.  Internal management reporting can be as simple and targeted as the user wants it to be and indeed should be.  The point of keeping the books on GAAP basis is to ensure that transactions are not overlooked at year-end; Otherwise both management and the auditor have to put more effort into the accounting than is likely warranted.  But if no one minds paying extra to address the conversion from one accounting basis to another, it is likely fine with the auditor.  I know it is fine with us.