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.

 

 

Impact of New Accounting Standards on Condo Associations Chapter 1.

During our weekly meetings, we identified the upcoming changes to revenue recognition codified in ASC 606 could likely be a significant disruption for community associations and how they report activity.  Currently, condominiums and HOA’s follow the guidance provided in ASC 972-605 for reporting revenues.  Beginning in 2020, this industry specific guidance goes away and associations will need to follow ASC 606 Revenues from Contracts with Customers.

The first thing to understand is that ASC 606 will apply to associations.  Associations enter into contract agreements with their unit owners which state that unit owners will agree to provide resources to pay for the expenses incurred for the common good.  Since it is an agreement between the parties it is considered a contract.  Since you have identified the existence of a “Contract”, the next big question is, “Now what?”

First, it depends on whether you identify a single contract or n number of contracts where n represents the number of units in your association.  Our take on it right now is that there is a single contract between the association and its unit owners.  We believe this is conceptually correct as the unit owners, as a group, vote to ratify the budget.  Plus we believe it fits since the association has a single contractual purpose which is to maintain the common elements.  But you can see that, right off the bat, there is a basis for a disagreement.

We believe the next step would be to record the following transaction once the budget is approved and ratified:

Owner Contract Asset                   $XXX,XXX
Unearned Contract Revenue                         $XXX,XXX

This identifies that the association expects to receive, as payments from the unit owners as the party to the contract, a certain amount to address the expenditures to maintain the common elements.

I can see the confused looks.  It’s ok, we understand.  Think about it this way:

Your association has a fiscal year which begins January 1 and ends December 31.  In November the board passes a budget for $250,000 in assessments.  The owners meet and ratify the budget on December 1.  Because the association passes the budget for the annual cycle, it is creating the claim for the contract which begins January 1.  Since it won’t begin to perform work until January 1 the association would not recognize the revenues until that date.  Never-the-less, because the final step of the contract, its ratification, happened in December, we believe it is appropriate to record the transaction as stated above on the date of ratification, even though it is clearly not effective until January 1.

On a practical basis, what this means is that your management company should be changing its account structure and its memorized transactions – ASSUMING you want your manager to report the association’s accounting information in accordance with GAAP.  If you want to follow some other accounting principle, well this blog is not for you.

What does this mean to you as a board? That the issuance of a paper statement, a coupon book, a web portal, no longer dictates when something is revenue.  All these items do is determine the timing of when payments are received.  What you will be most focused on, as a board, is this series of transactions

Owner Receivable                       $XXX
Owner Contract Asset                         $XXX

Followed by this when payment is received:

Operating Bank Account         $XXX
Owner Receivable                             $XXX

We will delve more into this over the next 10 days, but the key takeaway today is that your association will still invoice unit owners when you want payment and the money will still be deposited to your bank.  How and when it is recognized as revenues will be independent of the billing.

Obviously, even at this point you can see where there could be lots of opportunity for confusion.  We have always been taught that it is revenue when invoiced.  While I can prove that this is hardly ever the case, it is what has been treated as truth for as long as I can remember.  And moving away from this will require boards and management to think long and hard about the process.

Next up: Performance Obligations for associations – No more “Net Income” on your Management Reports.

Have a great weekend.  If you have questions or would like to participate in a discussion about how ASC 606 will impact community associations, feel free to email me for an invitation to our next webinar on the subject.

 

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.

Debit This, Credit That, isn’t that Accounting?

Sometimes all you can do is simply stare at a speaker and wonder what is going through his mind.  “Accounting says you have to debit receivables and credit revenues.”

Um, no.

Accounting makes no such claim.  Effective accountants (and auditors) know that often earning revenues is divorced from demands for payment.  Demanding payment is a contract right – your attorney might require a retainer, your roofer wants a deposit, you want to be paid for the feet of pipe laid; but none of these are revenues. Yet.

Accounting is about reporting the economic substance of a transaction.  Accounting has to look for features which support the premise that the efforts necessary have been expended and accepted by the buyer in order to record revenue.  It doesn’t have to be hard, but it does have to be consistently applied.

Take for example, that piping contractor.  Let’s say he has a contract to

  • Dig a 1,000 foot ditch for $20/foot
  • Lay 1,000 of 24″ concrete pipe at $18/foot
  • Backfill and compact the trench for a lump sum of $8,000

The contract requires that the contractor submit a schedule of values (work completed) in order to be paid.

On the first billing, the contractor submits the schedule for the 1,000 feet of ditch dug for $20,000.  The effective accountant does not immediately do this for the invoice:

  • Accounts Receivable       $20,000
  •     Contract Revenues                         $20,000

That is because the rules for recognizing revenues is not based upon something as arbitrary as a schedule of values.  The smart accountant understands that the true measure of the revenue for a contractor is based upon an analysis of costs expended to actual anticipated costs.  So the accountant creates a little spreadsheet:

Anticipated Period Actual
Contract Revenue Costs Gross Profit Costs % Complete Revenue Billings Over/Under CIE BIE
ABCD     46,000   35,000          11,000   6,500 18.57%       8,543   20,000          11,457     –   11,457

The Company incurred only $6,500 of costs in the period.  This represents less than 20% of the total anticipated costs for the project.  The reality is, the contractor front-loaded the bid.  This is perfectly acceptable – provided the owner accepts the schedule of values and is a great way to get project funds in early.  But, GAAP says to recognize the contract’s revenue based on the relationship between actual costs incurred and the estimated total costs to complete.

In this case, only 18.6% of the project costs were incurred so really only 18.56% of the contracts revenues are earned.  The remainder is considered unearned revenues or, in construction accounting parlance, Billings in Excess of Costs and Gross Profits.  The accounting principle is called the percentage of completion method of accounting for long-term construction contracts.  The rule says that the form – the schedule of values – is not the appropriate measurement for recording revenues: The comparison of actual to anticipated costs is the appropriate basis for recording revenues.  Economic substance over the form.  $8,500 not $20,000 for revenues.

Accounting is more than debits and credits.  That is, assuming you need to know what is actually happening economically in an enterprise.  Most non-employee investors in a business should be thinking about the true substance of transactions and how they impact today’s profits and tomorrow’s cash flows.  Revenues and profits generate true cash flow, not the other way around.  The effective accountant knows this is far more important than debits and credits.