Category: GAAP

Accounting Standards

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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

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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.

Review Procedures

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I was asked yesterday to explain my blog about reviews the other day and how the CPA overlooked the fact that the manager recorded the full special assessment instead of unearned interest income.  It was a great question.

What actually tipped us was the foot note for the receivable.  It said, in part, that monthly payments were required by owners (including interest).

When we looked at the manager’s profit and loss statement for the special assessment fund, it showed

Interest income $0
Interest expense $20,000

The second clue was looking back at the special assessment fund balance.

2014 $80,000
2015 $65,000
2016 $50,000

Each year the equity is being reduced because the interest expense was being recorded but there was no offsetting interest income.  Since there was a special assessment receivable, an effective review test would be multiplying the average receivable balance by the stated interest rate.

In this case, the average receivable balance was $300,000.  This multiplied by the 6.0% interest rate meant $18,000 of interest income would be expected.  The association recorded no interest income.  This is a very large deviation from expectations.

Under SSARS, Statement on Standards for Accounting and Review Services, the accountant performs certain analytical tests and compares those to industry standards, historical evidence and certain expectations driven by experience with both the client and the particular industry.  In this case, our experience with special assessment receivables led us to believe that there should have been interest income.  Although if the accountant simply compared it to the prior year, then the zero matched the zero in the prior year and even the year before that.

This would be incorrect though.  Another requirement of SSARS and GAAS is to maintain professional skepticism, or the willingness to look beyond the assumption that an explanation may be correct.

So, we said, “Wait a second, how can it be zero if we calculate $18,000?  How could the prior year be zero when the average receivable was $400,000?  We then asked the question of management and they said it was always zero.

And our response was, so what?  It didn’t feel right.  In short, we were skeptical that their explanation was sufficient.  Remember, the foot note said each payment included interest.  This meant that somewhere along the way the preparer of the financials read a document that stated this.

Sure enough we found that document.  Sure enough we found the next document which showed the original entry and that it included the full amount of the special assessment – including interest.  That is, by the way, why the fund balance had a positive balance all the way back when it was created.  The special assessment “revenue” was higher than the costs of the renovation project.  It should have, at best, been a  break even.

We could then model it and show the board how the financial statements were incorrectly reporting the special assessment.  We then showed them how it was supposed to be.

No, it hasn’t been cheap for the association.  It was all driven, unfortunately, by not having the financial statement reviewed in the year of the special assessment.  Having the statements reviewed years later almost guaranteed that it would be overlooked.  It is possible that it could have been overlooked in a review of that year too, I am not saying that it would have been caught necessarily, but the odds would have definitely been improved.

So yes, board members, especially treasurers, you can run your own analysis.  If you would like, I can send you a spreadsheet with some of the more common ratios and analysis to help you get a good overview of your financial statements before your accountant sets in on the review.  It can’t hurt and could potentially head off a disaster.

Have a great day.  If you would like to learn more about how to analyze your non-profit, business, or property association, feel free to contact me and request the spreadsheet.  C.O.R.E. Services is here to be of service to you.