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.

 

How Small Business Can Apply GAAP Successfully

There are two big GAAP changes coming up that could have a major impact on small business if decision makers do not start thinking about the issues.  These are changes to lease accounting and the new revenue recognition standards.  The lease accounting is probably the more challenging of the two, as I will hopefully explain below.

New Lease Standards

The new lease standards will challenge every small business who needs access to capital and where the money people want GAAP financial statements.  So, if you are even thinking of going public or taking on substantial bank debt, you need to think about implementing the new lease standards.

The new lease standards now require you to record an asset and a liability as though you bought the asset on a contract.  You then amortize (depreciate) the new asset over the lease term.  This is substantially different from old GAAP which handled leases off balance sheet – meaning payments were treated as an expense in the period incurred.  The commitment for the lease was then reported in the disclosures.

Obviously, the kicker here is that you will now have additional debt on your books which did not exist before.  And like all debt, the current portion, that amount due in the next twelve months, is considered a current liability.  So businesses with tight current ratios (say 1.1:1.0) and an affirmative covenant to maintain a current ratio of 1.0:1.0 may find themselves out of compliance.  Noncompliance is a default condition.

So, if you are thinking about leasing equipment you may want to reconsider this approach IF GAAP statements are a business requirement.

Recognizing Revenue from Service Contracts

This is a major rewrite for GAAP but is probably will not have a huge impact on most small businesses.  Yes, conceptually the issue exists, but most small businesses do not have agreements with customers which extend for long periods of time.  But, where your business does have an ongoing customer relationship where money is changed hands intermittently and service is on-going, then you will want to start looking at this ASC.

The biggest change is realizing that billing a customer no longer drives revenue.  For QuickBooks users, this could cause problems.  As an example, lets say your business enters into a maintenance contract which runs for twelve months.  You agree that the client gets up to 20 hours of on-call service plus a 5 hour preventative maintenance visit monthly.  The on-call hours do not roll-over and you charge $100 per hour for any hours over 20.

Historically, you know that your clients use about 300 hours additional during the year and you anticipate that this new client will be the same.  The new ASC, ASC 606, would require you to anticipate this when you recognize revenues.

What is happening is that we are separating out the revenues from what customers are going to pay.  This separation is a good thing, even though it may not seem like it.  But anyone who has ever worked with contractors and percentage of completion will understand this concept.  Billings are the offset to the accounts receivable and costs and gross profit on contracts is the offset to revenues.  The separation will make almost all businesses with contractual relationships with customers record revenues similar to contractors.

This is because we are moving into a transfer of control (knowledge, ability, compute cycles, etc.) instead of transfers of products.  Stores will likely continue their accounting the way they used to; unless they have after-sale service offerings.  Then, this will become a little more complex but still somewhat like what you are already doing.  But you need to start analyzing your processes now to see what can remain the same and what you need to change – assuming GAAP is required.

If you have questions or would like to discuss how the new accounting standards might impact your business, make sure you talk with your CPA.  Or, if you would like some help understanding what is about to happen, feel free to contact me with your questions.  We are here to help.

Have a great day.

Thoughts on Accounting and Reserve Funds

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.