Tag: associations

Complexity

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

The past 10 days has seen us dealing with a lot of challenges which come about through complex entities trying to be simple.  Most of the challenges come from participants claiming they don’t understand but in reality it is they don’t want to pay the underlying cost of their organization structure.

The condominium association where the board didn’t want to address the interest charges to owners for financing a special assessment over 10 years.  Their stated argument was that they were trying to keep it simple.  The real issue was that they didn’t want to pay a manager or accountant money to track the owner accounts.  Eight years later, they need to perform a new special assessment to come up with the shortfall that is owed the bank.  This is going to be complex.

The investment partnership which wants to shift income between partners.  They crafted a simple partnership agreement and right from the beginning started doing this.  In the beginning they had lots of equity so the tax preparer was not worried about the unequal distributions.  Five years later six of eight members have negative capital accounts and it needs to be fixed.  They created a complex structure and thought a simple partnership agreement would allow them to do what they wanted.  They didn’t understand.   The truth is they didn’t want to pay someone to manage the complex modeling of the cash flow reallocation to ensure it was done correctly.  It is their profit after all.

The Corporation who borrows money from the bank and then retires their majority shareholder.  They write an agreement which says that the Company will repurchase 1/10th of the shares every year for the next 10 years.  At a stated price.  And then they fire the accountant who tells them they need to record a $5.0 Million debt – which of course puts them out of compliance with the bank.  They find a more accommodating CPA to prepare the financial statement.  Bank still finds out and calls the bank loans.  They didn’t understand GAAP.  No, the didn’t want to pay for effective advice.

Complexity has a price.  If you don’t want to pay higher prices, keep it simple.  There are no rules which say that profit can’t be distributed equally amongst all partners.  Shockingly  simple.  There is no rule which says you can’t buy back the owners shares.  But you should probably discuss that with the bank before you borrow money.  And then talk with someone who knows what GAAP might have to say about that kind of transaction.

The old adage is very true: Pay me now or pay me more later.  Alright I confess I added the more but it should have always been there.  It is never cheaper to fix the problem later.  NEVER.

There is another old saying: Accountants have the magic wand and attorneys have the way back machine.  Notice though that you have to go to the true wizards of Oz to fix the problem.  Accountant’s to create the numbers to correct the problem you created and the attorney to create the right paperwork at the right time.  In hindsight.

Today is about clichés apparently.  I believe it was Einstein who said, “A problem can never be solved by the same intellect which created it.” or something to that effect.  What this means, in my world, is that the client goes to one accountant and lawyer to “be simple” and then fires them to find someone to fix the “complexity”.  That means coming up to speed, understanding what you originally did, and then trying brainstorming for hours trying to come up with a plausible solution.

Yes, there is a better way.  Plan for complexity.  Accept that some modes of transacting business require new, or at least different, processes.  Maybe new software; perhaps a new department; perhaps a new legal structure.

The entities above each spent under $2,500 to create the original simple way they wanted.  Each has to be in excess of $20,000 to fix the problem.  I don’t think planning to deal with complexity right up front would have cost anywhere near the cost to fix it.

Complexity.  You will pay for it.  The smarter play is to accept it upfront and make it a cost of being in business.  Or don’t.  You simply pay more to fix it.

Have a great weekend.

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.

 

 

Auditing investments

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

It is always refreshing to see associations which take responsibility for their future replacements by trying to find investments which can actually grow beyond the rate of inflation.  A solid investment plan can help them ease the burden of reserve assessments by using collected funds to grow at an accelerated, but reasonably safe, rate of return.

Auditing these investments is challenging though.

Conceptually, auditing investments is not any harder than auditing cash.  Except that investments carry certain additional disclosure requirements and the treasurer typically has little to no exposure on how to record the transactions let alone report them to be audited.  Which means that our work as the auditor grows significantly.

You see, Generally Accepted Accounting Principles (GAAP) requires that the investments be reported as either trading, available for sale or held to maturity.  How many investment advisors even understand what can be assigned to these categories?  And our role, as auditor, is to make sure that the investments are properly categorized and that the related gains, losses, and earnings is properly reported in the statement of activity; i.e. the profit and loss statement.  To ensure that they are properly recorded in the period, the accounting department has to know the difference between realized and recognized gains and losses, temporary impairment, other than temporary impairment and put those in the right reporting areas.

Which of course leads to another big accounting issue, accumulated other comprehensive income.  This is the series of holding accounts for the unrealized gains.  You have to know how to close out the transaction to recognize the ultimate sale of the investment.

Did I mention that you have to also track bond premiums and discounts and do some accounting work to get the amortization right?  Again, all this has to be tracked correctly to report in accordance with GAAP.

The rub is that treasurers and boards don’t really understand the complexity of this and often don’t really care.  Their issue is the investment and the return, not its reporting.  Which brings us to our dilemma.

Trying to account for, and then audit, investments can add a substantial cost to the engagement.  It is a cost that probably won’t be valuable to the board and owners in the association.  So, do we allow for a GAAP departure on the investments and simply say they are recorded at cost and have associations report gains and losses at the time of sale?

It is a difficult position.  On the one hand we want the statements to fairly represent the financial activity of the association but on the other hand we don’t want to drive up the cost of the engagement to the point where they find another auditor.  One who perhaps will take huge shortcuts on the reporting and auditing side.  Yes, we see that far too often as well.

So, putting your reserve fund to work by investing it strategically and at reasonable risk is a fair approach to managing the money.  But there are other things to consider besides the actual investing and you, as a board, need to be aware of these issues and take a position on how to report this to the owners in your association financial statement.

Have a great day and an awesome weekend.  And, if you are looking for an experienced audit team to help you maintain effective controls over your association’s finances, feel free to contact us anytime.  We look forward to the opportunity to be of service to you.