When Assessments become loans

We had an interesting one come up last week.  A 100 unit condo Association passed the following in a resolution:

  • Monthly payments of $200 per month
  • Term of the assessment is for 10 years
  • The assessment is transferred to the buyer at time of sale unless the buyer demands it to be paid in full at time of sale

This passed in February of 2016.  The association waived the 2016 audit (not wise) and then contacted us for a 2017 audit.  The dilemma?  How should this transaction be recorded?

The board and management argued that it is a monthly, on-going assessment.  But we are not so certain that is the correct way to handle it.  As we dug deeper we discovered:

  • Bank loan with a principal balance of about $1.8 Million dollars at 4.0% interest
  • Monthly payments on the loan of $20,000
  • Can pay any amount of principal after year 3 of the loan

We believed their assertion was incorrect and requested they capitalize the full receivable as a loan.  Our reasoning?

  • The present value of the payment stream could be calculated using the interest rate provided by the bank as the minimum interest charged
  • The assessment was directly tied to the repayment of the bank loan
  • The assessment was assumable but only if the buyer accepted it, otherwise it had to be paid in full at time of settlement

It is important because most state laws require disclosure of outstanding balances due from owners.  There is a huge difference between stating that the amount in arrears on an assessment is $0 and there is a $20,000 special assessment balance outstanding.  In some instances, the amount disclosed on the resale certificate is the maximum amount of liability that the buyer can assume at closing.  Management disclosed the seller’s maximum amount due on the disclosure.

Finally, since the buyer could assume, but didn’t have to, all the available evidence indicated that it should be treated as a loan to the owners.

Now there is a 10 year receivable to record.  There is interest to charge to the owner which splits their payment into two parts – principal and interest.  And because they didn’t adjust it correctly for 2016, the Association’s cost for the financial statement is going to almost double to correct for the prior year.

All of this could be avoided by consulting with a CPA firm which specializes in association (CIRA) accounting and auditing.  If you are a board that is looking at doing something that hadn’t been done before, it will be well worth the few hundred dollars you will be charged to get an idea of the complexity involved in accounting for the activity.  Can your management handle this type of transaction?  Will their software perform the calculations correctly?  How will our reports change?  All of this is as important as making sure you legally dot your “I’s” and cross your “T’s”.  Otherwise, don’t be surprised when your auditor says, “No, sorry it can’t work that way.”

Ask your accountant or feel free to reach out to us.  We are happy to assist you in any way we can as a little work up front can stop a landslide later.

At C.O.R.E. Services, we focus on being a strong independent check on management and their assertions. Which is why we enjoy working with Property Owner Associations. The boards are dedicated but typically outsource the management who record the transactions and prepare financial statements for the board to review. Our audits are designed to help the board and owners rely upon those statements. You can find more information about us on our website.

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.


The Dilemma of the Review Engagement

GAAP can be incredibly complex.  A review engagement under SSARS requires the independent accountant perform analytical tests to determine if GAAP is being complied with.   A review is not an Audit.  It is “substantially less in scope than an audit…” which is a fancy way of saying that the reviewer is not looking deeply into the financial statements.  This means that some complex GAAP issues can be overlooked during a review because the analytic procedure may not discover the problem.

Case in point:

Alpha Condo Association was faced with a dilemma.  The 20 unit complex had substantial leaking through the roof last winter.  Sadly the roof was at its end of life and was going to cost $200,000 to tear-off and replace and also upgrade their elevator and HVAC system.  The association had only $50,000 in their reserve fund.

No, I am not going to rant about the lack of foresight by the board.  My other blog is addressing that issue.  What I am going to discuss is how things can go sideways and it might take years to discover.

Back to the issue at hand.  The board votes to have a special assessment for $10,000 per unit to deal with the problem.  The owners approve the special assessment 13 to 7.  Here is where things go wrong.

The board apparently provided owners two payment options.  Full payment within 30 days or payment over 10 years with interest.  The resolution which passed stated the interest rate charged was going to be equal to the interest rate on any bank loans taken out.

Five owners paid the $10K within 30 days.  The remainder took the payment option and the board borrowed $200,000 from the bank to do the work.

Apparently the board decided that, to make things easier, they would include the interest due from the owners in the initial assessment.  So, instead of their special assessment being $10K, it was $16,000.  Yes, that’s right.  The bank’s interest rate times the ten years for the repayment term of the special assessment.  The actual interest ended up being about 9.6%.

Ignore, for the moment, the fact that this does not calculate out to 6.0% interest, the real problem is that the management company recorded a receivable of $290,000 and special assessment revenue of $290,000.  The special assessment of $200,000 and the interest charge of $90,000.

The financial statements were reviewed by several different independent CPA’s (not us) over the years which reported the financial statements were prepared according to GAAP.

No they weren’t.  The original entry was incorrect by treating the interest as special assessment revenue.

Today’s missive is not about GAAP per se, it is about the inherent risk of a reviewed financial statement.

I am not trying to defend the fact that the CPA’s overlooked the problem.  In hindsight it is obvious that the $90,000 was not “earned” as special assessment but it was rather unearned interest on the special assessment receivable.  Now, almost a decade past the original special assessment we are performing the review and we stumbled across this matter.

Of course, like any good story there is lots of murkiness.  Like the fact that the unit owners voted to pass on having a review in the year of the special assessment as well as the two years after.  It wasn’t until 3 years after the transaction that the CPA was asked to review the financial statements.  And sadly, this issue was overlooked.

Again, this isn’t about GAAP; directly.  This is about the fact that the owners decided against spending money on an assurance service.  That’s right, hiring a CPA to perform an attest function on your financial statements is a means to ensure that what you are being told in those statements is prepared according to the rules everyone agreed to.

Most state condominium laws require at least a review of the association’s financial statements.  The law also typically requires that the financial statements be prepared according to GAAP.  But the law also typically gives boards and/or owners the right to waive compliance with the attest of the financial statements.

The owners agreed to waive the preparation of the financial statements for three straight years.  For three straight years the presumption is everyone was cool with how the accounting was done.  Finally a review is done and, because the reviewing CPA missed the original transaction, they want the CPA’s head on a platter.  Talk about shooting the messenger.

If you, as a non-profit board, as a business owner, as an investor, take a pass on hiring an independent CPA to perform an attest service, don’t blame the CPA when things don’t go right.  And, if you think saving money by having a review instead of a very painful (and valuable but costly) audit performed is a great idea, don’t be surprised when things are not working like you were lead to believe.  After all, the accountants’ report clearly states that a review is substantially less in scope than an audit… buyer beware.

No one likes to make mistakes but it happens.  As professionals we are ok with being held accountable for our work.  But when you elect to take the cheap route and things are wrong, don’t go looking to blame the professionals when it suddenly comes to bite you in the butt.

We haven’t worked out yet how we are going to handle this.  It is a problem to be sure – on several levels.  But the point is, don’t skimp on an audit if you want reasonable assurance that the financial statements are prepared correctly; and don’t skimp on a review if you are not involved in the day-to-day operation of the entity.  Neither service will catch everything that might be wrong but, what doesn’t get told in a financial statement is often worse than what is in there.

Have a great day.