Tag: investments

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.