Published in the ECHO Journal, November 2007
What They Are & What They Should Contain
Each year, most homeowner associations will engage a CPA to review or audit their annual financial statements and/or prepare their annual income tax returns. These compliance services meet the requirements of the association’s governing documents, the California Civil Code and tax law. For many, this annual ordeal ranks somewhere between standing in line at the DMV and a root canal. Yes, it’s necessary but what does the association get from these services? In my years of providing accounting services to homeowner associations, I have noted that association boards of directors as well as their managing agents are receptive to observations and suggestions that I make that arise as a result of my providing the income tax and financial statement services.
Accounting standards require CPAs to communicate “matters coming to the auditor’s attention that, in his judgment, should be communicated to the audit committee because they represent significant deficiencies in the design or operation of the internal control structure, which could adversely affect the organization’s ability to record, process, summarize and report financial data consistent with the assertion of management in the financial statements.” In addition, “the auditor may also identify matters that, in his judgment, are not reportable conditions as defined above; however, the auditor may choose to communicate such matters for the benefit of management.” (AICPA Auditing Standards)
I have found that the “management letter” can be the most discussed portion of the documents that I provide an association at the conclusion of an accounting engagement. CPAs who have provided services to associations for years have become knowledgeable of the wide range of disciplines that affect association operations. While we can’t (or won’t) take the place of your manager, lawyer, insurance agent or maintenance experts, we can offer recommendations on a wide variety of issues for the association to consider in future operations. What follows is a sampling of financial and other issues that I have encountered that should be considered in improving association operations.
Cash and Investments
Cash and investments are typically the largest assets that an association has. Many times, these assets will be under-invested either in non-interest or low-interest checking and saving accounts. Sometimes, checks will be held for days or weeks without being deposited, reducing the average balance on deposit which means less interest or paying bank charges because of low balances. Bank investments such as higher interest money market accounts and certificates of deposit are available to associations. Many associations have opted for US Treasury bills and notes for a portion of their reserve investments. Principal is guaranteed if held to maturity and, in most cases, the interest income is California tax-free.
Some associations will have over $100,000 in cash in the same bank. Because FDIC insurance does not cover balances over $100,000, there is the possibility of loss for balances over $100,000. Some associations have placed funds in mutual funds to take advantage of the rising stock market. These funds are subject to market fluctuations and also early withdrawal penalties if redeemed within 5 years of the investment. Capital losses on securities sales are only deductible against capital gains received by the association for income tax purposes.
Signature cards are frequently not updated when officers change. Reserve accounts require the signature of two officers or an officer and director of the association. No one else is allowed to withdraw or expend funds from an association reserve account. Some managing agents will use a commingled cash account where funds from multiple associations are deposited in the same bank account. California law restricts this practice to managing agents that provided this service in February 1990 or earlier. CPAs are concerned about the controls that the managing agent uses to safeguard your association assets and that they are accounted for properly.
Are bank statements being reconciled monthly? Are copies of bank statements and reconciliations being provided to the board at least quarterly in compliance with Civil Code requirements? Is the association able to segregate (by using two different people) the issuance of payments for bills and the mailing of the checks? Does the board approve maintenance and nonrecurring invoices for payment?
The prompt and efficient collection of assessments is the lifeblood of association operations. When the economy is strong, collections are generally easier. Increases in members’ equity in their property will convince most people to not risk the loss of that equity by failing to pay assessments. The economy is cyclical and some members who purchase at the “top of the market” will find their equity eroded or completely gone in a down real estate market. It is important to establish a diligent collection policy that is consistent and equal to all members. Late notices and late payment penalties should be sent on the sixteenth day of the month (or later if your governing documents specify a later date). Follow-up should be made and further collection activity should be pursued (pre-lien letters, lien filings, small claim judgments and/or foreclosure as necessary). Lenders are wary of providing financing to unit owners in associations where large amounts of delinquent assessments exist.
I have noted, fortunately on infrequent occasions, that board members will fall behind in paying their assessments. If the delinquency is large enough, a disclosure will be made on the financial statement indicating the amount due from the officers and directors. Some associations simply have an inadequate monthly assessment. Political pressures not to raise assessments or increase them enough conflict with the reality of increased costs. Many times, reserve funds will not be funded at the level specified in the budget or reserve study. Over time, this underfunding of reserves will generally result in a large special assessment.
Speaking of reserve funding, California law has mandated disclosures about reserve information for 15 years now. Many more associations are obtaining the required reserve information either through a reserve study professional or on their own. As with high delinquent assessments, lenders are frequently reluctant to lend on units in associations with low reserve fund balances.
Other Operational Issues
Employee vs. Independent Contractor
Is the association using independent contractor workers who should be classified as employees? The IRS has a checklist of 20 factors to review when making this determination. Areas such as who controls the worker, licensure, how the worker is paid go into making this determination. Are workers covered by insurance, especially workers compensation?
Is the association carrying the proper kinds of insurance in accordance with its governing documents and the Civil Code? Does the board meet with its insurance agent annually to discuss necessary coverages and policy limits?
Statement of Nonprofit Corporation
Is the association filing its annual statement with the California Secretary of State listing current officers and other required information? Failure to file this form can result in the corporation’s being suspended by the Secretary of State and the loss of corporate powers (ability to contract, sue, and collect assessments). Changes of address during the year can result in this form not being received from the Secretary of State by the association. Thousands of California corporations have been suspended.
Are minutes complete? Are they signed? Are executive session minutes included with regular minutes and improperly disclosed? Are relevant accounting issues such as major expenditures, assessment changes, open/close bank accounts, tax elections and budget approval included?
Has the association filed 1099 forms for independent contractor services? Is the association paying property tax assessments that are only chargeable against residential parcels? Does the association have tax-exempt status with California? Are income tax filings up to date? (This is another area that can cause a corporation to be suspended)
Is the association a member of ECHO or another trade organization? Can the board members benefit from the seminars and newsletters published by these organizations?
Other topics such as record retention, accounting system recommendations and comparative financial information are worthy of discussion with your CPA. Ask your CPA about any of these issues. We welcome the opportunity to provide guidance in these areas and to provide a service that you really want! We can attend board meetings and/or annual meetings to present relevant information. Your CPA is part of your professional team.
Michael Gartzke is a certified public accountant with a practice in Goleta, CA, that emphasizes accounting for California common interest developments. He is also the executive director of the South Coast Homeowners Association, which has a membership of more than 140 community associations in Santa Barbara County.