Fund Accounting Vs. Equity Method of Reporting: Which One is Right for You?

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Published in the ECHO Journal, January 2013

Financial statements for a homeowners’ association may be presented using either the Fund Accounting Method of Reporting or the Equity Method of Reporting. Both methods are permitted (when properly formatted) and both can be used on an interim basis in the homeowners’ association industry. However, the question is, which one is right for you?

We recommend that you prepare your interim (monthly or quarterly) and year-end financial statements using the Fund Accounting Method of Reporting, simply because we believe it is the most informative method of presenting the separate activities (e.g., operating, reserves, etc.) of your homeowners’ association.

We will describe the 2 Methods of Reporting (Fund Accounting Method and Equity Method) that are available for your financial statements, highlight their effect on your financial statement presentation, and address the year-end review or audit report prepared by your independent CPA.

Fund Accounting Method of Reporting

The Fund Accounting Method of Reporting is in conformity with Generally Accepted Accounting Principles (GAAP). Moreover, the guidelines issued by the American Institute of Certified Public Accountants (AICPA) state that this method is preferred for the homeowners’ association industry.

When you choose the Fund Accounting Method, the effect of this choice on your financial reports will be as follows:

Balance Sheet

Your Balance Sheet will show a separate column for each fund, and a column listing the totals of all funds. There will be a separate column for your operating fund activities, your reserve fund activities, and any other activities that you wish to segregate from the operating and reserve funds (e.g., litigation, special assessment, etc.).

Each column will identify the fund it represents, listing only those assets and liabilities related to that specific fund, along with the fund balance. The totals reflected in the last column combine assets and liabilities for all funds (these “Totals” should be the same amounts that are reported under the Equity Method).

Income Statement

There will be one Income Statement for each separate activity. One for your operating fund activities, another for your reserve fund activities, and another for any other activities that you wish to segregate (e.g., litigation, special assessment, etc.).

Please note the “Current Year–Excess (Deficit)” listed on the Income Statement for each separate fund must agree to the amount reported as “Current Year–Excess (Deficit)” on the Balance Sheet for that fund.

In addition, there will be a separate “Income Statement-Reserves Fund” to track reserve fund activities (e.g., members’ assessments and expenditures). You can also prepare a separate “Income Statement-Other Fund” (e.g., litigation, special assessment, etc.) for each separate activity that you wish to track.

For litigation, under Section 1365.5(d) of the California Civil Code, “…the association shall make an accounting of expenses related to the litigation on at least a quarterly basis. The accounting shall be made available for inspection by members of the association….”

In other words, you need to track all receipts (amounts collected through the legal process) and expenditures (amounts necessary to support the law suit and to repair the defects) related to defect litigation. A separate “Income Statement-Litigation Fund” is the ideal way of tracking these items without having to create a separate special report for the membership.

Equity Method of Reporting

The Equity Method of Reporting (sometimes called Non-Fund or Commercial) is also in conformity with GAAP, when properly used. Although the AICPA has stated that the Equity Method is acceptable, they recommend Fund Accounting for the homeowners’ association industry.

When you choose the Equity Method, the effect of this choice on your financial statements will be as follows:

Balance Sheet

Your Balance Sheet will show only one column for all funds. Unlike Fund Accounting, there will not be a separate column for your operating fund activities, your reserve fund activities, nor any other activities that you wish to segregate (e.g., litigation, special assessment, etc.).

Although both Balance Sheets (Fund Accounting and Equity) will list the totals for each separate account (e.g., assets and liabilities), the Equity Method may not have the extra information related to the individual funds. The effect is that it could be deficient in the information presented to the reader; therefore, not in conformity with GAAP.

Further, instead of showing a “Fund Balance” for each separate fund, this Balance Sheet lists Members’ Equity, which is supposed to be broken down into “Undesignated” (operating fund), “Designated for Future Repairs and Replacements” (reserve fund), and “Designated for Litigation” (litigation fund). As a result, the amount listed as “Current Year–Excess (Deficit)” in the Income Statement may not agree to the Balance Sheet, and it may not be the same amount listed on the Income Statement presented under the Fund Accounting Method either. This is simply because all financial activities for multiple funds may be imbedded into one Income Statement.

One disadvantage of the Equity Method is that the Balance Sheet may not clearly identify which assets and which liabilities belong to which fund – this can be done with account descriptions, but it can be very confusing to the reader if not clearly marked.

Another disadvantage, if there are interfund accounts (due to/due from) that are not on the Balance Sheet, it will still appear to be in balance (assets = liabilities + members’ equity), when in fact it is not complete. Whereas, under Fund Accounting, if interfund accounts are not listed in their appropriate funds, the individual funds will not be in balance. This simply means that when using Fund Accounting, all interfund balances must be reported for each separate fund to be in balance.

Income Statement

When using the Equity Method, there often will be only one Income Statement combining all activities. That is, there might not be a separate Income Statement for the operating fund, nor the reserve fund, nor any other fund.

Although the Equity Method may be in conformity with GAAP, the AICPA still requires a separate Income Statement for the operating fund and reserve fund activities; therefore, if the reserve fund activities are imbedded in this one Income Statement, or are listed on the face of the Balance Sheet only, then these financial statements will not be in conformity with GAAP.

Year-End CPA Reviewed or Audited Financial Statements

Finally, keep in mind that regardless of which method of reporting that was chosen for your financial statements, whenever your year-end financial statements are reviewed or audited by the association’s independent CPA, the CPA reviewed or audited financial statements will, more often than not, be presented using the Fund Accounting Method of Reporting.

Therefore, it makes sense that your interim and year-end financial statements be presented under the same method of reporting that is used for the annual CPA reviewed or audited financial statements.

Conclusion

Fund Accounting Method of Reporting (Recommended)

There are a variety of reasons why we recommend using Fund Accounting for your interim financial statements.

Your Balance Sheet will clearly identify which fund the various assets and liabilities are associated with. The “Current Year–Excess (Deficit)” listed on the various Income Statements will agree to the amounts reported on the Balance Sheet. Your interfund balances (due to/due from), if any, must be listed; otherwise, the individual funds will be out of balance. Further, the method used by most CPAs is the Fund Accounting Method (preferred by the AICPA); therefore your annual financial statements would be presented using the same method.

Equity Method of Reporting (Not Recommended)

There are a variety of different reasons why we do not recommend using Equity Method for your interim financial statements.

Your Balance Sheet may not have the same detailed information with regard to assets and liabilities and their corresponding members’ equity. The Income Statement may have information related to other funds (e.g., reserve revenues and expenditures) which may cause the amount reported as “Current Year–Excess (Deficit)” to not agree with the amount reported on the Balance Sheet. Interfund balances can be easily left off while giving the illusion that the financial statements are complete. Finally, although the Equity Method can be in accordance with GAAP, the AICPA prefers Fund Accounting.

However, if you choose the Equity Method, make sure you provide a separate Income Statement for each separate activity (e.g., operating, reserves, etc.) – do not imbed reserve fund activities into a single Income Statement or on the face of the Balance Sheet. Further, make sure all assets and liabilities are clearly identified by fund, and your interfund accounts are reported on the Balance Sheet. Otherwise, your financial statements may be incomplete; therefore, not in conformity with GAAP. More importantly, they may be confusing to the reader.

Sample Financial Statements on our Website

Please visit our website (www.Ernst-CPA.com) and select “Homeowner’s Associations” under the tab “Our Services” to view sample Balance Sheets and Income Statements illustrating the Fund Accounting Method and the Equity Method of Reporting.


James H. Ernst, CPA, MS-Tax, CCAM is a Certified Public Accountant and a member of ECHO. His CPA firm, James Ernst Accounting, has been providing accounting and tax services since 1993, and he specializes in providing professional services for the homeowners’ association industry. He can be reached at 866.289.6000 or jim@ernst-cpa.com.