Financial Reports: The Need, the Problem, and the Solution
The oldest surviving form of the Greek language is crude scratchings on clay tablets found buried in the ruins of ancient Greek palaces destroyed 3,200 years ago. Known as Linear B, this primitive script does not recount neither Homeric deeds nor record mythological fables nor preserve primitive philosophy. Translated, these ancient tablets tell us “Kokalos repaid the following quantity of olive oil to Eumedes…648 liters.”
Hardly soaring prose, this passage would fit perfectly in your association’s financial reports beside the journal entry “Arthur Koenig/Reimbursement for carport damage…$543.92.” What did these illiterate barbarian kings over three thousand years before the California Civil Code have in common with your board of directors? They shared a common need to protect their assets and enumerating them in writing was the most effective way to account for them. Archaeologists believe that these accounts were kept by a small and specially trained class of scribes who alone understood the meaning of the strange ideogrammatic script.
Today, we record assets as invisible electromagnetic impulses inside remote computers instead of scratches in clay tablets. This information is then processed and printed out together with your liabilities, income and expenses in your association’s financial reports. Each month that pile of papers with its neatly ordered columns of numbers faithfully reports what your association is worth, how much it owes and is owed, and how well you on the board are managing its financial affairs. Yet, most directors find these documents as difficult to read as ancient Greek tablets.
Whether for a business or a nonprofit homeowners association, regular accounting reports provide managers and boards of directors with the information needed to make prudent decisions and control daily activities. Furthermore, they supply legally mandated information to homeowners and government agencies. Recognizing the importance of financial reports, the State of California has legislated their review by boards of directors—in essence, forcing boards to go through the motions of fulfilling their fiduciary responsibilities. Specifically, Civil Code §5500 states that the board of directors must:
- Review, at least quarterly, current reconciled bank statements of the association’s operating and reserve accounts.
- Review, at least quarterly, income and expense statements for the association’s operating and reserve accounts.
The need to require this stems from the widespread aversion that board members have to financial reports, which they regard as confusing, cryptic and intended only for highly trained specialists called CPAs. This attitude, coupled with the time constraints most volunteer directors experience, causes them to feel exempt from both understanding financial documents and the responsibility that accompanies them. This is a grave error. While the board may delegate various activities and functions to others, their ultimate legal duty, including the fiduciary responsibility to preserve and protect the assets of the association, is inalienable.
This development is not only unfortunate but also unnecessary. For most laypersons, financial statements can be easy to read and comprehend once their purpose and format is understood. With a brief orientation, the normal human fear of financials can be easily overcome and reviewing the monthly financial reports can be easy, informative, and even (yes!) enjoyable.
Accounting Periods
An association’s basic accounting period is its fiscal year. Comprised of 12 calendar months it may be divided into 12 monthly reporting periods or, less often, 4 three-month “quarters.” Whatever the length of the reporting period, they define the “activity” or “transactions” (assessments charged, payments made, checks disbursed, etc.), which occur between their first and last day. Thus, the “March Financials” are the financial statements containing the accounting activity occurring during the March reporting period in addition to the cumulative year-to-date activity.
Often but not always, fiscal years start in January and end in December. Fiscal years may encompass any 12 consecutive months; for example, April to March or June to May.
Reconciled Bank Statements
State law currently requires that boards review a reconciliation of the association’s operating and reserve accounts quarterly. At the heart of comparing the association’s cash accounts with reconciled bank statements is the test to determine whether your bookkeeper and your banker agree on how much money the association has. Directors often skip this fundamental audit check in their review of the financial reports. Many directors are simply unaware of its importance or do not understand that this check is one of their principal responsibilities pertaining to the protection of the association’s assets.
Reconciliation involves comparing the ending balance in the current month’s bank statement with the cash reported in the corresponding account on the Balance Sheet. Bank statement balances often must be adjusted to reflect outstanding checks (checks written in the accounting month which have not yet cleared the bank) or deposits in transit (not yet posted). Conversely, miscellaneous bank charges (e.g. check printing charges, returned check charges, etc.) and unrecorded bank deposits (e.g. interest earned) must be reflected in the association’s ledgers. Reconciling the bank and ledger balances with the relevant adjustments is performed on a reconciliation sheet, often attached to a copy of the actual bank statement. The reconciliation sheet will show the beginning balances, adjustments, and matching ending balances.
The Balance Sheet
The association’s single most important financial report is the balance sheet. It is a concise summary of the association’s financial condition and all other reports are subsidiary to it. For this very reason, it is the report most often requested by mortgage companies and banks when considering loans for homebuyers and associations. Paradoxically, it is the report sometimes not included in the board’s financial packets.
Representing the fundamental accounting equation, the balance sheet is divided into two parts: assets on the one hand and liabilities and equity on the other. Its name draws on the fact that total assets must balance to liabilities plus equity.
Assets
An association’s assets are comprised principally of cash drawn from homeowner assessments. On the balance sheet, this cash is represented by the totals in the association’s bank accounts. Cash accounts should be separated into those containing operating cash and those holding cash for replacement reserves. This is because, increasingly, state legislation is restricting the use of replacement reserve cash for nonreserve purposes and requiring separate controls for these funds. Mingling reserve and operating cash in common accounts invites charges of misuse of funds. It is best to represent each separate bank account as a separate balance sheet account, thereby making the task of comparing the association’s reconciled bank statements with the balance sheet easier.
In addition to cash, monies or services owed to the association are also considered assets. Therefore, accounts receivable (those assessments, fees, late charges, fines etc.), which have been billed by the association but not paid by homeowners, are considered assets together with prepaid taxes and prepaid insurance premiums.
Liabilities
Liabilities include all monies or services owed by the association. Included here are accounts payable (bills owed to service providers, utilities, etc.), bank loans, taxes, insurance premiums, etc. Also included here are prepaid assessments, considered a liability because they represent future services owed by the association to homeowners who have paid assessments in advance.
Equity/Funds
Those familiar with accounting know that the value of assets remaining after all liabilities have been accounted for represents “equity,” a term often equated with “ownership.” Homeowner associations use what is known as fund accounting, where the value of the assets after liabilities have been deducted represents the fund balances. A “fund” is comprised of the prior year’s ending fund balance plus the net of the current year-to-date income and expenses. To facilitate their management and conform to Civil Code requirements, operating and replacement reserve fund balances should be reported separately.
The Delinquency Report
The list of delinquent homeowners often receives considerable attention from boards of directors. This report is essential to effectively manage your association’s collection policy, a topic that requires a separate article. Strictly as a financial report, the Delinquency Report should provide the following information. First, it should contain a list of all delinquent homeowners and their outstanding assessments on an aged basis, that is, delinquent amounts shown in categories of “30-day,” “60-day,” “90+ days,” etc. The sum of all delinquent amounts should match the Accounts Receivable total on the Balance Sheet.
Incorporated in or together with the delinquency report should be all the prepaid homeowners and their prepaid amounts. The sum of the prepaid assessments should balance with the Prepaid Assessments account on the Balance Sheet.
Income and Expense to Budget
This report allows directors to see how much income the association has generated, how much expense it has incurred and to compare these amounts with the corresponding amounts budgeted by the association. With this report, directors can manage their association’s financial operations. So critical is it to the board’s ability to control the association’s profit and loss that the California Civil Code requires that boards review it at least every three months.
As its title suggests, the report lists the association’s income and expense on a monthly as well as a cumulative, year-to-date basis. By convention, income accounts are reported above expense accounts. All income accounts should be listed: assessments, interest, special assessment, etc. Being more numerous, expense information is usually presented by major category, such as “Administration,” “Utilities,” “Landscape,” etc. Corresponding budgeted amounts are typically provided in adjacent columns.
Included in the report, often as a summary at the bottom, is a statement of the association’s year-to-date profit or loss. The resulting year-to-date profit or loss figures should balance to the respective Fund Balance on the Balance Sheet. It is important to understand that the statement of profit or loss refers only to the current year’s income and expense and does not reflect balances carried over from the prior year.
Since expenses are compared directly with the budget, directors can readily see whether year-to-date expenses are within budget and manage expenses accordingly. It is expenses that must be managed; the budget itself cannot be changed to accommodate expense overruns. Remember that your current budget was formally approved in the prior fiscal year, is tied to the amount of monthly assessments and replacement reserve plan, and has been published to all homeowners as well as prospective buyers, loan officers, etc. It is not to be tampered with!
(It is important to note at this point that the Civil Code requires that your budget be prepared on an accrual basis. Under an accrual basis of accounting, cash is posted when it is due whereas under a cash basis, it is posted when it is received. Income and expense reported on a cash basis cannot be compared with a budget prepared on an accrual basis. An accrual basis of accounting is assumed throughout this discussion.)
The Cumulative General Ledger Listing
A cumulative listing of all general ledger entries from the beginning of the fiscal year, this report is the association’s ultimate accounting reference document. In it, account by account, are shown all the entries that comprise each account’s balance in the association’s financial reports. Virtually any inquiry may be answered with it by locating the account in question and reviewing all entries from the year’s “opening balance” amount to the current total. It is also a rather bulky report containing a large quantity of detail. For this reason, it is seldom distributed to all board members. However, it is relied on heavily by treasurers, managers, and accountants.
Conclusion
With the exception of marauding pirates, many of the financial uncertainties that bedeviled the ancient barbarian princes remain a threat to the modern homeowner association. However, in the intervening millennia, enormous improvements have been made in financial recording and reporting. Understanding those reports is the key, which gives the director access to powerful management tools. By overcoming the dread of financial reports and using them to their fullest advantage, directors can comply with legal requirements, meet their fiduciary responsibilities, manage their association effectively and avoid the fate of those ancient Greek kings.
Steve O’Brien is a principal at Digital Accounting Services a community association financial and bookkeeping service. He was a member of the ECHO board of directors and the North Bay Resource Panel.