When it comes to interpreting your HOA management company’s financial reporting, it’s helpful for HOA members to understand the accounting process used by their management company, especially if they wish to maintain and manage community funds in a practical manner. Below, you’ll find a guide to some basic accounting terms and concepts used by HOAs and HOA management companies, as well as some information to ensure you are doing everything right when running your HOA board.
Basic Accounting Terminology
- Assets are the positives of a business. It’s the cash in a business’s bank accounts and all of its investments, including the checking/operating account, reserve account, and any investments such as certificates of deposit.
- Liabilities are the negatives of a business–monies that a business owes. Liabilities include any funds that are due payment to other people (unpaid bills), money that owners have paid that are not yet owed (prepaid assessments), and other expenses.
- Equity is kind of a paper concept; it is not a representation of how much cash a business has, or how much it can spend. It is a term of art used to represent the monetary value of the business. It might be represented on the balance sheet as retained earnings or losses, or as a current year income or loss.
Positive versus Negative Equity
If an HOA has more savings, cash, and funds that it may collect than it has money to pay, it has a positive equity. On the other hand if a community association owes more money than it has and can take in, it has negative equity.
Remember; The Balance Sheet Should Reflect Positive Equity and Should Balance
When looking at a balance sheet, first make sure that the assets are equal to the liabilities and equity. If they are, the finances are balanced.
Next, check to see that the business has positive equity or retained earnings. A board should not be spending more than it is receiving in income, so if its liabilities are greater than its assets, the business should consider increasing the dues or levying a special assessment so it doesn’t deplete its reserves. If you see negative equity on the balance sheet, discuss it with your HOA management company property manager. Find out if any expenses are more than the income and determine what action, if any, is best for the HOA or Condo Association.
Budgets are formulated through standard costing, where a unit cost is multiplied by estimates for the coming year, for total costs of labor and services. A budget is used to determine what the cost of service would be under reasonably ideal conditions. Keeping these records makes it possible to figure out whether costs are out of line and, if so, where. Standard costing is primarily a device to assist community managers in the control of costs. The comparison between budgeted costs (or standard costs) and the amount of costs as recorded may be referred to as “budgeted versus actual,” or “standard versus actual.” Budgets vary from year to year depending on reserve studies and planned community projects or activities.
Having a budget allows an HOA to more closely control its financial operations. Budgets are used as baselines to determine owner assessments, and to help minimize unexpected expenses. They provide for the continuity of community services, maintaining the community’s desired quality of life. Ultimately, budgets provide an opportunity for a community to balance its needs and desires.
For communities with reserve funds and/or active investment funds, it is always best to review quarterly reports, as well as pay close attention to variances. Boards may request to review interim reports to directly monitor fund balance and proper allocation. It is highly recommended to prepare budgets for the new fiscal year several months in advance. Proposed budgets should be approved at least 45 days prior to the start of the fiscal or budget year.
Your HOA management company’s responsibility in this process is to give you the information to make the correct choices and allocations in your budget.
HOA Reserve Studies
Reserve funds are a community association’s version of a “rainy day” fund. The financial health of your HOA can be determined by calculating the strength of that fund through a reserve study. If you’re considering moving into a new community governed by an HOA, one of the first things you’ll want to look into is their financial health. If you’re already living in such a community, you should know when the last time your HOA conducted a capitol reserve study. Community associations should conduct a reserve study every few years. A reserve study verifies the strength of all those common areas which fall under the responsibility of the HOA. Items such as roofs, courtyards, building foundation, elevators, air conditioning, or swimming pools would all be part of this study. The results should provide an estimate for any future repairs or maintenance.
A reserve study will also predict an amount that the fund should have on hand to address these findings. These funds will be used by your HOA management company to make repairs as needed. For instance, if you have a roof with a twenty year life and it’s only one year old, you are 100% funded if you have 1/20th of its replacement cost in your reserves, because that is the amount of the life of that component which has been expended or “used up” at that point in time. However, this term is generally applied to all of the components collectively, so you would need to perform the process for each individual component. If you repeat the process and see that you have reached the necessary funding level for all components, you may then proclaim that you are “100% funded”.
This process, in essence, is the whole purpose of the reserve study. Following this process ensures an equitable financial relationship between current and future owners in any community. You’re probably already paying into a reserve fund as a portion of your monthly homeowner’s fees. The goal is to have that amount funded as close to 100% as possible. Reserve funds that have reached a 70% target are in decent shape, but anything under 50% should be cause for alarm. Why? Because if one of these projects comes up for completion and the reserve funds can’t cover the costs, then the homeowners will be charged with potentially huge assessments, which no one wants to deal with. While it might be attractive for an HOA to charge lower fees, chances are they’re not going to be buffering their reserve fund that way. Oftentimes, this is an indication of a faulty HOA management strategy. An HOA who wants to keep the “status quo” doesn’t want to aggravate residents with high monthly fees. Such an approach will hurt the HOA later if a sudden capital improvement is needed.
Inadequate reserve funds also affect your HOA’s ability to sell homes. The Federal Housing Authority (FHA) won’t offer loan assistance to a community which has low reserve funds, preventing or complicating the selling procedure for current owners hoping to sell their homes.
Community Associations should seek a balance between setting monthly homeowner’s fees and contributing to the reserve fund. Your HOA management company should help you find a reputable engineering company to conduct the reserve study for your community.
Fidelity bond coverage provides protection for loss of money (i.e., reserves or operating expenses, additional securities and property) that would occur as a result of fraudulent or dishonest acts by people in charge of handling the association’s money. Fidelity bonds may also be known as “employee dishonesty” bonds or crime coverage.
A fidelity bond should provide coverage for theft or forgery by any employee of the insured, and should also include the HOA management company and their employees among the additional named insured. Most legitimate HOA management companies are also covered by a bond. The amount of coverage that is generally recommended for an association to carry a fidelity bond would be at least three times that of the monthly assessments, plus the amount that the association has in reserves. Associations that collect on a quarterly basis may require even more coverage. Some association documents may define the type of coverage that is required, as well as the amounts of coverage. Consult with your HOA management company or your association’s attorney and insurance agent as to what would be required or what would be an appropriate amount for coverage.
Both the FHA and FNMA (Fannie Mae) also require fidelity bonds. The FHA requires three months of assessments; the reserve funds should also be covered. Fannie Mae calls for fidelity bonds to be in the amount of at least three months of an association’s assessments. Your HOA management company should aid the association in finding fidelity bond coverage, in order to allow any real estate sales.
Your HOA management company should be straightforward and accessible when communicating over financial matters with your HOA’s board of directors and homeowners at large. However, if you and other members of your HOA are able to comprehend and conceptualize these accounting terms, any issues over financial clarity will be easier to address.