The central financial questions in HOA land are:
- Are the regular and special assessments sufficient to handle the routine annual operating expenses and to satisfy the Major Repair and Replacement (MRR) obligations?
- If special assessments are required, are they fully disclosed, understood and agreed upon?
- Are these assessments fairly allocated among former, current and future owners?
(Note: the question for another day is – at what standards of care is the common area maintained?)
If you are an HOA leader, your objectives for all things financial are:
- To answer those questions accurately, clearly, simply, understandably, compliantly and relevantly.
- To assure that all interested parties know and understand the financial situation, the path forward, and the desired outcomes.
In my opinion, the current CPA reviewed/audited financial statements and related MRR (Reserve) studies do not answer those questions or achieve those desired outcomes. Moreover, in most cases these reports mislead and fail to reflect economic reality. Therefore, association leadership make sub-optimal decisions and interested parties are financially clueless.
This commentary’s purpose is to support that opinion, tell you why it matters, and to offer alternative solutions.
If you are a CPA or Reserve Study colleague, it is not personal. I just think we can do better. A lot better.
First, my CPA colleagues will assert that they are just following the “rules.” And, to some extent that is a defensible position. However, there are acceptable alternative rules from which to pick. Moreover, it is also a “rule” that when following the rules produces a report or work product that misleads, the presentation must be modified to not be misleading. Did you follow that?
The misleading label is, of course, a judgment call. My judgement call after 50 years as a CPA licensee and 40 years actively engaged in the HOA finance world is that the today’s typical CPA reviewed/audited HOA financial statements do mislead and, in some cases, fraudulently misrepresent economic reality.
Second, Reserve Study specialists are pioneers in an evolving emerging discipline that is not yet a “profession” because it lacks the markers. There are:
- No academic requirements
- No agreed upon body of knowledge
- No rigorous testing
- No content and format standard setting body
- No agreed upon information sources
- No deep and wide research library
- No vigorous dialogue and debate forums
- No continuing education requirements
- No disciplinary framework or sanctions for substandard work.
They are in their comfort zone and not entertaining alternate theories of the crime. The objective should be and a reasonable expectation by HOA owners is that two reserve study specialists evaluating the same community should produce reasonably similar outcomes. That is not the case today.
Here is a quick example. In a two-year period of temporary insanity, I became a board member and president of a large-scale community in Palm Springs (1,000 plus units, golf course, 34 pools, tennis courts, etc.). The first reserve study indicated the total current cost to replace the major components was about $12 million. The second study by a different group stated the number was about $32 million. A third study indicated it was $22 million. Now, I understand and accept that competent professionals in any field will have different opinions and methods. Moreover, those opinions and methods evolve and change with new information and research. However, such a wide range of outcomes produced by current reserve study practitioners is – Not Acceptable.
Ok, mister CPA and status quo challenger person, tell us the gospel according to you in a way we mere mortals can understand, accept, and promote. Thank you for asking and I am pleased to do so.
Since a complete professional and academically sound response is beyond the scope of this commentary and would be unintelligible to most, I will submit a provocative Cliff Notes summary.
Here are my main findings and flaws with current practice:
1. Fund Accounting is useless. The acceptable commercial or enterprise method, properly presented produces a much clearer picture of economic reality.
I will not bore you with the flawed process that delivered “fund accounting” 27 years ago in 1991 as the preferred method or how the standard setting bodies have moved away from “fund accounting” since then. I will state that the current practice defies all information theory principles and provides zero basis for interested parties to ascertain the association’s financial position (balance sheet), results of operations (income statement) and its economic reality.
The Fund Accounting Balance Sheet typically shows a column labeled “Replacement Fund.” There are two numbers in this column “Cash” and “Fund Balance” usually the same number. This presentation is like asking “What is the score in the Giants/Dodgers game?” and getting the answer “4” which, of course, tells you nothing that you need to know such as what the other team’s score is, what inning it is, etc. Example: new client to us has $100,000 in CPA reviewed “Replacement Fund.” Nowhere in the statements, notes or supplemental information is it disclosed that next year the community must replace the roofs and levy a special assessment of more than $1,000,000. Yet that information is readily available in the Major Repair and Replacement Study.
The fund basis income statement is equally useless. The “Replacement Fund” column shows amount of the annual assessments designated for replacements and the actual cash expenditures for those items that year. This presentation tells you nothing about the “should be.” What should be the annual charge to the income statement for the “wearing out” cost of the common area major components, which the association has the inescapable reasonably estimable contractual obligation to maintain at an ascertainable standard of care?
2. The Major Repair and Replacement (MRR) obligation and its related funding issues are, at best, buried in the annual financial reports. At worst, and typically, those issues are omitted and not disclosed to the HOA owners. Yet, the recognition and funding of these probable and reasonably estimable obligations are the Critical Success Factors (CSFs) in HOA financial planning and leadership decision making. Lack of full disclosure and clarity on this issue in the financial statements is not worthy of the CPA profession.
3. Fixed asset accounting is improperly handled. In large scale communities we sometimes find that CPAs have put common area amenities such as land, buildings and real property improvements on the balance sheet as “assets”, which creates a large “contributed” capital in the net assets (equity) section. This is clearly misleading and does not reflect economic reality. Rarely does the HOA have the normal bundle of ownership rights to these “assets.” With rare exception, these assets are owned by the owners in common and not by the HOA. The HOA has the inescapable contractual obligation (CCRs) to maintain these common area elements at an ascertainable standard. But it does not “own” them. It is a form and substance thing.
4. The Major Repair and Replacement studies (MRR) in their current structure and content suffer from several theoretical and technical flaws. Here are a few of my favorites:
- Percent funded on a stand-alone basis is misleading and fails to move the needle on the “so what” meter. It requires more context. A community could be 30% funded and be just fine. It could be 80% funded and be in deep trouble because its “whale” (gargantuan expenditure) presents next year and the money isn’t there. Whether there are appropriate provisions for other uninsured risks is another risk management conversation. See Giants/Dodgers analogy above.
- Including items that occur every year in the study is clearly erroneous. Those items should be in the “operating” budget.
- Material personal property assets such as trucks, maintenance equipment, technology and other such items are not major components and do not belong in the MRR study. They are not common area elements, not contractual obligations, and ownership is discretionary (you can outsource the service). Their replacement should be separately analyzed.
- The study itself is not a major component to be included in the reserve obligations. It is an operating expense in the year incurred.
- My personal logically impaired favorite is when the remaining life is longer than the typical life.
- Contingency items that are not probable and not reasonably estimable should not be on the study (a lot of “nots”). There is a separate accounting “Net Asset Designation” method for the recognition and funding of uninsurable unpredictable financial risks.
- Net new material proposed capital improvement items should not be in the study. They are not yet Major Components. They also are recognized using the “Net Asset Designation” method.
- Small items are not “…major components…” (California Civil Code 5550). Surely, if the item is less than $1,000 to replace or if the annual straight-line cost is less than $100 per year, it is not a major component. Put those items in a pool. Figure out an annual allowance for them and include a provision to service those items in the annual operating budget.
- Funding models should not produce “are you kidding me?” 100% funded cash balances at the end of the projection period. Example: (See temporary insanity above) In 252 pages of mind- numbing detail about 1,080 MRR components (including personal property assets) and buried on page 38 is a 30 year “Target Fully Funded Balance” of close to $30 million. The Association has an annual average major repair and replacement expenditures of $2.5 million with a peak of $6 million in one year. In what reality does the Association need $30 million of cash on hand in year 30?
- These studies imply a precision level that does not exist. They are sun-dial estimates not swiss watches. The idea is to obtain a common sense understanding of the reasonable and probable cash outflow demands over a reasonable projection period; to figure out who pays for what, when and why; and to overcommunicate the situation and the plan until all interested parties know and understand the situation, plan, standard of care, and desired outcome.
I could go on, but my blood pressure would rise to life threatening levels.
Given all this insanity what should be done?
Here is Don’s multi step recovery program that HOA’s leaders can take:
- Insist that the annual CPA review/audit be prepared using the perfectly acceptable “non-fund” or enterprise method. Put major project accounting information in the supplemental information section.
- Insist that the annual CPA review/audit accrue the probable and reasonably estimable Major Repair and Replacement obligation as allowed and acceptable by FASB, the U.S. Accounting Standard setting body. I submit to you that this method should be the industry standard. It is our firm’s standard. It has been found acceptable in our firm’s four peer reviews (CPAs must undergo work product peer reviews every three years) and by the Association of International Certified Professional Accountants (AICPA) in a Quality Review of the method in 1999 almost 20 years ago.
- Insist that your Major Repair and Replacement Studies are free from the theoretical and technical flaws described above. If they are not, make them do it over until they are.
- Obtain competent financial counsel. It always amazes me that HOAs will spend thousands of dollars on legal advice to handle disputes that could have been avoided if they just had paid up front for competent advice in the first place. It always costs more in the Emergency Room than if you sought proper care when the symptoms first presented. Or, as we used to say when I was in the banking business, your first loss is your cheapest loss.
Ok. That is the gospel according to Don. “Why should I care?” You ask.
Two legal reasons (not an attorney, just saying):
- Breach of Fiduciary Duty (for the HOA leadership)
- Malpractice (for the professionals)
Competent counsel can scare you straight on those elements. The plaintiff’s (the person suing you) allegations will be:
- You did not tell me the gun was loaded;
- You did not comply with your standards (and even if you did, they are not good enough);
- I relied on the information you gave me to my detriment; and
- Now you must cure my loss.
One leadership reason:
If you are an HOA leader, your objectives for all things financial are to:
- Deliver accurate, clear, simple, understandable, compliant, relevant and actionable information.
- Assure all interested parties know and understand the financial situation and plan.
Adopt the gospel according to me and you have a reasonable possibility of achieving those outcomes. Otherwise, the 3 “M’s” prevail – Myths, Mistakes, Misunderstoods which of course produces the 3 “Ds” – Dysfunction, Disruption, Dispute. What is your future?
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