CHAPTER 5

BUDGETS AND
R E S E RVE S

KEY TERMS
Assessment, p. 101 Operating expenses, p. 102
Baseline funding, p. 104 Percent funded, p. 104
Budget, p. 98 Reconciliation of expenses and revenue, p. 111
Chart of accounts, p. 106 Replacement fund, p. 103
Discretionary budget line items, p. 106 Reserve cash flow statement, p. 111
Expenses, p. 102 Reserve formula, p. 111
FHA, p. 99 Reserve Specialist, p. 110
FHLMC, p. 99 Reserve study, p. 108
FNMA, p. 99 Revenue, p. 101
Full funding, p. 105 Special assessment, p. 101
Historical trend budgeting, p. 107 Threshold funding, p. 105
Mandatory budget line items, p. 106 VA, p. 99
Major improvement expenses, p. 102 Zero-base budgeting, p. 107
Operating budget, p. 107

This chapter provides an overview of the role of budgets and reserves in community
associations.

The chapter explains:

■ Roles and responsibilities in the budget process

■ Budgets and reserves and their use

■ The sources of budget and reserve requirements

■ Budget preparation

■ Budget presentation

What You Will Learn

After reading and reviewing this chapter, you should be able to explain and
understand:
■ Roles and responsibilities in the budget process for the board of directors,

the treasurer, the owners, and the manager

■ The definition of a budget

■ The role of a budget in a community association and its uses

■ Sources of community association budget requirements

■ Sources of revenue for a community association

■ Types of expenses for a community association

M-100: The Essentials of Community Association Management 95

 ■ Reasons for maintaining a replacement fund
■ Development of budget line items
■ Preparation of an operating budget
■ Preparation of a replacement fund budget
■ Reconciliation of expenses and revenue
■ Methods of budget presentation

Your community governing documents will define formal roles and responsibilities in the
budget process. However, it is important for you to find out as soon as possible what
people’s informal expectations are—for everyone involved.

Become familiar with the budgetary roles and responsibilities of:

■ The board of directors

■ The treasurer

■ The owners

■ Yourself, as manager

Board of Directors
Most boards of directors are responsible for establishing, approving, and monitoring the
community’s budget. Although they have the power to establish a budget, most will del-
egate preparation authority to their manager.

When directors review a proposed budget, they should take into consideration:

■ Legal requirements of state statutes and governing documents

■ Owners’ needs and desires (balancing mandatory and discretionary items—see

page 106)

■ Committee and owner feedback

■ The need to reconcile revenue and expenses

■ Any financial forecasts and analyses of past financial activity prepared by the
manager

As the board has the power to approve the budget, you, as the manager, are responsible for
providing all owners with a summary copy of the proposed budget before it is officially
adopted by the board.

96 Professional Management Development Program

Treasurer
The community treasurer is usually responsible for seeing to it that the draft budget is pre-
pared and reviewed. He or she will usually delegate initial preparation of the budget to the
manager. Then the treasurer will usually review the draft budget with a finance committee.

It is important that the treasurer consult all committee chairpersons and invite owner
input to ensure support.

Their participation and support would be especially important where a vote of owners
is required or recommended for:
■ A required increase in assessments (see page 101)

■ Special assessments (see page 101)

■ Major improvements (see page 102)

■ Funding reserves (see pages 102-105)

Usually the treasurer presents the proposed budget to the owners at an open community
meeting. Frequently, community governing documents require that an open meeting be
held before the board adopts a budget.

Owners
Some states and some community governing documents require that the budget be
passed by a vote of the owners. The preceding discussion explains when and why own-
ers should be involved in reviewing the proposed budget—even when the board is respon-
sible for its adoption.

Manager
As community manager, your formal budget responsibilities are more likely to appear in
your contract than in the community’s bylaws.

Even if neither the bylaws nor your contract spell out your budget responsibilities,
informally you will be expected to:

■ Prepare or be involved in the development of a draft budget

■ Review it with the treasurer, finance committee if one exists, and ultimately the
board and membership

■ Revise it after any changes are made

■ Mail a summary of the proposed budget to the owners before it is approved

M-100: The Essentials of Community Association Management 97

INTRODUCTION TO THE BUDGET
This section explains:
■ The definition of a budget

■ Its role in community management

■ How it is used

What is a Budget?
A budget is a financial plan for an organization—in this case, a community association.
A budget provides an estimate of a community’s revenue and expenses for a specified
period of time. It is the first step in your community’s financial operations.

The Role of a Budget in Community Management

A budget establishes:
■ What services and programs the community will provide

■ When they will be done

■ How they will be done

In other words, a budget reflects a community’s policy decisions about what will be
accomplished and what will not be accomplished during the budget period.

How a Budget Is Used

A budget has many uses:

■ It is a way for the community to plan its activities

■ It is the basis for determining owner assessments (see Chapter 6)

■ Together with financial reports (see Chapter 7), it is a means of controlling the
community’s financial operations

■ It provides for continuity of community services

■ It helps the community maintain its desired quality of life

■ It helps to minimize the unexpected

■ It provides an opportunity for a community to balance its needs and desires

(mandatory and discretionary items, see page 106)

98 Professional Management Development Program

SOURCES OF BUDGET REQUIREMENTS
Budget items will vary from one community association to another. They also will vary
from year to year for the same association.

Many budget items develop in the normal course of doing business. However, a num-
ber of budget items appear because they are required by:
■ Federal laws and regulations

■ State statutes, regulations, and court decisions

■ Local laws and regulations

■ The community’s governing documents

Federal Laws and Regulations

Federal laws and regulations can lead to community expense items. For example, all com-
munity associations must conform to Internal Revenue Service requirements in the area
of income and payroll taxes.

Federal agencies may also establish expense requirements that your community will have
to meet. For example, in the environmental area, you may have to budget for oil tank
testing, hazardous waste disposal, or chlorofluorocarbon (CFC) removal. Your communi-
ty association may also be taking steps to conform to the requirements of the Americans
With Disabilities Act (ADA).

Federally established secondary mortgage institutions may set requirements that your
community association will have to meet if owners are to participate in their financing
programs.

These agencies include:

■ Federal National Mortgage Association (FNMA or Fannie Mae)

■ Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)

■ Federal Housing Administration (FHA)

■ Veterans’ Administration (VA)

These agencies regulate and influence such items as the amount of insurance a communi-
ty association must carry, procedures for financial operations, and requirements for the
upkeep of property.

If you know you are regulated by a particular agency, contact that agency’s local repre-
sentative for more information on requirements that affect your community association’s
budget process. Or you can call your congress person's local office.

M-100: The Essentials of Community Association Management 99

State Statutes, Regulations, and Court Decisions
As we said in Chapter 1, most states have statutes that enable the establishment of condo-
miniums and corporations. Some states have statutes that enable the establishment of
cooperatives or planned communities. In several states, these statutes require or regulate
such community association budget items as reserves for replacement, audits, insurance,
and the conduct of financial operations.

States may have other laws and regulations that apply to community associations and
have budgetary implications. To find out about any applicable laws and regulations, call
your attorney or local state legislator.

What a specific state statute says very often will override what your community’s govern-
ing documents say. Check the state statute’s wording carefully to determine its applica-
bility to your community association. And in so doing, keep in mind that your communi-
ty association’s governing documents may not be current with the state statute that
enables establishment of your type of association.

If your community association employs at least one person (you), it must follow all appli-
cable state requirements for employers. This can result in such expense items as workers’
compensation insurance and unemployment taxes.

State courts have also made decisions that affect the types of expenses community asso-
ciations incur. For example, there have been “security” cases involving the adequacy of
lighting, patrols, and off-duty police. There have been other cases involving parking and
sign requirements, and there have been “slip-and-fall” cases involving the adequacy of
snow removal. To find out more about the case law that applies to your community asso-
ciation, consult the Community Association Law Reporter, a monthly publication from Com-
munity Associations Institute reporting on current laws and legal decisions affecting
community associations.

Local Laws and Regulations

Your local government may have codes, laws, and, possibly, taxes that your community
association must meet. Any requirements in these areas will result in expense items for
your community’s budget.

For example, your local fire code may require such items as sprinkler systems, exit signs,
fire extinguishers, or elevator inspections. Your local health and safety codes may require
pool inspections, water quality tests, or mandatory procedures for sewage disposal or
recycling.

100 Professional Management Development Program

Property taxes may or may not be levied on land commonly owned by the community
association, depending on your state or local jurisdiction.

Governing Documents
The governing documents of your community:
■ Define the property to be maintained by the community association

■ Specify maintenance and service responsibilities and requirements

Maintenance and service items will appear in the “expenses” section of your community’s
budget (see next page).

BUDGET COMPONENTS
Before you begin reading this section, you may want to pull out a copy of your commu-
nity budget to look at as you read through the following pages. The two main compo-
nents of a community budget are revenue and expenses. The revenue and expense cate-
gories used in your budget must be the same categories used in your financial records,
reports, and statements.

Revenue
Revenue consists of the collective items or amounts of income which, in the case of a
community association, are appropriated for public expenses. The typical sources of rev-
enue for a community association include:

1. Owner assessments: An assessment is the owner’s financial obligation to the

community association during a given period of time—usually one year. It
covers the owner’s share of the common expense. An annual assessment may be
paid on a monthly, quarterly, or annual basis. Most of a community’s revenue
will come from owner assessments. (See Chapter 6 for more information on
owner assessments.)

Occasionally, special assessments may be levied. A special assessment is a one-

time assessment often voted on by the owners to cover a major expense that
was not included in the annual budget or replacement reserve.

2. Interest: A typical source of revenue for communities is interest or dividend

earned on their cash savings and investments.

3. Penalty fees: Exampes include—fines for violating community rules and

regulations, reimbursements for legal fees and lien filings, and late payment fees.

M-100: The Essentials of Community Association Management 101

 4. User fees: For example—parking space rentals, laundry machine use, guest
privileges, swimming pool use, and move in-move out fees.

5. Other revenue: Other sources of revenue include—rent from commercial

tenants, rent from lease of units, charges for resale packages, collection on
insurance claims, legal settlements, easements, and antenna rental.

Expenses
Expenses consist of the cost of goods and services used to operate and maintain proper-
ty. Typically, there are three types of expenses for community associations:

1. Operating expenses: Operating expenses are those items that occur on a

regular basis—day to day, week to week, month to month, and year to year.

For example—
■ Swimming pool management costs

■ Professional and administrative services (management, legal, accounting,

insurance)
■ Utilities (electric, gas, water, oil)

■ Contract services (lawn maintenance, elevator, trash removal, janitorial

services, painting)
■ Repairs (plumbing and pipe, electrical, door and lock)

■ Personnel costs (compensation and benefits for community employees)

■ Educational costs for employees and volunteers (courses, publications,

membership in Community Associations Institute)

2. Major improvement expenses: Major improvement expenses consist of items

that are not necessarily required, but are added to improve the overall welfare,
safety, or life of the residents—or to enhance the value of the community
association as reflected in the resale value of units.

Improvements are different from maintenance, repairs, or replacements. They

increase the life, usefulness, or value of a property. They are called major
improvements because they typically last more than one year and involve a
large amount of funding for the community association. Examples of major
improvement expenses are the addition of a new tennis court, more picnic
areas, or additional street lights.

3. Replacement fund: The establishment of a replacement fund is a community asso-

ciation expense that requires detailed explanation. Please see the next page.

102 Professional Management Development Program

REPLACEMENT FUND
The replacement fund consists of funds put aside—in reserve—for the replacement of
major components of a community’s common property. Typically, the replacement fund
might be used to replace asphalt paving, concrete sidewalks, roofs, central heating and
cooling plants, swimming pool, tennis courts, elevators, and many other varied property
components. Revenue raised for adding a major item will be a major improvement
expense. Revenue raised for replacing that item when it deteriorates will come from the
replacement fund.

Major items that either come with the initial construction or are added later are placed on
a replacement reserves schedule. The schedule is a framework for accumulating and spend-
ing the funds for replacing major components of the property. (See the sample replacement
reserves calculation on page 112 for a sample schedule.) The funds are put aside over a
period of time to ensure that adequate amounts are available to replace components when
they need to be replaced either for deterioration or technological improvements. The
components, cost to replace the components, and the remaining useful lives of the com-
ponents will determine your reserves for replacement.

It is important to note that the Internal Revenue Service considers the expenditure of
certain replacement funds for regular maintenance and repairs—such as painting—as an
action that may expose the community association to possible taxation.

Until recently, community associations referred to the replacement fund as “replacement

reserves,” “reserves for replacement,” or just “reserves.” However, the Common Interest Reality
Associations Audit and Accounting Guide prepared by the American Institute of Certified Pub-
lic Accountants for community associations refers to these funds as a replacement fund.

Reasons for Maintaining a Replacement Fund

Because some items may not need to be replaced for several years, you—and the own-
ers—may question the value of their contributions.

Here are some reasons for maintaining a replacement fund to convince you—and the
owners—of the importance of budgeting reserves for replacement:

1. Maintaining a replacement fund meets legal, fiduciary, and professional

requirements. A replacement fund may be required by:
■ Any secondary mortgage market in which your community association

participates, e.g. Fannie Mae, Freddie Mac, FHA, VA

■ Your state’s statutes, regulations, or court decisions

■ Your community’s governing documents

■ Industry standards

M-100: The Essentials of Community Association Management 103

 2. Maintaining a replacement fund provides for the planned replacement of
major items. Owners expect the community association to fulfill its obligations.
At some point in time, the work will have to be done.

3. Maintaining a replacement fund equalizes the contributions of old and new

owners. Major items deteriorate during use. Although a roof will be replaced
when it is 25 years old, every owner who lived under that roof should pay a
share of its replacement. Just as both old and new owners benefit from the
presence of such an item, both contribute to it.

4. Maintaining a replacement fund minimizes the need for special assessments.

Owners, especially those on fixed incomes, have limited resources. They may
not be able to afford the large special assessments that would be required if
reserves are insufficient to cover a major replacement. Special assessments have
the reputation of being indicative of poor management.

5. Maintaining a replacement fund enhances resale values. Lenders and real

estate agents are aware of what a replacement fund is and the ramifications for
a new buyer if reserves for replacement are inadequate. Many states have
reserves disclosure requirements for buyers into a community association. Some
states require reserves for replacements and/or replacement reserve studies.

Funding Goals
The answer to the critical question of how much reserves is “enough” or “adequate” is not
simple. Each association has different needs, so $100,000 may be excessive to one associ-
ation but an extremely small amount to another.

One standard method of measuring the size of an association’s replacement fund, provid-
ing information about how the fund measures up against the needs of the association, is
the concept of percent funded. Percent funded allows an association to measure the rela-
tive size of their reserves as compared to a ‘fully funded’ reserve balance.

Depending on the association ’s funding objectives, the association’s funding plan can
range from conservative to aggressive. Note that reliance on future special assessments is
not considered part of a responsible funding plan. There are three distinct funding goals:

■ Baseline funding: Establishing a reserve funding goal of keeping the reserve

cash balance above zero (never purposefully running out of money or having
special assessments). This is the most aggressive methodology, characterized by
lower (typically) reserve contributions and reserve balances. This funding plan
is also the riskiest of the three, with a greater potential for special assessments
and/or bank loans when things do not go according to plan.

104 Professional Management Development Program

 ■ Full funding: Setting a reserve funding goal of attaining and maintaining reserves
at or near 100% funded. This is a conservative methodology, characterized by
higher (typically) reserve contributions and higher reserve balances. This funding
plan results in the least likelihood of special assessments and/or bank loans.

■ Threshold funding: Establishing a reserve funding goal of keeping the reserve

balance above a specified dollar or percent funded amount. Here a specific
minimum figure is chosen (either a cash value or percent funded value) below
which the reserve fund never drops. The threshold funding approach is often
used to define an objective that results in more “safety net” funds available than
under baseline funding, while not as conservative as fully funding. This funding
plan typically falls between baseline funding and full funding in terms of the
possibility of requiring special assessments and/or bank loans.

Funding plans are expected to project the revenue and expenses of the replacement fund
for 20 or more years. Many associations include the effects of interest earned from their
replacement funds ‘on deposit’ and the effect of inflation on projected future expenses.
While interest earnings tend to reduce the effects of inflation, the two factors do not off-
set each other since interest is earned only on the reserve balance, while inflation affects
the total replacement cost of all the reserve components.

BUDGET PREPARATION
A budget usually applies to a 12-month period.

For example—
■ January 1 to December 31

■ July 1 to June 30

Your community’s budget should be approved at least 45 days in advance of the start of
the fiscal or budget year. This will enable you to distribute copies of the approved budg-
et to your owners before it goes into effect.

To meet approval and distribution deadlines, you will have to begin work on the next
year’s budget several months in advance. Before you begin work, pull together all the
related documents and reports you and your community association’s accountant have
prepared over the past year. (For example—this year’s budget, any comparison of actual
expenses to budgeted expenses, any other financial reports or statements, bills paid over
the past year.)

The budget should include estimated revenue and expenses, and a summary of the most
recent reserve study. (For more information on reserve studies, see page 108.) This budg-

M-100: The Essentials of Community Association Management 105

et, a statement as to whether special assessments are contemplated, and a description of
the association’s collection policies, should be distributed to the members within the
time frame stated above.

Development of Budget Line Items

Each line in a budget represents a different account or category of revenue or expense.
This is why accounts are commonly called line items in a budget.

There are two types of expenditures in a community budget—mandatory line items and
discretionary ones:

■ Mandatory line items—These are items based on community and owner

needs. They are requirements that the community is obligated to meet, e.g.
income taxes, repairs, utilities, and maintenance.

■ Discretionary line items—These are items based on owner, board, and

committee desires. They are items people would like to have—given their
values, lifestyle, and preferred level of service, e.g. social and recreational
expenses, picnic areas, etc.

There are standard ways to describe common line items for community associations, as
the sample on the next page illustrates. It consists of an excerpt from a chart of accounts
for a condominium association.

A chart of accounts is an organized list of the titles, descriptions, and assigned numbers
of all accounts in an organization’s general ledger. The assigned number helps you locate
the account. The title describes the purpose of the account.

There are three rules of thumb to keep in mind when selecting line items for your com-
munity’s budget:
1. Select line items that reflect your community’s activities
2. Select line items that will give your board the information it needs to plan and
control your community’s operations
3. Keep line items as simple as possible

Even though there are customary ways of listing common line items in a budget, your
community association can decide how detailed a set of line items it wants to use.

It is very important that the same account numbers and names be used in the budget, the
general ledger, and all financial reports. Without this consistency, it is impossible to get a
clear picture of the community’s financial operations over a period of time.

106 Professional Management Development Program

When you are preparing a
draft budget, list your line EXCERPT FROM A CHART OF
items in as much detail as ACCOUNTS FOR A CONDOMINIUM ASSOCIATION
possible to help you assign
EXPENSES
costs. For example, utility
line items may include: Administrative Personnel
52310 Office Supplies and 63330 Maintenance Staff
water-domestic, water-irri- Expense 63350 Swimming Pool Staff
gation, sewer, electricity, 52490 Management Fee 63410 Service Coordinator
streetlights, fuel oil, natural 52491 Audit Expense 63520 Secretary
gas, steam, garbage, tele- 52492 Legal Expense 63750 Central Plant Engineer
52500 Staff Training and 63810 Payroll Taxes
phone, and cable TV. This Development
same level of detail should 52750 Insurance Utilities
appear in your community’s 72250 Electricity
financial records. (In order Maintenance of Buildings 72430 Natural Gas
and Grounds 72460 Water and Sewer
to prepare line items for 62250 Plumbing Repairs 72750 Fuel Oil
specific types of goods and 62420 Lawn Maintenance
services, you may have to Service Reserves
solicit bids and proposals, 62425 Snow Plowing Service 81940 Asphalt
62510 Building Repair and 81950 Concrete
e.g. insurance, lawn mainte- Maintenance 81960 Roofing
nance, and pool manage- 62520 Janitorial Service 81970 Swimming Pool
ment.)

However, when you prepare published copies of the adopted budget and any monthly or
annual financial reports, it is appropriate to combine detailed line items under a more
general one. For example, “utilities” might be the only line item that appears in place of
the previous list.

Preparation of an Operating Budget

The section of a budget devoted to operating activities includes operating expenses and
major improvement expenses—but not the replacement fund.

There are two basic methods of budget preparation:

1. Zero-base budgeting: With this method, all line items are set to zero and the
amount of funds allotted to each must be justified.

2. Historical trend budgeting: This method begins with the assumption that
existing line items are needed. The amount of funds allotted to each during the
current year is adjusted for expected changes in the coming year. Sources of
historical information include financial reports, existing contracts, and bills
from the past year.

M-100: The Essentials of Community Association Management 107

A highly effective approach to developing the operating activities section of a budget is
to combine elements of both zero-base budgeting and historical trend budgeting. The
zero-base approach keeps you from accepting this year’s figures at face value. It requires
you to analyze the reasons for the actual amounts spent. The actual dollar figure may be
less or more than the budgeted figure because of circumstances you cannot assume will
exist during the coming year. For example, lawn maintenance costs during a dry season
will be low—but a community cannot assume that the coming year will be just as dry.
The historical trend approach gives you information to start from when you develop
your estimates for the coming year.

Preparation of a Replacement Fund Budget

To maintain the association’s major common area assets, the board and manager must
determine an appropriate level of income to segregate into a reserve account or replace-
ment fund to offset the repair or replacement of those assets as they wear out during the
life of the development. Without a plan (called a reserve study, see below), it is strictly a
“hit or miss” proposition.

Usually, a separate section of the budget is prepared for a replacement fund.

Zero-base budgeting is the only practical method for preparing a replacement fund
budget. The reason is the lack of frequent cost comparisons for large, long-term items.
The Common Interest Reality Associations Audit and Accounting Guide prepared by the American
Institute of Certified Public Accountants for community associations has separate report-
ing requirements for replacement funds.

Reserve Study
Maintaining the association’s common property is among the manager and board’s high-
est responsibilities, and it takes a long range plan to prepare successfully for repair or
replacement of the association’s major common area assets. The reserve study is the plan
by which the association expects to offset ongoing deterioration and prepare for
inevitable future expenses. Reserve projects are typically the largest expenses that an
association faces, and proper financial preparation takes many years.

A reserve study is a budget planning tool that considers the current status of the replace-
ment fund and determines a stable and equitable funding plan to offset the anticipated
future major common area expenditures. The reserve study can also be very useful for
developing a replacement fund budget. The study addresses all items that the association
must repair, replace, restore, or maintain. The study should contain at a minimum a state-
ment of the remaining useful life of each item, an estimate of the current cost of repair,

108 Professional Management Development Program

replacement, restoration, or maintenance of those items, and an estimate of the total
annual contribution necessary to defray the cost of repair, replacement, restoration, or
maintenance of those items after deduction of existing reserve funds. In essence, the study
must include all items for which the community has long-term replacement responsibility.

Consequences of not having a reserve study—

■ Underfunding: Special assessments, bank loans, deferred maintenance, or a

combination of these

■ Overfunding: Paying too much (more than owners “fair share”), for the benefit
of future owners

■ Board member liability: Exposure to claims of fiscal irresponsibility and loss of

D&O insurance coverage

Reserve study benefits to community managers and board members—

■ Fulfilling fiduciary responsibility

■ Meet individual state requirements (for regulated states)

■ Compliance with the American Institute of Certified Public Accountants’

(AICPA) audit guide for community associations (An auditor must modify his
or her report if the disclosure about funding is absent or inadequate.)

■ Reduce personal liability from claims of financial mismanagement

■ Save valuable time with prioritized business plan for capital repairs and
replacements

■ Effective communication tool to keep owners informed

■ Reserve study can turn up items that haven’t been budgeted in ongoing
operations

Associations are constantly changing. As a reserve study is based upon facts at the time
when the study was conducted, managers and boards should plan for an update of their
reserve study on a regular basis—from one to three years—to ensure accuracy.

M-100: The Essentials of Community Association Management 109

The manager and board should review its reserve study, particularly its funding plan,
annually because the association’s physical assets may deteriorate at different rates, inter-
est and inflation rates change, and the association may change its reserve strategy from
conservative to aggressive (or vice-versa). Associations should be encouraged to plan
responsibly for the future with the valuable reserve study as a tool.

In addition, each replacement fund budget line item should be updated each year using
new current cost, new estimated remaining life, and new funds on hand. If you update these
line items each year, the interest earned on these reserve funds can be used to offset
operating expenses.

Interest earned on the investment of reserve funds can be added to the reserves on hand.
If you do not update your replacement fund budget each year, you should add its interest
income directly into the reserves. This will help your replacement fund keep up with
increases in prices due to inflation.

Reserve Specialist
Whenever possible, use an experienced, qualified person to prepare a reserve study
because of the technical detail involved. If you feel you cannot afford to use a specialist
or one is not available to you, you will have to pull together all the relevant information
yourself. CAI’s A Complete Guide to Reserve Funding & Reserve Investment Strategies (Guide for Associ-
ation Practitioners Series, Report #24) can assist you.

CAI established the Reserve Specialist (RS) designation program to help community
managers and board members identify qualified reserve study providers and to assist
communities in developing their reserve study. Utilizing a Reserve Specialist means man-
agers and boards can obtain proposals from competent reserve providers and make
informed business decisions to responsibly fund their association’s reserves.

What is the value of having the reserve study conducted by a Reserve Specialist?

■ Reduced liability exposure: Community managers and board members can

limit liability by relying on expert advice.

■ Independence: No potential conflict of interest.

■ Focus: Allows managers and board members to concentrate on running the

association.

110 Professional Management Development Program

 ■ Credibility: If the person or committee preparing the reserve study isn’t
credible enough to effect a change in the association’s budget, it is a waste of
time from the start.

■ Accuracy: The Reserve Specialist does this year-round, and is well-versed in

the implications of all the decision points.

Calculating Replacement Fund Budget Line Items

To calculate replacement fund budget line items, you will need the information from a
reserve study and the amount of your current reserves for replacement. Use the follow-
ing reserve formula to calculate each line item:

Current Replacement Cost – Funds on Hand = This Year’s Budget Line Item
Remaining Useful Life in Years

On the next page you will find a sample replacement reserve calculation for a community’s
asphalt paving. Page 113 features an excerpt for asphalt paving from a 20-year reserve cash
flow statement. A reserve cash flow statement shows the amount to be funded and the
amount to be expended from the replacement fund over a given period of time. The charts
illustrate the gradual replacement of an item (asphalt). Note also that an item can be
replaced all at once.

Reconciliation of Expenses and Revenue

After you draft both your operating and replacement fund budgets for the coming year,
you must reconcile your estimated expenses with your community’s anticipated revenue.
To reconcile means to bring together after a difference.

If estimated expenses exceed estimated revenue, you will have to weigh discretionary
expense items against the probable impact of any increase in assessments—or a special
assessment. On this basis, decide whether a reduction in expenses is appropriate—or an
increase in revenue from assessments.

When reconciling expenses and revenue, be certain about the exact powers your board
has to establish assessments. In some cases, it may be necessary to have a vote of your
owners to approve an increase in assessments or to impose a special assessment.

BUDGET PRESENTATION
There are two questions to ask yourself when you are preparing to present a budget:
■ What information will help my audience understand and accept my estimates

of revenue and expenses?

■ How can I present that information in an easy-to-understand format?

M-100: The Essentials of Community Association Management 111

 SAMPLE REPLACEMENT RESERVE CALCULATION
NOTE: Current reserves for replacement of asphalt are $75,328.
#81940 Asphalt Paving 30,000 square yards $16,359.00

PRICE/ UNIT
YEAR ITEM SQ. YDS. LOCATION SQ. YD. PRICE
2002 1 1⁄2" Top. 7,500 11300-15 $5.00 $37,500.00
2003 Seal Coat 15,000 11316-85 1.00 15,000.00
2004 Seal Coat 7,500 11386-400; 1.00 7,500.00
Rec Area
2005 Seal Coat 7,500 11300-15 1.00 7,500.00
2007 Seal Coat 15,000 11316-85 1.00 15,000.00
2008 Seal Coat 7,500 11386-400; 1.00 7,500.00
Rec Area
2009 Seal Coat 7,500 11300-15 1.00 7,500.00
2011 Seal Coat 15,000 11316-85 1.00 15,000.00
2012 Seal Coat 7,500 11386-400; 1.00 7,500.00
Rec Area
2013 Seal Coat 7,500 11300-15 1.00 7,500.00
2015 1 1⁄2" Top. 15,000 11316-85 5.00 75,000.00
2016 1 1⁄2" Top. 7,500 11386-400; 5.00 37,500.00
Rec Area
2017 1 1⁄2" Top. 7,500 11300-15 5.00 37,500.00
2019 Seal Coat 15,000 11316-85 1.00 15,000.00
2020 Seal Coat 7,500 11386-400; 1.00 7,500.00
Rec Area
2021 Seal Coat 7,500 11300-15 1.00 7,500.00
$307,500.00

For basketball court 15,000.00

For major patching before paving or sealing 80,000.00
$402,500.00

Current Replacement Cost – Funds on Hand = This Year’s Budget Line Item
Remaining Useful Life in Years

$402,500 – $75,328 = $16,359.00

20 years

112 Professional Management Development Program

There are two common mistakes to avoid when
presenting a budget: EXCERPT FROM A SAMPLE
■ Neglecting to present any information
20-YEAR RESERVE CASH FLOW
STATEMENT
on how estimates were developed.
■ Presenting so much explanatory #81940 ASPHALT
information that people are BALANCE
overwhelmed and confused. 12/31/01 $75,389
FUNDING
When you are preparing to present your 2002 16,359
budget: EXPENSES
2002 37,500
BALANCE ______
1. Identify the line items that your 12/31/02 54,248
audience is likely to be interested in or FUNDING
question. 2003 16,359
EXPENSES
2003 15,000
2. Identify any comparisons or trends BALANCE ______
that would help your audience 12/31/03 55,607
understand why your estimate is what FUNDING
it is. 2004 16,359
EXPENSES
2004 7,500
3. Decide whether a table or a visual BALANCE ______
presentation such as a pie chart or bar 12/31/04 64,466
graph will most clearly demonstrate FUNDING
what is happening with the numbers. 2005 16,359
EXPENSES
2005 7,500
On the following pages, we’ve included samples BALANCE ______
of three different ways to present historical 12/31/05 73,325
information on line items to support budget
estimates for the coming year. We use utilities as
the sample because they are major expenses for community associations.

1. Line graph—The line graph on the next page plots the actual utility expenses for
a community association from 2003 through 2011. More importantly, it
compares utility expenses to the community association’s total cash and reserves
for the same period. What conclusions can you draw from this line graph?

2. Bar graph—The bar graph on page 115 plots the utility expenses for another
community association from 2007 through 2012. This graph allows the reader
to see the changes in utility expenses over a six-year period. It also shows how
these utility expenses compare to expenses for trash and landscaping and
grounds during the same period. What conclusions about utility expenses can you draw
from this bar graph?

M-100: The Essentials of Community Association Management 113

 3. Table—The table on the following page provides a utility analysis for a third
community association’s electricity use. The table includes historical data on
kilowatt-hours used. It also presents a comparison of budgeted and actual use
and costs for 2011.

Notice how the past four years of use were averaged to create an estimate of
the number of kilowatt-hours to budget for in 2011. An average of past use is a
more reliable estimate than one based on a percent increase in the past year’s
use. You can never be sure how typical a single year is.

Reliable estimates are important for utility use and costs because even a small
difference in estimates can make a large difference in terms of the amount of
money involved.

What conclusions can you draw about the estimates for budgeted use and cost for 2011 when
you compare them to the actual use and cost?

SAMPLE COMPARISON OF TOTAL CASH, RESERVES FOR REPLACEMENT,

AND UTILITY EXPENSES 2003–2011

1600

1400
DOLLARS IN THOUSANDS

1200

1000

800

600

400

200
2003 2004 2005 2006 2007 2008 2009 2010 2011

TOTAL CASH

RESERVES

UTILITIES

114 Professional Management Development Program

SAMPLE COMPARISON OF EXPENSES FOR UTILITIES, TRASH, AND
LANDSCAPING/GROUNDS 2007–2012

350

300
DOLLARS IN THOUSANDS

250

200

150

100

50

0
UTILITIES TRASH LANDSCAPING/GROUNDS

2007 2008 2009 2010 2011 2012

20 07 20 0 8 20 0 9 2010 2011 2012

Utilities $295,000 $275,000 $310,000 $305,000 $315,566 $325,000
Trash 21,000 22,000 23,000 32,500 30,500 34,000
Landscaping/Grounds 15,500 18,000 15,500 17,500 23,001 23,000

SAMPLE UTILITY ANALYSIS— #72250 Electricity

KWH KWH KWH KWH KWH KWH BUDGETEDACTUAL COST COST
USED USED USED USED BUDGETED ACTUAL # OF DAYS 2011 2011 2011 2011
MONTH 2007 2008 2009 2010 2011 20111 (IN DOLLARS) (IN DOLLARS) (IN DOLLARS) (IN DOLLARS)

JAN 261426 279536 292426 313186 286700 279862 32 $0.062 $0.049 $17,776 $13,581
FEB 283522 274674 278574 261763 274700 263577 29 0.062 0.049 17,032 12,911
MAR — 221998 268174 261301 246300 258402 30 0.062 0.051 15,270 13,267
APR 467364 277996 266010 289545 266900 265871 31 0.062 0.055 16,548 14,533
MAY 244890 213992 272592 345063 269200 316489 29 0.062 0.056 16,690 17,690
JUNE 538216 464618 417936 397412 454600 667041 31 0.087 0.082 39,550 54,431
6 MONTH
TOTALS 1795418 1732814 1795712 1868270 1798400 2051242 182 $0.066 $0.062 $122,866 $126,413
JULY 690192 726024 698236 678616 704900 824233 32 0.087 0.073 61,327 60,396
AUG 1052506 929850 821316 747898 934600 769092 28 0.087 0.081 81,311 62,418
SEPT 773844 801662 569364 633895 715000 727011 30 0.087 0.081 62,205 59,205
OCT 550608 424656 586806 523726 520700 548650 32 0.062 0.092 32,284 50,559
NOV 239370 273508 303876 400265 272300 268742 32 0.062 0.056 16,883 14,992
DEC 279250 261132 287278 266826 275900 278169 31 0.062 0.054 17,106 15,057
TOTALS 5381188 5149646 5062588 5119496 5221800 5467139 367 $0.070 $0.071 $393,982 $389,040

M-100: The Essentials of Community Association Management 115

FOCUS QUESTIONS
Use the following questions to help you identify and review the core concepts in this
chapter. (Hint: Once you look up the answer to a question, you may want to jot down
the page number next to the question for future reference.)

1a. What are some sources that typically provide information on the financial
duties and responsibilities delegated to a community association manager?
b. What are some examples of financial duties and responsibilities typically
expected of a professional manager?

2a. What is the role of a board of directors in the budget process?

b. What is a treasurer’s role?
c. What do committees do?
d. What is the role of the owners?
e. What does a manager do?

3a. What is a budget?

b. What is the role of a budget in community management?
c. What are some of the uses of a budget?

4. What are the different sources of budget requirements? Give an example of

each for your community association.

5a. What is revenue?

b. Name the different types of revenue for a community association. Give an
example of each from your association.

6a. What are expenses?

b. Name the three types of expenses. Give an example of each from your com-
munity association.
c. How do the three types of expenses differ from one another?

7. What are the reasons for maintaining a reserve or replacement fund?

8a. What is the typical time period covered by a budget?

b. Why should a budget be passed at least 45 days before the budget year
begins?

9a. What are budget line items?

b. What’s the difference between mandatory and discretionary line items?
c. What are some characteristics of meaningful budget line items?

116 Professional Management Development Program

 10a. Name and define the two basic methods of budget preparation.
b. Why should a combination of both methods be used to prepare an operat-
ing budget?

11a. What is the purpose of a reserve study?

b. What do the line items in a replacement fund budget consist of?
c. What three items of information do you need to calculate a replacement
fund budget line item?

12. What does it mean to reconcile a community association’s revenue and

expenses for the coming year?

13. What are some “rules of thumb” to follow in order to make an effective
budget presentation?

THOUGHT/DISCUSSION QUESTIONS
Use the following questions to help you apply the information in this chapter to your
own situation.

1. What are some financial duties and responsibilities your board expects of
you? How do you know?

2. What are the formally required roles in your community association’s budget
process for the board, the treasurer, committees, owners, and yourself? (Hint:
See your community’s governing documents and your contract.) What are
the informally expected roles for each? (Hint: What do people ask of one
another or act as if they expect?)

3. When you look at this year’s budget for your community, what policy deci-
sions do you think it reflects in terms of what your community association
will do and will not do this year?

4. What budget requirements are set for your community association by:
■ Applicable federal laws and regulations

■ Applicable state statutes, regulations, and court decisions

■ Applicable local laws and regulations

■ Community association governing documents

5. When you look at the line item expenses in your community’s budget, can
you tell which are mandatory and which are discretionary?

M-100: The Essentials of Community Association Management 117

 6. Check your community association’s software or records to find its chart of
accounts. Are the same account titles and numbers used in the budget and in
financial reports?

7. Can you find out what method or methods were used to prepare your com-
munity’s current budget?

8. What historical information is available to you for preparing the next budget?

9. Does your community association have a replacement fund budget? If not,

can you find out why not? How can you help your board and owners see
the need for one? If so, how has the replacement fund budget been pre-
pared? Given what you learned in this chapter, are there any changes in line
items to propose? Are there any changes in how the budget is prepared to
propose?

10. Find out what documents were used to present the current budget to the
board before it was adopted. (Hint: Check the files.) Were any documents
other than the draft budget prepared? If so, what were they used for? If not,
what other documents do you think could have been prepared to help
explain the proposed budget?

118 Professional Management Development Program

RESOURCES
For further information on budges and reserves, we suggest the following:

A Complete Guide to Reserve Funding & Reserve Investment Strategies (Guide for Association Practitioners
Series, Report #24), Fifth Edition, Mitchell H. Frumkin, P.E., P.P., RS, MBA, and Christopher
J. Juall, Editors. How to set up and implement reserve funds. Chapters cover investing
reserve funds, investment policies and options, and lists the pros and cons of each. Con-
tains a summary of state reserve fund requirements, the complete reserve standards, and
the reserve specialist code of ethics. (Community Associations Press, 2001.)

Common Interest Reality Associations Audit and Accounting Guide, by the AICPA. Provides the
AICPA recommendations on the application of generally accepted auditing standards
plus audits of financial statements of community associations. Also describes and recom-
mends reporting principles and practices. (American Institute of Certified Public
Accountants, 2003.)

The Role of the Association Treasurer, (Guide for Association Practitioners Series, Report #22), Second
Edition, by Howard A. Goldklang, CPA, MBA. Although written for community association
treasurers, this guide provides useful information for everyone on all aspects of association
finances—basic financial statements, balance sheets, assets and liabilities, member’s equity,
cash versus accrual accounting, interpreting accounting information, reserves, investments,
audits, and tax filing options. (Community Associations Institute, 1998.)

M-100: The Essentials of Community Association Management 119

Note taking

120 Professional Management Development Program

 CHAPTER 6

COLLECTING
ASSESSMENTS

KEY TERMS
Acceleration, p. 134 Fair Debt Collection Practices Act, p. 122
Assessment, p. 122 Foreclosure, p. 135
Bad debt write-off, p. 138 Lien, p. 135
Chapter 7 bankruptcy, p. 137 Personal money judgment, p. 136
Chapter 11 bankruptcy, p. 138 Special assessment, p. 122
Chapter 13 bankruptcy, p. 138

This chapter provides an overview of assessments—the lifeblood of a community

association as its major source of income. If adequate assessments are not collected
in a timely manner, the community association will not be able to operate, preserve,
maintain, and enhance its common property.

The chapter provides basic information a manager can use to assist and support a
board’s efforts to fulfill its duty to establish and collect assessments. It explains:
■ Owner assessments and special assessments

■ Authority to collect assessments

■ Establishing annual assessments

■ Collection policies and procedures

What You Will Learn

After reading and reviewing this chapter, you should be able to explain and understand:
■ Assessments

■ Special assessments

■ Community association authority to collect assessments

■ Process of establishing annual assessments

■ Consequences of delinquent payments

■ Benefits of an established collection policy

■ Characteristics of an effective collection policy

■ Collection procedures and remedies

■ Lien

■ Foreclosure

■ Lawsuit for a personal money judgment

M-100: The Essentials of Community Association Management 121

 ■ Three types of bankruptcy
■ Bad debt write-off
■ Solutions for collection shortfalls

Definitions of Assessments
Assessment: As covered in Chapter 5, an assessment is the owner’s financial obligation
to the community association during a given period of time—usually one year. It covers
the owner’s share of the common expense (known as “common expense liabilities” in
some states). An annual assessment may be paid on a monthly, quarterly, or annual basis.

An assessment for an owner’s share of the common expenses is a binding legal obligation
based on the community association’s governing documents. In condominiums and
planned communities, assessments are binding obligations that the owner cannot avoid
without board consent. In a cooperative, however, the governing documents may allow
suspension or reduction of the assessment if a unit is unoccupiable.

Special assessment: A special assessment is—

A one-time assessment, often voted on by owners, to cover a major expense (e.g.

a major repair or replacement or improvement, see page 102) that was not
included in the annual budget.

To protect your community association’s interests, your governing documents

should include a broad definition of assessments, if your state law does not. A
broad definition includes:
■ Monthly (or quarterly or annual) and special charges against all units for common

expenses, and
■ Special charges that may be levied against a particular unit, e.g. late fees and

interest, collection costs (including attorney’s fees), fines, fees, payment for
damages to the common property

Authority to Collect Assessments

Authority to collect assessments can come from three sources:

1. Federal laws and regulations: The federal Fair Debt Collection Practices Act
may apply to your community association’s collections. The Act requires that
the person who owes a debt receive written notice containing:

■ The amount of the debt;

122 Professional Management Development Program

 ■ The name of the creditor to whom the debt is owed (in this case the
community association);

■ A statement that the debt will be assumed to be valid by the debt collector
(in this case the community association), unless the debtor disputes the
validity of the debt, or any portion of it, within 30 days after receiving the
written notice;

■ A statement that the debt collector will mail a copy of verification of the
debt or a copy of a judgment against the debtor if he or she notifies the debt
collector in writing within the 30-day period that he or she disputes the debt,
or any portion of it; and

■ If appropriate, a statement that the debt collector will provide the debtor
with the name and address of the original creditor, if it is different from the
current debt collector, upon the debtor’s written request within the 30-day
period.

Notice that the sample collection policy on pages 129-133 fulfills the first four
requirements for a debt notice under the Fair Debt Collection Practices Act.

2. State statutes: State statutes that enable the establishment of a community

association typically state that the association board has the power to collect
assessments. These statutes also state what procedures a community association
must follow in order to collect delinquent assessments.

3. Governing documents: Governing documents typically cover the following

items:
■ Mandatory nature of assessments

■ Authority to collect assessments

■ Purpose or use of assessments

■ Basis for calculating assessments

■ Reasons for levying fines, fees, etc.

■ Payment procedures

■ Collection procedures for delinquent payments

On the next two pages is a sample of covenant language on the collection of assessments.

M-100: The Essentials of Community Association Management 123

SAMPLE: Covenant Language on the Collection of Assessments

CREATION OF LIEN AND PERSONAL OBLIGATION

The trustee, for each unit ownership hereby covenants, and each
owner of a unit ownership by acceptance of a deed therefore, whether
or not it shall be so expressed in any such deed or other conveyance,
shall be and is deemed to covenant and hereby agrees to pay to the
association such assessments or other charges or payments as are
levied pursuant to the provisions of this declaration. Such assessments,
or other charges or payments, together with interest thereon and
costs of collection, if any, as herein provided, shall be a charge on the
unit ownership and shall be a continuing lien upon the unit ownership
against which such assessment is made. Each such assessment, or
other charge or payment, together with such interest and costs, shall
be the personal obligation of the owner of such unit ownership at the
time when the assessment or other charge of payment is due.

PURPOSE OF ASSESSMENTS
The assessments levied by the association shall be exclusively for the
purposes of promoting the recreation, health, safety and welfare of
members of the association, to administer the affairs of the associa-
tion, and to pay the common expenses.

ANNUAL ASSESSMENT
Each year at least sixty (60) days before the end of the association’s
fiscal year, and at least thirty (30) days before final adoption thereof,
the board shall furnish each owner with a proposed budget for the
ensuing fiscal year which shall show the following, with reasonable
explanations and itemizations:

A. The estimated common expenses with an allocation of portions

thereof for the payment of real estate taxes, if any;

B. The estimate amount, if any, to maintain adequate reserves for

common expenses;

C. The estimated net available cash receipts from sources other than
assessments, including, without limitation, receipts from any leas-
es, licenses or concessions;

124 Professional Management Development Program

SAMPLE: Covenant Language on the Collection of Assessments, continued

D. The amount of the “annual assessment,” which is hereby defined as

the amount determined in “A” above, plus the amount determined
in “B” above, minus the amount determined in “C” above, minus
excess funds, if any, from the current year’s operation; and

E. That portion of the annual assessment which shall be payable by the

owner with respect to his dwelling unit each month until the next
annual assessment or revised annual assessment becomes effective,
which monthly portion shall be equal to one twelfth (1/12th) of the
annual assessment multiplied by the dwelling unit’s undivided interest.

PAYMENT OF ASSESSMENT
On or before the first day of the fiscal year, and on or before the first
day of each and every month thereafter until the effective date of the
next annual assessment, each owner of a dwelling unit shall pay to the
association, or as it may direct, that portion of the annual assessment,
which is payable by such owner.

NONPAYMENT OF ASSESSMENTS
Any assessments or other charges or payments that an owner is required
to make or is liable for hereunder which are not paid when due shall be
deemed delinquent. If an assessment or other charge or payment is not
paid within thirty (30) days after the due date, it shall bear interest from
the due date at the contract rate permitted in _____, but not to exceed
eighteen percent (18%) per annum, and the board (i) may bring an action
against the owner personally obligated to pay the same, together with
interest, costs, and reasonable attorneys’ fees of any such action, which
shall be added to the amount of such assessment or other charge or pay-
ment and shall be included in any judgment rendered in such action and
(ii) may enforce and foreclose any lien which it has or which may exist
for its benefit, together with interest, costs, and reasonable attorneys’ fees
of any such action, which shall be added to the amount of foreclosure
judgment. In addition, the board may in its discretion charge reasonable
late fees for the late payment of assessments or other charges. No owner
may waive or otherwise escape liability for the assessments or other
charges or payment provided for herein by nonuse, abandonment, or
transfer of his dwelling unit.

M-100: The Essentials of Community Association Management 125

Establishing Annual Assessments
Annual assessments are based on the community’s budget for the fiscal year. The amount
of the total annual assessment is the amount of income that the board decides to obtain
from owner assessments—given the community association’s other income sources. (See
the discussion of revenue and expenses in Chapter 5.)

Each owner is assigned a share of the community’s annual obligation. Frequently, an

owner’s share is based on the number of owners in the community or on the square
footage the owner’s unit occupies.

In condominiums, an owner’s share is based on his or her percentage interest in the com-
mon elements. Here is the formula for calculating assessment fees for condominium
owners:

Total Assessments Required Percentage Interest as Found

in Annual Budget X in the Declaration

Number of Installment Payments in a Year

For example—
1. Assume a total required assessment of $410,000
2. Assume a percentage interest in the common elements of .4682% for a two
bedroom unit
3. Assume monthly payments

$410,000 x .004682 = $160 monthly assessment fee

12

Always obtain percentage of interest as found in the declaration. Do not rely on prior
year’s percentages as computational errors can occur and be perpetuated.

Note that the above calculations are among the most common methods for determining
an owner’s share of the total annual assessment. But also be aware that there are others.

INTRODUCTION TO ESTABLISHING A COLLECTION POLICY

A formal collection policy is the foundation of a successful program for:
■ Maintaining necessary cash flows

■ Reducing financial loss from owner defaults on assessment payments

It provides a systematic approach to delinquencies. It can be done without special owner

approval—unless it requires amendments to the governing documents.

126 Professional Management Development Program

 CHAPTER 7

F INANC I AL STATE ME NTS,

A U D I TS, I NC OME TAXES,
& INVESTMENTS
KEY TERMS
Accrual basis of accounting, p. 145 Investments, p. 165
Assets, p. 149 Investment safety, p. 167
Audit, p. 159 Investment yield, p. 169
Balance sheet, p. 149 Liabilities, p. 149
Bond, p. 169 Management letter, p. 160
Cash basis of accounting, p. 145 Members’ equity, p. 149
Certificate of deposit, p. 169 Modified cash basis of accounting, p. 145
Commercial reporting method, p. 147 Net income, p. 148
Comparison to budget, p. 148 Net loss, p. 148
Compilation, p. 161 Notes to financial statements, p. 159
CPA, p. 151 Opinion letter, p. 153
Deficit in members’ equity, p. 149 Representation letter, p. 152
Engagement letter, p. 152 Revenue, p. 147
Excess of revenues over expense, p. 147 Review, p. 161
Expense, p. 148 Statement of cash flows, p. 154
FDIC, p. 167 Statement of changes in members’
Fund balance, p. 149 equity (or fund balances), p. 154
Fund reporting method, p. 147 Statement of income and expense, p. 147
GAAP, p. 151 Statement of revenue and expense, p. 147
GAAS, p. 153 Treasury bills, p. 168
Income, p. 148 Treasury bonds, p. 168
Investment liquidity, p. 168 Treasury notes, p. 168

This chapter provides an overview of additional financial operations for community

associations.

It explains:
■ Financial reports

■ Independent certified public accountant services

■ Federal income taxes

■ Investments

M-100: The Essentials of Community Association Management 143

What You Will Learn
After reading and reviewing this chapter, you should be able to explain and understand the:
■ Purpose of financial reports

■ Sources of variation in reports among community associations

■ Accounting methods used for reports

■ Warning signs to watch for when reviewing reports

■ Commercial and fund reporting methods

■ Statement of income and expense

■ Comparison to budget

■ Balance sheet

■ Role of a CPA

■ Engagement and representation letters

■ CPA’s letter or opinion

■ Statement of revenue and expense

■ Statement of changes in members’ equity (or fund balances)

■ Statement of cash flows

■ Notes to financial statements

■ Audits, reviews, and compilations

■ Federal income tax filing responsibilities for community associations

■ Federal income tax filing options for community associations

■ Investments for community associations

■ Investment checks and balances

■ Manager’s typical investment duties

■ Investment policies and procedures for community associations

■ Essential investment objectives

This section provides some background information on financial reports in general.

Financial reports have two primary purposes:

1. To provide their internal and external users with the economic information
needed to make appropriate decisions on behalf of the community association.

2. To enable the community association board and manager to control the

community’s financial operations.

144 Professional Management Development Program

Sources of Variation in Reports Among Community Associations
Do not be surprised if the form and content of your community association’s financial
statements differ from those of other associations. Variation may be due to the:
■ Community association’s unique informational needs

■ Software package used

■ Expertise and experience of the internal users—the owners

■ Expertise and experience of the preparers

■ Reasons for preparing the report

Accounting Methods Used For Reports

A community association’s financial reports will reflect one of three possible accounting
methods:
1. Cash basis: This method records income when it is collected and expenses
when they are paid.

2. Accrual basis: This method records income when it is earned (or assessed to
owners) and expenses when they are incurred or acquired.

3. Modified cash basis: This method records income and expenses on a cash basis
with selected items recorded on an accrual basis. Modified cash varies in format
depending on the number of items accrued. The most common modified cash
basis financial statements record income (assessments) on the accrual basis and
expenses on the cash basis.

Warning Signs to Watch for When Reviewing Reports

Here are some warning signs about the financial health of a community association to
watch for when you review its financial reports:

■ A steady decline in the amount of cash on hand

■ The inability or failure to set aside planned additions to reserves (no formal
reserve study)

■ An increase in the amount of owners’ assessments owed to the community

■ An increase in the amount the community association owes for bills

■ The failure to resolve any differences between bank statements and the
financial reports in a timely manner

M-100: The Essentials of Community Association Management 145

 ■ Significant and/or unexplained differences between actual and budgeted figures
for items (See page 148 for an explanation of the difference between actual and
budgeted figures.)

■ Members’ equity (operating fund balance, retained earnings) balance is less

than one to three months of operating expenses

■ Unpaid amounts showing as due between funds (when fund presentation is

used)

Statistical analysis is helpful in this area. A useful indicator is to evaluate assessment

delinquencies as a percentage of annual assessments:

Percent Delinquent Rating

3% or less Excellent
4% to 5% Good
6% to 10% Poor to Average
Greater than 10% Deteriorating Financial Position

An association’s operating fund should be at 10% to 20% of annual assessments.

INTRODUCTION TO INTERIM FINANCIAL REPORTS

Interim financial reports are prepared during the year to provide the board and manage-
ment with accurate economic information that will allow them to make decisions and
take action in a timely manner. Interim financial reports are often presented on a modi-
fied cash basis. For example, a modified cash basis report may include an accrual item
such as assessments owed but not paid yet (accounts receivable). This gives a more com-
plete financial picture.

At a minimum, interim financial reports should include:

■ A statement of income and expense with a comparison to budget

■ A balance sheet

Accompanying information to the financial reports should include:

■ Bank statements with reconciliations

■ Aged receivables report (amount owed by owners)

■ Open payables report (amount owed by the association)

146 Professional Management Development Program

Commercial and Fund Reporting Methods
Most community associations use the commercial reporting method for their interim
financial reports—as do most of the samples in this chapter.

However, there is a growing trend for community association financial reports to be pre-
pared according to the fund reporting method—which is based on fund accounting.
The fund reporting method consists of preparing separate columns for operating, reserve,
and any special funds. This is different from the commercial method which combines
operating and reserve activities in the same column.

Where significant reserve expenditures are occurring or a special assessment is in

progress, consider using the fund reporting method to issue separate reports on normal
operations, reserve transactions, special assessments, and for the receipt and expense of
any litigation/insurance proceeds.

The American Institute of Certified Public Accountants recommends the use of fund
reporting for community associations—especially for year-end financial reports.

The two reporting methods also use some different terms for key items:

Commercial Fund
Members’ Equity Fund Balances
Statement of Income and Expense Statement of Revenue and Expense
Income Revenue
Net Income (or Loss) Excess (or Deficiency) of Revenue
Over Expense

Statement of Income and Expense

The statement of income and expense records the community association’s financial
transactions during a given period of time—generally for a given month plus the fiscal year to
date. It is a way to keep track of the community’s financial activity.

The sample statement of income and expense on page 150 reports on a community asso-
ciation’s financial activity for the month of April in the first column and the year to date
in the second.

M-100: The Essentials of Community Association Management 147

There are three major components of a statement of income and expense:

1. Income: Income represents the earnings of the community association.

■ Income on a cash basis statement consists of money received and deposited.

■ Income on an accrual basis statement consists of money earned, including

amounts assessed to owners in accordance with the budget.

■ Income can either be received or earned on a modified cash basis statement. Generally,

however, income is on the accrual basis for a modified cash statement.

What three types of income are recorded on the sample statement on page 150?

2. Expense: Expenses are the cost of goods and services used to operate and
maintain the community’s property.
■ Expense on a cash basis statement consists of any amounts paid.

■ Expense on an accrual basis statement consists of any amounts owed, whether or

not paid.
■ Expense on a modified cash basis statement is generally calculated on a cash basis.

What two broad categories of expenses appear on the sample statement on page 150?

3. Net income (or loss): Net income is the amount left after deducting expenses
from income. A net loss occurs when expenses are greater than income. A loss
is indicated on a statement of income and expense by putting the figure in
parentheses. The net income or loss can be significantly different depending on
whether a cash, accrual, or modified cash basis is used.

What is the net income for the actual year to date on the sample statement on page 150?

Comparison to Budget
Comparison to budget involves comparing the community’s actual income and expenses
with its planned or budgeted income and expenses. This is more meaningful when the
budgeted amounts are shown in the months the income or expense occur, rather than
simply dividing the total expense by 12 and showing 1/12 each month. For example,
snow removal would show in winter months, pool lifeguard in summer months, etc.

When you compare actual figures with budgeted figures:

■ Identify all significant differences or variances between actual and planned figures

■ Determine the reasons for the differences and notify the board

■ Advise the board of any necessary corrective action it needs to take as soon as

possible
■ On accrual basis reports, the budgeted assessment income should equal the

actual assessment income

148 Professional Management Development Program

On the sample statement of income and expense on the next page, the second column
consists of the actual income and expenses for the year to date. The third column con-
sists of the budgeted figures for the year to date. Often financial reports will have an
additional column showing the variance/difference between actual and budget.

Do you see any significant differences between the two sets of figures that the community association should
monitor?

Balance Sheet
A balance sheet is a summary of a community’s financial position at a specific point in
time. It tells you how things stand on a certain date.

A balance sheet summarizes:

■ What your community association owns

■ What your community association owes

■ The “net worth” of the association

It is called a balance sheet because what the community association owns and what it
owes to others (including the owners) must balance out. A balance sheet typically is pre-
pared on a monthly basis to allow the community association to track its funding for
reserves and accounts receivable. (The sample balance sheets on pages 155 and 156 were
prepared for the entire fiscal year.)

There are three major components of a balance sheet:

1. Assets: Assets include anything owned that has value. Unlike commercial
businesses, however, the actual land and buildings of the community
association are not generally shown as an asset. For cash basis reports, cash is
the only asset.

2. Liabilities: Liabilities consist of what is owed to others or collected in advance

(e.g. owner assessments received prior to the billed month).

3. Members’ equity: Members’ equity is called the fund balance under the fund
method of reporting. It equals the difference between the community
association’s assets and liabilities. Industry standards suggest a minimum balance
of 2-5% of gross assessments with 10-15% being very good.

When a community association’s liabilities exceed its assets, this condition is known as a
deficit in members’ equity. It occurs when a community association has incurred expens-
es that it cannot pay until it collects future assessments from owners.

M-100: The Essentials of Community Association Management 149

SAMPLE: Commercial Reporting

ABC Condominium Association, Inc.

Statement of Income and Expense
for the Month Ending April 30th and 20XX to Date
(Four Months Ended)
With a Comparison to Budget
April Actual Year Budget Year
20XX to Date to Date
INCOME
Assessments $ 62,623 $ 250,492 $ 250,490
Interest 3,894 15,577 15,248
Other 2,050 8,198 5,667
Total Income $ 68,567 $ 274,267 $ 271,405

EXPENSES
Administrative:
Management Fee $ 3,316 $ 13,265 $ 14,465
Legal & Audit 528 2,111 2,363
Insurance 2,182 8,727 8,653
Telephone 416 1,664 2,364
Other 1,553 6,212 6,322
Total Administrative $ 7,995 $ 31,979 $ 34,167

Operating:
Payroll & Related Taxes $ 12,263 $ 49,052 $ 46,726
Professional Fees and Training 287 1,149 2,000
Utilities 23,964 95,857 103,979
Elevator 1,029 4,116 4,637
Security 328 1,313 570
Lawn Maintenance 531 2,127 3,406
Trash Removal 1,610 6,438 7,003
Pool 1,332 5,328 6,229
General Repairs & Maintenance 6,220 24,879 17,811
Depreciation 250 1,000 —
Income Taxes 1,838 3,677 2,821
Total Operating $ 49,652 $ 194,936 $ 195,182
Total Expenses $ 57,647 $ 226,915 $ 229,349
Net Income Before
Contribution to Reserves $ 10,920 $ 47,352 $ 42,056
Contribution to Reserves (10,514) (42,056) (42,056)

Net Income $ 406 $ 5,296 $—

150 Professional Management Development Program

A community association may have an operating deficit but will reflect replacement reserves.
When this occurs the association is in effect borrowing from reserves to fund operations.

Occasional small deficits are common during a normal fiscal year due to such things as sea-
sonal fluctuations in expenses. A continued or increasing deficit, however, is an indication
of an inadequate level of assessments or overspending, and a signal for board action.

Can you locate all three components of a balance sheet on the samples on pages 155 and
156? Notice how the three components balance out:

ASSETS = LIABILITIES + MEMBERS’ EQUITY

and
ASSETS – LIABILITIES = MEMBERS’ EQUITY

INTRODUCTION TO YEAR-END FINANCIAL REPORTS

Accounting standards are called GAAP, Generally Accepted Accounting Principles.
Their purpose is to provide uniformity among reports from different organizations.

GAAP requires the following set of year-end financial reports for a community association:
■ Balance sheet

■ Statement of Income and Expense (or Revenue and Expense)

■ Statement of Changes in Members’ Equity (or Fund Balances)

■ Statement of Cash Flows

■ Notes to Financial Statements

■ Unaudited supplementary information on future major repairs and replacements

GAAP also requires the use of accrual accounting (see page 145) for certified annual reports.

Because many state statutes and community association governing documents specify the role
of a CPA in preparing annual reports for associations, we will begin this section with a discus-
sion of that role. Then we will move on to discuss the various types of reports prepared.

Role of a Certified Public Accountant (CPA)

Community association governing documents and state statutes may require that an
independent certified public accountant be involved in preparing a community’s annual
reports (audit, review, or compilation). An independent certified public accountant
(CPA) is one who is not a community association employee or owner. There are certain
circumstances, however, such as in very large community associations, where an owner is
considered to be independent.

M-100: The Essentials of Community Association Management 151

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

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