Budgeting
Budgeting
Once again it is everyone’s favorite time of year… budget preparation time. The purpose of this article is to provide a brief overview of the most common budgeting approaches.
A budget is more than just revenue and expenses balanced to a net zero. A budget should be viewed as an Association’s operating plan for the upcoming year. There are two basic approaches to creating a budget – zero based and historical. With a historical approach, expenses are budgeted based on the last few years of actual expenses. With a zero based approach, the expenses are budgeted based on factual information calculated from scratch annually.
To begin, separate the budget into categories and work on one line item at a time. This will make the budget process easier to manage. Below are some of the most common categories with specific details and budgeting approaches on each:
Revenue
What to include: Member assessments, fees for common area use (e.g. cabana rental), move-in/out fees, interest income (be cautious not to use interest on reserve funds to offset operating expenses), sale of access devices, and other potential sources of revenue;
Approach: Top down or bottom up? Most Community Associations, as non-profit entities, generally take the bottom up approach. Revenue (e.g. member assessments) derives from expenses the Association will need to cover in the upcoming fiscal year. Often times, the expenses are trimmed and/or services are eliminated to minimize the necessary increases in member assessments.
Professional Services
What to include: Management service, accounting, tax preparation, audit, legal fees, reserve study, etc;
Approach: A mix of zero based and historical. Use zero based for recurring contracted services such as management, accounting and reserve study. Base the budget on the value of the contract, check with the service providers to see if they will be increasing their rates next year and update the budget accordingly. For non-recurring services such as legal fees, use a historical approach. Checking the last two to three years of legal expenses will provide an idea of how much the Association relies on its legal counsel. Take into account “special needs” that the Board knows the Association will require next year such as a Declaration Amendment.
Personnel Expenses
What to include: Gross payroll, payroll taxes, bonuses, benefits, recruiting expenses, staff education, etc.
Approach: Zero based for the most part. Calculate the budget based on pay rates from employment agreements between the Association and staff. Take into account projected pay increases for next year, bonuses, benefits, etc. Be sure to include a budget for extra coverage when staff members take paid vacations.
Administrative Expenses
What to include: Copies, postage, etc., fees and licenses, taxes (income and property taxes), insurance, loan interest expenses, Board education, etc.
Approach: A mix of zero based and historical. Use a zero based approach with fees, licenses, permits, insurance, loan interest, etc. Check with your insurance provider to determine the Association’s insurance needs and the premium cost for next year. If the Association has a loan, confirm the amortization schedule and work with the Association’s CPA to estimate next year’s income tax obligations. Use a historical approach for other miscellaneous administrative expenses such as copies, postage, Board education (attendance at CAI seminars/events), etc.
Utility Expenses
What to include: Utilities paid by the Association – water/sewer, garbage, recycling, electricity, natural gas, etc.
Approach: Historical for the most part. Check the Association’s utility consumption for the past two to three years. Look for unusual changes in consumption (a sudden increase in water usage may indicate a hidden leak somewhere on the property). Use a zero based approach for items such as telephone lines and sewer capacity charges. Use a zero based approach for garbage as well – review/assess the Association’s refuse removal needs, determine the size of the containers and frequency of pickups and budget in accordance with utility company’s rates to meet the refuse removal needs.
Maintenance Expenses
What to include: All property maintenance expenses. It is generally a good idea to separate expenses by type – landscaping, elevator, fire safety systems, janitorial, etc.
Approach: A mix of zero based and historical. Use a zero based approach for recurring contracted maintenance. Review contracts for each provider (elevator, fire systems maintenance, etc.) to determine the monthly cost of service and create the budget after first checking with vendors for next year’s increase. For routine day-to-day maintenance (light bulb replacement, touch up painting, etc.) review actual expenses for the last few years, account for inflation and budget extra for special projects if planned. It also helps to better track expenses if they are split up between “recurring contracted services” and “incidentals”. Using landscape maintenance as an example, landscape related expenses would be separated into two separate budget line items – “Landscape Contract” and “Additional Landscape Maintenance”. If the Association’s financials follow the budget and there is a question on “landscaping expenses”, it is much easier to see if the issue is with contracted monthly maintenance or if a significant amount of additional non-recurring work is being performed (replacement of dead plants, broken sprinkler heads, etc.). Splitting up expenses between “contracted” and “additional” also helps during the budgeting process. Contracted expenses such as an elevator maintenance agreement are generally mandatory. Things like additional landscaping work (i.e. annual summer flower plantings) are “negotiable”. One could decrease the frequency of such service or eliminate it altogether if the Association is unable to meet its financial needs.
Reserves – A reserve study should be used as a tool to budget for monthly funding of reserve contributions, and for forecasting major projects for next year and their associated reserve expenses. Separating contributions to reserves and reserve expenses from day-to-day operating expenses will provide a better picture of the true financial needs of the Association.
There are a few additional things to consider while preparing a budget. Bad Debt – many Associations struggle with high delinquency rates due to the state of the economy. It is important to include a provision for bad debt write-offs as there is a high possibility that an Association will write-off some portion of uncollected assessments, especially due to the current high foreclosure rate. Associations have several options to pursue owners for unpaid assessments after foreclosure, however if the prior owners do not have assets and/or verifiable income to garnish the Association may struggle to collect on the debt while continuing to incur legal fees to pursue the collection effort.
Contingencies – Always try to include a contingency in the budget. The level varies depending on each Association’s financial situation, however a contingency equal to 10% of the annual budget is advisable. A contingency will also assist in better management of annual increases in the Association’s assessments. If other costs drastically increase, the Association can temporarily reduce the contingency and then increase it back to the original level over time.
Monthly vs. Annual budget – A budget written by month provides better tracking of an Association’s revenue and expenses throughout the year because some expenses are incurred once annually. For ease of calculation, let’s assume the projected cost of an Association’s audit is $1,200 and it is scheduled to be completed in March. Budgeting $1,200 in March is much more accurate than budgeting $100 per month for January through December.
A note on expense allocations – many governing documents, especially mixed-use developments with commercial and residential units, include provisions as to which units pay for specific expenses. This important part of a budget is often overlooked.
Budget approval – there are two basic approaches to budget approval depending on whether the Association is an “Old Act Condominium” (pre-1990), “New Act Condominium” (created after July 1, 1990), or a Homeowner’s Association. The Association’s Declaration will provide specific guidance on the budget approval process, however typically the Board of Directors approves the budget in “Old Act Condominiums”. “New Act Condominiums” and Homeowner’s Associations generally follow a budget ratification process – the Board of Directors approves the budget and holds a budget ratification meeting with the general membership. At that meeting, unless the majority (or any larger percentage specified in the governing documents) of the Association members reject the budget, whether or not quorum is present, it becomes effective as approved by the Board of Directors.
Hopefully by the time this article comes out everyone will have at least a draft of next year’s budget ready and will find this article useful in preparing a final version for the Board of Directors to review and approve.
Why does an Association need reserves?
Equipment and major components (like the roofs) must be replaced from time to time, regardless of whether the expense is planned for. Most Association members prefer to set the funds aside now instead of having to pay a Special Assessment to cover cost of a major project such as a roof replacement. Reserve funds aren’t an extra expense – they just spread out expenses more evenly. Funds for a particular project are accumulated over a period of several years instead of a one-time Special Assessment levy. There are other important reasons why Associations put monies into reserves every month:
1. Reserve funds meet legal, fiduciary, and professional requirements. A replacement fund may be required by:
– Any secondary mortgage market in which the association participates (e.g. Fannie Mae, Freddie Mac, FHA, VA);
– State statutes, regulations, or court decisions;
– The community’s governing documents;
2. Reserve funds provide for major repairs and replacements that will be necessary at some point in time. Although a roof may be replaced when it is 25 years old, every owner who lives under or around it should share its replacement costs.
3. Reserve funds minimize the need for special assessments or borrowing. For many association members, this is the most important reason.
4. Reserve funds enhance resale values. Lenders and real estate agents are aware of the ramifications for new buyers if the reserves are inadequate. Reserve Study bill passed in Washington just recently requires Associations to disclose the amounts in their reserve funds to prospective purchasers. It also contains specific requirements for Reserve Studies.
The Tax Season for Associations
No matter what type of “business entity” (Condominium, Homeowner, Planned Unit Development, Co-Op, incorporated or not) your Association is, a tax return must be filed with IRS (some States also require Associations to file State income tax returns in addition to Federal taxes). While most Associations are “non-profit” under State corporate statutes, they must file a Federal income tax return. There are very few Associations, which Internal Revenue Service classifies as non-profit.
There are a couple of ways an Association can file its tax return – as a regular corporation (Form 1120) or as a Homeowner Association (Form 1120H). There are some benefits and restrictions with each. For example, an Association must file as a regular corporation if it is not “substantially residential”. Substantially residential usually means that at least 85% of the Association must be Residential (so, if there is a total of 20 Units in the Association and 5 of them are Commercial, your Association may not qualify to file as a Homeowners Association).
While Form 1120H has a higher tax rate (30% for Residential Associations and 32% for Timeshare Associations), most Association revenue is exempt from taxes (i.e. member assessments). Taxable items include, but aren’t limited to, interest on reserves, rental income, and “use fees” (i.e. clubhouse, Guest Suite, etc.).
There may be benefits in electing to file Form 1120. The tax rate is lower (15% for the first $50,000); however, the IRS will see the Association as a regular business/corporation. This means the tax exemption (member assessments) available with Form 1120-H no longer applies. Total taxable income is offset by total allowable expenses and you pay taxes on what’s left. So, if in a given year, your Association’s operating expenses greatly exceeded income and you had substantial interest on reserve funds (which would be taxable under 1120-H), filing as a regular corporation may reduce your tax bill.
Most CPAs familiar with Community Associations will look at your particular situation and recommend which form to file. However, you should double check with your Association’s CPA to make sure they do so as a normal course of business.
Methods of Accounting
There are three commonly known methods of accounting:
- in “Cash Basis”, income is recorded when it is received and expenses are recorded when they are paid;
- in “modified accrual basis”, income is recorded when it is earned, and expenses are recorded when they are paid;
- in “accrual basis”, income is recorded when it is earned and expenses are recorded when they are incurred. Accrual basis provides the most accurate financial reporting and is in compliance with GAAP (Generally Accepted Accounting Principles).
There are several ways to determine the basis on which the financial statements are presented. Accounts Receivable, Prepaid Assessments, Accounts Payable, and Prepaid Expenses will appear on the Balance Sheet if financial statements are prepared on an accrual basis. Accounts Receivable and Prepaid assessments will appear on the Balance Sheet if financial statements are prepared on a modified accrual basis. Since expenses are recorded when they are paid in a modified accrual financial statement, neither Accounts Payable nor Prepaid Expenses will appear on the Balance Sheet. A Balance Sheet prepared on a cash basis will not contain any of these line items.
Accounts Receivable is an Asset and indicates the total amount of income earned (i.e. assessments levied against owners) but not yet received as of the date of the financial statement.
Prepaid Assessments represents assessments, which owners paid in advance. Prepaid Assessments are a Liability to the Association as this is income already received but not yet “earned” (or not charged against owner’s accounts).
Accounts Payable represents expenses incurred but not yet paid and is a Liability to the Association. Accounts Payable may consist of actual expenses for which an invoice was received but not paid as of the date of the financial statement, and expenses accrued but for which an invoice was not yet been received (or paid).
Prepaid expenses are expenses, which were not yet incurred but already paid as of the date of financial statement. Prepaid expenses are an Asset to the Association. An example of a prepaid expense is an insurance premium, which is paid in full for the entire year when an invoice arrives. When the insurance premium is paid, it appears on the Balance Sheet under Assets but it does not appear as an expense on the Profit and Loss Statement. The premium would then be “expensed” on a monthly basis in equal monthly installments.
Profit and Loss Statement (P&L) can also help determine on which basis the financial statements are prepared when a budget comparison/variance is shown on the statement. Because income and/or expenses are recorded when they are incurred, items such as “Homeowner Assessments” in the income section of the P&L, and all “Contract” line items in the Expenses Section of the P&L, should have zero variance from the budget in an accrual basis. Member of the Association are charged based upon a budget prepared in advance, so 100% of income for a given period will be recorded at the time it is budgeted for and charged to owners’ accounts. Expenses based upon contracts should also match the budget and have a zero variance because they are recorded when incurred whether or not an invoice is received from the vendor.
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