FUND ACCOUNTING VS. EQUITY METHOD OF REPORTING WHICH ONE IS RIGHT FOR YOU?

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1 Financial statements for a homeowners association may be presented using either the Fund Accounting Method of Reporting or the Equity Method of Reporting. Both methods are permitted (when properly formatted) and both can be used on an interim basis in the homeowners association industry. However, the question is, which one is right for you? WE RECOMMEND THE FUND ACCOUNTING METHOD OF REPORTING We, at James Ernst Accounting, recommend that you prepare your interim (monthly or quarterly) and year-end financial statements using the Fund Accounting Method of Reporting, simply because we believe it is the most informative method of presenting the separate activities (e.g., operating, reserves, etc.) of your homeowners association. In a prior article, we described the 3 Basis of Accounting (Accrual, Cash and Modified Accrual) that can be used for a California homeowners association. In that article, we defined Basis of Accounting simply as the timing of the recording of various financial transactions for an entity (when revenues and expenses are recognized, and assets and liabilities are reported), and we recommended using the Accrual Basis of Accounting. In this article, we will describe the 2 Methods of Reporting (Fund Accounting Method and Equity Method) that are available for these same financial statements and highlight their effect on your financial statement presentation, and we will address the year-end review or audit report prepared by your independent CPA. 2 METHODS OF REPORTING FUND ACCOUNTING AND EQUITY METHOD THEIR EFFECT ON YOUR FINANCIAL STATEMENTS FUND ACCOUNTING METHOD OF REPORTING The Fund Accounting Method of Reporting is in conformity with Generally Accepted Accounting Principles (GAAP). Moreover, the financial reporting guidelines, issued by the American Institute of Certified Public Accountants (AICPA), stated that this method of reporting is the preferred method for the homeowners association industry.

2 When you choose to present your interim financial statements using the Fund Accounting Method, the effect of this choice on your financial reports will be as follows: BALANCE SHEET When using the Fund Accounting Method of Reporting, your Balance Sheet will show a separate column for each fund used by the association (e.g., operating, reserves, etc.), along with a column listing the totals of all funds. That is to say, there will be a separate column for the operating fund activities of your association, a separate column for the reserve fund activities, and a separate column for any other activities that you wish to segregate from the operating and reserve funds (e.g., litigation, special assessment, etc.). Each column will be clearly identified as to the fund it represents, listing only those assets (e.g., cash and investments, members receivables, interfund (due from), etc.), as well as only those liabilities (e.g., accounts payable, prepaid assessments, interfund (due to), etc.) that are related to that specific fund, along with the fund balance for that specific activity. The totals reflected in the last column simply combine all assets and liabilities for all funds listed on the Balance Sheet (these Totals should be the same amounts that are reported under the Equity Method). The following example is representative of a Balance Sheet presentation using the Fund Accounting Method of Reporting at year-end (with 3 funds: operating, reserves and litigation). The only limitation on the number of funds presented under this method is the size of the paper you will be using to print the Balance Sheet. Balance Sheet (Fund Accounting Method of Reporting) DESCRIPTION OPERATING RESERVES LITIGATION TOTALS ASSETS Cash $ 20,000 $ 500,000 $ 50,000 $ 570,000 Investments 0 1,000, ,000,000 Members Receivables 25, ,000 Allowance for Doubtful Accounts ( 5,000) 0 0 ( 5,000) Interfund (due from reserves) 10, ,000 Total Assets $ 50,000 $ 1,500,000 $ 50,000 $ 1,600,000 LIABILITIES and FUND BALANCES Accounts Payable $ 20,000 $ 3,000 $ 15,000 $ 38,000 Prepaid Assessments 12, ,000 Interfund (due to operating) 0 10, ,000 Total Liabilities 32,000 13,000 15,000 60,000 Beginning Balances Excess (Deficit) 16,000 1,450,000 2,000,000 3,466,000 Current Year Excess (Deficit) 2,000 37,000 (1,965,000) (1,926,000) Total Fund Balances Excess (Deficit) 18,000 1,487,000 35,000 1,540,000 Total Liabilities and Fund Balances $ 50,000 $ 1,500,000 $ 50,000 $ 1,600,000 JAMES ERNST ACCOUNTING PAGE 2 OF 8

3 INCOME STATEMENT With regard to your Statement of Revenues and Expenses (Income Statement), when using the Fund Accounting Method of Reporting, there will be a separate Income Statement for each separate activity within your association (e.g., operating, reserves, etc.). That is to say, there will be a separate Income Statement presented for the operating fund activities of your association, for the reserve fund activities, and for any other activities that you wish to segregate from the operating or reserve funds (e.g., litigation, special assessment, etc.). The following example is representative of an Income Statement presentation using the Fund Accounting Method of Reporting for the year. This example is for the operating fund only; there will be a separate Income Statement for each other fund used by your association. There are no limitations on the number of Income Statements you can have. Please note that the $2,000 excess that is listed as Current Year Excess (Deficit) in the Actual column for the Year-To-Date must agree to the amount reported as Current Year Excess (Deficit) on the Balance Sheet for the same fund (see the Operating Fund column on the Balance Sheet). Income Statement-Operating Fund (Fund Accounting Method of Reporting) YEAR-TO-DATE YEARLY DESCRIPTION ACTUAL BUDGET VARIANCE BUDGET (Note: The columns for the Current Period were intentionally left off.) REVENUES Regular Assessments-Operating $ 200,000 $ 200,000 $ 0 $ 200,000 Interest Income Other Income 2,000 1,000 1,000 1,000 Total Revenues 202, ,000 1, ,000 EXPENSES General and Administrative $ 150,000 $ 153,500 $ 3,500 $ 153,500 Maintenance and Repairs 31,000 27,500 ( 3,500) 27,500 Utilities 19,500 20, ,000 Total Expenses 200, , ,000 Current Year Excess (Deficit) $ 2,000 $ 0 $ 2,000 $ 0 In addition, there will be a separate Income Statement-Reserves Fund to track the reserve portion of the members assessments along with all reserve expenditures for the current period and the year-to-date. You can also prepare a separate Income Statement-Other Fund (e.g., litigation, special assessment, etc.) for each separate financial activity that you wish to track. Keep in mind that, under Section (d) of the California Civil Code (Davis-Stirling Common Interest Development Act), the association shall make an accounting of expenses related to the litigation on at least a quarterly basis. The accounting shall be made available for inspection by members of the association JAMES ERNST ACCOUNTING PAGE 3 OF 8

4 In other words, you need to track all receipts (amounts collected through the legal process) and expenditures (amounts necessary to support the law suit and to repair the defects) related to defect litigation. A separate Income Statement-Litigation Fund is the ideal way of tracking these items for the current period and the year-to-date without having to create a separate report for the membership. EQUITY METHOD OF REPORTING The Equity Method of Reporting (sometimes called the Non-Fund or Commercial Method of Reporting) is also in conformity with GAAP, when properly used. Although the AICPA has stated that the Equity Method is an acceptable alternative method of reporting, they recommend using the Fund Accounting Method for the homeowners association industry. When you choose to present your interim financial statements using the Equity Method, the effect of this choice on your financial statements will be as follows: BALANCE SHEET When using the Equity Method of Reporting, your Balance Sheet will show only one column for all funds used by the association (e.g., operating, reserves, and other). There will not be a separate column for each separate fund as is the case when using the Fund Accounting Method. That is to say, there will not be a separate column for the operating fund activities of your association, nor the reserve fund activities, nor any other activities that you wish to segregate from the operating and reserve funds (e.g., litigation, special assessment, etc.). Although both Balance Sheets (Fund Accounting and Equity) will list the totals for each separate account (e.g., assets and liabilities), the Balance Sheet presented under the Equity Method does not have the extra information related to the individual funds. The effect is that the Equity Method could be deficient in the information presented to the reader; therefore, not in conformity with GAAP. Further, instead of showing a Fund Balance for each separate fund, this Balance Sheet lists Members Equity, which is supposed to be broken down into Undesignated (operating fund), Designated for Future Repairs and Replacements (reserve fund), and Designated for Litigation (litigation fund). There may be other descriptions used by your accounting department but the effect is the same. As a result, the amount listed as Current Year Excess (Deficit) in the Income Statement presented under the Equity Method may not agree to the amount listed on the Balance Sheet, and it may not be the same amount that is listed on the Income Statement presented under the Fund Accounting Method, either. This is simply because there may not be a separate Income Statement for each fund; instead, all financial activities for multiple funds are imbedded in the one Income Statement using the Equity Method. One of the disadvantages of using the Equity Method is that the Balance Sheet may not clearly identify which assets and which liabilities belong to which fund this can be done with account descriptions and sub-categories, but it can be very confusing to the reader if not clearly marked. JAMES ERNST ACCOUNTING PAGE 4 OF 8

5 Another disadvantage of the Equity Method is that if there are interfund accounts (due to/due from) but they are not listed on the Balance Sheet, then the Balance Sheet will appear to be in balance (assets = liabilities + members equity), when in fact it is not complete. Under the Fund Accounting Method, if interfund accounts (due to/due from) are not listed, their absence will be obvious because the individual funds will not be in balance (see the Fund Accounting Balance Sheet). This simply means that when using the Fund Accounting Method, it requires that all interfund balances be reported, providing a good financial statement control. The following example is representative of a Balance Sheet presentation using the Equity Method of Reporting at year-end. However, this example has two Total columns to show the effect when interfund accounts are not listed on the Balance Sheet. The first Total column lists the same amounts as in the Totals column under the Fund Accounting Method because it includes Interfund (due to/due from) accounts. The second Total column is not the same because it does not include Interfund (due to/due from) accounts, but both are still in balance. Balance Sheet (Equity Method of Reporting) DESCRIPTION TOTAL TOTAL (Interfund) (No Interfund) ASSETS Cash $ 570,000 $ 570,000 Investments 1,000,000 1,000,000 Members Receivables 25,000 25,000 Allowance for Doubtful Accounts ( 5,000) ( 5,000) Interfund (due from reserves) 10,000 Total Assets $ 1,600,000 $ 1,590,000 LIABILITIES and MEMBERS EQUITY Accounts Payable $ 38,000 $ 38,000 Prepaid Assessments 12,000 12,000 Interfund (due to operating) 10,000 Total Liabilities 60,000 50,000 Members Equity Undesignated Beginning Balance 16,000 16,000 Current Year Excess (Deficit) 2,000 2,000 Total Undesignated 18,000 18,000 Designated for Future Repairs and Replacements Beginning Balance 1,450,000 1,450,000 Assessments 50,000 50,000 Major Repairs and Replacements ( 13,000) ( 13,000) Total Designated for Future Repairs and Replacements 1,487,000 1,487,000 Designated for Litigation Beginning Balance 2,000,000 2,000,000 Litigation Proceeds 0 0 Litigation Expenditures (1,965,000) (1,965,000) Total Designated for Litigation 35,000 35,000 Total Members Equity 1,540,000 1,540,000 Total Liabilities and Members Equity $ 1,600,000 $ 1,590,000 JAMES ERNST ACCOUNTING PAGE 5 OF 8

6 INCOME STATEMENT With regard to your Income Statement when using the Equity Method of Reporting, there generally will be only one Income Statement combining all activities of your association (e.g., operating, reserves, and other). That is to say, there might not be a separate Income Statement listing only the financial activities for the operating fund, the reserve fund, or any other fund of your association. Although the Equity Method may be in conformity with GAAP, the AICPA still requires that there is a separate Income Statement for the operating fund and reserve fund activities; therefore, if the reserve fund activities are imbedded in this Income Statement, or are listed on the face of the Balance Sheet only, then these financial statements will not be in conformity with GAAP. The following example is representative of an Income Statement presentation using the Equity Method of Reporting for the year. This example covers all financial activities (operating, reserves, and other) for the year. Sometime, however, as noted above reserve fund activities (revenues and expenditures) are listed on the face of the Balance Sheet. The result is that the $(1,976,000) deficit that is listed as Current Year Excess (Deficit) in the Actual column for the Year-To-Date does not agree to the $2,000 excess that is reported as Current Year Excess (Deficit) on the Balance Sheet for Undesignated Members Equity (i.e., operating fund). This is because this Income Statement includes reserve fund activities ($13,000 reserve expenditures) and litigation fund activities ($1,965,000 litigation expenditures), all of which are unrelated to the operating fund. Income Statement (Equity Method of Reporting) YEAR-TO-DATE YEARLY DESCRIPTION ACTUAL BUDGET VARIANCE BUDGET (Note: The columns for the Current Period were intentionally left off.) REVENUES Regular Assessments $ 250,000 $ 250,000 $ 0 $ 250,000 Interest Income Other Income 2,000 1,000 1,000 1,000 Total Revenues 252, ,000 1, ,000 EXPENSES and TRANFERS General and Administrative $ 150,000 $ 153,500 $ 3,500 $ 153,500 Maintenance and Repairs 31,000 27,500 ( 3,500) 27,500 Utilities 19,500 20, ,000 Total Expenses 200, , ,000 Transfer to Reserves 50,000 50, ,000 Reserve Expenditures 13,000 0 ( 13,000) 0 Litigation Expenditures 1,965,000 0 (1,965,000) 0 Total Expenses and Transfers 2,228, ,000 (1,977,500) 251,000 Current Year-Excess (Deficit) $ (1,976,000) $ 0 $ (1,976,000) $ 0 JAMES ERNST ACCOUNTING PAGE 6 OF 8

7 YEAR-END CPA REVIEWED OR AUDITED FINANCIAL STATEMENTS Finally, please keep in mind that regardless of which method of reporting that was chosen for your financial statements, whenever your year-end financial statements are reviewed (required by Civil Code 1365(c) if annual gross income exceeds $75,000) or audited by the association s independent CPA, the CPA reviewed or audited financial statements will, more often than not, be presented using the Fund Accounting Method of Reporting. Therefore, it makes sense that your interim and year-end financial statements be presented under the same method of reporting as used for the annual CPA reviewed or audited financial statements. FUND ACCOUNTING METHOD OF REPORTING IS RECOMMENDED As indicated above, your association s interim financial statements can be prepared using either of these 2 different methods of reporting. However, we recommend that the interim financial statements of your homeowners association be prepared using the Fund Accounting Method of Reporting. FUND ACCOUNTING METHOD OF REPORTING (Recommended) There are a variety of reasons why we recommend using the Fund Accounting Method of Reporting for your interim (monthly or quarterly) and year-end financial statements, as follows: When using the Fund Accounting Method, your Balance Sheet will clearly identify which fund the various assets and liabilities of your association are associated with. In addition, the Current Year Excess (Deficit) listed on the Income Statement for each fund will agree to the amount reported on the Balance Sheet for the same fund. As for your interfund balances (due to/due from), if any, when using the Fund Accounting Method these balances must be listed; otherwise, the individual funds will be out of balance. Further, the method generally used by most CPAs when performing their annual review or audit of your year-end financial statements is the Fund Accounting Method (preferred by the AICPA); therefore your annual financial statements would be presented using the same method as your independent CPA. EQUITY METHOD OF REPORTING (Not Recommended) There are a variety of different reasons why we do not recommend using the Equity Method of Reporting for your financial statements, as follows: If you use the Equity Method of Reporting, when you issue your interim financial statements your Balance Sheet may not have the same detailed information with regard to assets and liabilities and their corresponding members equity. The Income Statement may have information related to other funds (e.g., reserve revenues and expenditures) which may cause the amount reported as Current Year Excess (Deficit) to not agree with the amount reported on JAMES ERNST ACCOUNTING PAGE 7 OF 8

8 the Balance Sheet. Interfund balances (due to/due from) can be easily left off the Balance Sheet while giving the illusion that the financial statements are complete. Further, the method generally used by most CPAs when they issue their annual report will be presented using the Fund Accounting Method of Reporting, which will be different than the method used on your year-end financial statements, creating confusion as to the nature and extent of these differences. Finally, although the Equity Method can be in accordance with GAAP (if properly formatted); the AICPA prefers that homeowners associations use the Fund Accounting Method of Reporting. However, if you choose to use the Equity Method, please make sure you provide a separate Income Statement for each separate activity (e.g., operating, reserves, etc.) do not imbed reserve fund activities into a single Income Statement or on the face of the Balance Sheet. Further, make sure all assets and liabilities are clearly identified by fund, and your interfund accounts (due to/due from), if any, are reported on the Balance Sheet. Otherwise, your financial statements may be incomplete; therefore, not in conformity with GAAP. More importantly, they may be confusing to the reader. CONCLUSION I hope this information has clearly described the 2 methods of reporting that are available for interim financial statements of a homeowners association (Fund Accounting and Equity Method of Reporting). More importantly, however, I hope this explains why our firm feels that the Fund Accounting Method of Reporting is the right one for you when preparing the interim (monthly or quarterly) and the year-end financial statements for your association. JAMES ERNST ACCOUNTING PAGE 8 OF 8