Board members are often asked to decide on specific services to be performed by CPA’s and this is where we step in with specialized services for HOA’s which include:
1. Financial statements preparation
2. Tax returns preparation for HOA’s: Form 1120 or 1120-H
3. Developers turnover audits
There are three types of assurance services CPA’s place on financial statements. These assurances in order of reliance are as follows:
Compilation of financial statements
Compilations are generally the lowest level of assurance rendered by a CPA associated with the financial statements. When a CPA compiles financial statements for a client, the CPA presents information obtained from the client in the form of financial statements in accordance with generally accepted accounting principles. The CPA does not audit or review the information and thus places no assurance on the statements. However if, in the course of this preparation, the CPA notices anything peculiar about the information, the CPA is required to investigate to satisfy himself/herself that the information would not be misleading to a user.
Under Florida law, community associations must, each year, have a compilation if gross revenues are over $150,000 but less than $300,000.
Review of financial statements
Reviews are generally the second highest level of service rendered by an independent CPA in preparing year-end financial statements. In a review, the financial statements are subjected to analytical review procedures and inquiry as a means of insuring compliance with generally accepted accounting principles (GAAP).
Under Florida law, community associations must, each year, have a review if gross revenues are over $300,000 but less than $500,000.
Audit of financial statements
There are several reasons to conduct an audit of your HOA. Whether you have hired a new management company and want to provide them with a fresh starting point or your covenant requires an annual audit.
Audited financial statements require the CPA to perform such auditing procedures as promulgated by generally accepted auditing standards to enable the CPA to express an opinion as to the fairness of the financial information. This basically means the CPA will tell you if the amounts reported in the financial statements are materially correct. An audit also requires the CPA to document and analyze the system of internal controls inherent in the accounting system. Any weaknesses in internal controls and other operational efficiency comments are normally communicated via a management letter to the board of directors. Because a detailed examination of all transactions is not performed, there is a risk that errors, irregularities and/or illegal acts, including fraud, may exist and not be detected.
The true value of an audit is the fulfillment of the fiduciary responsibility of the Board in helping to assure that amount used in the budgeting and operation phases of the financial process are correct and to assure the membership that everything possible is being accomplished to protect the financial investment that owners have in their unit and community assets. Boards should view an audit as an investment in the financial health of the Association and care should be taken to choose an audit firm with industry experience and the understanding that the evaluation of internal controls and the communication of weakness to the Board in an integral part of the engagement. Under Florida law, community associations must, each year, have an audit if gross revenues are over $500,000.
1. Selection of an Auditor
HOA boards are often comprised of individuals from varying professional backgrounds, many of whom may not necessarily be familiar with the audit process. For your benefit, we outline the process bellow.
By now your board has given serious consideration to undertaking an audit and you have begun to research firms who are qualified to perform an HOA audit. Make sure to always choose a certified public accounting (CPA) firm who has experience auditing HOA's. While many firms claim to be able to perform the work, be sure to make inquiries relating to the number of HOA audits the firm has performed, as well as how many management companies the firm has worked with. Because of the intricate complexities, as well as ever evolving audit regulations, it is best to choose an accounting firm who has HOA audit experience. Finally, inquire as to whether the accounting firm has been peer reviewed. The Peer Review Program, administered by the AICPA (the profession's governing body) is designed to enhance the quality of accounting and auditing services performed by AICPA members. A peer review report will signify that the firm places an emphasis on quality and will be best suited to serve as a trusted advisor to your HOA.
2. Planning Process
Once an auditor has been selected and an engagement letter (contract) is in place, the next step is to plan for the engagement. The term "audit" is defined as "one who hears", so naturally the planning process features a significant amount of dialogue between the auditor and the association’s BOD. To effectively perform an audit of an HOA, or an audit of any type of organization, the auditor must first become familiar with the HOA, its operations, its board and its internal controls. Typical questions asked of the HOA board during the planning process may include the following:
• Why are you seeking an audit at this time, is it to satisfy by-law requirements, debt covenants, or for some other reason?
• Are your financial statements prepared on a cash or Accrual basis of accounting?
• How large is your HOA?
• How active is your BOD?
• What is the dues structure (i.e. timing, amount and frequency of dues)?
• Does the Association have any bank debt?
• Does the Association meet regularly and does it prepare board minutes?
• When is the audit needed by?
While the BOD of an HOA is certainly encouraged to make inquiries of their auditor/advisor whenever they feel necessary, the planning process of the engagement is typically when the most BOD/auditor interaction occurs. As you will see below, the majority of the audit is performed in partnership with the Association's management company.
3. Testing Process
Once the planning process has been finalized and the auditor has become familiar with the HOA, the auditor will send a document request list to the Association's management company. The great benefit of choosing an accounting firm with prior experience auditing HOA's is that the firm will likely already be familiar with the management company, its operations, people, and accounting system. Because the association's management company often maintains all of the financial documents and records of the HOA, the majority of the audit testing is generally completed at the management company's office. This practice eases the burden of an already very busy BOD. Typical audit tests may include the confirmation of bank accounts directly with banking institutions, performance of the association's bank reconciliations, verification of the completeness and accuracy of the association's revenue, expenses and fund balances and analysis of accounts receivable and payable. Depending on the timing and cooperation of the management company and the 80D, an audit is generally completed within a 3-5 week window. It is highly recommended that the BOD requests a completion date within the engagement letter (See Planning Process above). Doing so assures the association will receive their audited financial statements in a timely manner, which is critical for budgeting purposes.
4. Audit Wrap-Up
The final step of the audit process involves the auditor preparing a draft set of financial statements for review by the management company and BOD. Included with the draft is a listing of all journal entries (corrections) proposed by the auditor during the course of the audit engagement The draft of the audited financial statements allows the BOD and management company a chance to review the financial statements and to bring to the attention of the audit firm any questions/comments/concerns they may have. Once all parties agree on the draft, a Management Representations Letter is presented to the BOD for signature. The Management Representations Letter confirms all of the statements made by the BOD and management company during the course of the audit Once the adjusting journal entries and Management Representations Letter are signed, dated and returned to the auditor, finalized financial statements are issued. In most cases, a PDF copy as well as bound copies of the financial statements are issued to the association. In many cases, a management comment letter is also issued in conjunction with the audited financial statements. The management comment letter often features issues that the auditor has identified, recommendations for improvement as well as an overall summary of the audit process.
At this point, you have made a decision as to whether to seek an audit of your association's financial statements. The benefits of undertaking an audit include the following:
1. Satisfaction of Fiduciary Responsibility:
By joining an Association's BOD, a board member has a legal and ethical responsibility to the homeowners of the association in regards to the association's management of funds. Many association by-laws clearly outline that audited financial statements are a requirement of the association, and a responsibility of the BOD. By seeking an independent audit, the BOD is adequately satisfying its fiduciary responsibility to the homeowners of the association.
2. May Add Value to Homeowners within the Association:
this very difficult housing market (for sellers), homeowners are often seeking any advantage they can utilize in order to sell their homes. Many prospective homeowners, especially those seeking condominiums or townhomes, will look to see that the condo or townhome they desire has had a prior audit. By providing the prospective homeowner a copy of the audit, the homeowner is able to see whether the association is fiscally sound, financially prudent, and adequately reserved for future major repairs and replacements. In short, audited financial statements may provide the prospective homeowner with added peace of mind, and the prospective seller a greater return on their sale.
3. Comfort over Management Company Transition:
One-Way HOA's save funds is by changing their property management company. Changing management companies can often be a cumbersome process and often involves the transfer of significant funds between banks. To provide reasonable comfort over the transition, HOA's often seek a financial statement audit to ensure the transfer was done properly and that funds are completely and accurately stated. By being proactive and seeking a financial statement audit, the BOD is able to obtain comfort that the transfer between management companies is efficient, effective and that the financial position of the association post-transfer, is identical to the financial position pre-transfer.
By now you have a very good understanding of the audit process from what to look for when selecting a firm to perform the audit, to the receipt of your finalized audited financial statements. The benefits of performing an audit are numerous and the process allows the association's BOD to spend more time governing their association. By upholding your fiduciary responsibility as a board member, you have added peace of mind that you have acted in the best interest of the association you govern. To speak more in depth about your Association's audit needs, contact IRO CPA today for a no-cost consultation.
1. An audit may be found beneficial when changing management companies, when transitioning from self-management to professional management, or when the association is transitioned from the developer to the homeowners.
2. To achieve compliance with state laws and regulations, in Florida when the revenues exceed $500,000 a year.
3. To provide board of director members and units owner accurate financial statements with all required disclosures following generally accepted accounting principles (GAAP) guidelines. This allows consistency when financial statements are used by unit owners or third parties such as bankers, potential buyers, IRS, government agencies, among others.
4. To provide assistance to the board of directors in their fiduciary duties and responsibilities.
5. If association is experiencing financial difficulties. It may seem strange that the HOA should spend more money when it is losing money. However, it may be that the Association needs a CPA to verify the books in order to ensure that everything is being property recorded.
6. An audit is recommended when there is minimal or no appropriate internal control structure to safeguard the assets of the association. The typical example of this is when the association is self-managed and the treasurer is in control of preparing and signing the checks as well as preparing the monthly bank reconciliation.
Also, an audit is beneficial to reduce the risk of any possible deterioration in the internal controls structure established to carry out the daily operational and administrative functions, as well as to reinforce and / or improve existing internal controls procedures.
7. When there is suspected fraud or embezzlement.
8. When there is unusual replacement reserve fund activity, association is not following budget expectations.
For federal tax purposes, homeowners associations are treated as corporations. Even if an HOA was created as an association or a nonprofit corporation with its respective state, it is still considered a regular corporation for federal tax purposes. The only exception is the rare instance in which the HOA has filed for recognition and been accepted as a nonprofit by the IRS. Such recognition is expensive, relatively difficult to obtain, and most often requested by filing form 1024 with the IRS and utilizing tax code section 501(c)(4).
Corporations are generally required to file Form 1120, U.S. Corporation Income Tax Return, annually. Filing form 1120 has several distinct disadvantages for an HOA. First, Form 1120 is fairly complex. A second disadvantage of filing Form 1120 is that all of the HOA’s “income” is taxable. Basically, this means that any funds collected and not spent (for example, funds set aside for road maintenance or replacement) during the year may be subject to corporate income tax. A third disadvantage of Form 1120 for an HOA is that it may subject the HOA to making estimated tax payments, another burden for the often overburdened volunteer treasurer.
The tax code gives many HOA's the ability to avoid Form 1120 by making a special election. Section 528 allows Homeowner Associations that meet certain requirements to bypass Form 1120 by filing Form 1120-H, an income tax form specifically designed for Homeowner Associations. Although most HOA’s qualify, each must meet certain requirements to utilize this election. To file Form 1120-H, at least 60% of the HOA annual revenue must be “exempt-function income.” Exempt-function income includes membership dues, assessments, fees and interest on those fees. Also, 90% of the HOA’s expenditures must be for management, maintenance, acquisition and construction of association property.
If the HOA qualifies to file Form 1120-H, only its “non-exempt” income is taxable. Non-exempt income includes interest and dividends, rental income from property owned by the association, and laundry/vending machine income. The HOA is allowed to deduct expenses directly related to the generation of non-exempt income but must have written records to prove the deductions. Form 1120-H allows for a $100 deduction from non-exempt income to arrive at taxable income. The HOA’s taxable income is then subject to a flat tax rate of 30% (32% for time share associations).
Filing Form 1120-H is an election that must be made each year. The election is made by filing Form 1120-H by its due date (the 15th day of the third month after the end of the HOA’s tax year - a six month extension to file can be obtained by filing Form 7004). Once made, the election cannot be revoked without IRS consent.
If Form 1120-H is not filed within twelve months of its due date (including extensions), the HOA may lose the opportunity to file the form 1120-H for that tax year. The HOA must then file the longer and more complex Form 1120. The HOA may also be required to pay penalties for late filing and late payment of any tax due.
The main purpose of an internal control structure of an organization is to prevent or detect on time any possible material error in the financial statements.
During the planning stage of a financial audit, the auditor must obtain information to understand and evaluate the design and implementation of the entity’s internal control system, as well as, perform risk assessment procedures.
What are Risk Assessment Procedures? Risk assessment procedures represent a defined category of audit procedures performed near the beginning of the audit to obtain an understanding of the entity and its environment (including its internal control) for the purpose of assessing the risks of material misstatement. They consist of inquiry, observation, inspection, and analytical procedures. The auditor's analysis of the results of these procedures is an assessment of risk that in itself provides evidence that ultimately supports the auditor's opinion on the financial statements.
Based on the above, the auditor should have experience in the industry so that he can identify the most dangerous risk factors in each of the entities that will perform an audit.
Following are some of the most common malpractices in the industry of Condos and HOA’s, which increase the risk to the auditor when preparing his work plan for each audit that is to be carried out.
• The management company having too much authority, for example giving the property manager the right to sign checks and only requiring one signature. A board member’s signature should be required on checks.
• Inadequate board oversight - not reviewing invoices when signing checks, not receiving or reviewing monthly financial reports (financial statements, bank records, AR aging, cash disbursements report, GL), not being involved in obtaining and approving competitive bids for significant projects (if it's board that meets regularly, many times discussion of bids is included in the minutes)
• Paying fictitious vendors/duplicate payments to vendors that may indicate kickbacks - This would be very hard for an auditor to find, which is why the best defense is an active board that reviews the financial activity closely. But while reviewing the GL, be aware of vendors that look unusual, expenses that don't make sense for the CIRA, and amounts that may be duplicates (although in many cases they'll pay 50% down and 50% at completion of a project).
• Credit cards - If there's a lot of credit card activity (Home Depot, Lowe's, etc.), you may want to review some statements to make sure the purchases appear to be for normal maintenance and not for personal items. Also check the statements for the credit limit; a limit that seems really high for the size of the CIRA could be a red flag.
• Evaluating the allowance for uncollectible accounts receivable accounts. Most of CIRA don't evaluate uncollectible accounts during the year; they wait for auditors to review it with them during year-end work.
• Policy for units CIRA has foreclosed on - There are many ways to handle this situation when the bank will eventually take ownership, but there should be a consistent approach used.
• A/P - Many management companies don't record A/P because the board wants to see cash disbursements only during the year, so we end up proposing an adjustment to record it based on our search for unrecorded liabilities.
• Paying operating expenses with reserve funds - this is always a risk, even if there are no cash flow pressures. The property managers sometimes just misunderstand what can be charged to reserves.
• Moving funds from a reserve account (either to another reserve account or to the operating fund) without a prior membership vote. Many will document a board vote for this, but a full membership vote is required, at least under Florida statutes.
• Not updating reserve studies - Many CIRA's perform their own reserve studies, which they update every year. But some have a formal reserve study done and don't have it updated for several years afterward.
• Special assessment revenue - Not recording deferred revenue for the amount that has not been expended.
• Litigation against the CIRA - There may be litigation against the CIRA that the management company doesn't inform the auditor. Examine legal invoices and review minutes for any discussion of legal issues. Many times this is adequate; we request legal letters only when necessary based in the invoices, minutes, and discussion with the management company.