A significant percentage of decisions made by board members of cooperatives and condominiums requires knowledge of the entity’s financial position. Boards must have the ability to read and understand the annual audited financial statements of these so-called “common interest realty associations” (CIRAs). The annual audited financial statements, also known as the annual report, can provide valuable information and answer many basic questions about the financial position and operations of the entity.
Some of the more relevant questions include:
• Does the entity have enough cash on hand to meet its recurring obligations in the normal course of business?
• Are maintenance or common charges being collected on a timely basis? If not, what is the impact on cash flow?
• Are there other significant receivables that may impact cash flow?
• Are there enough funds held in reserve to meet ongoing and future capital improvements?
• Does the entity have an investment policy that ensures principal protection while maximizing returns?
• Are there any outstanding liabilities the entity has not addressed or for which it has not provided?
• Are there any contingent liabilities which may have to be funded in the future?
• Is the entity operating on a break-even basis, i.e., do the operating revenues cover operating expenses?
• What are the sources of revenue? Are all of them recurring or are some dependent on economic climate or other variables?
The answers to these and other questions may be found in the financial statements. Therefore, the financial statements are an extremely important tool that should be utilized by board members to acquire knowledge with respect to an entity’s financial position.
The key elements in a set of basic financial statements are generally presented in the following order:
Balance sheet – the financial position at the end of the period.
Income statement – net income for the period.
Statement of changes in stockholders’ equity – changes to the equity section of the balance sheet.
Statement of cash flows – changes in cash flows for the period.
Notes to financial statements – includes descriptions of accounting policies and other required disclosures providing significant information about the entity.
The balance sheet generally presents three major categories: assets, liabilities, and stockholders’ or members’ equity. Along with the notes to the financial statements, it is considered to be the CIRA’s presentation of its financial position. Balance sheets may be presented as classified or unclassified. A classified balance sheet is when asset and liability components are separately disclosed and an unclassified balance sheet is when asset and liability components are not segregated by current or non-current components. Since the asset and liability components are relevant to the CIRA industry, most CIRAs present a classified balance sheet.
Generally, the balance sheet is presented on two pages but may be presented on a single page for an entity that has fewer accounts. The first page is a statement of all assets owned by the entity and the second page is a statement of liabilities and stockholders’ equity.
On the asset page, the components generally consist of current assets, investments, fixed assets, and other assets. A condominium may not have a fixed asset section since the real property is owned by the unit-owners in common and not by the association.
Current assets are cash and other assets that are reasonably expected to be realized in cash, sold, or consumed during the following year. Current assets usually include cash and cash equivalents that are available for current operations, receivables, and prepaid expenses. Additional current assets may include inventory and mortgage escrow. Prepaid expenses will not convert into cash but are current assets since they were paid in advance and do not require the use of current assets. An example of a prepaid expense is the portion of an insurance policy premium that had been paid in full even though the term has not fully expired on the balance sheet date. That unexpired portion will be consumed in the next operating cycle.
Balance Sheet Questions
Are there enough funds held in reserve to meet ongoing and future capital improvements? Does the entity have an investment policy that ensures principal protection while maximizing returns?
Investments may include cash and marketable debt and equity securities segregated to be used for capital replacements. Many CIRAs include their investments under the heading “Reserve Funds.” These funds are not intended to be used for normal recurring operating expenses. The amounts held in reserve will dictate the CIRA’s ability to fund capital improvements without imposing capital assessments or incurring additional debt.
Before considering any new and/or future commitments, board members must be knowledgeable about how much the entity holds in reserves and whether those funds are held in liquid investments. The amount held in reserves will be stated on the balance sheet; how those reserves are invested should be disclosed in the footnotes to the financial statements.
In general, the overall investment objective of a CIRA should be to protect principal by investing in high-grade fixed income securities and cash and cash equivalents. The long-term goal of funds in the reserve fund is to support the CIRA’s future needs for capital improvements.
The fixed asset section of the balance sheet states the property and improvements to the property at the cost of acquisition, not fair market value, minus an amount for accumulated depreciation. Depreciation is a non-cash annual expense which provides a tax benefit to the entity. The notes to the financial statement may disclose what improvements were made during the year.
Other assets will consist of security deposits held or unamortized portions of expenses incurred that are amortizing over the remaining life of an obligation, i.e., finance costs. New board members should be familiar with these accounts but generally they will not affect any major decisions.
Are there any outstanding liabilities that the entity has not addressed or provided for? Are there any contingent liabilities that may have to be funded in the future?
The components of the liability section of the balance sheet are segregated into current and long-term liabilities. The current liabilities consist of accounts payable and other liabilities that will require payment within one year. Accounts payable are expenses incurred in the normal operating cycle for which the entity has been billed but has not paid as of the balance sheet date. Other current liabilities include expenses incurred that have not been billed as of the balance sheet date. These expenses are defined as accruals, i.e., utilities consumed in the last month of the year but which will be billed in the following operating cycle.
Long-term liabilities are obligations that extend beyond the current year or operating cycle. The most common of these obligations include long-term debt, such as mortgages and loans payable. The footnote disclosures provide significant information about the terms of long-term obligations such as maturity date, payment terms including interest rate, required principal payments, and prepayment premiums, if any. Such information is vital to making decisions about raising funds for capital improvements and refinancing decisions. Additionally, the footnotes will disclose any contingent liabilities which are liabilities that may arise in the future because of an uncertain circumstance, i.e., litigation.
The equity section of the balance sheet will be equal to the total assets less the total liabilities. Increases to this section will come from contributions to capital, i.e., capital assessments and increases or decreases to retained earnings for cooperative corporations or fund balance for condominium associations based upon the net income or net loss in the statement of operations.
Now that we have discussed all of the components of the balance sheet, we can address questions that relate to cash.
Does the entity have enough cash on hand to meet its recurring obligations during the normal course of business?
To determine the answer to this very important question, we need to determine the ratio of two components of the balance sheet. The ratio is known as the working capital ratio or current ratio and is an indicator of whether or not an entity has sufficient short-term assets (current assets) to cover its immediate or current liabilities. To determine the ratio, divide total current assets by total current liabilities. If the ratio is less than 1, then the entity has negative working capital or insufficient short-term assets. If the ratio is over 2, it is not necessarily a good thing either as it indicates that the entity may not be investing their excess cash. Most believe that a ratio between 1.5 and 2 is sufficient. This ratio reveals more about the financial condition of a business than almost any other calculation.
Are maintenance or common charges being collected on a timely basis? If not, what is the impact on cash flow?
Board members have to monitor shareholders’ or unit-owners’ outstanding receivables. If receivables are not collected promptly and are allowed to increase over time, the entity’s cash flow will be negatively affected. To measure the time it takes to collect account receivables, we have to compute “Days Sales Outstanding,” commonly referred to as DSO. This will provide an understanding of the effectiveness of the entity’s collection policies and those in charge of executing those policies.
The formula to calculate DSO is total shareholder receivables divided by one-twelfth of the annual maintenance times 30 days. This will give you the number of days it takes to collect outstanding receivables. Generally, a CIRA should be collecting outstanding receivables well below a 30-day time period.
The income statement, sometimes referred to as the “statement of operations” or “statement of revenues and expenses,” will be informative about the operations of the property. Board members should be familiar with every line item within the income statement as these are the revenues and expenses the board should be monitoring all year.
Is the entity operating on a break-even basis, i.e., do operating revenues cover operating expenses?
This is one of the most important questions that can be answered by the income statement. Are maintenance or common charges set at an appropriate level to provide a break-even operation?
If the answer is no, then go back and compare cash balances and reserve fund levels from last year to the current year. You will probably see a decline in such funds as money will have to be drawn down to cover operating deficits.
If the answer is yes, then the financial condition of the entity will be more stable. Review all revenue and expense accounts and notice the variances from one year to the next and compare these figures to the operating budget. Inquire how the variances came about until you are familiar enough with the operations to answer these questions on your own.
The cash flow statement is the least understood by most novice readers of financial statements. However, it is actually fairly straightforward and can be very informative about how cash was consumed during the year. The cash flow statement begins with the net income or loss of the entity. There are many non-cash adjustments to arrive at net income or loss. These include prepaids, accruals, and depreciation. The statement of cash flows removes all of these adjustments and is therefore able to present the net change in cash from the beginning of the year to the balance sheet date.
With the knowledge of some of these tools, you will be surprised at how quickly you will learn from your CIRA’s financial statements. Happy reading!