How do you find warning signs in your financial documents?
That’s a timely question for most boards. At the beginning of each year, accountants throughout New York will begin the process of reviewing the financial records of cooperatives and condominiums in order to prepare an audited financial statement. At least once a year, the financial records must be reviewed by an independent certified public accountant to confirm their accuracy and to provide assurances to the owners that the records are properly maintained.
This process is known as an audit, which means it verifies the financial statements and contains an opinion by the auditor as to their accuracy. Its purpose is to provide reasonable assurance to the owners and other interested parties that the financial statements are presented fairly, in all material respects, and provide a true view of the property’s financial condition in accordance with generally accepted accounting principles.
Unfortunately, few owners and boards understand how to read the report, or even why it’s significant. Every year I attend annual meetings and hear the accountant and the treasurer grilled on matters that are not really significant, while important issues are ignored.
A financial statement has several parts: (1) the opinion letter from the auditor; (2) the statements (balance sheet, income and expenses, cash flow); and (3) the footnotes. Because these and other documents play a role as warning signs, over the next three months we’ll be examining them in some detail. This month I’ll explain the financial statement; next month I’ll focus on the audit procedure, including the “Representation Letter” that boards are asked to sign; and then in the final month, I’ll focus on identifying fraudulent activity.
The audit report, which is usually addressed to the residents and the board, should contain what is called, a “clean opinion.” This is one in which the auditor takes no exception to the financial statements and gives his or her opinion that the statements present “fairly” the financial position of the property at a certain point in time (i.e., the last day of the fiscal year), and the results of its operations and cash flows for the stated period (usually a year).
Understanding that the reported finances are presented “fairly” is different from stating that the report is correct. When something is correct, that implies that it is accurate to the dollar or even to the penny. Presenting “fairly” however only requires that the information be accurate and complete enough so that a knowledgeable reader can use the financial statement to make a well-informed decision. The presence of a clean opinion does not guarantee that the cooperative or condominium is in good financial condition; it simply means that the information, as presented, is clear enough to allow the reader to make decisions based on them. Similarly, the presentation of something other than a clean opinion does not signify the cooperative or condominium is in trouble. All it indicates is that uncertainties or a lack of information left the auditors unable to satisfy themselves that the financial statements present fairly the cooperative or condominium’s financial records. In such cases, the auditor will offer an explanation in the report and, especially, in the footnotes. What you do not want to see in the opinion is a comment from the auditor that questions the ability of the entity to continue as a going concern.
After determining that the auditor has rendered a clean opinion, the next things to review are the statements of income, expenses and deficit. The primary interest in reading the financials is the cash flow and how it will affect the maintenance or common charges that are paid. The issue is whether the maintenance/common charges, together with the property’s other income, cover the operating expenses, or if there will be a deficit that will have to be funded from reserves or assessments.
If the expenses exceed the income and have not been caused by an extraordinary circumstance (such as an unexpected major repair), there will probably be a maintenance or common charge increase that will have to be assessed. While some of the components of operating expenses increase from year to year, if one or more happen to increase or decrease significantly more than the others (heating fuel, insurance, repairs, and maintenance), it is important to find out if there is an explanation for the change in the footnotes.
The next thing to look at is the cooperative’s or condominium’s cash position. This can be found at the top of the balance sheet. If the property has little in cash and cash equivalents, is without a reserve fund, and does not have a revolving line of credit, the board would be dependent on the receipt of the maintenance or common charges each month in order to meet its obligations. Additionally, in a property that has little cash, any major repair or replacement will have to be funded with an assessment, which would put a further strain on the ability of the co-op or condo to meet its obligations, and could foretell an increase in maintenance or common charges above that required to keep up with inflation.
Another aspect of the amount of cash and equivalents and investments is the recurring question of the size of the reserve fund. The answer depends on many things, including the age and physical condition of the building and the wealth of the owners. An older, not-very-well-maintained building is more likely to require emergency repairs and/or replacements than a new building or one that has recently been rehabilitated or scrupulously maintained. Moreover, a property with elderly owners on fixed incomes cannot depend on assessments and must have adequate cash on hand or access to a line of credit to meet emergencies should they arise.
If, however, the owners are younger, in good financial condition and with significant resources, they may prefer to keep the reserves low and pay an assessment, if necessary. One common rule of thumb is that the cooperative or condominium should hold in reserve a sum of money equal to at least six months’ operating income. Of course, it is a mistake to fund operating losses with money from the reserve fund, which should be maintained for large capital projects and emergency repairs.
Next, you need to review the footnotes. These are an important source of information and should be read closely because this is where readers will find summaries of litigation, unresolved actions, and other issues of interest.
The first note usually describes the organization, while the second note usually reports on significant accounting policies. The third footnote may be a discussion of the remaining useful lives of the improvements and equipment. The footnotes also offer a definition of cash and equivalents and discuss the nature of the financial statement.
The fourth footnote may describe the property’s policy and future major repairs and replacements, presented according to the Common Interest Realty Association (CIRA) guidelines issued by the American Institute of Certified Public Accountants as a chart. It also describes the cooperative’s or condominium’s policies to pay for such work, including reserves and how the board intends to accumulate funds. But, because of liability issues, virtually no New York cooperative or condominium includes the information.
The problem with the CIRA guidelines is that they require the remaining useful life of each component to be shown in a table, but neither the auditors nor the engineer want to take a 100-page or longer engineer’s report and condense it into a table. Consequently, the lawyers are concerned about liability issues if the table is not accurate. The question is, who will be sued if a buyer relies on a table that indicates that the roof has a remaining useful life of ten years and, because of latent defects, it actually requires replacement in 18 months? The answer is that everyone will be sued, including the board. Therefore, it is safer if there is no table. As a result, the footnote indicating that the corporation or condominium has not satisfied the CIRA guidelines requirement is not indicative of fraud or wrongdoing.
It must always be remembered when reviewing an audited financial statement, that an audit is a photograph at a moment in time, usually reflecting the cooperative’s or condominium’s finances on December 31st of each year or the last day of the cooperative’s or condominium’s fiscal year. That means the information is skewed because some bills may be due on the first of January. Moreover, the statement is usually maintained on an accrual method of accounting rather than a cash method, so the presentation may be confusing. That is why the audit opinion is so important.