How to X-ray an HOA #2 – The Financial Statements and Budget

Every HOA is a business and must keep certain financial records for proper management.  Let’s start with the budget.  If you are buying a new unit directly from the developer, the budget you will be reviewing is almost always unrealistic. 

Developers typically understate their operating expenses to lure buyers with claims of low monthly fees.  The developer may be subsidizing expenses or not listing items that are definitely needed.  For example, the budget may show “window washing at $5,ooo per year.”  But in fact, this amount pays for only one cleaning per year when two cleanings are necessary.  And the true cost may really be $15,000 annually, but the developer got a special discount not available to the HOA.

How far from reality can developer’s budgets be?  Some experts say that as soon as the developer turns over control to the homeowners, the HOA Board should immediately raise the monthly fees by 20-25% to accommodate a realistic budget.  However, most new Boards decline to make such unpopular decisions, thereby perpetuating the problem. Keeping fees too low unfortunately sets the stage for funding problems as we will see later in this series. 

Now look at the Income & Expense statement where the “Actual to Budget Costs” comparison reveals if a particular item is within budget.  Some things like insurance are paid in lump sums, so a negative balance for a particular month is not necessarily worrisome.  But watch for significant discrepancies on maintenance costs and professional services, such as attorney fees.

Next examine the Balance Sheet, which is a snapshot of the HOA’s financial status at a specific point in time.  It is categorized into three areas: Assets, Liabilities, and Equity.  Their relationship follows this formula:  Assets = Liabilities + Equity.

Assets are items the association owns, such as cash, accounts receivable, property, and prepaid expenses.  Liabilities are amounts owed by the HOA for products, services, taxes or loans.  Equity is the association’s net worth and is sometimes called “retained earnings.”  Make a note of the reserve fund balance and whether the HOA has borrowed from the reserves to pay operating expenses.  That info will be important when we cover Part 4 – Reserve Funds.  

Check whether the HOA has enough cash to cover the operating expenses.  If the operating or reserve accounts appear under-funded when compared to the budget, find out why.  Is the deficit caused by an unexpected event, such as a major lawsuit, catastrophic storm or a newly-discovered construction defect?  Or does it instead seem that the HOA’s dues have not kept pace with actual expenses?

Finally, some states mandate annual reviews of HOA financial statements by an independent CPA.  Minnesota has this requirement, but gives owners the option to waive an audit on a year-by-year basis.  Always ask for a copy of the latest audit report if you are considering buying in a particular development. 

HOA assessments are the subject of Part 3.  See you then. 

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