Habitat Magazine / February 2011 /www.habitatmag.com
F is for FINANCIAL STATEMENT
The annual report should tell you where your money is going.
By Darren Newman
A
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
Darren Newman course of business?
Are maintenance or common
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charges being collected on a timely
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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.
significant percentage of decisions
Key Elements
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.
Habitat Magazine / February 2011 /www.habitatmag.com
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 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 longterm 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.
Cash Questions
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?
Habitat Magazine / February 2011 /www.habitatmag.com
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! •