By Michael Mezzo, CPA, MBA, Supervisor
One of the most common questions that we receive while presenting audited financial statements to Board members is “What are interfund balances and what created them?” In this article we will discuss what an interfund balance is, as well as some of the common causes and implications associated with these interfunds.
In order to understand what an interfund balance is, it is important to first discuss the concept of “Fund Accounting”. In general, Associations utilize the principles of fund accounting for purposes of tracking and recording their financial activity. A great way to understand the concept of fund accounting is to relate it to your own personal finances. A number of years back when I graduated from college, I knew that I had to replace my old “school kid” car, while also starting to save for the repayment of my student loans. In order to ensure that I would have enough money to cover these costs, I went to the bank and opened two new savings accounts. Doing so helped me to track and accumulate the necessary funds on a monthly basis to ensure that I would have suffcient funds to cover these upcoming expenditures.
Associations utilize fund accounting to achieve a similar goal. Instead of saving for student loans or new cars, Associations face the task of saving for replacement of their common elements, as well as for providing funds to cover the ongoing maintenance and upkeep of the site. The chart below summarizes the three most common funds utilized by Associations:
From a practical standpoint, this becomes a significant issue when authorizing financial transactions. Associations whose board members authorize financial transactions via email (for example, to approve the issuance of a check or wire transfer) with no other verification may be especially susceptible to fraud. If an attacker found out on Facebook or LinkedIn who you are and who you know, it can be relatively easy for them send a fraudulent email, which appears to be from a board member, authorizing or requesting a transaction. Organizations of all sizes have fallen victim to this kind of attack, resulting in loses ranging from tens of thousands to tens of millions of dollars. When designing your processes for approving transactions, consider a secondary confirmation system such as a text or phone call to verify that a transaction has been approved.
What is an Interfund, and What are the Common Causes?
In its simplest form, an interfund balance occurs when an Association utilizes one fund to pay for another fund’s activity. In a perfect world, activity for each fund would never cross paths with that of another fund. However, the reality of the situation is that many circumstances can arise throughout the course of the year which cause activity from each fund to be reflected within another fund. These situations are ultimately the cause of interfund balances. Some common examples are as follows:
Cash Flow / Deficits
Poor cash flows can lead to an interfund because the Association doesn’t have the available cash to make the monthly budgeted contributions to the non-operating funds. Associations will typically budget for annual transfers to the replacement and other funds. However, if cash flow is poor, these funds are often kept in the operating fund to cover monthly expenses and are never transferred to the respective funds, resulting in an interfund balance.
An example of a timing difference would be if an Association had an emergency repair that required immediate attention, and the Association planned to special assess the unit owners in order to cover the costs of repair. Similarly, there may be a large expense that comes due early in the year, before appropriate funds have been accumulated for the expenditures. In both of these situations, the Association may use another fund’s cash account to front the cost of the project until funds within the appropriate fund are available.
Associations often invest a portion of their replacement fund cash into time restricted investments, such as certificates of deposit (CD). In the event that an emergency replacement arises, it is not uncommon for an Association to borrow money from another fund for the cost of the project, rather than to prematurely withdraw an investment which has not reached its maturity date.
Implications of Interfund Balances
The two main implications of interfund balances are as follows:
- Insufficient Amounts Accumulated in Funds – Cash and investments that were supposed to be earmarked within a specific fund will not be available to cover upcoming expenditures within that fund. This could lead to special assessments or third party financing.
- Tax Implications – Tax implications arise when interfunds are present in the replacement fund. Replacement funds consist of contributions which have been earmarked for capital projects, and as such, those funds are considered capital contributions under IRS guidelines, and are not considered membership revenue. However, when the cash is used to pay for operating expenditures, the tax treatment previously applied to those funds can come into question.
What to do Next?
Once you are aware that interfund balances exist the best practice is to review the annual financial activity to see if the interfunds were caused by any specific projects or transactions during the year. The most simple solution is to simply transfer the required cash between the various fund’s bank accounts. If sufficient cash is not available to satisfy the interfunds, we recommend that Associations work with their Management teams and auditor to arrive at the best solution to eliminate the interfund.