As Board members and unit owners receive copies of their Association’s annual audited financial statements, the issue of Interfund Balances often surfaces. We have updated this article, which we originally published over a decade ago, to explain what Interfund Balances are, why they exist, and how Associations should deal with them.

Fund Accounting – The “Envelope System”

As we have discussed in this publication on a number of occasions, most Associations follow the principles of Fund Accounting in order to ensure observance of limitations, restrictions, and accountability placed on the use of their available resources. This allows Associations to track financial transactions by major type of activity.

A good way to think of fund accounting is to think of the “envelope system” that might have been used by your parents or grandparents to manage their financial affairs. As recently as a generation or two ago, it was not uncommon for monies to be segregated into various envelopes: one for the rent, another for food, yet another for utilities, etc. (You may even know someone who still uses this system!) Ideally, the monies in each envelope would be used only for the intended purpose. In addition, there would be enough money in each envelope to cover the planned expenses and monies would not have to be “borrowed” from one envelope to another.

Fund accounting is conceptually the “envelope system”; it uses separate bank or brokerage accounts instead of envelopes. Ideally, in fund accounting, each fund should:

  • Stand on its own.
  • Be segregated and kept in separate bank or brokerage accounts.
  • Be used only for its intended purpose.

This approach helps to ensure that sufficient funds will be available to pay for the particular fund’s designated expenditures, and that monies will not be “co-mingled” – that is, loaned/borrowed between/amongst funds.

Typical Association Funds

While Associations may establish any number of funds, the three most common funds are described in the following table:

 FUND PURPOSE  SAMPLE EXPENDITURES
Operating Daily operating expenses Lawn care, snow removal, managementexpenses, professional fees, etc.
Deferred Maintenance Scheduled maintenance expenses Painting, staining, caulking, etc. that recur on a less than annual basis
Replacement Accumulates monies over the lives of capital assets to ensure sufficient funds are available for the asset’s eventual replacement Roofs, sidewalks, swimming pools, etc.

At times, other special purpose funds are designated; these may include:

SPECIAL PURPOSE FUND DESIGNATION
Capital Improvement Future capital improvements (as opposed to capital replacements)
Sponsor/Developer Settlement To rectify construction defects (paid for by a sponsor/developer)
Tree Settlement To account for monies received in the Imprellis settlement

The Reality: Interfund Balances

Although the vast majority of Associations do maintain separate bank and/or brokerage accounts for each fund, the reality of Association financial life is that Interfund Balances are not unusual. A variety of circumstances may contribute to the creation of Interfund Balances including:

REASON FOR INTERFUND BALANCE CREATION POSSIBLE CAUSE
Cash Flow Associations earmark a certain amount of money per year for the Replacement Fund, but the Association lacks the sufficient cash flow to do so. As a result, at the end of the year, the Operating Fund “owes” this shortfall in funds that were not transferred to the Replacement Fund
Investment Considerations An Association does not want to prematurely break a certificate of deposit which is due to mature, so another fund “fronts” the money for a given transaction
Timing Issues Immediate need or desire for maintenance; lack of sufficient funds in the Deferred Maintenance account causes the Association to “borrow” from another fund, which will be replenished in future budget periods
Bookkeeping Procedures Checks are issued from the Operating Fund for all expenses; monies are then transferred back to reimburse the Operating Fund
Mislabeled Bank Accounts Incorrectly labeled bank account; (for an example an Operating account is labeled as a Deferred Maintenance account)
Disbursements from Incorrect Fund A major repair or replacement was made that should have been funded by the Replacement Fund; instead funding came from the Deferred Maintenance or Operating Fund account

 

“Interest” ing?

Another item that often adds to the creation of Interfund Balances is interest (and other investment) income. Before the beginning of each year, most Associations prepare and approve a budget that both estimates the Association’s expenses, and establishes the level of assessments for the coming fiscal year. The budget reflects the expectation that interest income will either be retained by each respective fund, or will be allocated to the Operating Fund.

“The goal of each fund is to ‘stand on its own.’ The bottom line, therefore, is that money should be transferred between and/or amongst funds, so that no fund owes any money to another fund.” 

If the budget calls for each fund to retain its own interest income, and each fund actually does earn and keep its own interest income, then no additional Interfund Balances are created. However if, for example, the budget calls for some, or all interest income to be utilized by the Operating Fund and the interest income is not physically transferred to the Operating Fund from the other funds, then Interfund Balances are created.

A Taxing Situation

Income tax payments on investment income can further complicate the situation. Some Associations budget for, and pay the income taxes due on all Association interest income out of one fund, usually the Operating Fund. Other Associations, however, budget for each fund to pay the income taxes applicable to the investment income earned by each respective fund. If, however, one fund (i.e., the Operating Fund) issues the check for all of the taxes due, then an Interfund Balance is created. These other funds would “owe” the Operating Fund the amount of income taxes paid on each fund’s behalf.

One last note should be considered regarding income taxes. Associations (other than co-ops) can file Federal tax returns under either Internal Revenue Code Section 528 (as a Homeowners Association) or under Internal Revenue Code Section 277 (as a regular corporation). While it is beyond the scope of this article to discuss the implications of Association filing status, it should be noted that Associations choosing to file as regular corporations are at greater audit risk if large Interfund Balance are not rectified.

How Do I know Whether My Association Has Interfund Balances?

Interfund Balances can be identified by looking at an Association’s balance sheet. Interfund Balances are usually shown as the last line in the Asset section of the balance sheet. If a columnar format is used, the Totalcolumn will be a dash or zero. The other columns will be positives and negatives that “net” to zero. (On some financial statements, the Due To line will be shown in the liabilities section.)

The following table will help to illustrate our point:

Sample Condominium Association Balance Sheet
12/31/20XX
ASSETS OPERATING FUND  DEFERRED MAINTENANCE FUND  REPLACEMENT FUND 
Cash (and cash equivalents)  $185,954  $10,000  $200,000
Money market mutual funds  –  –  –
Certificates of deposit  –  –  139,479
Accrued interest receivable  –  –  4,906
Assessments receivable, net of allowance for doubtful accounts of $15,500  9,234  –  –
Prepaid Insurance  14,750  –  –
Property, plant and equipment, net  6,286  –  –
Interfund Balances  (45,963)  –  45,963
 TOTAL ASSETS $170,261 $10,000 $390,348

For example, let’s assume that OPERATING FUND shows ($45,963) on the Interfund Balances line and the REPLACEMENT FUND shows $45,963. This means, that as of the balance sheet date, the OPERATING FUND “owed” the REPLACEMENT FUND $45,963.

Because there are so many possible ways for Interfund Balances to occur, many Associations wait for the conclusion of the year-end audit to make sure that exact interfund numbers are identified. Often, the auditor’s Letter of Communication that accompanies draft and/or final financial statements indicates what these numbers are.

As we discussed at the beginning of this article, the goal of each fund is to “stand on its own”. The bottom line, therefore, is that money should be transferred between and/or amongst funds, so that no fund owes another fund any money. While this seems relatively straightforward, the practical application of these principles should consider the following issues, as appropriate.

  • Audits are conducted and discussed with Associations’ Boards after the close of the fiscal year. Although the Letter of Communication may indicate the amounts that should be transferred, make sure that the amounts were not already transferred during the time in between the end of the fiscal year and the review of the audit.
  • Boards should have a clear understanding with their managing agents regarding the procedures that will be followed to authorize and make the required transfers. Some managing agents automatically move the funds as recommended in the Letter of Communication. Other management companies wait for the Board’s directive to take the appropriate action. Still others start the process and then get the appropriate Board approvals. Communication “before the fact” can help avoid uncomfortable situations regarding the authorization and appropriate timing of these transfers of monies.
  • Don’t ignore Interfund Balances and allow them to grow larger with each passing year. This will compound the problem, and often creates confusion and difficulties for future Board members as well as cash flow challenges.
  • Make sure that all bank and brokerage accounts are appropriately labeled. Mislabeled accounts can create confusion and cause unnecessary time and resources to be expended to identify and correct the cause of an interfund problem.
  • At times, there may be insufficient cash flows to make the required transfers. Often, this is due to a cumulative deficit in the Operating Fund. If this is the case, the Board should adopt a plan to extinguish the deficit and eliminate the Interfund Balances over time.