Has your association needed to replace a major common element earlier than anticipated? What if the actual expense to replace a common element exceeded the estimate in the engineering study or wasn’t included in the engineering study at all? In many instances, to maintain property values and uphold the safety of the residents in the community, these unforeseen projects may not be delayed and require immediate attention. This is a common issue that many Associations have been faced with in recent times. If this is the situation your Association is dealing with currently, or will need to deal with in the near future, here are some guidelines to adhere to before making any costly decisions.
In order to pay for a major project, the Board of the Association has a few options; they can use funds set aside in the replacement fund, utilize a cumulative operating surplus, obtain funds through bank financing, approve a special assessment to the unit owners, or any combination of these options. Each of these options has its nuances so it is critical to understand the impact of each of the decisions to the Association.
First and foremost, the Board needs to understand the scope and total cost of the project. One way this can be done is by engaging an engineer to assist with the navigation of the project. This will help the Board Members gain an understanding of the extent of the project and will be useful when obtaining bids from contractors. It is a best practice for the Board to receive a minimum of 3 to 5 bids when going out for major projects. This ensures the Association is getting exactly what they want to be done at the best possible price.
Once the Board knows the total cost of the project, it is time to figure out funding options. If the common element being replaced is included in the engineering study, and the Board is funding in accordance with study, a portion of the replacement fund may be utilized. Furthermore, if the Association has a large operating surplus, this may also be used to offset a portion of the cost of the project. In some instances, the replacement fund or operating surplus may not be enough to cover the entire cost of the project. Any difference between the total cost of the project and the available funds will likely need to be financed through the bank. Just as it is best practice to obtain multiple bids for a project, it is also important to interview banks and identify the one with the best terms. Please keep in mind, not all banks and lending institutions extend loans to community Associations. The main reason for this is that Associations do not have fixed assets, which makes securing the loan with collateral different than regular Corporations. There are banks that specialize in lending to Community Associations. As something to consider before securing a loan for the project, it may be beneficial to include a small contingency for any potential overages to avoid any setbacks in the completion of the project. It is usually unlikely that a large scale project is completed less than or equal to the original quoted amount.
In conjunction with obtaining the loan, the Board Members will need to determine how the loan will be paid back – either by increasing regular maintenance assessments or by approving a special assessment. The preferred method to pay back the loan is to approve a special assessment that is equal to the loan principal plus interest and that will coincide with the timing of the start and end date of the loan.
It is prudent for the Board to ensure that they are following all the requirements in their governing documents when obtaining the loan and approving the special assessment. In addition to the Board approving these options, the Association’s governing documents may require a vote of the community or have strict guidelines on the process. It may be beneficial for the Board to consult with their attorney to ensure they are in compliance with their governing documents.
Once all of these decisions have been approved by the Board, it is critical to understand the impact to the financial statements and subsequent budgeting periods. For purposes of this article, we will go into detail if the project is in the operating fund or the replacement fund.
In an instance where the project was not included in the engineering study, the Board may decide to utilize the operating fund for the project. For accounting purposes all the transactions will be shown in the operating fund. The total amount of the loan payable will be a liability on the Association’s balance sheet. The project cots will be recorded as an expense as they are incurred in the operating fund on the statement of revenues and expenses. The special assessment will be recorded as revenue in the operating fund equal to the annual debt service repayment total. The Association’s monthly debt service repayments will consist of principal and interest. The portion of the repayment that is allocated to interest will be reported as interest expense on the profit and loss statement and the portion of the repayment that is allocated to the principal will be reported as a reduction of the total loan balance on the balance sheet. The Board must include a line item in the operating budget to account for the total annual debt service payment, which includes both the principal and interest portion. Something to note, when comparing the actual interest expense to the budgeted annual debt service repayment; there will be a difference which is equal to the amount of the annual debt service repayment that is allocated to the loan that was used to reduce the loan balance on the balance sheet. In addition, the special assessment should also be budgeted for as revenue line item each year. This ensures that there is enough budgeted revenue allocated to repay the loan.
In the other scenario, where the Board Members decides to utilize the replacement fund for the project, all of the accounting mentioned above will be recorded in the replacement fund—which results in a few additional updates to the Association’s annual budget. Even though the actual costs of the project are being funded through the replacement fund, the Board still must budget for the debt service repayments and special assessment within the operating budget. This is where the most important caveat to the utilizing the replacement fund lies. The budgeted debt service repayment included in the operating fund budget will act as an additional contribution to the replacement to offset the interest expense and principal loan payments made during the year that are recorded in the replacement fund. This will ensure the replacement fund balance is not being depleted and funds will be recouped to offset these loan payments being recorded in the replacement fund. If this debt service repayment is not included in the budget AND NOT allocated to the replacement fund, the replacement fund will have incurred all the project costs, resulting in a greatly reduced replacement fund balance with no plan to replenish the fund over time to offset the deficit created by the project.
As you can see, the funding of a major project has many nuisances. It is prudent for Board Members to understand these nuisances and do their homework before making any decisions. The accounting and budgeting for the debt service repayments can get convoluted – especially when the project is in the replacement fund, which tends to be the more common situation. WilkinGuttenplan is here for to help you navigate these difficult accounting situations.