Funding the Reserve Account – It’s Not an Expense
I think that one of the toughest concepts for folks to understand during the FHA condo approval process is the balance sheet – assets, liabilities and equity. I am by no means professing myself to be an expert; I’ll get back to you after I take an accounting class this year.
But at this point, I know enough be dangerous and I am able to understand and explain the financial statements for condominium projects.
As I have written several times previously, one of the items that FHA investigates is how much the HOA is contributing to its reserve account annually. If you were to scan FHA’s Approved Condos list for the reasons why projects are in Rejected status, one of the most common reasons is insufficient funding of the reserve account. When this happens, FHA will request that the HOA get a reserve study done.
I am an advocate for reserve studies. FHA’s rule of thumb for transferring 10% of the annual budget to the reserve account may or may not be an adequate set-aside for future repairs and improvements. Obtaining a reserve study from a professional can make certain of this.
FHA requires certain pieces of financial information to be submitted for project approval: (1) current fiscal year’s approved operating budget, (2) previous fiscal year’s income/expense statement and (3) balance sheet dated not more than 90 days prior to review by FHA.
FHA requires that 10% of the annual budget be transferred to the reserve account for future capital repairs. This must be a designated line item and it can’t be whatever is left over at the end of the year. This must be on the budget and it must be demonstrated that this contribution was made the previous fiscal year.
It is easy to show on the budget; it’s either there or it isn’t. It’s easy to see the balance of the reserve account because it’s on the balance sheet.
However, one of the issues that we often run into is using the income/expense statement to demonstrate that the 10% contribution was made the previous fiscal year. This is because of accounting practices. Professional accountants would not include the funding of the reserve account on a line item in the expenses because it’s not an expense; it’s a transfer of equity.
Throughout the year, the HOA collects common charges from the unit owners and disburses them to different accounts (line item expenses) such as insurance premiums, landscaping, property management…even to an consultant for FHA project approval. In addition, a certain percentage is transferred monthly (or at least it is supposed to occur monthly) to a reserve account.
This transfer of money is not an expense to the HOA because it is transferring the money from one of its accounts to another. It is merely building equity. This should not be shown on the income/expense statement because it’s not an expense. It would appear on the balance sheet as an increase in equity. The income/expense statement just shows a net profit at the end of the year for around the amount that was transferred to the reserve account.
In a perfect setting, like with one condo project that we are currently assisting, the HOA did not use any reserve funds during the last fiscal year. Thus, the increase in the reserve fund increased by what the HOA contributed, which was a little more than 10% of the budget. We can show this by providing last year’s balance sheet and this year’s.
However, most HOAs use reserve funds for capital projects intermittently or even every year. FHA allows HOAs to use reserve funds for capital projects. So the question becomes: if the HOA contributed $100,000 to the reserve account but spent $100,000 in capital projects, did it make the proper contribution to the reserve account?
The answer to this is yes, however, we have to appropriately show it to FHA. Many accountants won’t place the contribution to the reserve account on the income/expense statement because…say it with me…it’s not an expense. In these cases, the best way to demonstrate that this contribution was made is to show an audited financial statement which breaks down the two funds: operating and reserve. This way it shows the income and expenses for both funds separately and we can show that the proper contribution was made.
Proceeds from loans, principal buy-downs (annual principal payments) and the outstanding principal balance are handled in the same manner, but I won’t get into that now.
Top image courtesy of Stuart Miles/freedigitalphotos.net
Lower image courtesy of PANPOTE/freedigitalphotos.net
The Condominium Project Approval Team at ReadySetLoan is dedicated to helping condominium projects across the nation to obtain their approvals with FHA and the VA or become recertified with FHA. We have assisted nearly 200 condominiums and we can help your association.
ReadySetLoan is an active member of the Connecticut and New England chapters of the Community Associations Institute (CAI) and is a frequent contributor to Common Interest Magazine as an expert in FHA/VA condominium project approvals.
Please contact us with any questions regarding FHA or VA condominium project approvals. You can email me at email@example.com or call me at 404-433-4565. I will be happy to answer any of your questions.
FHA/VA Condo Approval Specialist
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Check out our article in Common Interest magazine on page 19!