7 minute read
Understanding Financial Statements
By Hamlet Vazquez, MCAM-HR
A board of directors may be forgiving if, on a landscape walk, you can’t tell the difference between a Pothos and a Philodendron plant. But, on the other hand, if you don’t know if a pre-paid assessment is an asset or a liability, you may need to start job hunting. In writing an article on understanding financial statements, there are two challenges. The first is keeping it exciting. The second is speaking to a broad audience ranging from seasoned managers who are all too familiar with reading financial reports to newbies who maybe didn’t even realize they would need to know how to read a financial statement to be successful in this industry.
As professional managers, one of our primary responsibilities is to help ensure the financial health of the associations we manage, and the financial statement is vital to understanding the degree of that health. Knowing how to interpret financial information is akin to being a doctor assessing a patient’s health or a financial planner analyzing an individual’s financial health.
How, then, do we assess the financial health of an association?
At the most basic level, it starts with proper budgeting. If you don’t budget appropriately for the expenses that you know will be incurred and add some cushion, either by way of a contingency line item or a buffer in each significant line item such as utilities, then the financial health of your association will begin to suffer as soon as the first month of your fiscal year.
With that quick introduction out of the way, let’s look at a typical financial statement.
What is the Financial Statement?
A financial statement is a document that provides an overview of the association’s economic activities every month. It consists of several components that offer a snapshot of the association’s financial position, including income, expenses, assets, and liabilities.
Components of a Financial Statement
No matter the association, every financial statement includes at least the following two components:
Balance Sheet
The balance sheet provides a snapshot of the association’s financial position at a specific point in time. It consists of three main sections: assets, liabilities, and equity.
• Assets represent what the association owns, such as cash, accounts receivable, investments, and property.
• Liabilities represent what the association owes, such as accounts payable, loans, and other obligations.
• Equity is the difference between assets and liabilities.
The balance sheet helps assess the association’s financial stability and solvency by comparing its assets and liabilities to determine if equity has increased or decreased at a specific time.
Income Statement
Also known as a profit and loss (P&L) statement, the income statement provides an overview of the association’s revenues, expenses, and net income (or loss) during a specific period.
• It shows how much the association has earned from assessments, fines, and interest.
• It also reflects how much money was spent on various expenses such as utilities, landscaping, repairs, and staffing costs, to name just a few line items.
• To calculate the net income (or loss), subtract the total expenses from the total revenues. The figure arrived at indicates the association’s financial performance during that period.
Essential Items to Review in a Financial Statement
When reading a financial statement, there are several essential items to look for:
Income And Expenses
Review the association’s income and expenses on the income statement to understand where the association’s money is coming from and how it was spent. Look for any significant changes or trends in revenues and expenses, and compare them to what was budgeted and to previous periods to identify any irregularities or areas that may require further investigation. It is often helpful for the manager to create a variance report for the board that explains in narrative form why the positive/negative variance exists.
For example, if payroll is significantly over budget, the variance report explanation may be, “This is partially due to California’s supplemental paid sick leave for Covid” or “Overtime has been greater than normal due to regularly scheduled staff calling out sick.” In addition, it’s helpful to include an explanation if the dollar amount is large or if the variance is significant as a percentage of the annual budget for that particular line item.
To illustrate, if you budgeted $1,000 for pest control and spent $800 by March, while $800 may seem small, you may want to explain why the first three months of the fiscal year used up 80% of the annual budget.
Reserve Funds
It’s vital to check the association’s balance sheet for the reserve fund balance and compare it to the most recent reserve study update to ensure that the association has adequate reserves to cover major repairs or replacements of common assets like roofs, roads, plumbing, and pools.
Aging Report
Another crucial component to keep an eye on is the association’s delinquency rate. The aging report will indicate assessments and fees that are past due. It also shows how delinquent the debts are. Given that assessments are the lifeblood of any association, it’s essential to review the aging report every month and follow up accordingly.
BAD DEBT V. ALLOWANCE FOR DOUBTFUL ACCOUNTS
Here, you’ll find an explanation of two terms that new managers and board members misuse or misunderstand most frequently:
Bad Debt
Bad debt refers to accounts receivable deemed uncollectible and written off as a loss. In other words, it represents the portion of accounts receivable that the association has determined will not be collected and is therefore treated as an expense. Bad debts typically arise when homeowners fail to pay their assessments and cost-effective collection solutions have been exhausted. As a result, bad debts show up as an expense in the income statement of the homeowner’s association, which reduces the association’s net income.
Allowance For Doubtful Accounts
The allowance for doubtful accounts is a contra-asset account on the balance sheet of the homeowner’s association. It represents an estimate of the accounts receivable that may be uncollectable but still need to be identified explicitly as bad debts. It’s a journal entry based on the board’s assessment of the uncollectible accounts.
To establish the allowance amount, one should analyze historical data, current economic conditions, and specific circumstances related to the association’s accounts receivable. The adjustment aims to reflect a more accurate valuation of the debt on the balance sheet by reducing the gross amount of accounts receivable to the net amount expected to be collected.
In summary, bad debt is the actual amount of accounts receivable deemed uncollectible and written off as an expense. Conversely, the allowance for doubtful accounts is a guesstimate entry on the balance sheet to account for potential uncollectible accounts receivable that still need to be identified as bad debts. Both adjust for uncollectible debts but differ in timing and presentation in the financial statements.
Want to Learn More?
Suppose you want to learn more about understanding financials so you can better advise your clients. In that case, I encourage you to take the following CACM courses because it’s nearly impossible to fully explain or learn the ins and outs of financial statements via an article! And, if you could, it would be such a lengthy article that no one would read it.
So, if you are still confused or want to be better prepared to answer your board’s questions regarding your association’s financial statement, check out the following CACM classes: “Explaining Financial Statements,” “Budgeting for Community Managers,” “Reserves – What, Why, How,” “Assessment Collections,” and “Strategic Financial Planning.”
