Better Budgeting: Tips to Avoid the Possible Traps

BETTER BUDGETING

Tips to Avoid the Possible Traps

BY DAVID LEVY, CPA

BETTER BUDGETING

According to Merriam-Webster, a budget is “a plan for the coordination of [financial] resources and expenditures.” While most financial and management professionals agree that an annual budget is a good idea, California state law mandates that residential community association members receive one every year. The typical community association budget consists of two parts: the operating budget and the reserve budget. Tips and traps for each are discussed below.

How Much Should Be Budgeted for Expenses?

The operating budget covers most day-to-day expenses incurred by an association: utilities, building and landscape maintenance, management, legal and other professional services, etc. The unwritten rule for the operating budget is that, ideally, the operating portion of assessments (plus any miscellaneous income) should equal operating expenses – with little or no remaining “revenues in excess of expenses” (profit) or loss. Continued on page 16

Most associations create the budget for the next year by looking only at the current year’s budget and actual expenses. A better way to prepare a budget would be to look at the preceding two or three years of actual expenses to detect possible trends that might not otherwise be noticeable. It may be appropriate to consider going out to bid if certain categories of expenses have been trending upward and the expenses can best be accounted for by the price charged by a vendor rather than the usage incurred by the association.

For larger expenses, in addition to considering the possibility of going out to bid, one might contact the vendor for an estimate of the expense amount for the next year. This can be particularly important for certain

expenses that may be subject to less predictable market pressures, such as insurance and consulting expenses.

Unlike individual owners, board members have a fiduciary duty to represent the best interest of all the homeowners, and included in this duty is the long-term funding of reserves.

How Much Should Be Budgeted for Reserves?

When an association begins its existence, the project developer prepares a budget of both operating and reserve expenses. The reserve expense portion of the original developer budget is supposed to cover commonarea major components with a

life of more than one year and, usually, a substantial cost. Reserve items often consist of painting, roofing, paving, and many other larger projects with high costs. In general, the original reserve budget should be computed for each item by dividing the current replacement cost by the useful life of the item. For example, if the roof costs $100,000 to replace in current dollars and is expected to

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last 10 years, then the budget for the roof would call for funding of $10,000 in the first year. In future years, the original cost would be increased by inflation, or the thencurrent cost would be used to calculate the amount of funding.

Once an association is in operation, its board typically seeks the assistance of a professional reserve study company to assist with estimating current replacement costs and useful lives of components. While such firms will generally make recommendations to fund reserves, the board of directors ultimately makes the final funding decisions. Most owners, and perhaps board members, prefer to keep assessments as low as possible. But, unlike individual owners, board members have a fiduciary duty to represent the best interest of all the homeowners, and included in this duty is the long-term funding of reserves. In at least one study of approximately 100 Southern California community associations, a national reserve study company found that there was a significant difference in the market value of well-funded associations compared to those that were less well funded.

In California, there are mandatory financial disclosure laws, but not mandatory funding requirements. In other states, such as Hawaii, funding of reserves is required, but not necessarily as much as the amount of annual depreciation (wear) of all the major components. Based on several large-scale financial surveys of California associations (totaling approximately 55,000 HOAs statewide), most existing associations are only 50% to 60% funded. Newer and larger California associations tend to be a little better funded than the average, and older and smaller associations tend to be less well funded.

What is the risk of underfunding reserves (not keeping up with the expected rate at which the major components wear out)? The simple answer is that the HOA will require a “special assessment” to pay for the repair or replacement of the failed component. In essence, the board will have abdicated its duty by simply “kicking the can down the road” and accumulating financial risk and additional burden on homeowners. The impact of a special assessment, especially on older owners with limited financial resources, could be the difference between being able to stay in

Continued on page 18

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A Final Thought

As with many things in life, the more effort put into something, the better the result. The same is true of the budget process. Starting early and paying attention to budget versus actual monthly expense variances will pay dividends in creating a better budget for the next year.

David Levy is an almostretired CPA and financial consultant who has served nearly 5,000 California community associations over the past 45 years. In addition to extensive financial, tax, and expert witness experience, he has worked with law enforcement, including the FBI, on several theft-of-funds cases. David has also been a prolific author for industry publications and a frequent speaker at events.

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