For Budgets, Your Best Guess is Not a Best Practice
One of the more challenging tasks an association board faces every year must be their annual budget. Requiring the number-crunching aptitude of skilled accountants, coupled with the board’s clairvoyance to predict not only repairs needed in the year ahead but also global inflation, budgeting is not to be approached without careful introspection into the facts and figures of the community. We spoke with John Grady, CPA of Bogush & Grady CPAs, LLP in Rhinebeck, New York for an accountant’s insights on this topic.
What are some of the most common mistakes associations make when doing their annual budgets? “One big mistake that I see a lot is that the amount [associations] budget in reserve contributions is a number that they either plug in to balance the budget, or it’s a number that isn’t grounded in reality or a reserve study for that matter,” said Grady. “Associations can have an engineer do a reserve study that can identify what that reserve contribution should actually be, as opposed to it being a guess,” he added.
When coming up with a new budget, a common mistake Grady sees is the board not considering prior years. “The other thing I see is they don’t take into account a prior year’s profit or loss,” he said, “obviously, the loss is more important.”
“If there was a loss in a prior year, the association should be trying to make that up in the next year. Conversely, if there’s a profit, they should consider the fact that they’re carrying a profit into the next year. That should be taken into account for budgeting purposes,” said Grady.
The budget’s main goal is to set the correct amount for the association fees, otherwise known as assessments, dues or common charges. “When association boards are doing these budgets, what they’re trying to get at is what the common charges are going to be. If there’s a profit for the prior year, conceivably the monthly common charges could be less than they would be if they didn’t take into account the prior year’s profit,” said Grady. “Likewise, if there’s a loss in the prior year and they don’t take that into account, then the common charges that they are going to charge the unit owners wouldn’t be high enough, because they should be trying to make up the prior year loss.”
Proper accounting for profits or losses is important for the integrity and exactness of the budget. “A lot of times, if there is a profit it goes into the reserve fund. If there isn’t it doesn’t. If they need extra money, they take it out of the reserve fund. Then the reserve fund isn’t a scientifically derived number that makes sense. It’s just ‘the best savings we could do,’” he said.
Grady stressed the importance of an accurate, professional reserve study. “The reserve study will tell the association exactly what the annual contribution should be [toward the reserve fund] in order for there to be enough money to do repairs and replacements when the time comes. So without that, it’s kind of a best guess scenario.”
So how can boards ensure they’re fulfilling their fiduciary duty when creating their budgets? “A big part of this whole thing is the reserve,” said Grady. “That’s the long term part of the budget. If they don’t do it right, they’ll be staring down major expenses.”
Grady pointed out some practices that can take the guesswork out of the equation. “What they need to do is be diligent when it comes to the normal operating expenses. They need to see how many contracts they can get in place,” he said. He advised that boards ask themselves questions such as: what is our snow removal going to be; what is our landscaping cost going to be; what projects do we plan on doing this year that we can put in the budget so that there’s less surprise and more of a plan?
Grady explained that there are budget line numbers that can be exact with proper planning of annual costs. “What is our pool going to cost this year? Let’s talk to the pool management company and see what their prices are going to be. Let’s try to make this budget number a good number as opposed to a guess,” he said.
He went on to use another example that involves a renewable contract — landscaping. “Are we dealing with a three-year contract that we’re in the second year of so we know exactly what the number is going to be? Or are we going out to bid again? If we are going out to bid again, let’s go out now, so we know when we put together the budget what those prices are going to be, and it’s less of a guess.”
Should the board include a budget line for emergencies? “Sometimes associations have a miscellaneous line. But most of the surprise stuff is going to be repairs and maintenance that they weren’t anticipating. It’s more important to have that line item appropriately sized for what they think is coming up.”
The right way to handle an unforeseen expense is again, to have a strong reserve fund. “If the roof fails, that’s more of a reserve expense,” said Grady. “That’s going to fall outside of the actual budget itself. The reserve money is used for that.”
“The reserve fund’s main function is to have a systematic, planned savings that yields having the money there when they need it. The reserve funds aren’t legally restricted, so if something happens they could borrow from the reserve fund and then pay it back,” Grady added.
What are some of the options for associations if there is a shortfall in the budget? According to Grady “the next year they would need to take that into account and try to recover it.”
For example, Grady explained “let’s say you have a $20,000 loss this year. Next year, in a perfect world, you want to try to make it so you have a $20,000 profit.”
What should associations do if there is a budget surplus? “Assuming the reserve savings is being done correctly, if they have a $20,000 profit, next year they should be budgeting for $20,000 loss,” says Grady.
He suggested another option for surpluses in associations with less than accurate reserves. “If the reserve savings is not as scientific as one would want in a perfect world, in that case, if they have a surplus it may be prudent just to put it in the reserve fund as opposed to using it the next year on operations,” he said.
Grady offered another option that doesn’t appear to be used that often. “They could theoretically refund [the profit] to the unit owners, but I’ve never seen that happen,” he said.
Is the manager, accountant or board typically in charge of an association’s budget and its accuracy and workability? “The board is ultimately responsible,” said Grady. “They may hire a management company to help with certain functions. The property management company’s expertise may come into play in developing a budget. But ultimately the board needs to approve it. It is ultimately their fiduciary responsibility to run the association the best way that they can and to prepare for the future.”
Again the reserve study comes into play. “If they relied on the reserve study that was done by an engineer, in good faith, they are going to be fine in their fiduciary responsibility,” said Grady.
Grady pointed out that acting in good faith is multifaceted. “Did they act in good faith? Did they do the best that they could do? Did they do their due diligence? Did they figure out what they should be putting in the reserve fund, what the budget numbers should be, or did they do more guessing than that?” he posed.
Another mistake boards make when budgeting, Grady pointed out, is that some budgets are built in a backward fashion. “A lot of times what you see is the budget is dictated by what they want the end result to be, as opposed to the other way around. They enter into the budget saying we’re not going to increase common charges and we’re going to make them work one way or the other. That’s where it becomes problematic,” he said.
Grady said it is faulty logic to think that association fees won’t go up, because the costs of things in general typically rise every year. Common charges have to go up at least the cost of inflation. “If you were increasing common charges two, three, or four percent a year, you wouldn’t get hit with a big increase in one year,” he said.
Finally, in looking for the best way to present the budget and communicate any surplus or shortfall to owners, according to Grady, is through transparency. “The best way for them to do it, whether they legally have to or not, is to just present the budget. Let the membership see the budget,” he said. He said to tell them ‘this is what it costs to run our association. This is the document by which the common charges for next year were derived.’
“Full disclosure. That would be my opinion,” he said.