January, 19 2018 Published by Toronto and Area Chapter - By Edmund Leong
Warning Signs - Condominium Audited Financial Statements
From the Winter 2017 issue of the CCI Toronto Condovoice Magazine.
If my professional standards would allow, I would fill my audited financial statements with text bubbles, red underlining, yellow highlighter and with today's younger generation's emojis to alert the readers of actual and potential warning signs. Unfortunately, the audited financial statements are meant to service a broad based set of readers, and adding a negative bias to the statements would certainly conflict the auditor. Most of all, the lack of professionalism of having on the statements an unhappy face with tears spraying out of both eyes would certainly put me under disciplinary review.
Having attended over 750 annual general meetings in my entire career, I have found that the majority of the readers of the financial statement are unit owners who likely only see one set of financial statements a year. There are those who study public company financials for their investments or look at their own business' financials; however, the condominium statements are quite different due to the disclosure and funding requirements as required by the Condominium Act and audit standards.
I believe that if the auditor, board, management and owners can get a deeper understanding of the financial statements, there would be less conflict as the communication lines as well as transparency are spearheaded by the disclosures in the audited statements.
Taking the statements from back to front front, in my opinion, is the best way to read the statements. The notes to the statements are a wealth of information, and sometimes the numbers do not tell the entire story.
Notes to the Audited Financial Statements
One of the greatest caveats that can be placed on the audited statement is the contingency note. In the event there is a reasonable possible loss that eventually will be incurred, the statements must disclose the details of this potential loss. However, if the loss is highly probable and subject to reasonable estimation then that loss would have been already reported as a liability. The warning signal here is that trouble is looming ahead, and owners should be aware of such matters to prepare themselves for this issue. A good example of a contingency is a lawsuit commenced against the condo for a slip and fall case due to negligent snow removal. Owners and prospective buyers should educate themselves on the potential that this contingency may end up becoming a liability which in turn would either increase condo fees or force the board to levy a special assessment to cover the costs of both the legal fees and the settlement.
The commitment note disclosure is a disclosure where the condominium has entered into a financial agreement bound by contract. Where this becomes a warning sign is when a large commitment has been entered into after the year end. A large commitment would be, for example, a contract to replace the roofing subsequent to the corporations' year end. Given that such a large project would have likely been budgeted for in the reserve fund study, the reserve fund would likely have room to absorb this cost. However, if the roofing work arose much earlier or was more costly than expected, then the burden of such work could also result in a special assessment from the owners. The board and management should have a good understanding of the major project, as well as should have consulted with the engineer about the major commitment. Owners should become aware of large future projects and ascertain if there is any future financial impact to their condo fees accordingly.
Subsequent events are material events that occurred after the fiscal year end of the condo and up to the auditors' report date found on the auditors' report. Generally, the matters disclosed as a subsequent event can be legal, financial or both in nature. The auditor should have inquired with the board, management as well as the condominium's lawyer to ensure that all material subsequent events are adequately disclosed. The subsequent event note, where financial and legal problems exist, provide a valuable window for warning signs of issues that will arise in the next fiscal year. Having a handle on these issues and keeping all parties informed of progress in the current fiscal year increases both transparency as well as trust with all parties involved.
Emphasis of matter note disclosures come about when the condominium corporation has materially violated the act and its regulations. These note disclosures would appear after the audit opinion as well in the notes to the financial statements. The appearance of these notes would indicate that there has been some carelessness with respect to the handling of both the financials and as well as the operations of the condo under the Condo Act. The most common violations that I come across include the improper handling of the reserve bank accounts and its investments. Some of the main rules which are commonly violated, are as follows:
- The total of the reserve cash and the reserve investments have to be greater than or equal to the reserve fund balance;
- The corporation must maintain at minimum an operating and a reserve bank account;
- The bank accounts need to be in the name of the condominium corporation
- Reserve fund investments must be eligible (typically GIC, Government Bonds, and TBills);
- The condominium corporation must have a borrowing bylaw if it chooses to take on debt; and
- The reserve fund study must be updated every three years.
Repetitive and numerous violations are a strong indicator that there is wanton disregard for the act and sends a warning signal to readers that the corporation is not well managed. Trust for those in the fiduciary role would be weakened and gives for poor optics of transparency.
Statement of General Fund Operations and Fund Balance
This statement is commonly known outside of condominium corporations as the income statement. I find that, at some of the AGM's that I present at, there are often questions about the adequacy of the ending general fund balance, which is essentially the cumulative excess of income over expenses (surplus) or cumulative excess of expenses over income (deficit). The industry rule of thumb is that the surplus should equate to 2/12th of the annual budgeted expenses. This rule of thumb essentially allows for some buffer in the event that unforeseen expenditures arise and to allow for positive cash reserves for large expenses that may occur in one month over another. However, the rule of thumb should factor in the time of year the corporation's fiscal year ends at. If the condo's year end is in the winter months, the surplus may be non-existent as it is burdened by larger-than-average utility bills. The warning signal should be raised where there are perpetual deficiencies below the rule of thumb. I find that condominiums that have an extreme amount of pressure from owners demanding that the Board not raise condo fees in light of increasing expenses, end up in this situation. This then in turn causes deficiencies in attempting to keep up with ongoing expenditures and as well keeping the reserve fund in line with the funding plan.
Large variances between the actual expenditures versus the budget and the fiscal year are warning signs that there were unforeseen expenditures that attempting erode the surplus. The reader of the statements should pay particular attention to variances in utilities as they can make up 30-40% of the total budget in some condominiums. Increases in demand or rate changes can cause havoc to the corporation as the reaction time to increase condo fees may not happen until near the end of the fiscal year, which may only correct the following year's utility charges. However, this would still leave a shortfall in the current year over expenditure. Astute management should catch onto this trend early enough to buffer in an increased budget in the following fiscal year and convey to owners early enough the reasons and the necessity of the increase in condo fees.
Another line item on the statement that can trigger a warning signal is a substantial increase in legal fees. This may indicate an ongoing lawsuit which may cause contingencies for the corporation or there may be substantial changes to the corporations bylaws. In either event, the reader should be warned and become aware of the reasons for the increases in such fees to ensure they can discuss with board and management the legal and financial implications of the advent of increased fees.
Statement of Reserve Fund Operations and Fund Balance
This statement shows the activity inside of a corporation's reserve fund including the opening balance, transfers to reserve, investment income, expenditures and ending balance. Generally, if the engineer predicts accurately the required annual expenditures, the reserve fund ending balance on the reserve fund statement should follow the engineer's cash flow summary. If your ending reserve fund balance has a large variance (eitherpositive or negative) it, is a warning sign that the board elected to chose a different path than was prescribed by the engineer. At times, there may be some solid reasons for spending more ,such as an unforeseen expenditure, cost increases, or compliance with code. On the other hand, if necessary expenditures have been intentionally delayed, this may mean that the item outlived the engineer's expectation or in the worst case scenario, the board decided to defer necessary maintenance. In any event, readers of the financial statement should be reading the reserve fund statement alongside with the engineers report and should query the variances and the reasons for the variances against the study.
Statement of Financial Position
Commonly known as the balance sheet, this statement discloses the assets and the liabilities of the corporation. Typical warning signals here would be excessive accounts receivables and or accounts payables. Condo corporations fortunately have the right to lien unit owners for the collection of receivables; however, this process is not timely where the corporation requires cash over its receivables. Good management should have receivables down to a manageable level and not allow for any condo fees to go outstanding more than 60 days. Care should be taken to differentiate condo fees, receivables, and interest receivables, which is interest on investments earned prior to maturity. Large payables, on the other hand, also indicate cash flow issues as the timely payment of the vendors has been delayed due to a shortfall in cash. This duality of the problem that this creates is that vendors become less responsive to the corporation's needs when called upon if they are owed funds. The quality of service, as well the appearance of corporation can be hampered quite noticeably. Think landscaping and snow-removal.
The auditor's report is the auditor's opinion as to whether the statements are free of material misstatement. If there is no reservation of opinion, then the statements are adequately presented. To be clear, a clean audit opinion does not necessarily mean that the condominium is in good financial shape. However, in the case where there is a reservation of opinion, this is the auditor's formal warning signal which indicates that there generally has been some information or documentation that the auditor could not gain access to form his or her opinion. This is not a great situation for a condominium to be in as it really casts doubts for the reader as to why documentation went astray or was perhaps hidden from the auditor. The warning signals of poor record keeping or, in the worst case, fraud, could exist as the auditor could not verify the completeness and the existence of expenditures, revenues, liabilities, and/or assets.
Having all parties become educated readers of the financial statements enhances the relationship between owners, management and the board. The audited financial statements tell part of the story and the rest can be simply followed up on management and the board via regular communication, alignment of objectives, and expectations. Smiling face with open mouth and smiling eyes emoji.
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