Part of preparing the annual budget for a community is either creating, reviewing or updating the Reserves for Replacement Analysis.
What are Reserves?
Reserves are monies set aside for the future replacement or renovation of the major community components. Every major improvement to the community that the community is responsible to maintain, such as driveways, parking lots, street lighting, playground, pool, roofs, painting, etc. will eventually need major renovation or replacement. Therefore, a reserve “fund” should be set up for each of these major assets the community is responsible for.
Reserves vs. Maintenance
There is a distinction between “Reserves” and “Maintenance Expenses” which are part of the yearly operating expenses, like lawn maintenance. “Reserve Contributions” are accumulated for years until the component needs replacement or renovation. In effect, the Reserve Contribution each owner makes as part of their annual community assessment pays for the wear-and-tear and deterioration of these assets during the time the owner owned a home in the community—it’s similar to funding depreciation of an asset’s replacement cost.
What should our Reserve Contribution Be?
The tricky part of preparing or updating a Reserve Analysis is knowing how much the annual Reserve Contribution should be, because doing a reserve analysis means looking into the future and predicting when an asset will need to be renovated or replaced and how much it will cost at that time. It means literally:
- Identifying all the replaceable assets and listing them
- Identifying their current condition
- Forecasting when each might need to be replaced
- What the cost will be, and
- How much money was already been set aside for each asset in the existing Reserve Fund—which should match an actual bank account balance kept separate from the operating funds of the community (the funds that pay the annual expenses of the community).
Thankfully, there are a number of reserve analysis companies and reserve analysis software, as well as engineering companies, that can help with creating or updating a Reserve Analysis. While a management company can do an acceptable job of creating or updating a Reserve Analysis, I think it would be in the best interests of every community to have a professional reserve company or engineering firm prepare or update the Reserve Analysis every few years.
Fully funded vs partial funding
There is a long-standing debate as to what percentage of the replacement cost should be funded by the Reserve Contribution. There are many differing views on this because the Reserve Analysis is a forecasting tool rather than an exact science. Some communities budget the full 100% forecasted replacement cost for each asset, while others fund a portion of it, like 60% or 75%. The argument for funding only a portion is that, frequently, an asset can be renovated rather than replaced thus saving the cost of 100% replacement. There is good logic behind either budgeting for 100% replacement cost (most conservative) or budgeting for some percentage of the full replacement cost—so I cannot give any firm guidance here, just raise the issue for your consideration.
The annual Reserve Contribution has to be considered when preparing the annual budget because each owner must pay their fair share of the Reserve Contribution as part of their overall annual assessment amount. This should be based on a Reserve Analysis rather than just “winging it”, which means, using a more scientific approach to determine the amount even though, by its nature, a Reserve Analysis can never be 100% accurate.
Reserves as a Part of Fund Accounting
The reserve funds must be kept in a separate bank account from the operating funds. if they are not, the IRS can look at them as taxable income to the community. This is called “Fund Balance Accounting” where community funds must be kept track of by their fund type—typically “Operating”, “Reserves” and “Other”. The AICPA Guidelines* for community association accounting recommend reporting on a fund balance basis.
Proper Reserve Fund Accounting requires keeping reserve funds separated from the operating funds of the community. This means you’ll need to actually move money earmarked for Reserves from the checking account where the total maintenance fee income is deposited, over to a separate bank account where the Reserve Funds are kept on deposit.
Normally, a check is issued from the Checking Account for the amount of the Reserve Contribution for each month as authorized by the Board of Directors when they approve the yearly Budget.
Spending Reserve Funds
Since Reserves are a direct contribution to Capital, they must be removed from the Income/Expense Statement so they do not inflate the Net Income of the Community. Likewise, when Reserve Funds are spent, you do not want to run the expense back through the Income/Expense Statement since this would also affect the actual Net Income for the year.
Instead, Reserve expenses should be charged directly against the Reserve Fund balance in the
Equity section of your Balance Sheet. Your gross maintenance fee income normally includes a contribution to Reserves, but this portion of the income is not available to pay your operating expenses like Electricity, Insurance, etc. Therefore, you must take it out of your Income/Expense section of your General Ledger so it does not affect the operating income or Expenses for the current year. This is normally done by journal entry.
Whenever Reserve Funds are actually spent, there are typically two steps to handle this situation:
- Move Money to Checking
Once the Board of Directors has approved an expenditure from Reserves you must move the money to pay for the cost of the work from the Reserve Savings, or other bank account, back to the Checking Account so the bill can be paid. This is normally handled as a money transfer.
- Charge Against Reserve Fund Balance
The check you write to pay for the reserve expense should be charged against the Equity account for the Reserve Fund where the money was spent. Do not charge the check against the Reserve Savings Account since you have already moved the money out of there when you did step #1.
NOTE: Do not expense this amount against an Income/Expense account in your General Ledger. It should have no affect on your Income/Expense Statement at all since you are simply spending a portion of the Community's Equity (contributed capital).
At the end of the day, every Board needs to make the decisions that are right for their own community. As a community association management professional, the most important thing you can do for the communities you manage is ensure there is a strong reserves policy in place, and that you are properly handling the funds in your accounting department. I strongly recommend that you look into an accounting package that is designed for managing community associations so you can avoid potential problems that off-the-shelf accounting packages introduce to this process.
* AICPA Audit and Accounting guide for Common Interest Realty Associations: This item must be purchased from the AICPA library. However, the University of Mississippi has generously provided a scan of this document circa 2003 for online review. Use the thumbnails on the right to navigate the document.
*Image credit: Horst Schwalm via Pixabay