The Road Map

It has been said that "money speaks in a language all nations understand." Yet what if you don't understand how your money is being spent? In normal situations that is bad, but in the case of a co-op board, which is responsible for the financial well-being of a corporation, it can be catastrophic.

From tenant arrears and mortgages to underestimating for needed repair work, understanding financial statements is crucial. The statements are the backbone of the industry. So if you're buying into a co-op or joining a board of directors, how do you read one?

To begin with, a co-op's financial statements consist of several parts: the opinion letter, or auditor's report; the statements (balance sheet, statement of income and expenses and deficit, and statement of cash flows); and footnotes.

The auditor's report, which is usually addressed to the tenant-shareholders and/or the board, should be what is commonly referred to as a "clean opinion." What that means is that the auditor takes no exception to the statements, and gives his opinion that they "present fairly" the financial position of the enterprise at a point in time, and the results of its operations and cash flows for a stated period (usually a year).

The concept of "presenting fairly" is different from stating that something is "correct." When you say it is correct, it implies that it is accurate to the dollar, or even to the penny. Presenting fairly, however, only requires that the information be accurate and complete enough so that a knowledgeable reader can use the financial statements to make a well-informed decision.

The presence of a clean opinion does not guarantee that a co-op is in good financial shape. It means that the information presented is complete and accurate enough to make decisions based on them. Similarly, the presence of something other than a clean opinion doesn't signify that a co-op is in trouble. All it indicates is that uncertainties or a lack of information left the auditors unable to satisfy themselves that the financial statements "presented fairly." In such cases, the auditor will explain that in the report and footnotes.

What follows is a review of the financials for a co-op my firm audited on Manhattan's East Side. For this article, I have called it Any Housing Corp. (AHC).

INCOME

After satisfying yourself that the auditor has rendered a clean opinion, the first thing to look at is the statements of income, expenses, and deficit, or the "income statement" (in the case of AHC, Exhibit B, at right). Your primary interest, when reading the financials as a new director or prospective shareholder, is the co-op's cash flow and how it will affect the maintenance (carrying charges) that are paid to the co-op.

Accordingly, examine the maintenance charges and operating expenses. See if the maintenance charges, together with the cooperative's other income, have covered the operating expenses, or if there is a deficit. If the expenses greatly exceed the income for both years, and it has not been caused by an extraordinary circumstance (such as an unexpected major repair), expect a maintenance increase that will probably exceed the inflation rate.

When we do this for AHC, we discover that for 2001 and 2000, the net maintenance and other income was $2,670,434 and $2,670,417, respectively, and the operating expenses for those years was $2,603,719 and $2,637,992, respectively. In both years, the income exceeded the operating expenses by significant amounts and, in fact, the excess of income over expenses increased from 2000 to 2001.

While most of the components of operating expenses increased from year to year, we note several that have either increased or decreased significantly more than others (real estate tax, heating fuel, and repairs and maintenance). To find out why, you should see if there are any footnote references on any of the lines

Real estate tax refers us to Note 5. First, the note describes the city's cooperative and condominium real estate tax abatement program and shows the amounts of the abatement each year and its effect on maintenance charges. Then the note tells us that the corporation reached a settlement with the city over a protest the co-op made of the real estate tax assessment for the years 1999/2000 to 2000/2001. As a result, real estate taxes have been reduced for 2000 as well as for prior and future years, and a refund of those prior year taxes was received in 2000. Because the refund was relatively small we have to assume that the reason for the increase in real estate tax was increased assessments.

Concerning the changes in fuel and repairs and maintenance, there are no explanations within the financial statements and you would have to inquire of management or the board to determine why. Even without inquiring, however, we can guess that the decrease in fuel costs is attributable, in great part, to the general decline in the price of fuel oil.

THE MORTGAGES

The next items to look at are the mortgages. The information about the mortgages will be found in the liabilities section of the balance sheet (Exhibit "A" for AHC, at left). According to the balance sheet, the amount due on the mortgage is $11,788,647, and we are referred to Note 3 for more information. Turning there, we discover that the first mortgage is due on August 1, 2013, that it carries an interest rate of 6.87 percent and that the monthly payments are $73,441 for principal and interest. We also learn that there is a second mortgage in the form of a revolving line of credit that matures on August 1, 2008, or five years before the first mortgage. The interest rate, which is adjusted monthly, is 2.25 percent above the 30-day LIBOR (London Interbank Offered Rate) and the balance at December 31, 2001 was $1,094.

There are two important items to note about the mortgage: the due date and the interest rate. In this case, because the mortgage is not due for almost 11 years, you can be assured that that portion of the cooperative's expenses will remain stable for that period. However, because the interest rate is relatively close to the current market rate, you would probably expect no significant change in the interest rate even if the mortgage were refinanced sooner. At maturity, if interest rates hold steady, or decrease, this would have a favorable effect on the co-op's maintenance. Conversely, if the interest rate were lower than the market and the loan were due shortly, you could probably anticipate an increase in the rate and the payments with a similar effect on the co-op's ability to keep maintenance stable.

The existence of a revolving line of credit is important in that it enables the cooperative to cover emergency needs without an assessment if it so chooses. To some extent it exists as a substitute for reserve funds.

CASH AND EQUIVALENTS

The next thing to look at is the co-op's cash position. This can be found at the top of the balance sheet under the heading "Cash and Equivalents." Find the cash position. Are there investments such as U.S. government securities and money market accounts? Taken together will these give the co-op sufficient cash to meet its operating expenses as they come due? If the co-op is "cash poor," it may have to increase maintenance or levy an assessment in order to meet bills. AHC, for example, has operating costs of about $220,000 per month ($2,670,000 divided by 12), and cash of about $243,000 (one month's expenses) in the bank. In addition, it has almost $600,000 invested in certificates of deposit in its reserve fund. The co-op is in a good cash position.

If the corporation had only $100,000 in cash and equivalents and no reserve fund investments, or, in some cases, a revolving line of credit, it would be very dependent on the timely receipt of the maintenance each month in order to meet its obligations. Additionally, in a building that has little cash, any major repair or replacement would have to be financed with an assessment or more loans. This would put a further strain on the co-op's ability to meet its obligations and could portend an increase in maintenance above that required to keep up with inflation.

THE RESERVE FUND

Another aspect of the amount of cash and equivalents and investments is the recurring question: how big a reserve fund should a co-op have? The answer is a non-answer: "It depends!" It depends on many things, including the age and condition of the building and the types of shareholders living there.

An old building in bad physical condition, for example, is more likely to require emergency repairs and/or replacements than a new building or one that has recently been rehabilitated. Such a structure, or one with elderly shareholders, should not depend on assessments but should have adequate cash on hand, or access to a line of credit, to meet emergencies should they arise. If the shareholders are younger, however, in good financial condition, and with significant resources, they may prefer to keep the building's reserves small and pay an assessment if necessary.

FOOTNOTES

Getting back to the financials, I would next review all the footnotes, (above left and on page 36) that I had not yet read. In the case of AHC, they are notes 1, 2, 4, 6, 7 and 8:

Note 1 describes the organization: when it began operations and how many units there are.

Note 2 reports on the cooperative's significant accounting policies, including the "methods and useful lives" used to depreciate (i.e., allocate the cost of an asset over its useful life) the co-op's building and improvements. It says that the costs of obtaining the mortgage were deferred and are being amortized over the life of the mortgage. It also offers a definition of cash and equivalents and discusses the use of estimates in financial statements.

Note 4, which is referred to in the auditors' opinion, describes the cooperative's policies concerning future major repairs and replacements. Like virtually all other cooperatives and condominiums in New York, the cooperative has not presented the estimated costs of major repairs and replacements that may be required in the future. It also describes any requirements or policies, to establish and/or accumulate funds to finance that work. This cooperative has no such policy or requirements. However, if it did it would be noted here. For example, if the mortgage required a specific contribution to a reserve fund, it would be noted here.

Note 6 deals with treasury stock (i.e., the corporation's stock that it has acquired and not canceled) and describes the fact that the cooperative acquired the shares and proprietary leases allocated to 20 apartments from its subsidiary. It also discloses other treasury stock transactions, the number of shares and apartments at year-end, as well as the rental income from those apartments.

Note 7 discloses the existence of a master lease for the stores and garage showing the expiration date, a brief description of the rental terms, and the minimum rents for the next five years.

Finally, Note 8 reports the costs and kinds of improvements made during the year.

As you can see, the footnotes are an important source of information and should be read. This is where you will find summaries of litigation, unresolved tax matters, and so on. The reading of financial statements is not complete unless you have read these.

As the final step in your review of the co-op's financials, you should then look at all remaining items, noting those which seem out of line or which you don't understand. Ask the building's treasurer to explain what the items are and what they mean.

When you finish reviewing the financial statements, you should have a better understanding of your corporation's finances and be better able to participate in the task of running your co-op.