Best practice: Managing financial reserves

Best practice: Managing financial reserves

Careful planning for future repairs and replacements is in the best physical and fiscal interests of the community association. Maintaining a reserve fund not only meets legal, fiduciary and professional requirements, it also minimises the need for special levies, and enhances resale values. How does an association properly determine and compile adequate reserves to fund necessary repair and replacement costs? By conducting reserve studies.

Reserve studies

There are two components of a reserve study – a physical analysis and a financial analysis. During the physical analysis, a reserve provider evaluates information regarding the physical status and repair/replacement cost of the association’s major common area components.

A reserve study should include:

  • a summary of the association, including the number of units/stands, physical description and the financial condition of the reserve fund
  • a projection of the reserve starting balance, recommended reserve contributions, projected reserve expenses and the projected ending reserve fund balance for a minimum of 20 years
  • an inventory with component quantity or identifying descriptions, useful life, remaining useful life and current replacement cost
  • a description of the methods and objectives utilised in computing the fund status and in the development of the funding plan
  • source(s) utilised to obtain component repair or replacement cost estimates
  • a description of the level of service by which the reserve study was prepared and the fiscal year for which the reserve study was prepared.

In the interests of transparency and disclosure, experts recommend that a comprehensive reserve study also includes:

  • a statement disclosing other involvement(s) with the association that could result in actual or perceived conflicts of interest
  • a narrative description of the physical analysis that details how the on-site observations were performed
  • a description of the assumptions utilised for interest and inflation, tax and other outside factors for the financial analysis
  • a written explanation of the credentials held by the individual who prepared the reserve study
  • a report on how the current work is reliant on the validity of prior reserve studies
Best practice: Managing financial reserves
  • discussion of material issues which, if not disclosed, would cause a distortion of the association’s situation
  • reliable information provided by the association’s official representative regarding financial, physical, quantity or
    historical issues.

The reserve study process consists of four stages, namely:

  • determining a reserve schedule
  • establishing a preventive maintenance schedule
  • selecting a funding plan
  • developing an investment policy

Determining a reserve schedule

A reserve schedule is the financial summary of the reserve study. Its format depends on the funding method used, but its development will usually follow the steps detailed in the figure below.

Establishing a preventive maintenance schedule

Preventive maintenance is done for two primary reasons:

  • If associations do not maintain the components on the reserve schedule, they will not attain their full useful life. Consequently, the components will need to be replaced earlier and the replacement cost will need to be collected over a shorter period of time. This could result in special levies being imposed.
  • If associations do not maintain the components that are not included in the reserve schedule, they may require replacement, whereas if they were maintained, they would not.

The flowchart below describes a preventive maintenance schedule.

Selecting a funding plan

Once your association has established its funding goals, the association can select an appropriate funding plan. You should consult a professional for help in choosing between the three basic strategies:

  • The full funding strategy is to attain and maintain the reserves at or near 100%.
  • Baseline funding involves keeping the reserve cash balance above zero. This means that while each individual component may not be fully funded, the reserve balance does not drop below zero during the projected period.
  • Threshold funding is based on the baseline funding concept, but the minimum reserve cash balance is set at a predetermined rand amount.

 

Developing an investment policy

Developing a policy for investing reserve funds allows boards to make consistent choices, and brings structure and continuity to investment decisions.

Some terminology

Accrued fund balance (AFB): The total accrued depreciation – an indicator against which the actual or projected reserve balance can be compared to identify the direct proportion of the used-up life of the current repair or replacement cost.
Cash flow method: A method of developing a reserve funding plan where contributions to the reserve fund are designed to offset the variable annual expenditures from the reserve fund.
Component inventory: The task of selecting and quantifying reserve components.
Component method: A method of developing a reserve funding plan where the total contribution is based on the sum of contributions for individual components.
Condition assessment: The task of evaluating the current condition of components based on observed or reported characteristics.
Current replacement cost: see Replacement cost.
Deficit: An actual or projected reserve balance less than the fully funded balance.
Effective age: The difference between useful life and remaining useful life. Not always equivalent to chronological
age, since some components age irregularly. Used primarily in computations.
Financial analysis: The portion of a reserve study dealing with financial reserves.
Component full funding: When the actual or projected cumulative reserve balance for all components is equal to the fully funded balance.
Fund status: The status of the reserve fund as compared to an established benchmark such as per cent funding.
Funding goals: Independent of methodology utilised, the categories of funding plan goals are baseline funding, component full funding and threshold funding.

Funding plan: An association’s plan to provide income to a reserve fund to offset anticipated expenditures from that
fund.
Life and valuation estimates: The task of estimating useful life, remaining useful life, and repair or replacement costs for the reserve components.
Per cent funded: The ratio, at a particular point of time (typically the beginning of the fiscal year), of the actual (or projected) reserve balance to the accrued fund balance, expressed as a percentage.
Physical analysis: The portion of the reserve study where the component inventory, condition assessment, and life
and valuation estimate tasks are performed.
Remaining useful life (RUL): The estimated time, in years, that a reserve component can be expected to continue to serve its intended function.
Replacement cost: The cost of replacing, repairing or restoring a reserve component to its original functional condition.

Reserve balance: Actual or projected funds as of a particular point in time that the association has identified for use to defray the future repair or replacement of those major components that the association is obligated to maintain.
Reserve component: The individual line items in the reserve study developed or updated in the physical analysis.
Reserve provider: An individual that prepares reserve studies.
Special levy: A levy applied to the members of an association in addition to regular levies.
Surplus: An actual or projected reserve balance greater than the fully funded balance.
Useful life (UL): Total useful life or depreciable life is the estimated number of years that a reserve component can be expected to serve its intended function if it is properly constructed in its present application and/or installation.


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