Letter from Byron Maynard and Robert Bumgarner
September 23, 2015
Mr. Mike Rodriguez
Lake Wildwood Association
Thank you for meeting with By and me on the 20th to review our concerns regarding what we consider to be a number of inaccurate or misleading Association financial reports, reporting procedures that are inconsistent with FASB standards, non-compliant replacement reserve reporting and funding practices, and potentially improper Clubhouse funding arrangements.
As you know, rather than devoting a great deal of time to review of the exhibits we submitted in support of the nine issues stated in our IDR demand letter, we offered and discussed a five-point settlement concept. Our aim in doing so was to provide the Board with the information it needs to identify and correct the causative system factors, policies, and procedures that enabled inappropriate actions. It was not our intention to discredit past or present Board Members.
In our view, the magnitude of current financial pressures demands that the Board do everything in its power to amend the governing documents as needed to ensure that members are never again hit with a multi-million dollar increase in deferred maintenance costs or previously undisclosed replacement reserve obligations. Without such amendments, the next Board could easily reverse all of the good works of recent Boards.
Consistent with that goal, we ask the Board to promptly implement the following five actions, which are needed to correct the most risky and immediate issues:
- The Board shall promptly review and correct any and all false or misleading financial reports to members or lenders, including financial statements, the Reserve Study and Reserve Funding Plan, and Independent Audit reports.
The 2015 Reserve Funding Plan projected a need for $68.6 million in reserve assessments over the next 30 years. That will generate an increase in per-property assessments that is ten times the amount of the Clubhouse special assessment and certainly calls into question why such a huge sum of money is needed to maintain, repair, or replace assets with a reported value of only $5.6 million in the Association’s 2014 audited financial statement.
That obvious discontinuity resulted from the Board’s January 2013 incorporation of all previously excluded common facilities and infrastructure (golf course, all building structures, culverts, roads, the dam, etc.) into the replacement reserve study and its concomitant failure to amend the long-standing exclusion of those same assets from the balance sheet. Please refer to the 2014 Audit, Note 2. B., which reads, in pertinent part, as follows:
“Property of the Association includes certain facilities turned over to the Association by the developer in prior years. These facilities include a golf course, tennis courts, a lake and dam, pool, parks and greenbelts, a recreation center and clubhouse, roads, and certain common land. The Association has not reflected these assets on the books since the original cost of the assets is not determinable.” (Emphasis supplied)
The omission of those assets also explains why the Association’s 2014 annual report reflected absolutely no adverse financial impact as a result of the closure and destruction of the Clubhouse, a building that was insured for $2.5 million (refer to Audit Note 15).
Finance Rule R-4.20 requires that the Association shall maintain records of all capital assets. Rule R-4.20.80 further requires the Association to capitalize assets valued at over $2,500 on the Capital Asset Schedule, which must include land, land improvements, building improvements, and equipment, including assets purchased or received by donation. Traditional accounting standards indicate that the value of assets contributed to a non-profit corporation should be booked in one of three ways: (1) the market value of similar assets, (2) the net present value of future cashflows, or (3) appraised value. We urge you and the Board to discuss that issue with your accountant and consider reporting the fair value of all excluded assets in the Association’s financial statements.
We are also concerned that Exhibit 12 in the 2014 Audit understated replacement reserve obligations by $10 million since it was based on the results of the 2013 reserve study, not the study completed by the Association in March 2014. That is contrary to the requirements of Civil Code ¶5565, which requires that, “the summary of association reserves be based on the most recent review or study conducted pursuant to Section 5550.” That very significant misrepresentation was then included in loan applications to prospective lenders, which could, if not corrected, result in litigation against the Association at some point in the future.
We wonder how many members would have voted in favor of the proposed $4 million Clubhouse special assessment if they had been provided with a timely audit that showed they already faced at least $10 million in increased replacement reserve obligations.
- The Board shall adopt a financial policy that requires annual Management Representations Letters to the Auditor to be signed by the President of the Board and the General Manager.
The Board did not present the 2014 audit to the membership until October 28, 2014, two months late. Contrary to the requirements of Civil Code ¶5565, Schedule 12 in the Audit included a statement of replacement reserve obligations that was based on the Association’s 2013 reserve study, not the most recent study conducted in March 2014. Consequently, the current replacement cost of all major common elements was understated by nearly $10 million.
When we discovered that irregularity, we brought it to the attention of the Board and the G.M. We later received a message from the G.M., explaining that, “Due to an error on the part of Association staff, the audit firm was provided the Reserve study completed in 2013 with an understanding that this was the most recently completed study.” We then asked to review a copy of the 2014 Management Representations Letter to the Auditor.
That letter, dated October 21, 2014, was signed by a single manager, the Chief Financial Officer, and was not counter-signed by a Board member. Item 23 in the letter advised the Auditor that, “The board of directors is collecting funds for future major repairs and replacements in conformity with Lake Wildwood Association policy to fund those needs based on a study conducted in 2013.”
Given the Board’s very substantial and courageous 2014 effort to develop an entirely new replacement reserve policy and increase replacement reserve funding accordingly, it is inconceivable that it would have approved a Management Representations Letter that did not accurately reflect the results of that effort.
FASB audit standards (AU Section 333) require that management representation letters be signed by at least two responsible managers, typically, the President and the Chief Financial Officer. Without properly validated financial representations, auditors are cautioned to issue a draft report, not an unqualified report. Clearly, the significant misrepresentations in the 2014 Audit suggest the need for tighter financial controls and better oversight. The Board should adopt a new finance policy that requires the Association President and the General Manager to sign future management representations letters.
Further, given that most volunteer Board Members are not accountants and may have little background in corporate finance, it is very important they accord significant respect to the comments and recommendations of the Finance/Audit Committee, as well as their other advisory committees. We were very surprised to read the following statement in Finance/Audit Committee comments to the Board regarding the proposed 2015 budget:
“Again this year, the proposed budget package was not made available to members of the Finance/Audit Committee until the night before the annual budget review meeting. . . . The quality of our review was diminished due to the lack of time/material to prepare for the meeting.”
We urge the Board to amend Finance Rule R-4.20.10, Provision 4 to provide the Treasurer and Finance/Audit Committee with a period of at least seven days to review and validate the proposed budget prior to the Board budget review meeting.
- The Board shall promptly provide a supplement to the current Reserve Study that reports planned annual contributions to, expenditures from, and ending balances for restricted replacement reserve and non-capital reserve funds, respectively.
The Association maintains a Replacement Reserve Fund and Non-Capital (Maintenance) Reserve Fund. Funding for each of those reserve funds must be held in segregated, restricted accounts and may not be commingled. Expenditures from either account require two signatures and are limited to specific purposes not associated with general business operations and for which the respective fund was established (Civil Code ¶5510 and LWA RULE R-4.10.80). The fact that most major common elements were excluded from the reserve fund until 2014 may significantly limit the expenditure of reserves saved for other purposes on previously excluded capital assets such as the Clubhouse.
Finance Rule R-4.10.31 defines non-capitalized major components as an identifiable part of a common area and specifies maintenance activities such as road resurfacing, annual lake and pond dredging, and aquatic weed abatement. We were surprised to find that the 2015 reserve study had allocated $342,588 in future reserve study costs to the Non-Capital Reserve Fund. We believe that the cost of a reserve study is a normal operating expense that does not satisfy the Finance RULE R-4.10.31 definition of a non-capitalized asset. Those inappropriate expenditures should be reallocated to the general operating fund.
To enable members track funding discipline, the Association has traditionally provided a discrete accounting of contributions to, expenditures from, and balances remaining in each of the reserve funds. Finance Rule R-4.10.30 and 4.10.31 both require the General Manager to produce, for Board approval, an annual accounting of the funded status of each reserve fund in a 30-year matrix format. Until this year, that information has been reported to the membership on a single page with the annual pro forma budget and summary of the reserve fund.
The Board’s 2015 Budget broke with that tradition and consolidated contributions to the two reserve funds into a single line item. Similarly, the discrete 30-year member summary regarding the funding status of capitalized and non-capitalized assets was eliminated. What concerns us about that action is the 2014 summary of reserve funding reported that the replacement reserve fund for capital assets was only 19% funded while the Non-capital Reserve Fund was 148% funded. Obviously, the looming demand for funds to defray the $1.2 million shortfall in Clubhouse funding could tempt those who write the checks to improperly expend non-capital reserves on improvements to capital assets.
We reported that issue to the Finance/Audit Committee and suggested that discrete reporting regarding the status of capital and non-capital reserve funds should be restored. The Chairman of the committee responded that, “One of the problems BRG has with their software was the inability to provide the replacement reserve financial information separated out between capital and non-capital reserves. This shortcoming has been discussed with BRG and hopefully a solution will be found to provide this information in future reserve studies.”
In the meantime, we ask the Board to promptly provide members with a discrete supplemental status report for replacement reserve and non-capital reserve funds at the beginning and end of fiscal year 2015-2015. Existing Association software is available for that purpose.
- The Board shall commit to conform the current Reserve Study and summary reports to members in accordance with the requirements of Civil Code Section 5565 and the LWA governing documents, particularly with regard to excluded major components, accounting for the current replacement cost, estimated life, and remaining useful life of major components of each common facility / infrastructure element, and discrete reporting of replacement reserve and non-capital reserve accounts. That update shall be implemented not later than the 2016-2017 fiscal year.
Although the 2015 reserve study — the first conducted by a credentialed reserve specialist — represents a major step toward correcting the false and misleading reserve studies produced during the last 15 years, it does not provide members with the summary information they need to understand the current status of replacement reserve obligations or the reserves funding plan.
This year, summaries of the reserve study were produced in a form that makes it impossible for members — or Board Members — to determine the extent to which major common facilities are funded or to assess the reasonableness of reserve assessments. For example, the reserve summary projects reserve cash flows based on the yearly estimated cost of replacing sub-component parts of common facilities and infrastructure. Categories listed include concrete, flooring, structural repairs, roofing, or painting, etc. without linking those sub-component parts to any particular common facility. The projection also makes no mention of culverts and excludes six common elements, including all ditches and swales, the dam, Deer Creek Bridge, and all building foundations. If all building foundations and the dam are excluded from the report, where is concrete being used?
That approach may provide a valid estimate of annual cash flows from reserve funds but does not provide members with the current replacement cost, estimated life, or remaining useful life of each major common element, as required by Civil Code ¶5550, Civil Code ¶5565, and Association RULE R-1.30.10, Provision 1A. On May 28, 2015, I sent the Finance/Audit Committee and Board Members a detailed report, disclosing our 2015 Reserve Study Concerns. The Chairman of the Finance/Audit committee responded to that report on June 13, 2015, as follows: “. . . we believe that the BRG report would be more useful if it grouped replacement reserve information by Common Facility. And, we also believe that it is difficult to analyze the reserve report on a major component basis. This has been discussed with BRG and hopefully a solution will be found to provide the information in a Common Facilities format in future.”
Our report also noted that the full BRG reserve study currently categorizes reserve obligations by major component; it just doesn’t provide a summary of that information to members, as required by Civil Code ¶5565 and Association Rule R-1.30.10, Provision 1 A. (3).
- The Board shall submit any future special assessments related to the Clubhouse Improvement Plan to a vote of the membership.
In September 2014, the membership approved a special assessment of $4 million to partially fund the razing and replacement of the Clubhouse. The total budget for the project was reported to be $5.5 million, with $1.375 million to come from sale of Association-owned lots and the small remaining balance from replacement reserve funds. That budget included only a 5% cost overrun allowance of $225,000.
Because the Board initially understated the cost of the project and permitted special interest groups to modify and expand the plan after assessment approval, the total estimated cost of the project increased to $6.7 million (+22%) prior to the start of construction. To fund the $1.2 million gap, the Board has discussed the need to impose additional special assessments of $384,000 and $422,000 and/or to increase expenditures from replacement reserves during the construction period. It was specifically stated that no further member approvals would be needed for additional assessments, whether in the form of a special assessment or reserve assessment.
In our opinion, any additional special assessment(s) for the Clubhouse project would constitute serial assessments that should have been included in the original budget. Such serial assessments are illegal and, thus, should be subject to approval by the membership.
And, as previously noted, the expenditure of replacement reserve funds on the Clubhouse that were accumulated to fund repair and replacement of other common elements would likely be improper. Consequently, we ask the Board to fund Clubhouse pre-construction funding shortfalls primarily through special assessments and that those assessment be subject to approval by a vote of the membership.
To do otherwise would be deceptive and unfair to members, many of whom are retired and live on modest fixed incomes. They deserve an opportunity to vote on funding for cost increases that resulted from changes to the Clubhouse Improvement Plan prior to the start of construction.
Robert R. Bumgarner
cc: Board of Directors