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HOA Retained Earnings

What is it?  How does it affect your HOA?  If you took one accounting class in your life you probably learned that on a Balance Sheet, Assets equal Liabilities plus Retained Earnings.  Simple math, right? Well, I heard a joke once that if you ask an engineer what 2+2 is they will look you in the eye and say “4”.  If you ask an accountant what 2+2 is, they will look you in the eye and say, “What do you want it to be?”  How can this be?  Retained Earnings.

You have to remember that what goes on a Balance Sheet is set by GAAP and taxed accordingly by the IRS to determine what they should tax you.  HOAs do not typically pay tax because the IRS views HOA dues income as money that was already taxed to the homeowner and doesn’t tax the HOA a second time. 

So, what does Retained Earnings mean on HOA Financials?  The first journal entry of the year is to credit HOA Dues as if everyone has paid their dues, and then debit Accounts Receivable (AR) as if all dues are owed.  As homeowners pay their dues you credit Accounts Receivable and Debit the Cash Bank Account.  The last journal entry of the year is to Debit Net Income (Loss) and Credit Retained Earnings. 

Simply put, Retained Earnings is the sum of the accumulated Net Income and Loss since the HOA started. For tax purposes, during the Great Depression, FDR felt that companies were not spending money and threatened a Retained Earnings Tax. There is no Retained Earning Tax in the Tax code, for HOAs or any other company. Net Income/Loss is what is taxed, and HOAs have many exemptions.

Retained Earnings graphic

I once had a Board Member that wanted to use Retained Earnings to pay for a new pool.  Retained Earnings is not attached to a bank account and does not represent money available to spend.  I’ve also had Board Members wanting to transfer the Net Income at the end of the year from the Operating Account to the Reserve Account.  But Net Income does not take into account items that go on the Balance Sheet and not the Income Statement.  An example would be, if the HOA has a loan, the money spent on loan interest expense can be deducted from Net Income and is posted on the Income Statement.  The Loan Principal, for tax reasons, cannot be deducted so goes on the Balance Sheet and even though it reduces the cash on hand it does not reduce the Net Income. 

Why should I care about Retained Earnings?  If it is negative, that means the HOA has had successive years of losses.  If you know how long the HOA has been in existence and divide the dollar amount in Retained Earnings over those years, you will have a rough idea of how much over/under budget a HOA has been over time.  A better way to assess the financial health of an HOA is to get a copy of the Reserve Study and see how much money is going to be needed in the coming years, and then look at how much money is in the bank.  Retained Earnings is meaningless in trying to determine the future cash needs of an HOA.

In short, Retained Earnings is a measuring stick, indicating the accumulation of net income and loss over time, other than that the more important items are always the Reserve Study first, then Cash on Hand, then Accounts Payable and Receivable, and is the budget and cash position able to meet the requirements of the Reserve Study plus unexpected expenses.