Strata Reforms [NSW] Update 6: Financial Matters
Money, money, money, must be funny, in the rich strata person’s world …
My apologies to Abba. But, in my experience, money is never funny in strata buildings since strata owners, managers & regulators [quite rightly] treat it very very seriously. Yet, when you look closely, there’s a looseness about strata financial records and reporting that belies that seriousness.
Introduction about strata financial matters
NSW strata laws include a variety of provisions relating to financial matters covering the following key things.
No debts in the initial period exceeding the available money [SSMA s 26(1)(a)]
No borrowing in the initial period [SSMA s 26(1)(d)]
The treasurer’s functions [SSMA s 44]
Delegating the treasurer functions to strata managers [SSMA ss 54(1) & 101,]
Strata manager disclosure obligations [SSMA ss 58 – 65]
Funds and account requirements [SSMA ss 73 – 78]
Rules for levies & other owner liabilities [SSMA ss 79-91] [SSMR rr 18 & 19]
Budgets, financial records & statements requirements [SSMA ss 79, 92 – 94, 96 – 99] [SSMR rr 21 -24]
Audit rules [SSMA s 95]
Borrowing rule [SSMA s 100]
Spending limits and controls [SSMA ss 102 – 104,] [SSMR rr 25 & 26]
The 2020 NSW Statutory Review Paper discusses decision-making issues at questions 74 to 78 and a few more relating to electronic records at question 93 which I’ve reproduced at the end of the article.
General comments about strata financial matters
The financial management provisions for NSW strata buildings are okay.
But, they were developed in the 1970s and have not been updated much since then. Whereas during that time, the financial sector has changed enormously.
So, most of my suggestions for strata law reform are focused on more and better financial records, improved accessibility and reporting, and the creation of operational controls for new financial products, services, and impacts.
I’m no accountant but these things are obvious. And, since money makes the strata world go round, this is a critical area to focus on.
Where strata law reform is needed & my suggestions
I’ve identified 9 things about strata building financial issues that should be addressed in these strata law reforms.
1. Balance Sheets & Profit & Loss are misnomers
A strata building is not the same as a company. Its purpose is not to make a profit and it doesn’t operate independently of its shareholders. So, applying financial operation and reporting functions from business into strata buildings is a mistake.
So, let’s consider this difference in relation to the required financial records and reports for strata buildings.
Financial statements and a statement of the key financial information must be prepared for each strata building fund in roughly annual cycles and the required information is detailed in the NSW strata laws. It’s not a profit & loss statement [in the business sense] but it kind of looks like it. However, if the financial statements and information are intended to help owners understand the building’s financial position they won’t do that. That’s because key information is missing as I outline in item 3 and because the required information requires the report to mix different types of information as I outline in item 2.
To me that makes these financial statements unrepresentative of the true financial position of strata buildings and difficult to interpret for strata owners and other relevant strata stakeholders.
Budgets are [sort of] required as part of the annual levying process, but the requirements are minimal, strictly limited to totals required in each fund. So, they definitely are not like business budgets, and since there’s no obligation to ever consider them again or to compare expenditures against budgets in the financial statements they have little real importance. Plus, there are no consequences if strata expenditures exceed any budgeted item or even the budget totals.
Typically, most strata buildings split anticipated expenditure into basic categories for budgeting purposes and apply some kind of re-assessment process each year. But, without any accountability for inaccuracies, there’s little accountability and, as a consequence, care taken.
Balance sheets are not required for strata buildings although arguably the required key financial information operates to provides information similar to one. But the absence of balance sheets makes sense too, since:
strata building don’t actually own anything [but rather everything belongs to the strata owners],
the concept of strata assets with value is misconceived as any potential value in strata assets can’t be realised, and
a strata building has no real liabilities since any amounts it can’t immediately pay from its cash reserves or expected levies should be levied against strata owners who have unlimited liability to pay them.
Yet, most strata buildings produce a balance sheet. Why?
What’s actually required from strata financial records and reporting is a clear picture for strata owners and other insider stakeholders to understand where they stand in relation to strata buildings operations and why.
In other words, the following things:
money the strata building has now,
what part of the existing strata building money is reserved [and for how long they are being kept]
money the strata building expects to receive [and when],
expenses the strata building paid in the current cycle,
expenses the strata building still has to pay in the current cycle,
money the strata building has to pay in future cycles [if any],
expected shortfalls or surpluses [and when they will occur], and
That information needs to be available in summary and detailed form [so strata managers, committees, and owners can drill down into it].
The financial information also needs to be provided in ways that strata owners can see their individual position as well as the strata building as a whole in case they need to cover more [or all] of it.
Ideally, strata financial information should also be able to be compared to previous financial cycles and include cashflow analysis/projections covering the short/medium-term future.
Oh, and all that information should be recorded and available electronically [obviously].
So, I suggest that the strata laws restructure the financial information that needs to be kept and reported to properly represent the strata buildings’ actual financial position.
So, I also suggest that the strata laws require that financial information is reported in ways that strata owners can see their individual exposure in normal and worst-case scenarios.
So, I also suggest that the strata laws require all financial information to be recorded electronically in a universally accessible format.
2. Cash vs accrual accounting & cashflows
Most of the required financial information in strata building accounting is recorded and reported on a cash basis.
But, sometimes there’s also some accrual information included in financial reports produced by and for strata buildings [like unpaid strata levies and GST refunds] which causes confusion in those reports.
Cash accounting is simple and is easier for most stakeholders to understand. But, it’s an inferior way to record, understand and manage a long-term entity’s [like a strata building] financial affairs. Plus, what do large strata buildings with an annual turnover exceeding $2M do since they’re required to report BAS on an accrual basis?
As I’ve outlined as part of my suggestions in item 1, without accruals-based financial, strata owners and other strata stakeholders can’t really know the true financial position of their strata building.
So, I suggest that the strata laws require strata building financials records to be recorded and reported on an accruals basis.
3. Creditors & Other Liabilities
It’s important for strata owners to know a strata building’s liabilities since they have unlimited exposure to pay them. That’s not only to pay them via levies according to their lot entitlement proportions but also because they are personally jointly and severally liable for all strata building liabilities under s 254(3) of the NSW strata laws.
Whilst s 94(1)(i) of the NSW strata laws requires key financial information report to include ‘the principal items of expenditure for maintenance proposed during the next year‘ that’s a vague and incomplete picture of a strata building’s liabilities or creditors. Plus, I’m not so sure it’s actually being provided by most strata buildings.
Ideally, information about all strata building liabilities and creditors should be maintained, up to date and readily available so that the strata building’s exposure [and consequently the strata owners’ exposure] is known. Only recording liabilities when they are paid is not good enough.
Plus, what about contingent liabilities for things that might arise in the future [like adverse judgements, costs orders, or, fines]? Where are they recorded in the financial records or reported to strata owners who are liable to pay them when making decisions about money are being made?
I’ve specifically addressed loans in item 6, but that’s only one obvious and more common example. There are plenty of others.
So, I suggest that the strata laws require strata buildings to record and report liabilities [actual and contingent] and creditors in their financial accounts and reports.
4. Audits vs Audits
Who knows how many strata buildings actually get audits?
Large strata buildings [over 100 apartments or with $250K plus annual budgets] must have their accounts and financial statements audited each year and other strata buildings must consider an audit at each annual general meeting.
But, what kind of audit are they requesting and getting?
According to NSW strata laws, audits must be carried out according to Australian Auditing Standards which, if you look, are very detailed, strict, and complex. You can read the audit requirements here.
But, strata audits are relatively cheap for traditional professional services [ranging from a few hundred to a few thousand dollars]. And, at $100 average hourly charge rates those charges only cover a few person-hours work in smaller buildings to 30 person-hours work in larger buildings.
So, I’m guessing strata buildings are not getting the same kind of audit that public companies, [or even self-managed superannuation funds] get. That’s fine since you only get what you pay for.
However, my concern is the disconnect between what strata committees and strata owners think they’re getting when they approve strata accounts audits compared to what is actually provided. It’s very likely, in my opinion, there’s a significant and important difference in that leads to unrealistic comfort levels amongst strata stakeholders.
So, I suggest that the strata laws require that when every strata building considers audits at general meetings that decision is supported with details of the proposed audit specifying the investigation scope and any limits or exclusions.
5. Too much & not enough details
Here’s a financial dilemma for strata buildings; despite all the financial information that is provided, they’re not getting enough.
Usually, the most substantial part [by a number of pages] of annual meeting notices are the financial reports, and yet [as I’ve outlined elsewhere in this article] there’s lots of financial information that isn’t there or available in them.
But, that’s only part of the strata financial information shortage issue.
Financial information needs to be supported by underlying materials [from invoices to the initiating service/work orders, contracts, and, banking records]. So, in many circumstances access to that information including primary sources is necessary to properly assess it.
But, strata owners who want extra information need to ask for it and, if not provided, must inspect the strata records [for a fee] to obtain it.
And since the NSW strata laws only require one report per cycle [usually yearly but not necessarily for the same period each year] the financial information is often old, out of date, and not very useful for current and future decisions. Plus, different reporting periods make year-to-year comparisons more difficult.
So, I suggest that the strata laws require strata buildings to make more detailed financial information available including source/primary materials.
So, I also suggest that the strata laws require strata buildings to prepare fixed cycle financial reports.
So, I also suggest that the strata laws require strata buildings to prepare up-to-date financial reports [including for part periods] to strata owners when making financial decisions if they are out of sync with financial cycles.
6. Borrowing disclosures & levying cycles
Whilst NSW strata buildings have been able to borrow money since 1961, it’s only in the last decade or so that it’s become more commonplace and lenders willing to make unsecured loans have emerged.
These strata loans are typically multi-year and paid from levies covering interest [and sometimes principal]. The levies can be determined once for the whole term [thus covering multiple annual financial cycles] or determined annually [covering only the current financial cycle payments[. And, depending on the loan purpose, the payout at the end of the term may come from levies or from a third-party windfall payment such as a judgment in a building defect claim or insurance payout.
These features impact the accuracy of strata financial statements and strata owners’ positions in relation to those liabilities.
Multi-year strata loans are not required to be included in the financial statements or key financial statements and often are not despite being real and substantial strata liabilities. They may sometimes be shown in balance sheets, but since balance sheets are not mandatory financial reports, that’s an unreliable source of information for strata owners.
At best, the levies raised to pay the strata loans can provide clues about the loan’s existence and size. But, where the levies for the strata loan are not multi-year or separated from the regular levies that will not be obvious. Plus, if the loan is for capital works there are also issues about whether to allocate repayments partly to the administrative fund [for interest] and partly to the capital works fund [for principal] which affects levying.
Plus, the way the loan repayment levies are structured can impact the positions of incoming and outgoing strata owners in sales during the strata loan term. Since already determined future levies are adjusted on a strata apartment sale [so that the incoming strata owner pays the levy liability from the transfer date and the outgoing owner benefits from any prepaid amounts], the structure of the strata loan and levy will make a big difference such that:
if the strata loan levy is multi-year interest and principal, then subject to accurate disclosure in strata information certificates the strata owners’ liability for it will be fairly apportioned,
if the strata loan levy is single year only for the current cycle strata loan liabilities, then only the current part of the strata owners’ liability for it will be fairly apportioned and the new strata owner will pay for the remainder, and/or
if the strata loan or the levy is interest only, then the incoming strata owner will pay for the full principal repayment when made unless there’s a third party windfall.
Finally, if the strata building expects a third-party windfall payment to cover the loan, that’s properly a contingent asset that should also be disclosed in the financial reporting.
So, strata loan disclosures and repayment strategies need better disclosures.
So, I suggest that the strata laws require the financial records and reports to more fully detail strata loans; amount, terms, repayments, and levy provisions.
So, I also suggest that the strata laws require strata information certificates to include strata loan information to allow purchasers to properly understand the liabilities they are taking over.
7. Owners Tax position disclosure
Strata buildings are taxable entities and treated as a company by the Australian Taxation Office. So, strata buildings are liable for income, capital gains, and goods and services tax and, subject to thresholds, must lodge tax returns and building activity statements.
But not all the money that a strata building receives is treated as income or capital gains by it and not all expenditures by a strata building are deductible by it. Rather, some of those are treated as income, capital gains, and deductions of the strata owners.
That’s because where the common property is held by the strata building as trustee for the strata owners [as is the case in NSW] then, principles of mutuality and non-mutuality operate. The ATO’s [simple?] explanation is as follows:
the income from common property is not assessable income of the strata title body in its capacity as trustee (and is assessable income of the individual proprietors),
the strata title body is not entitled to any deductions under section 8-1 of the ITAA 1997 in respect of common property (and proprietors will be entitled to deductions in proportion to their lot entitlements to the extent they otherwise meet the remaining requirements in that provision),
the strata title body is not entitled to any deductions under Division 40 and Division 43 of the ITAA 1997 in respect of common property (and proprietors will be entitled to deductions in proportion to their lot entitlements to the extent they otherwise meet the remaining requirements in those Divisions).
If you like reading taxation rulings, then you can read the ATO’s Tax Ruling TR 2015/3 Income tax: matters relating to strata title bodies constituted under strata title legislation here.
As a result, strata lot owners are routinely liable to disclose extra income, deductions, and capital gains in their personal tax returns for strata earnings and payments. Perversely, that’s so even though the strata owners don’t receive [or pay] the money. I suspect that rarely happens.
Partly, that’s due to strata stakeholder awareness issues [so I’ll be writing an article about taxation issues in strata buildings soon] and, partly that’s because strata owners are not provided with useful information about that non-mutual income, gains/losses, and deductions by strata buildings, treasurers, managers and/or accountants.
Strata buildings can do this if they are properly preparing their own tax returns and BAS correctly as they are separating those things anyway.
So, I suggest that the strata laws require strata buildings to record and report non-mutual income, deductions, capital gains, and losses to strata owners.
8. Depreciation information in new strata buildings
Another lesser-known financial matter that impacts a significant number of strata stakeholders is the deductibility of depreciation for common property capital items, plant, and equipment in new buildings for investor owners.
In simple terms, investor strata owners of newly built [and sometimes renovated] strata buildings are entitled to claim depreciation on the loss of value of the building structure, fixed items, and eligible removable plant and equipment assets as they experience wear and tear over time. There are complex rules about these deductions but they can be significant and in the case of the building structure, the deductions can be made for 40 years [yes, I said 40 years!].
So, since half of NSW’s strata apartments are investor-owned, tens of thousands of strata buildings have been built in the last few decades and there’s a lot of valuable capital items in them; that’s a lot of tax deductions for strata owners.
Again, I suspect that very few investor strata owners know about and/or are claiming these deductions at all or as extensively as they could.
But, without original construction information that may, or may not, be held by the strata building [or handed over by the developer], this is difficult for strata owners to do so.
Plus, without properly maintained asset registers in strata buildings [which are not mandatory] even newly acquired common property capital items aren’t recorded, reported, and, therefore, easily deductible.
So, I suggest that the strata laws require developers to provide capital items, plant and equipment details as part of the new building handover items.
So, I also suggest that the strata laws require strata buildings to keep and report capital items, plant, and equipment details annually.
9. Strata levy interest [and discounts] just aren’t right
Strata levying mechanisms are pretty well settled in NSW so not much needs changing here, except to fix some long-standing confusion about recovery costs which I’ll cover in Part 8: Housekeeping Issues in a few weeks.
So, instead, I’m going to highlight a more controversial issue here relating to interest charges on overdue strata levies [and also discounts] by proposing that they should be abolished, should be much lower, or [at least] that interest should reflect the actual cost [plus a small margin] of delayed payment to the strata building.
Overdue strata levies in NSW automatically attract interest at a fixed rate which [arguably] can’t be waived and can’t be reduced after the levy is set.
The NSW late levy interest rate has been 10% for a very long time when prevailing market rates have dropped significantly since then [the current RBA cash rate is 0.10%]. By, comparison the current NSW Supreme Court pre-judgment interest rate is adjusted annually and is currently is 4.1%.
Applying late levy interest that is 100 times the RBA cash rate is a strong incentive for strata owners to pay strata levies. But, that’s really an accident of market conditions and the converse has applied in the past, when interest rates were over 15% and strata levy interest was cheap unsecured finance.
So, 10% interest [or any interest] on late strata levies is really just punishment on strata owners who won’t or can’t pay. Or, perhaps, it’s just the adoption of domestic money management principles into a business-like process? Either way, I’m not comfortable with those rationales.
Whilst it’s important that strata owners pay their levies, why should delays be punished unless they actually impact the strata building or other strata owners?
In business, debtor levels affect business operations because they require the business to have the working capital to cover the average rolling debtors’ amount. And, since capital invested in businesses is given a cost [typically between the reasonable return on capital and overdraft interest rates] working capital to cover debtors impacts profit.
But, that’s not typically the case in strata buildings.
Strata buildings usually have cash reserves to cover expenses despite late paying strata owners; so they don’t need to borrow or find more money.
Strata buildings earn virtually nothing on cash reserves held in banks [zero if in a trust account and currently less than 1% for 12+ month fixed-term cash deposits]; so the cost of funding late paying owners is negligible or very low.
Strata buildings typically manipulate their creditors to match cashflows by not paying or delaying payments to non-essential creditors until they have money [who hasn’t said or heard ‘we can pay your account after the next quarter’s levies are paid’?] and rarely, if ever, are charged interest on the delayed payments by creditors; so they don’t incur any losses from money shortages due to late-paying strata owners
Plus, interest paid on overdue levies is actually money that exceeds the strata buildings’ budget and should [in theory] be surplus strata funds. After all, if every strata owner paid their levies 1 year late, the strata building would have 10% more money than it needed. So, where’s all that extra money, and what is it being used for?
This neatly leads me to discounts for early strata levy payments.
In NSW, a strata building can give strata owners a 10% discount [fixed] if they pay strata levies before the due date. Presumably, that’s an incentive for owners to pay on time. But if that’s so, then it’s too generous [just like penalty interest is too harsh].
After all, if a strata owner can pay a quarterly levy 1 day before it’s due and reduce it by 10%, that’s pretty good arbitrage on the cost of money for [100 times at RBA cash rates].
Plus, all the reasons why interest for late payments is not commercially sound apply in reverse for discounts:
strata buildings don’t need the strata levies early as they have reserves,
strata buildings can easily manipulate payments to handle cash flow delays,
strata buildings earn virtually no interest on the extra early money, and
strata buildings can’t usually get a discount for early payment of creditors.
Additionally, if everyone pays 10% less levies early then the strata building will have a budget shortfall and not enough money for the cycle. *
* I know, I’m about to be told that in those cases the building increases the budget by 10% to cover that … but, do I really need to explain the non-sequitur of raising higher levies so some strata owners can get a discount on early payment of them?.
So, I suggest that the strata laws are changed to so that there should be no interest on late paid strata levies unless the strata building actually suffers losses as a result [which could be calculated based on lost interest on reserves, cost of borrowing money to cover the shortfall, interest & penalties paid to creditors, etc]
OR AT LEAST,
So, I suggest that the strata laws are changed so that the interest rate for late levies should move regularly to better match prevailing market rates.
So, I also suggest that the strata laws are changed so that deductions for early levy payments are abolished.
Francesco ...
Feb 22, 2021
NSW STRATA LAW REFORM DISCUSSION PAPER QUESTIONS ABOUT FINANCIAL MATTERS
74. How well is money being managed in the administrative and capital works funds by your owners corporation? Are any changes needed and why?
75. Owners corporations can use money from one fund to temporarily cover the expenses of the other fund. How do you interpret the rules about repayment of money transferred from one fund to the other fund What should the rule be?
76. How well have the laws on levies and arrears been working? Please explain why and suggest any changes.
77. Are any changes needed on how financial records are prepared, for example, deposits and withdrawals for the owners corporation? Are any changes needed?
78. Is a $250,000 budget the right threshold for compulsory audits to be carried out? If not, what do you think is the right amount?
93. Should keeping electronic records be made compulsory? Why/why not?