FINANCIAL REPORTING OF T-NOTES

By Gary A. Porter, CPA

 

The changing financial markets have caused many associations to re-think their investment policies in recent years.  As interest rates have declined and then risen again, many associations have turned to T-Notes as investment alternatives to the more traditional Certificate of Deposit (CD) investment.  The allure of the T-Notes is:

1) Higher interest rates than CD's;
2) Longer term than CD's, generally 4 to 5 years;
3)Favorable tax treatment.  The interest on T-Notes is generally not subject to State income taxes.

The complexity and resulting problem lies in the reporting of these investments for financial statement purposes.  While they appear to be very simple in nature, the association must recognize that this relatively "simple" investment can cause significant additional accounting work, and possibly increased audit fees.  U.S. T-Notes may be a sound method of investing an association's reserve funds, but they are not as "simple" as they appear.

The problem stems from the two completely different approaches to measuring "value".

Most brokerage house monthly statements report the T-Notes at their then current market value.  To the investment advisor, market value is the logical focus of evaluating the performance of the investment.  And this is certainly the most appropriate measure for that purpose.

Generally Accepted Accounting Principles (GAAP) require the reporting of investments at lower of cost or market value.  This is because financial statements use historic cost basis (value), as the focus is to measure past performance.

The difference in measurement focus and method leaves many people uncertain as to what is the proper method of recording these investments.  Association financial officers are particularly sensitive to this issue when Board members question why there is a difference between the brokerage house statement and the financial statement.  We have noted many associations improperly reporting their T-Note investments at market value on their financial statements in an attempt to bridge the gap between brokerage house statements and financial statements.

GAAP requires that these investments be reported at their historic cost basis unless there is a permanent impairment of value.  Increases in market value may never be recorded.  Gains are recorded only on sale of the investments.  Since the investments mature in a reasonably short time period (usually 4 to 5 years), T-Notes are generally held to maturity to avoid incurring the loss.  Thus, no permanent impairment exists, and historic cost basis is the appropriate measure of value for financial statement purposes.

Recording investments at cost requires that the Association reconcile the market values to the book values monthly.  Market value will fluctuate with changes in interest rates, as T-Notes, being a mid-term investment, are interest rate sensitive.  As interest rates have risen since early 1994, market values have dropped.  This has caused many questions from board members shocked at the difference between market and book values of their T-Notes.

Financial reporting is further complicated when an association invests in "strips", or zero coupon bonds.  In addition to the market value changes, the association also has to contend with the calculation of interest earned.  The IRS has approved the "Treasury" method of calculating interest earned.  This is extremely important in calculating gain or loss on sale of the investments.

This leads directly into the tax aspects of T-Note investments.  The interest earned is fully taxable, at least for federal tax purposes.  Gains on sales are capital gains, and are fully taxable.  Losses on sales, however, considered capital losses, are not deductible.  Capital losses may only be offset against capital gains.  Losses may be carried back three years, and may be carried over for five years.

A significant book to tax difference in reporting losses may also give rise to the necessity of calculating and reporting a deferred tax provision for financial reporting purposes.

Associations and financial officers are cautioned to be aware of the different "values" used for different purposes.   It is not difficult to explain the differences between brokerage house statements and internal financial statements when you understand why they are different.

 

Gary Porter, CPA began his accounting career with the national CPA firm Touche Ross in 1971.  He is licensed by the California Board of Accountancy and the Nevada Board of Accountancy.  Mr. Porter has restricted his practice to work only with Common Interest Realty Associations (CIRAs), including homeowners associations, condominium associations, property owners associations, timeshare associations, fractional associations, condo-hotels, commercial associations, and other associations.

Gary Porter is the creator and coauthor of Practitioners Publishing Company (PPC) Guide to Homeowners Associations and other Common Interest Realty Associations, and Homeowners Association Tax Library.  Mr. Porter served as Editor of CAI’s Ledger Quarterly from 1989 through 2004 and is the author of more than 200 articles.  In addition, he has had articles published in The Practical Accountant, Common Ground and numerous CAI Chapter newsletters.  He has been quoted or published in The Wall Street Journal, Money Magazine, Kiplinger’s Personal Finance, and many major newspapers.

Mr. Porter is a member of Community Associations Institute (CAI), American Resort Development Associations (ARDA), and California Association of Community Managers (CACM).  Mr. Porter served as national president of CAI in 1998 – 1999.