The successful financial management of a condo, co-op, or homeowners association relies upon accurate, timely, and consistent financial statements. These statements represent the financial position and results of operations of the association, and understanding the details of these financials is essential to making sound management decisions. Also fundamental to this process is choosing the appropriate accounting method for your association.
Accrual vs. Cash Basis Accounting
In selecting an accounting method, trustees or board members should fully comprehend the differences between accrual and cash basis accounting. The differences in the methodologies have a material impact on how financial information is presented and evaluated by users, and therefore influence how they make far-reaching business decisions for their associations.
The fundamental difference between the two methods is rooted in the timeline in which expenses and owner assessments are recognized and recorded in financial statements. While each method has its advantages, our company primarily uses accrual accounting to create detailed monthly financial packages for our client associations—though sometimes a modified cash basis is requested and used.
What Is Cash-Basis Accounting?
In cash-basis accounting, transactions are recognized in an association’s financial records at the time when cash is received or disbursed. Put another way: the association only records transactions when they are reflected in the association’s bank account—cash in, and cash out. Therefore, assessment revenues are recorded when an owner pays their assessment and cash is received. Likewise, expenses are recorded only when a check is cut and payment is made to a vendor. This method is familiar to anyone running a household budget with a checking account, and so is often requested by smaller associations looking for a more simplified financial overview. Under a cash-basis approach, Accounts Payable, Receivable, and Accrual balance sheet accounts are not used, and budgeted cash receipts or disbursements are not part of the reporting process.
What Is Accrual Accounting?
With accrual accounting, revenue and expenses are recognized in an association’s financials during the time period in which the expense or revenue was incurred, which may not necessarily align with when the cash transaction occurs.
For example, under the accrual method, an association typically recognizes the full amount of assessed fee revenues on the first day of the month, even though many unit owners have not yet paid their fees. Before the fees are received, the asset is recorded in the Accounts Receivable account. As owners pay their assessments, the revenue is recognized in the cash account, while simultaneously decreasing the Accounts Receivable balance. The receipt of cash into the association’s bank account simply changes the classification of the asset on the balance sheet from Accounts Receivable to Cash.
Likewise, expenses are recorded when goods or services are received from a vendor, rather than when the invoice is paid. For example, though landscaping services rendered at the end of April may not be invoiced and processed until early May, the association will still record the expense on April’s income statement. Since the payment of the April landscaping service didn’t occur until May, an accrual is made as of 04/30/202X to recognize that the service was in fact received in April. The accrual journal entry increases both Total Operating Expenses on the Income Statement as well as an Accrued Expense liability account on the Balance Sheet. Thus, this journal entry records the expense in the period when the service was delivered, and also recognizes that the Association has a current liability that will need to be paid. The accrual is reversed next month when the invoice is entered and payment is made.
Our firm applies this method of accrual accounting for predictable expenses—like monthly contracts, for example—to ensure the highest level of accuracy in the monthly financial statements produced for the board. Similarly, accruals are entered for utility accounts such as electric, water and sewer, and gas usage. Since these services do not always perfectly align to a specific period, per diem utility accruals are made based on the most recently received utility invoices for a given period to ensure that the expense of the entire period is accounted for.
Which Is Right for My Association?
To decide which accounting approach is the best fit for your particular community, the first step is to conduct a needs analysis to help your board and management fully understand your community’s financial landscape. With that information in hand, you can then compare the benefits of both accounting methods in an applied, meaningful way—and then determine which makes the most administrative and financial sense for your condo, co-op, or association. Consider that:
Cash basis is simpler: Cash basis accounting requires less information tracking, and is a more familiar concept to most people, which can make it a more comfortable method with more easily readable financials. However, this method may not fully track either the assessed fees or expenses from goods or services received.
Cash basis ties to the checkbook: Since the cash method of accounting only records cash transactions, it is easier to see and understand your association’s actual cash on hand. Future anticipated revenues and expenses are not recognized or recorded.
There is one significant caveat when it comes to cash basis accounting, however:
Cash basis is not generally accepted: It is important to know that cash basis accounting does not conform to generally accepted accounting principles (GAAP). Therefore, it may not satisfy the requirements contained in your association’s organizational documents or the statutory accounting requirements of your state. Generally, a CPA firm will disclaim an opinion if cash basis accounting is used.
Accrual benefits cash flow management: This method provides more insight into future cash inflows and outflows via Accounts Receivable and Payable balance sheet accounts. Having AR and AP on the monthly balance sheet (and perhaps also having detailed supporting schedules) allows anyone reading an association’s financials to better understand the timing of cash receipts, as well as the amount of liabilities that must be paid. Certainly the collection of outstanding assessments due, and related collection issues, is a very important issue for many associations.
Accrual gives a fuller, more complete view: Accrual offers an association a more comprehensive view of both its operating results and its overall financial position. This is particularly true for: assessments, accrued but unpaid expenses (i.e., Accounts Payable), and prepaid expenses. With a more complete view of the association’s financial standing, it’s easier for a board to plan and make decisions, particularly when working with a complex budget.
If accrual has a drawback, it may be that it’s a more complex and nuanced accounting method, and therefore requires a bit more of its users than cash basis. Accrual accounting records and tracks all transactions that take place in each operating period without regard to when the cash transaction takes place. Non-cash-based transactions (like Accounts Receivable, Accounts Payable, and Prepaid Expenses) are recorded on the balance sheet of the financials, rather than having all transactions on the income statement. It can take some time to understand how this somewhat subtle difference affects the recorded transactions, and the interplay between the income statement and the balance sheet. However, because condos, co-ops, and HOAs often have complicated long-term capital reserve assets and expenditures, understanding how accrual accounting transactions are recorded and the relationship among these accounts is essential for good financial management.
To recap: for a small association with a limited number of people receiving and using the community’s financials, cash basis information may be appropriate. For larger associations with more complex budgets and capital reserve requirements, or those with many external users and stakeholders, accrual accounting is necessary to provide insights that are simply not available in cash basis accounting.
No matter the size or complexity of your community, however, performing a needs analysis prior to adopting or adjusting an accounting system is crucial to really understand the needs and wants of your particular organization. Ask yourself who’s using your statements; what information is important to them for their decision-making? Is a simple, easy-to-understand statement most important, or is more granular detail critical to making good decisions? Simply put, your choice of an accounting method and financial statement format should serve the purpose and needs of the primary users of the information.
Jim Merski, CPA, MBA, CFE, is the Chief Financial Officer at Newton, Massachusetts-based Barkan Management. He has over 20 years of experience in the real estate industry. Ryan Galvin is an Accounting Manager at Barkan Management, with 13 years of experience in property management.