Your Association’s Financial Statements: Basis of Accounting

Homeowners and boards receive association financial statements at various times during the year.  For many, reading and understanding financial reports can be challenging  Understanding the basis of accounting used to prepare financial reports is a vital first step to comprehending your association’s financial position and results from operations.

Understanding if revenues are recorded only if earned (billed) in the current period, or if revenues include receipts of amounts assessed for a previous or future period, affects your ability to assess operating results and the balance sheet.  Knowing whether operating expenses as presented in the financial statements are for the current period only, or if an expense account includes payments to vendors for past or future periods is incredibly important.

Most monthly statements of revenues and expenses include an association’s actual results, budget, and variance. What if the financial statements present actual assessments of $260,000 versus a budget of $200,000?   What if budgeted expenses for a period total $150,000 but actual expenses total $100,000?  What do these situations mean to readers? Understanding your association’s basis of accounting is necessary to provide readers of financial statements with a foundation of basic and useful knowledge.

The most common bases of accounting used for associations include the accrual basis, modified accrual basis and cash basis.  

Cash Basis

There are a variety of cash basis financial report presentations.   The cash basis approach most commonly used for associations present revenues that reflect the receipt of cash, and expenses that report the disbursement of funds.   On the balance sheet, the association would not present receivable from owners. The reader is not going to know how much is owed to the association.  If owners pay assessments in advance, some cash basis financial statements include such receipts in assessments revenues, some record a prepaid assessment liability on the balance sheet. There are several interpretations of what the cash basis of accounting represents.  It is vital to understand how the accounting has been presented in financial statements.

Modified Accrual Basis

The modified accrual basis is very commonly used for association monthly financial statements. Assessments and other member charges are recorded as revenue when they earned or billed to owners. This approach is the same as the accrual method. Expenses are typically recorded when disbursements are made, which is akin to the cash basis of accounting.  The modified accrual basis is a hybrid method requiring the reader to understand what revenue and expense accounts are recorded on the accrual basis and which are recorded on the cash basis. Again, additional knowledge is needed to fully understand how the financial statements you are reading have been presented.

Accrual Basis

Publicly traded companies present their financial statements using Generally Accepted Accounting Principles (GAAP). The accrual basis of accounting (GAAP) is the most complete and accurate method for recording revenues when they are earned (usually when billed to owners) and expenses when they are incurred, regardless of when an association receives cash or processes payments to vendors.  Under the accrual basis, associations present a balance sheet presenting the association’s financial position at a point in time that includes accounts receivable (assessments billed but not received) and prepaid assessments (assessments received from owners but not yet billed/earned), loans, deferred revenue, prepaid expenses, accounts payable.

Assessments are recorded and presented in the association’s statement of revenues and expenses when billed to owners, and typically represent budgeted amounts. Association’s usually bill assessments to owners at the beginning of each month in accordance with the association’s budget. The aggregate cumulative billed but uncollected assessment for all owners is combined and presented on the balance sheet as accounts receivable.  As owners’ payments are received, accounts receivable balances decrease. Using the cash basis, an association may have uncollected assessments, but because accounts receivable is not an account based on cash, accounts receivable is not presented on the balance sheet.

Assessments received from owners before assessments are earned are considered prepaid.  Under the accrual method, assessments are recognized as income when earned.  If an owner pays their assessments before they are due, the association does not recognize the assessment until the month they are billed, and therefore records such a receipt as a prepaid assessment. On the first of the next month, the prepaid assessment would be recognized as income.

Expenses that have been incurred but not paid as of the period-end should be accrued. An expense will typically be recorded based on vendor invoices or contracts.  On the balance sheet, the aggregate total of all expenses incurred but not paid will be presented as accounts payable or accrued expenses. 

When reviewing accrual basis financials, readers should develop an understanding of the relationships between cash balances, accounts receivable and other asset and liability accounts to revenue and expense accounts.  If assessments have been billed but owners have not paid, accounts receivable will increase.  Depending on the extent of delinquencies, a bad debt provision may be required. Further, the board of Directors should review the impact of unpaid assessments on cash balances. If delinquencies are significant, boards may need to review budgeted expenditures and decrease monthly costs in order to retain acceptable cash balances.

Consistency

Whichever basis of accounting is used, accountants and managers should ensure that the basis is applied consistently.

We encourage boards, owners and other readers to understand what basis of accounting is used for their association’s financials. Without that knowledge it is difficult to fully understand the accuracy and usefulness of financial statements.