BASIS OF ACCOUNTING WHICH ONE SHOULD YOU USE?

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1 Basis of Accounting, in its simplest form, is an accounting term that describes the timing for recording the various financial transactions (e.g., Revenues and Expenses) for your homeowners association. When preparing the interim financial statements for a homeowners association, managers and board members alike ask the question: Basis of Accounting Which One Should You Use? How you answer this question can have a far reaching impact on the quality and usefulness of your financial records. We, at James Ernst Accounting, recommend that you use the Modified Accrual Basis of Accounting when preparing your association s interim financial statements. Keep in mind, you re running a business, and having accurate and timely financial statements will enable you to effectively and efficiently manage the financial activity of your association. THREE (3) DIFFERENT BASIS OF ACCOUNTING To understand the different Basis of Accounting that are available for homeowners associations, we have provided a brief discussion of three (3) different Basis of Accounting that you can elect to use when preparing your interim financial statements; the Accrual Basis of Accounting, the Cash Basis of Accounting, and the Modified Accrual Basis of Accounting. ACCRUAL BASIS OF ACCOUNTING Under the Accrual Basis of Accounting, which is in conformity with Generally Accepted Accounting Principles (GAAP), all Revenues of your association are reported when earned and all Expenses are reported when incurred. Further, this Basis of Accounting will result in the automatic generation of three different, but very important, detailed supporting documents; Aged Members Receivable Report, Prepaid Assessments Report, and Accounts Payable Report (these reports may go by different names in your accounting software). Revenues Accrual Basis Members Assessments are reported as Revenue on your Income Statement (Statement of Revenues and Expenses) when they are charged to the members (i.e., earned by the association), which is usually on the first day of the month. At the same time, a corresponding Asset (Assessments Receivable) is reflected on your Balance Sheet.

2 As member s payments are received, your Balance Sheet will show an increase in Cash and a corresponding decrease in Assessments Receivable (if received after assessments are charged), or an increase in Prepaid Assessments (if received before assessments are charged). Aged Members Receivable Report The Aged Members Receivable Report lists all owners who have not paid their assessments, and other charges (e.g., late fees, interest, etc.), in full as of the end of the accounting period. This report shows who owes money to the association, how much they owe (the unpaid balance), how long it has been outstanding (e.g., current, over 30, over 60, and over 90 days), and the total balance due to the association. Prepaid Assessments Report The Prepaid Assessments Report lists all owners who have paid their assessments in advance of the due date (e.g., January s assessments are paid in December). This report shows who has paid in advance, how much they have prepaid, and the total prepaid balance. Validation To validate the accuracy of these reports: The amounts for total assessments and other members receivables that are listed on the Aged Members Receivable Report must agree to the amounts reflected as Assets (Assessments Receivable, etc.), and the amount for total prepaid assessments listed on the Prepaid Assessments Report must agree to the amount reflected as a Liability (Prepaid Assessments) on your Balance Sheet. Expenses Accrual Basis The cost of various services that are provided to your association (e.g., bookkeeping, insurance, landscaping, management, utilities, etc.) are reported as Expenses on your Income Statement when these services are provided. At the same time, your Balance Sheet will show a corresponding increase in Accounts Payable. As these items are paid, your Balance Sheet will show a decrease in Cash and a corresponding decrease in Accounts Payable. Accounts Payable Report The Accounts Payable Report lists all unpaid invoices as of the end of the accounting period. Validation To validate the accuracy of this report: The total for the unpaid invoices listed on the Accounts Payable Report must agree to the amount reflected as a liability (Accounts Payable) on your Balance Sheet, at least until these invoices have been paid. Annual CPA Review or Audit The Accrual Basis of Accounting is generally reserved for the Annual Review or Audit of your association s financial statements that is provided by your independent CPA. CASH BASIS OF ACCOUNTING Under the Cash Basis of Accounting, which is not in conformity with GAAP, all Revenues of the association are reported when received and all Expenses are reported when paid. Therefore, this Basis of Accounting will not result in the automatic generation of the Aged Members Receivable, Prepaid Assessments or Accounts Payable reports. JAMES ERNST ACCOUNTING 01/27/2016 PAGE 2 OF 6

3 Revenues Cash Basis Members assessments are reported as Revenue on your Income Statement only when payments are received. At the same time, only Cash is increased on your Balance Sheet. No Validation Although you could generate an Aged Members Receivable Report and a Prepaid Assessments Report, you could not validate the accuracy of these reports by comparing the totals in the reports to the amounts reflected on your Balance Sheet, because these accounts are not included on your Balance Sheet when using the Cash Basis. Expenses Cash Basis The costs of various services that are provided to your association (e.g., bookkeeping, insurance, landscaping, management, utilities, etc.) are reported as Expenses on your Income Statement as these services are paid. At the same time, only the Cash balance is decreased, there are no adjustments to Accounts Payable on your Balance Sheet, because this account is used only when recording expenses under the Accrual Basis of Accounting. No Validation Although you could generate an Accounts Payable Report, you could not validate the accuracy of this report by comparing the total in the report to the amount reflected on your Balance Sheet, because this account is not included on your Balance Sheet when using the Cash Basis. MODIFIED ACCRUAL BASIS OF ACCOUNTING The Modified Accrual Basis of Accounting is a combination of the Accrual Basis and Cash Basis; therefore, if you prepare your interim financial statements using the Modified Accrual Basis, the total amounts reflected on the Aged Members Receivable Report and Prepaid Assessments Report will agree to the amounts included on your Balance Sheet. However, the total amount of the unpaid invoices listed on the Accounts Payable Report, if provided, would not be reflected on your Balance Sheet, because Expenses are only recorded when paid. Revenues Modified Accrual Basis All Revenues are reported when earned, not when received. The timing for recording Revenues under the Modified Accrual Basis is the same as for the Accrual Basis. Expenses Modified Accrual Basis All Expenses are reported when paid, not when incurred. The timing for recording Expenses under the Modified Accrual Basis is the same as for the Cash Basis. JAMES ERNST ACCOUNTING 01/27/2016 PAGE 3 OF 6

4 Davis-Stirling Common Interest Development Act Although the Modified Accrual Basis is not recognized by the American Institute of Certified Public Accountants (AICPA), it is considered to be an acceptable Basis of Accounting for the interim financial statements for a homeowners association because its use has been codified in the Davis-Stirling Common Interest Development Act under Section 5200(a)(3) of the California Civil Code. RECOMMENDATION USE THE MODIFIED ACCRUAL BASIS OF ACCOUNTING As indicated above, your interim financial statements can be prepared using any one of three (3) different Basis of Accounting. However, we recommend that the interim financial statements of your homeowners association be prepared using the Modified Accrual Basis of Accounting. There are a variety of reasons that we recommend the Modified Accrual Basis, as follows: 1. Civil Code California Civil Code Section 5200(a)(3) allows for the interim financial statements of your association (Balance Sheet, Income Statement with Budget Comparisons, and Detailed General Ledger) to be prepared on the Modified Accrual Basis. 2. Revenues Assessments, and other revenues, are recorded when earned, which is the same as for the Accrual Basis. 3. Expenses As for expenses, you may not be able to record all expenses when incurred (Accrual Basis); instead, you may find it easier to record some, if not all, of the expenses when paid (Cash Basis). Even if you keep your books open long enough with the hope of capturing all expenses in their proper accounting period, you risk sacrificing your ability to present interim financial statements to the Board of Directors in time for their periodic review. 4. Budget Although the budget is, in theory, prepared on the Accrual Basis, expenses are often estimated on the Cash Basis; therefore, Cash Basis Expenses may still be comparable to Budgeted Expenses. 5. Cash Flow Information The need to know exactly how much cash was received and paid out each month is the argument often presented in favor of the Cash Basis, which reports only cash received and cash disbursed during the interim period on your Income Statement. However, you can capture this cash flow information simply by looking at the following documents, while still preparing your financial statements on the Modified Accrual Basis. a. Bank Statements and Bank Reconciliations Your monthly Bank Statements tell you how much Cash was received (deposited in the bank), and how much Cash was used to cover checks that were presented to the bank for JAMES ERNST ACCOUNTING 01/27/2016 PAGE 4 OF 6

5 payment, along with other bank charges. As for your Bank Reconciliations, they tell you which checks were issued, including those not yet presented to the bank for payment. Keep in mind that one of the duties of the Board of Directors, as specified in California Civil Code Section 5500(a) and (b) Board Review, is to review a reconciliation of the association s Operating and Reserve Bank Accounts on at least a quarterly basis (we recommend a monthly review). This bank information should be made available to management and the Board of Directors for each interim financial reporting period. b. Check Register In addition to examining the monthly Bank Statements and Bank Reconciliations, you can also look at your monthly Check Register, which lists all checks issued for the interim period. This information should also be included with your interim financial statements. c. Cash Received and Cash Paid Out Therefore, by examining the information provided in the Bank Statements, Bank Reconciliations and Check Register, you can determine exactly how much cash was received and how much cash was paid out during the period. d. Annual CPA Review or Audit Regardless of which Basis of Accounting that is chosen for your interim financial statements, when your independent CPA performs their annual Review (required by California Civil Code Section 5305, if annual gross income exceeds $75,000) or Audit (if required by your governing documents), they will usually present your financial statements on the Accrual Basis of Accounting. Therefore, you can prepare your interim financial statements on a timely basis using the Modified Accrual Basis of Accounting, which is in accordance with the Civil Code, while comparing reported revenues and expenses with the amounts listed in your budget, and still be able to capture the amount of cash that went into and out of your association. After the end of the year, your independent CPA s Annual Reviewed or Audited financial statements will be presented on the Accrual Basis. CALIFORNIA CIVIL CODE The following sections of the California Civil Code also support our recommendation that you use the Modified Accrual Basis of Accounting on your interim financial statements. Although some Code Sections require or suggest that your interim financial statements be prepared on the Accrual Basis, each Code Section also allows for them to be prepared on the Modified Accrual Basis of Accounting, as follows: Civil Code 5205(a) Record Inspection and Civil Code 5200(a) Definitions Under Section 5205(a), a member may request copies of their association s financial records for inspection; and, according to Section 5200(a)(3), these records shall be prepared in accordance with an Accrual or Modified Accrual Basis of Accounting. [emphasis added] JAMES ERNST ACCOUNTING 01/27/2016 PAGE 5 OF 6

6 Civil Code 5300 Annual Budget Report Under Sub-Section (b)(1) of this Civil Code, the association shall prepare A pro forma operating budget, showing the estimated revenue and expenses on an accrual basis. If the budget is required to be prepared on the Accrual Basis, then the Income Statement, which compares the revenues and expenses for the period with the revenues and expenses estimated in the budget, should be prepared on the same basis. However, budgeted expenses generally reflect estimated expenditures that are expected to be paid during the year (Cash Basis); therefore, allowing for the use of the Modified Accrual Basis of Accounting. Civil Code 5500(e) Board Review This Section of the Civil Code states that the board shall Review an income and expense statement for the association s operating and reserve accounts on at least a quarterly basis. However, we recommend a monthly review. Given that the budget is prepared on the Accrual Basis for revenues, but probably uses the Cash Basis for expenses, which is the Modified Accrual Basis, then it stands to reason that the interim financial statements that are required to be reviewed by the Board of Directors should also be prepared on the Modified Accrual Basis of Accounting. CONCLUSION As noted above, the Basis of Accounting describes the timing for recording financial transactions. There are three (3) Basis of Accounting that are available for the interim financial statements of your homeowners association (Accrual Basis, Cash Basis or Modified Accrual Basis of Accounting). As for the question: Basis of Accounting Which One Should You Use? We recommend that you use the Modified Accrual Basis of Accounting for your association s interim financial statements, because it provides both accurate and timely financial reporting. Under the Modified Accrual Basis of Accounting, management and the Board of Directors will have the ability to reasonably compare Revenues (Accrual Basis) and Expenses (Cash Basis) reported on your Income Statement with amounts listed in your budget. Further, your Balance Sheet will be supported by various detailed reports; Aged Members Receivable, Prepaid Assessments and Accounts Payable (to the extent you record some unpaid expenses on the Accrual Basis). You will also be able to separately capture cash flow information by examining your Bank Statements, Bank Reconciliations and Check Registers. Finally, when your annual financial statements are Reviewed or Audited by your independent CPA, they will be presented on the Accrual Basis of Accounting. JAMES ERNST ACCOUNTING 01/27/2016 PAGE 6 OF 6