When it comes to HOA accounting, the foundational step to success is to use the right basis of accounting. Learn why accrual accounting for HOA is the best accounting system you can use.
In this article:
The Importance of Accrual Accounting for HOA
Do you know which accounting system is best for your homeowners association?
It’s an important question that all board members and HOA managers should be considering. Choosing the correct accounting method is an important decision, as it can affect how a business’s financial state is managed. You also don’t want to find yourself choosing the wrong system then experience the pains involved with trying to switch.
There are three primary methods of accounting: accrual accounting, cash accounting, and modified accrual accounting. For homeowners associations, there is a preference for accrual accounting over the other two methods. To understand why this is so, let’s first take a look at these three bases of accounting.
What Is Accrual Accounting?
Using the accrual accounting method, your association reports all revenues and expenses the moment you earn or incur them. It doesn’t take the date of the actual exchange of cash into consideration. It’s also the only basis of accounting that conforms with GAAP, also known as Generally Accepted Accounting Principles.
Under this basis of accounting, it’s normal for your HOA to use account titles like “Prepaid Assessments” and “Assessments Receivable” in the books and statements. So, when it’s time to collect assessments, you can expect to see the “Assessments Receivable” increase. As homeowners pay their dues and the HOA receives them, the “Assessments Receivable” account decreases, and the “Cash” balance increases.
The process is similar when it comes to recording expenses. Liability titles like “Accounts Payable” appear on the balance sheet and books. When you incur expenses (i.e. when the services are provided), this account title increases. It only decreases when you settle your payables. At the same time, the “Cash” balance decreases because you made payments.
What Is Cash Accounting?
Cash accounting, on the other hand, takes a completely different approach. It heavily relies on when cash is actually exchanged, which is why it’s called cash accounting.
Using this method, you only record revenues when you receive the money. In a similar fashion, you only record expenses when you make payments.
Under this basis of accounting, account titles like “Assessments Receivable” or “Accounts Payable” don’t appear on the balance sheet.
What Is Modified Accrual Accounting?
Finally, modified accrual accounting is a combination of accrual accounting and cash accounting. Using this basis of accounting, revenues follow the timing of the accrual basis while expenses follow that of the cash basis.
To explain, you record revenues as you earn them. Under the modified accrual accounting method, you use account titles like “Assessments Receivable” and “Prepaid Assessments.” Once the association charges its members with assessments, the “Assessments Receivable” account increases.
Conversely, under this accounting system, you only record expenses upon payment, regardless of when they were incurred. So, for instance, after a vendor delivers their products or services, the HOA will not record the expense yet. It is only when the association pays for the products or services that the transaction will be reported.
The Disadvantages of Cash Accounting and Modified Accrual Accounting
While the cash accounting system can be ideal for small or cash-based businesses, there are some real downsides when using it for a homeowners association. The cash accounting method involves only recording expenses when the association makes payment and only recording revenue when the association receives payment.
While this makes the process less complex, it also leaves out the option to track beneficial information, such as accounts receivable or accounts payable. It is also possible to leave unseen expenses unaccounted for, which can make it seem like your HOA has more money than it actually does.
The cash accounting method can skew the numbers and be more deceiving, which can lead to doubt from residents and other board members.
Modified accrual accounting involves the same disadvantage, albeit only when it comes to recording expenses. Nevertheless, such a disadvantage can significantly influence your association’s finances. Therefore, it is not worth taking that risk. If nothing else, both cash accounting and modified accrual accounting aren’t in conformity with GAAP.
Why Accrual Accounting Is the Best Accounting Method for HOAs
The accrual accounting for HOA method involves recording your revenue when you earn them and your expenses when you incur them.
For example, if you hire a vendor for a property repair, the payment to them would be recorded as soon as the vendor performs the duty as opposed to when the payment goes through at the first of the month.
Using this accounting system helps your board keep track of the HOA’s actual profitability, regardless of cash present on hand or in the bank. You can also maintain a more accurate picture of your community’s financial health than with cash accounting or modified accrual accounting.
Refer to Your Governing Documents and State Laws
Accrual accounting for HOA remains, hands-down, the best method of accounting. However, it is still important for your HOA board to check your state laws and governing documents for any stipulations concerning accounting methods.
Some governing documents dictate a different method of accounting, while others permit using the cash basis or modified accrual basis for interim reports. In any case, referring to the governing documents and state laws can save you a lot of time and trouble.
If your governing documents mandate using the cash basis or modified accrual basis, consider amending them. After all, most experts consider the accrual basis as the best accounting system. Consult your association’s attorney on what you can do to remedy the situation.
The Right Homeowners Association Accounting Method
Overall, accrual accounting is more beneficial to HOAs over the cash accounting method or the modified accrual accounting method. Having a more accurate status of your financial situation will help in planning for things in the future, such as the budget for the next year. When in doubt, go for accrual accounting for HOA.
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- Why Is An HOA Annual Audit Necessary?
- How Can HOA Financial Management Help Your Community’s Finances?