HOA accounting is perhaps one of the most demanding facets of managing a homeowners association. Yet, it also remains integral to the smooth operations of any community.
Also known as the basis of accounting, the accounting methods dictate the timing at which you record your association’s financial transactions. There are three accounting methods to choose from — Cash Accounting, Accrual Accounting, and Modified Accrual Accounting.
Choosing which basis of accounting to use is the first step towards better financial management. Accrual Accounting is generally regarded as the best accounting method, though the method you select will depend on what state laws and your governing documents say. For instance, California Civil Code Section 5300 mandates the use of the Accrual Basis of Accounting when creating a pro forma budget.
To better understand how each accounting method works, let’s break them down one by one below.
Using the Cash Basis of Accounting, you must record income and expenses upon the exchange of money. This means you will only record income once you actually receive the payment as opposed to when you earn it.
This accounting method frequently uses Cash as an accounting entry, increasing when you receive income. It does not, however, use account titles such as Prepaid Assessments or Assessments Receivable. Again, this is due to the nature of the method wherein you only report income once you receive cash.
Similarly, you will only record expenses once you actually pay for them as opposed to when you incur them. As such, the Cash account decreases. Using this method, you will not use any payable account titles such as Accounts Payable or Notes Payable.
It is worth noting that the Cash Accounting method does not conform to the Generally Accepted Accounting Principles (GAAP).
What is Accrual Accounting? Using the Accrual Accounting method, you must record revenue upon earning it and expenses upon you incurring them. For instance, when you would record the Assessments Receivable account on the Balance Sheet when assessments become due. Once you receive the payments, the Cash account will increase and the Assessments Receivable account will decrease.
The same goes for your association’s expenses. When you incur an expense, you record the Accounts Payable account on the Balance Sheet. Once you pay for this expense and money changes hands, both the Cash account and the Accounts Payable account will decrease.
Interestingly, the Accrual Accounting method is the only method that conforms with GAAP. In addition to the standard financial statements, the Accrual Accounting method should also generate two additional reports:
The Modified Accrual Basis of Accounting, also known as the Modified Cash Basis, uses an amalgamation of the Accrual and Cash methods. Using the Modified Accrual method, the timing for income recording follows the Accrual Basis and the timing for expense recording follows the Cash Basis.
Accrual Accounting for HOA communities is considered by most experts to be the best basis of accounting. This is because the Accrual method gives you a more accurate picture of your financial situation. Since you report income and expenses as they occur instead of when money moves, you immediately know how much money you have.
In contrast, the Cash Basis might lead you to draw inaccurate conclusions about the state of your HOA finances. Because you don’t record expenses as you incur them, you might end up spending more money than you actually have.
You can also generate more accurate financial statements when you use the Accrual method. Even though you can create reports for Prepaid Assessments, Assessments Receivables, and Accounts Payables using the Cash Basis, you have no way of confirming their accuracy because no such accounts appear on the Balance Sheet.
Financial statements are written records of the association’s financial transactions. They reveal the financial position of your HOA community. Generally, there are five financial statements HOAs should prepare — Balance Sheet, Income Statement, General Ledger, Cash Disbursements Ledger, and Accounts Payable Report.
How do I find HOA financial statements? HOAs should make association records available to all homeowners as stipulated in state laws and your governing documents. You will usually find the proper procedure on how to request copies of your HOA financial statements within your bylaws or CC&Rs.
At the very least, homeowners should be able to review the association’s Balance Sheet and Income Statement, along with a statement of their account and the year’s budget. Though, you should remember that board members have a responsibility to keep homeowner information private. That means restricting access to more sensitive records such as delinquency reports and bank statements.
The Balance Sheet provides you with a look at your association’s financial health. It indicates your association’s net worth by subtracting your HOA’s liabilities from your assets. It also displays how much money the HOA has in its bank accounts.
As its name indicates, the Balance Sheet should always balance out. In other words, your liabilities plus equity should be equal to your total assets. Always keep the following equation in mind:
Assets = Liabilities + Equity
Also known as the Statement of Income and Expense, the Income Statement shows you the association’s revenue and expenses for the period (usually a month or a year). It deducts your total expenses from your total revenue to arrive at a net profit or loss.
This report also compares your actual expenses with your budgeted expenses. Furthermore, it covers year-to-date amounts. Using the Income Statement, you can evaluate your month’s or year’s performance in fiscal terms. You will know how much you are spending on a given expense which will allow you to make a decision on whether or not to cut back on it the following period.
Your General Ledger consists of all the association’s financial transactions. It acts as the basis from which all other reports are created and verified.
For General Ledger bookkeeping, you must record every transaction in numerical order — according to how you ranked them in your Chart of Accounts — and based on the date of occurrence. Every entry must consist of a debit and a credit account, with the total debit amount equaling the total credit amount. This is one of the most important homeowners association accounting rules.
Known to some as a Check Register, the Cash Disbursements Ledger consists of all the checks that have been written. This report should include all pertinent information such as:
The Cash Disbursements Ledger is not limited to checks issued by the association, though. You can also record transactions made in cash to keep track of the cash outflow of your HOA.
The Accounts Payable Report lists all of your association’s unpaid expenses. This report lets you know how much you owe, to whom you owe money, and any applicable due dates. With this report, you can determine what your expense obligations are for the period and manage your money more wisely.
An HOA audit is basically a review of your previous year’s financials. It is a necessary step in accounting for HOA communities and provides you with insight on how to prepare for the following year.
How often should an HOA be audited? To know how often to audit your HOA, you must first look at the laws in your state. Most states require associations to conduct an audit or review at least once a year. Some HOA governing documents say the same, while others only require it once every few years.
Even if no such requirements apply to your association, it is one of the HOA accounting best practices to perform an audit or review on an annual basis. In doing so, you can get a better grasp of your financial condition and make more informed decisions.
Keep in mind that you should never perform audits or reviews internally. You must always hire a third party, typically a Certified Public Accountant (CPA), so as to get an outsider’s perspective.
Homeowners associations, while non-profit, are still recognized as corporations by the federal government. As such, you should know how to prepare for tax season.
In general, there are two forms HOAs can use when filing taxes: Form 1120 and Form 1120-H.
Ideally, you would have at least one member on your board who is familiar with HOA accounting. But, the truth is that many HOA boards lack the knowledge or time to manage accounting duties. Here are some alternatives to taking the DIY approach:
HOA accounting is definitely one of the more difficult, not to mention boring, tasks that come with association management. But, since it plays a key role in the success of your community, it is unavoidable. Proficiency in the subject is not necessarily essential, though you do need someone who can help you navigate its complexities.
Find an HOA management company that can shoulder most of the burden of accounting. Start your search today using our online directory, which you can use to filter companies according to your area.