By: Helsing Admin

Accounting is the process of recording, summarizing, analyzing, and interpreting (money-related) activities to permit individuals and organizations to make informed judgments and decisions. By law, a homeowners association must keep accounting records. This article is designed to assist Community Association Managers, Boards of Directors, and homeowners in reading and understanding the financial records of the Association.

Accrual Accounting

Accrual Accounting is an accounting method that measures the performance and position of a company or business entity by recognizing economic events regardless of when cash transactions occur. The general idea is that economic events are recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made (or received). This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company’s current financial condition.
Accrual accounting is considered to be the standard accounting practice for most companies, with the exception of very small operations. This method provides a more accurate picture of the company’s current condition, but its relative complexity makes it more expensive to implement. This is the opposite of cash accounting, which recognizes transactions only when there is an exchange of cash.

Here is a simple example. Let us assume that a homeowners association is supposed to receive $2,000 a month in assessments. Let us also assume that it has vendors, all of which do work monthly and all of which get paid monthly. Let’s also assume that in one month 25% of the homeowners paid assessments late – they paid the next month, and that all of the vendors were paid monthly. Below is how the income statement for this association would look using both methods of accounting. As you can see, under the Cash Method of Accounting it would appear that the association lost money in the first month, and made a profit in the second month. Using Cash Accounting makes it difficult to see if income and expenses are as expected. The Accrual Accounting system assumes that all money will eventually be received, and all bills will eventually be paid. So income is counted when it is due, not when it is actually received; and expenses are counted when they are owed, not when they are actually paid. Therefore, it provides a clearer picture of how expenses and income are actually occurring.

Modified Accrual Accounting

Accrual Accounting is expensive because in many cases, the bookkeepers need to make entries based upon projected expenses, and then come back later and adjust them. For example, utilities are often only billed every other month. The exact amount of the billing is generally unknown until the invoice from the utility company actually arrives. So, assuming the last bill was for January and February, and the association is now preparing the Financial Statements for March – the bookkeepers would have to estimate (guess) what the March bill would be, and make that entry. Then, when they actually receive the March/April bill, they need to go back and make adjusting entries so that the actual March expenses are shown on the Financial Statements. Since the bookkeepers need to make more entries, the cost of maintaining the books increases.

Realizing that Accrual Accounting is a more appropriate way to manage the Association’s finances, but also that such accounting is expensive, California law currently allows associations to maintain their books using either Accrual Accounting or through a method called “Modified Accrual Accounting”. (NOTE: California Law does NOT allow associations to use the Cash Accounting Method.)

There is no such thing as “Modified Accrual Accounting” under Generally Accepted Accounting Principles (GAAP). It is a term used in the Common Interest Development industry to mean an accounting method where income is realized on an accrual basis (when it is earned) and expenses on a cash basis (when bills are received). Because Association Assessments are very easy to post on an accrual basis (you just post what is due from everyone on the first of the month) and are a known fact and not a guess – it is not more expensive or time-consuming to post them on an accrual basis. Posting expenses when you get bills from the vendors is actually a cash method – but over the year averages out close enough that the financials have meaning.

Some associations will keep a few important expenses on an accrual basis (if they would otherwise skew the financial reporting), and the rest of the expenses on a cash basis. Typically, accounting services may be kept on an accrual basis, since it is a large expense usually only incurred once a year. By accruing this entry, it allows the actual payments to be amortized over twelve months and make the comparison of the income statement to the budget more realistic.

Fund Accounting

Homeowners Associations, as well as many other non-profit and public sector entities, have a need for special reporting to financial statements that show how money is spent, rather than how much profit was earned. Profit-oriented businesses only have one set of self-balancing accounts or general ledger. On the other hand, nonprofits can have more than one general ledger depending on their needs. Homeowners Associations must be able to produce reports that can detail expenditures and revenues for multiple funds, and reports that summarize the financial activities of the entire entity across all funds. For example, under California law, the Association’s Reserve Account must be a separate fund from the operating account. The Reserve Account is bound by specific legal restrictions that do not apply to the operating fund.

Given that funds are essentially having more than one general ledger, the accounts can be designated by the special use of account numbers, each set of numbers representing a specific fund. Alternatively, they can be designated by using certain recording and reporting capabilities and features of the accounting software being used. For this reason, many nonprofit organizations and the public sector will often use off-the-shelf or custom-designed accounting software that is flexible enough to accommodate the needs of special reporting.

Fund accounting is a particularly useful financial reporting system for nonprofit organizations and the public sector, due to their unique operating requirements and the specific needs of their financial statement users. To that end, the accounting profession has recognized this need and continues to support the use of fund accounting by providing extensive standards and principles in this area.

While most associations will have both a reserve and an operating fund, many associations may have other funds. For example, there may be a cost center that provides services to only one sub-set of homeowners; those expenses, and sometimes the revenue against them, need to be tracked separately.

A Fund may or may not have its own bank accounts. By law, the Reserve Fund must have a separate bank account, but in other cases you can have different accounting funds for moneys that are all in one bank account.

The Balance Sheet

Balance Sheet-The financial statement which shows the amount and nature of business assets, liabilities, and owner’s equity at a specific point in time. It is also known as a Statement of Financial Position or a Statement of Financial Condition.

A Balance Sheet is simply a picture of a business at a specific point in time, usually the end of the month or year. By analyzing and reviewing this financial statement, the current financial “health” of a business can be determined. The balance sheet is derived from our accounting equation and is a formal representation of the equation

Assets = Liabilities + Owner’s Equity.

The categories and format of the Balance Sheet are based on what are called Generally Accepted Accounting Principles (GAAP). These principles are the rules established so that every business prepares their financial statements the same way.

Assets

Formal Definition: The properties used in the operation or investment activities of the association.

Informal Definition: All the good stuff a business has (anything with value). The goodies.

Additional Explanation: The good stuff includes tangible and intangible stuff. Tangible stuff is what you can physically see and touch, such as vehicles, equipment and buildings. Intangible stuff is like homeowners’ assessments that are due but have not yet been paid. Examples of assets that many individuals have are cars, houses, boats, furniture, TV’s, and appliances. Some examples of Homeowner Association type assets are cash, accounts receivable, notes receivable, inventory, and equipment.

Assets are listed based on how quickly they can be converted into cash; this is known as liquidity. In other words, they’re ranked. The asset most easily converted into cash is listed first, followed by the next easiest and so on. Of course, since cash is already cash, it’s the first asset listed.

Liabilities

Formal Definition: Claims by creditors to the property (assets) of the association until they are paid.

Informal Definition: Others’ claims to the business’s stuff. Amounts the business owes to others.

Additional Explanation: Usually one of the association’s biggest liabilities (hopefully they are not past due) is to suppliers and vendors where they have bought goods and services and charged them. This is similar to us going out and buying a TV and charging it on our credit card. Our credit card bill is a liability. Another good personal example is a home mortgage. Very few people actually own their own home. The bank has a claim against the home, which is called a mortgage. This mortgage is another example of a personal liability. Some examples of Homeowner Association liabilities are accounts payable, notes payable, and mortgages payable.

Owner’s Equity (Capital)

Formal Definition: The owner’s rights to the property (assets) of the association; also called proprietorship and net worth. Technically, in a Homeowners Association, because the homeowners are members, they don’t have an actual “right” to demand this equity as individuals.

Informal Definition: What the association owes the owner (again, it would never be paid unless for some reason the association was to be dissolved). The good stuff left for the owners assuming all liabilities (amounts owed) have been paid.

Additional Explanation: Owner’s Equity represents the owner’s claim to the good stuff (assets). Most people are familiar with the term equity because it is so often used with lenders wanting to loan individuals money based on their home equity. Home equity can be thought of as the amount of money an owner would receive if he/she sold their house and paid off any mortgage (loan) on the property. While homeowners in an association cannot really demand their share of this money, it is important to have positive equity should the association need a bank loan or other financial assistance. A negative equity might be a deterrent to a lender thinking about financing a home in the association.

Owner’s equity (or net worth or capital) is increased by money or property contributed and any profits earned, and decreased by owner withdrawals and losses.

All Balance Sheets contain the same categories of assets, liabilities, and owner’s equity.

Below is a Balance Sheet for an Association. Because this Association, like most associations, has more than one fund, this Balance Sheet has three columns: one for each of two funds, plus a total. In effect, it is three separate Balance Sheets displayed on the same page. Some Associations may choose to display a separate Balance Sheet for each fund, and that is perfectly acceptable. Note also the various Cash and Asset Accounts, and the various Liability Accounts. Each of those accounts will have supporting documentation elsewhere in the Financial Statements.

The Income Statement

The Income Statement is a formal financial statement that summarizes the association’s operations (revenues and expenses) for a specific period of time usually a month or year.

A fiscal year is the period used for calculating annual (yearly) financial statements. While a large number of associations use the calendar year (January-December) as their fiscal year, a business can elect to use any other twelve-month period such as June-May as their fiscal year.

The categories and format(s) of the Income Statement also follow the rules known as Generally Accepted Accounting Principles (GAAP) and contains specific revenue and expense categories.

The following types of accounts are used to prepare the Income Statement:

Revenue (Also Called Income)

Formal Definition: The gross increase in owner’s equity resulting from the operations and other activities of the association.

Informal Definition: Amounts the association obtains from assessments and other income like fines and late fees.

Expense (Also Called Cost)

Formal Definition: Decrease in owner’s equity resulting from the cost of goods, fixed assets, and services and supplies consumed in the operations of the association.

Informal Definition: The costs of doing business. The stuff we used and had to pay for or charge to run the association.

Additional Explanation: Some examples of association expenses are office supplies, management fees, landscaping services, utilities (gas, water and electric) and insurance.

Hopefully a business earns a profit called net income (revenues are larger than expenses). If expenses are larger than revenues, however, a net loss results.

The major sections of an income statement are the heading, the revenue section, the expense section, and the final calculation of a profit or loss. The heading should contain the name of the association, the title of the statement, and the period covered by the statement.

Below is a sample of an Income Statement. Just like in the Balance Sheet lesson, this association has two funds and this Income Statement displays both funds side by side. Some Associations might choose to produce a separate Income Statement for each fund, and that is perfectly acceptable.

Net Income is the excess of revenue (Income) over expenses. The YTD net income figure on the income statement needs to agree with the net income figure on the balance sheet.

Accounts Receivable

The Accounts Receivable (A/R) Report reflects the history of homeowners and others who owe money to the Association. While booking a receivable is accomplished by a simple accounting transaction, the process of maintaining and collecting payments on the accounts receivable subsidiary account balances can a very time-consuming activity. Under California law, a homeowner’s assessments are due on the first day of the month and late on the 15th, unless the governing documents provide for a longer period. This same law allows for a procedure of non-judicial foreclosure which provides for the filing of a lien as soon as the homeowner’s account is 45 days delinquent. The total balances due on the Accounts Receivable Report should equal the amount shown on the balance sheet for the same period.

Below is a sample Accounts Receivable Report for an association. This is an Aging 120-Day report, which is a common type of aging report. Notice that it includes each homeowner that is late, it indicates how delinquent that homeowner is, and at the bottom gives a breakdown of what the delinquencies are (assessments, late fees, interest) as well as credits against assessments for subsidies or 2792.16(c) exemptions.

Accounts Payable

The Accounts Payable (A/P) Report reflects accounts for vendors or suppliers that the Association owes money, but hasn’t paid yet (a form of debt). Thus, the A/P is a form of credit that suppliers and vendors offer to the Association by allowing them to pay for a product or service after it has already been received. Commonly, suppliers or vendors will ship a product or provide a service, issue an invoice, and collect payment later, which creates a cash conversion cycle – a period of time during which the supplier has already paid for raw materials, but hasn’t been paid in return by the final customer.

The Accounts Payable report should also total the same amount of money as is reflected on the Accounts Payable line item of the Balance Sheet. It is, in effect, the back-up for that line item providing the detail for who is owed money. Below is an example of an Accounts Payable Report.

Prepaid Reports

There are instances where some accounts may be Prepaid. Homeowners may choose to pay their assessments in advance. These assessments are therefore prepaid and still the property of the homeowner – and not of the association. (Depending on the governing documents, there may be some technical points which make that not true in every case, but for accounting purposes it is correct.) The Annual Insurance Payment is usually paid up front and then expensed each month (remember the lesson on accrual accounting!), so the amount still not expensed is also a Prepaid Account. Prepaid Revenues are Liability Accounts because the association has not “earned” the money yet. Prepaid Expenses are assets because the association has paid for something it has not yet used. Below is a sample of a Prepaid report. Prepaid reports can be delivered in many formats, but should show who is prepaid, and how much credit is in their account.

Budget Comparison

The Budget Comparison Report is one of the most useful of all of the statements and schedules contained in the financial statement. Under California law, the Board must review it quarterly. A properly prepared Budget Comparison Report lists in one column the actual income and expenses for the period, and in the next column, the budgeted income and expenses for the period. In the last two columns, it will list the budgeted income and expenses for the period as a number and as a percent, and the difference between actual income and expenses for the period. It is also typical for the Budget Comparison Report to list the actual income and expenses Year-To-Date, and in the next column budgeted income Year-To-Date. Similarly, it should provide the differences between the actual income and expenses for the Year-To-Date against the budgeted income and expenses Year-To-Date, both as a number and as a percent.

It is extremely important to review this report carefully and make sure you fully understand why there are variances from the budget. It is probably the most important financial management tool for homeowners associations. Is water way over budget because rates increased? Is there a leak in a line? Are homeowners wasting water? Was the budget wrong – and if so, why?

Every significant deviation between actual income and expenses and budgeted income and expenses should be understood.

There should be a budget comparison report for every fund the association maintains.

Check Register

The Check Register is simply a list of all checks that were printed during the accounting period for which the Financial Statements were prepared. The Check Register should give the name of the entity paid, the amount, the date of the check, and the account number to which the check was applied. The check register should also list any canceled checks such that all checks are accounted for.

Bank Reconciliation

The Association’s General Ledger contains a record of the transactions (checks written, receipts from customers, etc.) that involve its checking account. The bank also creates a record of the company’s checking account when it processes the company’s checks, deposits, service charges, and other items. Soon after each month ends, the bank usually mails a bank statement to the association. The bank statement lists the activity in the bank account during the recent month as well as the balance in the bank account. That bank statement also becomes a part of the Financial Statements provided to the board of directors for review.

When the association receives its bank statement, the association should verify that the amounts on the bank statement are consistent or compatible with the amounts in the company’s Cash account in its general ledger and vice versa. This process of confirming the amounts is referred to as reconciling the bank statement, bank statement reconciliation, bank reconciliation, or doing a “bank rec.” The benefit of reconciling the bank statement is knowing that the amount of Cash reported by the association (the association’s books) is consistent with the amount of cash shown in the bank’s records.

Because the association writes many checks each month and homeowners collectively make many deposits as they pay their assessments, reconciling the amounts on the company’s books with the amounts on the bank statement can be time-consuming. The process is complicated because some items appear in the company’s Cash account in one month, but appear on the bank statement in a different month. For example, checks written near the end of August are deducted immediately on the company’s books, but those checks will likely clear the bank account in early September. Sometimes the bank decreases the company’s bank account without informing the company of the amount. For example, a bank service charge might be deducted on the bank statement on August 31, but the company will not learn of the amount until the company receives the bank statement in early September. From these two examples, you can understand why there will likely be a difference in the balance on the bank statement vs. the balance in the Cash account on the association’s books. It is also possible (perhaps likely) that neither balance is the true balance. Both balances may need adjustment in order to report the true amount of cash.

After you adjust the balance per bank to be the true balance, and you also adjust the balance per books to be the same true balance, you have reconciled the bank statement. Most accountants would simply say that you have done the bank reconciliation or the bank rec.

If the association has a management company or an independent bookkeeping company, the actual reconciliation will be done by that firm. If not, the treasurer must do the reconciliation. However, it is important that the association’s Board of Directors (and the manager, if they have one) carefully review this reconciliation AND they compare it with an original bank statement. Most banks will provide an additional original bank statement to the association’s treasurer.