Deciding which Accounting method to use is not something to take lightly or to think that if you don't like it one way you can switch to the other method. When you chose your method, adherence to the initial choice is imperative for the sake of consistency in comparing financial reports from year-to-year.
Available Accounting Methods
- Cash Accounting: income is counted when cash (or a check) is actually received, and expenses are counted when actually paid
- Accrual Accounting: transactions are counted when they happen, regardless of when the money is actually received or paid.
- Modified Accrual: this is actually the method most often followed for community accounting. It simply means that if an AP bill has not been received for an expense incurred during an accounting period, the expense is not recorded (accrued) until the bill is actually received.
The Five Million Dollar Rule
Most state laws follow the rule if your community has revenue of less than $5 million per year, you are free to choose which accounting method to adopt. Whichever method you use, it's important to realize that each option has its positives and negatives.
Cash Accounting Method
Cash Accounting is the simplest accounting method for non-accounting people to grasp. But there is a danger that it may not accurately portray the true financial position of the community. For example, if there is not enough money to pay all the bills for the community, those unpaid bills will not show on the financial reports. The officers may think the financial position of the community is fine when, in fact, they are falling further and further into debt.
When to choose Cash Accounting
Smaller communities and those that do not have utility expenses paid by the community might be good candidates for Cash Accounting. Also, self-managed communities where there are no accounting types on the Board of Directors might want to consider Cash Accounting.
Accrual Accounting Method
In Accrual Accounting, revenue is recognized when it is charged regardless of when payment is received, and expenses are recognized when the product or service is received or completed regardless of when paid. If a bill for a product or service is not received but the delivery has been made or the work completed, then an ‘Accrual Entry’ is made in the General Ledger to record the expense. This is the most accurate accounting method because it shows the true financial position of the community. But it is hard for non-accounting people to understand accrual. They may ask “How come the electricity expense shows $300.00 on the financial statements but I don’t see a check to the electric company on the Check Register”. The answer is, of course, the expense was ‘accrued’ because the electric bill was received (or due) even though it was not paid during the accounting period.
Modified Accrual Accounting Method
This simpler version of Accrual Accounting simply means that if an AP bill has not been received for an expense incurred during an accounting period, the expense is not recorded (accrued) until the bill is actually received. There is good logic for this; the community manager most likely needs to review the each bill and approve it for payment and if no bill has been received yet, then it can’t be approved for payment. Under Modified Accrual, the accounts receivable system is generally handled the same way as it is under the full Accrual Accounting above. So Modified Accrual mainly means differences in how and when the community expenses (payables) are recorded on the books.
While simpler to understand, Cash Accounting can result in a see-saw (spiking) effect with revenue and expense reporting. Under Cash Accounting, expenses can be high one month because all the bills were paid, then low the next month because not all the bills were paid, making it hard to judge how the community is actually doing financially compared to the budget.
Both Accrual methods above have the effect of “smoothing out” the income and expenses from period to period. Accrual Accounting not only matches the income for an accounting period to the expenses incurred during that period, but it also is a better tool for comparing actual financial results to the approved budget. For reasons of accuracy and visibility of the true financial position of a community, either method of Accrual Accounting is better than Cash Accounting.
A good community accounting system will let you decide which accounting method to follow for a particular community, and be able to handle any of the three accounting methods discussed above. In the event a community demands one accounting method over another, the well designed accounting software will give you the capability to meet these demands on a community-by-community basis. It’s not unusual for a management company to have a mix of accounting methods within its portfolio of managed communities—and the accounting software needs to be capable of handling the preferences of each community.