HOA Accounting and Financial Statements Overview

HOA accounting is an important aspect of running a homeowners association, but it can be a tedious task. Board members have a responsibility to understand financial interim statements to guide the association’s financial course. This job can be complicated by inaccurate or incomplete financial reports. As poor reporting can make an already immense obligation harder to manage, it’s important for all board members to be able to understand and analyze financial reports to prepare the association for maintenance, repairs, homeowner bankruptcy, and even financial dishonesty.

To understand the association’s financial position, board members must have an understanding of the accounting method used. There are several methods that may be used to prepare your HOA’s financial statements. In most states, homeowners associations can choose one of three basis of accounting to prepare interim statements:

-- Accrual basis

-- Cash basis

-- Modified accrual basis

These accounting methods will be used to prepare several important financial reports for the homeowners association. The most important are the following:

Balance Sheet. The balance sheet explains the association’s financial situation by comparing assets minus liabilities to give a net worth. This report will show how much money is in the HOA’s bank account.

Statement of Income and Expense. This statement shows transactions for a certain time period — usually one month, quarterly, or annually. This report shows the amount the HOA spent for the time period compared to the budgeted amount for the period.

Associations are required to use specific accounting methods in some cases. While an accounting firm is not a requirement, it may be required to have an independent third party audit or review the association’s books once a year. Each accounting method comes with unique advantages with a different effect on HOA finances, thus it’s important for board members to understand which method the association will use.

Accrual Basis

Under the accrual basis of accounting, all HOA financial activities are reported on the financial statements. This type of accounting is usually considered superior because it offers the most complete overview of the HOA’s financial status compared to the modified accrual or cash methods. Using the accrual basis, all revenue is reported when it is earned and expenses are recorded on statements when they are incurred, regardless of when money actually changes hands.

How Revenues and Expenses are Recorded

The accrual accounting method significantly affects how the association records expenses and revenues.

Using this method, expenses are reported when they are incurred, not when they are paid. The Balance Sheet will have an Accounts Payable liability section. As items are paid, the association’s Accounts Payable and cash balance are reduced.

Revenues are also recorded when they are earned, not received. An asset section of the Balance Sheet titled Assessments Receivable is reported. As the association receives payments, the cash balance increases while Assessments Receivable is reduced or Prepaid Assessments increases.

Effect on Financial Statements

The accrual basis method means transactions are recorded daily, weekly, and monthly as they are incurred. This results in an automatic generation of very detailed reports. For every report, the total balance must agree with the amounts reported as a liability or asset on the association’s Balance Sheet. The balance sheet should have Aged Assessments Receiveable as an asset with Accounts Payable and Prepaid Assessments as liabilities until the amounts are paid.

The three financial reports generated with the accrual basis accounting method are:

Accounts Payable. This report lists unpaid invoices at the end of the current accounting period.

Aged Assessments Receivable. This report lists owners who have not paid assessments and other fees in full at the end of the accounting period. This report will show who owes the association money, how much is owed, how long the debt has been outstanding, and the total balance the association is owed.

Prepaid Assessments. This report lists owners who have paid assessments in advance, how much each owner has prepaid, and the total prepaid balance.

Cash Basis

The cash basis accounting method records expenses and income when money changes hands.

How Revenues and Expenses are Recorded

Using the cash basis, revenues are reported when they are received, not when they are earned, and Cash increases on the association’s balance sheet. The cash basis accounting method does not include Assessments Receivable or Prepaid Assessments accounts on the balance sheet. All expenses are also reported when paid, not when they are incurred. The Cash balance is the only balance that decreases. There is no Accounts Payable account on the balance sheet.

Effect on Financial Statements

With the cash basis method, amounts for Accounts Payable, Assessments Receivable, and Prepaid Assessments are not reported on the association’s balance sheet. While the board may choose to prepare Accounts Payable, Prepaid Assessments, and Assessments Receivable reports, the accuracy of the reports cannot be verified easily by comparing the totals to the amounts reported on the Balance Sheet.

Modified Accrual Basis

The modified accrual basis or modified cash basis combines the cash and accrual basis accounting methods.

How Revenues and Expenses are Recorded

Using the modified accrual basis method, revenues are reported when earned and not when they are received, just as with the accrual basis. Expenses, on the other hand, are reported when they are paid, not when they are incurred, the same as with the cash basis method.

Effect on Financial Statements

With the modified accrual basis method, the amounts for Prepaid Assessments and Assessments Receivable will be the same as the amounts on the balance sheet, just as with the accrual basis method. If unpaid invoices are reported under Accounts Payable, the amounts will differ than those recorded on the balance sheet because these expenses are recorded using the cash basis instead of the accrual basis.

California Law Governing HOA Accounting

The California Civil Code has many requirements for homeowners association interim financial statements.

Pro Forma Budget

Civil Code Section 5300(b)(1) requires that the annual operating budget that is distributed to the membership every year be prepared on an accrued basis. The law requires associations prepare pro forma operating budgets that include all estimated expenses and revenues using the accrued basis method of accounting.

Because the annual operating budget must be prepared using the accrual basis, the Income Statement should be prepared on the same basis. The Income Statement compares actual expenses and revenues reported for the period with estimated expenses and revenues reflected in the budget.

Board Budget Review

According to Civil Code Section 5500(c), the Board of Directors must review the current year’s actual expenses and revenues compared to the year’s budget at least quarterly. The HOA board must review HOA finances for reserve and operating expenses. Because the budget must be prepared using the accrual basis, financial statements should also be prepared on the accrual basis.

Right to Inspect and Copy Records

Civil Code Section 5200(a)(3)(d) states that records must be prepared with an accrual or modified accrual basis whenever an HOA member requests copies of the association’s financial records.

Which Accounting Method is Recommended for HOAs

The accrual basis of accounting is generally recommended for homeowners associations as it meets the requirements of California Civil Code. With the accrual basis, all revenue and expenses are reflected in the HOA’s Income Statement and amounts are comparable to the budget. The Balance Sheet will also include Accounts Payable, Prepaid Assessments, Assessments Receivable, and totals for each that agree with detailed reports for easier management of the association’s finances.

Drawbacks of the Cash Method

The cash method is popular because it is very straightforward: like a checking account, this method tracks when money comes in and when it goes out. While the cash method of accounting is easy to prepare and understand, it ignores unpaid bills and uncollected HOA fees.

While some associations use the cash basis, this comes with drawbacks. Under the cash basis, financial reports can be misleading because amounts are not always comparable to the budget and the income statement may not reflect all incurred expenses or revenue earned. Using the cash basis method, the balance sheet will not include Accounts Payable, Prepaid Assessments, or Assessments Receivable, and the association’s financial information may be incomplete. It’s true that board members and managers are usually more interested in how much cash was disbursed and received during any given period, but cash flow can be obtained from other financial information like bank records at the end of each month.

When an association uses the cash accounting method, it is especially important to consider the long-term. There must be some way to review upcoming expenses to avoid making financial decisions based on what financial reports and balances indicate is available. It’s also important to have a realistic budget to avoid making decisions based on income that may not be collected.

Drawbacks of the Modified Accrual Method

The modified accrual basis is used by many California HOAs as it offers some benefits of the accrual method with advantages of the cash method. Some HOA boards feel it is easier to record expenses as they are paid instead of when they occurred while recognizing that revenues should be recorded when they are earned as with the accrual basis method. The accrual basis method offers this advantage without compromising as long as the books are kept open for two weeks after the end of the accounting period to record expenses in the correct period.

While the modified accrual method is less complex than the accrual method, the main downside is it does not always accurately match all expenses and income in the fiscal month being evaluated. This can distort the association’s real financial situation. Because expenses are reported on a cash basis, monthly reports may be misleading. As an example, if the board approves a $50,000 roofing contract, it will not show up on monthly reports until the check is written. The board may think it has extra money because the $50,000 is an obligation not yet on the books.

Posted on NOVember 22, 2019 on /  BY ARTICLE CITY

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