Cash vs Accrual Accounting

Karen Danzinger - Friday, March 1, 2019

Most associations and management companies keep the books on a cash basis. What does this actually mean, and what is the effect on the financial statements?

The cash method of accounting is one where revenue is recognized when collected, and expenses are recorded when paid. So, when cash actually changes hands. While this may seem a logical way to report the association’s activity for the month, as it reflects actual cash in and cash out, it does not reflect the actual financial situation of the association. You might be reporting all your income (maybe you’re in a coop where everyone actually pays their maintenance on time), but maybe you haven’t paid $10,000 worth of bills. Your income statement bottom line, net profit or loss, would be overstated by $10,000, just because you opted not to pay a bill that month. Cash financial statements are that easy to manipulate.

So what’s the alternative?

Accrual accounting tracks and reports all transactions, if cash has not yet been received (accounts receivable) or paid (accounts payable). Income is reported when earned, and expenses when incurred, whether paid or not. So, if the plumber comes out on the 25th of the month to repair that broken pipe, that expense is recorded that month, not next month when the bill is actually paid. This method of accounting provides the most accurate picture of the association’s financial position and is the REQUIRED method of accounting for yearend financial reports – the review or audit performed by your independent CPA.

What is the effect on your financial statements?

Cash basis reports will not show line items like accounts receivable, accounts payable, prepaid insurance, or prepaid maintenance. You may know how much cash is in your bank account, but you don’t know how much of that cash actually belongs to next year (prepaid maintenance), how much more you should have (accounts receivable), or how much less (accounts payable). As I said earlier, they give you a very incomplete picture.

Accrual based reports will show all revenues earned and all expenses incurred and are therefore directly comparable to the budget. This allows management to use the budget and financial statements to more effectively control expenses and plan for future expenses. Of course, you can still get cash information from the cash flow statement, the check register, or the bank statements.

One of the biggest risks of using cash-based statements during the year, or even modified cash method (uses accrual method for income but cash method for expenses), is that you may find yourself in a position of having interim financial statements that may be quite different from the year end audited statements from your CPA. Maybe you are going along all year thinking you are doing ok, that you are in line with budget, and then find out at year end that your manager or management company hadn’t paid a lot of bills, and your expenses are a lot higher than you thought! You could easily find yourself in a situation where you were telling the membership that all is ok, only to find out at year end that it’s not ok, and you need to assess for a budget shortfall, or dramatically increase maintenance next year. Furthermore, accrual-based reports conform with GAAP, and would be required if the association applies for a loan. 

What’s the takeaway here? While accrual-based reports may be slightly more difficult to read at first glance, they do actually provide a much clearer picture of the association’s financial position. If you aren’t sure how to read them, as your CPA for a lesson. The time spent is well worth it.