There are many important characteristics of a successful community association. However, the cornerstone of an association is its financial position and accounting practices. This is why it is so important for board members to understand basic accounting vocabulary.
- What is GAAP?
- What is the difference between Cash and Accrual accounting?
- What is a Balance Sheet?What is an Income Statement?
- What is a General Ledger?
To some, the word “math” is gibberish and accounting causes their eyes to glaze over. Hopefully, the following five steps dissipate the confusion and provide you with basic accounting vocabulary knowledge.
GAAPFirst, there are accounting rules. Similar to grammar, the accounting process is based on predetermined rules, procedures, and forms. These concepts and standards are referred to as GAAP (pronounced “gap”). GAAP is an abbreviation for Generally Accepted Accounting Principles which are established by the American Institute of Certified Public Accountants (AICPA). The purpose of GAAP is to provide standardized formats and documentation that make it easy for professionals from different industries to comprehend other company financials. GAAP assists in making financial statements more useful and understandable.
CASH vs. ACCRUAL ACCOUNTING
Does your association use Cash or Accrual accounting methods? What’s the difference? Cash accounting recognizes transactions when you either receive payments or pay bills. An example of cash income is entries in your checkbook – you record income when money is added to your account, and deduct payments when you write a check or enter an automatic debit. An example of a cash expense is paying a utility bill. Cash accounting is best for small associations with few transactions that pay all their bills on time, as it provides limited information. Cash accounting records the “now” and does not recognize unpaid bills which impact available cash later.
In Accrual accounting, a transaction is recorded when it occurs, not when the funds are actually received or the bill actually paid. Some examples include recognizing pay when an employee accumulates their work hours as opposed to when they collect a paycheck. A second example includes recording a bill when the work is performed instead of when the invoice is paid. This accounting method is more complete than Cash accounting as it provides more detail with an overall picture of the general financial health of the association.
Most associations use a variation of these two principles, which is called a Modified Accrual method. In Modified Accrual (also called Modified Cash), financial statements include Accrual accounting’s accrued revenue numbers but excludes minor expense line items on the Balance Sheet. Some examples of omitted expenses include prepaid insurance and accrued expenses. The point of this Modified method is three-fold. First, it provides the treasurer and board with reasonable financial information. Second, this method may eliminate the need for a full-charge bookkeeper; thus, it can be more cost effective to the association. Finally, these financials are less confusing to the average homeowner. However, Modified Accrual does not provide the best picture of the overall financial condition of the association and may, in fact, distort the numbers such that the association seems to have more funds than it really does.
Regardless of which method an association chooses for their financial reporting, it is important that the board treasurer ensures that the association follows a consistent accounting method.
The Balance Sheet is a summary of account balances on a given date, typically at the end of a month, quarter, or annually. Balance Sheet accounts are categorized as Assets (what the association owns), Liabilities (what the association owes), and Owner’s Equity (what would be reimbursed to the owners if the association were to dissolve). Just as the name indicates, the Balance Sheet must balance by fulfilling the following equation: Owners’ Equity = Assets minus Liabilities.
Assets include cash, property, and other things of value owned by an association. This includes, but is not limited to, operating and savings accounts, investments, assessment delinquencies (funds owed to the association), prepaid insurance, utility deposits, prepaid expenses, and both property and equipment less accumulated depreciation. Depreciation is defined as a decrease or loss of value.
Liabilities represent what the association owes to others. Some examples of liability accounts include accounts payable (unpaid balances owed to vendors), mortgage payable (mortgage on a unit owned by the association), note payable (amount borrowed from a financial institution for a major repair project), and prepaid assessments (unit owner balances paid in advance that are not owed the association until the due date, typically the first of the following month).
Owner’s Equity represents the association’s net worth. This is the difference between Assets and Liabilities and can be subdivided into the following categories:
The Replacement Reserve is a savings account for replacement of major property assets such as roofs, sidewalks, elevators and amenities. The association must have a clear understanding of the replacement reserve’s purpose, asset values, projected useful life of assets, and projected remaining life of the assets. All associations should have a reserve study conducted by a qualified professional (preferably one with the RS – Reserve Specialist – designation) to determine how much should be set aside annually in order to have adequate funds when the useful life of every asset reaches an end. In fact, more and more states are mandating that community associations have reserve studies conducted, with updates every 3 – 5 years.
The Operating Fund balance represents current operating monies – actual if using the Cash method, actual and accrued if using the Accrual method.
Initial Working Capital includes funds collected from the first buyers in a new community, although the governing documents for some associations require a continuing collection of working capital from every subsequent purchaser as well. Depending on an association’s documents, home owners may or may not be able to collect reimbursement of this Working Capital fund from buyers when they sell their home.
An Income Statement summarizes both income and expenses by category for an association. The categories represent each budget line item, or account, as well as a Net Profit or Loss. Community association budgets should be reconciled so that income equals expenses, but the Income Statement will indicate variations to the budget. The Income Statement reflects whether an association is profitable. A profitable association is summarized at the end of the Income Statement as having net income and an association not doing as well would show a net loss. Other names for an Income Statement include Profit and Loss Statement (P&L), Earnings Statement, Operating Statement, Statement of Revenue and Expenses, and Statement of Operations.
A General Ledger is a formal, detailed record of all Association accounts, transactions and entries. Entries in a General Ledger are categorized under the same account names that appear on the Balance Sheet and Income Statement. If you question a balance on any line of a financial statement, then review the General Ledger for specific transactions under that particular category.
With this vocabulary of basic accounting fundamentals, Boards of Directors can explain to homeowners that GAAP defines how entries are made on the financial statements. Communicate the difference between cash, accrual, or modified accrual financial reporting methods. Understand the inter-connection between the Balance Sheet, Income Statement, and General Ledger. And, finally, have the vocabulary to communicate basic accounting information to homeowners and the association CPA to ensure that everyone understands the financial health of their community.
This article is provided by Principal Management Group of Houston.