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ACCOUNTING METHODS

Associations are not required to use accounting firms to keep their books but they are required to use certain accounting methods in the keeping of their books. Moreover, depending on the size of their budget and/or their governing documents, they may be required to have an independent third party review or audit their books annually. When hiring a CPA, associations should choose one who specializes in homeowner associations. There are issues involving an association's reserve accounts and tax filings that are unique to associations, which a generalist would not know.

Accounting Methods. Financial statements vary greatly depending on the accounting method used in their preparation. To understand the association's financial position, board members must know which method was used.

1.  Cash. This method is similar to keeping a checkbook. Cash is recorded when deposited in the bank. Expenses are recorded when a check is written to pay a bill. This is the simplest of the three methods but can be misleading. It does not reflect unpaid bills or uncollected assessments. If the board approves a roofing contract for $100,000, that obligation does not show up on the statement until a check is actually written to the contractor. As a result, the financial statement could show the association had a surplus when, in reality, it would be overdrawn if the association paid all its obligations.

2.  Accrual. Instead of tracking cash flow, this method tracks transactions. Income is recorded when earned and expenses are recorded when incurred. For example, income is recorded when the association bills owners not when the money is actually received. The same is true for expenses. If the board approves a roofing contract for $100,000, the expense is posted though the money may not leave the bank account for another six months.

3.  Modified Accrual. This method is also known as "Modified Cash" accounting and "Hybrid" accounting because it mixes cash and accrual. Modified accrual is allowed under the Davis-Stirling Act (Civ. Code § 5200(a).) Associations using modified accrual typically record assessments when due (accrual basis) but record expenses when paid (cash basis). This method is frequently used by management companies for their monthly financial statements to boards of directors. Because expenses are reported on a cash basis, monthly financial reports can be little misleading. If the board approves a $75,000 painting contract, it does not show up on monthly financial reports until a check is actually written to the contractor. As a result, the board may think it has excess funds when, in reality, it has a $75,000 obligation that has not yet shown up on their books.

Fund Accounting. Because most associations are created as nonprofit mutual benefit corporations, fund accounting rather than "profit and loss" is the more appropriate method of reporting monthly financial statements.

  • Operating Fund. The operating fund is used for general operations of the association. The membership's monthly dues are deposited into this fund and operational expenses are paid from this fund.
  • Reserve Fund. The reserve fund is for those monies designated for long-term repairs and replacements and may only be withdrawn upon the signatures of two directors.
  • Other Funds. Other funds can be created for special projects that may be paid for by (i) special assessments, (ii) litigation settlements, (iii) insurance payments, etc.

Pro Forma Budget. The annual operating budget distributed to the membership each year must be prepared on an accrual basis. (Civ. Code § 5300(b)(1).)

ASSISTANCE: Associations needing legal assistance can contact us. To stay current with issues affecting community associations, subscribe to the Davis-Stirling Newsletter.

Adams Stirling PLC