Yalnes, Inc. Blog

Methods of Accounting

There are three commonly known methods of accounting: 

• in “Cash Basis”, income is recorded when it is received and expenses are recorded when they are paid;
• in “modified accrual basis”, income is recorded when it is earned, and expenses are recorded when they are paid; 
• in “accrual basis”, income is recorded when it is earned and expenses are recorded when they are incurred.  Accrual basis provides the most accurate financial reporting and is in compliance with GAAP (Generally Accepted Accounting Principles). 

There are several ways to determine the basis on which the financial statements are presented.  Accounts Receivable, Prepaid Assessments, Accounts Payable, and Prepaid Expenses will appear on the Balance Sheet if financial statements are prepared on an accrual basis.  Accounts Receivable and Prepaid assessments will appear on the Balance Sheet if financial statements are prepared on a modified accrual basis.  Since expenses are recorded when they are paid in a modified accrual financial statement, neither Accounts Payable nor Prepaid Expenses will appear on the Balance Sheet.  A Balance Sheet prepared on a cash basis will not contain any of these line items.

Accounts Receivable is an Asset and indicates the total amount of income earned (i.e. assessments levied against owners) but not yet received as of the date of the financial statement. 

Prepaid Assessments represents assessments, which owners paid in advance.  Prepaid Assessments are a Liability to the Association as this is income already received but not yet “earned” (or not charged against owner’s accounts).

Accounts Payable represents expenses incurred but not yet paid and is a Liability to the Association.  Accounts Payable may consist of actual expenses for which an invoice was received but not paid as of the date of the financial statement, and expenses accrued but for which an invoice was not yet been received (or paid).

Prepaid expenses are expenses, which were not yet incurred but already paid as of the date of financial statement.  Prepaid expenses are an Asset to the Association.  An example of a prepaid expense is an insurance premium, which is paid in full for the entire year when an invoice arrives.  When the insurance premium is paid, it appears on the Balance Sheet under Assets but it does not appear as an expense on the Profit and Loss Statement.  The premium would then be “expensed” on a monthly basis in equal monthly installments.

Profit and Loss Statement (P&L) can also help determine on which basis the financial statements are prepared when a budget comparison/variance is shown on the statement.  Because income and/or expenses are recorded when they are incurred, items such as “Homeowner Assessments” in the income section of the P&L, and all “Contract” line items in the Expenses Section of the P&L, should have zero variance from the budget in an accrual basis.  Member of the Association are charged based upon a budget prepared in advance, so 100% of income for a given period will be recorded at the time it is budgeted for and charged to owners’ accounts.  Expenses based upon contracts should also match the budget and have a zero variance because they are recorded when incurred whether or not an invoice is received from the vendor.

December 12, 2008 - Posted by Dimitri Shein, CPA | Accounting | Accounting