What are Cash, Accrual and Modified Cash Methods of Accounting?
What are Cash, Accrual and Modified Cash Methods of Accounting?
Methods of Accounting
There are three methods of accounting. They are as follows:
A method of accounting defines how financial transactions are recorded in the financial statements. It is important that a board of directors understands what method of accounting is being used for their financial statements. Without this knowledge, they cannot accurately use the financial statements as a tool.
Cash
The cash method is the method most easily understood and is simple to maintain. It is simply what it states - cash transactions are recorded when they occur. That is, when cash (or forms of cash such as checks, money orders or charges) are deposited into the bank account the association recognizes income When checks are written or cash is taken out of a bank account, the association recognizes expenses on its financial statements.
The cash method can be compared to an individual’s checkbook. There are transactions recorded when money is put into or paid out of a bank account. A cash balance is kept as a running total. Generally, cash is the only asset on the balance sheet of the financial statement; that is, cash is the only recorded asset of the association.
The weakness of a cash system is that only those transactions that go into or out of the bank are recorded. If the person in charge of financial matters does not make a bank deposit or does not write a check, the board can be misled as to the financial status of the association. They could assume that there is less or more cash, less or more income and expenses, depending on whether all deposits have been made and all checks have been written.
For some very small associations who have very few transactions and make bank deposits and write checks in a timely manner, the cash method of accounting may be appropriate. For most associations, however, most accountants feel that an association needs to use the accrual method or at least the modified cash method of accounting.
Accrual
The accrual method of accounting is considered to be in compliance with “generally accepted accounting principles” (GAAP). It is the most accurate means of assessing the financial status of an association.
Under the accrual method, income and expenses are recorded when they are incurred, regardless of when they are deposited into the bank or when checks are written. Thus, income is recorded when the unit owners are assessed, not when they make a payment. The amount of unpaid dues is shown on the balance sheet as assessments/accounts receivable. An accrual basis financial statement will then, usually, have at least two assets on the balance sheet - cash and accounts receivable. Expenses are recorded when the product or service is provided, not when the check is written. For example, landscape contract for January would show in the January financial statements even though the landscaper was not paid until February. The amounts owed to vendors, but not paid at the end of the month would show as accounts payable in the liability section of the balance sheet. (There could be other assets and liabilities such as prepaid insurance or taxes, taxes payable, etc. but they will not be discussed here.)
A financial statement under the accrual method then states the true picture of the association. The board would know exactly what expenses had been incurred during the month and what income is due the association. Granted, the cash flow of the association may not agree with the net income as either cash has not been received yet or checks have not been written. But the board can better manage the future knowing exactly where they stand.
The draw backs to the accrual method are that 1) it is more difficult for users to understand, 2) it may require that the books be kept open later so that bills can be received and properly accrued, and 3) it requires a higher level of accounting/bookkeeping knowledge to properly prepare accrual basis financial statements. For that reason some associations prefer to use the modified cash basis during the year and only convert to accrual basis for their year end audit or review.
Modified Cash
The modified cash method of accounting is a hybrid between cash and accrual. There is no standard as to what items are modified. It is common for community associations to record income on the accrual method and expenses on the cash method. Thus, there is accounts receivable on the balance sheet but no accounts payable.
This method of accounting can be very viable for many associations due to the fact that most expenses are standard. The majority of the expenses occur on a monthly basis and are fairly static. Some examples are utilities, management contract, pool and landscaping. If expenses are paid promptly and if there are any outstanding, unusual type expenses remaining at the end of the month and those are brought to the board’s attention, the modified cash method may be considered to be appropriate for many associations.