An HOA’s board of directors is ultimately responsible for managing the association’s finances. So, it is wise for board members to be familiar with the various methods of accounting, financial documents, and budgeting techniques HOAs use. Here, we’ll provide a brief overview of these HOA accounting basics.
Identifying Methods of Accounting
To understand how the HOA’s finances are doing, it’s important to know which accounting method the HOA uses and how that accounting method works.
There are two basic accounting methods that businesses use: cash basis accounting and accrual basis accounting.
Under the cash basis method, revenue is recorded when it is received, and expenses are recorded when they are paid. This accounting method mimics the flow of cash into and out of a business’s accounts and should reflect the current funds available to it.
Conversely, using the accrual method, revenue is recorded when it is earned, and expenses are recorded when they are incurred. Instead of showing how much money is going into and coming out of a business’s bank accounts, this method provides a picture of how much of the business’s available funds can be and are being spent each month. Accrual basis accounting helps a business figure out and stick to its monthly budget.
For instance, just because the HOA receives the year’s annual assessments in January doesn’t mean it can spend the entire amount during the first month of the year. The HOA needs to make those funds last twelve months, and by breaking down finances on an as-earned basis (that is, dividing the yearly sum into twelve parts and recording one part each month), accrual basis accounting helps the HOA do just that.
In addition to these two primary accounting methods, there is a third method known as the modified accrual (or hybrid) method, which is a combination of both cash flow and accrual basis accounting.
Most HOAs use some form of modified accrual basis accounting. Typically, this will involve using accrual accounting to record revenue when it is earned, and a mix of cash and accrual accounting to record some (or all) expenses when they are paid and other expenses when they are incurred.
This method allows the HOA to recognize revenue only when it is available for use, but record applicable expenses when the funds actually leave the bank account. This way, an HOA can base its purchases off the $10,000 of revenue it earns each month and record monthly insurance payments when they are incurred, but still have the flexibility to record its maintenance invoices (such as the charge for fixing a leaking pipe) when the invoices are paid.
It is important to understand how the HOA records its revenue and expenses to better track the state of the HOA’s finances and make any adjustments that need to be made to spending and saving to stay within the budget.
Reviewing Accounting Documents
After you have a good understanding of the accounting method the HOA uses, you’re ready to review the different financial documents the HOA uses to record various transactions. Basic HOA accounting documents can include a balance sheet, income statement, and general ledger report, among others. The HOA should compare these documents to the bank statements it receives each period.
The Balance Sheet
The balance sheet compares the HOA’s current assets to its liabilities and equity by providing the totals of each item as well as any net income gains or losses. An HOA’s assets consist of everything the HOA owns, including the cash it has in the bank and the value of its property, such as a playground, clubhouse, or fitness equipment. Liabilities are items the HOA owes, like unpaid bills and invoices. Equity is the net value of the association, or what’s left over when the liabilities are subtracted from the assets. So, if the balance sheet is balanced correctly, the total amount in the assets section should equal the total amount listed in the liabilities and equity section.
By glancing over the balance sheet, a board member can learn the value of each item the HOA owns, the total cash worth of the association, and the amount of money the HOA owes. The higher the HOA’s equity, the greater its overall monetary value.
The Income Statement
Another important document to review is the income statement, which will provide a comparison of the HOA’s actual spending to the amount the HOA has budgeted for each item. This allows the board to see if the HOA is successfully following the budget, or if the HOA is overspending and needs to either make cuts or increase assessments to maintain the HOA.
Because the income statement breaks down spending by budget group and by the current period and year to date, the board can pinpoint when and where any overspending is taking place. Board members can easily locate the social committee’s overspending in March, for instance, or the total amount the HOA has spent on water bills since January 1. Both expenses can be compared to the amounts actually budgeted for these costs.
The General Ledger Report
The board should also review the general ledger report for each period, which records each individual transaction for each budget item and provides information about the recipient of (or person who paid) each listed amount.
Because the general ledger report also assigns each transaction to a general ledger code that ties it to its specific budget item, entries are easy to sort and categorize. For example, each individual electric bill payment can be located, as well as each different purchase for clubhouse office supplies made during the report’s period, such as March 1 through March 31.
Lastly, the board should compare the amounts listed on the HOA’s financial documents to the bank statements it receives. Uncleared checks and pending deposits will not appear on the bank statement, but will be recorded on the HOA’s financial documents. So, the HOA will need to reconcile the bank statement by adding the amounts of the pending deposits and subtracting the amounts of the uncleared checks from the ending balance shown on the bank statement to make it match the bank account balance listed on the HOA’s balance sheet.
If these two balances do not match after any pending or uncleared transactions have been accounted for, then any errors or discrepancies on the various charges and payments will need to be located and corrected. This way, payments are not missed (or vendors overpaid), and the budget amounts are assigned correctly.
Usually, the errors will be on the HOA’s financial documents, so a payment made to Paul’s Pool Maintenance for $1,115 on the HOA’s financial documents would probably be the result of a typo made when recording the actual expense amount, $111.50, that is listed on the bank statement.
Putting Budgets into Practice
Each year, the board will create an annual budget to designate how much money is needed to operate the HOA and how much should be saved for extraordinary expenses and capital improvements, which are improvements made to the community to enhance the quality of members’ lifestyles and the value of the association. Money used for the general maintenance of the HOA will be kept in the operating accounts, and money that the HOA is saving for future expenses will be placed in the reserve fund.
Effective planning for upcoming repairs can be done through taking a reserve study of the HOA every few years, which will assist the board in keeping tabs on all the assets owned by the HOA, how much they have depreciated, and when they will need to be repaired or replaced. This way, owners will not be surprised by special assessments needed to cover repairs that take the HOA by surprise.
By comparing the results of a reserve study to the current year’s financial documents, the HOA can plan the budget for the coming year. While there are many items your board must consider when planning a budget, here are a few important ones:
- Determine whether the HOA overspent or stayed within the budget. Can any costs be cut? The income statement should help with this!
- Determine whether any vendor or contractor costs will increase or decrease in the coming year (such as insurance policy costs).
- Using your reserve study, identify the costs of any major upcoming repairs or replacements.
- Additionally, put aside a sum of money for the HOA to place in its reserve account.
Thank you for joining us for this brief overview of HOA accounting basics. We hope this summary has been helpful in depicting the general aspects of managing an association’s funds wisely. For more board member tips be sure to check out our blog for monthly updates, and contact us today to sign up for a HOA board member training course.