FINANCIAL STATEMENTS MADE SIMPLE

FEELING OVERWHELMED BY ACCOUNTING JARGON?
HERE’S WHAT YOU NEED TO KNOW.

by Gayle L. Cagianut. CPA and Sandra K. Grunewald. CPA. MBA

The financial statement sits imposingly in front of you, a stream of numbers rolling endlessly down the page. You’re a new board member, studying the numbers, hoping to decipher their meaning. Then you’re hit with the accounting jargon: balance sheets and income statements; cash basis and accrual basis. You think you hear the financial statements quietly laugh at you, and you begin to wonder if the board should hire a psychiatrist instead of an accountant.

Don’t despair. Financial statements may seem confusing initially, but they’re not as difficult as you think. Here’s a look at the basics.

How they’re Prepared

Board members should be familiar with at least two basic types of financial statements: balance sheets and income statements. A balance sheet shows a picture of the association’s status at a particular date. It is sometimes called an assets, and liabilities statement. An income statement shows the association’s income and expense status over a period of time. It also may be known as a statement of revenues and expenses or a statement of profit and loss. A well-run association should receive both statements regularly - monthly or at least quarterly - and in a timely manner.

The first step in understanding financial statements is to determine whether they were prepared on a cash, accrual, or modified cash accounting basis. Why? Financial statements vary greatly depending on the accounting method. The reader must know which accounting method was used in order to accurately read the statement.

The three methods are defined as follows:

Cash Basis. Cash basis accounting is similar to a personal checkbook. Financial records track when cash is received or paid out. Income is recorded when a deposit is made to the bank. Expenses are recorded when a check is written to pay a bill.

Cash basis financial statements are easy to understand and to prepare. The disadvantage, however, is they don’t give a full picture of the financial condition. The records omit information on unpaid bills or uncollected assessments.

Accrual Basis. Accrual basis accounting tracks any and all transactions, even if cash is not received or paid out. For example, income is recorded when the dues are assessed, not necessarily when they are collected. The same is true for expenses. Expenses are recorded when they are incurred. For example, if the association buys new equipment, the purchase is recorded even if the bill has not been paid. Because it tracks all income and expenses, accrual basis accounting more accurately records the financial activity of a particular time period.

Modified Cash Basis. Most associations use modified cash basis accounting for their record keeping. It is a compromise between the cash basis and accrual basis. With this method, most transactions are recorded on the cash basis, but some are logged on an accrual basis. For example, accounts receivable (amounts owners owe the association) and income commonly are recorded as they are billed (accrual basis). Expenses are recorded as the bills are paid (cash basis). Other accrual adjustments, such as prepaid expenses and income tax accruals, are not made.

Modified cash basis is less complex than accrual basis financial statements. During the annual review or audit, however, a CPA often must convert the financial statements to accrual basis.

Income Statements

Why it important to know the accounting method? Because it has a great effect on the numbers that appear in the income statement.

The purpose of the income statement is to keep you abreast of income and expense status over a period of time; for example, "for the six months ended June 30, 1993." The income statement generally shows the current period - either the month or quarter - as well as a cumulative total for the year. At the end of each year, this statement "closes out" and starts again with the beginning of the new fiscal year.

An important feature of the income statement is the budget to actual comparison. This compares budgeted numbers to actual numbers. A variance column may also be added, showing whether the association is over or under budget for each account. This column helps to determine the reason for the variance.

Now the accounting method becomes important. If cash basis, is used, income is recorded as dues are paid and deposited. With accrual basis, the income is recorded as it is "earned." How does this difference affect the financial statements? Consider a 50-member association that bills its members $200 per month. In a given month, the association’s financial statement will show a $10,000 increase in the assessments receivable account’s balance.

Although the association has not received the money from the members, they have earned the right to collect that money. The assessment receivable account is reduced as members pay. Depending on the accounting method, the association may appear to have more income that it has actually earned.

For expenses, cash basis financial statements record expenses as checks are written. Accrual basis records expenses as they are incurred. When the association contracts or buys something, that amount is accrued as an expense, even if it isn’t paid for. As it is accrued, the accounts payable account on the balance sheet increases. For example, the utility bills for December do not arrive until January 10. On the cash basis method, the bills are January expenses. On the accrual basis, they are recorded in December.

Balance Sheets

While the income statement depicts the income and expenses of an association over a period of time, the balance sheet takes a "picture" of the association’s status at a particular date. The balance sheet is made up of three sections: assets, liabilities, and Fund balances (or member’s equity). They are defined as follows:

Assets. These are items the association "owns." Once again, the makeup of the balance sheet depends on the accounting method. Cash basis financial statements generally list only cash as an asset. An accrual basis financial statement may list cash, assessments receivable, prepaid expenses, and deposits (money held by the association which will be returned).

Liabilities. These are amounts "owed" by the association, whether for products, services, or taxes. Cash basis financial statements generally do not contain liabilities. Liabilities may appear on a modified cash basis statement, but they are only updated at the end of the year, since the expenses are not accrued monthly or quarterly.

Fund balances. This section is also known as members equity or retained earning. This generally states the current balance in the replacement (reserve) and operating funds. However, some accountants prefer to list reserves as a liability item. The sum of the assets must equal the sum of the liabilities and fund balances. This is a basic rule of accounting. Thus the term "balance" sheet.

It is important to understand what the reserve or replacement fund/liability indicates. Each accountant gives his or her own interpretation, so you need to understand what the fund represents. Usually it is the amount of money budgeted for future major repairs and replacements of the common areas. It is often the amount of cash the association has set aside. It also may be the amount the association projects it will have in its replacement fund by a particular dare. If the association falls short of its projections, "Due To" and "Due From" accounts may be set up to show the underfunded amount.

Once again, the presentation of the amounts allocated to reserves and the reserve fund balances vary greatly. The association, therefore, should discuss this with its financial statement preparer. At the end of the year, the CPA should adjust the financial statements to show the amounts budgeted for reserves, the amounts spent from reserves, and any permanent, approved transfers between operating and reserve funds.

As a board member, the association’s financial stability is one of your key responsibilities. This article should help you to understand the basics of financial statements. When reviewing the statements, don’t be afraid to ask questions. it is your duty to understand them.

What to Look for on the Balance Sheet

When reviewing balance sheets, ask yourself these questions:

• Is there sufficient cash to cover operating expenses?
• Is operating cash significantly increasing or decreasing? If it is increasing, should the excess be transferred to reserves or an operating savings account?
• Is the association’s reserves on target with projections?
• Are reserve expenditures being paid out of reserves?
• Does the cash balance equal the "fund" or "liability" reserve amount?
• Has the association "borrowed" from reserves to meet monthly expenses? If so, is there a plan to repay the amount?
• Are receivables - the amount members owe the association - increasing or decreasing?
• If receivables are increasing, does the board need to increase its collection actions? Does it need to "write off" bad debts or set up allowances for them?

Reviewing the Income Statement

Ask yourself these questions:

• Are there miscellaneous income items? If so, know what they are.
• Is the interest earned meeting the budget projection?
• If assessment income is logged using a cash basis, are actual collections keeping up with the budget?
• Compare the budgeted expenses to actual figures - are you over or under budget? In either case, understand the variance. If the association is severely over budget, you may need to adjust spending.

Gayle L. Cagianut, CPA, and Sandra K.Grunewald, CPA, MBA are with the accounting firm of Cagianut and Grunewald in Oak View, California.