Many people are unaware that there is more than one way to prepare financial records. There are two methods: cash accounting which involves recording revenue and expenses at the time they are paid, and accrual accounting which records revenue and expenses in the period that services are applicable to. Although cash accounting can be easier than accrual accounting, it does not provide an accurate picture of a corporation’s annual revenue and expenses. Accrual accounting not only gives a more accurate picture of the corporation’s revenue, expenses, assets, and liabilities, it is also required under the Generally Accepted Accounting Principles (GAAP). This means that auditors only audit based on the accrual method, therefore, if cash accounting was used to prepare the financial records, the books must be updated to reflect accrual accounting before having an audit completed.
Prepaid Expenses and Accrued Expenses:
Prepaid expenses are expenses that are paid for before services are provided and are considered asset accounts. An example of this would be a yearly insurance policy. The policy covers 12 months but, in many cases, not all 12 months of the policy fall within the corporation’s fiscal year. For example, the policy could cover May 1, 2023 – April 30, 2024, and the fiscal year end could be December 31, 2023. In this case, only 8 (May – December) of the 12 months fall within the fiscal year. The remaining 4 months would be a prepaid expense and would be grouped with the assets on the Statement of Financial Position. Under cash accounting, the entire insurance policy expense would be recorded in the fiscal year it is paid.
In contrast, when services have been provided but no invoice has been received yet, the expense should be accrued to be recorded in the correct period. Accrued liabilities are liability accounts and are often grouped with accounts payable. An example of an accrual is if the last utility invoice received in a fiscal year covers the period of November 15, 2023 – December 15, 2023, and the corporation’s fiscal year end is December 31, 2023, the utilities between December 16, 2023, and December 30, 2023, should be accrued so they can be recorded in the correct period. The invoice covering December 16, 2023 – January 15, 2024, is not likely to be received until late January, therefore, the accrual should be based off an estimate. The accrual for utilities from December 16, 2023 – December 31, 2023, would be grouped with the liabilities on the Statement of Financial Position. Under cash accounting, the invoice covering December 16, 2023 – December 31, 2023, would be paid when it is received in the 2024 fiscal year, and therefore, no utility expenses for that period would be recorded in the 2023 fiscal year.
Accounts Receivable and Deferred Revenue:
When Common Element Assessment fees are not paid on time, the revenue is still recorded in the period in which it occurred, and an accounts receivable is set up for the unit owing. Accounts receivable are assets accounts and will be grouped with assets on the Statement of Financial Position. Under cash accounting, the revenue would not be recorded until it is received, resulting in an understatement of revenue for the period the Common Element Assessment applied to, and an overstatement in the period the Common Element Assessment is received.
In contrast, a deferred revenue account is used when Common Element Assessments are received before services are provided. The revenue will not be recorded until the period in which it applies to. Deferred revenue is a liability account, which means it’s technically owed back to the owners until the revenue is applied, therefore it will be group with the liabilities on the Statement of Financial Position. Under cash accounting, the revenue would be recorded when it is received, resulting in an overstatement of revenue in the period the Common Element Assessment is received and an understatement in revenue in the period the Common Element Assessment applied to.
