Which Accounting Method does your Property Manager Use?
There are two commonly used accounting methods utilized by professional real estate management companies. One is the cash basis and the other is the accrual basis and both methods are widely used and accepted in the industry.
By far the most common method, and the one generally preferred by property owners, is the cash basis. As the name implies, the cash basis method of reporting reflects all items of income and expense when they are received or disbursed from the bank account. The major benefit of this method is that it is very straight forward and easy to understand and readily provides the property owner with a clear picture of what increased or decreased the property bank account. It functions just like a personal checkbook in that each receipt of cash increases the bank account balance and each disbursement of cash decreases the bank account balance as they occur. The different types of deposits and disbursement are grouped together to create a monthly operating statement showing each category of deposits and each category of disbursement. Receipts typically include items such as tenant rent, late payment fees collected and interest earned on savings accounts. Disbursements typically included payment for property repair and maintenance, real estate taxes, insurance and mortgage payment. The beauty of this method is that all activity can be reported on one statement and the monthly increase or decrease in the bank account is easily traced to the bank statement. This method is easy to understand and simple to report, but it does have a shortcoming. The main criticism of the cash basis method of accounting is that it does not provide any reporting for transactions that occurred during the month that did not hit the bank account. Therefore, the results of a particular reporting period may be distorted by the timing of cash receipt and disbursement activity. This is where the accrual method of accounting steps in.
Under the accrual basis of accounting all revenue and expense transactions for the period in question are recorded whether or not the cash is actually received or disbursed from the bank account. While this provides the property owner with a more comprehensive picture of the true income or expense generated for the reporting period, it also adds an additional level of complexity to the monthly reports. Using the accrual basis of accounting, items of income and expense for the month that were not yet received or disbursed must also be recorded. For example, income that is billed to the tenants but not received is recorded as accounts receivable and items of expense that have been completed but yet paid are included as accounts payable. These items are reported along with the bank account balance on a separate statement known as the balance sheet. The advantage of this reporting method is that is gives the property owner with a more complete picture of the economic activity that occurred for the month without the distortion of cash transaction that may relate to a past or future accounting period. The addition, the balance sheet report provides the owner with a monthly snapshot of the amount of the property accounts receivable and accounts payable to make sure the property manager is diligently collecting tenant rent and making payment to vendors and suppliers.
Both accounting methods are acceptable for reporting the results of your real estate investment, but if you do have a preference, be sure to clearly state which method you want your property manager to use in the management agreement.