What is the correct accounting method to use when evaluating and managing your real estate venture? There are several methods which can produce significantly different results. If decision making for your business is based on your internal financial statements, make sure you understand which method is being used and what that means to your bottom line. There are various motivations in preparing your financial statements (day-to-day operations, obtaining financing, valuation purposes, tax consequences, etc.) so your method of accounting should be aligned with these factors in mind whenever possible. In determining which method is appropriate for you, be aware of some of the following main differences:
Cash basis of accounting sounds exactly as you would expect and is the easiest method to account for as it does not take a special skill set of knowledge to track the activity as it occurs. The recording of income and expense items mirrors the cash inflows and outflows of the business. This does not necessarily match when income was earned and expenses were incurred; therefore, cash flows can vary from period to period making it difficult to forecast activity and plan accordingly. On the income side, occupancy rates or changes in rental terms over the life of the lease may not accurately reflect the income of the business, especially if some tenants are behind in their payments. On the expense side, there are certain payments which are not paid evenly throughout the year (i.e. real estate taxes, insurance or contingencies) which if not tracked and planned for may lead you to think the business is doing better than you realized.
Income tax basis
Income tax basis of accounting is intended to more closely mirror the preparation of your tax return; however, your tax return may be filed on the cash basis, accrual basis or some other basis of accounting. Therefore, this method can vary widely depending on how you are filing and some of the unique characteristics of your tax situation. One of the most significant differences between your tax return and internal accounting can be property valuations and related methods of depreciation. Generally, for internal purposes, property is valued at cost and depreciation is recorded evenly throughout the life of the asset. For tax purposes, property can sometimes be recorded at fair market value and depreciation is recorded using accelerated methods and various additional tax rules that are frequently changing which can allow up to 100% of the cost of the asset to be expensed in the year it is put in service. Using accelerated depreciation can significantly understate income in year of acquisition and overstate income in following years when there is no remaining offsetting deduction for depreciation.
Accrual basis of accounting can be more complicated and may require an experienced bookkeeper/accountant. This method records income when earned and expenses when incurred regardless of when the cash is received and paid. Accounts receivable and accounts payable are created to account for the timing differences between revenue earnings and cash receipts and expenses incurred and cash payments. Additionally, prepaids and accruals are recorded for items that are known or anticipated to spread the effect of the expense evenly throughout the year or reserves are created for potential unforeseen liabilities. As such it may be easier to compare actual results to budgeted figures to determine whether or not the business is operating as expected.
Terms of loan or lease documents or partnership agreements may dictate which method you are required to use. Additionally, often times the valuation of your property is based on a multiple of net operating income. These factors along with the factors noted above and the intended use of the financial statements will help you determine which method is right for you. The method you choose for internal accounting is up to you and should be dictated by the factors important to the overall analysis of your property and which factors are most important to the success of the business. In whichever method you choose, be sure to understand the key differences and the overall impact those may have on your monthly as well as year-end results when making decisions about your property.
If you need any assistance in determining which method is right for you, feel free to contact me at email@example.com.