Accrual method in an apartment rental business

A business owns a 200-unit apartment building. Each apartment tenant receives a monthly invoice (generated on the 8th of the month) for the following month. So for example on November 8th, the rent invoice for the month of December is generated. The invoice requests payment on or before December 1st. The invoice shows the rent amount due for the month of December, utility costs, and other incidentals such as billing for rule violations, special services performed for the tenant by the business, or late fees.

Likewise, on December 8th, an invoice is generated for the month of January.

The problem is that residential tenants are extremely unreliable. Some will pay before the end of December. Some will pay only a portion of the invoice amount. Some will pay during January. Some will never pay and will be evicted at some point.

We need to operate the books using the accrual method for clarity purposes. It is nice to see the accounts receivable (not visible under cash method). But for tax purposes we use the cash method. So, for example, if 137 tenants pay late (in early January) or not at all, there is absolutely no reason to include that income until the following tax year (for tax purposes).

So we need a method to see exactly which invoices still have outstanding balances at midnight on December 31st (which is when the tax year closes). And we need the ability to pick up that precise status as our starting point for the following year’s accounting.

The accrual method assumes reliable, trust-able customers who actually pay their bills. But not every industry works like that.

Since under the accrual method the invoices are recorded as income already earned by the business, there appears to be no way to separate paid balances from unpaid balances on December 31st. Yet this is precisely what we need to accomplish.

Is there some way to establish that cutoff at midnight of December 31st so that we can clearly see which invoice balances are assigned to this tax year and which invoice balances are assigned to the following tax year?

@Learner the issue raised is more of Accounting rather than Manager as software, the situation explained pertains to “Accrued Income” in other words income earned but not received.

Here it’s explained further:

Accrued income is income which has been earned but not yet received. Income must be recorded in the accounting period in which it is earned. Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the subsequent period in which it will be received.

Hope it explained the concept.

For income tax purposes you can set your Profit & Loss Statement to a Cash Basis as your Accounting Method. This does not prevent you from using the Customers tab and the Customer reports to manage your accounts receivable.

Accrual basis accounting makes no assumptions about the reliability of customers. With Manager, you can switch back and forth with the click of a button. Read the Guide.

The invoices have multiple lines and include monthly collections into an escrow account (which is a special liability account).

Not sure if the above is the reason, but when you switch from accrual to cash, the rent amounts change to lower numbers. It seems the escrow account gets some prorated rents and escrows and the rent account gets some prorated rents and escrows. What’s going on?

You need to be clearer, @Learner. The number of line items on a sales invoice makes no difference. And sales invoices do not include collections. Collections would be recorded on receipts. Perhaps you mean you are invoicing multiple lines that are posted to various accounts?

Again, rent amounts do not change. They are whatever you invoice. But they are not posted under cash basis accounting until you enter the receipt. So income account balances could be lower when you shift methods. If you do not understand why this happens, read this Guide: Choose between accrual or cash basis accounting | Manager. And talk with your accountant, who can explain it further.

This is not what is happening. Nothing is prorated. But income is not recognized until you receive the money. Under accrual basis accounting, income is recognized when it is invoiced, whether you receive money or not.

In a test business, 5 invoices were created:

  1. $275 to escrow
  2. $1150 to rent, $275 to escrow ($1425 total)
  3. $1150 to rent, $275 to escrow ($1425 total)
  4. $1150 to rent, $275 to escrow ($1425 total)
  5. $1150 to rent, $400 to escrow ($1550 total)

Invoices 1, 2, and 3 have been paid in full.
Invoice 4, only $1150 out of $1425 was paid.
Invoice 5 is not yet paid at all.

When you switch to cash method, the rent income account shows $928.07 (rent) payments three times and $221.93 (escrow) payments two times.

The escrow account shows $275.00 correctly for invoice 1, but shows $221.93 (rents) twice and $53.07 (escrows) twice for a total of $825 in payments.

This is what I meant by “prorated”. The real-life event was that $275 was paid three times into the escrow account for a total of $825, not as above.

So the rent income account shows “escrow payments” and the escrow account shows “rent payments”. This is very confusing.

First, descriptions of things are not very helpful. Post screen shots of the Edit screens of transactions that you believe are being misreported. And post screen shots of a drill down on the relevant account balances. Before you do, make sure your date settings on the Summary page are correct.

Second, to illustrate why verbal descriptions are of little use, you described the escrow account and “real life” as being different, but said both resulted in totals of $825. You did not support your claim that rent and escrows were both posted to the escrow account. And you’ve completely left out any mention of payment against the 4th invoice, which must be reflected somewhere.

Third, your statement that "the rent income account shows “escrow payments” and the escrow account shows “rent payments” is completely unexplained. What do you mean? You have only (partially) described the contributions to the escrow account.

Fourth, are you aware that partial receipts against a sales invoice with multiple line items will be distributed among the line items? To understand what has been posted where, you need to look at the Accounts receivable balance for the customer’s subaccount on every date where there is a transaction applied to it.

Lastly, the choice between accrual and cash basis accounting involves more than delaying income to put off paying income tax. It also controls when expenses are recognized. If you are delaying recognition of income, you should also be delaying recognition of expenses, which could be to your disadvantage. Switching between the two approaches in Manager only changes the reporting scheme, not the underlying philosophy of accounting. That part is your responsibility.

The fact is that cash basis accounting is not very well suited for an apartment rental business, where you hold deposits, escrow utility payments, assess late fees, and so forth. I would be surprised if any accountant recommended that approach to you.

Okay I can post screen shots of the test business. The $825 was because of $275 in suspense, I realize now. Anyway, what you wrote under “Fourth” is obviously the problem. Is there a way to distribute receipts to specific line items as I see fit? Leaving in suspense in accrual mode would work (showing $3450 in rent receipts and $825 in escrow receipts as of today’s date), but I see no way of recording an end-of-year status.

Accrual basis:

Cash basis:

Rents:

Escrow Account:

No. The receipt is posted against the invoice under Accounts receivable, not against any particular line item(s), which are posted to their accounts when the invoice is raised. From an accounting perspective, the tenant has not paid you for rent, utilities, or special services. You charged them for those things when you created the invoice. The tenant has paid all or a portion of the receivable. This is another reason to use accrual based accounting.

No, it would not. Transactions in Suspense are always mistakes. This automatic account exists only so you will not lose information already typed in before correcting them. Some accounting programs would simply ignore an erroneous transaction.

I urge you to accept reality. Cash basis accounting distorts both your position (as reflected on the balance sheet) and performance (as shown on the profit and loss). The natural desire to minimize income taxes in the current year leads you down rabbit holes, obscuring poor collection performance.

I understand your reasoning… but still… Is there a workaround?

If you invoice on December 8th, you are not actually delivering the “goods” until January. If they pay the invoice before the end of December, they are effectively paying in advance for something being delivered next year. They are “consuming the rent” during January, not during December. In an ideal world we could invoice on January 1st, however, people need some time to get their mail! The software should allow invoicing in advance for a future event.

The question is not necessarily when you are delivering the goods or services. The question is when you are entitled under the terms of the lease to demand payment. You will issue your invoices with a due date about 3 weeks in the future. If your leases are like most, they will specify payment in advance of the monthly lease period in order for the tenant to legally occupy the premises. And I assume you are not offering a rebate if someone departs prior to the end of the month. So you have earned the entire month’s income prior to the start of the month. This is just like a magazine subscription: you pay in advance. Or like an insurance premium.

And so it does, in the form of due dates. You will not, after all, specify that the invoice is due and payable upon presentation.

A workaround for what? You don’t need a workaround. Send out your invoices in advance. Specify a due date on the first of the following month. Assess late payment fees via the program if you want. Use accrual accounting. As you make the transition to this more informative accounting approach, you will notice an impact on taxes for one month’s income one time. After that, you’ll be glad you did it. And don’t forget to file whatever paperwork your tax authority requires for change of accounting method.

Hi @Learner

Invoicing now for services (or goods) to be earned/supplied in the future is called ‘revenue in advance’. Sometimes my clients ask me to do this towards the end of their financial year. If the amount is material, the normal accounting approach is to raise an invoice against a balance sheet liability item called ‘Revenue in Advance’ rather than against ‘Revenue’ in the Profit and Loss statement.

The transaction will be:
DR: Accounts Receivable X.XX
CR: Revenue in Advance X.XX

When the invoice is paid into your bank account, the transaction will be as per a normal invoice payment
DR: Bank X.XX
CR: Accounts Receivable X.XX

That clears the accounts receivable and you have the cash in your bank account.

You recognize the revenue later (it could be the next financial year) in the Profit and Loss Statement by making a journal entry:
DR: Revenue in Advance X.XX
CR: Revenue X.XX

The revenue in advance liability account is now cleared to zero, and the income is recognized in the period that you earned it. The above approach applies the accounting principle of matching the timing of income and expenses. However, it is only worth applying the extra steps to recognize revenue in advance if the amounts involved are material (perhaps >5% of turnover).

The above principle also applies to public grants (and occasionally donations to ‘non-profit’ organizations) if these have conditions attached as to when the grant/donation is earned, even through it is paid in advance.

The transactions may vary slightly from my example if you pay sales taxes (e.g. VAT, GST, etc) on an invoice basis rather than on a cash basis. If sales tax is paid on an invoice basis, the amounts in the ‘revenue in advance’ and the journal entries will be net of taxes. You can set the Tax Summary or GST/VAT Report accordingly to correctly see your GST/VAT/Sales tax balance for any period.

Cheers… Richard

1 Like

Thank you @Gillrich!

@Learner, if you adopt @Gillrich’s approach, you should not do that only at year-end. Tax auditors would regard that as a transparent ploy to avoid taxes. Your accounting procedures need to be both rational and consistent from accounting period to accounting period. Recognizing January rent income in January with his method would be fine, even though invoiced and received in December. That would be like receiving an advance deposit for custom manufacturing. But you then need to treat February rent the same way, even though there would be no tax consequences.

Thank you. Consistency is the goal for sure. In order to be able to use Manager’s feature “Show balances for specified period”, the individual transactions must be recorded on the correct dates if the business insists on continuing to use the cash method.

Yes. But understand that the “correct dates” are the dates the transactions occur, not some future date. Selecting cash basis accounting takes care of whether or not they are reported.

Then do all invoicing as per normal, as there is no need to do any special process or Journals for any month, especially year end.

Then do as @tony advised, when creating the financial reports (BS & P&L) select the cash basis option. No need to toggle the Summary tab between accrual / cash basis.

@Gillrich suggested process will only work if you are going to be doing accrual basis for tax reporting, that is, removing next year’s income from this year. But that suggested process won’t work if you are going to maintain doing cash basis tax reporting as the invoicing will be doubled up.

Lets assume you posted all Jan invoicing (dated Dec 8) to this “Revenue in Advance” account, so no P&L impact. Now a tenant pays in full on Dec 28, so their accounts receivable balance is nil as at Dec 31, and their Jan invoicing still remains at Dec 31 as part of the BS Liability “Revenue in Advance” account.

Now with cash basis tax reporting, that Dec 28 payment would be included as part of the current year’s income, yet when you come to do the next year’s Journal to clear the “Revenue in Advance” account, that same current year paid income will also become part of the next year’s income, as Journals don’t discriminate between accrual and cash basis.

Hence, under cash basis tax reporting paid income this year will also become Journal income next year.

So @Learner, the simplest way for you is to accrual basis for clarity and cash basis for tax reporting - no change of any processing required. However, if you are going to do accrual basis for tax reporting then adopt @Gillrich suggested approach.

@Learner
Whether you use an accrual or cash basis when accounting for tax will depend on your jurisdiction.

In the tax jurisdiction where I live (New Zealand), all business income tax accounts must use the accrual method without exception. However, sales tax (GST), and the frequency of returns, may be on a payments (cash) basis or accrual (invoice basis) depending on turnover. The accrual (invoice) basis may be used by anyone, but the cash basis may only be adopted if gross annual turnover is, or is expected to be, less than NZ$2.0 million. Different rules will apply elsewhere.

For management accounting purposes, accrual accounting is always preferred unless the business (or organisation) is small. The statement of cash flows reconciles your financial position with cash. Obviously, getting paid in advance is always a good thing as long as the monies are available in the Bank to offset costs in the future.

If the appropriate accounting approach, cash or accrual, not clear for your situation, then I strongly recommend you consult your accountant. However, Manger.io can handle either approach.

Cheers… Richard

This seems perfect. The Summary page shows all that has been invoiced in the current year. The P&L Cash Basis report seems to show a correct total of all that has been collected in the current year. Although if you click on the blue link in the P&L Cash Basis report, you get a long list of weird numbers (rather than the actual receipt transaction amounts) [Manager appears to break it down proportionately according to the number of line items in the invoice and the number of receipts for the same invoice]. But the total is correct (which is what the business needs for reporting current year income if they continue to use the cash method). .

Payments received in the new tax year will add up correctly on next year’s P&L Cash Basis report.

Delinquent (whole or partial) invoices will sit in Accounts receivable. Presumably accounts confirmed noncollectable can be moved to an expense account using a journal entry?