Cash vs. Accrual Accounting – What Should Nonprofits Use?
I know accounting isn’t the #1 most exciting topic for everyone in the nonprofit world, but let’s face it: when you run a nonprofit, the money matters. There are certain rules about money and expenses that you have to follow. It’s important that nonprofits of all stripes and sizes operate professionally and do things right. So, let’s get into the nitty-gritty! I’ll break down the two most common accounting systems- cash-based vs. accrual- and which one you should use as a nonprofit.
Cash-based accounting is what most of us think of when we think of bookkeeping. With this method, you don’t have an accounts payable or accounts receivable system. Instead, you record cash when it’s received and expenses when you pay them. If you get a check in the mail on October 15th, the revenue is recorded on that date. If you owe utilities on your building, the expense is recorded the day you pay the bill.
Cash basis accounting is popular among small businesses because it is simple to understand and maintain. For example:
- Transactions can be quickly identified (money in the bank or out of the bank) and there is no need for tracking receivables or payables.
- Business owners can look at their bank balance at any time and see exactly where they stand.
- Income isn’t taxed until it’s in the bank
Let’s say you book a venue in June and pay the one-time rental fee of $5,000 in September. Using the cash method of accounting, you report the expense in September, when the payment is made, rather than in June when the expense is incurred.
I can see how some small businesses find this system convenient when they’re starting out. But as a nonprofit, it’s really not for you. Nonprofits need to ensure compliance with GAAP rules for accrual accounting basics, such as properly recording donations and other contributions.
An accrual accounting method records revenues and expenses when they are earned, regardless of when they are received or paid. What does that mean? Here’s an example: you hire an artist to paint a mural on the side of your building. The artist comes out to do the work on December 15th, and you receive the bill for their work on January 5th. The expense would hit your book in December when they did the project, not when you pay in January. With this approach, you have a better idea of income and expenses during any given time, providing a long-term picture that you won’t get with cash-based accounting.
So, Why is It Called Accrual Accounting?
“Accruals” refer to the adjustments companies make before compiling and releasing financial statements. These adjustments account for potential problems, such as pledges promised but never actually paid, by making sure that your nonprofit has enough cash set aside to cover any of these setbacks. I’m gonna be honest – for everyday folks (including me! I’m waaaaaay more of a words person than a numbers person!), accrual accounting can be more complicated and confusing. But that doesn’t mean you shouldn’t do it – in fact, accrual accounting may be essential to helping you grow the organization.
What Does This Look Like in Practice?
Let’s say you get a letter from a very generous donor saying they’re going to give you $10,000. You want to recognize and record that revenue as of the date on the letter. If you’ve ever pledged to your favorite charity over the phone, they likely recorded your pledge the day you got the call.
This is what accrual accounting is all about with nonprofits. You record revenue when it’s promised and expenses when they occur instead of when you get the bill. This is especially handy when you have prepaid expenses, such as insurance contracts. If your fiscal year ends on December 31 but your policy period for insurance goes from October 1st through the end of September, that expense for the next fiscal year needs to be recorded.
The whole point is that when you‘re doing your Statement of Financial Position, you want to be able to take a look and have a sense of what you owe and what’s owed to you. This statement assigns a value to your assets based on net assets AND liabilities, and a cash-based accounting system just won’t cut it.
Still not convinced that accrual’s the right way to go? Here’s a little secret: most banks, foundations, and large grantmakers will only share their wealth if you provide accrual-based financials. Just sayin’. These financial statements provide detailed information about the financial stability and health of your nonprofit for:
- Lenders, and constituents
The generally accepted accounting principles (GAAP) approve accrual accounting as a historical, accurate overview of income, expenses, and receipts. So does practically everyone else!
Some Final Thoughts
Although cash accounting is faster and simpler, it isn’t ideal for creating accurate and straightforward financial plans. Accrual-based accounting, on the other hand, shows you when you are making money or losing money by matching revenues and expenses when they occur.
As you develop plans and budgets using your financial reports, having accurate month-by-month data will help you develop more accurate projections to maximize your resources.
Nonprofits seeking to grow are better off using accrual accounting. Some organizations do use the cash method when they’re starting out, especially if they don’t have an in-house bookkeeper. But for any organization looking to grow, you’ll want to make the switch.
From first-hand experience, I know nonprofits can thrive and make progress toward their mission with the right information, tools, and coaching. Don’t try to go it alone. If you need help getting your financial systems down, hire an accountant who specializes in nonprofit work. Surround yourself with experts so you can stay focused on the mission.
Want to learn more about nonprofit best practices? Check out Mission Guardian Toolkit, a legal resources program that allows even the tiniest orgs access to self-service legal tools like online courses, document automations, and live Q&A webinars.