Wednesday, August 27, 2008

Nonprofit Accounting: Cash vs. Accrual

It is very important to make sure you are using the right accounting system for your organization. Using the wrong accounting system can hurt your financial sustainability and cash flow. There are two principal types of accounting systems, cash basis and accrual basis:

Cash: With cash basis of accounting, you only record income when you actually receive it in the door. So, if you receive a pledge letter from a donor or foundation, you only count the money when you actually receive the check. The same thing with expenses. You only record expenses when you actually write the check to the vendor- not when you receive the bill. It sounds like common sense right? Why wouldn't everyone use this method? Well, not all nonprofits use this method because it can distort your revenue and expenses. For example, you may show that you had a hugely successful month but in reality it was a slow month and you just had several donors and foundations pay out their pledges. It also can make it difficult to match income and expenses to get an idea of net revenue. There are some positives though. The cash method shows a better picture of how much cash you have and helps ensure good cash flow (you have enough income coming in to pay the expenses you have at any given time). Most smaller nonprofit organizations use cash basis accounting because of it's simplicity.

Accrual: With the accrual method, you record revenue when you receive the commitment. So, for example, if you receive a letter from a foundation saying that they have awarded you a $50,000 grant, you would count that $50,000 on the day that you received the letter- even if you don't actually receive the money for several months. The same thing for expenses. You record an expense as soon as you receive the bill. For example, if you purchase a new printer on credit in December and you don't have to pay for it until May. You would count that as an expense in December, even though the money isn't leaving your bank account for several months. This method provides you with a clearer picture of the financial status of your organization. Although, it can hurt your cash flow because it is often difficult to tell how much exactly you have in reserves. You make think you have thousands in the bank because you received several commitment letters, but in reality you have no money in the bank because you haven't actually received the checks yet. There are also issues with counting restricted money in one year, when the money was actually intended for another year.

Overall, the accrual method is the preferred standard because it shows the relationship between income and expenses most accurately.

To read more, Beverly Goodman at The Non-profit Times wrote an excellent article about selecting the correct accounting method.


John said...

Most nonprofit accounting software has a cash basis format and because of it's simplicity as what you've mentioned, nonprofit groups rely on this type of software.