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Cash vs. Accrual Method of Accounting

Have you ever wondered whether you should simplify your accounting records by switching from the accrual method of accounting to the cash method?  What are the benefits of accrual accounting, and is it really worth the effort?  Do you know the difference between the two methods?

The strict cash basis of accounting only reflects one asset on your balance sheet – cash.  Revenues and expenses are only reflected in the financial statements at the time they are received or paid in cash.  In contrast, the full accrual basis of accounting reflects all assets the organization has rights to (e.g. pledge receivables) and all liabilities the organization owes (e.g. accounts payable).  This basis of accounting is considered to be “generally accepted” in the business community and strives to follow the matching principle (i.e. revenues are recorded when earned and expenses are recorded when incurred).  Some organizations utilize a modified basis of accounting in which certain assets and liabilities are recorded on the balance sheet in addition to cash (e.g. equipment and debt).

So what factors should an organization consider when choosing its method of accounting?

  • Who are the users of the financial statements? If your financial statements are distributed externally to granting organizations, national affiliates, or the bank, they may expect or even require full accrual accounting.
  • What volume of activity occurs each month? If the organization typically has very few transactions and does not accept long-term donations, does not sell inventory, and pays it bills regularly and timely, the cash basis method of accounting may be sufficient.
  • What are the qualifications of your management and board members? Does your accountant have the ability to record transactions on the accrual basis of accounting?  Will your board members and management team understand it?  If the answer is no, cash accounting may be a better alternative.  However, don’t let the lack of knowledge stop you from applying accrual accounting – options include outsourcing the accounting work and training internal users of financial statements to better understand them.
  • How significant is the cost? Cash accounting is cheaper to apply as less qualified staff can handle the day-to-day transactions, and there is no need for complex software.
  • What is the future of the organization? Will you grow to a point that accrual accounting will be necessary in the future to satisfy the demands of your resource providers?  If so, it may be prudent to implement it from the beginning.
  • Do you want to avoid the ability to manipulate financial results? If you are looking to show more or less net income, it’s easy to avoid paying or accelerating payment of certain bills  Your cash-basis financial statements can fluctuate significantly from period to period.  However, under the accrual basis, transactions are recorded in the period they occur, regardless of when cash is received or paid, thus providing consistency in your financial statements.

Consider the following set of facts for a nonprofit organization that received tax-exempt status January 1st and had the following transactions in January:

  • Office furniture totaling $5,000 was ordered, received, and paid for.
  • A fundraising event was conducted. $20,000 was received during the event and deposited in your bank account.  Expenses of $10,000 were incurred, but only $7,500 of those expenses were paid in January.
  • You paid the annual insurance premium of $1,200.
  • The following additional bills were received: January office supplies $250; January utilities $250; January rent $1,000; and January newsletter printing and postage $2,000.  The bills for utilities and newsletter printing/postage were not paid until February.
  • A respected community member fell in love with your mission and pledged $100,000 to the organization to be paid in annual installments of $25,000. The first installment was received in January.

The following illustrates the difference between accounting for these transactions on the cash vs. accrual basis of accounting.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As you can see, there is a striking difference in results, depending on which method is used.  Under the cash method, you are unable to determine what is owed to/by the organization at any one point in time.  In addition, the net proceeds of your fundraising event can’t be determined until all bills are paid.  The change in net assets (i.e. your net income for January) fluctuates by approximately $76,000 between the two methods.

Our nonprofit specialists would be happy to meet with your management team to discuss the pros/cons of either method of accounting.  In addition, we can help you understand how to read and interpret the financial statements, regardless of the method of accounting you’ve chosen to use.  Call us today at 342-5630.

 

Jean Smith

Jean Smith

CPA, Partner at Ketel Thorstenson, LLP
Jean joined Ketel Thorstenson, LLP in August of 1994 with the motivation to make the audit experience a positive one for clients. In November of 2005, she was named a Partner in the firm. She specializes in audits of non-profits, financial institutions, tribal organizations, and closely held commercial entities.
Jean Smith

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