Choosing an accounting method that best suits your nonprofit organization can seem like a difficult task. Understanding the definitions of each accounting method, the pros and cons, and which method is best suited for your type of organization will aide you in making the best decision. Below is a quick guide to help you understand both the cash and accrual accounting methods.
Cash Accounting Method
The cash basis of accounting recognizes revenues when cash is received, and expenses when they are paid. This accounting method will not recognize the use of an Accounts Receivable or an Accounts Payable. The cash method tracks how much cash the business actually has at any given time, and income isn’t taxed until the money is in the bank.
Accrual Accounting Method
The accrual basis of accounting records revenue and expenses when they occur, not when the money is actually received. This method is more commonly used than the cash basis of accounting. Accrual accounting allows for a more realistic picture of income and expenses during a period of time. This method also allows for a long-term snapshot of the business; something the cash accounting method cannot provide. Accrual accounting doesn’t provide any true awareness to cash flow; a business can seem profitable, but in actuality they have an empty bank account. The accrual accounting system requires close monitoring of cash flows; whereas the cash method is more easily tracked and understood.
How Each Method Affects Your Bottom Line
Understanding the definitions of each method is important in aiding your decisions, but a “real life” example can also be helpful. Listed below are example transactions for a month of operations:
August 5: Sent out an invoice to a builder for $6,000.00
August 7: Received a bill for materials in the amount of $300.00
August 21: Paid $100.00 in building permit fees for a bill that was received in July
August 30: Received $2,000.00 from a customer in payment of a June invoice
Under the cash basis of accounting, the profit for the month would be
$2,000.00
-$100.00
=$1,900.00 (in actual cash spent and received this month)
Under the accrual basis of accounting the profit for the month would be
$6,000.00
-$300.00
=$5,700.00 (in invoices generated and received this month)
You must also consider the effect on taxes. If the above transactions occurred in December 2014, and you were operating on the accrual method, you would pay taxes on the $5,700.00 as part of your 2014 taxes, regardless of whether or not you actually received the payment in 2014.
Accrual accounting is useful for larger, more complicated organizations because it gives you a bigger picture of your financials. If your organization is smaller and less complex, with few outstanding bills or grants, the cash method of accounting may make more sense.