From time to time, we share previous content that has enduring significance for nonprofit organizations. The following blog post was originally published on 8/6/15 and has been lightly refreshed.
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 aid you in making the best decision. Below is a quick guide to help you understand both the cash and accrual accounting methods.
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.
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 of cash flow - a business can seem profitable when they really have an empty bank account. The accrual accounting system requires close monitoring of cash flow, whereas the cash method is more easily tracked and understood.
The Bottom Line
Here's a real-life example to help you understand the difference between cash and accrual accounting methods. 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 of August would be:
$2,000.00 (cash received in August)
-$100.00 (cash spent in August)
Under the accrual basis of accounting the profit for the month would be:
$6,000 (invoice sent to customer in August)
-$300.00 (bill received from vendor in August)
As you can see, the cash method shows the actual amount of money that changed hands during the month. The accrual method shows the total amount of invoices and bills that will eventually be paid or received.
In deciding upon an accounting method, one must also consider the effect on taxes. If the above transactions occurred in December of this year, and you were operating on the accrual method, you would pay taxes on the $5,700.00 as part of this year’s taxes (regardless of whether or not you actually received the payment before year-end).
Accrual accounting is useful for larger, more complicated organizations because it gives you a fuller 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 for you.