One of the fundamental decisions a nonprofit organization needs to make is whether to use the cash or accrual accounting method. The method you select will determine how you classify, record, and report on your income and expenses.
What is the cash method of accounting?
Under the cash method of accounting (cash-basis accounting), revenue is recognized when it is received and expenses are recognized when they are paid. That means, for instance, that income is not recorded when a donor pledges to make a donation but rather when the funds are actually deposited.
What is the accrual method of accounting?
Under the accrual method of accounting, nonprofits recognize income when they earn it, not when they receive it. Similarly, expenses are recognized when they are incurred instead of when the bill is actually paid.
Using this method, pledges are treated as income on the date the pledge is made, not when the funds are received. Likewise, expenses that are charged to a credit card in October are treated as October expenses, even if the actual payment isn’t made until November.
Which accounting method should you use?
The cash method of accounting is generally preferred for:
- Startups and other very small nonprofits (under $100,000 revenue)
- Nonprofits that do not have paid staff
- Nonprofits that do not have set programs
- Nonprofits that do not have accounting staff or accounting professionals and need to keep accounting simple
The accrual method of accounting is required for organizations that follow generally accepted accounting principles (GAAP). Also, be sure to check whether your state regulations require it. In addition, the accrual method is generally preferred for nonprofits that:
- Have significant amounts of funding and funding sources
- Employ paid staff
- Receive grants
- Want to ensure accuracy and full transparency of their financial position
- Undergo annual financial audits – operating accrual basis eliminates the need for a conversion at year-end, as GAAP requires accrual accounting
Whichever accounting method you choose, keep in mind that there are ways to overcome some of the limitations of each. For instance, if you use the cash method, you can put mechanisms in place to track pledges, grants, and other anticipated income and expenses. With the accrual method, preparing regular cash flow statements and projections will help you better manage cash.
Chazin & Company is a premier provider of outsourced accounting and finance solutions for the nonprofit sector. Contact us to learn more about how to select the right accounting method and reach your overall financial goals.