When it comes to managing the finances of a nonprofit organization, choosing the right accounting method is important. Two of the most common approaches are cash accounting and accrual accounting. Each has its unique characteristics, benefits, and drawbacks. In this post, I’ll break down the differences between the two, and go over factors to consider when deciding which approach is best for your organization.
An Example of Cash vs Accrual Accounting
Imagine your nonprofit summer camp is promised a $5,000 donation in May to help fund supplies, but the check doesn’t actually arrive until July. Cash accounting only recognizes the donation in July—when the money arrives in your bank account—so your financial records don’t show those funds in May. In accrual accounting, the $5,000 is recorded as an accounts receivable in May, right when it’s pledged, giving you the ability to report on the money that you expect will be coming in.
In other words, with cash accounting, you can only report on the flow of cash in and out. However, with accrual accounting, you can report on money you expect to come in and money you expect to go out, in addition to reporting on the actual flow of cash.
Cash Accounting
The cash method is easy to understand and implement because it's familiar—it’s how most of us think about household finances. It's also less administratively demanding, as there are fewer transactions to record.
However, unless you're a very small organization with unusually simple financials, cash accounting won't provide the full, accurate picture of your financial situation. Your financials are the foundation for much of your decision-making, so it's important that they offer a complete view.
Cash accounting is good when:
You have few or no paid staff
You have only one program area
You do not accept restricted funds
You have no plans for expansion
Your have a small operating budget
What is Accrual Accounting?
Accrual accounting, on the other hand, recognizes revenue when it is earned and expenses when they are incurred, regardless of when cash is actually exchanged. This method provides a more accurate picture of a nonprofit’s financial health, as it captures all financial activities. With a more accurate reflection of income and expenses, organizations can plan budgets and allocate resources more effectively. Many larger nonprofits and those that receive government grants are required to use accrual accounting to comply with accounting standards and regulations.
Accrual accounting is good when:
You receive restricted funds
You have multiple programs
You a required to have auditable financials
Your operating budget is greater than 1,000,000
About Switching Methods
When your organization files Form 990, it indicates which method was used. If you decide to change methods, you may need to report the change to the federal government, state government and/or your grantors. Consult an accountant before attempting a change.
Conclusion
Choosing between cash and accrual accounting depends largely on the size, complexity, and needs of your nonprofit organization. Cash accounting may serve smaller entities with straightforward financials, while accrual accounting give the most complete picture of your financial situation. Regardless of the method you choose, a solid accounting foundation is essential for sustaining your mission and effectively serving your community.