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Should Nonprofits Use Cash or Accrual Accounting?

Aaron Sullivan : Jan 16, 2020 9:07:00 AM

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If your client is a nonprofit, you know better than anyone how their requirements and struggles are unique.

They're required to report tons of other information, like monetary and in-kind donations, grants, volunteerism, and funds raised from charity events. And while they're juggling all these crucial tasks, they have to maintain focus on the charitable or social cause their organization is upholding.

To tackle the endless financial challenges for nonprofit organizations, they need healthy cash flow. Enter you, the accounting deity.

Accounting for nonprofits is complex and challenging, warranting special attention. But equally important is the accounting method used to maintain the financial data.

Are they using the right method for a nonprofit? What are the advantages and disadvantages of a cash vs. accrual basis?

We answer some of these common questions here.

Accounting Methods for Nonprofits: Cash Basis vs. Accrual Basis

The two methods of accounting are cash and accrual. While cash accounting focuses on reporting transactions in the period in which they are fulfilled, accrual accounting focuses on reporting income and expenses in the duration in which they are earned and incurred.

So when it comes to cash accounting vs. accrual, which is better?

Cash Basis

With the cash method of accounting, financial information is presented solely based on incoming and outgoing cash (like receipts and disbursements).

In simple terms, income and expenses are recognized when they occur. Income is recognized when it’s received as opposed to when it’s earned. Similarly, an expense is recorded when the payment is disbursed, not when it’s incurred.

Say you book a club for an event in May and pay the one-time rental charge only in August. With the cash method of accounting, you’ll report the expense in August, when the payment is made, as opposed to May, when the expense is incurred.

Accrual Basis

The accrual method of accounting is also called Generally Accepted Accounting Principles (GAAP) and is based on the period in which events occur.

Revenue is recognized in the period in which it’s earned, not when it’s received, in contrast to the cash method. This is also known as the revenue recognition principle.

Similarly, expenses are reported in the period in which they are incurred, not when the bill is settled. For instance, in the case of a pledge, income is recognized when the pledge is made, not when the donation amount is received.

Which of these methods is better? Like everything, there are pros and cons to both cash and accrual methods of accounting. Let’s dig a little deeper.

Cash Basis vs. Accrual Basis: Pros & Cons

Both methods present different benefits and challenges in measuring and reporting financial data for nonprofits:

Advantages of Cash Basis:

Ease of Use – A cash basis is much easier to use and maintain on a daily basis, as income and expenses are recorded according to their cash transactions. There’s only one entry per transaction and no accruals to compute.
Quick and Straightforward – Cash basis is not only simpler but also quicker, as it requires less work, especially when a nonprofit is dealing with funding sources that are slow to pay. This is because a cash basis posts income only when the donation is received.
Realistic View of Cash at Hand – Cash basis presents a more realistic picture in terms of money on hand since it reports actual receipts. This is in stark contrast to the accrual method which reports earned income. It may show funds on paper, when in reality, the bank account may be empty.
No Adjustments Required – Since cash basis only reports the actual money receipts, it eliminates the need for adjustments if someone is unable to donate the full amount that’s pledged.

Disadvantages of Cash Basis:

Disclaimer – Cash basis requires a disclaimer in year-end reports stating that cash accounting has been used.
Limited Information – Cash basis provides limited information since it fails to report non-monetary events, like receipts of donated supplies.

Advantages of Accrual Basis:

Complete Picture – The accrual method of accounting presents a more complete picture of the financial state of an organization because it includes accruals, allocations, payables, receivables, outstanding obligations, and pledges.

Better and More Accurate Reporting – Accrual-based accounting provides more accurate reporting since it recognizes events as they occur.

Disadvantages of Accrual Basis:

More Complex – Accrual basis requires two entries per transaction. Plus, it may require adjustments if pledges are not fulfilled.
Time-Consuming – Computing accruals and allocations can take forever! So accrual basis demands more time and effort.

The cash basis for accounting may work for very small nonprofits thanks to its simple and straightforward approach. In contrast, an accrual basis tends to work best for larger nonprofits.

If you’re wondering whether your client's nonprofit is required to use accrual accounting, read further.

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So…Are Nonprofits Required to Use Accrual Accounting?

Not necessarily, but here’s why nonprofits should use accrual accounting:

GAAP and IRS

GAAP requires the use of accrual accounting. Similarly, the Internal Revenue Service (IRS) requires reporting of accrued income and expenses. Most funding sources require the accrual basis of accounting, too.

Funds Accounting

Most nonprofits — apart from very small ones — have diversified funding sources because they might receive funds from varied sources like government entities, foundations, corporate houses, and individuals.

Funds accounting that applies only to nonprofits can be accurately performed with accrual accounting as it has an accounting code for each type of incoming source. As a result, accrual accounting is perfect for all nonprofits with diverse fund sources.

Accurate Budgeting

Cash accounting is no doubt simpler and quicker. But does it fare well in terms of accurate reporting? Not really. And this is where the accrual basis scores.

Accrual-based accounting presents accurate reporting thanks to its focus on the period in which income is earned rather than received, and an expense is incurred rather than paid.

But how does accurate reporting help nonprofits? The financial reports and income statements for nonprofits allow them to plan and budget better by providing a robust and more accurate view of the varied elements like payables and receivables, pledges, and donations during a given period.

And since cash basis accounting doesn’t provide the complete picture in terms of outstanding payments or uncollected receivables, it may be risky to make financial decisions based on statements prepared by this method.

For these reasons, a large nonprofit that has a paid staff, plans for expansion, or diverse fund sources, is best off using accrual accounting.

Should Nonprofits Switch to Accrual Accounting?

Does accrual accounting require more sophistication and time? Definitely. But it’s worth their while if they're a mid or large-sized nonprofit.

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