Using the cash basis of accounting may make sense for your not-for-profit organization — at least at this stage. Many smaller nonprofits use the cash basis to prepare their financial statements because it’s generally quick, easy and intuitive and can alert them to current cash flow challenges. However, there’s a potential problem with cash basis accounting: It can require year-end adjustments. Let’s look at the issue.
Easy and intuitive method
Under cash basis accounting, income is recognized when you receive payments and expenses are recognized when you pay them. The cash “ins” and “outs” are totaled, generally by accounting software, to produce the internal financial statements and trial balance you use to prepare periodic statements.
The simplicity of this accounting method comes at a price, however: Accounts receivable (income you’re owed but haven’t yet received, such as pledges) and accounts payable and accrued expenses (expenses you’ve incurred but haven’t yet paid) don’t exist.
The result is that if your nonprofit periodically prepares internal financial statements for your board, your auditors may propose adjustments to these interim statements at year end. Why do auditors do this? Generally, it’s to reflect differences due to cash basis vs. accrual basis financial statements.
A truer picture
With accrual accounting, accounts receivable, accounts payable and other accrued expenses are recognized when they occur, allowing your financial statements to be a truer picture of your organization at any point in time. If a donor pledges money, you recognize it when it’s pledged rather than waiting until you receive the money — which could be next month or even next year.
Generally Accepted Accounting Principles (GAAP) require the use of accrual accounting and recognition of contributions as income when promised. Often, year-end audited financial statements are prepared on a GAAP basis. Larger nonprofits and charities with diverse funding sources typically use accrual accounting. Also, some charities are required by their funders to use it.
Note that internal and year-end statements can differ for reasons other than accounting method. For example, auditors may propose adjusting certain entries if, for example, your organization is party to a lawsuit for which there’s a reasonable estimate of the amount to be received or paid.
Disparities between monthly or quarterly and year-end financial statements can be confusing and inconvenient. Regardless of your accounting method, you can reduce such occurrences by using software suited to your nonprofit’s specific needs. Contact us for software recommendations and help with accounting estimates.