There’s a lot of paperwork to file when starting a nonprofit organization. In addition to filing articles of incorporation and filing for 501c3 tax-exempt status with the IRS, many states require filing detailed information about how the nonprofit handles finances. In some states, that includes indicating if the organization uses cash-based or accrual accounting. Choosing an unintended format can have long-lasting implications on how the nonprofit reports annual finances.
What follows is general information about accounting options and is not legal or tax advice. Contact the nonprofit professionals at BryteBridge for more information about your specific tax situation.
Before we get into the difference between cash-based and accrual accounting, it’s essential to understand the basics of all accounting systems. At the core, all organizations have income or revenue that comes in and expenses that go out.
The most common form of nonprofit revenue is what the IRS refers to as “Gifts, Grants, and Contributions.” Essentially, these are all the donations and grants the nonprofit receives. Other common types of revenue may include program fees, selling goods, and membership fees (for 501c6 organizations).
Expenses are anything the nonprofit spends money on. The IRS breaks these into a few categories, including salaries, professional fees, rent, advertising, and program fees. Additionally, if your organization provides scholarships or items to individuals, then the value of those transactions is also expenses.
Revenue should match expenses. While it does happen, a nonprofit should not be spending more money than it has available. Additionally, a nonprofit that receives more revenue than it has expanses should either increase services or reinvest those extra funds to expand the organization.
It’s All About Timing
Accounting is a historical record of financial transactions. For example, an annual balance sheet or quarterly income statement shows details for the nonprofit for that period. Likewise, IRS form 990 reports the organization’s financial history for the previous year. Deciding between cash-based and accrual accounting comes down to when revenue and expenses are recorded.
Cash-based accounting is the most common and simplest form of accounting. On a basic level, transactions are recorded when cash is exchanged. This process is how all individuals manage their finances. While you may know precisely how much money your next paycheck will include, you don’t record it and consider the funds available until it deposits. Likewise, if you buy groceries with a credit card, the expense shows up in your account when you swipe your card at the register and not when you pay the credit card bill.
Cash-based accounting applies these same principles to how the nonprofit records revenue and expenses. For example, if you buy a computer for the office, you record the expenditure on the date of purchase. When you receive a donation, you record the revenue on the date the check arrives. Likewise, many people will make last-minute donations on December 31 to ensure the nonprofit records their gift in the current year for tax deduction purposes.
While this method of accounting is incredibly simple, there are some potential issues as it may not accurately match income to expenses. For example, the organization may record donations when they arrive while not paying contractors for a few weeks.
This discrepancy may show considerable revenue and small expenses depending on the reporting period, even though committed costs are on the horizon. An unethical financial manager may take advantage of these discrepancies to provide unclear or inaccurate reports to the Board of Directors.
Despite the potential issue with reporting, cash-based accounting is the most appropriate method of accounting for most nonprofit organizations.
Since accrual accounting is not how individuals manage their financials, the method is a little more complex. Essentially, revenue is recorded when earned and not when received. For example, if a donor tells you they will provide $1,000 a month for the entire year, accrual accounting would record $12,000 in income before any money arrives.
Expenses are recorded when an agreement or transaction occurs, regardless of money changing hands. For example, if the nonprofit orders a computer for the office and agrees to pay the bill within 60-days, the expense is recorded when the agreement is made.
Typically businesses that carry large accounts payable and accounts receivable accounts will opt for accrual accounting. In these situations, accrual accounting provides a clearer picture of the company’s long-term health. When multiple invoices are waiting for payment, the company can still capture that income despite not having the cash on hand.
However, most nonprofit organizations do not carry large amounts of accounts receivable, making accrual accounting more complicated. Additionally, accrual accounting does not provide a clear picture of exactly what money the organization currently has available, making operational decisions difficult.
Keep It Simple
When a nonprofit files an annual form 990, it must indicate the type of accounting used. Mainly, the IRS wants to ensure financial accuracy year over year. If the organization switches accounting methods, it must explain why in an additional schedule with the return. While there are good reasons the organization may switch types, it is generally not advisable to frequently switch back and forth between cash-based and accrual accounting.
Switching accounting methods makes it difficult for the Board of Directors, potential donors, and grant-giving organizations to get a clear picture of the organization’s financial health. When financial reports are not consistent across periods, they create doubt and may be viewed as unreliable by stakeholders.
Most nonprofit organizations should use cash-based accounting because it is the simplest method to maintain. Contact the nonprofit experts at BryteBridge if you have additional questions or want to make sure your accounting method is correctly recorded.