Accrual Accounting Basics for Nonprofits
Accrual accounting is one of two methods that a nonprofit can use to record revenue. While it allows for a more accurate overview of your nonprofit’s financial health, and some organizations see it as one of the best financial practices for nonprofit organizations, there are some factors you should understand before diving in. In this article, we’ll tell you some nonprofit accounting basics, like exactly what accrual accounting is all about, why people tend to use it, and whether you should adopt it for use in your own organization.
Here is the content we’ll cover:
What is Accrual Accounting?
GAAP for nonprofits dictates your organization must utilize accrual accounting. For a quick breakdown of a few nonprofit accounting terms, accrual accounting is a form of accounting that follows what’s called the "matching principle". This means that you recognize income when it is earned rather than received. That is, the payment is not recognized until you follow through on the delivery of a product or service. As a result of this type of accounting, accruals will affect your statement of activities and the statement of financial position.
Essentially, accrual basis accounting accounts for a transaction before any assets are actually exchanged between parties.
So, why is it called accrual accounting? "Accruals" refer to the adjustments made by companies before issuing financial statements. These adjustments account for potential negative outcomes such as bad debts (member dues owed to your organization but never paid), sales returns, and obsolescence (reduced product value such as attempting to sell leftover PETA t-shirts with the year 2019 on them at a discount in the year 2021), by making sure that the organization has enough reserve money set aside to cover any of these costs.
For a clearer picture of what all of this means, let’s take a look at a couple of examples of accrual accounting in action.
Example #1: Let's say that you are a medical professional society that collects dues from its members on a yearly basis. You bill $3 million of annual dues in June. That amount is then divided by 12 and amortized as a monthly income over the one year period, not recognized as a lump sum.
Example #2: Imagine that you are an educational organization that collects money for a gala celebration held in October. This money is collected over several months and placed into the bank, but it will not be accounted as income until the gala actually takes place.
Example #3: You are the treasurer for a small cooperative preschool. To space out the expenses associated with a year-end party for the graduating four-year-old class, each family makes a payment of $5 per month. The journal entry for these transactions will show income when the party occurs.
Cash Basis vs Accrual Accounting
Unlike fund accounting for nonprofits, cash basis and accrual accounting are the two most common accounting methods and are the most up-to-date nonprofit accounting standards. Now we’ll compare and contrast these two nonprofit accounting techniques to determine the important aspects of both - including their respective nonprofit cash handling procedures.
What is Cash Basis Accounting?
Cash basis accounting is the alternative method to accrual accounting. In the cash method, income is recognized at the point of it being received. Many small organizations or nonprofits use cash basis accounting as it is simpler and makes it easier to record income and expenses.
Anthony is thinking hard about the differences between accrual and cash basis accounting!
Cash basis accounting also poses less risk for small organizations as there is no need to pay for expenses before the related influx of cash is received.
For instance, take the examples from the "What Is Accrual Accounting" section above. A smaller business or nonprofit may well be unable to absorb the kind of risk associated with certain events.
Example #1: Regardless of when the members pay their dues, the organization will only need to recognize them once they are received.
Example #2: The money collected to pay for booking a location, catering, and entertainment purchases associated with an educational organization-sponsored gala will show as individual entries leading up to the event taking place.
Example #3: The $5 payments from each preschooler family will be recognized monthly, when received, not at the time the party takes place.
What Are The Pros and Cons of Cash Basis Accounting?
To get a clearer picture of cash basis accounting, let’s look at the upside and downside of this system.
It is simpler to use
Can be managed with a single-entry system, which may eliminate the need to a more costly accounting program
Keeps your books according to your actual cash flow status rather than estimates
Allows you to control the timing of transactions and revenue
Not very accurate for larger nonprofits because it offers only a limited view of income and expenses
You must put a disclaimer on year-end reports to say that you are using a cash basis accounting method
Cannot be used for organizations that sell customer products or services on credit, have gross receipts in excess of the current IRS limit, or need inventory to account for income
If using a single-entry system, you will have less control of transaction posting and more room for error than if you use a double-entry system
What Are The Pros and Cons of Accrual Basis Accounting
For comparison, we will also break down the benefits and disadvantages of accrual basis accounting.
Offers a more complete view of your finances for monthly and quarterly financial statements, therefore offering a more complete picture of your organization’s overall financial situation. This makes for a more accurate (and therefore more useful) business analysis.
Auditors may only certify balance sheets and income statements with supplementary notes if the company uses accrual basis accounting. (Although they can compile either type).
Makes nonprofit budget planning easier
It’s GAAP (generally accepted accounting principles) compliant. This is the industry standard for preparing financial statements because it makes it easier for auditors and other organizations to access a clear financial picture.
Requires more work
You will need two accounting entries per transaction
Doesn’t provide a clear picture of your current cash flow status.
Pro Tip: You can overcome this minor drawback by asking your bookkeeper or the accountant for your nonprofit organization to produce regular cash flow statements, which can be compared to the company’s revenue and expenses. This is a smart move in any case, and most companies do this to keep an eye on their cash flow status.
Who Should Use the Accrual Method?
Whether you are a new or established organization, you will be interested to know that, per nonprofit accounting courses, the accrual method should always be used by bigger organizations with large amounts of funding and staff salaries to pay. In fact, most companies (for-profit and nonprofit) use this method in accordance with IRS requirements and also because it is a better determination of economic reality.
Cash or accrual? Salma is learning which type of accounting she should use!
The accrual basis method should also be used by organizations that plan to raise additional donations from large investors such as foundations or government bodies. It is especially important for nonprofits who take advantage of grants to use accrual-based accounting.
The reason that it is important to use accrual-based accounting in these cases is that accrual accounting gives a more accurate idea of a company or organization’s growth, profitability, and overall financial health at any given time. While a bit more labor-intensive, it also offers a better picture. Auditors are only able to certify financial statements if they are completed with accrual-based accounting.
Pro Tip: It is also a best practice to use accounting software to keep track of all of the transactions in accrual accounting. In larger organizations, the numbers can become overwhelming. This is especially true for those who have a lot of salaries to pay, sales of products and services, and/or large amounts of collected dues and donations. Software (like Springly!), and a few good nonprofit accounting resources, can help guide your accountant as well as track enormous numbers of separate income and expense streams.