Accrual, Cash, and Modified – What does it all mean?
There are three general basis of accounting that are used for nonprofits. These include the accrual basis, cash basis, and the modified cash basis. For GAAP purposes accrual basis of accounting is required. But for those nonprofits that do not need to adhere to GAAP due to no requirement by the board, no loan covenants, or no awards requiring GAAP finances the options of cash or modified cash may be appealing.
Advantages and Disadvantages of Accrual Basis Accounting
The accrual basis of accounting corresponds with the concepts of recognizing revenues as they are earned and expenses as they are incurred. This means that it provides the most accurate depiction of revenues and expenses on the financial statements.
The advantages of accrual basis accounting include greater transparency, more accurate depiction of the financial position and activities of the nonprofit, and compliance with various awards and debt covenants. Because of these factors many boards and large contributors prefer to see financials presented on the accrual basis. Additionally, it can make comparisons from one period to the next easier to compare which can lead to better identification of trends within revenues and expenses.
The disadvantages of accrual basis accounting are that it requires more skill and can require more time than cash basis accounting. This means that if you have an internal accountant, they need to be aware of the rules and prepare appropriate schedules as needed. If you are using an outsourced accountant, it may mean that they require more information from you to ensure the transactions are properly recorded and the accounting is accurate under the accrual basis.
Advantages and Disadvantages of Cash Basis of Accounting
The cash basis of accounting means revenue is recorded when received and expenses are recorded when paid. This means that it does not provide an accurate depiction of revenues and expenses on the financial statements.
The advantages of cash basis accounting include being able to hire someone at a lower rate due to the lower level of skill required and a greater focus on cash flows. While write-offs for contributions, program revenues, and membership dues are typically very low for most nonprofits since recorded revenues until cash is means not only avoiding bad debt expense write offs and allowance for doubtful accounts estimates, but it also means that management can more easily see the actual cash that has been brought in. Also, since the cash inflows and outflows are included on the statement of activities without accruals to it provides management with a better depiction of where the organization stands as far as cash flow is concerned.
The disadvantages of the cash basis of accounting include that they are not forward looking, are more difficult to compare from period to period, and revenues and expenses may differ from accrual basis accounting by months. Financials prepared on using cash basis will not include accounts receivable or accounts payable meaning that management will have less information on which to base short-term cash flow decisions. Likewise, the timing difference noted between revenues and expenses can make comparisons from period to period more difficult. Although this may be smoothed over longer periods, there may still be a significant difference.
Advantages and Disadvantages of the Modified Cash Basis of Accounting
The modified cash basis combines elements of the accrual basis and cash basis of accounting. Generally, this means that longer-term accrual items such as debt and fixed assets are included along with depreciation and amortization. On the other hand, short-term accrual items such as receivables and accounts payable and inventory are still not recorded.
The advantage of the modified cash basis is that it provides more relevant information that cash basis, but without the time or cost needed to do full accrual basis accounting.
The disadvantage of the modified cash basis is that it still lacks the transparency of accrual basis when it comes to expenses and revenue, which can result in less informed short-term decisions.
Converting from Cash Basis to Accrual Basis
If a nonprofit uses cash basis but debt covenants, the board, or awards require financials to be presented on accrual basis the nonprofit will have to convert from cash basis to accrual basis. The steps to convert from cash basis to accrual basis include:
1. Add accrued expenses—This means going through invoices received but not paid as of yearend, as well as invoices received after yearend to record a liability for any services or goods received prior to yearend.
2. Add prepaid expenses—This means identifying any expenses that were paid prior to the yearend, which are for services or goods that are were received until after yearend.
3. Add accounts receivable—This means identifying any revenues that were earned or contributions that were promised prior to yearend, but not received.
This process can be difficult and time-consuming requiring manual journal entries to make adjustments to properly reflect the balances in the statement of financial position and statement of activities. It should also be noted that it is possible that transactions will be missed during the process without reviewing all the accounting records. This means that the accuracy of the statements will depend on the completeness and organization of the accounting records maintained.
If you need to convert your nonprofit’s financials from cash to accrual basis, I recommend contacting a skilled CPA. If you have any questions, feel free to reach out to me at firstname.lastname@example.org.