Choosing to create a nonprofit is a great way to serve one’s community, however the process is definitely no easy task. The early stages of a nonprofit requires a lot of time, energy, and of course money. Being able to manage that money effectively is the key to any organization's success.
First, what is Nonprofit Accounting?
Nonprofit accounting focuses more on the accountability aspect of accounting, unlike for-profit accounting which primarily focuses on earning a profit. The rules and procedures that apply to nonprofits vary greatly for for-profits, but are essential in order to stay accountable to their donors and the community.
In order to keep up with the financial obligations of a nonprofit, it’s important to have a strong bookkeeping system in place. Developing one requires many steps, and one of the first things a nonprofit should consider is which accounting method they should base their accounting on.
Cash Basis or Accrual Basis
Deciding on an accounting method is an important first step to building your bookkeeping system. Choosing between the cash basis or accrual basis method of bookkeeping depends on the needs of your nonprofit and can greatly affect other accounting decisions that follow.
Cash basis method requires that you record incoming and outgoing cash transactions as soon as they occur. So basically income is recognized when you receive payment and expenses are incurred at the time of payment. In other words, until the money goes in or out of the bank, the transaction stays off the books.
Accrual method is also called Generally Accepted Accounting Principles (GAAP) and allows you to record transactions in the period it occurs. Income is recognized when the customer is billed using account receivables; ex: when a pledge is made, not when donation is received. This is also known as the revenue recognition principle. Similarly, expenses are recorded when you’re billed using account payable.
The Good and the Bad
Cash basis method is considered to be the simpler of the two methods because it does not require the tracking of account receivables or payables since you only deal with sales receipts. Other benefits are that it only requires one entry per transaction. No adjustments are needed since everything is paid upfront. Lastly, it gives you a realistic view of how much cash you have on hand at any given time.
One disadvantage is that a disclaimer stating that you used a cash basis method is required in the year-end reports. Another disadvantage is that the cash basis method provides limited information on non-monetary events, such as receipts of donated supplies.
Compared to cash basis, accrual basis method requires more complex accounting processes and is time consuming, however it is considered better suited for larger, more established organizations. Benefits of using the accrual basis method is that you get a complete picture of the financial state of the organization because it includes accruals, allocations, payables, receivables, outstanding obligations, and pledges. It also offers accurate reporting since it recognizes events as they occur.
A disadvantage of the accrual basis method is the two-entry system, unlike cash basis which requires only one. Also the possibility for adjustments due to pledges not being fulfilled is something to be considered, unlike with cash basis where the donation is paid upfront.
So which is the best option?
Depending on the size and needs of your nonprofit, you can accurately decide on whether to use the cash basis or accrual basis method. However, the majority of nonprofits use the accrual basis method because it not only abides by the GAAP and IRS rules and principles but it also provides a complete picture of an organization’s financial situation. This is essential to fulfil the accountability expectations donors have of nonprofits. Nonprofit donors and grant funders often set restrictions on their donations to ensure that their funds are being spent on the programs they are donating to, which is why nonprofits employ a type of accounting known as fund accounting. Fund accounting enables nonprofits to allocate their money into different groups or “funds” in order to keep them organized and only spend funds on what they’re designated for.
The next part of the series further explores fund accounting and how it affects the financials of a nonprofit.
HTH & Accounting Associates help organizations and business owners with accounting and/or financial consulting services.
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