Why Nonprofits Need to Switch from Cash-Basis to Accrual-Basis Accounting

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The type of accounting your organization uses could be holding you back from getting the most out of your accounting system. While many nonprofits start with cash-basis accounting due to its simplicity, this method often falls short of providing a comprehensive view of a nonprofit’s financial health.

Transitioning to accrual-basis accounting can offer a more accurate representation of finances and enhance long-term planning. Let’s look at the differences between cash-basis and accrual accounting and why you might want to switch.

Understanding Cash-Basis vs. Accrual-Basis Accounting

Before we can know why to switch accounting systems, it’s important to understand how each system works. The main difference between cash-basis and accrual-basis accounting is when revenue and expenses are recorded.

In cash-basis accounting, revenue gets reported only when the cash is physically (or digitally) received. Likewise, expenses are recorded when money leaves the organization’s account. Cash-basis accounting is most common for smaller nonprofits, where financials tend to be less complicated.

Accrual-basis accounting, on the other hand, records revenue and expenses when they are incurred. The accrual-basis method records transactions with the assumption that the money will physically change hands in the future.

For example, a nonprofit provides a paid service to a community member and issues an invoice. The revenue from the service is recorded now, even though the invoice hasn’t yet been paid.

Limitations of Cash-Basis Accounting for Nonprofits

Cash-basis accounting is a simple method that’s great for new or small nonprofits. However, there are two major limitations to using the cash-basis method:

• It inaccurately represents financial health.
• It can cause challenges in long-term financial planning.

The timing of an organization’s income and expenses in cash-basis accounting can misrepresent the actual financial state of the nonprofit. Additionally, the cash-basis method can make accurate forecasting and budgeting difficult.

Say a nonprofit hosts a large fundraising event in the second quarter. The costs for the event are all paid in the first quarter, but donation funds and other revenue won’t come through until the second quarter.

By using the cash-basis method, this organization would look like it’s struggling financially in the first quarter but has a major surplus in the second. The reality is somewhere in the middle, but the organization may be tempted to under budget for the first quarter and over budget for the second.

Benefits of Accrual-Basis Accounting for Nonprofits

Switching to accrual-based accounting can have a lot of benefits for nonprofit organizations. Most importantly, making the switch can help your organization:

• Enhance the accuracy of financial data
• Increase transparency
• Improve financial decision-making

Enhanced Financial Accuracy

By recording revenue and expenses when they happen, instead of when cash is exchanged, helps provide a more accurate picture of the organization’s financial health at any given time. You’ll get a better view of long-term financial transactions, rather than just seeing what cash is currently in an account.

Accrual accounting also helps keep related revenues and expenses together. Matching revenues with the expenses incurred to generate them reflects the true cost of running programs and services.

Improved Financial Transparency

Accrual accounting provides stakeholders with a detailed view of your organization’s financial activities, improving trust and confidence. Transparent financial reporting can also improve donor relations. With increased transparency through accrual accounting, donors can see how their contributions are being used and the impact they’re making.

Better transparency also helps you stay compliant with regulations or grant requirements. Many regulatory bodies and grantors require accrual-basis financial statements. Adopting the accrual method ensures compliance with Generally Accepted Accounting Principles (GAAP) and other relevant standards. By making the switch, you could open your organization up to more grants and funding opportunities.

Facilitates Better Decision-Making

A more accurate understanding of your organization’s financial health means nonprofit leaders can make better strategic, data-driven decisions. Accrual accounting provides the data needed to forecast cash flow, budget more effectively, and allocate resources where needed most.

An accrual-based accounting system also gives you insights into the efficiency and effectiveness of programs and services. Detailed financial reports generated using the accrual method can highlight inefficiencies and areas for improvement within your organization. By analyzing the financial performance of programs, you can determine which initiatives are delivering the most value–and which may need adjustments or more support.

Get Support for Your Cash-Basis to Accrual-Basis Transition

The cash-basis accounting method is simple, but simplicity could be holding your organization back. Moving from cash-basis to accrual-basis accounting can help your nonprofit better manage its financial health and improve transparency. 

While switching to accrual-basis accounting can be daunting, the easiest way to make the switch is to work with a trusted nonprofit accounting firm, such as The Charity CFO.

Our dedicated team of accounting professionals specializes in nonprofit accounting–ensuring your organization gets advice from accountants who understand the unique needs of nonprofits. Get in touch today to see how we can help you transition accounting systems!

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