Accounting Methods: Cash Versus Accrual

An accounting method is a set of rules that determines when revenue and expenses are recorded.  The method that an organization follows is determined when it is first created. 

Cash Basis

The cash basis of accounting is the easiest method, not only to follow but to understand.  Under the cash basis revenue is recorded when received and expenses are recorded when paid.  This is just like a personal checking account where revenue (i.e., your paycheck) is recorded as revenue to you when you receive your paycheck and expenses (i.e., your mortgage) is recorded as an expense when you write the check.

Accrual Basis

The accrual basis is more complicated.  Under the accrual basis, revenue is recorded when earned and expenses when incurred.  Often times foundations will send an award letter to a nonprofit telling them that they’ve been approved to receive a grant at a stated date in the future.  Under the accrual basis, the revenue for the grant is recorded when the grant letter is received, not when the check is received.  Some nonprofits receive program services fees.  The organization provides a service and in return receives payment.  For example, a nonprofit provides a Saturday day camp for kids and charges $25 per child to attend.  The families are billed and most pay the $25 fee after the day camp is held.  The organization would record the $25 fee in revenue on Saturday, the day that the service has been provided and set up a receivable for the amount to be received in the future.  Under the accrual basis, expenses are recorded when incurred, which means when the service was provided to the organization or when the goods were purchased, even though the payment may not be made until a later day.  The offsetting credit is recorded to accounts payable.  The accrual basis also requires additional accounts for prepaid expenses, fixed assets, depreciation, accrued payroll, and deferred revenue.

Modified Cash Basis

Some organizations follow the modified cash basis of accounting.  This is a mixture of the cash basis and accrual basis.  The organization starts with the cash basis of accounting but adds some accrual balances (modifications to the cash basis).  The most common modifications  are payroll withholdings, fixed assets and related depreciation, and investments recorded at fair value.  The modifications to the cash basis need to be reasonable.  For example, it would not be reasonable to record receivables or payables under the modified cash basis.

Which Basis Do I Use?

The basis that your organization follows depends on your situation.  The cash basis of accounting is best under the following circumstances:

• No third-party users of the financial statements
• No creditors requiring accrual based financial statements
• Cost of complying with the accrual basis is too much
• Operations are simple
• Accounting functions are unsophisticated
• Only one major activity
• Capital expenditures and financing are not significant

The modified cash basis of accounting may be best for your organization if the following apply:

• No third-party users of the financial statements
• No creditors requiring accrual based financial statements
• Cost of complying with the accrual basis is too much
• No complex set of books
• Decent amount of capital expenditures

If your organization receives significant grants or government funding, you may be required to use the accrual basis of accounting.  This is the most complex method of accounting and thus provides the most complete picture of the organization’s activities.  If your organization follows the accrual basis, you will want to make sure that your accounting staff are adequately trained to understand how transactions should be recorded. 

Whichever basis that your organization uses, it is important that management, the board of directors, and any other users of the financial statements understand what types of transactions are and are not recorded.  They organization’s financial statements will look different depending on the basis used and can impact the decisions made.

Contributed by Carrie Minnich, MAcct, CPA | Partner | DWD CPAs & Advisors