Making Everyone Look Good: Cash vs Accrual Accounting
In 2018, the good news was that a number of ZIM clients received multi-year grants. The bad news was that because of their methods of accounting, the total amount granted over multiple years was only accounted for in year one This put extra pressure on both ZIM and our nonprofit clients to increase general fundraising in the second and third year of these grants, because a year-to-year comparison would show a decrease. So, what was going on?
Every company, including nonprofits, need to use accounting methods to track income and expenses with the goal of gaining information on the financial health of the organization. There are two ways of doing this: the cash method or the accrual method.
If a nonprofit uses the cash method of preparing its accounting records and statements, it recognizes income and expenses when they occur. In other words, the nonprofit records income when money is received and not when it is pledged. Thus, expenses are only recorded as an expense when the bill is paid, not when the invoice is received. To apply this to aforementioned question, if a nonprofit receives an award letter for $25,000 a year for two years from a foundation, that donation would not be counted until the checks are received, $25,000 in year one and $25,000 in year two.
If a nonprofit uses the accrual method of accounting, it recognizes income and expenses when they are stated. In other words, the nonprofit records income when money is pledged and not when it is received. As follows, expenses are recorded as an expense when the bill is received, not when the invoice is paid. Using the same grant award scenario, the entire $50,000 is therefore considered income in the year the award letter was received, even though payment will be over two years.
Most experts agree that cash accounting is effective for small nonprofits because it is simpler and if there are a number of pledges that are not fulfilled, time is saved by not having to adjust the records later. However, for larger, organizations with multiple sources of funding, the accrual accounting approach provides for better budgeting and planning, as it tracks when expenses are incurred, and when revenue is earned.
So where does this leave ZIM, our nonprofit clients, and the extra pressure to increase general fundraising in the second and third year of these grants to avoid a perceived decrease? Sometimes we simply need to understand the story and provide detailed notes on income statements to clearly communicate what may visually look bad, but is actually excellent for the organization. After all, the nonprofits did receive multi-year grant funding!