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Cash or accrual? Selecting the correct method. (Balance Sheet).

When the American Academy of Dramatic Arts, the oldest theater school in the United States, received two multi-year pledges during 2000, it faced a conundrum. Should the organization record the full pledge amount roughly $25,000 each - in the year the pledge was made, or simply record the money it actually received and record the rest as the donors fulfilled their promises in the coming years?

The academy took what appeared to be the more prudent course of action, and recorded the $5,000 from each pledge ($10,000 total) that it received in 2000 and decided against reporting the additional $40,000 prematurely. The academy, however, was wrong. It takes a quick study in accounting, though, to realize why.

Nonprofits can choose between two primary accounting methods when preparing their financial statements, cash basis or accrual basis. For many, the choice is simple: the simplicity of cash basis accounting appeals to most small charities, while large organizations generally find the more sophisticated accrual basis better reflects their financial health.

But for the plethora of mid-sized organizations, the choice isn't always as clear-cut.

Whoever warned against counting chickens before they've hatched was clearly a proponent of cash basis accounting. The method, often referred to as "checkbook accounting," is so simple it hardly requires explanation. Revenue is reported when cash is received. Expenses are reported when money is spent. Financial reports are essentially generated by tallying the checkbook ledger.

This method is fine for small organizations with relatively straightforward financial accounting because accrual basis requires more financial sophistication on the part of the nonprofit. It also requires more staff, in most cases, and it can be a costly endeavor.

If financial statements done under the accrual basis don't show any material difference from those done under cash accounting, there's little reason to switch. "There's nothing wrong with using cash basis accounting so long as it reasonably and accurately represents the true financial accounting and position of the organization," said Andrew Lang, national director of nonprofit services for BDO Seidman, an accounting and management firm based in Chicago.

But as the organization grows and becomes more complex, cash accounting may no longer suffice. One of the primary goals of accounting is to match revenues and expenditures. That becomes harder to do when a busy nonprofit has revenues and expenses for the same events recorded in different years.

For example, let's say that late in the year, an organization puts on a training program for which it's to receive funding from New York City. The organization hosts the function, pays all the expenses, submits an invoice to the city and waits for reimbursement. If the reimbursement doesn't arrive until January, the nonprofit's year-end financial report will present a slew of expenses without any mitigating income. The following year's report, meanwhile, will show the income, but not reflect what it cost the organization to receive that money.

Whoever is relying on the financial statements -- donors, grantmaking foundations or management itself -- won't have a clear picture of the organization's financial machinations. "At the end of the year, an organization could easily have an entire month of outstanding receivables while all expenses have been paid," said Mitch Lewis, partner in charge of M.R. Weiser's nonprofit services group. "Financial statements will show 12 months worth of expenses and maybe 11 months worth of income. That tells the reader nothing about what the nonprofit is doing."

Similarly, a rash of pledges made in December won't be recorded under cash accounting until they're received, likely in the next calendar year. If the method is used consistently and the amount of funds raised doesn't change dramatically from year to year, the net effect on income in any given year is negligible. A growing organization, though, may find that cash accounting doesn't reflect its growth quickly enough.

So cash accounting's overriding appeal -- its simplicity -- is also its major drawback. Just as fundraisers need to assess who it is they're pitching to, nonprofits should choose a financial reporting method that meets the needs of its audience.

Donors will often want more information than cash accounting method provides, and management might prefer a tool that more aptly displays the organization's financial activity. Some nonprofits rectify this by using a modified cash basis of accounting. This solves some issues, since cash accounting can be modified a multitude of ways according to the organization's needs.

If a nonprofit purchases a building, for instance, true cash basis requires that the transaction be characterized as an expense. Most organizations, though, would find it far more beneficial to characterize it as an asset and depreciate it over 20 years. Some nonprofits may simply want to document its accounts receivable and payable along with its checkbook records.

Clearly, as a nonprofit's financial activity becomes more and more complex, a more thorough accounting method may be required.

Size of the organization has little to do with determining the accounting method. Estimates range from budgets of $500,000 to $5 million as far as when cash basis begins to fail.

More important is for whom the organization is preparing the financial statements. While donors and management might be satisfied with cash or modified cash accounting, grant-making foundations and government agencies that disburse funds generally require nonprofits to submit audited financial statements. That's when cash accounting gets more problematic.

Cash basis is not a generally accepted accounting principle (GAAP). That means an auditor would be unable to issue an "unqualified opinion," instead deeming it an "other comprehensive basis of accounting." Qualified opinions, while not necessarily indicative of something amiss, can pose a large obstacle in fundraising efforts and qualifying for grants.

Modified cash accounting, while it may be a solution in some situations, has even less legitimacy in the world of audited financial statements. Because there's no single method called "modified cash" (rather, it's up to organizations to decide when and how to modify their reports), an outside auditor couldn't even call it an "other comprehensive basis of accounting." Instead, modified cash financial reports would simply be stamped with a qualified opinion.

Accrual basis accounting

Not surprisingly, most CPAs advocate the accrual basis of accounting for organizations that are either growing quickly or have a multitude of financial issues that can't be properly reflected under cash accounting. "Anybody who wants their organization to have any respectability at all should be on the accrual basis," said Julie Floch, partner and director of nonprofit services at Richard A. Eisner & Co. in New York City "You risk a distorted view under cash basis."

Accrual basis brings nonprofit financial statements in line with those from public companies - a major goal of the Financial Accounting Standards Board (FASB) during the mid-1990s. And while some nonprofits balk at making the transition, the accrual basis offers more flexibility and specificity that usually benefits the organization.

Take the case of the American Academy of Dramatic Arts, which reports under accrual accounting. Accrual accounting dictates that multi-year pledges are reported as revenue in the year in which the promise was made. "Now I need to go back and add almost $40,000 to 2000's revenue," said Stan Corfman, the academy's chief financial officer.

Critics argue that in this instance, accrual accounting actually provides a murkier picture than cash accounting, since it allows income to be reported several years before it's received. And that's somewhat true, which is why organizations that issue financial reports under the accrual basis commonly keep their operating budgets using the cash basis.

Under the cash basis, multi-year pledges aren't even recorded, so readers of the financial statements would have no sense of an organization's fundraising efforts or the likelihood of potential income. Under accrual accounting, multi-year pledges are discounted (according to IRS tables), and it's just the present value of the pledge that's recorded as income. The remaining amount gets characterized as "temporarily restricted funds."

If an opera, for instance, receives a pledge for $100,000 over the next three years, that amount may be worth $240,000 (a conservative estimate) in the current year. The nonprofit would set up a $300,000 receivable account for the pledge (of which the present value of $240,000 would be recorded as income in 2002), along with a $60,000 contra-receivable. As the pledge gets paid in future years, a portion of the contra-receivable gets marked as additional income, essentially whittling away the $60,000 discount until the entire pledge is fulfilled.

Pledges that don't get fulfilled are written off in the year that circumstances indicate the pledge is no longer collectible. To mitigate this risk, nonprofits generally use historical figures to determine an allowance for bad debt. If, historically, 10 percent of an organization's pledges don't actually come in, 10 percent of all pledges should be written off immediately. That figure can be adjusted for a changing environment -- such as a plunging stock market or national crisis -- in which pledges are more or less likely to be fulfilled.

Accrual accounting also allows a clearer picture of restricted funds, such as those marked for a particular purpose. If a food bank receives a year-end $10,000 donation for the sole purpose of buying food, it may not spend it all immediately. The balance sheet would reflect the, say, $3,000 in income it did spend on food, and show $7,000 in restricted income that won't be spent until the following year (at which point it would be recharacterized as unrestricted funds).

All this detail comes at a price. The level of financial sophistication required for reporting under the accrual basis may exceed the needs of many smaller charities. While it's left to the nonprofit to decide how to prepare its financial statement, it's the readers of those statements that should make the call. Use them as a guide.

Beverly Goodman is a senior writer for TheStreet.com
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Title Annotation:recording income
Author:Goodman, Beverly
Publication:The Non-profit Times
Geographic Code:1USA
Date:Aug 15, 2002
Words:1640
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