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Cash accounting and accrual accounting

There are two different kinds of accounting for income and expenditure - cash accounting and accrual accounting - and one thing that the board absolutely has to do is to decide which one it wants. In order to decide on what it wants, the board has to understand the pros and cons of each kind. And in order to operate either kind of accounting, the board has to understand what that method can and can't do.

Cash accounting is the simplest format, and most small organisations use it. It works on the basis of tracking the actual dollars in and dollars out as if they were actual crumpled notes. If on Monday someone pays you $100 you enter it in the book as income under Monday's date. If on Tuesday you pay someone $100 you enter it in the book as expenditure under Tuesday's date.

That's very straightforward, and it may never have occurred to you that there was another way of doing things. But it does have its defects, and they have to do with the fact that your organisation is not in fact a processing machine for crumpled notes. What you do, and what people pay you to do, is carry out your mission. And your obligations here also have financial implications.

If your organisation gets all its income from no-strings donations, this isn't going to be much of a problem. If, however, your group gets any significant proportion of its income as payment for services - if you get grants for particular projects, or if you contract with the government to deliver client services - then simple cash accounting can mislead.

Let's say, for example, that the government contracts with you to deliver psychological services to homeless people for $100,000; to be precise, they require you to hire 1.5 psychologists for 12 months and hire clinic premises. According to the budget you submitted for the tender this is going to cost you $92,000. Simple cash accounting will drop $100,000 into the income column as soon as you get the cheque. It's not a loan, so you don't have to make an entry into the liabilities column.

And the risk is that the board, looking at the accounts and seeing them boosted by $100,000 without any offsetting debits, will go off and spend that $100,000 on frivolous things like photocopying and computers and new carpets or salary rises all round without remembering that within the next year they're going to have to find $92,000 for extra salaries and rent. Yes, you'd hope the Treasurer would speak up and point out the true circumstances, but if you can't see something in the accounts it's always possible that it'll get overlooked.

Accrual accounting recognises income only when it's been earned, and scores expenditures when they're incurred rather than when they're actually paid. You put that $100,000 as income in the accounts when you provide the services you're charging for, not when you actually get the cheque. You debit the accounts on the date you write cheques - the day you actually promise to pay all these people - not the often much later date after people have got their mail, got your cheques down to their bank, waited five business days, and actually seen the money drop out of your account into theirs.

Small organisations can get by with cash accounting, but most large organisations that deliver services in return for payment (by clients, governments, or grantmakers) use accrual accounting. It's more complicated, and requires more financial expertise, and it may require more resources for your finance section.

It's also possible to have an accounting system that incorporates elements of both modes, and that's even more complicated.

Both modes - cash and accrual - have their advantages and disadvantages, and which you choose is going to depend on your size, your business model, and your available resources.

Cash accounting

Advantages:

  • It's more intuitive and easier for non-accountants to use and understand.
  • It provides a reasonable view of the organisation's liquidity, for most of the time.

Disadvantages:

  • It doesn't capture obligations that are due but not paid - costs that will have to be incurred later, or income that's been earned but not paid over.
  • It doesn't give a complete picture of what's actually occurred, only on what money has passed from hand to hand.

Accrual accounting

Advantages:

  • It gives a more accurate picture of the organisation's overall financial performance and financial position.

Disadvantages:

  • It requires a sophisticated understanding of accounting and bookkeeping principles.

Which model you settle on isn't in itself so very important; what is absolutely vital, however, is that the board knows which one is being used and the reasons for choosing that approach, and understands how to read the financial reports produced under that model. If the board thinks the accounts they're reading are cash accounts and they're really accrual accounts, or vice versa, major misunderstandings are possible.

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