If your nonprofit periodically prepares internal financial statements for your board, you may have noticed that your auditors propose adjustments to these interim statements at year-end. Why do auditors do this? Generally, it reflects differences due to cash basis vs. accrual basis financial statements. But you can help minimize the need for such adjustments. Here’s how.
Cash basis accounting
Under cash basis accounting, income is recognized when you receive payments and expenses are recognized when you pay them. The cash “ins” and “outs” are totaled (generally by accounting software) to produce the internal financial statements and trial balance you use to prepare periodic statements. Cash basis financial statements are useful because they’re quick and easy to prepare and they can alert you to any immediate cash flow problems.
The simplicity of this accounting method comes at a price, however: Accounts receivable (income you’re owed but haven’t yet received, such as pledges) and accounts payable and accrued expenses (expenses you’ve incurred but haven’t yet paid) don’t exist.
Accrual basis accounting
With accrual accounting, accounts receivable, accounts payable and other accrued expenses are recognized when they occur, allowing your financial statements to be a truer picture of your organization at any point in time. If a donor pledges money to you, you recognize it now when it’s pledged rather than waiting until you receive the money — which could be next month or next year.
Generally Accepted Accounting Principles (GAAP) require the use of accrual accounting and recognition of contributions as income when promised. Often, year-end audited financial statements are prepared on a GAAP basis.
Internal and year-end statements also may differ because your auditors proposed adjusting certain entries for reasonable estimates. This could include a reserve for accounts receivable that may be ultimately uncollectible. Another common estimate is for litigation settlement. Your organization may be the party or counterparty to a lawsuit for which there’s a reasonable estimate of the amount to be received or paid.
We can help you reduce disparities between monthly or quarterly statements and those prepared at year-end by maximizing your accounting software’s capabilities. Also, we can work with you to improve the accuracy of estimates. Contact us.