Advantages of Cash Basis

The principal advantage of cash-basis accounting is its simplicity, and the ease with which nonaccountants can understand and keep records on this basis. The only time a transaction is recorded under this basis of accounting is when cash has been received or expended. A simple checkbook may be all that is needed to keep the financial records of the organization. When financial reports are required, the treasurer just summarizes the transactions from the checkbook stubs. This sounds almost too easy, but a checkbook can be an adequate substitute for formal bookkeeping records, provided a complete description is recorded on the checkbook stubs. The chances are that someone with no bookkeeping training could keep the records of the Johanna M. Stanneck Foundation on a cash basis, using only a checkbook, files of paid bills, files on each scholarship, etc. This would probably not be true with an accrual-basis set of books. In lieu of a “checkbook,” a simple accounting software package might also be used.

Some larger organizations, including those with bookkeeping staff, also use the cash basis of accounting primarily because of its simpler nature. Often the difference between financial results on a cash and on an accrual basis is not material, and the accrual basis provides a degree of sophistication not needed. For example, in Exhibit 1, what real significance is there between the two sets of figures? Will the users of the financial statements do anything differently if they have accrual-basis figures? If not, the extra costs to obtain accrual-basis statements may not be worthwhile.

Another reason organizations often keep their records on a cash basis is that they feel uneasy about considering a pledge receivable (often called a contribution receivable) as income until the cash is in the bank. These organizations frequently pay their bills promptly, and at the end of the period have very little in the way of unpaid obligations. With respect to unrecorded income, they also point out that because they consistently follow this method of accounting from year to year, the net effect on income in any one year is not material. Last year's unrecorded income is collected this year and tends to offset this year's unrecorded income. The advocates of a cash basis say, therefore, that they are being conservative by using this approach. Recent financial statement restatements by some very well-known public companies have contributed to the view held by some that an organization's cash flows may be a more meaningful measure of financial performance than an accrual-based “earnings” amount.

For organizations that choose to present their financial statements on the cash basis, a question often arises as to what, if any, notes and other disclosures should be made in the financial statements. Generally accepted accounting principles require many different disclosures in accrual-basis statements, but are mostly silent about the requirement to make such disclosures in cash-basis statements. Some guidance, however, has been issued that will assist financial statement preparers (and auditors) in determining the adequacy of disclosures for cash-basis financial statements, as well as financial statements prepared on the modified cash basis (discussed later in this chapter) and the income tax basis. During 1998, the Auditing Issues Task Force of the AICPA issued an Auditing Interpretation (Evaluating the Adequacy of Disclosure in Financial Statements Prepared on the Cash, Modified Cash, or Income Tax Basis of Accounting) of Statement of Auditing Standards 62, Special Reports. The Interpretation concludes that the discussion of the basis of accounting needs to only include the significant differences of the accounting basis from generally accepted accounting principles and that these differences do not have to be quantified. This information has now been incorporated into the AICPA's Clarified Auditing Standards in Section 800—Special Considerations—Audits of Financial Statements Prepared in Accordance with Special Purpose Frameworks.

FASB ASC 855, Subsequent Events, requires disclosure of the date through which an entity has evaluated subsequent events and the basis for that date (i.e., whether that is the date that the financial statements were issued or were available to be issued). The AICPA's Technical Questions and Answers, Section 1500.07, addresses whether this recent GAAP requirement would apply to financial statements prepared on another comprehensive basis of accounting (which would include the cash basis or modified cash basis). The conclusion is that it would. The date through which an entity has evaluated subsequent events and the basis for that date should be disclosed. (Generally, this will be the date of the auditor's report.) If there are nonrecognized subsequent events that are of such a nature that they must be disclosed to keep the financial statements from being misleading, these events should be disclosed using the guidance of FASB ASC 855.

In addition, if the financial statements prepared on these accounting bases contain elements, accounts, or items for which generally accepted accounting principles would require disclosure, the financial statements should either:

• Provide the relevant disclosure that would be provided under generally accepted accounting principles; or
• Provide information that communicates the substance of that disclosure.

Qualitative information may be substituted for some of the quantitative information required in a presentation in accordance with generally accepted accounting principles. In addition, disclosure requirements under generally accepted accounting principles that are not relevant to the measurement of the element, account, or item need not be considered. The disclosures described in the following section would be consistent with this Auditing Interpretation, although clearly cash-basis financial statement preparers should consider all disclosures that would be made under generally accepted accounting principles and then apply the above guidance to determine if they are relevant to the cash-basis statements.

The authors believe that, even in cash-basis statements, certain disclosures should be made to fully inform readers of matters affecting the financial situation of the organization. These include information about, at least, the following (to the extent applicable to the organization):

• Accounting policies and any changes in the policies used (FASB ASC 235-10-50);
• Related parties (FASB ASC 850-10, 958-810);
• Commitments, contingencies, and possible impairments of recorded assets (FASB ASC 450-20-50, 360-10);
• Unusual or infrequently occurring items, prior-period adjustments, and similar unusual matters (FASB ASC 250-10);
• Major categories of fixed assets (if capitalized) (FASB ASC 360-10);
• Major categories, and fair market value, of investments (FASB ASC 958-320, 325, 205);
• Mergers with other organizations (FASB ASC 958-805);
• Employee benefits (FASB ASC 715-20-50);
• Credit risk and information about financial derivatives (FASB ASC 815-10);
• Restrictions on contributions and net assets (FASB ASC 958-605);
• The format requirements for not-for-profit organization financial statements (FASB ASC 958-205, 210, 225, 230, 270);
• Joint costs of multipurpose activities (FASB ASC 958-720);
• Risks and uncertainties, including concentrations (FASB ASC 275-10);
• Disclosures about fair values of financial instruments (FASB ASC 825-10-50).

Advantages of Accrual Basis

What are the advantages of the accrual basis? In many instances, the cash basis just does not present the financial picture of the organization fully enough. The accrual basis of accounting becomes the more appropriate basis when the organization has substantial unpaid bills or uncollected income at the end of each period and these amounts vary from period to period. If the cash basis were used, the organization would have great difficulty in knowing where it actually stood. These unpaid bills or uncollected income would materially distort the financial statements.

In Exhibit 1, there probably is not a great deal of difference between the two bases. But assume for the moment that toward the end of 20X0 the foundation had made a grant of $100,000 to a medical school, to be paid in 20X1. Not recording this large transaction would distort the financial statements of both years.

Not-for-profit organizations are becoming more conscious of the need to prepare and use budgets as control techniques. It is very difficult for an organization to effectively use a budget without being on an accrual basis. A cash-basis organization has difficulty because payment may lag for a long time after incurring the obligation. For this reason, organizations that must carefully budget their activities will find accrual-basis accounting essential. (Chapter 17 describes not-for-profit organization budgetary considerations.)

Combination Cash Accounting and Accrual Statements

One practical way to avoid the complexities of accrual-basis accounting, and still have meaningful financial statements on an annual or semiannual basis, is to keep the books on a cash basis but make the necessary adjustments on worksheets to record the accruals for statement purposes. These “adjustments” could be put together on worksheets without the need to formally record the adjustments in the bookkeeping records.

It is even possible that monthly or quarterly financial statements could be prepared on the cash basis, with the accrual-basis adjustments being made only at the end of the year. In this way, it is possible to have the simplicity of cash basis accounting throughout the year while at the end of the year converting the records through worksheets to accrual basis accounting.

Exhibit 2 gives an example of the type of worksheet that can be used. It shows how the Johnstown Orphanage converted a cash-basis statement to an accrual-basis statement at the end of the year. Cash-basis figures are shown in column 1, adjustments in column 2, and the resulting accrual-basis amounts in column 3. The financial statement given to the board would show only column 3. Adjustments were made to the cash statement in column 2 as follows:

• Investment income—$20,000 of dividends and interest that were received during the current year applicable to last year were deducted. At the same time at the end of the year, there were dividends and interest receivable of $25,000 that were added. Therefore, on an accrual basis, a net adjustment of $5,000 was added.
• Fees from the city—This year the city changed its method of paying fees for children sent to the orphanage by the courts. In prior years the city paid $15 a day for each child assigned at the beginning of the month. This year, because of a tight budget, the city got behind and now pays in the following month. At the end of the year the city owed $25,000, which was added to income.
• Expenses—All the unpaid bills at the end of the year were added up and compared to the amount of unpaid bills as of last year (which were subsequently paid in the current year). Here is a summary of these expenses.

As can be seen, it is not difficult to adjust a cash-basis statement to the accrual basis in a small organization. The bookkeeper just has to go about it in a systematic manner, being very careful not to forget to remove similar items received, or paid, in the current year that are applicable to the prior year.

Actually, in this illustration there is relatively little difference between the cash and accrual basis except for the $25,000 owed by the city due to its change in the timing of payments. Possibly the only adjustment that need be made in this instance is the recording of this $25,000. However, until this worksheet has been prepared, there is no way to be sure that the other adjustments are not significant. It is recommended that a worksheet similar to this one always be prepared to ensure that all significant adjustments are made.

Modified Cash Basis

Some not-for-profit organizations use a “modified cash basis” system of accounting. On this basis of accounting, certain transactions will be recorded on an accrual basis and other transactions on a cash basis. Usually, on a modified cash basis all unpaid bills will be recorded on an accrual basis but uncollected income on a cash basis. However, there are many different variations.

Sometimes only certain types of unpaid bills are recorded. Payroll taxes that have been withheld from employee salaries but that have not yet been paid to the government are a good example of the type of transaction, not involving cash, which might be recorded. These taxes are just as much an obligation as the salaries.

On a modified cash basis, it is not necessary for the organization to have a complex set of books to record all obligations and receivables. In small and medium-sized not-for-profit organizations, it is sufficient to keep the records on the cash basis and then at the end of the month tally up the unpaid bills and the uncollected receivables and either record these formally in the books through journal entries or record them through a worksheet in the manner described above. Under the cash basis, one of the practical ways some smaller organizations use to record all accrued expenses is to hold the disbursement record “open” for the first four or five days of each month. This allows the bookkeeper to pay last month's bills as they arrive on about the first of the month and record them in the prior month's records. While the organization actually pays such amounts in the first few days of the new period, it considers the payment as having been made on the last day of the prior period. This means that the organization does not show accounts payable but instead shows a reduced cash balance. This is frequently a useful practice for reporting internally to the board because it gives reasonable assurance that all expenditures incurred are recorded in the proper period. In financial statements prepared for external use, such payments subsequent to the end of the period should be shown as accounts payable instead of a decrease in cash.

When Accrual-Basis Reporting Should Be Used

There are many advantages of cash-basis accounting and reporting, but the accrual basis is ordinarily necessary for fair presentation of the financial statements. Unless the organization does not have any significant amounts of unpaid bills or uncollected income at the beginning or end of the period, accrual-basis reporting is required to present an accurate picture of the results of operations and of the financial position of the organization.

Accrual-basis reporting is also required if an organization is trying to measure the cost of a product or service. It is impossible to know what a particular activity cost during the year if unpaid bills have not been included as an expense in the statement. The same is true where services are provided for a fee but some fees have not been billed and collected during the period. If a board or its membership is trying to draw conclusions from the statements as to the cost or profitability of a particular service, accrual-basis statements are essential. The same is true when an organization is on a tight budget and budget comparisons are made with actual income and expenses to see how effectively management has kept to the budget. Without including unpaid bills or uncollected income, such a comparison to budget can be very misleading and useless. Generally accepted accounting principles (GAAP) for both commercial and not-for-profit organizations include the use of accrual basis accounting. Organizations that have their books audited by certified public accountants, and who wish the CPA to report that the financial statements are prepared in accordance with generally accepted accounting principles, have to either keep their records on the accrual basis or make the appropriate adjustments at the end of the year to convert to this basis.