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What is Accrual Accounting?

During the Q&A of a recent webinar, a participant asked, “What is Accrual Accounting?”  It is one of the primary “best practices” for non-profit organizations, since it provides a more accurate assessment of an organization’s financial activity.  A longer explanation is available on pages 59-63 of A Church Finance Handbook, but here is a snapshot:

There are two types of accounting: cash and accrual.  Cash basis accounting counts expenses according to the date of the check and counts income as of the date of the deposit.  It seems simpler at first, but can lead to an incorrect analysis of an organization’s financial health, which is why accrual accounting is required for any external financial reporting.  Accrual accounting recognizes expenses when they are incurred and income when it is earned.  What are some examples, and why is this important?

If you receive and pay a phone bill each month, and then receive the December bill dated December 20th, but don’t pay it on January 4th, using cash accounting, your financial reports for the year  ending 12/31 wouldn’t include the December phone bill.  You might think your phone expense was lower than expected, but actually, it only appeared to be lower because the reports only included 11 monthly bills.  The distortion will be carried forward, since the next year’s reports will include 13 bills.  Using accrual accounting (in QuickBooks that’s the “Enter Bills – Pay Bills” procedure), the phone bill is recorded on December 20th and shows as an expense on that date, no matter when you pay the bill, so you’ll always be comparing 12 months to 12 months.

On the income side, examples of accrual accounting include recording a deposit paid for a wedding next year as income on the wedding date, rather than the date the deposit was received, or recording pledges as prepaid pledges or “pledges receivable” if they are designated for either next year’s or last year’s pledge.  This helps the congregation to more accurately compare one year to the next.  Check out the example on page 62 of a congregation that appears (on a cash basis) to have declining contributions over a three-year period, but actually has increasing pledges once the prepaid and postpaid pledges are recorded on an accual basis.

If you’ve heard the terms “Accounts Payable” and “Accounts Receivable,” these are a part of accrual accounting, defining the time after an expense is incurred, but before you pay it, or the time after income is earned, but before it is received.  There are several aspects of accrual accounting that are important for churches, including deferred revenue, accrued payroll and prepaid expenses, but if you begin by recording your expenses on an accrual basis, you’ll be well on your way to more accurate and useful financial reports.