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When preparing their annual financial report for submission to the ACNC, charities will use either cash or accrual accounting. Medium and large charities must use accrual-based accounting in their financial reports Small charities may use either cash or accrual accounting, unless they must use accrual accounting in accordance with their governing document (rules, constitution or trust deed), or by any government department or agency, or funding body. From the 2022 Annual Information Statement, small charities using cash accounting have an additional option to describe their assets and liabilities. The main difference between cash and accrual accounting is the timing of when revenue and expenses are recognised in the books. Cash accounting records revenue when money is received and expenses when money is paid out. Accrual accounting records revenue when it is earned and expenses when they are incurred. Therefore, cash accounting does not record payables and receivables, while accrual accounting does.
 On January 1, a donor enters into a regular giving arrangement for three months with a charity for a monthly donation of $50. The charity's financial reporting period is 1 January to 31 December. Under the cash method, the amount is not recorded until the $50 is received in the charity’s bank account. Under the accrual method, the $50 is recorded in advance of receiving the cash. Assuming that the donation is received on the 21st of each month:
By raising a receivable, a charity is able to keep a track of the money a donor owes or has paid them through the books. Under the cash method, a charity may not be fully aware of their future entitlements at any given point in time.
For the last 12 months, a charity has been paying $100 per month to a website provider to host their website. The provider normally increases the subscription by 2% per annum from 1 December each year. However, if the charity pays the subscription 12 months in advance, the increase will not apply. The charity decides to pay upfront, and pays the $1,200 to the provider on 1 December 2021. The charity's reporting period is 1 January to 31 December.
If you consider the end of year report for this charity, the subscription expense would be recorded as follows:
Cash method: From January 1 to November 30, the charity paid the provider $100 a month in subscriptions (11 x $100 = $1,100). On December 1, the charity paid another $1,200 to the provider. Therefore, the total is $1,100 + $1,200 = $2,300. Accrual method: From January 1 to November 30, the charity paid the provider $100 a month in subscriptions (11 x $100 = $1,100). On December 1, the charity paid another $1,200 to the provider. Under the accrual method only the amount that relates to December is recognised ($100) and the remainder is recorded in a pre-payment account as an asset in the balance sheet ($1,100). Therefore, the total is $1,100 + $100 = $1,200.
The accrual method better captures the subscription expense for the 12-month reporting period, as the accrual system considers the timing of when expenses should be incurred.
The timing of income and expense is imperative. If income exceeds expenses, there will be a profit, but only if there's enough income to cover expenses and keep the business operating as payments come due. A good way to learn respect for the concept of cash flow is to compare it to the idea of profit. As a business owner, you understand and strive to make a profit. If a retail business is able to buy a retail item for $1,000 and sell it for $2,000, then it has made a $1,000 profit. But what if the buyer of the retail item is slow to pay his or her bill, and six months pass before the bill is paid? Using accrual accounting, the retail business still shows a profit, but what about the bills it has to pay during the six months that pass? It will not have the cash to pay them, despite the profit earned on the sale. As you can see, profit and cash flow are two entirely different concepts, each with entirely different results. The concept of profit is somewhat narrow, and only looks at income and expenses at a certain point in time. Cash flow, on the other hand, is more dynamic. It is concerned with the movement of money in and out of a business. More importantly, it is concerned with the time at which the movement of the money takes place. Truthfully, the concept of cash flow is more in line with reality. If you use the accrual accounting method, it is helpful to know how to convert your accrual profit to your cash flow profit. To fully understand the difference, you need to become familiar with:
Accrual vs. Cash AccountingIf you keep your books on the cash method of accounting, this section doesn't apply. If, however, you keep your books on the accrual method of accounting, then please read on. Without waging into the details of accrual accounting, understand that it is an essential tool for the financial management of your business. Primarily, it shows the performance of your business over a period of time by matching income and expenses. Regardless of the cash flow, the accrual method of accounting recognizes income when a sale is made. Likewise, it recognizes an expense when the expense is incurred. Most accountants recommend using the accrual method because they feel that it is the most accurate method for measuring how your business is doing. In fact, for some types of businesses, you must use the accrual method. However, accrual accounting does have some drawbacks. The main disadvantage being the timing difference it creates between the recognition of income and expense transactions, and the actual inflows and outflows of cash. The cash method of accounting records the actual flow of cash through a business. It recognizes income when cash is actually collected from a sale. It recognizes expenses when cash is actually paid out, or when a check is written to pay a bill. It is not concerned with matching income and expenses, but rather the actual inflows and outflows of cash. This method of accounting more closely resembles your cash flow. Converting Profit to Cash FlowIf you keep your books on the accrual method of accounting, you'll have to make some adjustments to determine your actual cash flow. These adjustments are necessary due to certain expenses taken into account to determine your accrual net profit, even though these expenses do not currently require a cash outlay. To convert your accrual profit to your cash flow profit, you need a balance sheet for the beginning and end of the period under examination. As a general rule, you can convert your accrual net profit using the following formula:
Understanding Depreciation and Cash FlowDepreciation is an expense deducted from your business income to reflect the annual cost of assets used in your business. Since the depreciation deduction is purely a "paper" expense, it requires no cash outflow. If you use the accrual method of accounting, depreciation must be added back to your accrual net profit to determine your cash flow profit. Dealing with Changes in Various Financial ItemsDo you use the accrual method of accounting but want to compute your cash flow profit? If so, any increase in accounts receivable must be subtracted from your accrual net profit because it represents sales included in the net profit, but not yet collected in cash. Similarly, to determine your cash flow profit, any decrease in accounts receivable must be added to your accrual net profit because it represents cash collections that are not included in the net profit for the current accounting period. TipThese adjustments are fairly simple if you think about the reasoning behind the adjustments. In terms of accounts receivable, when a sale is made to a customer, the sale is recorded and the customer's credit account is increased by the amount of the sale. When the sale is recorded, your accrual income is increased by the amount of the sale, but no cash is collected until the customer pays his bill. To convert your accrual net profit to cash, you must subtract an increase in accounts receivable. The increase represents income that has been recorded but not yet collected in cash. A decrease in accounts receivable has the opposite effect — the decrease represents cash collected, but not included in income. Changes in InventoryIf you use the accrual method of accounting, any increase in inventory must be subtracted from your accrual net profit amount to determine your net cash flow profit. The increase in inventory represents an expense that was paid but not yet subtracted from your accrual net profit. Under the mechanics of accrual accounting, the purchase of inventory is not considered to be an expense until the inventory is sold. In terms of a cash flow, you've already paid for the inventory; therefore, it must be subtracted from your accrual net profit. Similarly, a decrease in your inventory amount must be added to your accrual net profit to determine your net cash flow. The decrease in inventory represents an expense subtracted from your accrual income to determine your accrual net profit. However, no cash left your business in this accounting period for the expense reflected by the decrease in inventory. Changes in Accounts PayableIf you use the accrual method of accounting, any increase in accounts payable must be added back to your accrual net profit to determine your cash flow. Under the accrual method of accounting, an account payable is recorded and an expense is increased when you receive a bill. Therefore, your accrual net profit is reduced by an expense that has not yet been paid in cash. Adding back the increase in accounts payable will adjust the accrual net profit so that it does not reflect the amount of expense not yet paid with cash or with a check. A decrease in accounts payable must be subtracted from your accrual net profit to determine your cash flow. The decrease in accounts payable represents the net cash that was paid out of your business but not reflected as an expense in determining your accrual net profit for this accounting period. Under the mechanics of accrual accounting, the expenses associated with the accounts payable were recorded at the time the bills were received. Changes in Notes PayableFor accrual method taxpayers, an increase in the amount of notes payable (bank loans) must be added to your accrual net profits to determine the cash flow of your business. Under the accrual method of accounting, a loan is recorded by increasing the amount of cash received from the loan, and increasing the amount of notes payable. No part of this transaction is reflected in your accrual net profits. Therefore, to determine your cash flow, you must add the increase in notes payable to your accrual net profit to reflect the real change in your cash balance. Similarly, a decrease in the amount of notes payable must be subtracted from your accrual net profits. Like the increase in notes payable, no part of the transaction to record a principal payment on a note payable is reflected in your accrual net profit. Therefore, it must be subtracted from your accrual net profit to determine the real effect on your cash flow. Figuring Your Actual Cash FlowBusinesses using the accrual method of accounting must make some adjustments to determine your actual cash flow. These adjustments are necessary because certain accrual accounting transactions are taken into account to determine your accrual net profit, even though these expenses do not currently require a cash outlay. The following example looks at the adjustments necessary to convert the accrual profits of Bug Busters Exterminating Service to its cash flow for its year ending December 31, 2011. To convert its accrual profit to its cash flow profit, Bug Busters will need balance sheets from the beginning and end of the period it wishes to examine. In this case, Bug Busters will examine the period starting on January 1, 2011, and ending on December 31, 2011. Below is the comparative balance sheet provided by Bug Busters' accountant for December 31, 2009, and December 31, 2010:
The conversion process also requires an income statement for the end of the period under examination. The income statement of Bug Busters Exterminating Service for the year ending December 31, 2011 is presented below. The income statement was prepared using the accrual method of accounting.
Bug Busters will have to adjust its accrual net profit to determine its cash flow for the year. As a general rule, Bug Busters can convert its accrual net profit using the following formula:
Using the formula above, Bug Busters can adjust its accrual net profit to determine its cash flow for the year:
Bug Busters' accrual net profit and the net cash flow for the year ended December 31, 2011, report two entirely different results. The income statement prepared using the accrual method of accounting reports a profit of $15,499 for the year. However, in terms of a cash flow, Bug Busters had a negative cash flow of $13,470 for the same year. In other words, Bug Busters spent $13,470 more than it collected during the year. |
Why is cash balance at the end of an accounting year different from the net profit of that year?
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