Our Comprehensive Guide to Nonprofit Accounting
Our Comprehensive Guide to Nonprofit Accounting
You’ve put in the hard work and your new nonprofit is finally receiving funding from a myriad of sources, you’ve beaten the odds and are ready to change the world for the better. The only catch is in order to continue receiving your 501c tax exempt status, you need to keep track of all that cash and report it in a way that’s compliant with IRS and other governmental agencies.
The problem is, accounting for nonprofits and accounting for for-profits are very different, even the software and management of bookkeeping isn’t the same. This is due to the way each type of business generates their revenues and the different reporting requirements set forth by the IRS for tax purposes.
While most regular businesses use a profit and loss statements for their balance sheets, nonprofits use something entirely different called fund accounting to keep track of all their funding. Although accounting for nonprofits is a little more complex than they typical for-profit accounting, once you're aware of what's required and set your own internal accounting process, the process isn't that much more difficult. It just comes down to understanding the basic principles which is what this article is all about.
Introduction to Nonprofit Accounting
Nonprofit accounting is very different than for-profit accounting because their end goals are so different. For-profits seek to generate profits from the money they invest into their businesses, whereas nonprofits seek to fulfill a mission or purpose that benefits society as a whole, and don't usually have have actual revenues from a service like for-profits, but rather look to the public for funding. Both entity's business goals are unique.
Nonprofits accept donations and grants from society at large in order to fund their operations. therefore the accounting that is required is more about accountability than the actual fixed numbers. Both the community that is donating and any other institutions that have supported your nonprofit with grant funds have the right to know where that money is going and what it is being used for. This is why transparency is the key to nonprofit accounting.
Your supporters also have the right to place stipulations on their donations. Sometimes these stipulations or restrictions will be community based, meaning they must be spent within a certain geographical location. Or they may have time restrictions, like a grant that states the funds can only be used for a specific reason until the nonprofit grows to a certain size, or reaches a specific goal within their mission statement.
With the variety of ways nonprofits can receive restricted or unrestricted funds, within the accounting realm, it’s much easier to classify your revenues or cash as funds and is why nonprofits use fund accounting as their primary means of bookkeeping. It’s much easier to break down each of the types of assets and expenses into item classes like Restricted Funds, Temporarily Restricted Funds and Unrestricted Funds as these types of funds or revenue are much easier to sort and report on.
And since there are no distributed funds to owners or shareholders like a for-profit, the transparency of your accounting is paramount in order to not only stay complaint with the IRS's 501c regulations, but also to demonstrate complete transparency with your donors and future potential supporters of your nonprofit.
And don’t forget, all of your bookkeeping needs to be open to the public at any time! In fact, it’s best practice to post your Form 990 on your website, or wherever you have information about your nonprofit that is publicly accessible. If you refuse to do so you will loose your tax exempt status and be required to liquidate your nonprofit.
Nonprofit vs. For-Profit Accounting
Distinguishing between nonprofit and for-profit accounting can be a bit confusing as they both have similarities, yet nonprofits have a few more regulatory requirements than for-profits do. This comes down to the fact that nonprofits are fundamentally dedicated to their mission, and as such do not aspire to maximize profits, but rather help the community or world at large in some impactful or meaningful way.
Unlike for-profit businesses that invest their cash in order to make a profit from their investments, typically through providing goods and services, nonprofits rely on public support through donations and grants to fund their daily operations. The complexity of accounting procedures for nonprofits comes from these types of funding and the stipulations often placed on them by their donors.
When supporters of a nonprofit make a donation, they can request how that money is being used whereas a for-profit doesn’t need to adhere to these types of limitations. And since donors are able to make these types of requests on how their cash is used by the nonprofit, the IRS requires all charities to be completely transparent with their finances, going so far as making them publicly available to anyone who wishes to see them at any time to be sure they are being used in accordance to the donor’s wishes. This is obviously the opposite for for-profit enterprises who rarely disclose their numbers to the general public.
Transparency and accountability are assured by using Fund Accounting as well as key GAPP accounting principles while keeping track of finances that are accounted for by the type of funding along with any donor or grant restrictions or intent on these funds. The extra Statements that need to be included in a nonprofit’s tax filings help demonstrate transparency and proper accounting procedures, giving both authorities as well as donors and sponsors the accountability they need.
Fundamental Principles of Nonprofit Accounting
The fundamental principles of nonprofit accounting are meant to make sure your charity or nonprofit stays in compliance through creating accurate financial budgets and reports that demonstrate your organization’s financial transparency and accountability, both for governmental tax agencies as well as their donors and supporters. While smaller nonprofits might not be required to prepare full audited financials, it's still good practice to maintain basic bookkeeping records. This includes a summary of income and expenses, a statement of financial position (balance sheet), and a cash flow statement.
GAPP - The Standard Bookkeeping Method for Nonprofit Business
In order for everyone looking at your organization’s numbers, including your bookkeepers and the general public, it's common practice to adhere to specific accounting principles when it comes to cash and expenses. The most widely used accounting method in the nonprofit sector is the GAPP principles. GAPP is an acronym for Generally Accepted Accounting Principles and is a standardized set of accounting principles, standards, and procedures that nonprofit organizations adhere to in preparing and presenting their financial statements both internally and externally.
By using these widely accepted accounting principles, it is much easier for your donors and the general public to understand and compare your nonprofit with others as far as the financial health and stability of your organization. This greatly helps in providing transparency and accuracy and allows larger foundations or institutions to evaluate your charitable organization for potential grants and other forms of assistance.
Furthermore, compliance with GAAP is often a legal or regulatory requirement for nonprofits, particularly when filing documents like Form 990 with the Internal Revenue Service (IRS) or submitting your financials to local and state government entities. Using these accounting principles also makes it easier if you change bookkeepers, or decide to use a different accounting firm at any time. Plus GAAP's role extends to audits and reviews, ensuring that financial statements withstand scrutiny and meet the highest standards of accuracy and transparency in nonprofit financial reporting.
Financial Statements Overview for Nonprofits
Most nonprofits will be required to generate four separate statements in order to evaluate its financial health and viability along with a general budget for each year. These include the statement of activities, the statement of financial position, the statement of cash flows and the statement of functional expenses. Each one of these statements have their own unique purpose and we’ll go into more in-depth specifics on each below, and each one is required by nonprofits that exist in the United States and must be submitted with your organization's Form 990 for tax purposes.
After these four basic statements, depending on the size of your organization, the financial structure can become quite complicated and more statements may be necessary to be able to clearly see how well your nonprofit is doing, or not doing.
The Nonprofit Organization Budget
In order to understand how much cash your charity needs in order to continue its daily operations, you’ll need a clear understanding of your organization’s current and projected financial positions in order to keep it running and to ultimately grow.
The nonprofit budget is what you and your team will use internally to forecast profits and losses over the coming year, although you can specify whatever time period that's required to get a clear understanding of your nonprofit’s financial health.
These yearly budget documents will never need to be submitted to a governmental agency or even be made available to the public, however they are a very important aspect of running a nonprofit successfully. Without these yearly projections, it’s extremely difficult to understand what needs to be done during the year in order to meet your organization’s financial obligations.
When you begin creating your budget, it helps to use any previous finance data you have which can help you and your accounting team create a budget that is realistic and obtainable. If you aren’t privy to past data, it can help to look at similar types of charities and see what their starting numbers were to better position yourself.
You’ll need to include revenue projections from grants, planned fundraising activities or existing donors as well as any other instances of income your organization receives or can potentially secure. Don't forget to make year end giving a priority when creating your budget. Each projection will need to be entered into an accounting spreadsheet or software and tallied.
Then of course there are your expenditures. Things like rent, payroll and all the other obligations that are needed to run your organization and allow it to function as far as attaining your mission. Any money that will need to be potentially spent must be added so you can understand when your charity is running at a profit or loss.
Once you’ve finished your budget it should be shared with any top executives including your Board of Directors for feedback and understanding of your current position and what you’re planning on achieving for the next year.
Anticipated Revenue Accounting
This is when you try to forecast the amount of income your organization will receive from all sources. It’s super helpful if your nonprofit has already existed long enough to have historical financial data to use to calculate realistic numbers. But if not, then look to other similarly sized nonprofits in the same sector as your own to see what their financials looked like when they were a startup. Remember, this is all public information.
This is anticipated revenue, so there is no guarantee that you’ll ever reach these goals. This is why many nonprofits rely on two standards of projecting revenues based on their probability of overall revenue realization. That means the numbers you’ll arrive at take into consideration is there is partial probability these goals won’t be reached, and leaves room for you to still realistically see what your financial health looks like for the coming time period.
This takes into account each different revenue stream you currently have or anticipate on acquiring. For each one, you decide the probability you will receive the amount of income you projected and then multiply individual revenue streams by their probability of realization. For example, with an 80% chance of securing a grant, multiply the grant funding by 0.8.
The discount method is basically the same but takes just one final number, your overall total projected revenues and then factors in the probability of overall realization of that projection. For instance, if you’re anticipating receiving $500,000 for the next fiscal year with a 75% likelihood that you’ll achieve that goal, input $375,000 into the budget.
Expense Budget Accounting
This is where you decide what departments or teams get how much of the overall pie of anticipated income. Common categories encompass fundraising, administration, and program-related expenses.
Key nonprofit budgeting factors include operational expenses such as salaries, rent, utilities, and other overheads. Again, look at past costs to get the most accurate numbers possible. Then you’ll need to look at your fundraising expenses, cost of donor acquisition and so on to get a clear picture of your yearly outlays.
Then of course your actual mission expenses. What does it cost to move forward with your mission, and what are the program costs involved. This could include things like vaccinations for a medical dispensary, or veterinarian care at an animal shelter. Whatever non-hard expenses that are involved and don’t fit into any other categories or classes.
One thing to note here, you should still adhere to the principles of Generally Accepted Accounting Principles (GAAP) even for your internal numbers. This will set a precedent that everyone can follow, and it’s much easier to train new staff and volunteers on a well established system that they may have been exposed to before.
Statement of Financial Position
The statement of financial position is a list of assets and liabilities and is also sometimes referred to as the balance sheet. This is what ultimately tells you and anyone looking at this part of your finances how well your organization is really doing. In the most simplistic terms, it boils down to the equation; Net Assets = Assets – Liabilities.
In order to arrive at the final numbers, you need to create a spreadsheet with all your organization’s assets and liabilities. These include both hard and soft assets like real property, buildings, even your charity’s computer equipment, or things that can be touched that are completely paid for and owned by the nonprofit.
Soft assets are things like copyrights or brand recognition. Things that can’t be touched but still have a monetary value or produce income for the organization. Again, these assets must be debt free and owned exclusively by your organization to be counted as an asset.
Liabilities are anything that your charity owes or any funds that must go out due to contractual obligations. This includes any loans or even a lease that has been agreed upon and entered legally.
Once you tally up all the assets, then subtract the liabilities you’ll arrive at a true financial position. Hopefully you are in the green and not red. But regardless, this finally value will let you clearly know if you’re doing the right things financially, or you need to do some serious auditing and repositioning of your funds.
The statement of financial position must be filed with the IRS when you submit your Form 990, 990-EZ, or 990-N, depending on the structure of your organization or if your nonprofit charges for a service or goods or owns an LLC. .
Statement of Activities
This financial statement can be referred to as an Income Statement or a Statement of Activities depending on who is doing your bookkeeping. But the correct terminology for nonprofit accounting is the Statement of Activities and the two statements can be used interchangably.
Your Statement of Activities is a detailed statement that is used to categorize all of your different sources of revenue against all of your expenses much like a balance sheet does for a for-profit business. But since we are not concerned with profits, we focus on demonstrating how funds are raised and used to achieve the organization's mission.
The emphasis is on the various sources of revenue your charity receives over a period of time including donations and grants, and the allocation of resources to different program and operational expenses that you’ve set forth in your mission statement. Or how you’re spending your money to do the things you created your non-profit to do.
For example, imagine your nonprofit has $50,000 set aside for its community outreach program. Recently, it decided to spend $5,000 on organizing a community event. Now, you might think the organization lost $5,000, but that's not the case.
Instead, the funds were used for their intended purpose. This spending is recorded in the nonprofit's Statement of Activities which shows where the money comes from and how it's used.
In this case, the Statement of Activities would indicate the $50,000 as revenues from contributions for the community outreach program. The $5,000 spent on the community event would be listed as an expense. After this, the Statement of Activities would show that there are still $45,000 left in restricted funds for future community outreach activities. This way, the organization can keep track of its financial activities, ensuring transparency and accountability in how it uses its funds.
It is also important to note that this statement is required to be included when you file your 1099 with the IRS if you're in the U.S.A.
Statement of Cash Flows
Your Statement of Cash Flows is the financial statement that tells you how liquid your organization is as far as cash reserves on hand during a specified time period, usually quarterly or yearly. This statement categorizes cash flows into three main activities: operating activities, investing activities, and financing activities.
This is important as you can use this information to be sure you can meet your financial obligations short term or in the near future. It can also help spot trends in cash generation and usage, providing a more comprehensive understanding of your organization's overall sustainability, and whether or not whether your fundraising efforts are generating sufficient cash to cover your program expenses.
Beyond these, this statement is also often required for reporting reasons to different governmental agencies, and it also helps keep your nonprofit’s finances transparent to donors and other supporters. This statement is required and must be included in your IRS nonprofit filing.
Statement of Functional Expenses
A Statement of Functional Expenses is a financial statement that provides a detailed breakdown of an organization's expenses by function, such as program services, management and fundraising. It is a quick way to see where your spending is being allocated within your nonprofit and how effective it is being used.
These expenses specifically have to deal with you organization's core mission or purpose. So if you’re running a mental health charity, then expenses like medications or educational programs would be included here.
You’d also include all of your employee salaries and any other administration or management expenses . Plus any money that was needed for fundraising is also added to this accounting section. This includes expenses associated with soliciting contributions, organizing fundraising events, and promoting the nonprofit to attract donors.
It’s important to note that this statement is required by the IRS (Internal Revenue Service) for nonprofit organizations in the United States. Nonprofits are required to include this statement as part of their annual informational tax return, which is usually filed on Form 990, 990-EZ, or 990-N, depending on the organization's size and revenue.
Furthermore, when you do file your Form 990, it will require the same types of cost accounting breakdowns you've included on your Statement of Functional Expenses. So you can save your accounting team a bit of work by making this statement as comprehensive and clear as possible.
Accounting Compliance Requirements for Your Nonprofit
In order for your nonprofit to comply with all of the specialized rules for nonprofit accounting, you must adhere to both the industry standard GAAP accounting principles and use fund accounting rules when creating your spreadsheets as we’ve already mentioned the sections above.
You’re also required by the IRS to produce the four Statements we also previously discussed as well as any other other documents or information that may be required by state or local authorities when it comes tax time.
IRS Form 990
Just like any corporation or business entity, you are required by law in the United States to file your organization’s tax returns. As a nonprofit you have the choice of filing either Form 990, 990-EZ, or 990-N depending on the level of income your nonprofit generated over the course of the year.
If your charity has received more than $200,000 in revenue or has more than $500,000 in assets, you will be required to file IRS Form 990 unless you are a religious organization. If your charity is still small however, you can file Form 990-EZ which is actually an easier filing process. Which ever way your charity moves forward, it’s is highly advisable to use a specialty accounting firm with comprehensive knowledge of nonprofit accounting methods.
State Reporting Requirements
It’s difficult to list all the requirements states require for nonprofit entities here as they are all different. It may be you live in a state where you won’t even need to file, while a different charity may be required to submit a comprehensive audit. It all depends on your state’s requirements. The one sure requirement will be a copy of your organization’s Form 990 that you’ve submitted to the IRS.
Nonprofit Accounting Best Practices
Managing the finances of a nonprofit organization requires careful attention to detail and adherence to best practices to ensure transparency, accountability, and compliance. Unlike for-profit accounting that stays private, all nonprofits must make their financials public. So sticking to standardized accounting principles and keeping compliant with all federal and state regulations is paramount. From petty cash to accrual payments and depreciation, organizations need to be sure their books are properly maintained. Below we’ll go over a few ways to be sure your financials will always be up to speck.
Maintain Separate Accounts
Due to the GAPP’s standardized rules for nonprofit account and the concept of Fund Accounting, always be sure to have separate accounts for each type of fund. For example, you should never keep your unrestricted donations in the same account as your restricted grant funds. This commingling can make it difficult to decipher which money is being used for which program making transparency of funding difficult to understand for donors and supporters.
Specialized Nonprofit Accounting Software
If your charity can afford it, using specialized nonprofit accounting software is one of the best tools you can implement to keep all of your bookkeeping and accounting tasks as organized as possible. Nonprofit accounting software is different than the typical for-profit software products, so be sure you are getting a system meant specifically for nonprofits.
Accounting software for nonprofits can dramatically cut down on the amount of work necessary to keep track of all of the different types of funding and expenses required to run a non-profit, as well as cut down on errors and increase accountability when handling your funds.
Many of these software tools like quickbooks also make it a breeze to generate all of the different types of statements that are required during your year end tax filings as well as the basics. They also make filing your Form 990 a much easier project and can decrease the time and expenses associated with a firm handling all of the details.
Financial Policies and Procedures
From day one you should have a clear policy on how money is handled within your nonprofit. From how to take a donation and what bank deposits should be made to who to go to in order to purchase something for a fundraising event, clear financial policies and procedures that everyone in the nonprofit follows are a must and one of the basic best practices of nonprofit accounting.
Regular Financial Reporting
Keeping up with regular financial reporting for nonprofits not only allows you to see how well or how badly the nonprofit is being run, but regular reports can also alert you to any fraud or non-standard accounting processes going on that can result in problems with your 501c tax exempt status or worse.
Generating regular accounting reports helps your board of directors and other key personnel within your nonprofit to understand how well or badly the company is being run, and where there may be potential pitfalls or even opportunities. Sharing these reports with supporters and donors also helps establish trust and can be used as an excuse to connect with your supporters in a positive way as far as donor cultivation and management.
Audits and Reviews
It’s good practice to conduct regular internal audits and reviews of your books in order to be sure proper financial policies and procedures are being adhered to. Depending on the size and complexity of your charity will decide how often you should commit to doing them.
One tip here, at least once a year, or every few if you are small, consider an external audit by a certified public accountant or accounting firm familiar with nonprofit accounting principles. It’s best if these types of audits are kept secret and not revealed until their team is present and ready to work. External audits can often spot problems or fraud that would otherwise go unnoticed. It’s always helpful to get an outside prospective when money is involved.
Donation and Grant Management
Keeping your supporters happy is always your major concern, and it all starts with making sure the funds your charity has received is being used in the way your donors stipulated. Always be mindful of any short or long term restrictions and be sure the funds are being spent in accordance with their restrictions to maintain a high degree of transparency. The same goes for grants and any other financial support your charity receives. Again, the correct software or a specialized nonprofit platform like PayBee can really help keep all of these different types of funds sorted.You can find a free demo here to see just how powerful our platform is.
Compliance with Regulations
Regulations regarding nonprofit bookkeeping have a way of changing over time. It’s important that you and your accounting team are always up to date with any local, state, or federal regulations affecting nonprofit organization accounting changes so you know your charity always in compliance. Also, be sure to file all the necessary paperwork within the required time frame or earlier in case there is a problem with your submission.
Incorporating these nonprofit accounting best practices, your nonprofit can establish trust with its stakeholders, and ensure the effective and ethical use of the resources granted your charity in support of your mission.
How are nonprofits funded, and how does that impact accounting?
Nonprofits are funded through donations, grants, fundraising events, and other external income and not through profits and loss statements like other forms of businessses. Therefore accounting principles like the GAPP’s Fund Accounting principles are used to make nonprofit accounting more transparent.
What are the key financial statements for nonprofits?
There are four financial statements that are required paperwork for filing the IRS Form 990. They include the statement of financial position (balance sheet), statement of activities (income statement), statement of cash flows and the Statement of Functional Expenses.
How do nonprofits handle donor restrictions and contributions?
Nonprofits use an accounting method called Fund Accounting that places all of the different types of contributions into their own fund (for accounting processes) according to their specific restrictions or lack there of.
How are overhead costs allocated in nonprofit accounting?
Allocating overhead costs is important for nonprofits to ensure that program expenses are accurately represented. Methods may include direct allocation or proportional allocation based on program usage.
How can technology be leveraged in nonprofit accounting?
Nonprofits can benefit from using accounting software and technology to streamline their day to day bookkeeping, enhance its accuracy, and generate meaningful reports and even link to bank accounts. Specialized software like intuit or quickbooks offer specialized software packages to do taxes for all types of businesses.