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A guide to the best accounting practices for nonprofits

Posted by Neha De

October 8, 2021    |     7-minute read (1313 words)

At its core, a nonprofit is still a business — a business that is required to follow a unique set of guidelines. A nonprofit needs to demonstrate an appropriate use of assets and resources for charitable purposes, instead of focusing on sales. A nonprofit organization has no owners or ownership interests. It receives donations or contributions from third parties that typically do not expect a return. 

Accounting for nonprofits involves a specific system of recordkeeping, reporting and financial management. It uses defined language and designations to capture what activities are being funded and come up with reports that allow donors to see how their donation (money, in most cases) is being utilized.

Programs - Services provided by a nonprofit organization are called programs. Each service usually has its own expenses, revenue and records.

Donor restrictions - Certain donors regulate their contributions; they donate to specific purposes or programs only. These contributions must be accounted for properly. Money that is not donor-restricted can be used for any service or program, administrative expense or other purposes.

Fundraising - This head is designated for tasks that are undertaken to raise the nonprofit’s profile or solicit donations via charity events or direct mail campaigns.

Administration - Administration or overhead funds are funds used for the management of a nonprofit. These funds are required to keep the nonprofit organization going and must be noted properly and reported to donors. Donors tend to be comfortable giving money to nonprofits that keep their overhead expenses, including salaries, as low as possible in order to channel the majority of money toward programs.

One of the biggest mistakes a nonprofit can make is the improper allocation of functional costs. Effective nonprofit financial management must ensure that the company can function and grow. However, if the functional expenses become too large, donors might hesitate to contribute.

How is nonprofit accounting different from for-profit accounting

Nonprofit and for-profit organizations are entirely different entities. The differences in accounting practices for the two begin with their core mission statements — a nonprofit organization exists to meet society’s needs, while for-profit companies are there to make a profit. 

While these two organizations’ accounting requirements have the same objective, that is, accurate and transparent financial disclosure, what each business must report to the government is different.

Here are four key accounting differences between nonprofit and for-profit organizations:
  1. Tax status - Once a nonprofit is approved by the IRS as (501(c)(3)s, it is exempt from paying federal income taxes. However, local and state taxes vary from city to city and state to state. Only taxes such as real estate or sales tax, which are taxes secondary to a nonprofit’s scope, are assessed by the IRS in addition to allowing people who donate to a nonprofit organization a tax deduction at the end of the financial year. 
  2. On the other hand, a for-profit business is subject to income taxes at local, state and federal levels.
  1. Balance sheet vs. statement of financial position - Both nonprofit organizations and for-profit businesses are required to prepare financial statements; however, the terminology and presentation of each is substantially different, starting with balance sheets. 
  2. A nonprofit organization does not have owners or shareholders. Instead, it puts together a statement of financial position that outlines its assets and debts. However, a for-profit business creates a balance sheet that details its net equity for owners and shareholders. 
  1. Income statement vs. statement of activities - A nonprofit organization must produce a statement of activities, which focuses on the entire organization instead of just the funds of that organization. It should include revenues (from sources like contributions, grants and membership dues) as well as expenses. The difference between revenue and expenses demonstrate the organization’s net assets.
  2. For-profit companies, on the other hand, must create an income statement — also called a profit and loss statement — that breaks down gains, losses, revenue and expenses. This lets the investors, potential creditors and others know whether the business has experienced a net profit or net loss during a specified period of time. 
  1. Net assets - The net assets are broken down differently for the two entities depending. A nonprofit’s net assets are broken down into three categories: unrestricted, temporarily restricted and permanently restricted, with each category governed by strict stipulations that dictate how each can be used.
  2. For-profit firms, net assets are defined as total assets minus total liabilities, with the resultant amount being profit. 
7 best practices for nonprofit accounting

Check out these seven tips to maintain an efficient budget for a nonprofit organization:
  1. Follow strict internal policies and ethics - One of the most important things to do when managing accounting practices for a nonprofit is to hire ethically responsible employees. Many nonprofits have faced difficulties due to individuals within the organizations who took advantage of having access to money. 
  2. You can avoid undue harm by performing background checks on staff members, including interns and new hires, developing a well-balanced code of ethics for the entire team, maintaining transparent and strict policies when it comes to handling money and requiring receipts and other proofs to monitor expenses. 
  1. Create a statement of financial position - Since nonprofit organizations do not have owners or shareholders, the financial position document is an outline of total liabilities and net assets. It provides a look into what the nonprofit owns, owes or has in cash reserves at any given moment.
  2. Build a realistic annual operating budget - Even if a nonprofit organization does not make a profit, it should not turn it’s back on having a realistic and responsible budget. Depending on the type of work a nonprofit does, the everyday costs could actually be considerable. When developing a budget, factor in things such as salaries (for both full-time and part-time employees), costs associated with events and programming, expenses to maintain facilities or rented spaces and advertising and other promotional activities. 
  3. Use specific language to define activities, events and funding - Typically, a statement of activities demonstrates how a nonprofit intentds to use donor funding to meet the needs of a community or specific group. Some nonprofits may develop an official statement of activities. 
  4. A statement of activities usually includes restricted and non-restricted donations, while clearly defining amounts associated with membership dues, grants, net assets (including cash earned from selling assets) and general contributions.
  1. Maintain a meticulous ledger - Bookkeeping is extremely crucial for nonprofits. Apart from being useful for general administrative purposes, it offers the transparency and accountability that these organizations rely on to stay operational. 
  2. Additionally, accurate and up-to-date records help ensure that taxes are filed flawlessly. 
  1. Develop a long-term strategic plan - The success of any nonprofit depends on several unique factors, but a long-term strategy can ensure longevity. By maintaining stringent financial standards, one can easily see exactly what contributions and expenses are needed in the future. This, in turn, encourages growth while developing new services or deciding which ones to discontinue. 
  1. Set feasible goals for fundraising - Depending on the size of the nonprofit organization, which areas it serves and how many individuals are working on projects, specific monetary and fundraising goals may differ. Irrespective, it is essential to monitor the fundraising metric, which may include event-related costs and grant-writing fees, carefully and to share results with donors and other key stakeholders.
Managing tax obligations for nonprofit organizations

Nonprofit organizations are often eligible for several tax incentives, which can reduce the overall tax burden for these organizations. In order to qualify for tax benefits, a nonprofit organization needs to:
  • File for tax-exempt status, as defined by the IRS.
  • File for official nonprofit status, as determined by laws in individual states.
  • Use Section 501 to receive tax-exempt incentives.
  • Responsibly pay for any non-tax-exempt activities, including sales, employment and real estate taxes.
  • Utilize Form 990 to accurately disclose any assets or revenue amounts to the public.

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