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What you should know about nonprofit vs. for-profit accounting standards
Posted by Neha De
May 1, 2023
Accounting standards for nonprofit organizations are widely different from those that govern for-profit businesses and organizations. The differences extend beyond taxation and donations — even the financial reporting methods are varied!
Whether you’re thinking of launching a new nonprofit, ready to get your nonprofit’s finances organized, or are just curious about how nonprofits and for-profits differ, keep reading for a simple comparison of these two main organization types.
How are nonprofit organizations and for-profit organizations structured?
Nonprofits are organized for public, environmental or social benefits
Nonprofits, also known as not-for-profits or NPOs, are organizations that exist for a specific social or charitable purpose. Some of the most common nonprofit organization types are health organizations (like hospitals and clinics), educational organizations, and social assistance charities and programs.
Nonprofits are exempt from federal income taxes because their primary objective is to provide a public benefit, rather than to generate profits for owners or shareholders.
Many people mistakenly believe that nonprofits don’t generate income. But in reality, nonprofits generate a lot of revenue every year. Nonprofits are the third-largest employer in the U.S., employing nearly 12 million people. And these organizations generate more than just donations — they’re permitted to earn income from the sale of goods and services, earn grants and make investments.
For-profits are designed to benefit owners, employees and shareholders
For-profits, on the other hand, are organizations that operate with the primary goal of generating profits for their owners or shareholders. They’re subject to corporate income taxes, plus other taxes and fees that aren’t applicable to nonprofits.
For-profits typically have an official owner or group of shareholders, they compensate all their employees (as opposed to accepting volunteer work), and they’re focused on profit and growth.
Nonprofits and for-profit organizations face differing levels of scrutiny and governance
One key similarity between nonprofits and for-profits is that both require strong financial management and accountability to achieve their goals. While those goals differ, the importance of careful financial management, reporting and forecasting remains the same.
When it comes to financial reporting, nonprofits face greater scrutiny regarding their use of donated funds and close adherence to nonprofit regulations. The price of tax-free operation is steep — nonprofits are held to a much higher standard of transparency and ethical behavior in order to maintain their status.
Another big difference between these two organization types is that nonprofits may have a more complex governance structure, with boards of directors and other key leaders responsible for keeping the organization true to its mission. Because every nonprofit has a dedicated goodwill goal, like educating children, feeding families or caring for pets, these organizations may nominate a key leader to keep the mission on track and operate in the best interest of the public.
For-profits, however, have a simpler governance structure. They may still choose a board of directors, but often one single owner or CEO is the main decision-maker. Their job is fully focused on maximizing shareholder value.
Overall, nonprofits and for-profits have distinct missions and operating models, but both play important roles in society and contribute to the economy in their own ways.
How do nonprofit accounting standards differ from for-profit standards?
In terms of accounting, the standards for nonprofit organizations and for-profit companies are widely different. Here are a few of the most notable distinctions:
1. Financial reporting
Nonprofits have different financial reporting requirements than for-profits. For example, nonprofits are typically required to produce a statement of activities, which shows the revenue earned and expenses covered by each program or activity they run. This documentation is meant to prove all funding is going towards the cause the nonprofit claims to support, and is being stewarded carefully.
In contrast, for-profit companies produce an income statement that shows revenue and expenses by product or service line. They aren’t required to break down individual expenditures or provide a granular look at their expenses because they’re allowed to use their profits as they see fit.
2. Revenue recognition
Nonprofits typically recognize contributions and grants as revenue when they are received or promised, while for-profit companies recognize revenue when goods or services are delivered or rendered.
For the most part, nonprofits are exempt from federal and state income taxes. They can even apply for tax-exempt status to shop tax-free.
For-profit companies are required to pay state and federal income taxes, do not receive a break on sales taxes, and are liable for all taxes incurred through the process of doing business.
4. Accounting for net assets
Nonprofits must provide greater transparency into their financial resources (called net assets) than for-profit companies. Instead of having one category for financial assets, as for-profits do, nonprofits must divide their assets into three categories:
Unrestricted net assets. These are financial resources that the nonprofit can use for any purpose that supports their mission.
Temporarily restricted net assets. These are financial resources that the nonprofit can only use for a specific purpose, for a certain period of time. For example, a donor may give money to a nonprofit for a specific program, and the nonprofit must use that money only for that program for a set period of time.
Permanently restricted net assets. These are financial resources that the nonprofit must always use for a specific purpose. For example, when a donor gives money to help establish an endowment, all income from that endowment must support the specified program.
Dividing their net assets helps nonprofits be more transparent about how they’re using revenue — providing greater transparency for the donors supporting the nonprofit’s programs. But because for-profits are free to use their income as they see fit, they’re not required to divide net assets into these clear categories.
Nonprofit boards are often focused more on outcomes and missional goals than profit margins and bottom lines. On the other hand, for-profit boards of directors are often solely focused on maximizing shareholder value, improving financial performance and growing the company.
The accounting standards used by nonprofits and for-profits differ widely. That’s why it’s beneficial to leverage the help of a professional accounting and financial services team before you start an organization of either type. To set your venture up for success from the start, consider working with an outsourced team with deep experience in managing the type of organization you’re hoping to launch.
Want more? Escalon has helped thousands of startups and nonprofits maximize their potential with our back-office solutions for accounting, HR, payroll, insurance, and recruiting and taxes — and we can help yours too. Talk to an expert today.
This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal or accounting advice in this article. If you would like to engage with Escalon, please contact ushere.