Nonprofit AccountingHow does accounting for a nonprofit work?

Patrick Louie

A nonprofit (or nonprofit organization), unlike a typical for-profit company, doesn’t have revenue generation as its primary goal.

Rather, it has a mission.

And its purpose is to further this mission.

The mission could be charitable, religious, educational, or scientific.

Because of the charitable nature of nonprofits, they are typically exempt from paying taxes.

However, the nonprofit status is not something to be taken for granted.

A nonprofit has to comply with specific rules and regulations in order to maintain its nonprofit status.

For example, the IRS requires a nonprofit to keep records that are financially transparent.

This is to ensure that its records show proof that it’s advancing its charitable purpose.

Now while the primary purpose of a nonprofit is to advance its mission, that doesn’t mean that it doesn’t earn money.

It does, but whatever money it earns, it will be use for the advancement of its mission.

This is unlike in a for-profit company where earnings are distributed to its owners.

The common way for a nonprofit to earn money is through receiving donations and grants.

These donations and grants are tax-deductible on the part of the donor.

Additionally, the nonprofit itself is exempt from paying taxes for the donations and grants it receives so long as it uses them to advance its mission.

To keep track of its financial position, a nonprofit will have to keep records.

That’s where nonprofit accounting comes in.

It’s pretty similar to how accounting works for a typical for-profit company with some differences here and there.

In this article, we’ll be talking about the basics of nonprofit accounting as well as how it differs from traditional accounting.

What is Nonprofit Accounting?

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Nonprofit accounting (a.k.a. fund accounting) is the financial recording and reporting system that is unique for nonprofit organizations.

It stresses the importance of accountability rather than profitability (which is usually the main focus of a for-profit company).

A nonprofit has to follow a specific set of rules and procedures, and nonprofit accounting can help in that regard.

Essentially, nonprofit accounting helps a nonprofit organization maintain its accountability to its donors and contributors.

With the emphasis on accountability, nonprofit accounting can help in tracking how a nonprofit organization spends the money it receives from its donors and contributors.

We refer to this money as funds, and nonprofit accounting’s goal is to monitor how the nonprofit organization manages its funds.

This is why we also refer to nonprofit accounting as fund accounting.

Fund accounting enables a nonprofit organization to categorize its funding as its spending into different groups.

This helps keeps its financial records organized and easier to track.

It also helps in ensuring that the nonprofit only spends its funds for the purpose that they’re made for.

Some donors want to see that their donations are spent on programs that the nonprofit organization supports, and fund accounting can help with that.

A nonprofit organization will typically separate its funds into three categories: restricted, temporarily restricted, and unrestricted.

Restricted Funds

A donor may sometimes restrict their donation to a specific project or activity.

For example, the nonprofit may only use the funds for a feeding program.

A nonprofit would categorize these funds as restricted funds.

Temporarily Restricted Funds

Temporarily restricted funds are much like restricted funds in that the nonprofit can only use them for specific projects and activities.

The difference is that the restriction only lasts for a certain amount of time. After that, the funds become unrestricted.

For example, a donor may agree to donate to the nonprofit on the condition that it only uses the funds for a specific charitable cause.

In exchange, the nonprofit can use any remaining amount from the funds after a year.

Unrestricted Funds

Unrestricted funds (a.k.a. annual funds) are a nonprofit’s money that it can use for whatever purpose it sees fit.

Spending on overhead costs will usually come from these funds.

Although unrestricted in nature, the nonprofit is still bound to spend these funds for purposes that advance its mission.

Nonprofit accounting also helps the nonprofit organization monitor its spending on overhead costs.

Donors typically want to see low overhead costs. And while that’s reasonable to an extent, they should understand that a nonprofit will have to incur these costs to maintain operations.

Additionally, overhead costs will increase as the nonprofit grows.

A more correct way of looking at overhead costs is through the lens of accountability.

A high overhead cost can be justifiable as long as the nonprofit has the right reason to back it up.

Nonprofit Accounting VS For-Profit Accounting

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Nonprofit accounting is pretty similar to for-profit accounting in that it still follows the guidelines set by the Generally Accepted Accounting Principles (GAAP).

The nonprofit still has to maintain a set of financial statements such as the balance sheet (a.k.a. statement of financial position).

However, since nonprofit accounting emphasizes accountability rather than profitability, it prepares a different set of financial reports and statements.

Firstly, a nonprofit doesn’t have an owner, meaning that there’s no equity.

This is why in the nonprofit’s statement of financial position, you’ll see “net assets” in place of the equity section.

Also, since profitability isn’t the primary concern, the nonprofit won’t prepare an income statement.

Instead, it will prepare two financial statements: a statement of activities, and a statement of functional expenses.

This further backs the “accountability” aspect of nonprofit accounting.

Let’s go back to the aspect that a nonprofit does not have equity.

This essentially means that no one owns a nonprofit organization.

Not even its founders. This is important as a nonprofit is subject to the non-distribution constraint.

This means that a nonprofit cannot distribute its net earnings to its leaders or any other members. Non-profit accounting ensures that the nonprofit organization enforces this constraint. This is unlike in a for-profit company where earnings are typically distributed among its owners.

Nonprofit Financial Statements

With nonprofit accounting, a nonprofit organization will typically prepare the following financial statements: Statement of Financial Position, Statement of Activities, Statement of Functional Expenses, Statement of Cash Flows, and Notes to Financial Statements.

In addition to these financial statements, the nonprofit organization will also have to prepare a nonprofit budget and an IRS form 990 for its tax return.

Statement of Financial Position

The statement of financial position is a nonprofit’s balance sheet. In it, we can see the assets and liabilities of the nonprofit.

Just like a typical balance sheet, it represents the financial well-being of the nonprofit.

Since a nonprofit doesn’t have equity, the accounting equation for it is slightly modified:

Net Assets = Assets – Liabilities

Additionally, “net assets” will replace the equity section of a nonprofit’s statement of financial position.

Positive net assets typically indicate that the nonprofit is doing well in terms of its finances. Negative net assets on the other hand may mean that the nonprofit has financial issues that it has to deal with.

Statement of Activities

The statement of activities is a nonprofit’s income statement.

It contains information regarding the revenue and expenses of a nonprofit for a particular period. Revenue sources and expenses are categorized depending on whether they are restricted or not. It’s also useful for determining the amount of change in net assets for the period.

To compare, in a for-profit income statement, the amount of change in net assets would be the net income (before any distribution).

Statement of Functional Expense

The statement of functional expense is unique to nonprofits as it doesn’t have a counterpart for for-profit accounting.

It breaks down a nonprofit’s expenditures into different categories according to their function (e.g. administration, fundraising, project management, program implementation, etc.).

This ties back to the accountability aspect of nonprofit accounting.

The detailed information that a statement of functional expense provides also helps in the preparation of IRS form 990.

Statement of Cash Flows

The statement of cash flows for a nonprofit is functionally similar to a for-profit company’s cash flow statement.

It provides information regarding the nonprofit’s cash inflow and outflow. It also shows the amount of cash available for the payment of expenses.

Just like a for-profit cash flow statement, the statement of cash flows categorizes cash flow into three activities: operating, financing, and investing.

This categorization helps in determining where the funds are coming from and where they go towards.

Form 990

The IRS Form 990 is a tax return that tax-exempt organizations are required to submit.

Since nonprofits are typically tax-exempt, they need to file for 990 annually.

This document is similar to a typical tax return in which the nonprofit lists down its revenues and expenses for the year.

Additionally, it also shows how the nonprofit utilizes its finances.

This helps in assessing whether the nonprofit is financially honest and legitimate.

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  1. University of North Dakota "What Does Accounting for Nonprofit Organizations Entail?" Page 1 . August 29, 2022