Nonprofit Accounting, Part 1 (#302)
/In this podcast episode we discuss the characteristics of nonprofit entities and several unique accounting issues.
The Purpose of a Nonprofit
As the name implies, a nonprofit organization is not in the business of earning a profit. Instead, it has some other operating purpose, it has no ownership interests at all, and a good chunk of its income comes from contributions. There are all kinds of nonprofits out there, such as animal shelters, churches, art museums, and food banks. A few of the better-known ones are Doctors without Borders, the American Heart Association, and the Sierra Club.
Net Assets in a Nonprofit
The accounting for a nonprofit varies a fair amount from what we use in for-profit businesses. I already referred to one of them, which is that a nonprofit has no ownership interests. This means there’s no equity. There’s no account for its common stock, or additional paid-in capital, or retained earnings. Instead, a nonprofit has net assets – which, despite the name, takes the place of the equity section on its balance sheet.
Types of Donations
What goes into the net assets section is mostly contributions from donors. They’re split up into two pieces, one of which is net assets with donor restrictions, and the other is net assets without donor restrictions. As an example of donor restrictions, you donate a pile of money to your local zoo, but with the restriction that it all be spent on the hippopotamus enclosure, because you like hippos. Which is a mistake, by the way. They’re smelly and aggressive. Anyways, the zoo has to record your contribution in the account for net assets with donor restrictions. If you had instead just sent in your money, then it would have gone to the net assets without donor restrictions account.
And incidentally, this is a big problem for a lot of nonprofits. They need people to make unrestricted donations, so that they can use the money to pay for their general and administrative activities, but the biggest donors are the ones most likely to put restrictions on their contributions. Which means that a nonprofit can be in the odd position of having a lot of assets, but not enough cash to pay for basic operations.
The Statement of Activities
Now, let’s move over to a nonprofit’s income statement – which is called the statement of activities. The main issue here is that the presentation is not the usual revenues and expenses format.
Instead, they have to subdivide everything into programs, fundraising activities, and management and administration. Programs are the key part. They’re the expenditures made for the main purpose of the organization. For example, one of my main charities is the National Forest Foundation, and one of their biggest programs is tree planting. Or, if the nonprofit is a food bank, then the main program is providing meals to people. The other two categories are pretty self-explanatory. The fundraising section includes expenditures for things like writing grant proposals, sending out email solicitations, and doing fundraising events. All of which is unique to nonprofits. In a for-profit organization, the closest equivalent would be sales and marketing.
Which brings us to the final classification, which is the management and administration classification. This contains everything else, such as accounting and finance, human resources, and legal fees.
These classifications are important, because big donors will only contribute money when they see that most of the funds they pay in are going to programs. So they look at the proportion of expenditures going to programs. And if that number is too low – like less than 80% of total expenditures – then they just take their money elsewhere. This is a big problem for the accountant, because you’re under constant pressure to allocate expenditures toward programs and away from everything else in the statement of activities, to make the programs percentage look better.
The problem can be big enough to verge on reporting fraud, so your best bet is to set up a standard methodology for how every single expense is going to be allocated to the three classifications, and have the board approve it. Then, if the executive director lays on the pressure to shift more expenses over to programs, you have a solid defense to fall back on.
Nonprofit Reporting
Running the accounting for a nonprofit can be difficult. Depending on the types of reporting that donors want to see, you might be forced to prepare a special report to each one, showing how their funds were used. If the nonprofit is a small one, with rudimentary accounting systems, it may not even be possible to generate the information they want. One way to get around this is to review the reporting requirements for the big donor organizations, to see if you’re even capable to generating these reports. If not, don’t apply for the money. Otherwise, you might have to overhaul your accounting systems just to create the reports that a few donors are demanding.
Donation Restrictions
Another accounting issue is that donors might send in money with all kinds of odd restrictions – each of which has to be tracked. Imagine a zoo receiving money that’s restricted for use on a polar bear enclosure, when it doesn’t even have any polar bears. To get around this, set up just a couple of sub-accounts for specific types of restricted activities, and encourage donors to donate just into those activities. By doing so, the nonprofit isn’t being forced to engage in any peripheral activities; instead, the money is flowing into just a few areas that the board wants the nonprofit to focus on.
Nonprofit Bank Accounts
Another accounting issue is mixing up the money. It’s way too easy to lose track of where the money for the various programs has gone. A good way to keep track of the cash is to create a separate bank account for each program. When money is contributed to a program, the money goes to the associated bank account. Then the staff can plan expenditures based on the remaining bank balance.
Other Nonprofit Accounting Issues
An associated control is to keep a close watch on any negative account balances. This shouldn’t happen in a nonprofit, since you’re only supposed to spend the cash you have. Any negative balance means that you spent too much, and probably took cash from another program to pay for it.
And yet another accounting concern is making sure that you stay in compliance with all those donor restrictions. A good way to keep control of the situation is to maintain a summary list of all the large donations and associated restrictions, and update it a lot – probably once a month. This is a report for the executive director, since that’s the person donors will call if they find out that their money has been mis-spent.
Here’s another accounting issue. When a donor pledges money to a nonprofit, this results in a receivable that’s called pledges receivable. This only happens when the donor commits to a pledge without reservation. If a donor imposes a condition on a donation, then there’s no receivable. Instead, you have to wait for the condition to be fulfilled, and then record the receivable. A common example of this is when a donor pledges money, but only if you can raise an equivalent amount of cash from other donors.
When there’s any question about whether a condition can be fulfilled, just wait for the issue to resolve itself, one way or the other. It never makes sense to record a receivable – and the associated revenue – when there’s any doubt about whether the donation is actually going to be paid.