Introduction to Nonprofit Accounting

From churches to youth organizations to the local chambers of commerce, nonprofit organizations
make our communities more livable places. Unlike for-profit businesses that exist to generate profits
for their owners, nonprofit organizations exist to pursue missions that address the needs of society.
Nonprofit organizations serve in a variety of sectors, such as religious, education, health, social
services, commerce, amateur sports clubs, and the arts.

Nonprofits do not have commercial owners and must rely on funds from contributions, membership
dues, program revenues, fundraising events, public and private grants, and investment income.

Accountants often refer to businesses as for-profit entities and to nonprofit organizations as not-for-
profit entities, or NFPs. We will be using the more common term nonprofit instead of not-for-profit.
Again, this is a very brief introduction to nonprofit accounting. There are many different types of
nonprofits, including governmental nonprofits, which we will not address.

Differences between Nonprofits and

For-Profits
The following table highlights some of the key differences between nonprofit organizations and for-
profit corporations:

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Mission, Ownership, Tax-Exempt
Status
Mission and Ownership
While businesses are organized to generate profits, nonprofits are organized to address needs in
society. As a result, nonprofits will issue a statement of activities instead of the income statement
issued by for-profit businesses.
Since nonprofits do not have owners, there is no owner's equity or stockholders' equity and there
cannot be distributions to owners.

Some people mistakenly assume that if an organization is designated as a nonprofit, it cannot legally
earn profits. In fact, earning profits (having revenues that exceed expenses) is almost a necessity for
a nonprofit if it hopes to withstand such things as:

• unexpected expenses
• uneven flows of revenues
• a decrease in revenues
• rising costs due to inflation
• an increase in staffing needs
• an increase in the need for its services
• a purchase or replacement of needed equipment
• other needs since a nonprofit cannot issue shares of stock

Tax-Exempt Status
Nonprofit organizations may apply to the Internal Revenue Service in order to be exempt from federal
income taxes.

A second issue is whether a donor's contribution to a nonprofit organization will qualify as a charitable
deduction on the donor's income tax return. For example, churches, schools, and Red Cross chapters
are some of the nonprofits that will qualify as tax-exempt and their donors' contributions will also qualify
as charitable deductions on the donors' income tax returns.
However, there are nonprofits that qualify as tax-exempt but their donors' contributions do not qualify
as charitable deductions (although they may qualify as business expenses). Examples of these
nonprofits include social organizations, chambers of commerce, college fraternities and sororities,
amateur sports clubs, employee organizations, and more.
Even if a nonprofit is exempt from federal income taxes, it is likely that its employees will be subject to
employment taxes. Nonprofits may or may not be exempt from sales taxes, real estate taxes, and
other taxes depending on which state in the U.S. they are incorporated or operate.

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Financial Statements of Nonprofits
The following table compares the main financial statements of a nonprofit organization with those of
a for-profit corporation.

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Statement of Financial Position

A nonprofit's statement of financial position (similar to a business's balance sheet) reports the
organization's assets and liabilities in some order of when the assets will turn to cash and when the
liabilities need to be paid. The amounts are as of the date shown in the heading which is usually the
end of a month, quarter, or year. (We will present a sample statement of financial position in a later
section.)

Net Assets
Since a nonprofit organization does not have owners, the third section of the statement of financial
position is known as net assets (instead of owner's equity or stockholders' equity).
A nonprofit's statement of financial position is represented by the following accounting equation:

Because of double-entry bookkeeping, the accounting equation and the statement of financial position
should remain in balance at all times. For example, if a donor contributes $500, the effect on the
nonprofit's accounting equation and its statement of financial position is:

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If the nonprofit pays $100 for supplies that will be used immediately, the effect on its accounting
equation and its statement of financial position is:

The items that cause the changes in Net Assets are reported on the nonprofit's statement of activities
(to be discussed later).

The net assets section of a nonprofit's statement of financial position requires at a minimum the
following:
Net assets
Without donor restrictions xxx
With donor restrictions xxx
Total net assets xxx
These classifications are based on the restrictions made by the donors at the time of their contributions.
1. Net assets without donor restrictions
If a donor does not specify a restriction on his or her contribution, the amount received by the nonprofit
is recorded as an asset and as contribution revenues. Unrestricted contribution revenues (reported on
the statement of activities) also cause the amount of net assets without donor restrictions to increase.
For instance, if a nonprofit receives an unrestricted contribution of $800 of cash, the effect on the
statement of financial position is:

If the nonprofit's board of directors designates some of the nonprofit's unrestricted assets for a specific
purpose, those assets must continue to be reported as net assets without donor restrictions.
2. Net assets with donor restrictions
If a nonprofit receives a contribution that has a donor-imposed restriction, the amount is usually
recorded as an asset and as donor restricted contribution revenues. Donor-restricted contribution
revenues (reported on the statement of activities) also cause the amount of net assets with donor
restrictions to increase. For example, James donates $20,000 with the requirement that the nonprofit
use it to purchase a vehicle that is urgently needed in one of the nonprofit's programs. The effect on
the nonprofit's accounting equation at the time the contribution is received is:

When the nonprofit purchases the vehicle at a cost of say $21,000, the purchase and the release of
the restriction will cause the following changes:

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Statement of Activities
Since a nonprofit's primary purpose is to provide programs that meet certain societal needs, it issues
a statement of activities (instead of the income statement that is issued by a for-profit business).
The statement of activities reports revenue and expense amounts according to the two classifications
of net assets discussed above. Here is an outline of the statement of activities without its heading and
without amounts:

* Actually will include revenues, gains, other support, and releases from donor restrictions.

Before we illustrate a sample statement of activities, let's take a closer look at its components.

Revenues, gains, other support, and releases from donor restrictions

This heading will be followed by items such as:

• Contributions
• Membership dues
• Program fees
• Fundraising events
• Grants
• Investment income
• Gain on sale of investments
• Reclassifications when net assets are released from restrictions (a negative amount in
the With Donor Restrictions column and a positive amount in the Without Donor
Restrictions column)

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Under the accrual method of accounting, revenues are reported in the accounting period in which they
are earned. In other words, revenues might be earned in an accounting period that is different from
the period in which the cash is received.

Expenses and losses

Under this caption expenses are reported according to the following functions (activities, services):

1. Program functions
2. Support functions
1. Program functions
Program expenses (or program services expenses) are the amounts directly incurred by the nonprofit
in carrying out its programs. For instance, if a nonprofit has three main programs, then each of the
three programs will be listed along with each program's expenses.
2. Supporting functions
Support expenses are reported in two subgroups:

• Management and general

• Fundraising and development
In order to accurately report the amount in each of these subgroups, it may be necessary to allocate
some management and general salaries to fundraising based on the time spent by employees
performing fundraising activities. For example, a management employee might be spending 30% of
her time in fundraising activities but her entire salary has been recorded as management and general
expenses.

Under the accrual method of accounting, expenses are to be reported in the accounting period in
which they best match the related revenues. If that is not clear, then the expenses should be reported
in the period in which they are used up. If there is uncertainty as to when an expense is matched or is
used up, the amount spent should be reported as an expense in the current period.

General Ledger Accounts and Chart of

Accounts
A nonprofit's transactions are recorded in accounts in the general ledger. A listing of the titles of the
general ledger accounts is known as the chart of accounts.
The accounts in the general ledger and in the chart of accounts are organized as follows:

• statement of financial position accounts

o asset accounts
o liability accounts
o net asset accounts
• statement of activities accounts
o revenues and gains

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 o expenses and losses
The number of accounts in a nonprofit's general ledger could range from 30 to 1,000 or more. The
number of accounts depends on the number of programs that the nonprofit has, the types of revenues
it earns, and the level of detail required for planning and control of the organization.

For example, a nonprofit is likely to have a separate general ledger account for each of its bank
accounts. It may also have 50 general ledger accounts for each of its major programs, plus many
accounts under its fundraising and management and general expense categories.

The detail in the general ledger accounts will always be available for management's use. However, all
of the account balances will be summarized into a few totals that are presented in the financial
statements and IRS Form 990.

Nonprofit recordkeeping can get a bit challenging, so it is worth noting that accounting software exists
to help nonprofits record transactions efficiently. The accounting software will also allow for reports of
revenues and expenses by function (programs, fundraising, management and general), by the nature
or type of expense (salaries, electricity, rent, depreciation, etc.), and/or by grant.

Illustration of the Statement of

Financial Position and the Statement
of Activities
We are now ready to present examples of the statement of financial position and the statement of
activities. To do that, we'll follow the activities of a nonprofit organization called Home4U, a daytime
shelter for adults.

Let's assume that Home4U was incorporated in January 2017 and its accounting years end on each
December 31. The following transactions occurred during a three-month period.

January Transaction
Transaction 1. On January 31, a donor contributes $10,000, without restriction, for the operation of
Home4U. This transaction affects the general ledger accounts as follows:

Assuming this is the only transaction in January, the general ledger account balances will result in the
following financial statements:

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February Transactions
Transaction 2. On February 1, Home4U rents office space. A check is written for $2,000. This covers
a one-time security deposit of $1,000 plus the February office rent of $1,000.

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Transaction 3. On February 2, a $400 check is written to the utility as a one-time security deposit for
electricity and heat service.

Transaction 4. On February 19, Home4U receives a contribution of $8,000 that the donor specifies
must be used for the purchase of furniture. The contribution is deposited into a money market account.
This transaction affects the general ledger accounts as follows:

Transaction 5. The electricity and heating invoice has not arrived. It is estimated that the amount for
February's usage was $350, so the following accrual adjusting entry is recorded on February 28:

Assuming that Transactions 2 through 5 are the only transactions occurring in February, the general
ledger account balances will result in the following financial statements:

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March Transactions
During March, Home4U paid the March rent of $1,000. Home4U also paid the February utilities which
were equal to the estimated amount of $350. Home4U estimates that March's utilities will be $300.

On March 31, Home4U paid $8,300 to purchase furniture (using the donor-restricted donation of
$8,000). The statement of financial position dated March 31 will report the following amounts:

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Statement of Functional Expenses
The statement of functional expenses is described as a matrix since it reports expenses by their
function (programs, management and general, fundraising) and by the nature or type of expense
(salaries, rent). For instructional purposes we highlighted the column headings to indicate the
expenses by function. We also highlighted the words in the first column as they indicate the nature or
type of expenses.

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The FASB now requires every nonprofit to present expenses by function and nature in one place
(statement or notes).

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Statement of Cash Flows

The statement of cash flows for a nonprofit organization is similar to that of a for-profit business. It
reports the organization's change in its cash and cash equivalents during the accounting period.

The statement of cash flows consists of three sections:

1. net cash from operating activities

2. net cash from investing activities
3. net cash from financing activities
The operating section reports the changes in cash other than those reported in the investing and
financing sections.
The investing section of the statement of cash flows reports the amounts spent to purchase long-term
assets such as equipment, vehicles and long-term investments. The investing section also reports the
amount received from the sale of long-term assets.
The financing section of the statement of cash flows reports the amounts received from borrowings
and also any repayments.
While the statement of cash flows, or cash flow statement, may be a bit difficult to prepare, it is an
important financial statement to be read.

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Notes to the Financial Statements
The notes to the financial statements are an integral part of the statement of financial position, the
statement of activities, and the statement of cash flows. The Accounting Standards Update No. 2016-
14 requires important additional disclosures regarding liquidity, restrictions, etc. for creditors, donors,
and others.

Budgeting for Nonprofits

Budgeting for nonprofits can become complex when it involves several overlapping categories, such
as grants, programs, function, and nature.

Budgeting is also complicated when sources of support are not secured at the time the budget is
prepared for the upcoming year. This could lead to the use of an account entitled Resource
Development in order to balance the budget.
Since resource development is often ongoing, budgets may require frequent modification. Good
accounting software will also allow directors to compare budgeted amounts to actual amounts and
make the necessary adjustments.

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What is a nonprofit organization?

A nonprofit organization is an organization without commercial owners and which addresses the
needs of society. Nonprofit organizations are also known as not-for-profits, NFP's or simply
as nonprofits. Nonprofit organizations are likely to be involved in areas such as religious,
education, health, social services, arts, etc.
Nonprofit organizations may apply to be exempt from federal income taxes. Donors' contributions
to nonprofit organizations may or may not be charitable deductions. For more information
regarding these issues see Publication 557 at IRS.gov.

A nonprofit organization's financial reporting includes a statement of financial position,

a statement of activities, a statement of functional expenses, and a statement of cash flows. Some
nonprofits are required to file IRS Form 990 or Form 990-EZ. Since nonprofits do not have
commercial owners, the difference between the amounts of assets and liabilities is reported as net
assets (instead of owner's or stockholders' equity). The net assets are presented as: without donor
restrictions or with donor restrictions.
The typical sources of a nonprofit's revenues are donor contributions, program fees, dues,
fundraising events, grants, and investment income. Expenses are presented as program activities
or supporting activities (management and general, and fundraising).

What is the meaning of net assets?

Net assets is defined as total assets minus total liabilities. In a sole proprietorship the amount of
net assets is reported as owner's equity. In a corporation the amount of net assets is reported
as stockholders' equity.
In a not-for-profit (NFP) organization the amount of total assets minus total liabilities is actually
reported as net assets in its statement of financial position. The net assets section for the NFP
organization is divided into two major classifications:
• net assets without donor restrictions

• net assets with donor restrictions

The changes in these net assets classifications are reported in the organization's statement of
activities.

What is the statement of financial position?

The statement of financial position is another name for the balance sheet. It is one of the
main financial statements and it reports an entity's assets, liabilities, and the difference in their
totals. The amounts reported on the statement of financial position are the amounts as of the final
moment of an accounting period.

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The structure of the statement of financial position is similar to the basic accounting equation. For
instance, a corporation will report amounts in the following format: Assets = Liabilities
+ Stockholders' Equity. A nonprofit organization's format will be: Assets = Liabilities + Net
Assets.
The statement of financial position must reflect the basic accounting principles and guidelines such
as the cost, matching, and full disclosure principle. Accordingly, the statement of financial position
is more meaningful when it is prepared under the accrual method of accounting.

What is the difference between a balance sheet of a

nonprofit organization and a for-profit business?

A main difference is the section that presents the difference between the total assets and total
liabilities. The nonprofit's statement of financial position refers to this section as net assets,
whereas the for-profit business will refer to this section as owner's equity or stockholders' equity.
The reason is the nonprofit does not have owners. This means that the nonprofit organization's
statement of financial position will reflect this equation: assets – liabilities = net assets.
The net assets section will consist of the following parts: net assets without donor restrictions and
net assets with donor restrictions. The amounts reported in each of these parts are obviously based
on the donor's stipulations.

What does it mean to report expenses by function?

To report expenses by function means to report them according to the activity for which
the expenses were incurred.
For a business, the reporting of expenses by function means the income statement will report
expenses according to the following functional classifications: manufacturing, selling, general
administrative, and financing.
For a not-for-profit organization, the reporting of expenses by function means the statement of
activities will report expenses according to the following functional classifications: 1) each of its
major programs, and 2) the supporting services which are a) management and general, b) fund-
raising, and c) membership development. It will also present the expenses by nature, such as
salaries, electricity, repairs, etc.
(Classifying expenses according to salaries, electricity, repairs, etc. is referred to as natural
classifications, or classifying expenses by their nature.)

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What is the statement of activities?

The statement of activities is one of the main financial statements of a nonprofit or not-for-profit
organization.
A nonprofit's statement of activities is issued instead of the income statement which is issued by a
for-profit business.

The statement of activities focuses on the total organization (as opposed to focusing
on funds within the organization) and reports the following:
1. Revenues such as contributions, program fees, membership dues, grants, investment income, and
amounts released from restrictions.
2. Expenses reported in categories such as major programs, fundraising, and management and general.
3. The change in net assets resulting from items 1 and 2.
The statement of activities will have multiple columns in order to report the amounts for each of
the following classes of net assets: without donor restrictions, with donor restrictions, and total.

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