Accounting for a nonprofit organization can be complex with the strict tax requirements. This guide will help you stay on top of your nonprofit accounting responsibilities.
For nonprofits, the ins and outs of accounting can be tricky. Tax requirements for nonprofits are stringent, and it can be hard to track all your variable funding sources. Luckily, with the right accounting practices, you can ensure complete compliance and transparency when it comes to your nonprofit organization's financials. This guide will help you better understand how accounting for nonprofit organizations works and the best methods to employ.
What is nonprofit accounting?
Nonprofit accounting is a system of financial management, recordkeeping and reporting that is uniquely used by not-for-profit groups. Nonprofits are organizations that …
- Have no owners or ownership interests.
- Receive contributions or donations from third parties that don't expect a return.
- Have a purpose other than making a profit.
Nonprofit accounting uses specific language and designations to note what activities are being funded and create reports that let donors see how their money is being used.
Programs: The services provided by a nonprofit are referred to as programs. Each program generally has its own revenue, expenses and records.
Donor restrictions: Some donors restrict their contributions to specific purposes or programs. These must be accounted for in financial management. Funds that are not donor-restricted can be used for any program, administrative cost or other purposes.
Fundraising: This is the designation for activities that are used to raise the organization's profile or solicit donations, such as direct mail campaigns or charity events.
- Administration: Funds used for the management of a nonprofit are designated as administration or overhead funds. These are funds necessary to keep the nonprofit operating and must be noted in all accounting and reported to donors. Donors generally prefer that nonprofits keep their overhead, such as salaries, as low as possible in order to direct the majority of funds toward programs.
According to Eileen Gwaltney, director of government contracting services at Wall, Einhorn & Chernitzer P.C., one of the biggest mistakes nonprofit organizations can make is the improper allocation of functional expenses. Good nonprofit financial management should ensure that the organization can function and grow. However, if your functional expenses become too large, donors might hesitate to give.
"With donors focused on making the most of their contribution, it is important for nonprofits to allocate costs correctly," said Gwaltney.
What is the difference between nonprofit and for-profit accounting?
Both nonprofit and for-profit organizations must produce regular reports detailing their financial activities, and they use many of the same accounting principles. However, the different goals of the two types of organizations result in significant differences in these reports.
Balance sheet vs. statement of financial position: A for-profit company produces a balance sheet that details its net equity for owners and shareholders. However, a nonprofit does not have shareholders or owners. Instead, it produces a statement of financial position that outlines its assets and debts.
Net assets vs. equity: In for-profit accounting, the stockholders' equity is equal to a company's assets minus liabilities, sometimes called net assets. A nonprofit does not have equity, so this line item is always referred to as net assets. Net assets are labeled as restricted or unrestricted.
Income statement vs. statement of activities: Because a company is trying to generate a profit, it produces an income statement showing its revenues, expenses, losses and gains. A nonprofit doesn't have a bottom line, since it is driven by a mission rather than the need to make a profit. Instead of an income statement, it produces a statement of activities that outlines the revenues and expenses associated with each program.
- Statement of cash flow: Both nonprofits and for-profits must track and report their cash flow.
Though the terminology is different, nonprofits and for-profits use the same accounting principles. According to Maggie Tallman, head of business development for inception services at Amazon Web Services, many nonprofits would be better off if they followed for-profit practices of sharing data on the relationship between income (donations in this case) and outcomes (their programs and services).
"Real-time insight into program, operational and financial metrics is imperative in today's environment," said Tallman, who has worked closely with nonprofits to streamline their accounting practices and business operations. "Those nonprofit organizations that understand how to manage their data, and the insights and results derived from that data, are the ones that will leapfrog everyone else in donor and constituent engagement and organizational sustainability."
Do nonprofits need accountants?
Like any organization that handles cash flow and pays taxes, nonprofits should invest in professional accounting.
Many nonprofit organizations don't allocate resources for a professional accountant to manage their finances. Instead, they assign the task to an untrained staff member or volunteer. Tiffany Couch, CEO of forensic accounting firm Acuity Forensics, says this is one of the biggest mistakes not-for-profit organizations make.
Nonprofits run the risk of fraudulent activity if the bookkeeping and accounting is not carefully managed. This is often unintentional, through a lack of oversight or experience. Volunteers, who often make up a large part of a nonprofit's staff, may leave an organization with short notice, which can cause gaps in recordkeeping.
Hiring a professional ensures that someone with training and experience is always paying attention to the accounts and may notice something that an untrained employee would miss. For example, many organizations meet the requirements that release temporarily restricted funds but don't realize it because no one is keeping track.
"Too often, temporarily restricted funds are kept out of mind until cash flow needs are tight," said Adam Holcombe, audit manager at BDO USA. "Maintaining an up-to-date net asset schedule allows for management to have a better idea of what funds are available to better budget their operating needs."
"Don't have a mindset of scarcity when it comes to ensuring you have appropriate resources in terms of handling your money," Couch advised. "There are plenty of CPAs who would be willing to provide a discount or pro bono services."
Tax accounting for nonprofits
The tax code for nonprofits can be confusing, and tax reforms can affect everything from how you report your income to how you manage volunteers. If not reported or managed correctly, for example, some of a nonprofit's income can be taxable. Whenever new tax laws pass, the rules outlining how nonprofits must handle and report income change.
"Under the 2017 Tax Cuts and Jobs Act, a nonprofit can no longer aggregate the profits and losses from various trades and businesses in computing their unrelated business taxable income (UBTI)," warned Julie A. Treppa, a tax attorney and partner at Farella, Braun and Martel LLP. "[Nonprofits must] be sure to segregate income and expenses from each trade or business in which it engages ... UBTI is now computed separately with respect to each trade or business."
Nonprofits must also be careful to record and report the valuation of certain employee benefits, which can count as taxable income if not reported properly.
"A nonprofit's UBTI includes any qualified transportation fringe benefits and on-premises athletic facilities provided to employees," said Treppa.
However, she added, proper reporting can save you from paying taxes on these benefits: "The organization can avoid the addition of these items as UBTI if it includes the cost of the benefits on its employees' Form W-2."
Tax accounting for nonprofits doesn't just involve expenses and donations. You also need systems to track labor and services. Volunteers, for example, may provide unpaid labor, but that labor still has value that can affect both your taxes and overhead.
"The market value of the donated services are reportable on [tax form] 990 as program service revenue and can reduce the percentage of administrative and management costs that is directly paid for by the organization's cash contributions," said Tab Burkhalter, CPA and tax attorney for Burkhalter & Associates.
To ensure proper tax reporting and guarantee that you get the most value from volunteers, nonprofits need to establish a system to track and record the work they do. Updating these records should be part of regular bookkeeping and accounting operations, and the tracking system should be standardized across the organization.
Do nonprofits follow GAAP?
Generally accepted accounting principles (GAAP) are a set of accounting procedures and standards issued by the Financial Accounting Standards Board (FASB). All public companies in the United States must follow GAAP, and private companies generally do as well. Nonprofits must follow GAAP standards too, though their rules are sometimes slightly different from the ones for-profit companies follow.
The goal of GAAP is to ensure that companies' financial statements are consistent across industries, allowing investors and the government to more easily interpret them. GAAP rules for nonprofits are intended to create transparency for donors and grant-makers, as well as helping the government monitor whether an organization should retain its tax-exempt status.
In addition to general GAAP principles, there are certain rules that apply only to nonprofits.
Labeling net assets: Assets in a nonprofit's statement of financial position should be labeled according to whether they are restricted (either by donors or grant conditions) or unrestricted.
Describing cash flow: In addition to quantitative information listed on the statement of financial position, nonprofits must provide qualitative information that describes how they manage their liquid resources to meet everyday expenses. In particular, nonprofits must show any limitations or restrictions that impact their cash flow.
- Investments: While nonprofits should be aware of any fees for their investments to be managed, they do not need to report these separately. Instead, nonprofits are required to report investment income net of related external and internal expenses.
Donations should be something your accountant or accounting staff monitor closely and record in compliance with GAAP. You must record promises of future donations when you receive the pledge, rather than when your nonprofit receives the actual donation.
What is the best accounting software for nonprofits?
No matter who does your books, your nonprofit will need to use an accounting program to keep track of everything and be prepared when tax season rolls around. Nonprofits should look for accounting software that covers general bookkeeping and accounting, as well as specific not-for-profit needs such as donor management, FASB compliance and grant management. There are several low-cost or free accounting software programs designed specifically for nonprofits.
- Nonprofit Treasurer is free online accounting software for charities and nonprofits. It supports multiple users and includes features for taking online payments and donations, tracking expenses, attributing income, and reporting or budgeting based on your organization's fiscal year.
Financial Edge NXT is Blackbaud's accounting software for nonprofits. It has most of the standard features that a nonprofit would need to handle bookkeeping and accounting, such as activity tracking, accounts receivable and payable, bank reconciliation, and FASB-compliant reports. It has the option for a free trial, but long-term use has a variable fee.
Aplos is cloud-based accounting software for nonprofits and religious organizations. The free version of the software contains the basic accounting features most organizations need, such as fundraising management, donation receipts and donor statements, pledge tracking, donor databases, and compliant reporting. You have the option to upgrade to a paid membership for additional features.
Sage Intacct Cloud Accounting doesn't offer dedicated donation tracking or payroll, but it includes most other features nonprofit accounting requires. It offers a variety of budgeting and compliance tools, as well as activity tracking and partnership management.
- AccuFund Accounting Suite has a core nonprofit accounting system that includes accounts payable, general ledger, bank reconciliation, form designer and report writer features. You can add on modules for accounts receivable, loan tracking, grant management, payroll and more to customize your accounting software.
No matter what system you end up choosing, the most important part of nonprofit accounting may actually be communication. Couch recommends keeping your staff and board members up to date on what your accountants do and discover.
"Make sure you have a CPA who will walk you through all of your numbers, ensuring that you understand the profit and loss statement, the balance sheet, and your cash flow statement," she said. "The more knowledgeable you become, the more empowered you become to make financial decisions that will lead to your success."
This communication between accountants and decision-makers, Couch said, is essential to creating a sustainable nonprofit.
"If you don't have a CPA assisting you in this understanding, find one who will."
Some source interviews were conducted for a previous version of this article.