You didn’t get involved with the nonprofit sector to tediously crunch numbers and fill out financial forms. However, accounting is a key aspect of the nonprofit sector, just as it is for the for-profit world. Even if you’re not in the weeds with your organization’s accounting needs, having a general understanding of how it works can help you ensure your organization is making informed decisions and investing in the most impactful strategies for growth.
Accounting offers a systematic approach to organizing funds for various projects and operational expenses that help drive your mission forward. If you’ve studied accounting in a general sense, you’ve probably discussed it in the terms of businesses and for-profit organizations. However, nonprofits are unique!
Nonprofits use a specific type of accounting, called fund accounting, to help better allocate funding according to various restrictions.
Nonprofit accounting differs greatly from for-profit accounting in several ways, which is what we’ll discuss throughout this article. We’ll cover the following attributes that make nonprofit accounting unique:
- Nonprofits Focus on Accountability
- Financial Reporting Differs for Non Profits
- Nonprofits Don't Pay Taxes
- Auditing Differs for Nonprofits
Nonprofits and for-profits differ significantly in many ways, from the part they play in the community to the way they approach their finances. Understanding how accounting for nonprofits differs from for-profits gives you better insight into how organizations like yours prioritize finances.
1. Nonprofits Focus on Accountability
One of the greatest differences between nonprofit and for-profit accounting is the organization’s overall focus. For-profits (just as the name implies) focus their energy and efforts on turning a profit. They want to make money and a lot of it.
Meanwhile, nonprofit organizations use a fund accounting system that shifts the focus away from profit and instead centers on accountability. This means staying accountable to those who contributed the funding in the first place. All of the funding that nonprofit organizations receive is turned around to reinvest back into the organization and those who contributed the funds to the organization.
This focus on accountability is why nonprofit organizations employ the use of fund accounting to organize their finances.
Fund accounting is a system of accounting that allows organizations to separate their money into different categories, or “funds,” to stay organized. The funds need to be separated from one another because different contributions made to your organization may have allocations and restrictions set on them from the start. Each of these funds needs to be individually balanced and records need to be kept in separate ledgers.
For example, it’s rare that you’ll receive a grant with no strings attached. More often than not, it’s provided to serve a specific purpose at your organization, such as fund a specific program or a scholarship. Now, imagine you’ve won three grants, all with different purposes. To stay accountable to your grantors, you’ll need both effective grant management strategies as well as a system of fund accounting to organize the money.
Grants aren’t the only reason to use fund accounting. Other restrictions may come from the donors themselves, particularly for large contributions or from specific campaigns. Crowd101’s quick financial guide provides the following examples of potential funds that organizations may leverage:
- Restricted funds
- Unrestricted funds
- Temporarily restricted funds
- Designated funds
For-profits don’t usually have restrictions placed on many of their funds. They have a little more freedom when it comes to budgeting and allocating their money to the various aspects of their organization.
However, nonprofits need to stay accountable to their funding sources. It increases the level of trust donors and supporters have with nonprofits when they know their money is used for its intended purpose.
2. Financial Reporting Differs for Nonprofits
Nonprofit organizations maintain different financial documentation than their for-profit counterparts. This is largely due to the difference we mentioned above: Nonprofits reinvest all funds back into their mission.
Let’s cover the differences in documentation, including the for-profit’s balance sheet vs. a nonprofit’s statement of financial position and the for-profit’s income statement vs. a nonprofit’s statement of activities.
Balance Sheet vs. Statement of Financial Position
For-profit organizations keep a balance sheet. This is a document that shows the assets owned by the company. These assets can be distributed out to the stockholders as retained earnings. As you know, nonprofits don’t have stockholders since no one actually owns a nonprofit. So why would they need a balance sheet?
Instead of keeping a balance sheet, nonprofits use a statement of financial position. Similar to the for-profit counterpart, this financial statement shows the assets of the organization. However, instead of listing the assets that can be distributed to shareholders, this report is used to show the assets that can be reinvested in the organization’s mission in the future.
Income Statement vs. Statement of Activities
To evaluate financial performance, for-profit organizations list their revenue, gain, expenses, and losses in an income statement. Essentially, this is a company’s bottom line, showing you how much they’ve earned or lost in a specific time period.
The bottom line for nonprofits differs from that of for-profits, focusing on the mission rather than the profit earned. Therefore, nonprofits create a statement of activities in lieu of an income statement. The statement of activities reports on the changes throughout the year in the organization’s net assets in relation to the earnings and expenses from fundraising activities.
While many of these financial reports may seem fairly similar, it’s the focus that makes all the difference. Rather than emphasizing income or profit, nonprofits focus on the future and what they’ll be able to accomplish for their mission with those funds.
These reports are one of the major reasons that it’s important for your organization to leverage effective software. The right accounting software that’s specifically designed for nonprofit organizations allows you to pull the proper version of these documents rather than trying to make do with the for-profit versions.
3. Nonprofits Don't Pay Taxes
As a registered 501(C)(3) organization, you have a major advantage over for-profits: Your nonprofit doesn’t have to pay federal taxes. That’s one of the main reasons organizations like yours register with the IRS!
While you don’t have to pay direct federal taxes, that doesn’t mean your organization gets off scot-free come tax season. You still need to file Form 990 with the IRS each year. According to Jitasa’s Form 990 filing guide, this form is “designed to help ensure organizations are acting honestly and with integrity.”
Unfortunately, some believe W.C. Field’s statement, “Anything worth having is a thing worth cheating for.” Therefore, there will always be people out there who try to take advantage of the lack of taxes for nonprofit organizations by setting up fraudulent organizations. The Form 990 helps the IRS keep track of tax-exempt organizations, ensuring they’re doing what’s intended with the funds they receive and working toward their respective missions.
While you may roll your eyes at the idea of another form to fill out, Form 990 actually has a few very specific advantages for nonprofits:
- It holds your organization accountable. Form 990 is publicly available online. This provides your organization with additional motivation to remain accountable to your supporters, as they can check in on your financial status and standing at any time.
- It allows for financial transparency. When supporters do check on your publicly posted Form 990 and see you’re using their money responsibly, it increases the amount of trust they have in your organization. Form 990 allows you to establish a deeper level of financial transparency that strengthens funders’ confidence in your team.
- You can avoid fees and penalties by filing. When you fail to file your Form 990, there are a number of penalties you might incur, including late fees between $20 to $100 per day and the potential loss of your tax-exempt status. It behooves you to file, and to file on time.
All of these advantages are related to your organization’s federal taxes. However, there are other taxes we have not yet covered: state taxes.
State taxes and regulations differ from state to state, which makes it difficult to be precise when discussing on a large scale. Your nonprofit might have to pay state taxes, but it might also be exempt. More than likely, you’ll need to register for charitable solicitation in the states where you operate.
In some states, this charitable solicitation registration will also exempt you from state taxes. And, it may help you avoid pesky, expensive fees and penalties with the state. Be sure to look up your own state’s policies to find out more about specific regulations.
4. Auditing Differs for Nonprofits
In the for-profit world, auditing means the IRS is reviewing all of the organization’s paperwork and financial records to be sure it’s paying taxes according to its legal obligations. In the nonprofit world, auditing is a little different.
Because nonprofits don’t pay federal taxes, they don’t need to be audited to ensure they’re providing the government with the proper amount of funding. Rather, nonprofits are audited to ensure their internal controls are up-to-scratch and sometimes to confirm they’re using funds appropriately.
Nonprofit audits are rarely required of organizations, except in very specific circumstances such as if:
- It's required according to your nonprofit's bylaws
- It's required by your state
- You've received more than $750,000 in federal funding in a given year
- It's required by your funding grantors.
Even if your nonprofit isn’t required to be audited, you might consider requesting one anyway. It can be hard for your organization to identify opportunities to improve your financial management. However, a trained auditing professional presents an impartial outside perspective to identify these opportunities, helping to ensure financial safety and better management.
And, if you communicate with supporters that you’ve voluntarily conducted a financial audit, you increase transparency with them and show you’re serious about the funding they contributed.
Nonprofits are unique in several ways, particularly in their approach to finances and accounting. When you understand how these organizations vary, you can better identify the differences in priorities between the two sectors and allocate funds more effectively.
Most nonprofit professionals can make do with a general understanding of these types of accounting concepts. However, when diving into the nitty gritty of it all, it’s best to have a trained nonprofit accountant on your team. Many nonprofit leaders believe this means hiring someone new, but often organizations can do more, maintain compliance, and save money by outsourcing. Consider outsourcing your bookkeeping and accounting needs for your organization.