Charitable institutions require distinct nonprofit accounting rules and methods to manage incoming funds and comply with tax requirements. To avoid turning away potential donors or facing legal consequences, knowing the basic accounting rules for nonprofits will go a long way in producing sound financial reports that potential donors will trust.Accounting for nonprofit organizations differs from what for-profit businesses normally do when managing their expenses, recording income, and paying taxes.
All companies aim to make a profit for the benefit of its owners. However, government institutions and nonprofit organizations run their operations with a different objective – to benefit the people, communities or causes they serve. Any surplus in their profit is reinvested into activities that will promote the welfare of the people or groups they protect.
The difference in their goals requires strategic accounting methods that 1) adhere to the laws governing accounting for nonprofits, and 2) follow the strict generally accepted accounting principles (GAAP) to ensure that accountants are well-guided on the best accounting practices.
This article will delve into how accounting for nonprofits works, and how decision-makers in these organizations can successfully fulfill the organizations’ financial responsibilities.
What are Nonprofit Organizations?
Nonprofit organizations are tax-exempt businesses because their operations are geared towards social causes or the general public’s well-being. The Internal Revenue Service (IRS) refers to these entities as charitable organizations in which their earnings are enjoyed by the general public and not by personal or private gains.
The IRS Section 501(c)(3) states: “No part of the net earnings of a section 501(c)(3) organization may inure to the benefit of any private shareholder or individual. A private shareholder or individual is a person having a personal and private interest in the activities of the organization.”
Donations, whether in cash or kind, are tax-deductible to the organizations that receive them. Accounting standards have been put in place to guide nonprofit founders and their accountants on the proper use and recording of funds.
What Can Be Classified as a Nonprofit?
IRS Section 501(c)(3) identifies entities that are exempted from paying federal taxes. These nonprofit organizations may be considered public charities or private foundations. These not-for-profit organizations are regulated and administered by the US Department of Treasury through the IRS.
- Public Charities
Public charities operate directly for the public’s benefit, soliciting donations from communities or individuals that support their cause. The IRS requires organizations belonging to this category to restrict its activities to charitable purposes since the funds are collected from public individuals or other charities.
- Private Foundations
Private foundations are those charitable organizations that use funds from a single benefactor, like family or corporate money. Many private foundations do not accept donations. However, they invest their seed funding and then allocate the income for philanthropic campaigns initiated by other public charities.
In private foundations, only 30% of the donor’s annual income is tax-deductible, whereas 50% is deducted from income for those donating to public charities.
What is Nonprofit Accounting?
Nonprofit accounting is a financial management method that reports what activities are being funded using donations or investments. The aim is to give donors a systematized overview of how their money is spent and where it was allocated.
Since nonprofits operate using the funds they receive from donors, they should provide transparent, accurate, and accountable financial reports to show that costs are spread correctly and that labor and other services are also considered. Donors give grants with explicit stipulations for how the funds should be used, so not-for-profit organizations are legally bound to honor those expectations.
For-profit vs. nonprofit accounting
Since nonprofit and for-profit organizations have different goals, they also produce different financial reports. Regardless, they both follow the same accounting principles. For instance, here are some comparisons:
1. Net assets and equity
- For-profit: Stockholder’s equity is equal to the difference between assets and liabilities. This is also recorded as net assets.
- Nonprofit: The organization has no equity, so all assets are automatically labeled as restricted or unrestricted. Net assets with donor restrictions have a designated purpose like scholarships or calamity initiatives. On the other hand, net assets without donor restrictions can be used for any activities initiated by the nonprofit organization. These funds can be used for operational costs or whatever the nonprofit needs to fulfill its projects.
2. Income statement and statement of activities
- For-profit: Business owners need to show income statements to demonstrate if the company is generating profit. The income statement shows the company’s revenues, losses, and expenses.
- Nonprofit: Decision-makers in nonprofits don’t have any income to show since their purpose is philanthropy and not profitability. They record statements of activities where they break down how much money each program was able to generate and how much was spent to make it happen.
3. Balance sheet and statement of financial position
- For-profit: Businesses prepare a balance sheet that captures what the company owns and what it owes. It describes the net equity for the owners, as well as the shareholders.
- Nonprofit: There are no owners nor shareholders in nonprofit organizations. However, they provide a statement of financial position that describes its assets and debts.
4. Cashflow statement
- For-profit & nonprofit: They both report the changes in income and outcome of cash and cash equivalents at any specific period: day, week, month, or year. Keeping a cash flow statement ensures that the organization doesn’t run out of cash.
Nonprofit tax accounting
Federal and state governments require quarterly and annual reports for taxes, grants, and contracts to ensure that nonprofits are able to maximize the donations they receive, and that all income should come from mission-driven causes.
However, being on a tax-free status under federal laws is not automatic. To be tax-exempt from state sales, property, and income taxes, nonprofits must apply for recognition of exemption from the IRS, which will provide them with a determination letter recognizing tax exemptions.
Charitable organizations need to apply within 27 months of when the nonprofit started operating in order to be exempt under Section 501(c)(3). This page elaborates on the required provisions to qualify for the exemption.
When the nonprofit has been recognized as a tax-exempt entity, they must submit Form 990 or the Annual Information Report to the IRS. This form will declare all financial activities – from the sources of income to expenses. This report will allow the government to evaluate whether or not the nonprofit is engaging in activities that may jeopardize its tax exemption.
Regular nonprofit bookkeeping also needs to keep track of what volunteers do and what benefits they receive to perform their duties daily. This is because tax accounting for nonprofits also involves labor and services, affecting both taxes and overhead.
Accounting and bookkeeping for nonprofits are still governed by tax laws, although they are on tax-exempt status. If not reported correctly, the income generated through mission-driven activities may become taxable.
Accounting for Donations
Donations are considered the lifeblood of any nonprofit organization. Almost anything of value counts as a donation, so proper nonprofit bookkeeping and accounting need to be practiced. This allows stakeholders to see where the support came from, what the grants are intended for, and what activities can be created out of that contribution.
Cash donations are reported as income in the nonprofit’s accounting statements. Items such as cars, clothes, services, etc. should have a designated acceptable value. The IRS Publication 561 has an existing guideline for determining fair market value for tax purposes.
The fair market value means that nonprofit accountants should identify what the donated item would sell for if placed on the open market. Household items that cost more than $500 that are donated to the nonprofit organization should be appraised to determine the value.
Also, accounting for donations to nonprofit organizations should include the list of its donors to identify where the support is coming from. There should be a database in place, which enlists names, addresses, affiliations, contact numbers, and other important information such as their donations’ value and frequency.
Leaders of non-profit organizations may use this data to appeal support from these people or organizations, should they create outreach programs in the future.
Do Nonprofits need to hire an accountant?
Nonprofit accounting basics may indeed be covered by anyone adept in handling financial statements and keeping transparent records of donations, but investing in an accountant will go a long way in minimizing the risks that come with fund mismanagement.
Nonprofit bookkeeping and accounting should be handled by trained professionals who know the ins and outs of federal state laws and the proper allocation of resources so that all donations are maximized and spread across its target beneficiaries.
A professional nonprofit accountant sees discrepancies, imbalances, or recordkeeping gaps that untrained staff would often miss. They provide insightful budget reports that help nonprofit leaders determine whether the next outreach campaign is feasible or not.
It doesn’t matter if the charitable institution decides to hire an in-house accountant, seeks CPA volunteers, or outsources its nonprofit accounting needs. What matters is that it gets professional help to avoid any oversight.
Nonprofit accounting software
When tax season is in full swing, non-profit accounting software will help provide crucial financial information. There are software programs designed specifically for not-for-profit accounting and bookkeeping, which charge little to no cost.
Here are some of the best nonprofit accounting software:
1. Aplos
Aplos has a proven track record in helping nonprofit organizations and church groups automate their donation processes. It provides mobile-friendly donation forms and a customized donation widget, which nonprofits may use on their websites.
The cloud-based platform also allows nonprofits to track their bookkeeping and donations in one dashboard. They can track where donations are coming from and where the funds are used. Users can also generate and share their reports with their members.
Aplos can also be used for monitoring fundraising activities. It sees who among the volunteers have not donated for the year and identifies people with outstanding pledges.
2. Xero for Nonprofits
Xero is another leading accounting software tool for nonprofits. It stores the organization’s bank accounts and credit card information so users can stay up-to-date on their expenses and income. It can be integrated with third-party payment solutions like Stripe and Paypal to reconcile all accounts.
The platform also helps users see the nonprofit organization’s cash flow in real-time, whether using laptops or mobile devices. Furthermore, Xero lets nonprofit leaders send payments to their staff using its online payroll feature.
3. Nonprofit Treasurer
Nonprofit Treasurer is a free accounting software for nonprofit organizations. It’s the perfect companion for volunteer treasurers in managing bookkeeping reports using simple and user-friendly design. It has tools for budgeting and creating reports, tracking expenses, and attributing income to its intended recipients.
This cloud-based accounting solution is highly secure as it uses bi-directional encryption. Nonprofit decision-makers can easily provide and revoke access to the account in just a few clicks.
4. AccuFund Accounting Suite
AccuFund Accounting Suite offers cloud-based and on-premise solutions to fit the nonprofit’s requirements. It provides robust tools for creating a general ledger of all financial data using customizable dashboards. It also allows users to track and pay bills on time, manage cash receipts, and reconcile all bank accounts.
What’s more, the AccuFund Accounting Suite offers modules for nonprofit financial reporting so users can meet their specific needs such as inventory management, grants management, loan tracking, client invoicing, payroll management, and program management.
No nonprofit organization is too small to make big changes
Not-for-profit organizations exist to bring positive changes to their communities. Whether they hire or outsource their nonprofit accounting needs to run their operations sustainably, it’s more important to maintain healthy communication within the organization to meet donor demands and bring about transformative change.
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