A non-profit organization is defined as an organization whose primary purpose is to serve its members for the benefit of the group or society in general.
Table of Contents
- Introduction to non-profit organizations
- Private Foundations
- Private Operating Foundations
- What is the purpose of Fund accounting for non-profit organizations?
- How is accounting for non-profit organizations different?
- Financial Statements and Accounting in Non-Profit Organizations explained
- Special items accounted for in non-profit organizations
- How does accounting of non-profit organizations differ from -profit organizations:
- Non-profit organizations taxes
- How to Start Accounting in non-profit organizations -Step-by-Step Guide
Introduction to non-profit organizations
A non-profit organization is often run by a trustee and is not driven by commercial desires. The most common types of non-profit organizations are Charities that rely primarily on donations to survive, but they can also earn income from other sources such as membership fees, fundraising activities, and grants.
Charities can be:
- Religious, Educational, or Environment Institutions
- Sports clubs
- International Development Initiatives
- Animal welfare programs
- Child sponsorship program
- Disaster relief organization
- Social welfare organization
- Research related, Health-oriented, or Literary Institutions Art Association
- Human rights initiatives
There are foundations to support charitable organizations and individuals through grants. The Foundation also does not raise money, or it does not fund its programs or activities. The income is given by the founder or company that founded the Foundation, and the money is invested. The proceeds from this investment are donated.
Private Operating Foundations
This is a combination of public charity and foundation. This type of foundation funds its programs and activities. The word "foundation" is often used in the official name of a charity. For example, the Clinton Foundation, founded by former US President Bill Clinton, is a charity that does not accept donations. It is self-funded by Clinton, and the money is donated to organizations that the Foundation deems necessary. Therefore, the Clinton Family Foundation is a private operating foundation.
What is the purpose of Fund accounting for non-profit organizations?
Fund accounting is used by non-profit organizations to measure accountability and profitability. Fund Accounting is a process in which all non-profit organizations need to be categorized into Restricted or Unrestricted institutions.
In this way, non-profit organizations can know how much money they handle, and where they spend it.
1. Unrestricted or Unlimited Funds
The charity money can be used for anything. For example, to buy assets or to pay for expenses.
2. Restricted or Limited Funds
The charity money can only be used for a specific purpose, as mentioned by the donor. This is an important difference as the same amount of money must be used as intended by law. For example, endowments, wherein only the amount of interest generated is spent, that too at the discretion of the donor.
How is accounting for non-profit organizations different?
- These types of organizations are tax-exempt, so the accounting process for non-profit organizations is different. As a result, non-profit organizations can usually focus on reducing overhead and inflow more money into the programs and services they offer
- Non-profit organizations can choose between cash accounting and accrual methods to record their costs and income
- The cash accounting method records the transaction amount when money is traded by hand
- Accrual accounting records the amount when a transaction is made
- Many believe that accrual accounting is more accurate
- It is legally binding for these organizations to provide financial records. These organizations prepare annual financial statements for legal requirements and to maintain asset/fund control
- Some of the important financial statements prepared by a non-profit organization on a regular business are:
- Receipt and Payment Account
- Statement of activities or Income and Expenditure Account
- The Balance Sheet made by non-profit organizations or the statement of financial position
Financial Statements and Accounting in Non-Profit Organizations Explained
1. Receipt and Payment Account
Receipt and payment accounts provide a summary of all cash and bank transactions made during the fiscal year. It is important to consider receipts and payments as they help you create income and expense accounts and balance sheets. This account begins with a record of the cash balance/bank balance on the receipt side, and the final balance includes the remaining cash balance/bank balance on the payment side.
Format of Receipt and Payment Account:
- Cash in Hand/Cash at bank
- General Donations
- Locker Rent
- Grant in Aid
- Interest in FD
- Interest on investments
- Membership fees
- Entrance fees
- Miscellaneous Receipts
- Balance b/d(Bank overdraft) Closing b/d/ Cash in hand/ Cash at bank
- Balance b/d (Bank overdraft)
- Audit fees
- Repair and Renewals
- Printing and Stationery
- Purchase of assets
- Purchase of investments
- Rates and Taxes
- Wages and Salaries
Features of Receipt and Payment Account
Its functions are shown below:
- This is similar to a cash journal with a receipt on the debit side and a payment on the credit side
- All income and payments are recorded regardless of the billing period
- Capital or income deposits and withdrawals are included under certain conditions
- Non-cash items such as depreciation, accrued, and prepaid expenses are not recorded
- There is no difference between cash or bank transfer receipts and payments
2. Statement of activities
The income statement of a non-profit organization is similar to that of any business organization. The Income records all revenue items for the period and, in the Expenditure area, record a deficit or surplus. The balance account is created on an accrual basis and it also considers non-cash items such as depreciation. The opening balance is not included and the closing balance is posted as a surplus or a deficit.
The statement of activities is also called the operating statement that tells you how “profitable” your non-profit organization was over a period by subtracting the expenses and losses from your revenue.
One difference between the statement of activities and the income statement is that it calculates the changes in net worth/assets rather than net income/profit.
Let’s look at an example:
The Real World Foundation - Statement of Activities - December 31, 2020
- Donations - $7000 (Unrestricted), $2,500 (Restricted)
- Fees - $12400
- Other Revenues - $670
Total revenues - $20070 + $2,500 = $22570
- Fundraising Events - $3250
- Other Fundraising - $4100
- Management - $6300
- General - $980
Total expenses - $14630
Change in net assets – Revenues – Expenses = 22570 – 14630 = $7940
3. The statement of financial position maintained by non-profit organizations – Balance Sheet:
The balance sheet determines a company's financial position. The balance sheet of a non-profit organization contains assets, liabilities, capital, or general funds and is created by income and expenditure.
The difference between a balance sheet and a financial position states that the balance sheet does not contain capital because the non-profit organization is technically unowned. Instead, it has a net worth. Net worth is what is left to a non-profit organization when all assets are deducted from all liabilities.
Equation Format: Assets-Liabilities = Net Equity
This is a non-profit organization accounting version of the balance sheet equation.
Let's look at an example of a non-profit organization balance sheet:
The Real World Foundation - Statement of Activities - December 31, 2020
Statement of Financial Position
- Cash and cash equivalents - $3500
- Grants - $6300
- Pledges Receivable - $4800
- Equipment - $1000
- Total assets - $15600
- Accounts payable - $2050
- Long-term debt - $3200
- Total liabilities - $5250
Total net assets= 15600-5250 = $10350
Special items accounted for in non-profit organizations
The financial statements of non-profit organizations are similar to the financial statements of a for-profit company, but certain terms appear only in non-profit organizations.
Let's take a look at them:
- Subscription: A subscription is an annual fee charged by a member of a non-profit organization annually
- Admission Fees: These are fees paid by potential members directly supplied to the Capital Fund
- Donations: Donations are general or specific gifts that an organization receives from an individual or company
- Donation/Endowment Fund: Included in the liabilities section of the balance sheet and related to gifts for a specific purpose
- Sale of old assets: This item normally appears in the receipts section of the receipts and payment account, but the profit and loss from this sale appear in the balance sheet
- Legacy: Legacy is the amount that an organization receives because it was bequeathed by a person and added to a capital fund
- Payment of Fees/Honorarium: Refers to payments for the services of guest performers
- Lifetime membership fee: A lifetime membership fee is a lump sum received by the member and added to the capital stock
- Magazine/Periodical Sales: Due to its recurring nature, this item will appear as revenue in your balance account
- Government Grants: The government supports non-profit organizations through grants
How does accounting of non-profit organizations differ from -profit organizations
Accounting for non-profit organizations is different in the following ways:
- Net worth - Since no non-profit investor takes an equity position, the balance sheet uses net worth instead of equity
- Donor limitations - Net worth is classified as either with or without donor restrictions. Assets with donor restrictions are restricted in use and are often assigned only to specific programs. Assets that don’t have any donor restrictions applied, can be used for any purpose
- Programs -There are non-profit organizations that offer a type of service called a program. Each program is accounted for individually so that you can see the income and expenses of each program
- Management and Administration Costs – These can be assigned as the general overhead structure of non-profit organizations. Donors want to keep this number as low as possible so that funds can be used for services and programs
- Fundraising Costs – These costs can be assigned to funding categories related to non-profit organizations' sales and marketing activities, such as grant proposals, solicitations, etc.
- Annual financial statements – These differ from for-profit organizations. For example, the income statement is replaced by the statement of activities, and the balance sheet is replaced by the statement of financial position. Both for-profit and non-profit organizations produce cash flow statements
- Budgets – These are not necessarily used in for-profit businesses, but are considered an important part of non-profit organizations' accounting. This is because non-profits usually have very limited sources of income and must always have tight control over their spending. As a result, budgets need to be consistently developed based on reasonable sales forecasts, and cost deviations need to be investigated promptly
Non-profit organizations taxes
After preparing annual financial statements, the non-profit accounting needs to straighten its tax obligations. Non-profit organizations are taxed differently than commercial corporations.
In most cases, non-profit organizations can apply to the IRS for a federal tax exemption under Section 501.
1. Section 501 - This is part of a tax law that affects non-profit organizations, charities, and religious groups that are exempt from paying federal taxes to the IRS. Tax exemption status may be determined by IRS and federal law, while non-profit status is determined by state law.
For this reason, the IRS requires you to obtain non-profit status from the state before applying for tax exemption status. After registering as a non-profit organization in your state, the next step is to apply for Section 501 tax exemption.
2. Form 990 - Most organizations that are exempt from income tax under Section 501 are required to submit Form 990 (or Form 990EZ, if applicable). This form exposes the changes in income, expenses, and net worth of non-profit organizations to the public.
The IRS has three tax exemption requirements for non-profit organizations
- Form 1023, for exemption under Section 501©(3) - This applies to "Charity, Religion, Education"
- Form 1024-A, which is for exemption under Section 501©(4) - This exemption is for "Social Services Organizations"
- Form 1024, which is for exemption under Section 501(a) – This exemption is for "Other Tax Exemption or non-profit organizations"
How to Start Accounting in non-profit organizations - Step by Step Guide
Step 1 - The first step in setting up a viable accounting system is to record all financial transactions in non-profit organizations. You can record them in a physical ledger, non-profit accounting software, an Excel spreadsheet, or hire an accounting service to enter the details.
Step 2 - You need to record and organize receipts, payments, transactions, accounts receivable, accounts payable, wages, and salaries.
Step 3 - Indulge in fund accounting
You would need to conduct fund or cash accounting. This means that instead of stacking money into one big "cash" account, you need to distinguish and track money in different buckets. This is important because non-profit organizations often have very specific rules for different sources of funding. Large non-profit organizations, such as universities, may have thousands of accounts, including foundations, scholarships, capital projects, and working capital. These accounts have very different rules about how to use them.
Step 4 - Open another bank account
Do not use your bank account to receive, hold or withdraw funds from non-profit organizations. Make sure that all non-profit organizations' transactions go through a dedicated bank account.
Step 5 - Start collating your bank accounts
Once you have your accounting system and your bank accounts, you need to make sure that the information is the same on both systems. Bank collation with financial statements helps with this. When collating a bank account, you only need to compare each transaction on your bank statement with the transaction listed on your books. This should be done at least once a month to ensure that your books are up-to-date and accurate, to track your cash flow, prevent fraud, and identify bank errors.
Step 6 - Start using the order
Non-profit organizations have strict rules about what they can and cannot spend money on. You need an organized system that ensures that your purchases are properly ordered, budgeted, and executed from the beginning.
Step 7 - Learn how to record donations in kind
Let's say a lawyer volunteers for three hours to consider your non-profit organization's contract. In this case, you must open another income account for the book to donate in-kind and post a donation receipt based on the market value of the donation.
Step 8 - Start budgeting
Most non-profit organizations operate on an annual operating budget. A good budget acts as a roadmap for non-profit organizations, determining where and when your organization is using resources, and whether you're on the right financial track or not. A budget is a financial plan (usually a calendar year) described as a long list containing two main categories: expected revenue sources and expected costs. However, budgeting generally involves four steps:
- To determine what non-profit organizations, want to achieve next year
- To make a realistic estimate of the cost of achieving all these goals
- To estimate your source of income this year
- To change your budget to meet your expectations
All non-profit organizations also need to maintain proper accounting using appropriate measures and following the legalities of accounting. Financial statements help collect donations from current and future donors. In addition, annual accounting helps you receive grants from various authorities. This way, the organizations can understand how the finances are handled, managed, and utilized within non-profit organizations.
- The accounting for non-profit organizations is quite similar to for-profit organizations and operates their businesses using similar business tactics and management techniques.
- However, there are some accounting names, rules, principles, and laws that vary considerably
- All non-profit organizations must comply with government agencies that regulate non-profit organizations at headquarters