A Detailed Breakdown Of Nonprofit Accounting Basics
We’re not going to lie, a lot of you are probably reading this out of obligation because nonprofit accounting is new to you. While this might be out of your comfort zone, you are entirely capable of understanding the basics! Additionally, you will need to understand these concepts to stay in compliance with the state and federal government.
Even if you won’t be the one in the deep-end of excel, speaking the same language as your treasurer, accountant, or software is a necessary evil that will serve you well in the future. As the leader of your nonprofit, you must know exactly where your internal and external contributions are going, not to mention understanding the financial health of your organization.
In this article we are going to be breaking down all of the major concepts you need to know about nonprofit accounting:
- Rules & regulations
- Cash vs accrual
- Reconciling accounts
- Petty cash
- Accounts payable & receivable
- Fixed assets
Rules & Regulations
As is the case for traditional businesses, there are several accounting rules and regulations that must be followed. There are a few that are for all accounting professionals, but some are particular to nonprofit organizations.
Generally Accepted Accounting Principles (GAAP)
The GAAP is a set of rules that detail the legal obligations of business accounting. The U.S. law requires businesses (and nonprofits) to follow their guidelines. They break down into 10 concepts:
Principles of regularity: Accountants must follow established rules and regulations.
Principle of consistency: There are consistent standards applied throughout the financial reporting process.
Principle of sincerity: Accountants pledge themselves to accuracy and to impartiality.
Principle of permanence of methods: Consistent processes are used in the preparation of all financial reports.
Principle of non-compensation: All aspects of an organization’s performance, either positive or negative, must be fully reported.
Principle of prudence: There is no speculation in the reporting of financial data.
Principle of continuity: Asset valuations assume the organization’s operations will continue.
Principle of periodicity: Reporting of revenue is broken down into accounting time periods like quarters or years.
Principle of materiality: Financial reports fully reveal the organization’s monetary situation.
Principle of utmost good faith: All parties are assumed to be acting honestly.
Each state has different regulations on GAAP compliance but it is highly recommended that you use the GAAP system even if not required to do so.
Why? This standardized system allows your financial documents to be understood pretty much anywhere. This is particularly important for lenders, donors and grantors. It also inspires confidence that your financial reporting is accurate and trustworthy which opens the door for lower interest rates on loans. If you are using a software to centralize your management that includes an accounting feature, nearly all of them are already GAAP compliant.
Source: Government Accounting Standards Board
Now that you have the fundamentals down, let’s get to the life of the party, the IRS!
The IRS has provided a document of guidelines that help nonprofits with their compliance.
In the FASB 117 the IRS establishes the standards for external financial documents that will be produced by a nonprofit. It does require the financial documents to provide a certain level of basic information that focuses on the whole organization and meets the needs of the external users who are using said documents. Let’s break that down a bit further:
All nonprofits must provide these four financial statements: A statement of financial position, a statement of activities, a statement of cash flows, and a statement of functional expenses.
All nonprofits are required to classify their assets based on the existence of donor-imposed restrictions. Donor restrictions just mean that the donor wishes their donation is used for a specific purpose. To make this easier, you should break down your assets into three different categories: permanently restricted, temporarily restricted, and unrestricted. You should put this in your statement of activities.
This is the wide scope of the guidelines, be sure to go over the fine print with a specialist to make sure that your organization is financially healthy in the eyes of the state.
Cash vs Accrual
There are two different accounting strategies that you can use when your nonprofit starts making money: the cash method or the accrual method. Both are perfectly capable of keeping your books and have their positives and negatives, you just need to pick which method is adapted to your organization and skill level.
The cash method of accounting is based on the inflows and outflows of cash. To put it simply, income and expenses are recorded when they occur. Income is recorded when it is received versus when it is earned. The same goes for expenses.
A good example of this is booking a venue for a fundraising event. You book a ballroom in December but pay the fee in January. With the cash accounting method, you would record the expense in January when the payment is made, versus December when the payment is incurred.
The cash method works a lot like your personal finances, there is little regard to when revenue was actually earned or when an expense is incurred, you are just focused on the cash flow. This system is certainly the easiest option because you can maintain it on a daily basis. There is one entry per transaction and no calculations to complete.
On the other hand, because of its simplicity, there is a margin for error when it comes to budgeting properly. The cash method tracks limited information and cannot report non-monetary income like in-kind donations. It also fails to foresee potential problems because it is only focused on what cash you have now.
A little more complex than the cash method, accrual accounting focuses on when revenue was actually earned and when expenses were actually incurred.
For example, let’s say you get a donation pledge in May but don’t receive the payment until June. Under the accrual method, you would record the revenue in May when the pledge was made, not when the money arrived in your account.
Pro Tip: The accrual method is used as a standard in the GAAP. If your state is required to be 100% compliant with the GAAP, then you must use the accrual method as your accounting standard.
This strategy is the best way to have a complete picture of what is happening in your organization. This method also allows for more complex information in your financial documents like accruals, allocations, payables, receivables, outstanding obligations, and pledges.
However, the accrual system is more complex and requires two entries per transaction and adjustment if a payment doesn’t come through as planned. It is also more time-consuming and requires a bit more expertise in excel and accounting principles in general.
Which To Choose
The cash method is best used for small nonprofit organizations with very few staff and reduced plans for expansion. If you have a simple setup or are just getting started, this is the way to go! Before using this method, be sure to check your state regulations because some states require the accrual method to be used.
The accrual method is best for organizations with larger amounts of funding, paid employees, and is seeking donations or grants from foundations or the government. It is the generally accepted standard, therefore while it may be more difficult in the beginning, it will be worth it in the long run.
"Balancing your checkbook," a phrase soon to be lost on the younger generations who will have never written a check, nor had to spend an entire weekend balancing their finances on paper. (Are we aging ourselves with this comment?)
In accounting terms, balancing a checkbook translates to "reconciling your accounts" and can either be done manually or by using software to do it for you.
You should reconcile your bank accounts and checkbooks once a month when you get your bank statement online or in the mail. Taking the time to clean up your accounts, make sure you have been paid and have paid others is essential to the health of your organization as it gives you a true picture of how much capital you have on hand.
If you are proactive with reconciliation, your end-of-year financial reporting will be far less complicated and your balance sheet, or statement of financial position, will be far more accurate. This exercise will verify that you are prepared for an audit at any time.
If you don’t have the software to do this for you, here is how to go about it in Excel:
Make a list of the deposits and withdrawals you think you made during the month.
Enter in Excel your bank balance in one column and the expected balance in another.
Compare the deposits on your list to those on your bank statement. Any deposit that is on your list that is not on the bank statement is now qualified as an outstanding deposit. Add them to the bank balance in Excel.
Verify that the bank statement has the same deposits as your list and edit the expected balance in Excel by adding the missing deposits.
Try to find all of the reasons why there could be missing deposits. For example, this could be due to double-entry, deferred payments, human error, or checks that didn’t clear.
Repeat with checks or any other withdrawals, just be sure to subtract any outstanding checks or withdrawals that are on your list but are not on the bank statement from your balance.
Compare the new bank balance to your bank statement. If they match, great! If not, double-check your work, and don’t forget to check for: extra fees, bank fees, credit card fees, interest, bank transfers, wire transfers, or even international fees.
In general, you do not want the same person handling the everyday cash flow to be in charge of the reconciliation, for ethical reasons. If this cannot be avoided, don’t hesitate to ask a board member for the second pair of eyes.
Most traditional businesses and nonprofits alike have a small amount of cash on hand for small, miscellaneous expenses (i.e. stamps, a taxi, small office supplies). These are expenses where a check isn’t beneficial and instead is usually stored in a petty cash account. Your nonprofit determines how much cash should be available and when it is to be restocked.
In general, these funds are stored in a lockbox and are replenished by writing a check for cash at the bank. The entry on the balance sheet should list debit to the organization’s bank account and a credit to the petty cash account.
The normal balance of the petty cash account can vary depending on the size of the organization, but $100 is considered to be a normal amount.
So, what is the most efficient way to handle petty cash?
Name one person responsible for the petty cash fund. They should be in charge of reviewing requests, reviewing and tracking receipts, maintaining the lockbox, and issuing vouchers.
Use the voucher system. Every time someone receives petty cash, a voucher with the amount taken should be signed and placed in the box. If there was a receipt issued for the purchase, that should be attached to the voucher. When the cash in the box is running low, the sum for the vouchers should be calculated and a check should be written for that amount. A summary of the vouchers should be attached check copy. This system will help keep track of the petty cash movements for your general ledger.
Determine what expenses are authorized. Having a running list of the common expenses that petty cash is used for will help answer any questions about when to write a check versus cash. For example, large office supply items like chairs or phone chargers are check-only, while pens, notebooks, and envelopes are available for cash.
While it may seem like an easy task, petty cash and their accounts should not be neglected. Auditors tend to use the petty cash accounts as an example of how your organization manages your internal finances, so be sure to regulate them with the same rigour as you would with your other accounts.
You will record your petty cash transactions in your general ledger. Below is an example of how to record the transactions correctly:
Source: Nonprofit Accounting Basics
Accounts Payable & Receivable
These two concepts are fairly simple (finally, we know). It is easy to understand but more complex to record, but don’t worry, we have examples for you.
To put it plain and simple, accounts payable is what you owe. It is a liability account where the organization records what it owes to someone for goods or services that it received on credit.
For example, you get an invoice for $300 of office supplies like computer screens. When you receive the invoice, it gets recorded as a debit. When the bill is paid, you add this transaction as a credit.
This should appear on your balance sheet, also known as your statement of financial position under the “current liabilities” section.
Source: Nonprofit Accounting Basics
As you might have guessed, accounts receivable is the opposite of payable, therefore, it is what is owed to you. It refers to the outstanding invoices you have given in return for a product or service. For nonprofits, we are talking more about donation pledges.
As a general rule pledges or donation promises are not recorded unless there is some sort of official statements like a signed pledge card or award letter. These documents should state the exact amount pledged as well as the timeframe in which they expect to proceed with the payment.
For example, your organization is awarded a $5,000 grant from a foundation in March. The foundation sends you an award letter with the amount disclosed and promises to pay by the end of the month.
This should appear on your balance sheet as follows:
Source: Nonprofit Accounting Basics
For a quick reminder, an asset is defined as an owned resource from which future economic benefits are expected. On any balance sheet, traditional businesses and nonprofits alike, the carrying amount of all assets is reported. Assets are broken down into two categories on the balance sheet: current assets and fixed assets.
Current assets are all assets that have a lifetime of under a year.
Fixed assets are recorded when an organization purchases items that have a useful life of more than one year. Be careful here, your organization needs to determine at what cap an item qualifies as a fixed asset versus a regular expense. A small nonprofit can qualify this of a purchase over $500, for example.
Fixed assets can be broken down into two categories:
Furniture & equipment
Real property can include things like land, buildings, large items from collection, vehicles, and machinery.
Furniture and equipment are pretty straightforward but can include things like computers, desks, chairs, and printers.
Now that you are clear on what a fixed asset is, let’s use that knowledge to dig into depreciation.
So what is depreciation exactly? It is the process of recording the use of an item by your organization over its lifetime until the value of the item is zero.
Once something has been recorded as a fixed asset (like a desk), its life duration needs to be determined so that depreciation can be calculated and recorded.
While there are many methods of depreciation, nonprofits most often use the straight-line method. It is a fairly easy concept to understand as the value of the item (aka, your desk) is split evenly over the lifetime of the item.
Let’s give an example to make it more clear. Let’s say you buy your desk for $300 and you determine its lifetime to be 3 years. Each year, $100 is recorded as depreciation.
You record depreciation in the statement of activities (income statement) and statement of financial position (balance sheet). In your balance sheet, depreciation should be recorded just below the fixed assets line. In the income statement, depreciation is recorded either as a program expense or a supporting services expense.
Once a fixed asset is thrown away, donated or sold, it should be no longer included in your bookkeeping.
Find an example below of how to record depreciation in your external financial statements.
Source: Nonprofit Accounting Basics
Payroll can be a complex subject, especially for nonprofits where every cent counts. While this can be done in-house, we highly suggest having a verified accountant that practices in your state review your payroll processing.
Payroll is not just moving funds from one account to another but must include all of the details that make up that amount. This includes topics like:
Both federal and state payroll taxes
Deductions for benefits (like public transportation, for example)
The final amount taken out of your nonprofits bank account
As a nonprofit, you have the choice to pay your team on whatever schedule suits you. The most common periods are paying weekly, biweekly, semi-monthly, or monthly.
If you are going to externalize your payroll, don’t hesitate to ask the filer to file both state and federal tax forms for you. This will save you a lot of headaches when it comes to nonprofit tax filing season for you and your employees. We highly recommend taking this avenue as most banks provide payroll services (or can recommend one) and they are often cheaper than hiring a person to do so.
Pro Tip: If you externalize your payroll service they often require that you have funds to cover two to three months of salaries.
If you have read through the rest of this article and thought, "I’m lost" then luckily, there is a solution that does not require shelling out thousands of your precious resources on a dedicated CPA.
There are many accounting software options available for nonprofits and for all skill levels. Using software is beneficial for many reasons, but mainly because many of the small tasks are done automatically for you and you avoid human errors like double entry. They help with tasks like:
Incoming & outgoing payments
Donation & membership management
Of course, software isn’t an end-all-be-all solution and is only as good as the information that you put into it. If you are truly new to nonprofit accounting, we highly recommend that you have a dedicated treasurer for your nonprofit put into place to be in charge of choosing, updating, and maintaining your software.
Before jumping headfirst into the first system that comes up in your google search, be sure you know exactly what you are looking for by asking yourself and the software representative these questions:
What is my budget?
Do I have to pay annually or is there a monthly option?
Pro Tip: If you pay annually for a software, they often provide a discount!
How easy is it to use?
Is there training included?
What kind of support is available? (Phone, email, live chat)
What do I want to accomplish while using this software?
What do I not need?
What is my "perfect" software?
Does this software integrate with other systems (like a database system, for example).
Can you have a free demonstration of the product?
What extra options are there? (Data import, premium support)
Once you have the answers to these questions, you will have a much clearer image of what your needs are, and what your wants are. Your needs are what you absolutely must-have for your software, and if you don’t have them they are considered deal-breakers. The wants are all of the extras that you would like to have (i.e. automatic bank reconciliation). The perfect software is that which answers all of your needs and most of your wants.
We hope this article gave you a helpful introduction to nonprofit accounting! You are now fully prepared to dive into Excel (or your new software) and make your treasurer proud. Let us know if you have any questions in the comments.