At Ben’s first meeting as a new member of the board of directors for a nonprofit, he discovered that he needed help. As he sat listening to the executive director, Ben realized that his knowledge of business accounting hadn’t sufficiently prepared him for his role as a board member of a charitable organization.
During the meeting the executive director did not discuss profitability; rather, she referred to achieving the organization’s mission. And Ben heard terms that were unfamiliar to him, such as statement of financial position and statement of operations. He knew that although the executive director and her staff handled daily financial matters, as a director he was responsible for the organization’s financial wellbeing. By now, however, he was not confident that he had a clear understanding of budgeting, accounting and financial reporting for this organization.
Ben’s situation is quite common. Many staff and volunteers who transition from the for-profit to the nonprofit world face a learning curve when it comes to accounting matters. Following are some of the key differences that are important to know.
Different users, different needs
First of all, it’s helpful to differentiate between for-profit and not-for-profit (nonprofit) entities. A for-profit organization is exactly that: an individual, partnership or corporation that carries on business for profit. The parties that are typically interested in the finances of a business entity include management, shareholders, investors, lenders, tax authorities, suppliers, and, in the case of public companies, the general public.
The Canadian Institute of Chartered Accountants (CICA), which establishes accounting guidelines for both types of entities, defines not-for-profit organizations as: "entities, normally without transferable ownership interests, organized and operated exclusively for social, educational, professional, religious, health, charitable or any other not-for-profit purpose. A not-for-profit organization's members, contributors and other resource providers do not, in such capacity, receive any financial return directly from the organization."
The differences are significant. Whereas business stakeholders are concerned with the bottom line, stakeholders of a nonprofit organization are concerned about the appropriate utilization and allocation of resources based on its mission. Nonprofit accounting is therefore focused on tracking the contributions made to an organization and how these are spent. Thus financial statements prepared for business purposes do not provide meaningful information for nonprofit stakeholders who are usually quite different than for-profit stakeholders. They may include board members, government agencies, members, contributors, volunteers, the general public and others. The CICA has therefore developed special accounting rules for nonprofits.
The principle of Generally Accepted Accounting Principles
The CICA is also responsible for developing Canada’s Generally Accepted Accounting Principles, usually referred to as GAAP. These are accounting rules that are used to standardize the reporting of financial statements. Most profit and nonprofit organizations comply with GAAP. For the latter, doing so reassures a nonprofit’s stakeholders that the organization’s financial reports accurately reflect its financial position. As well, a nonprofit must follow GAAP in order to obtain an unqualified audit opinion from a chartered accounting firm.
Fund accounting for nonprofits
The key difference in for-profit and nonprofit standards is the concept of fund accounting, which focuses on accountability rather than profitability. Whereas a profit entity would have a general ledger, which is a single self-balancing account, nonprofits typically have a number of general ledgers, or funds. This accounting framework enables these organizations to separate resources into various accounts in order to identify individual sources of funds and their use.
Nonprofit accounting records therefore represent a collection of funds, each of which have a different purpose and must be individually balanced. This provides a method of accounting segregation, although not necessarily a physical segregation, of resources. Financial reports subsequently detail expenditures and revenues for each fund and also summarize financial activities across all funds.
This is quite different than financial reports for business, which may retain individual revenue and expense accounts, but typically blend balance sheet accounts. Moreover, business financial statements focus on net income, return on investment and meeting lending covenants.
Different concepts and terminology
Beyond the concept of fund accounting, there are many other subtle accounting differences between for-profit and nonprofit entities, including differences in the concepts and terminology used for financial statements. Some common ones are listed below.
|Income statement or statement of operations
||Statement of operations
||Statement of financial position
|Statement of retained earnings
||Statement of changes in net assets
||Excess of revenues over expenditures
|Statement of cash flows
||Statement of cash flows (same)
|Revenue and expenditures
||Revenue and expenditures (same)
Nonprofit accounting is based on the premise of calculating changes in assets available for future services. This change is captured in the statement of operations, whereas a for-profit entity uses an income statement. Revenues represent an increase in assets available for future services and expenses represent a decrease.
There is another significant difference between profit and nonprofit organizations when it comes to revenue. Like a for-profit entity, a nonprofit can have earned revenue from such sources as selling goods, providing services or receiving rent, interest, or royalties from the use of its resources. Unlike a business, however, a nonprofit also receives revenue from direct contributions such as donations and grants. Nonprofits may use one of two optional accounting methods to recognize revenue from these contributions.
- The deferral method recognizes revenue when expenses directly related to the revenue are incurred.
- The restricted fund method segregates funds based on the type of restriction the contributor of the funds places on their use: unrestricted, temporarily restricted or permanently restricted.
- Unrestricted assets have no external restrictions and are available for general use; these typically include general operating funds and donations or grants without any constraints.
- Temporarily restricted assets have donor-imposed restrictions based on a defined period of time or the performance of defined activities. These might include, for example, a grant received to run a specified program or a donation to support a specific project. These donations may be used after the time period elapses or the event takes place.
- Permanently restricted assets are restricted by the donor for a designated purpose or a time period that never expires. An endowment would be an example, where the principal is retained as an ongoing investment and interest and investment returns are used for specified purposes.
Under the restricted fund method, contribution revenue is generally recognized in the period contributions are received, however the classification is essential to determining how these contributions are accounted for since there are special rules that apply to each.
There are some other key differences between profit and nonprofit accounting. A for-profit entity, for example, has a balance sheet indicating the availability of assets for distribution to shareholders as retained earnings. A nonprofit, on the other hand, has a statement of financial position that calculates total assets on hand and the availability of those assets for future services, or net assets.
The statement of changes in net assets (statement of net earnings for a profit entity) depicts how unrestricted, temporarily restricted and permanently restricted net assets have changed from one period of time to another.
Timing is everything
Timing obviously plays a very important role in nonprofit accounting. Not only is it significant in recognizing revenue and expenditures, but it is also critical in monitoring the financial performance of the organization. The timely development and monitoring of the annual budget, for example, ensures proper accountability and transparency and safeguards the rights of all stakeholders. The board should meet with management at least quarterly to compare the budget with actual revenues and expenses in order to ensure the organization is effectively carrying out its mission.
Regularly comparing the statement of operations, the statement of financial position and the statement of changes in net assets with the budget (and with the same statements from the previous year) also enables the board and management to identify significant trends or emerging problems and to develop appropriate solutions. This is a role that’s equally as important for profit as well as nonprofit organizations.
Finally, most nonprofits hold an annual general meeting where the financial statements are approved by the members. The timing of this meeting is usually set by the board and typically takes place a couple of months after year-end once the audited financial statements have been completed. While an independent professional auditing firm examines the organization's statements and supporting documents and provides an audit opinion, management and the board have an important duty to review and question these documents. After all, these audited statements serve to provide reassurance to a nonprofit’s stakeholders of the transparency and integrity of its financial information.
And so, the value of nonprofit accounting lies in providing meaningful information that tracks revenue and expenditures in the relevant funds and allows stakeholders to make appropriate decisions. Whereas business stakeholders are generally concerned with profitability and the bottom line, stakeholders of a nonprofit organization are concerned about the appropriate utilization and allocation of resources to achieve its mission.
When a nonprofit welcomes new staff members or directors like Ben who are unfamiliar with these vital differences in for-profit and nonprofit accounting, offering the appropriate orientation can help to transform an organization’s financial struggles into "mission accomplished."
Stephen Meade, CA, is a senior manager of BDO Canada LLP. He provides auditing, accounting and advisory services to both nonprofit and for-profit organizations. You can reach Stephen at (905) 272-7819 or email@example.com.