Not-for-Profit Accounting (Encyclopedia of Business and Finance)
The terms "not-for-profit," "nonprofit," and even "nonbusiness" have been used to describe organizations that have one basic characteristic in common: Their primary purpose is related to social objectives, not to profit. These organizations may also have other common characteristics, such as nonprofit tax status, an appointed board, and for some, oversight of their operations by a governmental agency. Examples of such not-for-profits (NFPs) include libraries, museums, performing arts organizations, zoological and botanical societies, trade associations, unions, professional associations, fraternal organizations, private and community foundations, voluntary health and welfare organizations, social and country clubs, religious organizations, and public broadcasting stations.
State and local governments are not considered to be part of this group, although the accounting practices for some NFPs may be the same as those used by state and local governments as a number of NFPs are part of a state or local government.
BUSINESS MANAGEMENT OBJECTIVES
These have a broader focus than traditional for-profit company management goals and objectives. The comprehensive management of NFPs incorporates a wide range of goals beyond the generation of profits. Evaluative measures closely related to profits, such as return on investment and earnings per share, are not relevant to the managers of NFP organizations.
Yet, simply meeting annual budget targets does not mean an NFP is successful. In fact, it could mean just the opposite if financial goals have been achieved through the minimization of important social and customer goals. Like for profit organizations, NFP management methods should begin with a mission statement and incorporate sets of interrelated goals that clearly relate the performance of numerous organizational activities back to the mission. Unfortunately, many times the evaluative focus is largely based on financial measures.
One recognized management method that uses a diverse approach beyond just financial measure for evaluating organizational performance is the balanced scorecard (BSC). BSC ties performance objectives together within the per spectives of the customer/client, financial, learning and growth, and internal business processes. Although traditional financial goals are in the mix, client needs, employee learning and growth, and the analysis of unique internal business pro cesses take on equal importance with financial goals. The BSC links short-term goals to a long-term strategy guided by the organization's mission statement. These four areas are linked with objective performance measures that support one another. The BSC is an example of a management method that uses more than bottom-line or budget criteria in guiding the performance of organizations. Such a method is particularly pertinent to nonprofit organizations with a wide range of objectives beyond traditional financial ones.
Clearly there is an underlying difference in NFP measures of performance when compared with similar for-profit measures. For example, financial concerns for an NFP may be focused on flexibility of resource usage rather than return on investment. Since NFPs may work with client caseloads, a performance measure may be related to the number of documents processed or response time tied to measures of customer satisfaction. Employee growth measures might relate to training levels or measures of expanding growth in job skills. Evaluations of internal business processes might trace the employee training to its innovative effect on older programs and the introduction of successful new programs.
NFP ACCOUNTING STANDARDS
These standards are established by the Financial Accounting Standards Board (FASB) or the Government Accounting Standards Board (GASB). Additionally, the American Institute of Certified Public Accountants (AICPA) influences the accounting for nonprofit organizations with its industry and accounting guides and Statements of Position (SOPs).
It may appear that the accounting methods used by NFPs are the same among all of them. Currently, this is not the case, however, because NFPs can be considered either "governmental" or "nongovernmental" NFPs for accounting purposes. The distinction is important because it affects the generally accepted accounting principles (GAAPs) to be followedodified accrual for "government" organizations and accrual for "nongovernmental" organizations. Even among organizations classified "governmental" NFPs, the methods of accounting may differ.
A governmental NFP has one or more of the following characteristics (American Institute of Certified Public Accountants, Not-for-Profit Organization, par. 1.03, New York: AICPA, 1996):
- Popular election of officers or appointment (or approval) of a controlling majority of the members of the organization's governing body by officials of one or more state or local governments.
- The potential for unilateral dissolution by a government with net assets reverting to a government.
- The power to enact and enforce a tax levy.
One of the most common characteristics that result in an NFP's being classified as a governmental NFP is that a majority of its board is appointed by a state or local government.
There are three different GAAP methods of accounting used to prepare financial statements for a nonprofit organization, depending on how it is classified. The choices are business accrual, nonprofit SOP accrual, and modified accrual. Governmental NFPs may use nonprofit SOP accrual or modified accrual methods of accounting. They would use nonprofit SOP accrual if they had been previously applying an SOP for nonprofit organizations or health and welfare organizations and decided to continue to use this method. These organizations have a choice of using either modified accrual or nonprofit SOP accrual.
The standard-setting organization that establishes modified accrual accounting standards for NFPs is the GASB. Nongovernmental NFPs follow the business accrual methods that are used by corporations. These accounting standards are set by the FASB. It should be clear that there are both governmental museums and nongovernmental museums, for example. This governmental/nongovernmental division is present among other NFPs, too. Therefore, if resources used in a program, for example, are compared between governmental/nongovernmental NFPs without adjustments for the accounting method in use, there can be serious misinterpretations.
There are other differences. Under accrual accounting for nongovernment NFPs, the Statement of Activities (income statement) uses the term "net assets" in place of "excess" or "deficiency," as is the case under modified accrual. Corporations call this the "net income." Typical revenue and expense items are included in the Statement of Activities, but nongovernmental NFPs also includes increases and decreases in restricted assets. Restricted assets are received grants or donations for which the organization has not completed its obligations under the grant or donation requirements. Thus, changes in restricted grants or donations are included in the calculation of net assets, whereas the excess or deficiency in a modified accrual statement for a governmental NFP does not include these items.
As an example, assume that Nonprofit A, a nongovernmental NFP, receives a restricted grant, and at the same time Nonprofit B, a governmental NFP, gets the same restricted grant. Under modified accrual accounting, the restricted grant is considered to be a liability because the terms of the grant have not been fulfilled. Under accrual accounting, it is not considered a liability; instead it is recorded as a revenue item. Under accrual concepts, the restricted grant is considered to be temporarily restricted, but its restrictions are assumed to be removed when expenditures are made under the grant. Because total revenues are different in the two hypothetical NFPs, the balances transferred to their respective balance sheets are also different.
On the balance sheet, another important difference is that the term "fund balance" is not used on an accrual-based balance sheet for a nongovernment NFP but is used on the balance sheet of a governmental NFP. A fund balance develops as a result of the difference between assets and liabilities. It represents the residual between those account groupings. For most funds, the balance in the Fund Balance is a source of additional appropriations. In the balance sheet for a nongovernmental NFP, the residual is termed "net assets." Net assets are a residual between assets and liabilities, but there is a difference. First, net assets are divided into unrestricted, temporarily restricted, and permanently restricted amounts. Permanently restricted net assets are those with a donor-related stipulation restricting the donated resources from being used and allowing only the income earned on the balance to be used. Temporarily restricted net assets are those donations that can be used for spending after the expiration of specific actions or the occurrence of a specified event. The remaining net assets are classified as unrestricted and include those resources that are typically found in the Fund Balance.
These classifications do not appear in the Fund Balance for a governmental NFP where all reserved amounts in the Fund Balance have been determined by the direct internal actions of managers, not by the external actions of granter or donors. Consequently, the Fund Balance reflects the summation of the appropriation process occurring inside the organization. Under modified accrual, the classifications within the Fund Balance show the restrictions on available spendable resources only. Reserve for Encumbrances and Designated Funds are examples of managerial restrictions of previously received appropriations that remain unexpended. Here, restricted grants are recorded as liabilities rather than as part of the residual, that is, the Fund Balance. This difference in the two methods is related to differing views about the resources that are actually available for spending.
Another difference between the methods is that accrual accounting for NFPs does not strongly support the fund concept whereby assets and related liabilities are grouped into self-balancing funds. Rather, accrual for NFPs views the entity's assets as being part of one entity rather than as separately grouped accounts for each fund. Modified accrual divides the organizational accounting activities into a series of separate funds that are viewed as separate entities within the organization. Separate funds make it easier to ensure that restricted monies and appropriations are being properly expended.
Obviously, the two methods support diverging accounting viewpoints. Accrual methods use a for-profit income measurement perspective that emphasizes proper matching of revenues and expenses within the correct time period. Modified accrual accounting emphasizes showing the amount of funding that is available for spending and clearly identifying that such funding has been properly used for the purpose for which it was intended. Thus, modified accrual does not emphasize profit determination, but rather fund availability and fund flows for expenditure purposes. The two systems do not even use the same terminology to refer to expended resources. Under accrual, the term "expenses" is used; whereas under modified accrual, the term "expenditures" is used.
Although both accrual and modified accrual accounting require a Balance Sheet and Income Statement, nongovernmental NFPs require a third financial report. For these organizations, a Statement of Cash Flows must be prepared. This statement shows how cash flowed into and out of the organization and analyzes the events that caused an increase or decrease in the cash balance from the beginning to the end of the year. Cash changes are shown as cash inflows or outflows from operations, investing activities, and financing activities. Operations are considered to be cash received from normal business operations with adjustments for the effects of depreciation, changes in receivables, payables, gains or loss on the sale of assets, and capital additions, for example. Investing activities refer to cash transactions such as sale of equipment, investments, or the purchase of buildings and equipment. Cash transactions related to obtaining or paying off notes, expired endowment transfers, and cash interest payments are considered financing activities. These three groupings help determine which types of activities are generating the cash inflows or causing cash outflows in the nongovernmental NFP.
With an accrual system, it is necessary to prepare a Statement of Cash Flows, too. Under modified accrual methods, this statement does not have to be prepared because modified accrual methods already closely correspond with cash methods.
Within this accounting framework of accepted accounting practices for NFPs, there are several real-world practices that are common. First, the small NFP of a larger government is usually considered to be a component unit of that larger governmental body. As a component unit, its financial reports may or may not be separately reported outside the larger governmental unit. In fact, the financial report produced for the NFP by the larger governmental unit may be aggregated with other component units. Consequently, the NFP's internal staff may prepare only separate financial reports issued by the NFP. As a result, the cash method of accounting may be in use. Unless these financial reports have been audited, there is little indication that they have followed GAAP.
The cash basis of accounting for NFPs is not considered to be GAAP, but the cash basis should not be ruled out immediately. If there is no significant difference between the cash system and one of the other methods of GAAP reporting, the cash basis may be acceptable to use. As a result, a fourth method of accounting may be acceptable for use.