Nonprofits are companies whose primary goal is supporting a specific mission, rather than generating profit for their owners and shareholders. Many focus on charitable, religious, scientific or educational goals. They account for a significant portion of economic activity, contributing 5.6% of U.S. Gross Domestic Product (GDP).
Because of their dedicated focus on charitable missions, nonprofits usually get generous tax breaks and attract funding from other organizations and from the public. But those benefits also result in accounting challenges. Nonprofits must comply with specific accounting rules, regulations and tax requirements. They must maintain financial transparency, carefully tracking the contributions they receive and showing how they use those contributions to further their mission. Keeping track of nonprofit finances isn’t easy, given the complexity and the fact that many nonprofits have very limited resources. These 17 best practices for nonprofit accounting and bookkeeping can help.
- Nonprofits must comply with specific accounting rules, regulations and tax requirements.
- Rigorous internal controls can help maintain financial accuracy and transparency.
- Focusing on budgeting and forecasting helps nonprofits create a realistic picture of finances and adapt to changing conditions.
- To comply with accounting rules, nonprofits must track all cash and in-kind contributions and produce specialized financial statements.
- Nonprofits must file returns annually to maintain tax-exempt status, in addition to managing other potential obligations, such as payroll taxes and tax on what the IRS calls “unrelated business income.”
17 Nonprofit Accounting Best Practices
The following accounting best practices can help nonprofits comply with regulations and maintain the trust of donors. Those are vital goals: Nonprofits need to comply with IRS rules in order to maintain their tax-exempt status, and they need to show that they use contributions responsibly in order to win continued funding from donors. These 17 best practices for nonprofit accounting cover a wide range of areas. They include establishing the right internal controls, following specialized nonprofit accounting rules and tax requirements, careful budgeting and planning, tracking financial and nonfinancial contributions, and choosing the right accounting system.
Establish rigorous internal protocols.
Accuracy and transparency in accounting are vital for nonprofits, not just for regulatory and tax compliance reasons but also to maintain the trust of donors and other stakeholders. Clear protocols and internal controls play a critical role in achieving those goals by helping prevent mismanagement, errors and fraud.
Creating written policies and protocols helps everyone understand exactly how to perform everyday bookkeeping tasks like recording donations and expenses. By ensuring that financial processes are performed correctly and consistently, rigorous protocols simplify analysis of the nonprofit’s financial position and detection of any anomalies. Of course, it’s not always easy to find the time to document procedures, especially for small nonprofits. But remember: Creating documentation also makes it easier to train new employees — and volunteers, if necessary.
Recruit individuals with strong ethical principles.
Ethical behavior is crucial to maintaining the organization’s reputation, not to mention the trust of stakeholders. Nonprofits are often held to a higher ethical standard than for-profit companies, and even a single ethical lapse can result in long-lasting reputational damage. That’s why it’s so important that every hire has strong ethical principles. The vetting process should go beyond interviews to include thorough background checks for all new hires and interns. In addition, many organizations develop a code of ethics that demonstrates the organization’s commitment to upholding its values — and serves as a constant reminder to employees about how they should behave. For example, an organization may emphasize that it will not accept contributions from donors that are not aligned with its mission.
Distribute financial duties among multiple personnel.
Internal financial controls help prevent and detect errors, such as unauthorized spending, theft and fraud. Segregating financial duties is one of the most basic financial controls. The goal is to safeguard against any single individual gaining too much control over transactions by making sure that the steps required to complete financial processes are divided among two or more people. For example, organizations may require that one person pays invoices but a different person must approve them. Many organizations require that two people sign checks. Other important financial controls include access controls to accounting software, delegated authority thresholds, audit trails, internal and external audits and account reconciliations.
Ensure complete independence of the Board of Directors from the organization.
The board of directors plays critical roles in a nonprofit’s success. In addition to setting strategic direction and hiring the nonprofit’s executive director, the board typically has responsibility for financial and legal oversight. That includes ensuring that the organization remains financially stable and manages money in accordance with its mission. To facilitate effective financial oversight and prevent conflicts of interest, it’s essential that the board remain independent from the organization’s management and employees — including any founders, who are usually among the people most passionate about an organization’s mission. Board members should work in the best interests of the organization, not in their own personal interest. If a board member has a personal interest in a transaction, that personal stake may undermine the member’s ability to act in the best interests of the organization. For that reason, many nonprofits have policies that prevent employees from also being board members.
Adhere to established accounting standards.
U.S. nonprofits manage their financial operations and report their finances based on the Generally Accepted Accounting Principles (GAAP) defined by the Financial Accounting Standards Board (FASB). The rules for nonprofits differ from the rules that apply to for-profit companies because nonprofits have specific accountability and transparency requirements. The FASB defined specific standards for nonprofit accounting in 1993 with the introduction of Statement of Financial Accounting Standards (SFAS) No. 116 and SFAS No. 117, which cover the ways that nonprofits record and report revenue and expenses. For example, nonprofits must be able to track whether there are specific conditions or restrictions attached to grants or endowments. Their financial statements also differ from those produced by for-profit companies. FASB periodically updates the standards for nonprofit financial reporting. In 2016, for example, the FASB issued updated guidance — Accounting Standards Update (ASU) 2016-14 — that aimed to simplify the presentation of nonprofit financial statements. ASU 2018-08 was issued two years later, in part to ensure more uniform reporting of conditional and unconditional grants.
Craft an operating budget.
Budgeting can be difficult for nonprofits because funding is often uncertain. But every organization needs an operating budget based on anticipated revenue in order to plan hiring and other expenses. So it’s important to create a detailed budget that shows all sources of funding, together with fixed and variable expenses. Creating a budget forces the organization to make practical spending decisions and provides a financial management blueprint. Once you’ve created the budget, revisit it frequently during the year to verify that the organization is on track to meet its financial goals or determine whether adjustments are needed. Given the financial uncertainties, it’s wise to maintain enough cash reserves to support the organization’s operating expenses for several months, if necessary. The budget typically should be seen and approved by the board of directors.
Invest in accurate forecasting.
Forecasting differs from budgeting in that it’s about predicting whether budgets and financial targets will be maintained, as opposed to determining how to allocate the funds already available. Financial forecasting is even tougher for nonprofits than for most for-profit businesses because a complex set of factors can play into how much income the organization can expect to receive. Competitive grants may or may not be won. Macroeconomic trends can influence the amount of individual donations and affect payment of membership fees. Still, without good financial forecasting, it’s hard to plot the organization’s future and invest in new programs and hires. That’s why many organizations invest in forecasting software, which takes into account multiple factors when generating forecasts, including historical patterns and current trends.
Using forecasting software also makes it much easier to continually adapt the forecast to changing conditions. Arbor Research Collaborative, a nonprofit that conducts disease analysis and research, implemented a planning and forecasting tool to improve its financial visibility and analysis capabilities. The tool’s functionality and integration with other software saved the three-person accounting team roughly 40 hours a month — freeing the nonprofit to devote more time to its core mission.
Establish realistic fundraising objectives.
When people are passionate about an organization’s mission, it’s easy to become overly optimistic about its ability to attract funds. But it’s important to stay grounded and set realistic goals — otherwise, a nonprofit may run into operational problems farther down the line. Take a critical look at past fundraising performance, including overall success rates, as well as where you’ve been most successful and where you need to improve. Examine potential funding sources and consider which other organizations are likely to be competing for those funds. Keep an eye open for events that can dramatically affect the funding picture, such as an economic downturn. If you’re planning to use new tactics or fundraising tools, it makes sense to establish conservative goals for how much they’ll bring in, at least until you see how they perform in action. During the year, keep a close eye on your fundraising performance, and don’t be afraid to adjust goals based on reality.
Formulate a long-term strategic plan.
If you want your nonprofit to continue to flourish in coming years, you need a long-term strategic financial plan. A long-term plan is valuable for both internal and external use. If you’ve identified your income targets three or five years out, you can use the information internally to determine when to execute any changes needed to support that growth, such as hiring staff. You can plan the programs that will become possible with receipt of the funds. Creating a realistic strategic plan is also valuable externally because it demonstrates your long-term commitment to your goals. That can help build the organization’s credibility and attract funding.
Monitor donations and in-kind contributions.
To comply with GAAP accounting rules, nonprofits must closely track all contributions. This can become extremely complex. For example, nonprofits often receive in-kind contributions, as well as cash donations. They need to record both types — and clearly distinguish between them. In-kind contributions may include tangible goods, like computers, or services, like pro bono work by accountants or other professionals. Adding to the complexity, some organizations receive grants or donations that are conditional on meeting specific requirements and should be recognized as revenue only when those conditions are substantially met. In addition, nonprofits need to track how their contributions are used to support their mission. For example, if money is donated for a specific program, it’s important to keep track of the funds to verify that they’re used appropriately for that program.
All of this requires nonprofit accounting expertise and careful tracking, which is why specialized nonprofit accounting software can help. Art in Action, a nonprofit that offers art materials and educational resources to schools, was spending countless hours manipulating spreadsheet data to track the efficacy of each grant-funded program. By adopting enterprise resource planning (ERP) software donated under the Oracle NetSuite Social Impact program, Art in Action was able to automate grant allocation and efficacy reporting, ship supplies to students faster and close the books 10-15 days earlier than before.
Nurture relationships with other departments.
To provide the most benefit to the organization — i.e., to provide the clearest picture of its finances — it’s important that nonprofit accountants maintain close relationships with other departments. You’ll need to work closely with other groups to create accurate budgets and forecasts and to monitor whether revenue and expenses stay on track. Regular meetings with these teams also provide opportunities to explain the importance of accurate accounting and yield insight into how to be certain that all transactions, including income and expenses, are accurately recorded. Gaining a detailed understanding of how other departments work also helps validate that the organization’s financial statements accurately reflect its activities, cash flow and assets.
Employ an experienced nonprofit bookkeeper.
Given their often limited resources, nonprofits sometimes assign bookkeeping tasks to staff who lack accountancy training or to inexperienced volunteers, which can lead to problems, because accurately recording revenue and expenses is complicated and it’s important to get it right. For example, bookkeepers must understand that grants may come with specific conditions about how the funds should be used. It’s essential that expenses are correctly assigned to grants and are accurately documented in compliance with any restrictions. Making errors can lead to serious problems with donors. Major accounting errors could even endanger the organization’s tax-exempt status and overall viability. So, even for smaller organizations, it pays to use an experienced bookkeeper who already understands how nonprofits operate, even if a part-time contractor or other type of fractional employee.
Maintain an accurate ledger.
An accurate ledger is a critical tool for tracking the organization’s finances, complying with regulations and perfecting financial reporting. An experienced bookkeeper will make sure that contributions and expenses are recorded promptly and accurately — no more bundles of receipts lying around the office for weeks. That helps the board, as well as staff, gain a clear, up-to-date view of the organization’s financial position. Accounting accuracy adhering to GAAP’s special “fund accounting” rules for nonprofits also helps demonstrate the organization’s financial transparency and accountability to donors and the public. Well-documented, accurate transaction records make it easier to generate financial statements, comply with grant requirements and file the forms required to maintain tax-exempt status.
Keep your accounting system up to date.
Maintaining an up-to-date accounting system requires more than just entering transactions promptly. It also means making sure your software is up to date. Federal and local tax requirements can change from year to year, and accounting rules also change periodically. Using out-of-date accounting software can expose nonprofits to the risks of noncompliance with tax and regulatory requirements, which could jeopardize their tax-exempt status. In contrast, the accounting trend toward newer, cloud-based solutions has gained steam, in part, because these systems are automatically updated to accommodate changes to tax laws and accounting rules. Cloud-based systems also include features typically lacking in older accounting software products, such as real-time analytics, personalized dashboards and easily customizable workflows.
Understand the tax laws relevant to nonprofits.
Nonprofits typically operate under section 501(c) of the Internal Revenue Code, which exempts the organization from paying federal income tax, as long as all of its operations are directed to an appropriate mission, such as a charitable, religious or educational purpose. However, nonprofits still may be liable for other taxes, so they need to understand the laws that apply and to manage the associated accounting challenges. For example, if a nonprofit has employees, it needs to pay federal and state payroll taxes for them and report employee wages and taxes to the IRS. Nonprofits also may be liable for state and local taxes, such as sales and real estate taxes, depending on where they operate. In addition, if a nonprofit generates income from sales or other work unrelated to its mission, it may be subject to unrelated business income tax (UBIT) on net income, calculated at the federal corporate tax rate.
Prepare timely financial statements.
Nonprofits must produce timely, accurate financial statements annually. In addition to providing a clear picture of the organization’s finances, detailed financial reporting demonstrates accountability and helps build trust with the board and other stakeholders. Financial information from these statements goes into the organization’s annual forms filed with the IRS. Nonprofits may also have to produce financial statements for other reasons, including complying with grant program requirements.
Nonprofits must produce specialized financial statements to comply with GAAP accounting rules specific to the nonprofit sector. Most of these statements are similar to those produced by for-profit companies, but the names of the statements and some of the details differ.
- Statement of Financial Position is the equivalent of a for-profit company’s balance sheet; in fact, it is sometimes simply called a balance sheet. It lists the company’s assets and liabilities, as well as net assets (assets minus liabilities). It must separate assets with donor restrictions from those without restrictions.
- Statement of Activities is the nonprofit equivalent of an income statement. It provides a categorized list of revenues and expenses, as well as the change in net assets (revenues minus expenses) — the equivalent of a for-profit business’s net income or loss.
- Statement of Cash Flows shows the cash inflows and outflows (also called sources and uses) of cash in an organization, organized into three categories of activity: operating, investing and financing. The equivalent for-profit statement goes by the same name.
- Statement of Functional Expenses is unique to nonprofits. It provides greater detail about how the organization spends money, breaking down expenses by both “function” and “nature.” The function classification groups expenses based on their purpose, such as fundraising or program services. The nature classification is based on the type of expense, such as salaries or rent.
Utilize nonprofit accounting software.
Accounting software designed for profit-making companies typically can’t handle the unique requirements of nonprofits. That’s why it is important to use accounting software specifically designed for nonprofit use. For example, the accounting software should be able to produce the GAAP-compliant specialized financial statements required of nonprofits. It should track restricted and unrestricted contributions and show how those funds are used and whether all conditions are met. For example, many nonprofits rely on grants that come with specific conditions; the software should be able to track all program expenses related to each grant and verify that spending matches the conditions of the grant. Good nonprofit accounting software automates these processes, saving enormous amounts of time and labor.
Managing Nonprofit Tax Obligations
Careful management of nonprofit tax obligations is essential to avoid penalties and eliminate the risk of losing tax-exempt status. Key procedures include the following:
- After incorporating within its state, a nonprofit should apply to the IRS for tax-exempt status using Form 1023 or Form 1024, depending on the organization’s stated purpose. The forms require detailed information about the organization, including its purpose, officers, activities, revenue sources and expenses.
Manage Your Nonprofit Accounting in NetSuite
NetSuite’s Social Impact program and purpose-built cloud software helps nonprofits worldwide grow and operate more efficiently. To ensure that nonprofits devote more of their resources to their mission, NetSuite assistance includes base software donations, educational offerings and employee skills.
With NetSuite’s program, nonprofits gain access to a powerful financial management system designed to meet the unique needs of nonprofits. In addition to comprehensive core accounting features, NetSuite includes a broad range of capabilities tailored for nonprofits, including automated GAAP-compliant financial reporting. Fund accounting helps nonprofits manage revenue streams, match revenue to expenses and accurately adhere to funding restrictions. NetSuite’s grant accounting increases visibility into the grant life cycle through its ability to track conditions, manage projects, automate time-and-expense management and manage expenses across multiple years. In addition, NetSuite can produce over 250 FASB-standard and customized reports, together with real-time dashboards and metrics designed specifically for nonprofit staff.
Nonprofits face a range of accounting challenges, due to their favored tax status and the need to ensure that they dedicate funds to their mission, not to mention compliance with any donor restrictions. Following accounting best practices can help nonprofits comply with accounting requirements and tax laws, demonstrate financial transparency and continue to win the trust of donors. Best practices include establishing strong internal controls, following specialized GAAP accounting rules, understanding and following the steps required for tax compliance, careful budgeting and planning, tracking how contributions are used and selecting the right accounting system.
Nonprofit Accounting Best Practices FAQs
What is the best accounting method for nonprofit organizations?
Smaller nonprofits may start out using the cash accounting method because it’s the simplest. Larger nonprofits generally use the accrual accounting method. The accrual method is more complex, but it complies with GAAP and it’s the standard for larger organizations.
What accounting standards do nonprofits use?
Nonprofits generally use the FASB GAAP standards produced specifically for them: Statement of Financial Accounting Standards No. 116 (SFAS 116) and Statement of Financial Accounting Standards No. 117 (SFAS 117). SFAS 116 covers recording and reporting of revenue, and SFAS 117 defines the financial statements that nonprofits use. FASB provided updates in 2016, covering asset classification and financial statements, and in 2018, covering grant management.
What are GAAP principles for nonprofits?
The 10 general GAAP principles apply to nonprofits and for-profit organizations alike. For example, the GAAP principle of consistency requires that consistent standards are applied to the entire financial reporting process, while the principle of regularity says that financial reporting should occur on a regular cadence. In addition, FASB has produced guidelines specifically for nonprofits. For example, GAAP has specific requirements for nonprofit financial statements and activities, such as grant management.
What 3 financial statements must a nonprofit organization prepare annually?
The three financial statements that nonprofits must produce annually are the statement of activities, which is the nonprofit version of an income statement; the statement of financial position, which is the organization’s balance sheet; and the statement of cash flows.
What are the key financial statements that nonprofits should prepare and analyze regularly?
Nonprofits should prepare three primary statements: the statement of activities (revenue and expenses), the statement of financial position (assets and liabilities) and the statement of cash flows. In addition, they may need to produce a statement of functional expenses, showing a breakdown of expenses by nature and function, if that information is not included in the statement of activities.
What are the best practices for budgeting and forecasting in the nonprofit sector?
It’s important to create budgets that are both complete and realistic. To get a realistic estimate of future revenue, the budgeting process should account for such factors as historical data, anticipated response rates and average donation size. If new marketing techniques or tools are being employed, the budget should make conservative assumptions about how successful they will be. It’s equally important to include all expenses, including fundraising costs and administration. Once created, the budget should be reassessed frequently to see whether adjustments are needed.
How can nonprofits use accounting software to streamline their financial management processes?
Nonprofits can benefit from using accounting software that’s specifically designed for the nonprofit sector’s specialized “fund accounting” GAAP requirements. Purpose-built software can streamline operations by automatically handling many processes that would otherwise require additional manual work. For example, nonprofit accounting software can automate production of GAAP-compliant nonprofit financial statements and handle management of grant revenues, expenses and compliance.
What role should the Board of Directors play in nonprofit accounting and financial management?
A nonprofit’s board of directors is responsible for overseeing the organization’s finances. Specific responsibilities include determining the executive director’s pay, approving the annual budget, ensuring compliance with regulations and accounting standards (often through a board audit committee) and ensuring that the organization is on a solid path to financial sustainability.
What are the most important metrics that nonprofits should be monitoring to track financial health and performance?
Organizations should track metrics related to their mission, so the choice varies depending on the organization. Many nonprofits monitor metrics, such as cash flow from operations, unrestricted revenue (i.e., donations that don’t have conditions attached), fundraising expenses as a percentage of contributions and liquid unrestricted assets. In addition, the percentage of donated funds required for administrative expenses is a commonly scrutinized metric referred to as “overhead.” Donors have historically used this metric to inform their giving decisions, so nonprofit organizations must monitor it as well.