Nonprofit leaders often feel misunderstood by people who think their operations are simple and straightforward, with none of the complexities faced by for-profit businesses. The reality is very different. Nonprofits grapple with multiple unique accounting challenges that create extra hurdles they must overcome before they can fulfill their missions. In particular, nonprofit-specific accounting rules lead to regulatory and compliance hurdles, revenue and expense complications, fund accounting dilemmas and internal control gaps. In addition, keeping up with the technology available to help meet these challenges presents even more hardships for nonprofits. Exploring these five common nonprofit accounting challenges can help nonprofit leaders overcome them and spend more time focused on mission-critical activities.
Key Takeaways
- Nonprofits are subject to special regulatory and compliance requirements to maintain their tax-exempt status and enhance transparency for donors and the general public.
- Nonprofit revenue comes from donors and grantors, with or without restrictions. This makes it unpredictable, which complicates planning and forecasting, and requires the use of specialized accounting rules called “fund accounting.”
- Scrutiny and pressure on a nonprofit’s administrative spending can lead to under-resourcing, which, in turn, leads to subpar internal control environments and outdated technology.
- Purpose-built nonprofit accounting software can solve many of these challenges.
5 Common Types of Nonprofit Accounting Challenges
At their core, nonprofits are businesses — they contributed $1.5 trillion to the U.S. economy during the first quarter of 2023. There are small, medium and big nonprofit businesses, all of which focus on fulfilling a core mission, instead of turning a profit. While that distinction might appear, to some, to minimize the likelihood of nonprofit accounting challenges, certain nuances of nonprofit operations actually promote a series of characteristic accounting and financial challenges. Some of these relate to the nonprofit sector’s unique accounting, tax and regulatory requirements; others are symptomatic of nonprofit operating dynamics, such as the tension between maximizing spending on mission-related programs versus administrative resources, a critical mass of which is necessary to a nonprofit’s growth and long-term sustainability. Overcoming such challenges becomes more likely with the right combination of accounting expertise and technology.
1. Regulatory and Compliance Challenges
Because nonprofits are funded by donations and grants, they are subject to additional layers of regulatory and compliance requirements designed to enhance transparency for donors and other stakeholders. These obligations also support nonprofits’ special tax status. They’re defined in unique nonprofit-specific accounting guidelines, as well as in the rules of government authorities, such as the Internal Revenue Service (IRS) and various state-level oversight agencies. Regulatory and compliance challenges require accounting and operational data and are typically managed by accounting and administrative staff.
- Tax regulations and compliance requirements: Most nonprofits are exempt from federal taxes. Not paying income tax helps conserve donated funds, maximizing their use toward the nonprofit’s mission. To maintain their tax-exempt status, nonprofits must file accurate financial reports and tax returns every year. The primary federal tax-filing requirement for nonprofits is IRS form 990, which includes information from the nonprofit’s financial statements. The IRS has the authority to audit nonprofits and can levy fines and revoke their tax-exempt status. In addition, nonprofits must also stay up to date with the tax codes and compliance requirements of state and local jurisdictions, which can vary significantly.
- Financial reporting and disclosure requirements: Nonprofit accounting follows Generally Accepted Accounting Principles (GAAP), as well as additional unique guidelines issued by the Financial Accounting Standards Board (FASB). Together, these guidelines provide the framework for the four primary nonprofit financial statements: the Statement of Financial Position (like a for-profit balance sheet but showing net assets, instead of equity), Statement of Activities (like a for-profit income statement but focusing on reporting revenue and expenses, rather than profit and loss), Statement of Cash Flows (pretty much the same as a for-profit business’s) and Statement of Function Expenses, which is a deeper dive into expense reporting that is unique to nonprofits. Because of all these nonprofit-only elements, nonprofit accounting requires specialized expertise.
- Governmental reporting and compliance requirements: Nonprofits have a plethora of government regulations and requirements to be aware of beyond tax issues. Some regulations impose restrictions or prohibit certain activities, while others mandate data reporting. For example, the way donors are solicited and how their information is maintained and used is highly regulated. As a result, public charities must file donor lists with their IRS form 990, although donor names are redacted in public disclosures. Nonprofits must also comply with state regulations on matters involving business organization, real estate transactions and consumer protection.
2. Revenue and Expense Recognition Challenges
Nonprofits get their revenue primarily from charitable donations and grants. Both can be considered “other people’s money,” are hard to predict and often come with strings attached — in other words, restrictions on how a donor’s funds can be used. These characteristics add complexity to the overall financial management of a nonprofit.
- Unpredictable funding sources: Nonprofits rely on the charity of their donors, which can make budgeting and forecasting revenue a much bigger challenge than, say, predicting how many people will buy toothpaste next month, gas for their cars, or eat out at restaurants. Are people feeling generous — or not? Is there a big benefactor this year, or just lots of small contributors? Further complicating this unpredictability is the need for accountants to estimate the ratio of unrestricted versus restricted donations. Restricted revenue is limited for specific program expenses, while unrestricted revenue can be used to fund any spending, including administrative operations and other overhead. These factors complicate budgeting, forecasting, resource allocation and cash flow management.
- Grants and contributions management: Revenue from grants and other contributions are not fungible — i.e., not interchangeable — which poses additional challenges for revenue and expense bookkeeping. Grants are funds from third parties, such as government agencies or private institutions, that don’t need to be paid back but are almost always restricted to specific purposes or periods. Recognizing grant revenue properly, in accordance with the restrictions and their timing, can become complex. What’s more, this particular challenge grows with the nonprofit’s success, due to the rising complexity of managing increasing numbers of restricted grant funds simultaneously. This makes tracking incoming funds and outgoing expenses a heavier accounting process burden than is usually the case in profit-making businesses.
- Expense allocation and tracking: Grantors and other restricted donors expect a nonprofit to spend their contributions according to their wishes. The enhanced transparency required by regulations mandates that nonprofits allocate and track spending in specific ways, so they can provide reports and periodic updates demonstrating how their spending aligns with donors’ restrictions. This calls for meticulous record-keeping and accountability, which translates into a bigger bookkeeping burden than that demanded of most for-profits. It also obliges accounting and operational staff to be familiar with the details of each grant.
3. Fund Accounting Challenges
Nonprofits use a specialized type of accounting to record financial transactions, called fund accounting. This approach is meant to result in a nonprofit’s ability to present information that makes it easier for various stakeholders — current and prospective donors, government regulators, grantors, as well as the organization’s leadership — to see that funds are being spent properly, according to their expectations. Fund accounting is different from other accounting methods and requires specialized expertise, tools and processes.
- Multiple funding sources and restrictions: Fund accounting is a way to separate revenue, expenses, assets and liabilities in accordance with the specific conditions assigned to donations and grants. So, fundamental to fund accounting is the need to keep detailed and meticulous records of cash inflows and outflows, per each funding source. Funds can be thought of as separate divisions within a company; together, they represent a nonprofit’s overall financial picture. But, separately, they house each funding source and show its specific transactions. This type of accounting is extremely tedious and gets exponentially more challenging as the number and variety of funding sources grow.
- Restricted and unrestricted funds management: Some donations are given without any restriction; others come with all kinds of strings attached, at the donor’s discretion. Unrestricted funds may be used to pay overhead expenses, like rent, while a restricted donation might be used only for a particular purpose, like a scholarship. Nonprofit accountants use fund accounting to separate unrestricted funds from restricted funds, then track restricted funds individually to demonstrate compliance with the terms of the donation. Managing the cash needs of a nonprofit, while adhering to such donation restrictions, is a challenging balancing act because regulations leave no “wiggle room.” If the electric bill comes due at a time when the million-dollar balance in a nonprofit’s account is all earmarked for research, it would be illegal to divert those funds for electricity.
- Financial statements preparation and interpretation: The financial close process is a significant undertaking for all types of organizations but can be especially challenging for a nonprofit. First, thin and/or volunteer staffing can lead to transaction processing backlogs, causing information to be incomplete or late. Second, lack of specialized nonprofit accounting expertise or systems can cause confusion, errors and inconsistencies, any of which would require extra time and effort to overcome or correct. These factors can cause nonprofit financial statement preparation to become cumbersome, inaccurate and untimely. Overcoming these challenges is paramount, as financial statements and financial analysis are important tools that help managers run the organization efficiently, and they are also necessary for compliance.
4. Internal Control Challenges
Internal controls are a system of policies and practices that serve to prevent and detect errors and fraud. All types of organizations benefit from a strong internal control environment, but, in the case of nonprofits, the control environment also serves to build credibility with donors that funds are being used appropriately. It is also a key to staying compliant with governmental and other regulations.
- Limited resources and staff: Recruiting, training and retaining talent is a perennial challenge for nonprofits, due to the limited pool of accountants, the even more limited number of accounting professionals possessing the necessary nonprofit expertise, and notably tight administrative budgets. Nonprofits are pressured to keep their overhead costs as low as possible in order to maximize spending on programs that support their missions. The limited resources become an even greater issue when nonprofits compete with for-profit employers to attract professional employees, like accountants. In a 2022 survey, 40% of responding nonprofits cited recruiting and retaining staff as their biggest challenge. As a result of this and other reasons, nonprofit workforces are notoriously small, which often forces staffers to wear multiple hats. This challenges their ability to properly segregate duties, an essential underpinning of a good control environment.
- Risk management and mitigation: There are several types of risk that nonprofits must be aware of and manage, with strategic, operational and compliance risks topping the list. Strategic risks are those that threaten the viability of the organization to fulfill its mission over the long term, such as macroeconomic conditions, changes in funding and shifts in public interest. Operational risks tend to be practical issues that affect delivery of the mission, such as supply chain disruptions or availability of volunteers. Compliance risk and reputational risk can influence donor perception and create funding issues. Risk management often falls within the scope of a nonprofit’s CFO, who is challenged to balance the probability of an occurrence of a specific risk with the potential operational and financial aftereffects of the various risks. Prioritizing risks so that the most likely and potentially damaging risks are addressed first is especially important for nonprofits, due to their usually limited resources.
- Fraud prevention and detection: Without strong internal controls, nonprofits can become susceptible to fraud, which can pose significant reputational, operational and compliance risks. While no level of internal controls can eliminate all fraud, subpar control environments allow more opportunities for fraudulent events to slip through the cracks. Additionally, cyber threat actors can take advantage of trusting donors, staff and volunteers by impersonating the nonprofit and stealing funds — i.e., by redirecting payments to their own accounts. Similarly, nonprofits may have a high proportion of cash or check donations that can be susceptible to theft in the absence of tight procedures that prevent skimming.
5. Technology Challenges
Technology can have a vital impact on nonprofit operations, helping improve donor accountability, reduce costs and better fulfill mission programs. But deploying up-to-date technology in ways that eliminate manual processes and raise an organization’s productivity requires IT investment and expertise. Both of these may be in short supply at many nonprofit organizations — and the investment is likely to face intense scrutiny.
- Limited access to technology and software: Nonprofits tend to have limited budgets, so they lag behind for-profits in IT investment. Many have outdated systems or still use manual processes. The limited funds for investment can leave many nonprofits in a “chicken or egg” situation. With the right technology in place, nonprofits could strengthen donor experiences and potentially grow revenue while also increasing the efficiency of mission program operations. But their outdated or manual systems lead to donor dissatisfaction and lower revenue. Some nonprofits may qualify for special partnerships with technology companies that provide pro bono software and services to support nonprofit missions.
- Cybersecurity risks: Nonprofits must take cybersecurity risks seriously for several reasons. First, they must protect their donors’ personally identifiable information, like Social Security numbers, health information and billing information. Like profit-making entities, nonprofits can be liable for any breach of confidential, protected information. Second, they run the risk of impersonation by cyber threat actors who portray themselves as being from the nonprofit to prey on well-intended donors and steal their contributions. Third, nonprofits can be subject to website hijacking, where all or part of the website is changed. This can cause visitor confusion and reputational damage.
- Training and education on technology: Modernizing a nonprofit’s accounting system calls for more than installing hardware and software or deploying a cloud-based solution. It also means staff training to build the expertise required to get the most out of the technology. This is another challenge that is exacerbated by the specialized demands of nonprofit accounting, because only accounting software engineered to meet those requirements will provide the boost nonprofits seek. And recruiting and retaining IT professionals is equally as challenging as bringing in accounting staff.
How to Solve Nonprofit Accounting Challenges With Technology
Purpose-built technology for nonprofits can solve many of these accounting challenges. NetSuite cloud accounting software provides all the core accounting features, such as general ledger, accounts receivable, accounts payable, cash management, statistical accounting, allocation schedules and real-time financial reporting, all within a nonprofit-specific, fund accounting framework. Plus, it has specialized modules for grant accounting and program-efficiency trackers. It also automatically generates key FASB and other required nonprofit reports, including Statement of Financial Position, Statement of Functional Expenses, Statement of Cash Flow, Statement of Activities, Supporting FASB Activity Report by Program/Fund, and Grant Statement of Activity. Because NetSuite’s cloud accounting software for nonprofits integrates with the company’s enterprise resource management (ERP) system, the entire nonprofit’s internal control environment can be improved by setting up automated prevent-and-detect controls. For example, grants can be set up so that only allowable expenses can be entered against them, and only up to a certain threshold amount. Together with automated workflow and approvals, NetSuite’s nonprofit accounting software can help organizations fill the gaps created by a too-small workforce.
Nonprofits share many similarities with for-profit businesses, but they also have unique accounting and financial requirements tied to the inherently greater transparency called for by their voluntary funding sources. Those specialized requirements lead to the five critical nonprofit accounting challenges of regulatory compliance, revenue and expense recognition, fund accounting, internal controls and optimal technology use — all of which can be overcome with the right combination of accounting expertise and technology.
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Nonprofit Accounting Challenge FAQs
Is nonprofit accounting difficult?
Nonprofit accounting is not necessarily difficult, but it requires specialized knowledge. Nonprofit accounting is used in organizations that have no ownership interests and that exist to fulfill a charitable goal. It complies with Generally Accepted Accounting Principles (GAAP), plus additional nonprofit-specific rules from the Financial Accounting Standards Board (FASB). Nonprofit accounting, which records and reports transactions using the fund accounting approach, differentiates between restricted and unrestricted donations and requires expenses to align with donations in each of those categories.
What are some regulatory and compliance challenges that nonprofit organizations face in accounting?
Nonprofits must comply with several layers of regulations. These come about due to nonprofits’ special tax-exempt status, unique accounting guidelines and increased government oversight. To meet their compliance challenges, nonprofits file four primary financial statements: the Statement of Financial Position, Statement of Activities, Statement of Cash Flows and Statement of Functional Expenses. There are also state and local tax and compliance requirements, which can vary significantly. Some government regulations impose restrictions on or prohibit certain activities, while others mandate special data reporting, such as how donors are solicited and how their information is maintained and used.
How can nonprofit organizations ensure proper expense allocation and tracking?
Nonprofits use a specialized type of accounting called fund accounting to keep detailed and meticulous records of cash inflows and outflows. Donations and grants are separated into funds, along with their related expenses, according to any specific conditions linked to the donations and grants. Because donations and grants may also be made without restrictions, fund accounting separates unrestricted funds from restricted funds before further separating the restricted funds based on the terms of the donation.
How can nonprofit organizations balance the need for financial transparency with donor confidentiality?
It is important for a nonprofit organization to protect its relationship with donors. This starts by establishing communication policies that comply with applicable laws of the jurisdictions in which the nonprofit operates and that meet professional standards, such as the Association of Fundraising Professionals (AFP) Code of Ethical Standards and AFP Donor Bill of Rights. The communication policies should include procedures for obtaining consent and protecting personally identifiable information, especially when sharing donor stories. As with most effective communication, it’s important to understand the audience and what is important to its members.
What are the biggest challenges facing nonprofits today?
Recent research suggests that nonprofit executives believe that rising operating expenses and difficulty hiring and retaining top talent are their two biggest challenges. Another major challenge is growing funding uncertainty, due to changing government policies and economic conditions, juxtaposed against increasing need for nonprofit services. At the same time, availing themselves of evolving technology for donor communications presents substantial hurdles for cash-strapped nonprofits.