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Nonprofit Accounting: Unique Challenges, Financial Reporting and Governance

26 Mar
Female volunteer takes account of items for a nonprofit organization.

Nonprofit organizations exist to benefit society rather than to make a profit. They work to improve many social, educational and environmental issues. Unlike for-profit businesses, nonprofits are funded through donations, grants and fundraising events. Because they’re exempt from paying taxes and people give them money in good faith, they’re held to strict accounting requirements.1

Accounting practices for nonprofits emphasize transparency and accountability to comply with regulatory standards and to maintain trust with stakeholders, including donors, beneficiaries and the public. Effective financial reporting and oversight can help nonprofits demonstrate their commitment to their mission by showing how their funds are allocated toward achieving their goals.1

This article will cover the unique challenges of financial reporting and governance for nonprofit organizations.

Financial Reporting for Nonprofits

Nonprofit financial reporting is governed by regulations and standards that are primarily set by the Financial Accounting Standards Board (FASB), which issues guidelines through the Accounting Standards Codification (ASC).1 Nonprofit entities are required to prepare and present financial statements that align with these standards so stakeholders can understand their financial health and operational effectiveness.1

Nonprofit accountants have to prepare financial statements such as:2

  • Statement of financial position
  • Statement of activities
  • Statement of cash flows
  • Statement of functional expenses

The statement of financial position is similar to a balance sheet in for-profit accounting. This important financial statement includes details about the organization’s cash flow, assets and liabilities at a specific point in time. This statement provides a snapshot of a nonprofit’s financial health, showing what it owns and owes.3

The statement of activities is similar to an income statement. It reports the organization’s revenues, expenses and changes in net assets over a period. This report shows how funds are generated and expended in pursuit of the nonprofit’s mission.3

The statement of cash flows tracks the inflow and outflow of cash over a specific period. It categorizes cash activities into three main sections: operating activities, investing activities and financing activities. This statement provides stakeholders with a clear view of how the organization generates and uses cash.3

The statement of functional expenses details the organization’s expenses, categorized by function. It breaks them down into program services and supporting services. This classification helps stakeholders understand how the nonprofit allocates its resources across different areas.3

Nonprofit Accounting Challenges

Financial challenges in nonprofit accounting are different from those that for-profit entities face. Nonprofits must manage restricted funds, for which donors specify how their contributions should be used. These funds are earmarked for particular purposes and must be tracked and reported on separately.4

Nonprofit accountants must also comply with regulatory requirements and standards. They must adhere to strict reporting guidelines set by government agencies and financial standards boards, which include preparing detailed and accurate financial reports and statements that reflect the organization’s financial status and the allocation of its funds.3

Fund Accounting in Nonprofits

Fund accounting ensures accountability and transparency in handling different sources of funds based on specific purposes or restrictions rather than on profit generation. Nonprofit funds are categorized into two main types: restricted and unrestricted. Restricted funds are donations or grants that donors have earmarked for a particular purpose or project, or a certain time frame.5

Unrestricted funds are resources that the organization can use at its discretion for any purpose that aligns with its mission. These funds offer greater flexibility in allocation, allowing nonprofits to cover their operating expenses, invest in their infrastructure or address unforeseen challenges they may face.5

Nonprofit Governance in Accounting

Governance boards steer nonprofits toward fulfilling their mission and engaging in transparent and ethical practices, especially in financial management. These boards are usually comprised of volunteers who oversee the organization’s activities and make crucial decisions regarding policies and practices.6

Nonprofit governance boards safeguard the organization against mismanagement or unethical use of funds. They review financial reports, approve budgets, and guarantee compliance with legal and regulatory requirements. By implementing strict financial oversight mechanisms, such as internal controls, audits and transparent reporting, the board helps the nonprofit demonstrate a commitment to using funds responsibly for their intended purpose.6

Governance boards also foster ethical practices within the organization. They set a tone of integrity with ethical fundraising practices that align with the nonprofit’s mission and values. Through diligent oversight, governance boards guide nonprofits to achieve their goals while maintaining the highest standards of integrity and public trust.6

Regulatory Compliance

To maintain their tax-exempt status, nonprofits must adhere to Internal Revenue Service (IRS) regulations, specifically Section 501(c)(3) of the Internal Revenue Code.7 They’re required to operate exclusively for exempt purposes, such as charitable, religious, educational, or scientific missions, and their earnings can’t unduly benefit any private shareholder or individual.7

Nonprofits are obligated to report annually to the IRS via Form 990, which provides an overview of their operations, financial activities, governance, and compliance with public disclosure requirements.7

In addition to annual reporting, nonprofits must follow regulations regarding fundraising, lobbying and political activities to ensure they don’t exceed limitations that could jeopardize their tax-exempt status. They also have to follow state and local regulations, which can include additional reporting requirements and compliance with charitable solicitation laws.7

Audit and Internal Controls

Conducting internal audits and implementing internal controls can protect a nonprofit’s assets and prevent the mismanagement of funds. Internal audits entail a systematic review of a nonprofit’s financial operations and compliance with laws and policies. Audits help identify potential discrepancies, inefficiencies or fraudulent activities while providing an objective assessment of how the nonprofit operates. By pinpointing areas of risk and recommending improvements, internal audits facilitate transparency and accountability.8

Internal controls are procedures and policies designed to prevent and detect errors or fraud in financial transactions so that assets are used appropriately and for their intended purpose. Examples of internal controls include segregation of duties, which prevents a single individual from controlling all aspects of a financial transaction; regular reconciliation of accounts; authorization and approval processes for expenditures; and secure handling of cash and financial records.8

Master Nonprofit Financial Statements and More as an Industry Leader in Accounting

Expert accountants play an invaluable role in strategic decision-making for their organizations. A master’s degree in accounting can prepare you to become a skilled leader in the nonprofit sector.

William & Mary’s rigorous Online Master of Accounting will show you how to go beyond the numbers and become a true leader. The faculty experts and robust curriculum instill more than skills. They shape you as a decision-maker and a business leader. You’ll learn from innovative scholars and experts with deep experience teaching online students to assess a company’s processes and think critically to solve problems.

As discussed in this post, financial statements are a key piece of both for-profit and nonprofit accounting. In BUAD 5739: Financial Statement Analysis and Valuation, you will first be introduced to the accounting requirements for measuring and recognizing fair value and then explore the valuation techniques commonly used to estimate fair values, such as a discounted cash flow model or a market-based approach. You will also learn how to carefully analyze financial statements, with an emphasis on risk management activities and transactions impacting owner’s equity.

Schedule a call with one of our admissions outreach advisors today to learn more.