Finance Nonprofits

Akindele Decker May 2007

Financial Management of Non-Profit

Introduction: An Overview of Non-profit Organization Several individuals define non-profits several ways. In a general definition, a Non profit organization is an entity that is driven by a mission and founded upon a cause, with no inherent importance in monetary profit and wealth for shareholders and owners. Non-profits may exist as a charity or as drivers for causes such as social issues, education, religion, politics, healthcare, and research. Examples of charitable non-profit organizations include Bill and Melinda Gates Foundation, Ford foundation, and Heritage Foundation. Examples of cause-driven non-profit organizations include Amnesty International, Red Cross, United Nations Educational Scientific and Cultural Organization (UNESCO), and the National Association for the Advancement of Colored People (NAACP). Non-profits may also be an association of members such as the American Anthropology Association. The organizational structure of a non-profit organization normally includes a board of directors, executive committee, and members or volunteers. The non-profit industry is one of the largest and growing industries in the world. “According to the NCCS Table Wizard, there are currently nearly 1.4 million nonprofit organizations in the United States.”1 This organizational form has been influential in battling global and domestic issues, such as poverty alleviation, human rights abuses, human trafficking, funding for other non-profits, and educating children. The formation of a non-profit in the United States usually includes preparing by-laws, articles of incorporation, and filing state and federal forms including tax forms from the Internal Revenue Service (IRS). The governing body of a non-profit, usually the Board of Directors are responsible for mapping the mission and objectives of the organization and ensuring that the organization’s direction is progressive. The executive committee usually includes the chief executive officer, vice president, secretary-general, treasurer, financial controller, chief operating officer, and volunteer manager. One of the most important departments or committees of a non-profit organization is the funding committee, which is responsible for acquiring funds for the organization’s projects and programs. Since a non-profit organization does not engage in sales, the primary source of financing comes from funding and donor sources. The funding committee or department usually includes the treasurer, financial controller, funding researcher, proposal writer, and program directors. This team usually works cohesively in developing program budgets, locating donors, writing funding proposals, and channeling funds to the organization. In the past, some of the financial activities of a non-profit organization were being outsourced due to the scant information available at the time and the 1

Foundation Center. http://foundationcenter.org/getstarted/faqs/html/howmany.html

complexity of non-profit financial management. However, with the growing emergence of this form of entity, financial management has shifted towards internal operations. The Non-Profit Financial Process, Structure & Components Financial management in a Non profit organization is very complex and drastically different from for profit entities. Non-profit relies on charitable donations, pledges, funding, and usually, subscription fees from members. Non-profit organizations are usually focused solely on a mission, therefore management and decision-making is centered on meeting set goals for accomplishing this mission. In most cases, management consists solely of individuals who are experienced in fields relating to the cause. This has been one of the primary reasons why non-profits usually outsource the financial aspect of the entity. However, financial management of non-profits have increasingly continued to be handled internally rather than outsourcing, as more nonprofits have begun to hire financial managers to manage the finances of the entity. The financial management of a non-profit organization begins in line with the formation of a non-profit. The financial aspect of a non-profit organization is equally as important as the management aspect because it is the uniqueness of tax regulations and the accounting information system that determines the legal and sometimes operation legitimacy of a non-profit organization. Financial reporting is another important aspect of a non-profit organization cycle, because it is the basis of which donor sources form their decisions whether to provide funding for the non-profit or not. Taking these into context, one can see that like a for-profit business, and even though a non-profit may be genuinely driven for a moral or social cause, financial management is all the same too important to avoid. It is as well, the legal and operational foundation of the continued existence of a non-profit organization. The first financial activities of a non-profit organization begins in the start-up process. The IRS imposes several tax requirements and regulations that the organization must meet in order to qualify legally as a non-profit organization. These requirements and regulations are strictly enforced and affect all strategic planning of the non-profit. This is mostly because of the tax-exempt status for most non-profit organizations. The IRS identifies several types of non-profits, based on the mission and objectives of each. The most common is the 501(c), which in itself has at least 28 types of non-profit organizations that are exempt from federal income taxes. In order for a non-profit organization to qualify for exempt status, the nonprofit must be organized and operated according to the purposes of the particular 501(c). Among these, the 501(3) c is the most popular. In addition to this requirement, any shareholders or owners cannot profit earnings, the nonprofit is limited in how much it can influence legislation, and the nonprofit’s documents must reflect the exempt purposes. When starting up a non-profit organization intending to gain exempt status, the Financial manager must work closely with the Board of Directors in drafting and filing all required documents, which include the organization’s By-Laws, articles of incorporation, fiscal budget, and other documents. In order to gain exempt status, the nonprofit must ensure that all of these documents reflect all of the guidelines and requirements of the IRS. Most nonprofits tend to

outsource this activity to third party entities such as Legal Filing2, which is a firm that specializes in 501(3) c registration. This is due to the complexity of the tax forms, which requires advanced knowledge in accounting and tax. Budgeting Non-profit organizations usually plan and implement programs and projects that meet the objectives of the organization. This is normally the core of operations. Financial management is one of the most important parts of the strategic planning process, particularly in the aspects of budgeting and financing of these projects and programs. Non-profits seek funding from pledges, donors, and member subscription fees in order to finance programs. It is likely that funding will be the key operational activity throughout the existence of the non-profit. Management, when determining the extent of the program or project, ensures that budgets are accurate enough to account for each expense, so that adequate or excess funding will be requested from financing sources. Budgeting in non-profit organizations is similar to non-profits. Some components of the budget include variable costs, fixed costs, and mixed costs. Variable costs are those that vary directly with the relative increases and decreases of activities. Examples of these include costs for food, fuel, and utilities. Fixed costs are those that are constant despite the increase or decrease of activity. Examples of fixed costs include rent, salaries, venues, and office expenses. Mixed costs are the combination of fixed and variable costs. Two budget systems that non-profit organizations use include the static and flexible budgets. A static budget is created for one level of activity with the assured notion that activities or costs will not change. Flexible budgets on the other hand, are created for an infinite level of activities.3 In carrying out effective forecasting, financial managers and the funding committee must ensure that sufficient funding is received to finance all expenses. Accounting Information System Similar to for-profit entities, non-profit organizations use related accounting components. The accounting system for non-profits is used to ensure that financial data and transactions are recorded accurately and financial statements are prepared and available for the users of it, such as management, donor organizations, and other financing sources. Non-profits use financial statements such as the balance sheet, income statement, and statement of cash flows. Newer non-profits without the capabilities to apply accrual basis accounting, usually use cash basis, although as these organizations grow larger with more transactions, they eventually transfer to accrual based. Nonprofits report to similar accounting regulatory boards such as the Financial Accounting Standard Board (FASB) and are under the same obligation to follow the general accepted accounting principles (GAAP) when recording and reporting financial statements. The accounting cycle in a non-profit organization includes financial transaction, analyzing transaction, recording transaction into the journal, posting into the general ledger,

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www.legalfilings.com Nonprofit World; May/Jun89, Vol. 7 Issue 3, p29-34, 6p

adjusting general ledger accounts, and preparing financial statements.4 Financial reporting is one of the most important and critical determinants of the likelihood of receiving funding from donor, public, and private entities. If the financial management is ineffective, then the financial statements will be filled with errors and inconsistencies, which is an automatic assurance that funding sources will reject any request for funds. Most donor agencies normally request the program budget, as well as the financial history of the organization. This is normally were non-profits tend to fail in the venture for funds, as without an effective and accurate financial report, it is unlikely that requests for funds will be accepted. Without funds it is most likely that programs and projects will have to be cut from the strategic plans of non-profits. Comparison: - Non-profit & For-profit Financial Management In for-profit financial management, the main goal of the firm is maximization of shareholder’s wealth.5 Financial managers of corporations, direct their decision-making to positively affect the analysis and viewpoints of shareholders, investors, and financiers, as well as the efficient use of inventories, products or services. To accomplish the firm’s preferred goal of the maximization of shareholder’s wealth, financial decisions and operations must be efficient and should include effective use of investments, budgeting, forecasting, and profitable financial operations. Nonprofit seeks a different goal than that of maximization of shareholder’s wealth. This is one of the main differences between the financial management of nonprofit and for-profit corporations. This is partly due to a fundamental difference in both entities. While for-profits accumulate and distribute wealth and profit, nonprofits, hence its nomenclature, are legally restricted from distributing profit to owners or shareholders. In part, while for profit entities are generally business entities with paid staff and customers, nonprofits consist of members, associations, students, and volunteers. Four key areas that non-profit and for-profit entities differ include accounting for contributions, capitalizing and depreciating assets, use of cash and modified cash basis accounting, and functional expense classification. In the area of accounting for contributions, tax-deductible contributions received from donors are what distinguish non-profits from for-profits. Non-profits receive contributions in the form of pledges, donations, membership dues, fundraising events, and donor funding, while for-profits acquire sales, loans, and investments. There is also requirement that non-profits follow reporting guidelines to contributing entities before, during, and after contributions are received. This must be recorded properly into journals and inserted to the proper ledger account, in order to display it accurately in financial statements. The Form 990 is also required by the IRS to be filed annually by non-profits that are tax-exempt with annual receipts exceeding $25,000. In regard to capitalizing and depreciating assets, while all business entities are required to record depreciation of assets, some assets such as museum collections, historical buildings, and library books are an exception to the rule for non-profit organizations. As stated earlier, another difference is that most new and 4

http://www.allianceonline.org/FAQ/financial_management/what_are_elements_of.faq Keown, Arthur. Financial Management: principles and applications. 10th edition. Pearson Prentice Hall, 2004

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small non-profit organizations have the capacity to use cash instead of accrual based accounting. A fourth difference between the two is that non-profit reports expenses as functional expense classifications, which include two types, program services, and supporting activities. Supporting services normally include such activities as management and fundraising activities. Though few, these differences are critical in making decisions and planning strategically. An override of these differences can cause a non-profit organization to provide inefficient financial statements, break state and federal tax laws, create unrealistic goals and objectives, and lose valuable funds. This is why it is important to have a sound financial management integrated into the general management of the organization, and a financial manager who is in line with the mission of the organization. Conclusion As non-profit organizations continue to increase in size, quantity, and impact, financial management will continue to play one of the most important role in the organization to ensure that the it is fully effective towards its goals and objectives of its mission. With the increase in available information on financial management in nonprofits, and the extensive academic courses offered in this field, it is most likely that we will see an increase in job opportunities for finance managers in non-profit management staff. Keeping management internal rather than the option of outsourcing, means that financial decisions will be directly in line with the programs, projects, and mission of the organization. Non-profits do face a challenge as they increase their capacity to internalize financial decisions within management, which is facing the issues that comes with globalization. With the numerous financial standards and accounting systems relative to different countries around the world, it may become more tedious to generalize financial decision making across borders. However, with increased information technology, it is likely that non-profits will increase their efficiency in handling financial management.

References: How many nonprofit organizations are there in the United States? Foundation Center. Retrieved May 2007. http://foundationcenter.org/getstarted/faqs/html/howmany.html Frequently Asked Questions. Alliance for Nonprofit Management. Retrieved May 2007. http://www.allianceonline.org/FAQ/financial_management/what_are_elements_of.faq Anne Abraham. Financial Management in the Nonprofit Sector: A Mission Based Approach to Ratio Analysis in Membership Organizations. Journal of American Academy of Business, Cambridge; Sep 2006; 10, 1; ABI/INFORM Global Financial Management Strategy in a Community Welfare Organization: A Boardroom Perspective. Financial Accountability& Management, 19(4), November 2003, 0267-4424

Keown, Arthur. Financial Management: principles and applications. 10th edition. Pearson Prentice Hall, 2004 Gain Control of Your Organization’s Finances: Flexible Budgets. Nonprofit World, VOL.7, No.3. Published by The Society For Nonprofit Organizations.