NOT-FOR-PROFIT ACCOUNTING

Not-for-profit organizations (NPOs) are like governmental organizations because they do not seek to earn a profit from their activities, yet NPOs are considered a separate sector for accounting purposes. An NPO differs from a for-profit entity in that its primary purpose is typically to fulfill a social mission instead of generating profits, and it differs from a governmental organization because in the United States it is not owned or controlled by any level of government. The NPO considered in this article is formally defined in the United States as an organization that has officially registered with the Internal Revenue Service (IRS) as a Section 501, tax-exempt organization.

NPOs are given tax-exempt status because as IRS Code Section 501 states, "no part of the net earnings shall inure to the benefit of, or be distributed to, its members, trustees, officers, or other private persons." The Financial Accounting Standards Board (FASB), which provides accounting guidance for NPOs, has a definition that corresponds to that of the IRS's, which describes an NPO as one that receives a significant amount of resources from providers who do not expect a return on those resources, does not operate to earn a profit, and does not have defined ownership interests that can be redeemed, transferred, or sold. NPOs, as identified by both the IRS and the FASB, therefore, exclude governmental organizations.

NPOs encompass a wide range of organizations, including entities as diverse as social service agencies, museums, cemetery organizations, major teaching hospitals, unions, private schools and universities, country clubs, and public radio stations. The sector is a "hybrid" that provides public goods (which is generally the primary function of government) through private organizations (typical of the commercial sector). Although NPOs do not operate to earn a profit and no ownership interest can ever be redeemed, transferred, or sold, they are similar to business organizations in the following ways: (1) They compete for scarce capital resources (whether in the form of loans, donations, or government contracts) and (2) they lack the coercive taxing power of government.

SIZE AND NATURE OF THE NPO SECTOR

NPOs in the United States, according to the Independent Sector (an advocacy group for NPOs), are a major industry: NPOs employ 7 percent of all workers, receive $665 billion in annual revenues, and constitute one of the fastest-growing segments of the U.S. economy. More than 1.5 million NPOs were in existence in the United States in 2006 and the IRS estimated that approximately 50,000 new NPOs were formed each year. NPOs tend to have the following characteristics:

Service Orientation

They exist to provide services rather than to generate profits. Profits measure effectiveness and efficiency of business organizations. The lack of a profit motive in the NPO sector makes measurement of their effectiveness and efficiency extremely difficult.

Diversity

They tend to be diverse in both sources of funding and services provided. Some types of NPOs receive a major portion of their funding from governmental sources and provide services that duplicate or supplement governmental services. For example, the government provides a significant portion of the total revenues of NPOs furnishing residential services for the mentally retarded. Others derive a major portion of their funding from fees for services or dues, and may even compete with for-profit organizations. For example, most of the YMCA's revenue is provided by fees or dues from its health-club facilities.

Multiplicity of Funding

They are subject to a myriad of increasingly complex reporting requirements. Many NPOs are multifunded, receiving funds from such sources as membership fees, local community fund-raising efforts (such as United Way), client fees, governmental grants, private foundations, and individual and/or corporate contributions. One result of the multiplicity of funding sources can be an abundance of complex reporting and accountability requirements. Each resource provider may require different year-ends, distinctive charts of accounts, and unique procedures for allocating indirect costs. (Universities' problems in the allocation of allowable indirect costs to be reimbursed by federal grants have been well documented in the popular media.)

Governmentally Regulated

Although both institutionally separate from government and self-governing, they operate in an atmosphere of increasing governmental regulation. For example, since 2003, fourteen states have increased both the reporting and internal control requirements of NPOs.

Publicly Scrutinized

They exist in an environment of significant public scrutiny. The 1996 Taxpayer Bill of Rights significantly increased NPO disclosure: NPOs are now required not only to supply a copy of their informational tax returns (Form 990) to any requesting party, but to make these returns "widely available." GuideStar—an organization that provides information about the finances, missions, and programs of NPOs—has placed the Form 990s of 1.5 million NPOs on the Internet; the National Center for Charitable Statistics has digitized this information, thus enabling benchmarking and in-depth financial analysis by NPO management, potential donors, external auditors, and investigative reporters. Both GuideStar and the National Center for Charitable Statistics impose fees for some of the information they provide.

Interestingly, NPOs are not, in general, required to supply their audited financial statements to outside parties. There are, however, reporting requirements at the state level.

MANAGEMENT OBJECTIVES

The objectives of NPOs are significantly broader in focus than the objectives of traditional for-profit entities. Since NPOs do not generate profits, evaluative measures that are closely related to profits, such as earnings per share, are not relevant to NPO management. Yet, actual focus of effort finds that many NPO managers focus almost exclusively on meeting budgeted targets. Simply meeting annual financial targets, however, does not mean that an NPO is successful; just the opposite could be the case if these targets have been achieved by minimizing important social and consumer goals that were established by the board of the not-for-profit entity. Like for-profit organizations, the managers of NPOs should begin with a mission statement and incorporate sets of interrelated goals that clearly relate the performance of numerous organizational activities back to the original mission.

FOCUS ON FRAUD

Because of the increased scrutiny under which NPOs are operating, management and board members have become increasingly aware of internal controls needed to reduce the possibility of fraud. The general belief that not-for-profit entities are under the leadership of officers and boards motivated by generous, altruistic individuals who are genuinely committed to the social goals of their organizations has been undermined by disclosures of financial scandals, especially in the post-Enron era, which began in late 2001. NPOs have been found guilty of flagrant violations of laws and fraud. A church-related foundation in Arizona was found guilty of a Ponzi scheme (in which contributions of later participants are used to return "dividends" to earlier participants) in 2002 that fraudulently misdirected tens of millions of dollars from contributors. A superintendent of schools and his colleagues at a school district in New York State in 2004 were found guilty of $11.2 million in fiscal mismanagement.

Boards of not-for-profits are expected to be aware of the potential for fraud in the use of resources. This is important for three major reasons. First, every dollar lost to fraud represents a lost ability to provide needed public services. Second, the sector is facing increased public scrutiny, primarily as a result of detailed financial information becoming more available. Finally, a Gresham's law for nonprofits may be at work—the publicizing of fraud cases may result in an unwillingness of donors to give to any nonprofit. The Association of Certified Fraud Examiners estimated in 2005 that approximately 6 percent of all organization revenues in the United States was lost to fraud every year. Applied to the U.S. NPO sector, this means that more than $40 billion could be lost to fraud annually, a significant amount.

ACCOUNTING STANDARDS

The FASB has jurisdiction over the standards of all private NPOs. The Governmental Accounting Standards Board (GASB) has jurisdiction over government-owned entities. This can result in difficulty in comparing similar organizations. For example, a state university's accounting is governed by the GASB; a private, not-for-profit university's by the FASB.

NPO accounting standards, while similar to the standards for for-profit accounting, do have some differences. External reporting is wholly on the accrual basis, regardless of how NPOs maintain their internal records. In FASB's Statement No. 117, requirements for financial statements prepared according to generally accepted accounting principles are provided. Among the guidance in this statement are the following:

1. Three financial statements are required to be issued: a statement of financial position (balance sheet), a statement of activities (income statement), and a statement of cash flows.
2. Net assets in the statement of financial position must be classified into three categories, based on the presence of donor-imposed restrictions: unrestricted net assets (when no donor restrictions exist), temporarily restricted net assets (for assets that will be used for explicit purposes or periods), and permanently restricted net assets (typically endowments).
3. Revenues must be reported as increases in one of the three categories of net assets (as mentioned in item 2, above). All expenses, however, must be reported as decreases in unrestricted net assets. Thus, an NPO must make two journal entries whenever it expenses a restricted asset: one to record an increase in assets released from restriction (and a decrease in cash or other asset), a second to record a decrease in unrestricted net assets (and an increase in expense).
4. Cash flows must be classified into three categories: (1) cash flows from operations, (2) cash flows from financing, and (3) cash flows from investing. Cash flows from financing must include contributions restricted for long-term purposes and the interest and dividends from these contributions. Contributions not restricted for long-term purposes and the related interest and dividends must be presented in cash flows from operating activities.
5. Voluntary health and welfare organizations (which include most social service organizations) are required to prepare a separate statement of functional expenses in which they classify its expenses by function (such as program, fund-raising, and management) and by object (such as salaries and interest), in a matrix format.

FLEXIBILITY ALLOWED

Because of the variations among NPOs, the FASB has provided flexibility in the presentation of financial information in the statements. For example, the statement of activities (equivalent to the income statement of a for-profit entity) must report expenses by functional classifications, either in the statements or in notes. The guidance, however, does not have a list of required functional classifications. This allows the NPO to determine those classifications that will reflect their activities most accurately. The statement of financial position may be formatted in one of a number of ways. There are alternatives for recording fixed assets. Additionally, there are some specific requirements for certain types of NPOs, such as universities and health-care organizations.

THE GUIDANCE PROVIDED BY THE AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

From time to time, the American Institute of Certified Public Accountants (AICPA) issues statements of position that relate to NPOs. Among these statements of position are: (1) accounting for advertising costs and (2) costs of activities, which includes fund-raising costs and the handling of joint costs and their appropriate allocation. For example, specific details are provided for determining the allocating of costs to "program" and to "fund-raising" at an event to raise funds when there is a presentation about the organization's program goals.

ANALYSIS OF FINANCIAL DATA

A number of measures are used to assess the performance of an NPO. Among financial measures that are relevant are: (1) the ratio of program expenditures to total expenditures; (2) the ratio of administrative overhead to total expenditures; (3) the ratio of fund-raising expenditures to total expenditures.

SUMMARY

NPOs in the United States provide valuable services to large numbers of individuals and groups. Considered in total, they are successful in securing funds from individuals and business entities as well as from governmental sources. Responsible accounting in accordance with the guidance provided is critical in knowing how effectively such organizations are meeting their missions and goals. Reporting, based on comparable accounting standards and principles, is a valuable means of presenting relevant information to state agencies that provide oversight to such organizations and to individuals and businesses that are selecting those organizations they wish to support with funds.

The Sarbanes-Oxley Act of 2002 is applicable only to publicly owned businesses. Nevertheless, there has been some questioning about its possible value, in some respects, for NPOs. A number of state legislatures (as of January 2006) and attorneys general were considering proposals to increase the accountability of NPOs.

see also Accounting ; Government Accounting

bibliography

American Institute of Certified Public Accountants. (n.d.). Statement of position. New York: Author.

Copley, Paul A., and Engstrom, John H. (2007). Essentials of accounting for governmental and not-for-profit organizations (8th ed.). Boston: McGraw-Hill.

Financial Accounting Standards Board. (1980). Financial accounting concepts no. 4. Norwalk, CT: Author.

Financial Accounting Standards Board. (1993). Financial statements of not-for-profit organizations [FAS No. 117]. Norwalk, CT: Author.

Greenlee, Janet S. (2000, Spring). Nonprofit accountability in the information age. New Directions for Philanthropic Fund Raising, 27, 33–50.

GuideStar. http://www.guidestar.org

Independent Sector. http://www.independentsector.org

Internal Revenue Service. (2005). Publication 501: Exemptions, Standard Deduction, and Filing Information. Washington, DC: Author.

National Center for Charitable Statistics. http://www.nccs.urban.org

Janet S. Greenlee

G. Stevenson Smith