Nonprofit Organizations and Financial Management

Executive Summary

The modern organizational environment has many types of organizations. While some organizations exist to increase the welfare of the shareholders by maximizing profits, others emerge to address humanitarian and environmental issues devoid of profit-making motive. Both organizations apply financial and accounting standards and principles when revealing their financial information. Due to the differences in the objectives of the organizations, their financial statements, and balance sheets are different. In the paper, the differences are discussed in detail. The differences include sources of funds, use of debt, performance evaluation, and governance mechanisms.

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Introduction

Organizations emerge for various reasons. On the one hand, nonprofit organizations operate without the objective of making profits. On the other hand, for-profit organizations operate with the main objective of maximizing profits and increasing the value of the stockholders. Nonprofit organizations have the main objective of meeting the needs of communities. As such, their primary purpose is to address humanitarian needs as well as environmental issues. Even though nonprofit organizations do not seek to make any profits, they need to have enough cash flow that will facilitate their attempts to address human needs. Financial management for the organizations is, therefore, a critical element that allows them to be sustainable (McLeish, 2010). This paper seeks to explore financial management practices in both nonprofit organizations and for-profit organizations. Besides, the article will explain the differences by focusing on such features as sources of funds, use of debt, performance evaluation, and governance mechanisms in nonprofit organizations.

Nonprofit vs. For-Profit Organizations

At the outset, the two organizations have different sources of funds. In for-profit organizations, sales revenues are an intrinsic part of their financial systems. The rationale is that the organizations rely heavily on their incomes to fund their activities (Daze, 2010). Also, the organizations may opt to look for credit arrangements with lenders and other financiers. Nonprofit organizations, however, do not emphasize sales revenues since most of their funding comes from donors and grants. According to McLeish (2010), donations may come from government entities and institutions, individuals, and organizations. It is worth noting that the two types of organizations rely on their sources of income to accomplish their different goals. Due to the sources of funds for nonprofit organizations, they attempt to increase the benefits that communities reap from their activities. On the contrary, for-profit organizations earn their revenues, and as such, they spend their money in a manner that increases their profit margins (Drucker, 2011). Nonetheless, the two types of organizations ought to ensure that they apply generally accepted accounting standards to achieve their objectives.

It is important to note that some nonprofit organizations may get some income from trading activities. Daze (2010) points out that trading activities that some nonprofit organizations engage in do not have a profit-making objective. It is a way of ensuring that they increase their income to address the humanitarian and environmental issues that they prioritize. All sources of income for nonprofit organizations have special features that ought to be disclosed in the financial reports and statements in an appropriate way (Drucker, 2011). For instance, if a nonprofit organization receives donations and grants that are aimed at accomplishing specific objectives, the conditions of the receivership of the income ought to reflect in the financial statements. Particularly, reciprocal grants have preconditions on the way a specific nonprofit organization should utilize the contributions. When reporting such contributions in a financial statement, nonprofit organizations ought to indicate the stages of completion of the specific project for which the contributions fund (McLeish, 2010). This is measurable by indicating the extent to which the project is complete. For non-reciprocal grants, nonprofit organizations should comprehend that the contributions reflect the transfer of resources from one entity to another. Transfers do not directly get a similar value. Since non-reciprocal grants reflect gifts and donations, they need to appear in financial statements as cash or assets. Nonetheless, reciprocal grants are major sources of funding for nonprofit organizations as well as governments.

Second, it is important to highlight the significant differences in the considerations of taxes and liabilities accruing both types of organizations. For-profit organizations pay taxes in many ways. This is hugely dependent on the size and form of the organization. Small and medium-sized businesses, in particular, take the form of sole proprietorships as well as partnerships. In the United States, the Internal Revenue Code (IRS) treats the incomes for small and medium-sized organizations similar to personal incomes (Daze, 2010). To that end, it is imperative to articulate that the owners of the organizations are personally liable for any form of debt that their respective organizations incur. Many nonprofit organizations apply for income tax exemptions in numerous countries where donations and grants do not invite taxes (Drucker, 2011). It is also critical to say that governments offer donors and grantors some tax incentives that motivate them to increase their contributions. For tax purposes, the government and tax codes of different countries treat nonprofit organizations equally as legal entities. Hence, the nonprofit organizations’ founders are not liable for any form of debt that the organization may incur.

Third, it is important to articulate that people with the knowledge of Generally Accepted Accounting Standards (GAAS) will find the financial management in both types of organizations to be very similar. However, accounting for contributions differ significantly in both types of organizations. All nonprofit organizations that enjoy tax exemption under the tax code of the country of operations receive donations and grants that are tax-deductible to the financier (McLeish, 2010). Such procedures are not emphasized in profitable organizations. According to the Financial Accounting Standards Board (FASB), nonprofit organizations ought to indicate the number of contributions they made or received in the financial statements (Drucker, 2011). This allows nonprofit organizations to follow strict guidelines when handling pledges and people’s promises to contribute to the welfare of the organization. Pledges that potential donors make should only be recorded in financial statements and accounting records only if the law can enforce the pledges. This includes unconditional pledges where the donors and grantors promise to give some contributions devoid of future considerations and other uncertainties.

Moreover, nonprofit organizations should account for all materials and services they receive as contributions and donations. FASB requires nonprofit organizations to account for contributions that they receive in terms of goods (Drucker, 2011). However, the general requirement exempts such goods as works of art and other goods in museums. Since the organizations depend hugely on the role that the volunteers play in facilitating the organization to meet its objective, the time they spend within the organization ought to appear in the financial statements. This is in recognition of the fact that volunteer time leads to the creation of non-financial assets such as the provision of food to the hungry (Daze, 2010). Besides, the services that the volunteers provide may be specialized. For instance, when an accountant decides to volunteer in a specific nonprofit organization, it is obvious that he or she provides specialized types of services.

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Further, the expenses incurred by the two types of organizations are different. For nonprofit organizations, the income must appear against the total expenses incurred during a specific financial period. The expenses may include wages and client support services for nonprofit organizations, while the expenses in the for-profit organization are numerous. They include the costs associated with marketing and sales, promotional activities, among other expenses that are not typical of nonprofit organizations (McLeish, 2010). Reporting such expenses is, therefore, different for the two categories of organizations. Nonprofit organizations classify their expenses in functional classifications. This method of reporting appreciates that program services, as well as support activities, belong to two bold categories. Program services are identifiable to the accountant, who can record them separately (Drucker, 2011). For instance, in situations where an organization carries out some workshop and training activities, all costs and expenses associated with specific activity will appear separately in the financial statement. For supporting activities, all expenses are recorded against their respective activities associated with support (Daze, 2010). Nonetheless, it is important to indicate that the functional expenses classification can differ from one nonprofit organization to the other.

The two types of organizations also vary in the way they record capitalizing and depreciating assets of their respective organizations. Nonprofit organizations ought to record the procured long-lasting equipment and property in terms of assets in the financial statements. They charge depreciation of such assets as a proportion of costs in every year that the asset has been in use. In other words, depreciation of an asset is hugely dependent on the useful life of the equipment (McLeish, 2010). This process is typical for-profit organizations. It is referred to as capitalizing and depreciating assets. Up to there, the calculation of depreciating assets is similar in both categories of organizations.

Nevertheless, the fixed assets in nonprofit organizations are specially treated when recording them in financial statements. They include works of art, monumental and historical buildings, and animals in the zoo, among others. For instance, an organization cannot record the work of art as an asset because the value of such work is variable. Besides, Daze (2010) says that none of the donated assets that an organization holds to meet specific needs appear in the financial records. This implies that an organization can only sell those assets and direct the proceeds to their activities. The rationale is that such assets do not culminate into formal assets that financial statements recognize.

While many for-profit organizations utilize cash-basis accounting procedures, many nonprofit organizations use the accrual basis method of financial accounting. Indeed, the latter only record revenues when they receive contributions from their potential donors (McLeish, 2010). The organizations also record expenses only when they issue payment for such expenses. Nonetheless, the accrual-basis method of accounting does not apply to some large nonprofit organizations that opt for a modified cash basis model of financial accounting. According to Drucker (2011), this method allows the organizations to record such items as payroll taxes and large-expense revenues and expenses using the accrual basis accounting method. Again, this implies that nonprofit organizations can record income and revenues when they are earned and record expenditures when the organization meets its obligations. As aforementioned, all nonprofits categorize their expenses in terms of classification of functional expenses. As such, they must reflect the specific activities in which they spend money when meeting their objectives. It is important to articulate that organizations that operate without the motive of making profits evaluate financial ratios that reveal the financial health of the organization. Importantly, the organizations calculate the quick ratio that FASB recommends to stand at 2:1 for a conventional organization (Daze, 2010). However, nonprofit organizations can operate at a lower ratio because their revenues come from donors and grantors.

Also, nonprofit organizations use the concept of fund accounting. Its primary focus is the accountability of the organization as opposed to the profitability of the same. To that end, for-profit organizations have a general ledger that balances itself in an account. Drucker (2011) articulates that nonprofits organizations, on the other hand, have numerous ledgers where they record funds received from donors and grantors. McLeish (2010) points out that fund accounting enables organizations to differentiate and separate various resources. This is to establish specific and individual sources of funding for their intended usage. Nonprofit financial records, as such, reflect the collected funds and contributions, which have dissimilar objectives and purposes and can balance off individually (McLeish, 2010). This way, nonprofit organizations can segregate their models of accounting though it does not necessarily imply segregation of the funds or resources used. As such, the financial statements and reports represent detailed expenses and incomes for each source of funds. The reports summarize all financial activities are accruing all sources of funds within a nonprofit organization.

The variations in accounting procedures of for-profit and nonprofit organizations are also apparent in the balance sheets of their respective organizations. On the one hand, a balance sheet for profitable organizations shows the retained earnings that the stockholders should get in terms of dividends. On the other hand, the nonprofit organization states the financial position (Drucker, 2011). This statement puts in mind the total; assets and their utilization of the assets in future activities of the organization. In other words, the nonprofit organizations detail the net assets that are available for their activities. Also, for-profit organizations provide the statement of their retained earning while nonprofit organizations provide a report that details the changes in the overall assets (net assets). According to the IRS code of financial reporting, for-profit organizations ought to provide a profit and loss account when issuing financing statements (McLeish, 2010). This is contrary to the nonprofit organizations that do not issue a profit and loss account, given the fact that the organization exists mainly for nonprofit objectives and goals. In the balance sheet that the two organizations report their financial information, for-profit organizations have the responsibility of calculating the net income. For nonprofit organizations, the calculation of net income is not mandatory. Instead, the organization ought to reveal any excessive revenues when compared to expenses.

Drucker (2011) says that the audit standards for the two categories also contrast sharply. A nonprofit organization must always be ready for an auditing process. This implies that all financial records that are important to programs of the organization must be accessible for audit. Indeed, it is important to note that failure by nonprofit organizations to provide documentation and financial reports could raise eyebrows among the donor and grantors. Besides, they could lead to disallowances of costs that the organization has already spent, implying that they must refund the total amount of the disallowed costs to the donor.

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On the contrary, for-profit organizations have to invite an external auditor and allow the process to continue without hindrances (Drucker, 2011). However, the profitable organization is not subject to a disallowance of costs incurred and, as such, provides refunds to the shareholders. The auditing processing in a for-profit organization aims at revealing the financial position of the company and its compliance to GAAS (McLeish, 2010). It also provides investors with reliable information about the status of the company. Indeed, investors evaluate the financial position of a company through audit reports and the profitability of a company. For nonprofit organizations, the major objective of an audit is to analyze the utilization of contributions in the achievement of specific objectives that the donors provided them. It aims at enhancing accountability and transparency to all stakeholders of the organizations (McLeish, 2010). To that end, the auditing processes in the two categories of organizations have different objectives and goals.

Human resource considerations in the two types of organizations are different (McLeish, 2010). While profitable organizations aim at acquiring talented and skilled labor that is salaried, nonprofit organizations have a small number of employees but with a high number of people who volunteer for the organization. As such, the nonprofit organizations must be able to account for the volunteer time that the unpaid workers in the organization spend. Besides, the procedures for acquiring and firing new members of staff differ substantially. The rationale is that employee motivation for the two organizations is also different (Drucker, 2011). To this end, the employees working nonprofit organizations may get the motivation from the provision of humanitarian support to people as opposed to an increase in remuneration. The compensation model that a for-profit organization may adopt motivates the employees. To this end, their job satisfaction and motivation result due to an increase in benefits as opposed to the achievement of the goals of the organization. Volunteers in nonprofit organizations do not increase their productivity to receive rewards and benefits. Still, they accomplish their objectives by assisting nonprofit organizations in fulfilling their activities of helping people and individuals (McLeish, 2010).

Conclusion

In essence, the financial management of nonprofit organizations contrasts with the financial management of for-profit organizations. They vary in the sources of funds, financial reporting, auditing, and governance structures. While much of nonprofit organizations’ revenues come from donors and grantors, sales revenues and earnings are the most important sources of funds for-profit organizations. Besides, the two categories of organizations reveal their financial information in varied ways. Nonprofit organizations do not have a profit and loss account, while profit organizations must have the account when issuing their financial information. These are among many other differences.

References

Daze, P. (2010). Economy of Nonprofit Organizations Charities and Donations. International Research Journal of Finance and Economics, 90(52), 234-256.

Drucker, P. (2011). What Business Can Learn from Nonprofits Organizations. Harvard Business Review, 4(5), 1-7.

McLeish, B. (2010). Successful Management Strategies for Nonprofit Organization. New York: McGraw Hill Publishers.

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