In GDI’s experience incubating initiatives, a working understanding of non-profit finance, accounting and operations are tools in a successful toolkit for early-stage organization leaders. However, these entrepreneurs, board members, and senior leaders are rarely subject area experts in these fields, and digestible descriptions of the most relevant content are difficult to find. To support our colleagues, we focus on user-friendly background in these key areas.
We look forward to using this platform as an opportunity to share our thinking with our colleagues and community. We also invite you to share with us your own refinements, questions, and ideas for areas you think should be explored further.
One of the first things we recognize at GDI is that every non-profit organization is different. There may be some variation in finance and accounting policy and procedure, including how transactions are categorized, how costs are distributed, and what names are used for different accounting functionality and reports. This is entirely appropriate. So while this background applies to most organizations, not every element may apply to your organization. For example, an organization that primarily receives funds from one donor with no restrictions requires significantly less accounting complexity than an organization with funding from multiple donors that require detailed tracking.
In general, most early-stage accounting systems should be designed to maximize three priorities:
- Complying with accounting standards: in the United States, this is GAAP (Generally Accepted Accounting Principles)
- Tracking expenditures and revenues by activity and type to facilitate necessary reporting
- Providing adequate information for management analysis of areas of organizational interest
Accounting systems can track an almost unlimited amount of information, but information that does not serve one of the purposes above does not need to be tracked. For example, an organization could separately track the expenses associated with purchasing index cards, printer cartridges, and calculators. This level of detail is (1) not necessary to comply with the accounting principles, is (2) unlikely to be required by a donor, and (3) almost certainly is not necessary for management analysis. In our experience, as organizations seek out great granularity of tracking, staff become less diligent at segregating their time and expenditures into an ever-growing list of projects. At the same time, a significant administrative burden is created in the process. We encourage management to think critically about what information is truly valuable and necessary in their system design. Here are examples of when it is appropriate to track this information, and when it is not:
- An organization has staff use separate timesheet designations for time spent on work in South Asia vs. work in South America. At this level of detail staff are likely to complete their timesheets with a high degree of accuracy, and this information has the potential to provide significant value to management.
- An organization requests that staff use separate timesheet designations for time spent preparing for meetings, attending meetings, preparing meeting minutes, and editing meeting minutes. Staff are unlikely to complete their timesheet with a high degree of accuracy, and as a result this information provides limited value to management.
To understand the financial model of non-profit organizations, it is helpful to understand areas where non-profit accounting most significantly diverges from for-profit accounting. The vast majority of primary technical accounting remains the same regardless of the business model or type. Still, there are a few concepts and treatments in non-profit accounting that we highlight as unique.
Non-profit accounting records generally assign each expense to a specific “class”. In a for-profit context, this would be similar to a client. Classes allow the organization to quickly identify costs associated with a particular activity for reporting to donors. When expenses are recorded into the accounting records, they are assigned to groups of classes that generally fall into one of three categories:
- Program costs – These are expenditures that are directly associated with a project. These charges might include travel costs, meetings, computer purchases for the use of program staff, and other similar expenditures. Classes are generally named for a program or a specific donor or client depending on the level of tracking required. For example, one program that has many donors may have several subclasses to segregate expenditures between donors, while other programs only have one funding source, so a single class is adequate.
- Distributed costs – There are a range of expenses that may be assigned to a temporary “holding” class and subsequently distributed as direct costs to projects at month-end. These might include expenses such as staff wages and employee benefits. For example, wages for all staff are often recorded as a lump sum during the month. After timesheets are received, wages are allocated to different program classes based on those timesheets. In this case, wages of staff working on a program are considered program direct costs, even though they are only allocated out to the program at month-end. After these costs are distributed, they become program costs.
- Indirect costs – Indirect costs are expenses that are not easily identified as benefiting a specific program. Examples might include audit fees, payroll processing fees, software, administrative staff time, bank fees and the like. These costs are generally pooled together and distributed to program classes at month-end. Depending on the organization, indirect may be further broken down into subcategories (e.g. indirect supporting programs vs. indirect of running the organization). Different organizations use different terms to describe this pool of costs such as indirect, overhead, or general & administrative costs.
The majority of traditional foundation grants provide restricted funds to organizations. Restricted funds come with criteria on how they are spent. Common examples of restrictions include, but are not limited to:
- The timeframe in which the funds are spent
- The specific activities on which the funds are spent
- Restriction on spending on certain expense types
- Requirements to spend on pre-approved budget items
In non-profit accounting, we usually recognize the entire value of a restricted award when the pledge is made or the agreement letter is received, even if we have not received the cash and/or expect to spend the award over several years.
Example: An organization receives a 3-year award for $3,000,000 to support an initiative. A $1,000,000 payment is made on the signature of the award, and additional payments will be made at the beginning of each year. The organization records $3,000,000 in restricted revenue, $1,000,000 in cash, and $2,000,000 in accounts receivable.
Generally, if restricted funds cannot be spent according to the donor restriction, they are returned to the donor. Restricted funds are segregated from unrestricted funds and reported in the equity section of the balance sheet.
For a 501c3 organization, unrestricted funds must be used to support the organization’s mission, but generally are not time-bound, do not require significant (if any) reporting to a donor, and are not restricted to any specific costs or activities.
Unrestricted funds generally come from one of two sources:
- Unrestricted donations made to the organization (Example: An individual donor gives an organization $50,000 to support the organization’s mission.)
- Revenue above expenditures, whenever the organization is permitted to keep the excess funds (Example: The organization signs a contract to provide services for a fixed price of $250,000, but actual expenses to provide the service are $225,000. The remaining $25,000 in funds becomes unrestricted.)
Unrestricted funds are segregated from restricted funds and reported in the equity section of the balance sheet.
While non-profit finance and accounting may be new to many entrepreneurs, we’ve learned investment in understanding the core concepts pay significant dividends in discussions and decision making with donors, partner, board, and staff. With all of our entrepreneurs, we seek to create a supportive environment to explore and understand these concepts, in relevant and accessible ways. This early understanding strengthens the management skillset of any new organization leader as they bring their mission to life.