What are nonprofit organizations?
A nonprofit organization is an organization whose main aim is to fulfill a charitable, educational, religious, or scientific purpose, as opposed to earning profits or maximize revenue. These organizations do generate profit, but their primary function is to be put back into their main mission.
These organizations are usually set up for the welfare and benefit of the society, or for promoting art and culture or religion in society. These are charitable institutions that exist to serve society.
Nonprofits are getting tax exemptions and have a different way of accounting and making financial statements. Nonprofits aren’t required to pay federal income or corporate taxes but might still need to pay state and local income taxes.
Tax-exempt nonprofits are known as 501(c)(3) organizations. The members of the organizations elect trustees, who are the people that manage these organizations. The nonprofits raise funds through its members as well as the general public to meet their goals.
Generally, the main purpose of these organizations is not to manufacture or trade goods or services, so they don’t prepare the normal financial statements any manufacturing or trading company would.
So like we know so far, nonprofit entities do not buy and sell goods or services or provide them with a motive like profit maximization. But still, they need to keep a record for incomes, expenses, assets, and liabilities, like any other organization.
The main source of income for nonprofits is donations, subscriptions, and grants. Most of their funds are in cash form and transactions are done in cash or through the bank.
So to be able to show proper records and be accountable to the members, donors, and contributors, and also because the government requires these records for provision of grants, they must prepare financial statements.
Accounting done properly also lessens the exposure to fraud risks. Along with ledgers and cashbook, they are required to have a stock register as well. In a Stock Register, an entire record of fixed assets and other assets and consumables is maintained.
In nonprofit accounting, instead of a capital account, organizations maintain a capital fund or a general fund. This account is credited when they generate profit and receive donations, membership fees, grants, etc.
Nonprofit organizations are also required to have financial statements prepared at the end of an accounting year or period, according to accounting principles. These should be the final accounts for these organizations:
- Receipts and Payments Account: It should summarize all the cash and bank transactions. This account helps them prepare a statement of activities and balance sheet. They are also required to submit it to the Registrar of Societies along with the statement of activities and balance sheet.
- Statement of Activities: This account is similar to any profit or loss account or income and expenditure account and discloses any surplus or deficit.
- Balance Sheet: This is also prepared in the same way as the balance sheet of an organization with a profit motive.
Statement of Activities: This is a financial statement nonprofit prepare instead of the income statement. An income statement usually shows a business’s profitability during an accounting period, while this statement of activities shows any changes in the value of the assets the organization owns.
An income statement shows revenue from trading of goods and services and expenses show the cost of goods sold. A statement of activities would show the revenue generated because of certain contributions and any expenses incurred during fundraising.
At the end of this statement of activities, it would show “Net Assets”, whereas income statements show “Net Income”.
Balance Sheet: In the Balance sheet for nonprofit accounting, instead of assets= liabilities + shareholder’s equity, it is assets= liabilities + net assets. This means that there is no shareholder’s equity, as it’s a not for profit organization and it doesn’t have any owners so no one has any claim on its assets.
Choosing an accounting method
Nonprofits need to choose an accounting method to keep a track of incoming and outgoing funds. Healthy cash flow is necessary to keep the organization running, as you have to pay for expenses like salaries, utilities and rent, and any other expenses that may arise.
Even though nonprofits do not engage in selling products, they still have many sources of revenue (donors, fundraisers, etc.) and all this revenue must be recorded, along with outgoing payments. There are two methods to choose from- cash-basis or accrual accounting.
Cash-basis accounting is a method where you only record the expenses incurred or income/cash received when you receive or pay them, not when the transaction occurs.
So for example, in a nonprofit where members are required to pay, you have to record the payment when you receive those dues. But this method cannot be used in the nonprofit only works on credit.
Accrual accounting is a method where you record transactions when they take place rather than when the money is received or paid.
This accounting method requires a double-entry bookkeeping system. If the nonprofit organization is collecting membership dues, they should be recorded when the invoice is sent, even if the money hasn’t been received physically.
Nonprofit organizations should apply (to internal revenue services) in order to be exempted from federal income taxes. An issue occurs which is whether a donation to any nonprofit organization can be exempted from the donor’s taxes on the basis of being a charitable deduction on the donor’s income tax return.
For example, churches, schools, etc., are some nonprofits that can qualify for being tax-exempted along with being exempted as charitable deductions on the donor’s income tax returns.
Even though nonprofits do get exempted from federal income taxes, not all donors get their donations exempted. And for the employees working for these nonprofit organizations, they are likely to be subject to employment taxes.
Nonprofit organizations can also sometimes be exempt from sales taxes, real estate taxes, and corporate taxes and other taxes depending on the state or country they are in.