9 Important Nonprofit Accounting Terms Explained

If you're operating a nonprofit organization or have a role of responsibility within, you should be familiar with a few certain key terms to understand its financials better. Here are nine of the most important nonprofit accounting terms explained:

1. Financial Statements

It's important to be familiar with the various financial statements that a nonprofit organization uses in its reporting, as the titles differ slightly from for-profit entities. These include:

• Statement of Financial Position. This statement provides an overview of the nonprofit's finances at a given point in time. It is similar to a balance sheet.
• Statement of Activities. This statement details the revenues and expenses for a nonprofit organization within a reporting period. It is similar to an income statement.
• Statement of Functional Expenses. This statement provides greater detail of the expenses that a nonprofit incurs and lists the various items that fall under each functional expense category (such as rent, utilities, salaries, benefits, and so forth). It is unique to nonprofits.
• Statement of Cash Flows. This statement reports the change in a nonprofit's cash and cash equivalents during a reporting period. It is the same as a for-profit entity.

2. Functional Expenses

There are three basic functional expense classifications:

• Program Expense
• Management and General Expense
• Fundraising Expense

Expenses are classified based on how they are used within the entity. If the expense furthers the mission of the nonprofit, it is treated as a program expense. If the expense is not specifically used to further the mission of the nonprofit, it is treated as either a fundraising or a management and general expense. The classification of which is dependent on what the underlying purpose of the expense was for.

Functional expenses must also be reported in terms of their "natural classification" (i.e., what the money was actually spent on). Within the functional expense classification, expenses are reported for classifications such as wages or utilities.

3. Grants vs. Contributions

The key differences between a grant and a contribution are that:

• Grants are usually tied to a specific activity, whereas contributions can often be used as the nonprofit sees fit.
• Grants may have a deadline for their use, while contributions typically don't come with such a condition.
• Grants often require reporting to the grantee throughout the grant period, as opposed to contributions that do not have any reporting requirements.

4. Restrictions vs. Conditions

Some contributions do come with restrictions from the donor. These restrictions may be related to the contribution's purpose (e.g., the money can only be used for a particular project), the location at which the contribution is used, or the time frame in which it is used or received.

When it comes to contributions, conditions are different from restrictions. The three questions to ask to determine if a condition exists are:

• Is there a barrier?
• Is there a right of return?
• Is the right of return directly related to the barrier?

In general, restrictions limit how the contribution can be spent, and conditions limit when the revenue is recognized.

5. Tax-Exempt

Nonprofit organizations are generally income tax-exempt. In other words, they are not subject to the tax liability on the income that a for-profit business would incur. Nonprofits are still subject to other taxes such as sales tax and possibly real estate taxes.

6. Bylaws

A nonprofit's bylaws are important for at least two reasons:

• They are a legal document that helps to establish the nonprofit as a recognized corporation. Among other things, this allows the nonprofit to operate as a tax-exempt organization.
• They function as a "roadmap" for the nonprofit's actions. Bylaws are a type of agreement between the corporation and its owners that the nonprofit organization will conduct itself according to a prescribed pattern of behavior.

Nonprofit organizations usually fall under the oversight of a Board of Directors, depending on the specific terms of the bylaws.

7. IRS Form 990

Form 990, the Return of Organization Exempt From Income Tax, is the nonprofit's version of a tax return. Form 990 is used by tax-exempt organizations, charitable trusts, and certain political organizations to report the nonprofit's activities, detailed financial information, and a summary of how it is governed to the IRS. There is also a section in the form for the nonprofit to outline its accomplishments in the past year, thus justifying its tax-exempt status. Failure to file a Form 990 for three consecutive years can result in the loss of the tax-exempt status with the IRS.

8. Articles of Incorporation

A nonprofit's articles of incorporation are a charter that establishes the corporation's legal existence in the United States and Canada. The articles of incorporation for a nonprofit must explicitly state that:

• The nonprofit's activities are limited to the purposes set out under the specific subsection of the Internal Revenue Code, generally 501(c)(3).
• The nonprofit will not participate in any political activities prohibited for the organization.
• If the nonprofit dissolves, it will distribute its remaining assets to a qualifying public entity (another nonprofit, a government agency, etc.).

9. IRS Determination Letter

An IRS determination letter is a document that verifies the agency's approval of a nonprofit's tax-exempt status. The IRS posts copies of all the determination letters it writes on its official website, where they can be easily found with a search tool. The IRS can also provide a nonprofit with a copy of its determination letter in the event that the original is lost or stolen.

If you have any more questions about nonprofit accounting terms, contact us today, or read our blog for related articles.