Nonprofit accounting rules explained

What is nonprofit accounting?

Nonprofit accounting is the process in which nonprofits plan, record and report on their finances. The key focus of nonprofit accounting is on accountability, where money is spent and why. The rules surrounding nonprofit accounting aim to keep charities accountable to donors and the general public.

How is nonprofit accounting different from traditional accounting?

The key difference between nonprofit and traditional accounting is the focus on accountability whilst traditional accounting focuses on making a profit. Nonprofits need to prove that they are spending money in a way that supporters approve of so that they know where their donations are going.

As a result, nonprofits use fund accounting which enables them to allocate their money into different ‘funds’. Money will typically be separated into funds such as the following:

• Restricted funds - funds that must be spent on specified projects and activities.
• Temporarily restricted funds - funds that must be spent on specified projects and activities within a certain time frame before they become unrestricted funds.
• Unrestricted funds - an annual fund to spend on areas that require the money.

Another accountability aspect of nonprofit accounting is the non-distribution constraint. This means that nonprofits are not allowed to distribute net earnings to leaders in the organisation.

Nonprofit accounting statements

Nonprofits must follow certain rules and guidelines when it comes to accounting. Some of these rules are specific to nonprofit organisations whilst others are general accounting principles. Understanding these various statements is key to navigating the financial responsibilities of your nonprofit.

Statement of financial position

A nonprofit’s balance sheet is also known as the statement of financial position. This document represents the financial health of a nonprofit. The statement of financial position will include assets and liabilities which results in telling you the net assets of a nonprofit.

The simple equation is as follows:

Assets - Liabilities = Net Assets

Positive net assets mean healthy financials. Negative net assets could mean that a nonprofit needs to reprioritise its finances. 

Statement of activities

A nonprofit’s statement of activities is also known as the income statement. This statement shows revenue and expenses, their different categories and how net assets have changed over time.

The revenue and expenses can be separated into different funds and categories. This is a great way to keep track of spending and to clearly see where funds are going and why.

Statement of functional expenses

A statement of functional expenses breaks down expenditures into different categories with a function for each expense. The three functions include:

1. Program expenses
2. Administrative expenses
3. Fundraising activity expenses

The nature of the expenses must also be included in the statement. This might include subcategories such as rent, insurance, salaries and more. This information also helps when reporting as it’s clear to see what expenses were used for.

Statement of cash flow

A statement of cash flow demonstrates how cash moves in and out of the nonprofit whilst showing how much money is available for paying expenses.

The nonprofit statement of cash flow breaks down operating, financing and investing activities to reflect how cash moves within the organisation. This allows donors and the public to see how a nonprofit uses its funding.

Nonprofit accounting rules and regulations

As with all businesses, accounting rules and regulations must be followed by all nonprofits. This ensures that an organisation is recording its accounts correctly and all information is provided.

Generally Accepted Accounting Practice (GAAP)

The GAAP details the legal obligations of business accounting. The UK GAAP requires businesses to adhere to the following principles when collating financial information for reporting:

• Principle of regularity - act in compliance with enforceable laws and rules.
• Principle of consistency - standards, methods and procedures remain the same.
• Principle of sincerity - the nonprofit’s financial status must be reflected in accuracy and impartiality.
• Principle of permanence of methods - consistent processes must be used in all accounting to allow easy comparison.
• Principle of non-compensation - the full scope of financial accounting information must be covered.
• Principle of prudence - financial facts must be presented “as they are” with no room for speculation. Data shouldn’t be made to look more appealing and revenue only recorded if certain.
• Principle of continuity - financial information presented as though businesses will not be interrupted.
• Principle of periodicity - revenue reporting is broken down into quarters or years.
• Principle of materiality - accounting must disclose the full extent of the organisation's financial position.