Almost every organization, whether for-profit or non-profit, will have accounting processes in place. After all, where there is income and expenditure, there must also be accounting. Without accurate bookkeeping and cash flow monitoring, businesses and non-profits run the risk of falling into financial ruin or incurring significant fines for the incorrect or non-payment of taxes.
However, just because both for-profit and non-profit organizations require accounting doesn’t mean the process looks the same across the board. While some processes are naturally the same, such as calculating budgets and creating invoices, non-profit accounting is often more complex than for-profit. As a result, it’s recommended that charitable companies use bespoke accounting software for non profit organizations while paying close attention to detail. There is little room for error and every effort must be made to ensure complete compliance with legal regulations.
To understand the differences better, here is a list of some of the ways non-profit accounting diverges from for-profit accounting.
While some for-profit businesses may be able to claim tax deductions on particular products or use tax thresholds to their advantage, many non-profit organizations enjoy a reduced tax bill based purely on their charitable status. The type of tax exemption a non-profit receives will usually be based on its classification. For example, non-profits qualifying for 501(c)(3) are exempt from all federal income taxes and may have to file form 990 annually. Form 990 is to allow the public to inspect the finances of a non-profit, helping to inform their decision to donate and educate them on the organization’s dealings.
Non-profits qualifying for tax exemptions may need to produce detailed annual reports of their functional expenses. Functional expenses are expenses that relate to fundraising activities and charitable services. Accounting professionals need to keep a record of these and any associated evidence to secure tax exemptions, especially in the event of an audit.
For-profit income typically doesn’t need to be classified, as it’s often revenue that’s been generated by the business through the sale of products or services. Non-profit income is more complex, as organizations may generate revenue, but they may also receive funds from donors. These funds may sometimes have restrictions, which affects the way that a non-profit reports them in its books.
For instance, if a large donation is received by a non-profit for an event or project that will only take place in a year’s time, this revenue may need to be classified as deferred. Because while the organization has the money, it can’t yet use it for the intended expenses.
Donations can be restricted in different ways, but some donations will be free from restrictions, leaving non-profits to use the money as they see fit. Money that comes from an endowment or trust typically has the most restrictions and can only be used for a specific cause. Sometimes the amount of money that can be used from a trust is limited during a specific timeframe, or non-profits are only permitted to spend the interest a trust accumulates each year. Whatever the restrictions on the income a non-profit receives, accountants must take these into consideration and record them accordingly.
Annual Income Declaration
Despite a non-profit’s purpose being to not make a profit, they are allowed to have more revenue than expenses in the financial year. However, this money must not be considered as profit, rather it should be allocated to funding future projects or covering expenses in years to come. Non-profit cash flow isn’t always consistent, particularly if they rely heavily on donations, so having a reserve of cash can help non-profits to continue to function without going into debt. Cash reserves may also be spent on renovations or new equipment where necessary.
If non-profits are often taking in more revenue than they spend, they may be flagged by the tax authorities. Accountants may then need to prove that the money is being saved for a particular purpose and not being used as profit. If this isn’t possible, the organization may not be viewed as a non-profit anymore.
Statement of Financial Position
Both non-profit and for-profit organizations need to create financial statements that are distributed to financial investors, tax authorities, and the public. These statements differ slightly depending on whether the business is charitable or not.
Non-profits usually draw up a statement of financial position, as opposed to the more commonly understood balance sheet used by for-profits. A statement of financial position helps others to understand what a non-profit’s financial standing was at the time it was created. The document usually includes information on the non-profit’s assets, which may include cash, equipment, investments, and endowment funds. It will also detail any liabilities such as credit cards, debts, and loans, as well as information about any restrictions a non-profit has on its assets, as discussed previously.
A for-profit’s balance sheet is very similar to a statement of financial position with a few notable differences. Balance sheets are typically created each quarter, helping businesses to understand whether they’ve met certain targets while also informing future forecasts and goals. Key information that’s included on a balance sheet encompasses assets and liabilities but also covers shareholder’s equity. Shareholder’s equity is essentially how much the company is worth and it may change depending on how much the business pays its investors.
For-profits and non-profits: key differences
The main way that accounting differs across for-profit and non-profit organizations is through tax exemptions and charitable donations. Non-profit accounting can be more complex due to the types of reports that need to be filed and the ways that different types of revenue need to be treated. Accountants may also encounter challenges surrounding restrictions on certain types of assets and income, forcing them to keep careful records in order to create accurate budgets for upcoming projects.
However, despite these differences, both non-profits and for-profits must have an accounting system that allows them to track their financial situation, helping them to continue growing and offering their services to their target audience.