Not-for-Profit Formation, Accounting, and Income Taxes

We are familiar with the accepted accounting principles for not-for-profit organizations. There are, however, some significant differences which include:

• Accounting for Contributions
• Capitalizing and Depreciating Assets
• Use of Cash – and Modified Cash-Basis Accounting
• Functional Expense Classification

People who pay to attend fundraisers (such as dinners, auctions, fashion shows, bake sales, etc.) often receive a tangible benefit in return (a meal, a performance, etc.) Similarly, membership dues may entitle individuals to use facilities, receive services, etc. The portion of the special event charge or membership dues which represents the reasonable value of the benefit received is not tax-deductible to the donor. Some minimal benefits are excluded from this rule.

In addition, the accounting profession has established guidelines for responsibly tracking monies that have been restricted by the donor for specific use (e.g., buying a new building, starting a new program, adding to the endowment, etc.) How these monies are tracked and reported depends on the nature of the donor & restriction, what conditions, if any, the donor has imposed on the organization before it can receive or use the money, when the restrictions are met, etc.

As in for-profit accounting, nonprofits are required to record the purchase of long-lasting, substantial property and equipment (such as computers, vans, buildings, etc.) as assets in the financial records, and to charge a portion of the cost of those items in each year in which they have a useful life. This process is called capitalizing and depreciating fixed assets. While all businesses, including nonprofits, are required to record the depreciation of assets, some assets in the nonprofit sector receive special treatment. These include museum collections, historical buildings, library books, zoo animals, etc.

Donated items that are added to collections that are held for public exhibition, protected, and kept unencumbered, and subject to the policy that, if sold, the proceeds are used to acquire equivalent replacements for the collection, do not have to be recorded as revenue and are not recognized as formal assets in the financial statements.

Nonprofits are required to report their expenses by what is known as their functional expense classifications. The two primary functional expense classifications are program services and supporting activities. Supporting activities typically include management and general activities, fundraising, and membership development. Practices vary widely from organization to organization in the nonprofit sector as to how expenses are categorized by functional areas.

To determine a nonprofit’s success, you must also refer to its goals: these are the group’s self-determined replacement for the bottom line of profit-making. The board can measure (a nonprofit’s) success by comparing the results achieved with the results sought. This points to the importance of a clear mission statement as well as regularly updated short and long-term goals that reflect the purpose of a volunteer agency. It also underscores the need to include service statistics in conjunction with financial statements. In this way, board members can begin to grapple with the complex issues of efficiency and effectiveness as their organization pursues its stated goals.