Critical Issues in Financial Accounting Regulation for Nonprofit Organizations
Although there are few laws or regulations that directly state how nonprofit organizations must operate their finances internally, there are many that have a strong indirect impact. These indirect influences include IRS reporting requirements and the accounting standards most funding agencies require supported organizations to follow. In practical terms, these "recommended" standards all but demand certain accounting and other financial practices be followed by nearly all nonprofit organizations.
This text provides only a preliminary introduction to some major issues in nonprofit financial accounting regulations and practices, specifically in the context of legal requirements. Nonprofit organization staff and advisors with direct financial responsibilities will need to consult other, more detailed resources to gain a sufficiently complete understanding for them to fulfill their duties. However, others who are new to NPO finances, and who are interested in learning about its unique aspects, should find this discussion adequately introduces the main critical issues in nonprofit accounting. There is some emphasis here on 501(c) tax-exempt organization issues. This document may not be considered a source of professional financial advice.
This page is still in its initial draft form, and will always be subject to change based on new developments in NPO accounting practices and regulation. Please feel free to send comments and suggestions to the author.
The IRS requires most tax-exempt organizations to submit an annual information report, the Form 990 and its relations, which includes a significant amount of financial reporting. The report requires tax-exempt NPOs to complete
Because the IRS provides specific categories and classes into which revenue and expenses must be allocated, any organization that does not build its accounting system around these categories and classes would face serious hurdles preparing its annual IRS report. This provides in part a de facto basic standard for NPO financial reporting. Fortunately, most of the categories given in the revenue & income and the balance sheet are standard accounting categories.
Other aspects of the reporting requirements are more complex than would be required in small commercial businesses, but are not foreign to larger commercial operations. The report of expenses for individual program services roughly corresponds to divisional accounting methods, for tracking expenses incurred by different segments of an organization's total operation. Also, while the categories of income the IRS requires to be delineated are specific to nonprofit organizations (i.e. public contributions, unrelated business income), a fine resolution analysis of income sources is typical in large corporate financial accounting. As in that case, the various classifications of income are necessary because the IRS requires different treatment of the income classes for determining taxes. Unlike in commercial reporting, the IRS also uses these revenue classifications to help determine if an NPO will retain its tax-exempt status recognition. Some important classifications of revenue for NPOs are discussed further below under "Revenue."
However, commercial accounting typically does not face the additional requirement that all expenses be assigned to either program services, fundraising, or operations classification. In other words, every expense will have at least two and possibly three labels. First it will have an object expense label, e.g. a printing expense. Second, it will have a functional expense label, e.g. if the printing expense was associated with activities that advance the organization's nonprofit mission it would be labeled "program services" rather than as a fundraising or operations expense. Finally, all program services expenses will be labeled with the particular program service project for which it was incurred, e.g. an educational program to promote AIDS prevention. The term "fund accounting" is commonly used to refer to the complete segregation of revenue and expenses into "funds," each of which typically corresponds to an individual program service area. Such fund accounting is commonly required by granting agencies. Inferior accounting software is sometimes able to provide for two but not three labels, and therefore may be unsuitable for nonprofit organizations. However, there are sometimes methods for stretching weaker software into NPO usability. The specific meanings of "program services," "fundraising," and "operations" are further discussed below under "Expenses," since these are critical for IRS and other public reporting requirements.
If an organization's financial accounting system does not or cannot assign these types of labels to income and expenses as required, completing the annual IRS report becomes an extremely arduous task, and adherence to financial standards required by regulators and granting agencies may be impossible. Fortunately, a wide variety of popular accounting software systems are available that have been designed to satisfy these needs. If the nonprofit organization uses an adequate accounting system, sets up its categories and classifications in line with the IRS reporting requirements, and assiduously labels all revenue and expenses appropriately, then completing the IRS annual report is a relatively painless matter.
Links to online IRS resources are given below.
To ensure that all organizations report similar transactions uniformly, many states require that contributions, gifts, grants, etc., and functional expenses be reported according to the AICPA industry audit guide, "Not-For-Profit Organizations," supplemented by the National Health Council's "Standards of Accounting and Financial Reporting for Voluntary Health and Welfare Organizations." Fortunately, the IRS annual information report is structured in accordance with these guidelines, and therefore states will typically accept a completed IRS report as the organization's financial report. However, it is useful for NPO staff and advisors who have financial responsibilities to be familiar with these guidelines. As described below in the section on "Published Guidelines," these form a significant portion of what are considered Generally Accepted Accounting Principles (GAAP) for NPOs.
Organizations that receive federal grants have an additional set of financial accounting regulations to follow, which are established by the Office of Management and Budget (OMB) in a set of published circulars. These provide detailed instructions for determining how to categories specific costs, as well as indicating which types of costs may be funded by federal grants and which the organization must pay for through other means. The OMB circulars are further discussed under "Published Guidelines" below. Furthermore, organizations may be required by granting agencies to obtain a financial audit, which is a detailed examination of the organization's financial practices and records by an independent third-party. The OMB and AICPA both publish auditing standards that are commonly used. Additional references addressing nonprofit organization audits are listed below.
There are three major bodies that issue standards for nonprofit organization financial accounting, and some supplementary guidelines that are commonly referenced, which regulators typically relay on for determining if an NPO is conducting its finances responsibly. The standards bodies are the Financial Accounting Standards Board (FASB), the American Institute of Certified Public Accountants (AICPA), and the U.S. Federal Office of Management and Budget (OMB). The FASB is the primary standards issuing body for nonprofit organizations in the U.S. However, this hasn't been the case for very long, and at this time it has developed only a limited set of "Statements of Financial Accounting Standards" for NPOs, although two are critical ones. These are No. 116, "Accounting for Contributions Received and Contributions Made," and No. 117, "Financial Statements of Not-for-Profit Organizations." Unfortunately, the complete text of these is not available online, since the FASB sells printed versions as a fundraising mechanism.
The AICPA publishes the primary guide to GAAP for nonprofit organizations, the "Not-for-Profit Organizations Audit & Accounting Guide." It also releases its own standards, called "Statements of Position." The most recent, and controversial, is SOP 98-2, "Accounting for Joint Activities Accounting for Costs of Activities of Not-for-Profit Organizations and State and Local Governmental Entities That Include Fund Raising." Further discussion of joint costs allocation is presented below.
The OMB develops standards and guidelines specifically for NPOs that receive federal grants. However, even if an organization doesn't currently receive such revenue, there are few that wouldn't like to be able to at some point. Therefore, some familiarity with the OMB guidelines can be useful. Unfortunately, they are rather arcane and picayune, and not something most people would choose to read if they had a choice. The potential size of many federal grants is typically the primary motivation for doing so.
In addition to the standards and guidelines developed by official bodies, several works by other organizations have become valuable tools for administering financial accounting operations. Of particular note are the National Health Council's "Standards of Accounting and Financial Reporting for Voluntary Health and Welfare Organizations," and the United Way of America's "Accounting and Financial Reporting: A Guide for United Ways and Not-for-Profit Human-Service Organizations."
Several book publishers have recently released guides to GAAP standards for NPOs. These essentially combine the various standards and guidelines issued by official standards bodies into a more unified form. As such, they are very useful for obtaining a complete picture of the commonly accepted accounting practices, and make good desk references for accountants. They are not especially written for people other than accounting specialists. Fortunately, there are also various books targeted to nonspecialist NPO managers, which provide a suitably detailed introduction to accounting principles both general and unique to NPO operations.
As described earlier, the IRS and various standards and guidelines require revenue to be assigned within a specific set of categories. The most important of these for most nonprofit organizations are revenue from public support and from exempt-purpose activities. These are described more fully below, along with a short discussion of other revenue and unrelated business income tax (UBIT). Correct assignment of revenue to the appropriate category is critical for most NPOs, since the IRS uses this information as a primary means of determining qualification for tax-exempt status.
The most detailed and significant guide for nonprofit administrators to assigning revenue to the various typically required categories may be found in the instructions for the IRS Form 990/990EZ. These are further amplified by various written IRS releases, such as IRS Revenue Procedures statements. The other standards and guidelines described here are generally followed by the IRS when developing its own regulations.
Federal law defines several types of nonprofit organizations that qualify for recognition of federal tax-exempt status. The type most people usually think of when the term "nonprofit organization" is used, is the publicly-supported public charity, which is actually just a small segment of the nonprofit sector in terms of assets or revenue. A key qualification for this NPO type is the fraction of its revenue that comes from public support. For example, other related NPO types for which public support isn't critical are private foundations, and charities supported by exempt-purpose activities.
Public support usually takes one of three forms. One is direct public support, which is usually charitable donations by individuals, private foundations, and businesses. Although always classified as public support, this revenue may only be counted toward an organization's "public support percentage" (used to determine tax-exempt recognition) to a limited extent, based on the organization's total revenue. This is to prevent an organization from serving as a tax-shelter for a limited group. Instead, direct public support must come from many individuals contributing amounts that are relatively small compared to overall revenue.
Other common forms of public support are indirect, the two major sources being from governments and from publicly-supported granting agencies (including other publicly-supported public charities, and public foundations). This support is also considered to come from the general public, but via an intermediary. This form of public support is particularly valuable to publicly-supported public charities because the full amount may be applied to the public support percentage used to determine tax-exempt recognition.
Simply stated, exempt-purpose activities are those that directly advance the organization's stated mission. This mission must be stated and described in the organization's application for tax-exempt status recognition as submitted to the IRS, and the IRS refers back to this application to determine which activities are exempt-purpose ones. As described above, federal law defines various types of tax-exempt organizations, one of which is the set for which exempt-purpose revenue is a primary means of support. There is a specific set of requirements that this class of tax-exempt organization must meet to retain its exempt status recognition.
Organizations may modify or redefine their missions, but doing so requires that the IRS be notified. Also, there is a broad set of revenue-generating activities for which their classification as exempt-purpose activities or otherwise is ambiguous. The IRS may consider such activities as exempt-purpose ones or not, depending on the details of the organization's mission statement and description, and how the IRS has treated such revenue in the past.
There are many other potential sources of revenue for nonprofit organizations besides public support and exempt-purpose activities. Examples include special fundraising events, membership fees, interest and investment income, and other unrelated business income. "Unrelated" in this sense refers to revenue that doesn't fit any of the other specified categories, and which comes from activities that are unrelated to the organization's exempt-purpose activities because they aren't considered to directly advance its mission. The IRS defines a specific set of categories of income other than public support and revenue from exempt-purpose activities. Any income that can't be assigned to any of these categories is considered unrelated business income. Unlike other sources of NPO revenue, unrelated business income is taxed at normal corporate income tax rates. This assessment is called unrelated business income tax (UBIT). Other resources addressing UBIT issues are listed below.
Just as income must be correctly assigned to specific categories, expenses must also be properly labeled. A unique aspect of NPO accounting is the "third label" that must be attached to all expenses, marking them as for program services, fundraising, or operations. Although states have historically tried to establish laws specifying the required allocation that NPOs must make among these (e.g. a maximum fundraising expense percentage), these have been struck down by the U.S. Supreme Court as unacceptable restrictions of the organizations' rights. However, there is no doubt that the costs of fundraising and operations, which don't directly promote the organization's mission, are of interest to donors and other supporters. Organizations with low fundraising and operations expenses are typically considered to be more efficient and to make better use of their assets. Accordingly, the IRS requires that expenses be allocated between these classifications and that information be made public. In short, rather than try to legislate specific percentages, regulators now encourage the public to examine the relative expenses among organizations that they might support, and make their own judgments.
The details of how to allocate expenses under the three categories are presented in detail in the instruction for the IRS Form 990/990EZ. Other standards and guidelines may amplify and expand these explanations. In particular, the AICPA's SOP 98-2 addresses the issue of accounting for activities that fit in part under more than one classification (so called "joint costs").
Program services expenses are those amounts specifically expended in support of activities that directly advance the organization's nonprofit mission. In other words, if an organization exists to promote the development of a cure for AIDS, amounts spend in grants to AIDS researchers is a program services expense. Funds spent to raise donations that will eventually go to grants, and funds spent to pay for the organization's office, only indirectly support the nonprofit mission, and therefore do not qualify as program services expenses. A particular class of program services, public education, are often tied to fundraising purposes, and this is further discussed below under joint costs allocation.
Fundraising expenses are those amounts used to bring in additional revenue, typically (but not only) through public donations. An example of fundraising expenses are the costs of printing and mailing to the general public flyers that encourage them to support the organization's mission by sending a donation. As such mailings often include educational material that advances the organization's mission, such costs are sometimes treated as program services expenses in part, a subject further considered below under joint costs allocation.
Operations expenses are those that don't clearly fit under either program services or fundraising expenses (nor in part under both). Examples of operations expenses are the salaries for senior staff who aren't specifically responsible for only fundraising or a particular exempt-purpose activity, the cost of a staff office, and any legal or accounting fees that can't be clearly assigned to any particular program.
In 1998, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position 98-2, "Accounting for Costs of Activities of Not-for-Profit Organizations and State and Local Governmental Entities That Include Fund Raising." SOP 98-2 is effective for fiscal years beginning on or after December 15, 1998.
SOP 98-2 focuses on expenses associated with certain joint activities, which in part serve a fund-raising function, but also have elements of program services or operations. For instance, the expenses associated with an educational mailing that also includes an appeal for donations might be jointly allocated between program services and fundraising expenses. The greater extent one can assign a cost to the program that truly incurred it, the more accurate the organization's financial records and reports. Joint costs allocation is unfortunately an area where NPOs sometimes use questionable financial practices, such as arbitrarily dividing up and spreading most or all of their actual fundraising and/or operations costs in their financial reports among their various program services in order to make it appear that they have very low fundraising and overhead costs. That contrasts with legitimate accounting procedures for accurately assigning a particular program service (or fund or grant) its true share of the operations and overhead costs.
Accordingly, SOP 98-2 prescribes the conditions under which costs may be split between fundraising and another activities. If the conditions are not met, then the entire amount must be treated as a fundraising cost. Because these conditions are quite strict, many organizations have objected to SOP 98-2, but it is likely that its acceptance will lead to more accurate accounting and greater public financial accountability by nonprofit organizations. Resources that provide further information about SOP 98-2 and joint costs allocation are listed below.
Excess benefits transactions are a relatively new area of nonprofit financial concern. Historically, the IRS had only one tool it could use when an organization acted in a manner inconsistent with its nonprofit mission: to strip it of its tax-exempt status recognition. This was sometimes considered overly draconian for minor infractions, but the IRS had no other mechanism to encourage compliance. The "intermediate sanctions" laws were therefore devised to give the IRS more discretion in these matters. These are "intermediate" because the provide less of a punishment than being stripped of exempt recognition. A major part of the current set of intermediate sanctions regulations concerns "excess benefits transactions." These are expenditures by a tax-exempt organization that are suspect primarily because they either appear to be or in fact are a misuse of the organization's funds. In order to maintain the public trust in NPOs that receive tax-exempt recognition, particularly those for which donations are tax deductible, the IRS serves as a public watchdog for improper practices by organizations it regulates.
The IRS has only recently released its proposed intermediate sanctions regulations for excess benefits transactions, which implement federal laws passed several years ago. The regulations are complex and in some parts highly disputed. It is likely that at least some modification of the proposed regulations will occur before the final regulations are released. However, the regulations once released will apply retroactively to when the associated laws were passed in 1996. This is one of the main reasons why many NPOs are particularly upset about the proposed regulations. Not following the proposed regulations as written may dangerously expose an organization to the risk that its current and recent activities will subject it to sanctions when the final regulations are released, yet parts of the proposed regulations are quite contentious and may be changed.
The issue of excess benefits transactions, and the intermediate sanctions rules in general, are far too complex to be presented succinctly here. The reader is encouraged to explore some of the other resources available on this subject.
These are links to additional resources, mostly other than at this site.
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