What’s the difference between nonprofit and for-profit accounting?

by | Nov 17, 2021

If you’ve run a for-profit business, then you probably expect that nonprofit accounting will be a cinch. There can’t be a big difference between nonprofit and for-profit accounting, right?

And if you’re “not a numbers person,” you’ve probably filled your board of directors with the most experienced business folks that you know.

Certainly, those brilliant minds will make quick sense of your financial reports, right?

Well, not so fast…

There are some significant differences between nonprofit and for-profit accounting

Many successful business people have found themselves befuddled the first time they face a nonprofit’s financial statements.

In nonprofit accounting, the terminology is different. Some of the processes are different. And even the rules are different.

But don’t worry– in this article, we’ll walk you through the main differences between nonprofit accounting vs. for-profit accounting. So you can get yourself, your team, and your board onto the same page.

Ready? Let’s get started.

The 6 main differences between nonprofit and for-profit accounting:

1. Tax Status

One of the biggest differences between nonprofit and for-profit companies is that most nonprofit companies don’t pay any federal taxes.

And in the case of 501(c)(3) nonprofits, a donor’s contributions are also tax-deductible on their personal or business tax returns.

That part is pretty easy to understand. But from there, things get complex quickly…

To start, most nonprofits don’t pay federal taxes. But they still need to file a tax return each year. If you don’t file IRS Form 990 each year, you’ll lose your tax-exempt status.

irs_form_990

Failure to file an IRS 990 can cause you to lose your nonprofit status.

Plus, some nonprofits DO pay federal taxes, because not all nonprofit income is tax-exempt.

A nonprofit has to pay federal taxes on income from “unrelated business activities.” So what does that mean?

Suppose your nonprofit is set up to battle the homelessness crisis in your city. You wouldn’t pay taxes on any donations you receive. But if you open up a shop to sell artisan crafts, you’d probably have to pay unrelated business income tax to the IRS on any profit generated by the store even if those profits go to support your programs.

Nonprofits have to pay payroll taxes for their employees, just like for-profit companies. And your employees pay income tax on their salaries too.

But your nonprofit may or may not have to pay sales and property taxes. Some states grant nonprofit tax exemptions for sales taxes and property taxes. But others don’t.

The issue of taxes is a crucial differentiator between accounting for nonprofit and for-profit organizations. But, as you see, the tax rules for nonprofits aren’t straightforward or intuitive.

So take your time to research the rules in your area, or hire a professional, to keep yourself out of trouble later.

2. Revenue Recognition

One of the critical rules in for-profit accounting is “the matching principle,” which states that “the revenue and its associated costs must be reported in the same accounting period.”

In its simplest form, this means that if you sell a car in January, the costs associated with building that car must be reported in January too.

Because the revenue and expenses are reported in the same period, it’s easy for shareholders and management to see if they’re making money or losing money.

With nonprofit accounting, there is no such rule. In fact, it’s kind of the opposite.

In most cases, you need to record donations when they are pledged instead of when they are received.

That means:

    • If a grant-maker pledges a $200,000 donation today, you have to report that income today. Even if you won’t receive the donation for another 6 months
    • If a donor promises to make a $500 gift every year for 3 years, you’ll recognize $1,500 of revenue today.

In both cases, you can’t spend that money yet because you haven’t received it yet. But the revenue will show on your monthly reports, making your net revenue number look high.

Then, when you actually do receive and spend the money next year, you won’t show any associated revenue. So your quarterly reports will reflect a loss.

These kinds of swings are normal for a nonprofit.

But they can cause panic for an inexperienced nonprofit accountant, board member, or executive director.

An experienced nonprofit CFO will understand these significant variations and explain them simply to the board and other management staff.

3. Restricted Funds

In almost all cases, when a for-profit company receives revenue, they can use that revenue however they want– to pay employees, buy inventory, or invest in new ventures.

But that’s often NOT the case for nonprofits.

Some donations, and many grants, will come with limitations on how and when your nonprofit can use them.

You may have specific funds that can only be used on particular programs, which means you can’t use them to pay core operational expenses, like payroll or rent.

Or you may have an endowment that you can invest but never actually spend.

Finally, some grant funds may have strict timelines in which you need to use them, or you’ll have to pay them back.

program_restricted_funds

You may not be able to use certain funds for your operational expenses, like payroll, rent, and utilities.

The number of possible scenarios is pretty much unlimited.

A nonprofit accountant must design bullet-proof systems to track all these funding sources correctly and match them to the appropriate program. So you know exactly where every penny is at each moment.

Because if you violate the terms of your grant or lose the trust of your donors, your funding sources could disappear.

You may want to hire an experienced nonprofit accounting team to track your restricted funds to keep your donors happy and your funding safe.

4. Terminology and Financial Statements

When comparing nonprofit accounting vs. profit accounting, the same core financial principles apply to each.

But the terminology is so different that it can often feel like you’re speaking an entirely different language.

If you’re looking at a nonprofit’s finances for the first time, here are a few things you need to know:

Statement of Financial Position = Balance Sheet

The balance sheet for a nonprofit works pretty much the same as a for-profit one. But in a nonprofit, it’s called the Statement of Financial Position instead. You’ll also see some extra lines to account for restricted funds. And some different terminology, like “Net Assets” in place of equity…

Net Assets = Equity

Legally, a nonprofit doesn’t have an owner. So there is no Owner’s Equity or Shareholder Equity. Instead, you’ll find “Net Assets” in its place on the bottom half of the balance sheet (or Statement of Financial Position).

Statement of Operations = Income Statement / P&L

Your Statement of Operations shows you how much money you “earned” above expenses over a given period. It’s essentially the nonprofit’s version of the Income Statement, or Profit and Loss Statement.

5. Internal Controls

Historically, nonprofits have been easy targets for theft, embezzlement, and misuse of funds. So to protect donors and their donations, the FASB requires nonprofit accounting departments to follow a series of strict internal controls.

Most importantly, a review of your internal controls is a vital part of an independent nonprofit audit.

Not all nonprofits are required to be audited, but you may need to be audited depending on your state, your size, and your funding sources.

Many large grant-makers will only give funds to organizations with fully audited financial statements. So if you choose not to be audited, you could cut yourself off from potential funding sources.

Below you’ll see some examples of internal controls you may need in your nonprofit. Be sure to talk with your nonprofit accountant or CFO about the specific controls that you do or don’t need.

 

Nonprofit_internal_controls_examples

Of course, many for-profit accounting departments have processes and procedures for some of these things too. But the standard of expectations is higher in nonprofits.

Even if you don’t need to be audited today, you should still set up effective controls today.

Because if you wait until you need to be audited, you’ll find yourself with a messy audit result, a big bill, and a LOT of work to do to catch up.

Now that you know the differences between nonprofit and for-profit accounting…

You should better understand what’s expected of you as a nonprofit leader, employee, or board member.

If you’d like to continue your nonprofit financial education, sign up below for our free Nonprofit Accounting & Reporting Masterclass.

In 3 short video lessons, we’ll walk you through the differences between nonprofit and for-profit accounting, discuss the basics of nonprofit accounting, and walk you step-by-step through real-world examples of nonprofit financial statements.

 

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