May 25, 2019
Accounting: No Need to Be a Necessary Evil

Generating income from fees and fundraising is a challenge enough, while accounting for where it goes is a dreaded chore.

For most nonprofit executives, accounting and financial reporting are necessary evils. Federal reporting Form 990 is an arena where “good” program-related activities battle the “bad” cost centers of fundraising and administration. Ratios of these areas are used as a baseline rating of the efficiency and effectiveness of individual nonprofits and the sector as a whole.

Funders, especially the federal government, likewise bring their own requirements to reporting, further complicating an already convoluted undertaking. Financial reporting is often an afterthought undertaken solely to close one grant to make a new request.

Managers and boards that have access to detailed accounting information can make informed decisions and plans based on financial viability, as well as the impact a program has in the community. Funders are becoming more sophisticated in looking at an organization’s financial statements and are asking harder questions about controls and allocations.

A better understanding of where the money goes helps an organization demonstrate that it is a good steward of public support and more likely to be compliant under new regulations bringing Sarbanes-Oxley-like standards to the sector. Good cost accounting and financial management practices can make overhead more understandable and show how all of the pieces fit together to advance mission.

Risky Business

The 2004 Nonprofit Overhead Cost Study conducted by researchers at the Urban Institute’s National Center for Charitable Statistics (NCCS)/Center on Nonprofits and Philanthropy and the Center on Philanthropy at Indiana University examined Form 990s from 220,000 nonprofits. Among the findings: 37% of nonprofits with at least $50,000 in contributions and 25% reporting $1 million to $5 million in contributions show zero fundraising costs. Another 13% of nonprofits reported zero management and general expenses.

Grant writing costs are the most likely to be misclassified. The researchers examined two organizations claiming zero fundraising costs and found “one had more than $500,000 in actual fundraising costs, as shown on its audited financial statements. No one had noticed the zero until researchers asked about it, almost a year later. The other organization had a staff person who did nothing but fundraising, and they also did some direct mail fundraising. Despite this, both the audited financials and the Form 990 showed “zero fundraising costs,” according to the study.

Irregularities between Form 990s and audited financial statements are an obvious place for regulators to look. Funders often request financial statements with grant requests, and the availability of Form 990s on watchdog Web sites make it very easy to compare the two.

Frank Kurre, national managing partner, Not-For-Profit Industry Practice at Grant Thornton in New York explained that “more than 50% of the 990s are done by nonprofit staff themselves. If they’re doing them themselves, they need training; or the forms should be given to an outside firm to complete.”

In the November 20,2006 report Fiscal Year 2006 Enforcement and Service Results, Internal Revenue Service (IRS) Commissioner Mark W. Everson reported that “We’ve placed renewed attention and added resources in the charitable arena to help protect the integrity and maintain faith in the charitable sector.... These results show we are taking important steps to combat abuse in exempt organizations.” He went on to state that the IRS audited 7,079 exempt returns in FY 2006.

Even with increased IRS scrutiny “finessing your 990 is considered low risk” according to Dottie Johnson, CPA, former director of program services at the Nonprofit Financial Center (NFC) in Chicago. “They bow to the pressure to show good ratios, but they end up looking at best na´ve, and at worst liars. They need to understand that under reporting fundraising and administrative expenses is going to raise flags. Nonprofits are also going to have to look inward at their program expenses so that they can relate costs to impacts.”

Nonprofits Should Adopt a Cost Accounting Mindset

According to Kurre, “More nonprofits need to take a cost accounting mindset, and manage by cost center. One of our clients looks at everything by cost and income, and while they lose money, they know where to put fundraising and investment income.”

He recommended that organizations divide costs into three primary areas:
  • Direct program
  • Program administration
  • Agency administration
An example is an organization that has multiple programs, such as a meals-on-wheels and senior services. There will be direct program costs for food and staff specific to each program. On top of that are administrators managing several programs who, while 100 percent program, are part time on any program. Finally, on top of that are the executive director and accounting manager, who would be allocated across all programs as well as across fundraising and general administration.

Planning for these kinds of allocations is often missing in many organizations. “What typically happens is that the accounting records – the general ledger and subsidiary ledgers – don’t have enough detail” explained Kurre. “You need enough detail to look at salaries and other expenses across activities and programs. New software is an opportunity to rework the chart of accounts.”

Cash Flow Balancing Act

Integrating accounting and operations can help avoid crisis. Knowing where money is coming from, where it has to be spent, and when bills and cash are due are critical to a program’s stability.

Greg Smyth, associate director at Greenlights for Nonprofit Success in Austin, Texas, advised, “A very simple example is providing a cash flow projection – we had one client that was ahead of budget with money in the bank, but when we showed them the cash flow projections and the impact of bi-weekly pays and the forecasting of a payroll shortfall in those months where there were three payrolls, they were able to plan several months in advance and they felt in control of their destiny. They deferred some payments and accelerated a fundraising event and were able to meet payroll.”

Terry Blake, CFO of Area Resources for Community and Human Services in St. Louis, said, “You need a financial strategic plan: Is there a reserve fund? Is there an investment policy? Are there growth goals – and how are you going to get there? Look at cash owed – if you’re on a cash basis, you won’t know, but with an accrual system you’ll know – even if you’re going to defer payment.”

The Bottom Line

There are numerous software tools capable of tracking the numbers, but the nonprofit sector is only beginning to look at how those numbers are organized to tell the complete story. Knowing where the dollars come from and where they go is important to managing existing services and planning for new offerings.

While there is a donor tendency to want to see every dollar go directly to program, overhead is an important part of service delivery and keeping an organization viable. Increased scrutiny of Form 990s and financial statements – not only by regulators and funders, but by investment-minded donors – will make it harder to fudge the numbers.

According to Kurre, “What nonprofits need to do is make sure that there’s a good understanding for the costs being incurred and how overhead and general and administrative costs are being managed. Nonprofits are under more scrutiny than every before.” Self appointed watchdog organizations are issuing analyst reports, “and we’re asking clients if they have a relationship with these monitors,” said Kurre.

Charting a Path

Creating an allocation and reporting system that properly distributes costs and provides useful information requires a combination of good design and good tools. Experts agree that good design in your chart of accounts is the most important factor in creating an accounting system that is both useful and easy to use.

Differences in accounting software packages will play a major role in how your chart of accounts is organized. The biggest distinction in accounting packages is fund accounting and general or commercial accounting.

Fund accounting software is designed to help nonprofits and governmental bodies demonstrate that monies have been spent according to specific restrictions. Essentially, fund accounting software allows an organization to operate projects and programs as if they were independent organizations, each with its own bank account. The advantage of fund accounting is that all of the monies can move through a much smaller number of bank accounts – sometimes even a single checking account. General accounting software can’t restrict financial activity as closely as fund accounting solutions.

However, many packages do have the ability to track income and expenses across departments, jobs, and customers and these features can be used to track nonprofit cost allocations. Government funding almost always requires a true fund accounting package to comply with reporting and auditing requirements. Commercial accounting software can meet the reporting needs of many nonprofits that rely on individual and foundation support as well as earned income.

In addition to looking at external reporting requirements, you should consider internal needs when choosing between commercial and fund accounting solutions. While your funders might allow for fairly broad functional allocations, your management team could want to look at costs and income from multiple perspectives and a true fund accounting solution may be the best choice. Keep in mind that the desire to track an expense (meals, for example) across multiple programs (Head Start, ESL, etc.) requires a commitment to data entry at an increased level of detail.

Getting staff on board will require additional training, both on why it is important to work at a higher level of detail as well as training on how to make specific entries.

A comprehensive cost allocation system will expand beyond the accounting software to other systems as well. Client or case management databases and time reporting software may also be called into play to make sure that allocations match the real world and that expenses can be linked to non-accounting activities such as hours of service and/or event attendance.

Consistent methods of allocating cost through time tracking, square footage, or other means have to make sense internally and externally. Executive and board commitment to putting those tools in place will give you the ability to track your agency’s financial position and performance and comply with new financial disclosure requirements.

This article has been republished with permission from the January 1, 2007, issue of The NonProfit Times. For a free subscription, click here.

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