Four Terms Every Nonprofit Financial Team Member Must Know
Nonprofit organizations like yours often recruit and hire finance professionals whose experience, while rich, has been exclusively with for-profit entities. Members of your governing board and finance committee, as well, may only be familiar with for-profit financial statements. When they start learning the ropes at your nonprofit, they scratch their heads over esoteric terms like “restricted net assets” or “statement of functional expenses.” But these and other terms are indeed part of the nonprofit financial vernacular, and it’s important that your team members grasp their definitions and functions. When they do, they can more meaningfully participate in the financial management of your organization.
To help you help them, here’s a description of terms that I find stump nonprofit novices the most. You can share this overview with anyone needing a primer on your organization’s financial statements.
Net assets are similar to equity in for-profit accounting. But in the nonprofit world, the majority of an organization’s revenue stream comes from donors, and donations often come with strings attached. Those strings are what sort net assets into three distinct categories:
- Unrestricted net assets — This line shows the net worth of a nonprofit after taking into account any donor-imposed spending restrictions on the organization.
- Temporarily restricted net assets — These are net assets (equity) the organization has but are only to be spent on certain items. Sometimes donors don’t place restrictions on their funding contributions, which are reflected in the unrestricted net assets (above). But when donations come with specific instructions, perhaps to be used only for a designated purpose or program, they are known as purpose-restricted net assets. In cases where donors place restrictions on when the funds can be spent, those are time-restricted net assets. All these restricted amounts cannot be spent within the normal course of operations; they are limited to covering strictly designated expenses. There are serious consequences to nonprofits that spend funds outside their donor-restricted use.
- Permanently restricted net assets — Donors occasionally contribute amounts to organizations with requirements that those funds be kept in perpetuity. However, the earnings on the contributions can be spent based on what the donor stipulates in the original contribution. The only way to spend the funds contributed to help in operations is to get approval from the donor.
Unlike accounts receivable, where the balance is recognized after a purchase or service is performed, pledges receivable reflect commitments of funds to be received in the future. Pledges receivable can be recognized once made, even though actual money donations aren’t received until later and the project the donor is contributing to is scheduled for the future. It’s important to note that corresponding revenue is also recognized but captured as a temporarily or permanently restricted net asset (see above).
Statement of functional expenses
Most nonprofits are required to present a statement of functional expenses on their financial statements. There are generally three categories under this statement: program, management and general, and fundraising.
Nonprofits must track how much of every dollar is spent in each of these three categories. Most donors are encouraged by a nonprofit’s financial prudence when the statement of functional expenses shows that the majority of each contributed dollar is spent on programs. They believe their donations will go to your organization’s mission rather than your administration. It is imperative that your expenses are correctly allocated among these three categories.
Nonprofit financials often include a supplementary section relating to federal awards. This is a report on a previously conducted uniform guidance audit. When nonprofits have federal expenditures of more than $750,000, they must have a separate audit known as a single audit.
Before a single audit is performed, an auditor needs to evaluate the organization’s programs that used federal funds. The auditor then determines which federal programs are considered major and, as such, must be tested.
Each major program has certain compliance requirements dictated by the Office of Management and Budget. Auditors report any findings in the single audit related to that compliance, which are made available to the federal grantor. If there are findings year over year, grantors conduct a review to ensure that these are not repeated. If findings are repeated, grantors can reduce their funding to your organization. It is very important, then, that all findings are rectified, if necessary, as soon as possible.
These four terms often boggle the minds of those uninitiated to nonprofit financial statements. Understanding them helps finance team professionals and governing board and committee members see a whole host of related issues more clearly.
How we can help
CLA’s nonprofit industry professionals help organizations with the audit, review, and compilation of their financial statements. We can also train your people and board and committee members on both basic and more complex aspects of financial compliance.