Understanding nonprofit financial management: how practices differ from for-profit organizations.

As the nonprofit community experiences unprecedented growth and scrutiny, it becomes the responsibility of leaders of these organizations to establish and monitor sound financial practices that will ensure the appropriate use of resources in meeting their organizations' missions.

Unfortunately, the combination of a unique governance structure, heavy reliance on volunteers, and industry-specific tax and accounting rules often makes it difficult for nonprofit leaders to understand and adapt to their critical role in the financial management process. The many volunteer leaders who come from the for-profit sector may tend to apply the financial practices of business in executing their oversight responsibility. While many of these practices are useful and long overdue in the nonprofit world, there remain important distinctions between for-profit and nonprofit organizations that can make such wholesale adoption of financial practices designed for business inappropriate as well as potentially harmful to the health of nonprofit organizations.

Structure and mission

Unlike for-profit organizations, nonprofit organizations are incorporated as nonstock entities where ownership rests with the members or supporters of the organization. The lack of stock ownership and the absence of a profit motive are in stark contrast to for-profit organizations and to the factors that drive many of the unique financial management issues prevalent in nonprofit organizations.

Like for-profit entities, a nonprofit organization prepares and adopts documents such as articles of incorporation and bylaws that set forth the organization's basic mission, governance structure, and overall operating procedures. Most nonprofit organizations establish a board of directors, elect officers, and appoint various committees from a select group of individuals who are leaders in the core business of the organization (e.g., manufacturing, cancer research, franchising). This group of volunteers is responsible for hiring a chief staff executive, who directs the work of paid staff to achieve the overall goals of the organization.

Unlike for-profit entities, which are typically governed in a more centralized autocratic manner by corporate insiders and compensated boards, nonprofit leadership turns over frequently because of its voluntary nature and the organization's desire to involve and benefit from the diverse talents of its supporters. While this provides for a healthy collaborative style of leadership, it can also result in costly delays and confusion in developing and implementing key programmatic and financial strategies.

Tax treatment

Federal and state taxing authorities generally exempt nonprofit organizations from the payment of income taxes on any annual excess of revenues over expenses because of the beneficial nature of these organizations' activities to society. Organizers apply for such exempt status under their organization's appropriate classification (see sidebar, "Categories of 501(c) Tax-Exempt Organizations"). Assuming such approvals are granted, a nonprofit organization can avail itself of this significant subsidy, which is not available to for-profit entities.

Such a tax subsidy comes at an ever-rising price. In addition to a common perception of entitlement by many in the public and the media, a frequent complaint of the for-profit sector is that many nonprofit organizations are afforded an unfair competitive advantage. Furthermore, nonprofit organizations must comply with complex regulatory requirements.

While it is permissible to generate some portion of income from activities unrelated to an organization's exempt purposes, such income is required to be disclosed on Form 990-T and the state equivalent and is subject (after appropriate deductions) to the regular corporate tax rates. Such activities require a system of cost allocation between related and unrelated activities that is reasonable and consistently applied.

In recent years an increasing number of nonprofit organizations have established for-profit subsidiaries to house such activities to protect their tax-exempt status and take advantage of other tax preferences. Most nonprofit organizations are required to file an extensive annual information return (Form 990), which details the financial results, operations, and relationships of an organization to demonstrate compliance with the ongoing requirements of tax exemption. Unlike a for-profit corporate income tax return, this document is required to be made available to anyone who requests it.

Greater degree of accountability

Because of the nature of their missions and the sources of their support, nonprofit organizations are held to a higher standard of accountability than for-profit entities.

Leaders of nonprofit organizations must ask themselves two key questions:

* Is there a system of internal controls in place to ensure that assets are safeguarded?

* Can accurate and timely reports be produced that demonstrate the organization raises and expends its assets in accordance with the purposes for which it qualifies for tax-exempt status?

At the core of accountability are sound internal controls. Internal controls are those policies and procedures that, when taken together, ensure that assets are safeguarded and transactions are recorded and summarized accurately and on a timely basis.

The individual charged with the primary responsibility in this area is the organization's treasurer. The treasurer is elected on behalf of the board to ensure appropriate oversight. While in the past this position was often ceremonial, in today's environment of dwindling resources and increasing exposure, the treasurer's role is especially critical and must be filled by an individual with the appropriate skills and time commitment to ensure that the organization and its constituents are protected from fiscal mismanagement.

Move toward decentralization 

In addition, nonprofit organizations are increasingly decentralizing the responsibility for sound financial management from the accounting and finance department to all areas of an organization, to establish a sense of ownership by nonprofit staff in their budgets. Nonprofit organizations are growing closer to for-profit organizations in this respect, developing extensive cost-allocation systems and scrutinizing the bottom line both overall and by each significant activity.

While such financial decentralization and performance monitoring are appropriate and extremely useful to nonprofit organizations, unlike in a for-profit business, the results of this exercise do not necessarily indicate that activities (e.g., annual conference, publications, educational seminars, government relations) will or should be cut or eliminated.

The purpose of decentralized financial management in nonprofit organizations is to establish accountability and provide the leadership, volunteers, and supporters of the organization with the financial information necessary to answer the key question: Are we balancing our resources against the current and future needs of our constituents while providing for the long-term health of the organization?

RELATED ARTICLE: Categories of 501(c) Tax-Exempt Organizations

You will likely hear references to your association's tax-exempt status. The IRS Code created the 501(c) designations, which include:

* 501(c)(3) - religious, charitable, scientific, public safety, and educational organizations;

* 501(c)(4) - civic leagues or organizations established for the promotion of public welfare;

* 501(c)(5) - labor, agricultural, or horticultural organizations; and

* 501(c)(6) - business leagues, chambers of commerce, and boards of trade that are not organized for profit.

Note: A nonprofit association is required to maintain its nonprofit status by continuing to fulfill its nonprofit mission. If the association provides services and benefits that the IRS does not consider related to the association's nonprofit mission, the association will be required to pay unrelated business income tax, commonly known as UBIT. In extreme cases, an association's nonprofit status may be jeopardized. Consult with your chief staff executive regarding the association's IRS reporting procedures and whether the association's auditor sees a potential problem regarding the association's nonprofit status.

John P. Langan is president of Langan Associates, P.C., a Washington, D.C., accounting and consulting firm.