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Financial Management in Nonprofit Organizations Analytical Essay

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Updated: Jul 26th, 2019

Executive Summary

Organizations are established to perform different functions. For profit-making organizations, the main motive is to increase profitability to their owners. On the other hand, nonprofit-making organizations are mainly concerned with increasing the social welfare of the people they are established to serve.

While there are many criteria for distinguishing the two types of organizations, in the current paper, financial accounting as a mode of financial reporting and governance approach is used to distinguish between profit and non-profit-making organizations.

While nonprofit-making organizations prepare statements of financial position of the organization, profit-making organizations prepare balance sheets.

There are also differences in governance approaches in the two types of organization in that nonprofit-making organizations are headed by boards of trustees while the profit-making organizations are led by the board of directors.

Introduction

Profit and nonprofits making organizations adopt different approaches in preparation of their accounting statements.

In the context of this paper, the term accounting is deployed to refer to “a process of identifying, recording, summarizing, and reporting economic information to decision makers in the form of financial statements” (Hartigan, 2010, p.357).

In the bigger discipline of accounting, financial accounting aims at satisfying particular needs of various decision makers who are external to an organization. Such stakeholders encompass suppliers, government agencies, stockholders, and banks among others.

For both nonprofit and profit-making organizations, stakeholders who are interested in the financial statements of the different organizations are different since they (stakeholders) also anticipate organizations’ financial statements to be prepared differently.

In this perspective, the focus of the paper is to discuss the differences between financial management approaches in nonprofit and profit-making organizations.

Financial management in the profit-making organization in comparison to nonprofit-making organizations

In both profit-and nonprofits making organizations, preparation of financial statements is necessary to aid in informing the decision-making processes.

However, in the preparation of the statements, differences are reflected in many aspects right from the terminologies applied, documentation of sources of funding, and subsequent allocation of the proceeds realized from the operations of an organization.

For nonprofit-making organization, finances for running the activities of an organization are obtained from a variety of sources including government grants, contributions made by members, program revenues, investments incomes, membership dues, and fundraising events among others (Haddad, 2011, p.12).

In case of profit-making organizations, financial statements itemizes things such merchandise sales, fees levied from services offered, gains realized from investments, and investment incomes as some of the sources of financial resources to run the business.

It is crucial to note that the application of the term business is restricted to discussion of profit-making organizations (Tyler, 2011, p.220).

Indeed, some of the financial statements prepared by profit-making organizations are not applicable to nonprofit-making organizations. Where such statements are similar, the contents of the statement may also vary.

Preparation of Balance Sheets

In the preparation of balance sheets and other financial statement of the profit-making organizations, a reflection of the financial position of organizations is made in the effort to provide an insight to the owners of organizations on the success of the business in increasing returns to them.

A profit-making organization operates such that its profit and loss account reflects higher profits and hence better gains to the owners based on the goal of profit-making organizations of maximizing “profits coupled with forwarding them to the company’s owners and shareholders” (Alnoor, 2012, p.192).

Comparatively, since the noble objective of nonprofit-making organization is to deliver value in terms of increased social welfare to the people, profits, and loss accounts are not prepared.

However, it is crucial that a nonprofit-making organization utilizes efficiently and effectively the financial resources contributed by donors and the members.

As a requirement, to aid in the financial management, profit-making organizations must prepare balance sheets at the end of a fiscal year or on a quarterly basis.

It provides lists of an organization owner’s equity that comprises the “assets, everything the company owns and liabilities the company owes to others (Alnoor, 2012, p.191).

Indeed, “owner’s equity has a direct impact on the company’s common and preferred stock, if applicable” (Alnoor, 2012, p.191). The fact that nonprofit-making organizations have no persons who are considered true owners, the concept of balance sheets is not applicable.

Rather, nonprofit-making organizations prepare statements of financial position of the organization as at a particular date. The statements of financial position only contain lists of liabilities and assets. When these two items are summed together, net assets are obtained.

Depending on the magnitude of the net assets, accountants can assess the size and threshold of the extent to which the organization achieves the purpose for which it was established. An example of the structure of statement of financial position of a nonprofits making is shown in appendix 2.

The differences between balance sheets for profit making and the statement of financial position for nonprofit-making organizations are clear by considering appendices 1 and 2.

In the analysis of the balance sheet shown on appendix 2, the equation that assets are equal to liabilities plus surplus of income over expenditure must hold. Alternatively, the equation can be represented as surplus of income being equal to assets minus liabilities.

Assets encompass all the resources that are available to an organization, which can resort to or cause a future increment of cash flows for an organization. Put differently, all assets are things that a nonprofit-making organization owns (Alnoor 2012).

Liabilities are the obligations placed to an organization by outsiders, or claims of the outsiders on a nonprofit-making organization’s assets. These debts of a nonprofit-making organization are incorporated or converted into the organizational assets.

The goal of the financial managers of nonprofit-making organizations is to ensure that there are adequate assets, which are not in liability if a nonprofit organization has to run smoothly.

A self-sustaining nonprofit-making organization must have a statement of the financial position indicating surplus of income over expenditure.

Income Statement Accounts

Apart from the preparation of balance sheets, as argued before, profit-making organizations are required to prepare income statements. Depending on the jurisdiction in which a profit-making organization operates, income statements are prepared on either a yearly or a quarterly basis.

The income statements reflect the revenues of an organization, losses, expenses, and or gains. In this extent, Hartigan (2010) asserts, “the main purpose of an income statement is to assess the company’s financial performance on a quarterly basis” (p.357).

Such an assessment is critical in making financial management decisions. In fact, implementation of new strategies such as business expansion for continued increment in the organization’s capacity to deliver more values to its owners in terms of profitability cannot be attained without clear and precise knowledge of the available financial resources at the disposal of an organization to cater for such strategic decisions.

The shareholders and other stakeholders of a profit-making organization are interested in the income statements of an organization since profit levels play pivotal roles in indicating the share price and value of a company.

The management of a profit-making organization has an obligatory role to avail income statements to the shareholders as a matter of legal right in all jurisdictions.

While income statements for a profit-making organization must be elaborately prepared and subjected to scrutiny and audit, non-profit organizations do not prepare them.

Rather, they are required to prepare a statement of activities only. Comparatively, the statements of activities are not as elaborate as the income statements prepared by profit-making organizations since they only list the organization’s revenue generated.

Net assets are then added to the results to give an indication of the performance of the nonprofit-making organization in question.

Taxes Management

Elaborating the nature of the income statements prepared by the profit-making organization makes the owners not only to digest the analysis of the performance of their organization but also to form an integral part for other issues such as taxation.

In fact, profit-making organizations have a mandatory responsibility to a state in helping it in running its affairs through payment of taxes (Green & Media, 2012, Para.2). Nonprofit making organizations are exempted from paying taxes. Their goal is to hike the welfare of the society.

Consequently, the government is indebted to help the nonprofit-making organization to realize this objective by minimization of costs. For this reason, the nonprofit and profit-making organizations have different approaches in matters of tax accounting.

Not all aspects of nonprofit-making organizations are exempted from taxes. In this extent, Accounting Couch (2013) reckons that financial managers for nonprofit organizations need to “determine whether a donor’s contribution to a nonprofit organization will qualify as charitable a deduction on the donor’s income tax return” (Para.12).

For example, organizations such as Red Cross chapters, religious centers, and academic institutions encompass some of the nonprofit-making organizations, which have their donors securing endowment freedom from excise duties.

The donors also meet the threshold for charitable deductions in the computation of the donor’s income taxes. This argument implies that there are instances in which nonprofit organization may qualify for tax exemption while their donors fail to qualify the test of charitable deductions.

Some of the organizations in this category include “employees’ organizations, college fraternities, commerce chambers, sports clubs, and social organizations among others” (Accounting Couch, 2013, Para. 12).

For the case of profit-making organizations, IRS is mandated to conduct a thorough scrutiny of all earnings made by the organization including secondary taxes.

Since nonprofit-making organizations do not have definite owners to whom they must be accountable, federal states provide various guidelines to enhance their accountability.

In the next section, governance in the nonprofit-making organization is discussed as an essential component of enhancing accountability in financial management.

Governance in nonprofits making organization versus profits making organization

In financial management, accountability is a significant component in organizational managerial process. Adoption of amicable principles of governance in the effort to enhance transparency is an incredible measure towards enhancing accountability.

Governance is executed through structures for systems of organizational administration. A board of directors runs both profit-making organization and nonprofit-making organization. However, in the nonprofit-making organizations, the board of directors is referred as board of governors.

Alternatively, it is termed as board of trustees to distinguish it from the profit-making organizations.

In case of a profit-making organization, the principle function of governance is executed by “small and efficient boards whose responsibility is to protect the company’s assets and or maximize its profits for the benefit of the shareholders” (Haddad, 2011, p.4).

The members of the board are selected from the business and competence acumens. They are also the persons who are charged to set the board’s policies for enhancing conformity of accounting standards to the established procedures for enhancing transparency and accountancy ethics.

Comparing the board of directors for the profit-making organization and the board of trustees for nonprofit-making organizations, the board of trustees constitutes more members. Members are also drawn from myriads of diverse constituencies.

Consequently, according to Green and Media (2012), the boards of trustees are seen as less efficient in comparison to the boards of directors (Para.8). However, this does not imply that the board of trustees is not able to discharge its governance roles passionately, with professionalism, and within time constraints.

The main mandate of boards of trustees is to ensure that an organization can achieve its mission, goals, and objectives to ensure that the organization possesses adequate and effective governing systems. It also ensures that adequate resources are available to an organization to conduct the two functions.

Conclusion

Profit-making and nonprofit-making organizations use different approaches to prepare financial statements. The approaches are articulated to the fact that the two organizations are established to perform different proposes.

The primary goal of a nonprofit-making organization is to enhance the social welfare of the persons whom it is established to serve. Profit-making organizations are meant to increase value to the owners’ investments.

Hence, they must operate to yield optimal profitability. These primary goals are reflected in the governance principles and in the selection of people to serve in the organizational governance bodies.

Appendices

Appendix 1: Format for balance sheet of a profits making organization

Fixed assets
Land
Buildings
Office equipment
Furniture
Machines (less depreciation)
Good will
Trade name
Total fixed assets
Total assets
Long terms liabilities
Bonds
Mortgages
Notes
Stock holders equity
Common stock
Retained earning
Less treasury stocks
Total stockholders’ equity
Total liabilities and stockholder’s equity

Source (Haddad, 2011, p.28)

Appendix 2: Format statement of financial position of a nonprofits making organization

Assets
Current assets
Cash (on hand and bank)
AC/R
Note/R
Prepared expenses
Investments
Fixed assets
Land
Buildings
Furniture/equipments (less depreciation)
Total assets
Liabilities
Current liabilities
AC/P
Accrued expenses
Note/ P
Wages/ P
Reserve fund account
Reserve fund-fixed assets
Reserve fund-accumulated surplus
Total current assets
Surplus of income and expenditure
Total liability

Source (Haddad, 2011, p.19)

References List

Accounting Couch. (2013). . Web.

Alnoor, E. (2012). Making sense of accountability: conceptual perspectives for northern and southern nonprofits. Nonprofits management and leadership, 14(2), 191-212.

Green, J., & Media, D. (2012). . Web.

Haddad, M. (2011).The Difference in the Financial Accounting between Profits and Non Profits Organizations. Web.

Hartigan, P. (2010). Nonprofit or Not-for-profit — Which are you?. Business strategy review, 3(2), 357-361.

Tyler, M. (2011). Benchmarking in the non-profit sector in Australia. International Business Journal, 12(2), 219-235.

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