Nonprofit Accounting 101 - Principles, Tools, and Challenges

Contrary to popular belief, nonprofit accounting isn't just about numbers. It's about transparency, accountability, staying focused on your organization's mission, and maximizing impact.

In this guide, we explore the basics of accounting for nonprofits to help your financial and operational teams gain financial clarity and confidence. 

Besides an accounting tool, your system should include a dedicated nonprofit financial management platform that integrates budgeting and reporting into one central place. 

Martus fits this role nicely, allowing you to manage and report your finances through collaborative budgeting, automated financial reporting, and automatic data pulls from your linked accounting software. 

Check out Martus today to streamline how you manage and account for your finances. 

How Nonprofit Accounting Differs from For-Profit Accounting

Nonprofit accounting relies heavily on a purpose-driven mission, where financial management practices center around accountability to funders and the public, rather than creating profits for shareholders. 

The mission-first approach leads to the following differences in how a nonprofit records, categorizes, and reports financial information compared to a for-profit business. 

• Fund Accounting: Unlike a for-profit business, a nonprofit uses fund accounting to separate resources into categories or funds based on their function and grantor or donor restrictions. The system ensures your organization uses restricted and unrestricted funds in compliance with donor intent, which increases transparency and accountability. 
• No Profit Motive: While a for-profit organization lives to maximize shareholder value through profits, a nonprofit focuses on fulfilling its set charitable mission. Any nonprofit surplus revenue goes back into programs and services, rather than being distributed to owners or shareholders. 
• Categorizing Functional Expenses: Nonprofits allocate resources into three expense categories, namely programs, administrative, and fundraising. The process leads to functional expense reporting, which shows how you allocate resources per your mission. Funders and other stakeholders can analyze these categories and evaluate your efficiency and impact. 
• Unique Reporting: Your nonprofit has to file Form 990 with the Internal Revenue Service to protect its 501(c)(3) status. As a comprehensive public disclosure document, the form includes information on your nonprofit finances, governance, compensation, and mission-based activities. Completing this reporting process reinforces your commitment to accountability. 

Core Principles of Nonprofit Accounting

When managing a nonprofit, you'll want to understand the basics of nonprofit accounting to ensure you manage your finances properly and maintain your nonprofit status. 

Let's review the key principles that guide accounting for charitable organizations. 

• Fund Accounting: Fund-based accounting tracks how you use restricted and unrestricted funds. Any funds given for a specific purpose, such as running a scholarship, are called restricted funds. Unrestricted funds are available for general operations or wherever your organization needs them most. Through fund accounting for nonprofits, you ensure you are honoring the wishes of the funders, which can encourage them to continue supporting you. 

• Accountability and Stewardship: Your organization must be accountable to grantors, donors, volunteers, the government, and the communities you serve. Nonprofit accounting helps you show exactly how you use funds, build trust with funders, and make informed strategic decisions. 

• Consistency and Compliance: Every charitable organization must follow accounting best practices to comply with legal and regulatory requirements. For example, you must comply with IRS rules such as filing Form 990 and following GAAP (Generally Accepted Accounting Principles). You must also keep clear, accurate, and up-to-date financial records for grant reporting and audits. 

Key Financial Statements for Nonprofits

Nonprofits use the following set of core financial statements to track their financial health, demonstrate transparency, and show how they use their funds to support their mission. 

• Statement of Financial Position: This is similar to a balance sheet and shows your nonprofit's assets, liabilities, and the difference between the two (net assets). You split your net assets into restricted and unrestricted categories to match donor conditions. They are the surplus available for reinvesting in programs and operations. 

• Statement of Activities: You need to show your nonprofit's revenue, expenses, and net asset changes over a specific period. You capture these in the Statement of Activities to show how well you generate revenue and manage expenses in line with your mission. 

• Statement of Functional Expenses: You use the Statement of Functional Expenses to categorize expenses based on their function (programs, fundraising, or administrative), and mature (supplies, rent, salaries, and more). The statement shows stakeholders how you use your resources to fulfill your mission. 

• Statement of Cash Flows: This statement indicates how cash moves in and out of your organization across operating, investing, and financing activities. The statement helps you keep track of your finances to ensure you have enough cash on hand for expenses and service delivery. 

As part of nonprofit financial reporting, these statements are important when it comes to showing accountability. They also help you make strategic decisions based on evidence and reliable data. 

How Nonprofit Accounting Works

Accounting for nonprofits is easy once you know the process. Here's a quick look at how the process works to support transparency and mission-driven financial management. 

• Tracking Income by Source: A nonprofit receives income or revenue from multiple sources that may include donations, grants, and program service fees. You must use fund tagging (restricted or unrestricted) to track incomes and link them to specific programs. The practice helps you use finances according to the donor's or grantor's intent. 

• Categorizing Expenses by Function and Nature: As mentioned, you must categorize your expenses by their nature/type (rent, salaries, and more), and function (program services, fundraising, and administrative). Categorizing them this way shows how efficiently you use your resources to further your mission. 

• Reporting to Boards and Funders: To show accountability and compliance with legal and funder requirements, you must report financial information regularly. You compile comprehensive reports for the board of directors, funders, and regulatory agencies. These reports, such as financial statements and grant reports, depend on accurate program tracking and fund tagging. 

Nonprofit Accounting Software

When choosing the right software for nonprofit accounting, it's best to consider platforms built with nonprofits in mind. 

Let's check out the best accounting software for nonprofits for modern solutions. 

1. Martus

As a tailored nonprofit financial management platform that integrates with over 25 accounting tools, Martus specializes in budgeting, forecasting, and financial reporting. 

Martus is ideal for medium to large organizations looking for advanced budgeting and reporting tools. Such organizations usually manage multiple programs, grants, and departments, which require enough financial visibility and collaboration across teams. 

With Martus, you get key features such as: 

• Fund Tracking: Martus connects with your preferred accounting software for nonprofits, enabling you to keep tracking funds based on your set dimensions or tags. 

• Multi-Program Support: You can use Martus to monitor how you spend resources across different programs and departments. You'll be able to see where funds go and how each program or department performs. 

• Grant Reporting: Martus allows you to generate accurate and detailed financial reports for grantors to account for restricted or unrestricted grants. 

• Role-Based Access and Lock Controls: With Martus, your sensitive financial data is protected with customizable user permissions and audit trails of every activity. Your completed and approved worksheets are also safeguarded with lock controls, which prevent users from making accidental changes. 

Request a personalized demo to see Martus in action. 

2.  QuickBooks Nonprofit

QuickBooks Nonprofit is ideal for small to medium organizations that are just starting to make their accounting professional. 

The tool allows you to use the following features:

• Track donations and grants
• Create grant and donor reports
• Integrate with your fundraising tools
• Tag revenue and expenses by class or program 

3. Aplos

Aplos is ideal for small to medium nonprofits looking to combine accounting with donor management and program tracking without needing separate systems for finance and fundraising. 

You can have the following key features with Aplos:

• Fund and project tracking 
• Grant tracking and reporting 
• Budgeting and financial reports 
• Donation and pledge management 
• Role-Based permissions and audit logs

The platform you choose depends on how complex your organization is and how much you need beyond basic accounting. With Martus, you get better accounting functions through accounting software integrations and transformative financial management solutions. 

Best Practices for Effective Nonprofit Accounting

To keep your organization financially healthy and aligned with your mission, here are some top nonprofit accounting best practices to apply. 

• Monthly Reconciliation: Use your bookkeeping and accounting system to reconcile your fund balances, bank accounts, and credit cards every month. Regular reconciliation allows you to catch and address errors early before they escalate into significant issues. You also avoid surprises during reporting and audits. 

• Categorizing All Transactions Properly: Ensure you classify each transaction, revenue, and expense by type, fund, function, or program. Proper classification leads to accurate expense tracking and reporting. You also make it easy to meet donor or grant requirements. 

• Building Collaborative Workflows Between Finance and Programs: Your finance team and program staff should communicate and collaborate to ensure better planning, fewer errors, and more informed decision-making. 

• Tagging Donor and Grantor Restrictions Clearly in Your Accounting System: Keep restricted donations and grants tagged at all times in your accounting system to ensure you use funds according to donor intent. Your grant reporting and audits will be much easier, and you'll maintain legal compliance and the trust of your funders. 

Common Nonprofit Accounting Challenges

Like many nonprofits, you may face accounting hurdles that could slow down your operations or risk compliance. You should be on the lookout for the challenges below.

• Spreadsheet Overload: Managing budgets, tracking funds, and preparing reports using spreadsheets often leads to errors, version confusion, and wasted time. A centralized accounting system with the right accounting tools and financial management software makes it easier to account for your finances. 

• Difficulty Tracking Restricted vs. Unrestricted Funds: You may struggle to separate restricted funds from general operating funds. Poor fund tracking leads to resource misallocation and violates funder agreements. 

• Preparing for Audits with Incomplete Data: Both internal and external audits are stressful and time-consuming when your financial records are scattered or missing. You must maintain clear data processes that include consistent documentation and audit trails. Martus can centralize your accounting and help you pull actuals in real-time from your accounting tool, ensuring you have up-to-date data for accurate reporting. 

• Lack of Financial Expertise on Small Teams: Most small nonprofits usually lack a fully constituted finance department. You might have to assign accounting tasks to administrative or program staff who lack formal training, which can lead to costly mistakes. Promoting collaboration and using clear financial processes for data input, review, and approval can be good short-term remedies. 

Frequently Asked Questions (FAQs)

Let's end the guide with a few questions people usually ask about nonprofit accounting. 

What Is the Role of a Treasurer in a Nonprofit?

The treasurer in a nonprofit is usually part of the board and acts as the financial link between the board and the organization's staff. 

They collaborate with cross-functional teams in budgeting, strategic planning, and financial reporting. Nonprofit treasurers also help manage risks, prepare for audits, and develop financial policy. 

What Is the Difference Between Program and Administrative Expenses?

A nonprofit's program expenses are the costs directly related to delivering the core mission and services. Administrative expenses are the costs of running the organization itself. 

For example, a tutoring program may include direct expenses such as staff salaries, transport, and learning supplies. 

You can incur regular administrative expenses such as rent for office space, salaries for executive leaders and accounting staff, or office supplies and equipment. 

How Often Should a Nonprofit Conduct an Audit?

Most nonprofits conduct audits annually or every few years. The frequency depends on the purpose of the audit, the complexity of your organization, and government regulations. 

You can always conduct an audit whenever your organization undergoes a significant change in operations. 

Can Nonprofits Invest Their Funds?

Yes, nonprofits can invest their funds to promote financial growth and sustainability. You can invest some of your funds in bonds, treasury bills, stocks, money market funds, and mutual funds. 

Conclusion

For a nonprofit organization, strong accounting is the foundation for funder trust, financial health, and mission success. 

Proper accounting demonstrates transparency, which builds funder trust and encourages them to continue supporting your mission with finances and other resources. 

You can adopt and implement accounting tools and best practices that support transparency and streamline compliance with funder or legal requirements. 

Martus stands out as a tailored nonprofit financial management platform that integrates with your accounting software to streamline how you plan, record, and report your finances. 

You can enjoy collaborative budgeting, automatic importation of actuals from your accounting tool, and even automated financial reporting. 

Book a customized demo today to see Martus in action at your organization.