In his second lesson, Ron delves further into the differences between for-profit and not-for-profit accounting. These differences include customer demand (supply & demand doesn’t work the same way for the two types of organizations), as well as restricted assets and ownership issues. Finally, Ron describes the two formal bodies that develop and promulgate accounting and reporting standards - one each for not-for-profits and for-profits.
The most important relationship between funding and expenses in not-for-profits (NFPs) is that expenses drive funding. NFPs determine the funding required for operations by determining the level of service or goods that the organization can provide and then, through budgeting, calculating the costs for those services. Because NFPs operate in a competitive market, there is a constraint on the price that may be charged for their services, so the level of service must be a reasonable estimate of reality. NFPs have a very important responsibility to attain a balanced budget and not engage in deficit spending, because then the burden of payment is merely shifted to future operating periods. Long-term accumulated deficits may jeopardize the survivability of the entity.
Sometimes it is very difficult for musicians to admit that in the entertainment world, there are many different ways in which potential customers can spend their discretionary income, and a live classical music performance is only one of many.
Funding for NFPs is not directly linked to customer demand as in the business world. In the business world, revenues are generated through demand for the product. If product demand increases, then revenues will increase, thus establishing a direct relationship between demand and revenues. In NFPs demand does not have a direct relationship but rather has an indirect effect on revenue, because support is needed in order for the entity to meet the obligations incurred by providing services.
Support is usually a function of generosity (or a needed tax break), not the demand for a specific set of services. It is not uncommon for NFP funding to not even be related to expenses or services provided. Public support through grants, donations, fundraising, etc. may increase or decrease from year-to-year without any corresponding change in the cost, level, type, or quality of services provided. Because it is very difficult to directly match funding to specific expenses, the approach that NFPs utilize is to indirectly associate funding to a wide range of expenses.
NFPs are constantly confronted with the concept of restricted assets (future funding). In general this does not occur in the business world and would be considered rare. The donors determine the restrictions placed upon the assets. The donors may require that funds be utilized for specific purpose(s) or for specific accounting period(s). NFPs must segregate the restricted funds in the budget and financial reports, to show that they cannot be utilized for any other purpose or time period.
The consequences of using restricted funds for a purpose other than that specified by the donor may result in past and future amounts being lost. In a future installment, the concept of restriction will be discussed thoroughly.
Ownership does not pose a problem for NFPs because they are not owned by any one individual or group. The result of this characteristic is that a NFP will not be transferred to anyone through a sale or inheritance. There are no stockholders that may receive residual interests. If a NFP does completely fail without the emergence of a succeeding entity, the remaining resources will usually be sold to satisfy creditors.
The multitude and diversity of organizations in the not-for-profit sector is vast. All types of entities, ranging from government, educational institutions, social, civic and fraternal organizations to hospitals and religious and cultural organizations are included in this group. It is estimated that there are over one million NFPs in the United States.
Two formal bodies develop and promulgate accounting and reporting standards. The Governmental Accounting Standards Board (GASB) develops the accounting and reporting standards for governmental entities, while the Financial Accounting Standards Board (FASB) does the same for non-governmental entities. Both GASB and FASB are trying to develop a common model for all entities but it is a difficult task.
A “one size fits all” standards approach creates the possibility of distorting the comparability of results when NFP entities are different. It is not a given that utilizing this approach will be successful – only the future will determine if that philosophy will meet the needs of the NFP entities and the users of those financial reports. The focus of this column will be on the FASB concepts, objectives, and statements.
Until the next installment, here are two things that you can do for yourself: