Statement of Functional Expenses

	Counseling Program	Training Program	Total Program	Management and General	Fundraising	Total Supporting
Salaries and Fringe:
Executive Director	$12,500	$12,500	$25,000	$7,000	$6,000	$13,000
Program Directors	25,000	25,000	50,000
Secretary	7,000	10,000	17,000	8,000	2,000	10,000
Rent	4,000	6,000	10,000	1,565	435	2,000
Supplies	2,500	4,500	7,000	3,000	1,000	4,000
Telephone	1,000	1,100	2,100	1,000	200	1,200
Postage	500	1,000	1,500	800	200	1,000
Copying	300	2,000	2,300	500	150	650
Total Expenses	52,800	62,100	114,900	21,865	9,985	31,850

Total Program Costs	114,900
Total Supporting Costs	31,850
Total Costs	146,750

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How can we allocate indirect costs to programs?

What Are Indirect Costs?
Why Allocate Indirect Costs to Programs?
What Are the Methods for Allocating Indirect Costs?
Is There More Than One Way to Calculate an Indirect Cost Rate?
What is the Standard for Allowable Indirect Costs?

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What Are Indirect Costs?
In a multi-program organization, all costs can be divided into two different types: direct and indirect. Direct costs are those which are clearly and easily attributable to a specific program. For example, the cost of new basketballs is clearly related to the after-school athletics program. Similarly, it is easy to justify charging counselors salaries to the counseling program.

Indirect costs are those which are not easily identifiable with a specific program, but which are, nonetheless, necessary to the operation of the program. These costs are shared among programs and, in some cases, among functions (program, management and general, and fundraising). The executive director's salary is a common example of an expense which benefits all programs and functions. Other indirect, or shared, costs may include rent, telephone, postage, printing and other expenses which benefit all programs and functions of an organization.

Why Allocate Indirect Costs to the Programs?
The full cost of a program rightfully includes a share of the overall costs of the organization. Knowing the full cost of a program sets a basis for financial analysis of the program, for pricing fee-based services, and for requesting reimbursement from funders for the full costs of providing services.

What Are the Methods for Allocating Indirect Costs?
There are several methods for allocating indirect costs. The two most common are case-by-case allocation and developing an indirect cost rate.

• Case-by-Case Allocation
  One method of allocating indirect costs is to determine a rate of actual usage for each program. For example, you may decide to keep track of long distance telephone calls and charge them to the appropriate program when you pay the phone bill each month. Similarly , some organizations use a counter or log to track copying expenses for each program and/or function. Time sheets may form the basis for allocation of salaries for the executive director, accountant, and staff whose work benefits more than one program or activity. A different method can be adopted for each line item or case.
  
  The advantage of this method is that it seems to "make sense." A major disadvantage, however, is that it often requires a great deal of time consuming record keeping. Even if you keep the records needed to precisely allocate shared expenses among programs, not all expenses will be covered. If, for example, the rent is allocated by square feet, how should you allocate the hallway and rest rooms? What about the local phone calls which can not be tracked using a code?
  
  For those shared expenses which cannot easily be divided directly into programs and functions, an indirect cost rate is useful.
  
  
• Developing an Indirect Cost Rate
  The first step in determining an indirect cost rate is to separate all costs into two groups: direct and indirect costs. The indirect costs are aggregated into an indirect cost "pool" and then allocated to the programs based on a set proportion or rate.
  
  There are several measures used to determine the proportion of indirect costs to allocate (apply) to each program. The following simple example illustrates an indirect cost rate based on the relationship between total indirect costs and total direct costs:
  
  Example 1-- The Tadpole League
  The Tadpole League has a total budget of $3,300. The budget is distributed as follows:
  Program A has direct costs of $1,000
  Program B has direct costs of $2,000
  Indirect costs to run the programs is budgeted at $300
  Total costs are $3,300
  
  Since Program A's direct costs are one-third of the total direct costs of the agency ($1,000 out of $3,000), it should bear one-third of the indirect costs. Similarly, since Program B incurs two-thirds of the total direct costs of the agency, it should bear two-thirds of the indirect costs, as well.
  
  The Tadpole League can create an indirect cost rate which will allow it to easily accomplish this allocation. An indirect cost rate (using direct costs as a base) is established by dividing the total indirect costs by the total direct costs. For the Tadpole League the indirect cost rate is:
  
  Total Indirect Costs divided by Total Direct Costs = $300/$3,000 = 10 percent of total costs
  
  Each program s share of indirect costs can be calculated as a proportion of its direct costs:
  Program A Indirect Expenses: $1,000 x 10% = $100
  Program B Indirect Expenses: $2,000 x 10% = $200
  Total Indirect Expenses = $300
  
  After the indirect costs have been allocated to the programs, the budget now reads as follows:
  Program A has direct costs of $1,000, indirect costs of $100 = $1,100
  Program B has direct costs of $2,000, indirect costs of $200 = $2,200
  Total costs are $3,300
  
  This illustrates that after Program A has picked up its fair share of indirect costs, the true cost of running Program A is $1,100. As you can see from this example, using direct costs as a basis for your indirect cost rate will result in larger programs being charged with more of the indirect costs than smaller programs.

Is There More Than One Way to Calculate an Indirect Cost Rate?
The Office of Management and Budget Circular A-122, Cost Principles for Nonprofit Organizations, describes the method of developing a federal indirect cost rate, using these same principles. However, even within these guidelines, indirect cost rates for the same organization may vary from federal agency to federal agency. Organizations may allocate indirect costs based on how many people are served in each of their programs, how large each of their sites is, or other logical methods.

What Is the Standard for Allowable Indirect Costs?
There is little agreement in the nonprofit or funding community about how to calculate the rate, what to include, and how much is fair. There are no across-the-board standards or maximum levels for indirect costs. Some foundations have informal, unwritten guidelines for a maximum level. Under federal guidelines, allowable indirect costs range from 3 percent to 70 percent, varying from agency to agency.

Contrary to popular belief, indirect costs are not an easy measure of an organization s efficiency or stewardship. For example, imagine a multi-service agency where each program has its own bookkeeper, purchases its own supplies, and has all its own equipment. Such an organization would have no indirect costs at all, but would be clearly less efficient than if the programs shared bookkeeping costs, supplies and equipment.

Final Comments
Because the presentation of financial information influences the way we assess an agency's finances, the selection of indirect costing methods and accounting procedures has an important impact on decision-making. Several urgent and perhaps conflicting demands are made of the indirect costing process: to attribute indirect costs in the fairest way possible, to attribute the most indirect costs to the programs that can best afford them, to eliminate as many indirect costs as possible by having each program buy its own supplies, etc. Finding a balance among these demands that clears confusion and informs decision-makers is a responsibility of all participants in the nonprofit sector.

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What is the Difference Between Cash-Basis and Accrual-Basis Accounting?

Example of Cash-Basis Balance Sheet
Example of Accrual-Basis Balance Sheet

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Cash-basis and accrual-basis accounting use different criteria for determining when to recognize and record revenue and expenses in your financial records. On a cash-basis revenues are recognized when cash is received and deposited. Expenses are recorded in the accounting period when bills are paid. In accrual-basis accounting, income is realized in the accounting period in which it is earned (e.g., once contracted services are provided, grant provisions are met, etc.), regardless of when the cash from these fees and donations is received. Expenses are recorded as they are owed (e.g. when supplies are ordered, the printer finishes your brochure, employees actually perform the work, etc.), instead of when they are paid.

To illustrate, let,s take a simple example. At the end of a summer camp,s fiscal year, it has recorded the following deposits and expenditures (left hand statement) from its checkbook. A balance sheet has also been prepared to show the camp,s assets, liabilities and fund balance.

Example of Cash-Basis Balance Sheet SUMMER CAMP
September 1 - August 31, 19xx

INCOME STATEMENT			BALANCE SHEET
INCOME			ASSETS
Grants	$ 3,000		Cash	$ 127
Contributions	4,500		Property, Plant and Equipment	120,000
Fees from Campers	25,000		Less:
			Accumulated Depreciation	<100,000>
Total Income	$32,500		Net Fixed Assets	20,000
			TOTAL ASSETS	$20,127
EXPENSES
Salaries	$20,000		LIABILITIES
Food and Supplies	6,000		Loan from President	$5,000
Insurance	4,200
Utilities	2,000		FUND BALANCE	$15,127
Telephone	750
Printing and Postage	3,500
Total Expenses	$36,450		LIABILITIES AND FUND BALANCE	$20,127

Since the information was taken from activity in the checkbook, we know these statements were produced on a cash basis. However, some pertinent information has not been recorded. For example,

• A foundation has given the camp a grant of $10,000 to provide scholarships for low-income children. The children did attend the camp, but the foundation has not yet sent in the check.
• Because cash is tight, the camp has not paid the final installment to their printer for this year,s brochure. They owe her $1,500.
• The insurance premium was paid in December, and covers the period December through November. So, it is good for another three months.

To take these three factors into consideration on the financial statements, revenues and expenses need to be recorded on an accrual basis. Several line items need to be added to the balance sheet in order to update the financial statements. These are:

• Accounts Receivable
  Reports revenues which have been earned, but not yet received. For example, a payment from a government grant which has been vouchered, but not yet received is an account receivable. In this case, the camp has a grant receivable of $10,000, since the children have already attended the camp and the camp has therefore "earned" the scholarship money from the foundation.

  IMPACT:
  Increase grant income by $10,000 to $13,000
  Increase grants receivable to $10,000

• Accounts Payable
  Reports expenses which are owed to others. The money owed to the printer for completing the brochure is a $1,500 account payable.

  IMPACT:
  Increase printing expenses by $1500 to $5000
  Increase accounts payable to $1500

• Prepaid Expenses
  Reports expenses which have already been paid, but are for a future period. In this example, three months of insurance is considered a prepaid, rather than a current, expense.

  IMPACT:
  Decrease insurance expense by $1,050 ([$4,200/12 months] x 3 months) to $3,150
  Increase prepaid expense to $1,050

Reported on an accrual basis, using the categories described above, the camp's financial statements now look as follows:

Example of Accrual-Basis Balance Sheet

SUMMER CAMP
September 1 - August 31, 19xx

INCOME STATEMENT			BALANCE SHEET
INCOME			ASSETS
Grants	$ 13,000		Cash	$ 127
Contributions	4,500		Accounts Receivable	10,000
Fees from Campers	25,000		Prepaid Expenses	1,050
			Net Fixed Assets	20,000
Total Income	$42,500
			TOTAL ASSETS	$31,177
EXPENSES
Salaries	$20,000		LIABILITIES
Food and Supplies	6,000		Accounts Payable	1,500
Insurance	3,150		Loan from President	$5,000
Utilities	2,000		FUND BALANCE	$24,677
Telephone	750
Printing and Postage	5,000
Total Expenses	$36,900		LIABILITIES AND FUND BALANCE	$30,177

This example illustrates how preparing financial statements on an accrual basis, using these categories, will give a much more accurate and complete picture of an organization,s financial condition. However, cash-basis accounting is easier to use on a day-to-day basis since there are fewer transactions to track. For this reason, many nonprofits, especially those with smaller budgets, choose to keep their books on a modified cash-basis. This means they do one or more of the following:

• Keep the books on a cash basis and prepare reports on an accrual basis. One way to accomplish this is by making accrual adjustments for receivables, payables, etc. on a worksheet and incorporating this information into the financial statements, without formally entering it into the books.
• Record small transactions (e.g., under $100) on a cash basis, but larger transactions and withheld payroll taxes are recorded on an accrual basis.
• Record income on a cash basis and expenses on an accrual basis. This is the most conservative method for recording income and expenses, since you only report cash which has actually been received, but you include expenses whether or not they have been paid.

Many organizations do not have the resources or need to keep their books on an accrual basis. Factors to consider when deciding which basis your organization should use include:

• The extent to which your organization has payables, receivables, etc. on an ongoing basis. If you have few unpaid bills or outstanding grants or fees throughout the year, cash-basis accounting will give essentially the same financial picture of your organization as accrual-basis, and will be easier to use.
• The expertise and time constraints of your bookkeeping staff.
• The cash flow position of your organization. If cash flow is an ongoing concern you will want to keep close track of accounts payable and receivable.
• The size of your organization,s budget. Many small or new nonprofits do not have many payables or receivables, nor do they have the ability to keep track of accruals on an ongoing basis. These organizations will use cash-basis accounting. On the other hand, as their budgets grow, and with them the number of financial transactions, it may become more important to keep track of all activity. They will then switch to using a modified cash or accrual system.

No matter which system you use throughout the year, financial reports must be prepared on an accrual basis according to generally accepted accounting principles.

Return to List of FAQs

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What is the Difference Between Cash-Basis and Accrual-Basis Accounting?

Example of Cash-Basis Balance Sheet
Example of Accrual-Basis Balance Sheet

---

Cash-basis and accrual-basis accounting use different criteria for determining when to recognize and record revenue and expenses in your financial records. On a cash-basis revenues are recognized when cash is received and deposited. Expenses are recorded in the accounting period when bills are paid. In accrual-basis accounting, income is realized in the accounting period in which it is earned (e.g., once contracted services are provided, grant provisions are met, etc.), regardless of when the cash from these fees and donations is received. Expenses are recorded as they are owed (e.g. when supplies are ordered, the printer finishes your brochure, employees actually perform the work, etc.), instead of when they are paid.

To illustrate, let,s take a simple example. At the end of a summer camp,s fiscal year, it has recorded the following deposits and expenditures (left hand statement) from its checkbook. A balance sheet has also been prepared to show the camp,s assets, liabilities and fund balance.

Example of Cash-Basis Balance Sheet SUMMER CAMP
September 1 - August 31, 19xx

INCOME STATEMENT			BALANCE SHEET
INCOME			ASSETS
Grants	$ 3,000		Cash	$ 127
Contributions	4,500		Property, Plant and Equipment	120,000
Fees from Campers	25,000		Less:
			Accumulated Depreciation	<100,000>
Total Income	$32,500		Net Fixed Assets	20,000
			TOTAL ASSETS	$20,127
EXPENSES
Salaries	$20,000		LIABILITIES
Food and Supplies	6,000		Loan from President	$5,000
Insurance	4,200
Utilities	2,000		FUND BALANCE	$15,127
Telephone	750
Printing and Postage	3,500
Total Expenses	$36,450		LIABILITIES AND FUND BALANCE	$20,127

Since the information was taken from activity in the checkbook, we know these statements were produced on a cash basis. However, some pertinent information has not been recorded. For example,

• A foundation has given the camp a grant of $10,000 to provide scholarships for low-income children. The children did attend the camp, but the foundation has not yet sent in the check.
• Because cash is tight, the camp has not paid the final installment to their printer for this year,s brochure. They owe her $1,500.
• The insurance premium was paid in December, and covers the period December through November. So, it is good for another three months.

To take these three factors into consideration on the financial statements, revenues and expenses need to be recorded on an accrual basis. Several line items need to be added to the balance sheet in order to update the financial statements. These are:

• Accounts Receivable
  Reports revenues which have been earned, but not yet received. For example, a payment from a government grant which has been vouchered, but not yet received is an account receivable. In this case, the camp has a grant receivable of $10,000, since the children have already attended the camp and the camp has therefore "earned" the scholarship money from the foundation.

  IMPACT:
  Increase grant income by $10,000 to $13,000
  Increase grants receivable to $10,000

• Accounts Payable
  Reports expenses which are owed to others. The money owed to the printer for completing the brochure is a $1,500 account payable.

  IMPACT:
  Increase printing expenses by $1500 to $5000
  Increase accounts payable to $1500

• Prepaid Expenses
  Reports expenses which have already been paid, but are for a future period. In this example, three months of insurance is considered a prepaid, rather than a current, expense.

  IMPACT:
  Decrease insurance expense by $1,050 ([$4,200/12 months] x 3 months) to $3,150
  Increase prepaid expense to $1,050

Reported on an accrual basis, using the categories described above, the camp's financial statements now look as follows:

Example of Accrual-Basis Balance Sheet

SUMMER CAMP
September 1 - August 31, 19xx

INCOME STATEMENT			BALANCE SHEET
INCOME			ASSETS
Grants	$ 13,000		Cash	$ 127
Contributions	4,500		Accounts Receivable	10,000
Fees from Campers	25,000		Prepaid Expenses	1,050
			Net Fixed Assets	20,000
Total Income	$42,500
			TOTAL ASSETS	$31,177
EXPENSES
Salaries	$20,000		LIABILITIES
Food and Supplies	6,000		Accounts Payable	1,500
Insurance	3,150		Loan from President	$5,000
Utilities	2,000		FUND BALANCE	$24,677
Telephone	750
Printing and Postage	5,000
Total Expenses	$36,900		LIABILITIES AND FUND BALANCE	$30,177

This example illustrates how preparing financial statements on an accrual basis, using these categories, will give a much more accurate and complete picture of an organization,s financial condition. However, cash-basis accounting is easier to use on a day-to-day basis since there are fewer transactions to track. For this reason, many nonprofits, especially those with smaller budgets, choose to keep their books on a modified cash-basis. This means they do one or more of the following:

• Keep the books on a cash basis and prepare reports on an accrual basis. One way to accomplish this is by making accrual adjustments for receivables, payables, etc. on a worksheet and incorporating this information into the financial statements, without formally entering it into the books.
• Record small transactions (e.g., under $100) on a cash basis, but larger transactions and withheld payroll taxes are recorded on an accrual basis.
• Record income on a cash basis and expenses on an accrual basis. This is the most conservative method for recording income and expenses, since you only report cash which has actually been received, but you include expenses whether or not they have been paid.

Many organizations do not have the resources or need to keep their books on an accrual basis. Factors to consider when deciding which basis your organization should use include:

• The extent to which your organization has payables, receivables, etc. on an ongoing basis. If you have few unpaid bills or outstanding grants or fees throughout the year, cash-basis accounting will give essentially the same financial picture of your organization as accrual-basis, and will be easier to use.
• The expertise and time constraints of your bookkeeping staff.
• The cash flow position of your organization. If cash flow is an ongoing concern you will want to keep close track of accounts payable and receivable.
• The size of your organization,s budget. Many small or new nonprofits do not have many payables or receivables, nor do they have the ability to keep track of accruals on an ongoing basis. These organizations will use cash-basis accounting. On the other hand, as their budgets grow, and with them the number of financial transactions, it may become more important to keep track of all activity. They will then switch to using a modified cash or accrual system.

No matter which system you use throughout the year, financial reports must be prepared on an accrual basis according to generally accepted accounting principles.

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What Should Our Chart of Accounts Include?

What Should Our Chart of Accounts Include?
Your chart of accounts, which is a list of each account that the accounting system tracks, should be designed to capture the financial information you need to keep track of your financial information and make good financial decisions. Only information recorded with an account code from the chart of accounts will be recorded into the financial records, and from there into financial reports.

The chart is divided into five categories: assets, liabilities, net assets or fund balances, revenues, and expenses. Each account is assigned an identifying number for use within the accounting system. Aside from certain conventions regarding numbering and the order in which information is presented (see below), you can tailor your chart of accounts to your organization,s specific needs.

In order to decide what to include in your chart of accounts you will want to consider each of the following questions:

• What reports do you want to prepare?
  
• What financial decisions, evaluations and assessments do you need to make on a regular basis?
  
• What level of detail do you require?
  
• What is your capacity for tracking financial information?

The best way to design a chart of accounts is to first consider what reports you want to prepare to satisfy external requirements and help you with internal management assessment and decision-making. You can then determine which categories to include in the reports you plan to produce. For example, your chart of accounts should correlate to the categories in your budget so you can easily prepare reports comparing budgeted with actual income and expenses. The Model Chart of Accounts, developed by the Nonprofit Management Group at Baruch College/CUNY, cross-references each account number to the corresponding line items required for reporting on Federal Form 990 (see the Sample Chart of Accounts provided at the end of this FAQ)

As you think about the different types of income your organization receives, you might want to consider what questions you will want to address in your financial reports: Will you need to distinguish between corporate and foundation grants so you can monitor your fundraising efforts? Are some contributions restricted? Do you earn fees for some of your services? If so, can all fees be combined into one account, or do you want information on fees from each type of activity?

You can ask yourself similar questions regarding your organization,s expenses: What is the lowest level of detailed information that you would like from your financial records? How will you use the information if you record it? For example, most organizations want to keep track of office supplies in the aggregate rather than accounting separately for paper clips, pens, rubber bands, etc. A less obvious example might be in postage. Do you want to include in the postage expense category fees for messengers and express delivery, or do you want to report these separately? If you are worried about the amount being spent on express delivery you should create a separate expense category. If you do not plan to analyze this level of detail, however, it would be advisable to combine the two categories. You can always pull specific invoices related to express delivery to do a periodic analysis without tracking the information in your general ledger.

In addition to the types of income and expenses you want to keep track of there may be other factors to consider as you put together the chart of accounts. If you have more than one site, do you want to keep track of information separately for each site? Or, if you have more than one program, do you want to keep track of items such as supplies, postage, salaries, etc. for each program? And finally, under the new Financial Accounting Standards Board Statements No. 116 and 117, nonprofits will have to report revenues and expenses in three categories: unrestricted, temporarily restricted, and permanently restricted. It is important, therefore, that the chart of accounts supports these reporting requirements, as well.

The greater the level of detail you require, the greater the likelihood that you will need accounting software to keep track of your financial transactions. Accounting software often allows you to divide up transactions into many small pieces, and then determine what level of detail to use in your reports. Keeping track of very detailed information manually is time consuming, and few nonprofits have the staff to do so.

Of equal importance is the ability and availability of your bookkeeper to manage a complex number of variables. For example, your bookkeeper may need training to be able to support a more complex chart of accounts as your accounting systems becomes more complex.

A good rule of thumb is to keep the chart of accounts as simple as possible, and revise it as your need for information increases over time. Throughout the year, as you write checks or receive money, keep track of those times when it was unclear to you which account number to assign to the transaction. That can be an indicator that the chart of accounts needs to be revised or that the criteria for assigning account numbers need to be clarified.

What are the Features of a Simple Chart of Accounts?
The sample chart of accounts provided at the end of this FAQ illustrates how you might track income and expense items, along with conventions which are usually observed when assigning account numbers. This sample is intended to be a guide which you can use for developing your own chart of accounts. It is not comprehensive and some of the accounts included in the sample may not be useful to you. You should note to the following features of the sample chart of accounts:

Account categories are presented in a standard order, beginning with the accounts presented in the Statement of Position (Balance Sheet.) These are:

• Assets
  Assets are the tangible items an organization has as resources, including cash, accounts receivable, equipment and property. Assets are usually listed in descending order of liquidity. This means that cash and other assets which are easily converted to cash are listed first, and fixed assets such as property and equipment are listed last. Asset accounts usually start with the number "1."
  
• Liabilities
  Liabilities are obligations due to creditors, such as loans and accounts payable. Current liabilities, those obligations which fall due within the next year, are usually listed first, followed by long-term liabilities. Accounts payable and payroll taxes payable are usually listed before other payables. Deferred revenue and other liabilities are often further down on the list. Liabilities often begin with the number "2."
  
• Net Assets (or Fund Balances)
  Net assets, formerly referred to as the fund balance(s), reflect the financial worth of the organization. They represent the balance remaining after obligations are subtracted from an organization,s assets. Accounting software designed with for-profits in mind may report net assets under the heading "equity." Organizations which only receive unrestricted gifts will have only one net asset account. Those with temporarily or permanently restricted net assets, such as endowments will have more than one net asset account. Net asset accounts begin with the number "3."

Income and Expense accounts follow the Statement of Position Accounts.

• You will notice that account numbers proceed from lowest to highest, with room between numbers in each category. This allows you to expand the level of detail presented in the chart of accounts as your activities grow.
  
• Certain related accounts are grouped together with related numbers. For example, the general number for payroll taxes is 7310. However, each type of payroll tax expense has been assigned its own account number " F.I.C.A. expense is 7311, Unemployment Insurance is 7312, etc. Some computerized accounting software will allow you to prepare reports which aggregate all accounts with the code 731x into a single line item. Even manually, this type of expense grouping simplifies consolidating information for reports.
  
  Please note, however, that typically you would not post information to account 7310. This account is considered the "heading" for all related expenses.

How can we Capture More Complex Financial Information?

If you need to keep track of separate funds (temporarily and permanently restricted), separate programs or departments, separate sites, etc., your chart of accounts can be designed to accommodate these needs using a "multi-tiered" chart of accounts. The sample chart of accounts shows a single tier. Adding a second section or tier to your account codes allows you to code line items into various categories.

For example, suppose an organization has three programs: counseling, tutorial, and recreation. Each program would receive its own account code as follows:

	Counseling	01
	Tutorial	02
	Recreation	03

Adding these to the codes for natural expense items found in the sample chart of accounts, you would now attribute salaries for counselors as follows:

7210-01

7210	-01
Salary	Counseling Program

Supplies for the recreational program would be posted to:

7710 - 03

7710	-03
Supplies	Recreation Program

You can even keep track of both programs and sites by adding a third tier. For example, if you have a tutorial program at each of two schools, you might assign the first school the letter "A" and the second the letter "B." So, salaries for tutors would be divided between:

7210 - 02 - A and 7210 - 02 - B.

7210	-02	-B
Salary	Tutorial Program	School B

As the chart of accounts becomes more complex, it can enable you to produce reports which are more and more detailed. Again, however, doing so depends on the time and ability of the financial staff and the sophistication of your financial systems since multi-tiered accounting is difficult to maintain without a computer.

Sample Chart of Accounts

Assets			Expenses
1010	Cash		7110	Salaries & Wages of Officers, Directors, etc.
	1011	Checking Account
	1012	Petty Cash
1020	Savings and Temporary Cash Investment		7210	Other Salaries & Wages
1030	Accounts Receivable		7310	Payroll Taxes, etc.
1040	Allowance for Doubtful Accounts			7311	FICA Payments (Employer,s Share)
1050	Pledges Receivable			7312	Unemployment Insurance & Taxes
1060	Allowance for Doubtful Accounts			7313	Workers, Compensation Insurance
1070	Grants Receivable			7314	Disability Insurance
1130	Prepaid Expenses		7520	Accounting Fees
1610	Land			7520	Audit & Accounting Fees
1620	Building			7521	Bookkeeping Services"Outside
1640	Equipment			7522	Payroll Services"Outside
				7523	Bank Service Charges
Liabilities			7710	Supplies
2010	Accounts Payable
2410	Loans from Trustees & Employees		7810	Telephone
2510	Mortgage Payable		7910	Postage & Shipping
Net Assets
			8010	Occupancy
3100	Current unrestricted net assets			8011	Office Rent
				8012	Janitorial & Similar Service Fees
Revenue
			8110	Equipment Rental & Maintenance
4010	Contributions (Direct Mail)
4050	Special Events (Gift Portion)		8210	Printing & Duplicating
4100	Donated Services and Use of Facilities		8220	Publications
4220	Corporate Grants
4230	Foundation Grants		8310	Travel
4510	Government Contributions
			8710	Insurance
5040	Sales to Public of Program-Related Inventory
5060	Other Program Service Fees
5110	Membership Dues"Individuals

This sample has been developed using some of the broad account headings and codes presented in the Model Chart of Accounts developed by the Nonprofit Management Group for nonprofit organizations. This example illustrates the way in which the Model Chart of Accounts can be tailored to the specific needs of an individual organization To obtain a copy of the complete model chart of accounts please contact:

Nonprofit Management Group
Department of Public Administration
Baruch College/CUNY
17 Lexington Avenue, Box 336,
New York, NY 10017
(212)447-3659

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What is Depreciation?

Nonprofits are required to record the purchase of long-lasting, substantial property and equipment (such as computers, vans, buildings, etc.) as assets in the financial records, and to charge a portion of the cost of those items to each year in which they have a useful life. This process is called capitalizing and depreciating fixed assets.

For example, suppose that on January 1st an organization acquires a computer with an estimated useful life of four years. The computer costs $2,500. When the purchase is recorded, the following journal entry is made:

Fixed Assets (increase by)		$2,500
	Cash (decreases by)		$2,500

Explanation: To record the purchase of a computer for $2,500

At the end of each of the next four fiscal years, including the current year, the following journal entry will be made:

Depreciation Expense (increases by) ($2,500/4 years = $625 per year)		$625
	Accumulated Depreciation (increases by)		$625

Explanation: To record depreciation expense for the year.

It is very important to remember that the cash for the computer was spent in the first year. However, one-fourth of the expense for the computer will appear on the Statement of Activity (Income Statement) for each of the four years it is deemed to have a useful life. Therefore, in the three years after the purchase a depreciation expense of $625 will appear on the financial statements even though no cash was expended during those years.

Accumulated depreciation, as the name implies, reports on the amount of depreciation which has accumulated over time. By the end of the first year, one-fourth of the computer will be depreciated. At the end of the second year, two-fourths (i.e., one-half) will be depreciated. By the end of the fourth year the computer will be fully depreciated. In other words, the full cost of the computer will have been recorded as an expense.

The fixed asset portion of the Statement of Position (Balance Sheet) will represent this accumulated depreciation for the computer as follows:

Year 1
Computer (cost)	$2,500
Less: Accumulated Depreciation	<625>
Net Fixed Assets	$1,875
Year 2
Computer (cost)	$2,500
Less: Accumulated Depreciation	<1,250>
Net Fixed Assets	$1,250

Over the remaining two years, accumulated depreciation will increase by $625 per year and net fixed assets will decrease by $625 per year, until accumulated depreciation is $2,500 and net fixed assets is zero.

In this example, the organization determined that the useful life of the computer was four years, and that at the end of that time the computer would have no remaining value. Most nonprofits charge an equal amount of depreciation expense to each year of the assetís useful life. This is called ìstraight-line depreciation.î

To calculate depreciation charges for each fixed asset, you must know how much the asset cost (including all costs necessary to make the asset operational), how long the asset can reasonably be expected to last before it needs to be replaced, and whether the item will have any salvage value at the end of its useful life. Since there are certain conventions for items such as computers, vehicles, furniture, buildings, and other fixed assets, you should consult with your accountant when estimating the useful life of a new capital purchase.

Since depreciation expense is a non-cash expense (that is, cash is usually paid out in the year the asset is acquired, but the expense is distributed over several years), it is important to plan for the replacement of fixed assets as they wear out or become obsolete. For example, some organizations set aside an amount of cash equal to the amount of their yearly depreciation expense so that money will be available to purchase a new asset once the current one is fully depreciated. See Financial Management FAQ No. 19, How Much Cash Should We Hold In Reserve?, for some guidelines.

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What is the Unrelated Business Income Tax?

All 501(c)(3) organizations, with the exception of federal agencies, are subject to a tax on unrelated business income. Unrelated business income is income generated by a trade or business activity not substantially related to the exempt purpose of the organization and regularly carried by that organization.

A trade or business activity is an activity conducted for the purpose of generating income from the sale of merchandise or performing a service. For instance, a university bookstore selling trade books to students and the general public is engaged in a business activity. An activity is substantially related to the exempt purpose of the organization if it is causally related and contributes importantly to the exempt purpose. For example, an art museum regularly charges an entry fee for admission to exhibits. In addition, the museum operates a restaurant which is open to the general public. The earnings from the restaurant are used to support museum activities. The admission fees are substantially related to the purpose of the organization and are not considered unrelated business in come. However, the restaurant income is unrelated business income, even though it is used to support the general mission of the museum.

Taxes paid by a nonprofit on unrelated business income are paid at corporate rates. Without such a tax, nonprofits would be at a substantial advantage in the marketplace when competing with for-profit organizations.

Organizations engaged in conducting unrelated business activities are not subject to income taxation under the following conditions:

• All work is performed by volunteers
• Substantially all of the merchandise being sold has been acquired by gift
• The activity is being conducted for the convenience of the organization's members, patients, employees, etc. For example, in the case of trade unions, work-related clothing and equipment may be sold at the job site and, therefore, not subject to the unrelated business income tax.

It should be noted that if unrelated business gross income (income before related expenses have been subtracted) is less than $1,000, it is not necessary to file an unrelated business tax return (Federal Form 990T).

There are several special rules and exceptions relating to special types of unrelated business income.

• Income from bingo games is not considered unrelated business income if the bingo game is legal under both state and local law and commercial bingo games are not legal in the jurisdiction.
  
  
• Tax exempt organizations can exchange or rent donor or membership mailing lists without generating unrelated business income.
  
  
• As part of an exempt organization s solicitation activities, it may distribute low cost items (e.g., stickers, stamps, etc. with an aggregate value of less than $5) without unrelated business income consequences.

Will Unrelated Business Income Affect Your Nonprofit Status?
The following information, excerpted with permission from Advising Nonprofits, published by the Lawyers Alliance for New York, details the conditions under which unrelated business income might and might not affect your nonprofit status:

• Tax exempt organizations are permitted to carry on business activities which further their exempt purposes.... However, activities which do not further the organization's purpose could jeopardize its tax exempt status if they go beyond boundaries established by courts and the IRS....
  
  In general, cases upholding the tax-exempt status of organizations engaged in profit-making activities have found that one, or more, of the following conditions existed:
  
  
  • the organization was primarily operated for non-commercial purposes
    
    
  • the activity in question has some direct relationship to a non-commercial exempt purpose of the organization
    
    
  • the size of the commercial activity was reasonable in comparison to the organization s overall activity and not greater than necessary to accomplish the exempt purpose
    
    
  • the commercial activity did not further private interests or confer an undue benefit on insiders...

  
  
  On the other hand, courts have upheld the denial or revocation of tax-exempt status for organizations carrying on profit-making activities when the following conditions exist:
  
  

  • the commercial activity does not directly further any exempt purpose of the organization, and the profit-making activity is a substantial part of the organization s overall activity or appears to be its primary purpose
    
    
  • the profit-making operation is carried on at a scale which is out of proportion to the exempt purpose being supported
    
    
  • the commercial activity is a kind normally carried on by for-profit businesses and the nonprofit is competing directly with commercial enterprises
    
    
  • insiders of the nonprofit such as directors or employees benefit inappropriately from the business activity...

You should consult your accountant if you think there is even a possibility that some of the activities your organization performs would qualify as unrelated business income and, therefore, make your organization liable for taxation.

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What accounting software package should we buy?

Prerequisites to computerizing an Accounting System
What Account Software Should We Buy?
What to Look for When Selecting a Software Package
Can't We Just Put the Books on Spreadsheet Software?
Alternatives to In-House Computerization

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Even prior to asking this question, it is important to ask whether you should computerize your organization's accounting function at all. Most organizations seek the following benefits from automation:

• increased efficiency
  
• lower costs (less staff time supporting accounting activities)
  
• greater accuracy
  
• more timely reports
  
• better control

But the questions are: Will you achieve these results? And how quickly? One of the biggest mistakes an agency can make is to believe that an accounting system in trouble can be improved by putting it on the computer. This is virtually never the case: a mess put in to the computer can be worse than a mess on ledger paper.

Prerequisites to Computerizing an Accounting System
The most important factor to consider when deciding whether to computerize the accounting system is the accounting expertise of responsible people at your agency. People, not computers, do accounting. Computers add numbers very quickly, and enable you to enter the number into the system once for it to appear in all journals, ledgers and other reports. However, a human being has to decide where to enter that information and then to key the data into the system. Someone in the organization still has to understand debits and credits, decide what account code to charge each transaction to, determine whether an error has been made and, if so, how to correct that error. So, computerizing the accounting function does not automatically lead to greater accuracy or better control.

It is important to have "clean," that is accurate, up-to-date beginning balances to enter into your new computerized accounting system. This is one area where "garbage in, garbage out" really applies. Many organizations choose to enter data starting from audited financial statements to get them off to a fresh start.

What Accounting Software Should We Buy?
There is no one right answer to this question. To understand why, imagine answering the question, What's the best car to buy? In order to answer, you would first need to ask questions such as: How many passengers do you normally have? How much are you willing to spend? What features are important to you? One of these considerations might outweigh all of the others. Once you have all the information, there might be two or three cars which meet the criteria. The final decision will be based on personal preference. A similar set of questions and circumstances can be applied to selecting an accounting software package.

What to Look for When Selecting a Software Package
The following factors often play an important role in the final selection of accounting software for nonprofits:

• 
  
• Standard and Ad Hoc Reports
  The first consideration in selecting an accounting package is the type of reports you want the software to produce. Many packages lack the ability to easily define reports (despite their claims to the contrary), so it is important to look at those reports already built into the software. Be aware that every document the system produces is considered a report. Do not assume that standard elements of a manual system (including a check register, cash disbursements and receipts journals, trial balance, etc.) can be produced in the way that you are accustomed to seeing them, if at all.
  
  The following reports are often useful to nonprofits:
  
  • 
    
  • A printout of your general ledger, detailing each transaction posted to each account
    
    
  • A printout of a consolidated general ledger, not displaying detail
    
    
  • A bank reconciliation format, showing monthly receipts and disbursements
    
    
  • Income and expense statements for each program or grant and a consolidated (agency-wide) statement of income and expenses for the year to date
    
    
  • Balance sheet information for the entire organization and balance sheet information by fund, if applicable (see the Fund Accounting section, below)
    
    
  • A budget to actual comparison for each grant and/or the entire agency

  
  
  

• Tracking Transactions by Fund, Department or Program, or Grant
  
  Fund Accounting
  Fund accounting is a method for accounting for restricted gifts. Many nonprofits mistakenly believe that software which can accommodate fund accounting, because it was developed for the nonprofit sector, is the only appropriate software for nonprofits. Whether you need fund accounting depends on the nature of your restricted gifts, and the types of reports you want to produce. Most non profits are able to use so-called business software, that is typically less expensive than fund accounting software, to meet their accounting requirements. This software can often produce data that can be translated into fund accounting statements. However, larger nonprofits might be wise to invest in fund accounting software which will allow them to prepare the detailed reports they and their funders require on an ongoing basis.
  
  The nature of fund accounting is shifting due to new practices detailed in FASB's Statements of Financial Accounting Standards Nos.116 and 117. Be sure to check with software vendors for fund accounting packages to see how they are adapting the package to meet the new reporting requirements, and what the charge for those upgrades will be.
  
  Cash-Basis Accounting
  Most nonprofits want to keep their books on a cash- or modified cash-basis, instead of on a full accrual basis. For example, when a check is written, most nonprofits want to post it directly to the expense account. However, many software packages require these accounts to be posted through the Accounts Payable module.
  
  See Financial Management FAQ 5: What is the Difference Between Cash-Basis and Accrual-Basis Accounting?, for a discussion of the difference between cash- and accrual-basis accounting.
  
  Departments or Programs
  Many nonprofits need to track expenses and/or revenue by department or by program. For example, an organization serving the mentally retarded which has several residences might want to keep track of expenses for each residence. It may also have training programs in areas such as vocational skills, daily living skills, entitlements, etc. which serve all residents and by which expenses or revenues need to be tracked. Ideally, the software should report costs by residence or by training program across the whole agency.
  
  
• Ability to Keep Prior Months Open and Flexible Reporting Periods
  Many organizations find it convenient to make adjustments in prior months, and then re-issue statements for those months. Similarly, an important feature for some nonprofits is the ability to select which months to compile for reports, such as when preparing reports to funders for grants which do not correspond to your fiscal year. Some software will not permit you to make changes or access data in prior months.
  
  
• Exporting Data to Other Software Programs
  Typically, organizations want to transfer information directly from the general ledger into spreadsheet software (such as Lotus or Excel) for more flexible reporting. By exporting software to software you avoid mistakes from re-entering the data into the spreadsheet software.
  
  
• Cost
  Fund Accounting, and other more sophisticated high-end accounting packages cost more than software designed for small businesses, or low-end software. High-end software is often organized into separate components, called modules, for each accounting feature (General Ledger, Accounts Payable, Accounts Receivable, etc.) You pay for each module you will use. Low-end software is usually all in a single package with more limited functional capabilities.
  
  
• Other Factors to Consider
  Other factors to consider when evaluating software packages include:
  
  • How many checking accounts are permitted?
    
  • Can the software handle the payroll function, including W-2s and 1099s? How easily?
    
  • Is there room to grow into the software? Will it be able to accommodate your needs as they become more sophisticated?
    
  • Does the software include security features which prevent unauthorized personnel from accessing and/or manipulating data in the accounting system?
    
  • What installation and ongoing support is available?
    
  • How long has the company been in business?
    
  • Are there user groups or other support mechanisms outside of the vendor?

  
  

Can't We Just Put the Books on Spreadsheet Software?
No. Since there are so few controls for spreadsheet software, numbers can be easily changed, damaging the integrity of your financial reports. However, you can export, or electronically transfer, data from your accounting system into a spreadsheet package such as Lotus or Excel to prepare more customized reports.

Similarly, it is not a good idea to keep your books on database software which does not have the controls or reporting capability of accounting software. Finally, many consultants do not recommend using checkbook software for nonprofit bookkeeping. The attraction of checkbook software is that it is easy to use. However, most nonprofits outgrow checkbook software quickly because it does not use double-entry bookkeeping and its reporting capabilities are often very limited.

Alternatives to In-House Computerization
If you lack the resources for computerizing your accounting function in-house and still hope for the benefits from an automated system, you might consider using an outside bookkeeping service with its own computerized accounting system. These service bureaus will enter your data into their computer software, either directly from your checkbook or using forms you complete. From this data they produce monthly reports. Especially if you can find an accounting firm or other service provider familiar with nonprofit requirements, this might be a useful interim solution until you can afford to bring on more experienced personnel or train your staff.

The biggest drawback organizations have found with service bureaus is that the turnaround time can be slow, defeating the objective of producing more timely financial reports. Also, a service bureau does not pay attention to the management aspect of financial management -- making decisions about how much to spend, when to spend, variances with the budget, etc. Sometimes nonprofits are so relieved to have the accounting function managed by someone else that these other, equally important considerations are forgotten.

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What is an audit?

An audit is a process for testing the accuracy and completeness of information presented in an organization's financial statements. This testing process enables an independent certified public accountant (CPA) to issue what is referred to as an opinion on how fairly the agency's financial statements represent its financial position and whether they comply with generally accepted accounting principles (GAAP) . GAAP is determined by the American Institute of Certified Public Accountants (AICPA). Board members, staff, and their relatives cannot perform audits because their relationship with the organization compromises their independence.

The audit report is addressed to the board of directors as the trustees of the organization. The report usually includes the following:

• A cover letter, signed by the auditor, stating the opinion, as described above.
  
  
• The financial statements, including the statement of financial position (balance sheet), statement of financial activity (income statement), and statement of cash flows. Health and social service organizations also have a statement of functional expenses. Many audits show comparative information between fiscal years.
  
  
• Notes to the financial statements, as required by GAAP, which might include information about functional expenses, a depreciation schedule, further information about contributions, volunteer services, and other significant information not obvious in the financial statements.
  

In addition to the materials included in the audit report, the auditor often prepares what is called a management letter or report to the board of directors. This report cites areas in the organization's internal accounting control system which the auditor evaluates as weak.

What an Auditor Does
The auditor will request information from individuals and institutions to confirm bank balances, contribution amounts, conditions and restrictions, contractual obligations, and monies owed to and by your organization. The auditor will review physical assets, journals and ledgers, and board minutes to ensure that all activity with significant financial implications is adequately disclosed in the financial statements. In addition, the auditor will select a sample of financial transactions to determine whether there is proper documentation and whether the transaction was posted correctly into the books. In addition, the auditor will interview key personnel and read the procedures manual, if one exists, to determine whether the organization's internal accounting control system is adequate. The auditor usually spends several days at the organization s office looking over records and checking for completeness.

Auditors are not expected to guarantee that 100 percent of the transactions are recorded correctly. They are only required to express an opinion as to whether the financial statements, taken as a whole, give a fair representation of the organization's financial picture. In addition, audits are not intended to discover embezzlements or other illegal acts. Therefore, a "clean" or unqualified opinion should not be interpreted as an assurance that such problems do not exist.

An unqualified opinion includes wording such as, "In our opinion, the accompanying financial statements present fairly the financial position of ABC Agency at the fiscal year ending June 30, 19XX, ... in conformity with generally accepted accounting principles."

A qualified opinion is issued when the accountant believes the financial statements are, in a limited way, not in accordance with generally accepted accounting principles. A qualified opinion might include wording such as, "In our opinion, except for the omission of... the accompanying financial statements present fairly..."

Many auditors provide nonprofits with year-end financial management services which are not part of the audit. These include preparing:

• year-end financial statements based on client records
  
• notes to the financial statements
  
• depreciation schedules
  
• accrual and other adjustments based on client information

Smaller nonprofits with limited accounting expertise may choose to pay their auditors for these tasks. However, you should know that these services are provided in addition to the audit and can be completed by staff or volunteers to lower the cost of the audit.

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Should we get an audit?

An audit is a process for testing the accuracy and completeness of information presented in an organization's financial statements. This testing process enables an independent certified public accountant (CPA) to issue what is referred to as an opinion on how fairly the agency's financial statements represent its financial position and whether they comply with generally accepted accounting principles (GAAP).

Some nonprofits are legally required to obtain audits. Many states require an audit for nonprofits which receive contributions over a specified amount (the amount varies from state to state) and/or nonprofits who hire a paid fundraiser. You may contact the Secretary of State or Office of the Attorney General for regulations in those states where you raise money. In addition, nonprofits which receive $25,000 or more in direct or pass-through federal funding during a single fiscal year are usually required to have an audit.

You may choose to obtain an audit even if you are not legally required to do so. Many funders commonly request audited financial statements. In some cases, they will accept statements prepared in-house. Alternatively, they may accept a CPA review (see below.)

In addition to these external requirements, the board may seek reassurance that the financial information they are considering as part of their oversight function is accurate and complete. In cases where financial problems or irregularities in the financial system have occurred, the board and the general public may look to an audit to provide assurance that these problems have been resolved. Also, the audit process can be valuable to your executive director and finance staff since it confirms the financial picture and helps you strengthen internal control procedures.

Finally, an audit signals a new phase in the organization's maturity. As your organization's financial transactions become more complex, undergoing the rigors of an audit will help your staff understand and develop the financial systems required to track and manage finances responsibility. In addition, as others become attracted to your organization's work, many will expect you to be able to provide them with audited financial statements as they are considering making a contribution as a donor and/or a volunteer.

Alternatives to an Audit
A review is a more limited examination of the financial statements by a CPA. During a review, the CPA asks questions of management and conducts some analysis, but does not undertake the extensive testing required for an audit. As a result, the review provides only limited assurance that the financial picture is fairly presented. A review may cost less than half of an audit and may satisfy state requirements for smaller nonprofits.

A compilation is a report prepared by an accountant using financial data supplied by the organization. The accountant organizes this financial information into standard financial reporting formats, but does not review the numbers for accuracy or provide assurance regarding the information that is included.

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What is an A-133 Audit?

What is an A-133 Audit?
In 1990, the Office of Management and Budget (OMB) issued Circular A133, Audits of Institutions of Higher Education and Other Nonprofit Institutions, which defines audit requirements for nonprofits receiving more than $25,000 in federal funding. Your organization is subject to these audit requirements even if the federal money you receive is passed through another agency. For example, a city housing authority may make a grant to a local nonprofit housing developer which contains H.U.D. funding. The local housing developer is subject to A-133 audit requirements even though the grant was not directly from H.U.D.

When is an A-133 Audit required?
Fortunately for smaller nonprofits, the federal guidelines may permit you to combine a regular audit of your whole agency with a ìprogram- specificî A-133 audit of the program receiving federal funding. The amount of your total combined federal funding will determine the type of audit you are required to have under A-133. The following table shows when an A-133 audit is not required, when a program-specific A -133 audit may be elected, and when you must have an agency-wide ìsingleî federal audit:

Total Amount of Federal Awards	One Program	More Than One Program
$0 -- $24,999	No Audit	No Audit
$25,000 -- $99,999	Program Specific or A-133 Single Audit	Program Specific or A-133 Single Audit
$100,000 or More	Program Specific or A-133 Single Audit	A-133 Single Audit

A-133 audits, like non-federal audits, test financial statement information. However, the A-133 audit looks more closely at tracking and classifying revenue from federal sources. In addition, the auditor looks for compliance with general and specific government audit requirements, which cover both financial and non-financial factors such as program effectiveness, client eligibility, efficiency with which resources are used, etc. The auditor must also test internal control procedures more rigorously than in a standard audit, making sure that adequate systems are in place for complying with the requirements noted above. Because of the expanded procedure involved and increased reporting requirements for the auditor, the audit may cost substantially more than a traditional audit and involve more time from your staff. You should be allowed to build these additional audit costs into your grant. In practice, however, many nonprofits receiving pass-through federal funding have had difficulty convincing their government funders to include audit money in their grant.

In summary, if your organization receives over $100,000 in federal funding, whether directly or indirectly, and that funding is for more than one program, you are required to have an agency-wide A-133 audit. In addition, a program which receives more than $100,000 in combined federal awards is likely to be classified as a ìmajor program,î and, therefore, subject to significantly more testing by the auditor. ìWhether a program is major or non-major is based on the dollar value of expenditures during the audit period. A program is a major program when total expenditures equal or exceed three percent of total federal funds expended or $100,000, whichever is greater. A program is non-major when expenditures are below this threshold.î In other words, if one program spends $100,000 or more in total federal funds it is a major program, unless you have received more than $3,333,333 in total federal funding for all programs.

How often will you be audited?
You are subject to A-133 guidelines for each year in which you receive federal monies of $25,000 or more. However, the guidelines are somewhat unclear as to how often these audits must be conducted. According to Position Statement No. 6 issued by the Presidentís Council on Integrity and Efficiency Standards Subcommittee, ìthe A-133 single audit must be annual when the not-for-profit has annual financial audits.î In other words, if you are usually audited annually, you must also have an A-133 audit annually. If, however, you are usually audited every other year, you may also undergo an A-133 audit every other year, but the report must cover both years under consideration.

As you can see, receiving federal money can require a lot of extra work. This work begins as soon as you receive a grant award. If your organization receives funds from a non-federal agency or grantor, you are expected to ask whether your grant includes federal monies. In some cases your funder will not know the answer, even though they are required to inform you whenever federal funding is included in your award. You are required to make a good faith effort to determine whether federal money is included, and if so how much. Each federal award is identified with a number from the Catalogue of Federal Domestic Assistance (CFDA). Your granting agency should tell you the CFDA number(s) for any federal funds included in your award since you are required to report this information as part of your audit. When you do receive federal funding, alert your auditor right away so you can get help setting up the proper systems for complying with government regulations. You may also want to get a copy of the OMB Compliance Supplement, which describes the A-133 requirements. Alternatively, your auditor may have prepared guidelines for you to follow. Then identify the person on your staff who will monitor compliance with the federal guidelines. The sooner you learn of the extensive requirements which go along with federal funding, the better able you will be to incorporate them into your accounting system.

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What are the elements of an accounting system?

An accounting system is comprised of accounting records (checkbooks, journals, ledgers, etc.) and a series of processes and procedures assigned to staff, volunteers, and/or outside professionals. The goals of the accounting system are to ensure that financial data and economic transactions are properly entered into the accounting records and that financial reports necessary for management are prepared accurately and in a timely fashion.

Components of an Accounting System
Traditionally, the accounting system includes the following components:

Chart of Accounts

The chart of accounts is a list of each item which the accounting system tracks. Accounts are divided into five categories:
Assets, Liabilities, Net Assets or Fund Balances, Revenues, and Expenses. Each account is assigned an identifying number for use within the accounting system. (See Financial Management FAQ 6: What Should Our Chart of Accounts Include? for information on designing the chart of accounts and using it for reporting.)

General Ledger

The general ledger organizes information by account. The chart of accounts acts as the table of contents to the general ledger. In a manual system, summary totals from all of the journals are entered into the general ledger each month, which maintains a year-to-date balance for each account.

In a computerized system, data is typically entered into the system only once. Once the entry has been approved by the user, the software includes the information in all reports in which the relevant account number appears. Many software packages allow the user to produce a general ledger which shows each transaction included in the balance of each account. For example:

Acct. No. 5105 Account Name: Office Supplies
Beginning Balance @ April 30: $1,535.26
Ck. No. 1443 John s Office Supplies 5/12 $347.40
Ck. No. 1451 Quality Paper Store 5/17 $32.89
Closing Balance @ May 31: $1,915.55

Journals and Subsidiary Journals

Journals, also called books of original entry, are used to systematically record all accounting transactions before they are entered into the general ledger. Journals organize information chronologically and by transaction type (receipts, disbursements, other). There are three primary journals:

• 
  
• The Cash Disbursement Journal is a chronological record of checks that are written, categorized using the chart of accounts.
  
  
• The Cash Receipts Journal is a chronological record of all deposits that are made, categorized using the chart of accounts.
  
  
• The General Journal is a record of all transactions which do not pass through the checkbook, including non-cash transactions (such as accrual entries and depreciation) and corrections to previous journal entries.
  

As organizations mature, and handle greater numbers of financial transactions, they may develop subsidiary journals to break out certain kinds of activity from the primary journals noted above. The most common examples of subsidiary journals include:

• The Payroll Journal, which records all payroll-related transactions. This may be useful as the number of payroll transaction s grows and becomes too large to handle reasonably within the cash disbursements journal.
  
  
• The Accounts Payable Journal and Accounts Receivable Journal track income and expense accruals. These are useful for grouping income and/or expense accruals which are too numerous to track effectively through the general journal. Some accounting packages require you to set up all bills as accounts payable and all revenue as accounts receivable, eliminating the cash disbursements and receipts journals altogether.
  
  

The process of transferring information from the journals to the general ledger is called posting. Computerized accounting systems often require users to post all income and expense transactions through the accounts receivable and payable journals. Other automated systems allow users to post to cash disbursements or receipts journals, but cannot produce detailed financial information from these journals (such as a list of checks written presented in numerical order.) See Financial Management FAQ 9: What Accounting Software Package Should We Buy? for further information.

Checkbook

In very small organizations, the checkbook may serve as a combined ledger and journal. Most financial transactions will pass through the checkbook, where receipts are deposited and from which disbursements are made. Smaller organizations receiving few or no restricted contributions find it easier to keep track of financial activity by running all of their financial transactions through a single checking account. Very small organizations, with few deposits and disbursements, may prepare reports directly from the checkbook after the balance has been reconciled with the bank balance.

Accounting Procedures Manual

The accounting procedures manual is a record of the policies and procedures for handling financial transactions. The manual can be a simple description of how financial functions are handled (e.g., paying bills, depositing cash and transferring money between funds) and who is responsible for what. The accounting procedures manual is also useful when there is a changeover in financial management staff. See Financial Management FAQ 24: What is an Internal Accounting Control System and How Can We Make Ours Effective? for further ideas of what to consider as part of an accounting procedures manual.

The Accounting Cycle
The accounting cycle may be represented schematically as follows:

financial transactions -> analyze transaction -> record transaction in journals -> post journal information to general ledger -> analyze general ledger account and make corrections -> prepare financial statements from general ledger information

The routine aspects of the accounting cycle (recording transactions, posting, etc.) are generally done by bookkeepers or data entry clerks. Accountants focus on the more analytical aspects of the accounting cycle (analyzing transactions, preparing financial statements.) Many small organizations rely on a single individual to perform all of these functions.

Maintaining the Integrity of an Accounting System
The key tasks for maintaining the integrity of an accounting system include the following:

Trial Balance

In a manual system all balances from the general ledger are tallied on a monthly basis to make sure that debit balances equal credit balances. Once debits equal credits, financial statements can be prepared using trial balance amounts. Computerized accounting systems almost always produce a trial balance as a built-in report. Many software packages will not allow you to post an entry to the general ledger until the debit and credit balances are equal.

Bank Reconciliation

Each month you will need to reconcile the balance in your checkbook with the balance in your account according to your bank. This process has three basic steps:

1. Compare deposits and checks as they are recorded in the checkbook with those reflected in the bank statement. Adjust any discrepancies.
   
2. Adjust for bank charges or interest earned into the checkbook balance.
   
3. Subtract uncashed checks from the bank s balance and add in checks you have deposited which are not yet reflected in the bank's balance.
   

See Financial Management FAQ 21: What Internal Controls are Needed for Cash Disbursements?, FAQ 23: What Internal Controls are Needed for Payroll?, and FAQ 24: What is an Internal Accounting Control System and How Can We Make Ours Effective? for additional information about policies and procedures which will help you maintain the integrity of information entered into the accounting system.

Stages in the Development of an Accounting System
Your accounting system will change as your organization's needs and resources change. A new, small organization may only need to keep an accurate record of activity in its checkbook. As the number of transactions grows, that organization will add manual cash disbursements and receipts journals, but may still prepare monthly reports using a summary sheet of income and expense items. Finally, as the organization acquires assets other than cash, accruals are added, and transactions become more complex, a full general ledger system will need to be incorporated.

As their volume and complexity grow, the financial management activities will also require increasingly sophisticated staffing, whether by paid or volunteer staff or a combination of staff and outside service providers. An accounting system is only as good as the staff's ability to put it into practice, and should be designed with its users in mind.

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What is tax deductible for membership dues, special events, and other fundraisers?

How to Determine the Fair Market Value of Fundraising Items
What Wording should We Use on the Solicitation?

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Questions about tax deductibility fall into two categories:

• What is tax deductible to the donor?
  
• What wording should we use on the solicitation?
  

A related question, regarding disclosure of the actual amount of money from a solicitation that will be used to directly support charitable purposes, falls under state regulation. Many other questions related to special events, bingo, and other fundraising activities also fall under state regulation. You may contact the Secretary of State or Office of the Attorney General in your state or the states in which you fundraise for information on state regulations for nonprofits. An annual survey of state laws regulating charitable solicitations may be obtained from the AAFRC Trust for Philanthropy (25 W. 43rd Street, New York, NY 10036, (212) 354-5799).

The U.S. Congress and the Internal Revenue Service have expressed concern about situations in which some charities, intentionally or unintentionally, have misled donors about the extent of the deductibility of their contributions. Furthermore, experience has shown that fundraising returns are better served in the long run by fair and accurate disclosure about deductibility, and by encouraging prospective donors to seek additional information from their tax accountants or from one of the references at the end of this article.

How to Determine the Fair Market Value of Fundraising Items
The following quotation is excerpted from Tax Planning and Compliance for Tax-Exempt Organizations: Forms, Checklists, Procedures by Jody Blazek:

• Contributors to nonprofit organizations have grown accustomed to receiving benefits in return for their gifts: dinner, entertainment, and prizes. Often, the proceeds of fund-raising events add directly to an organization's coffers because businesses and patrons donate the items of benefit offered to the attendees. Until 1988, a charity was neither expected nor required to assign value to such benefits, or to inform the givers that the ticket price is not fully deductible.
  
  Misconceptions and indecision plague fund-raisers because there is no absolute legal requirement underlying the IRS s request that an organization voluntarily furnish donors information in connection with fund-raising events, membership drives, and other revenue programs, when donors are given premiums, discounts, meals, prizes, or other valuable items in return for their donation. Ethical and tactical issues are involved.
  
  In a deceptively simple fashion, the Internal Revenue Code states that an income tax deduction is allowed for a contribution or gift to or for the use of qualified charitable organizations (IRC 170(c)). Neither the Code nor the regulations define contribution. The commonly understood definition of a contribution is a voluntary transfer without consideration. In other words, only a gift for which nothing is received in return is fully deductible.
  
  For example, a $25 meal provided during a $100 benefit reduces the deduction to $75. A $25 meal, plus $35 performance, plus a $20 chance for the door prize, would reduce the gift to $20. Fortunately, intangible recognition, such as having one's name placed on a building or donor listing, is, as a general rule, considered to be of incidental or tenuous benefit, and does not reduce the value of the gift (Reg. 53.4941 (d)-2(f)(2); Rev. Rul. 66-358, 1966-2 C.B. 216; Rev. Rul 73-407, 1973-2 C.B. 383).
  
  To add to the difficulty, items of tangible personal property given for resale in a charity auction or resale shop are also limited in their deductibility. Such property is only deductible to the extent that it is given to or for the use of the charity itself (IRC 170*e)(B)(i)). A work of art given to a museum to exhibit on its wall is used by the museum directly in its exempt programs, so the full value of the art is deductible. If instead, the work of art is given to an AIDS hospice for a benefit action, the deduction is limited to the giver's tax basis.

There are countless individual situations for determining the fair market value of items involved in fundraising appeals. Here are some examples for determining the fair market value of some such items:

Item Guideline for Fair Market Value:

• Meals at hotel or restaurant would be worth the price of the same meal in a dining room or at a restaurant, including drinks and tips.
  
• Attendance at a reception has the value of the food and drink served, but the intangible value of associating with other guests not valued.
  
• Ticket to a theater or dance performance equals the normal ticket price available to public.
  
• Bumper stickers, buttons, pens, and other low cost tokens--for gifts of $25 or more (adjusted with inflation from 1987 price index), the fair market value of such items, if each token cost less than $5 (again adjusted from 1987 levels), the fair market value of the token is zero and the contribution is fully deductible.

What Wording Should We Use on the Solicitation?
The following list provides a few examples of wording that might accompany solicitation for several fundraising events:

Event Cost Sample Wording:

Fundraising luncheon at $50.00 per ticket; $100 to be a sponsor, etc.

The invitation to the luncheon states, "$25.00 of each ticket is not tax deductible," or "Contributions over the value of this luncheon and entertainment ($25) are tax deductible."

An Auction

A catalog is issued listing each item and the fair market value for each item. The catalog states, "Purchasing an item for more than the fair market value as listed in this catalog results in a deduction for amounts above the price listed."

Raffle ticket priced at $1

Not a charitable deduction. Do not state that the purchase of the ticket is a "donation."

Membership where a $35 minimum includes newsletter and a $75 membership includes umbrella with logo

The newsletter's subscription price to non-members is $15. "$15 of your $35 membership is not tax deductible as a charitable contribution." The umbrella's fair market value is $10. "$25 of your $75 membership is not deductible as a charitable contribution."

Jody Blazek comments, "Since an exempt organization is not required to report the deductible portion of its contributor's gifts and since the burden of proving value is placed on the contributor, some charities choose not to comply with the IRS request that benefits be valued and reported voluntarily. Some of these charities take a silent approach and disclose no information; others continue to use the old refrain, deductions to the extent allowed by law, which may ironically serve as a red flag to the IRS. Most individual donors wish to comply with the tax laws and welcome cooperation on the charity's part. On the other hand, reduction of tax benefit is perceived to discourage giving. (This is clearly true in the case of appreciated property gifts of stock, art, and land.) Fortunately, most charities are making the ethical choice to comply and furnish deductibility information. They are happy to report no significant reductions in giving levels as a consequence. Nonetheless, donor goodwill is both enhanced and crippled by voluntarily furnishing Fair Market Value information. Some contributors want it, some do not, and therein lies the dilemma."

For More Information:
Tax Planning and Compliance for Tax-Exempt Organizations: Forms, Checklists, Procedures, 1993, by Jody Blazek. John Wiley & Sons, 605 Third Avenue, 10th Floor, New York, NY 10158, (800) 225-5945.

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Is there a way to just show a figure for "net fundraising events" rather than listing each event under both income and expense?

Some nonprofits find that it distorts their budget to show both the income and expense from a fundraising event. Some use accounting software that isn't set up to show only the "Net."

It's true--fundraising income and expense can distort the budget. For example, if an organization's annual dinner brings in $25,000, but costs $15,000, the budget should really show only the $10,000 as net income (a separate, break-out worksheet should show the expected gross income and expenses for analysis purposes). In line with this clarity, Federal Form 990, the annual form required for most nonprofits, asks only for the net of fundraising special events.

There are two approaches. One solution is simply to track both income and expense to the same account; If, for example, account #488 is for the Annual Dinner, you can post both income (Credits) and expenses (Debits) to that account. The printout will show only the net. If you want to know the grosses, you will have to look at the year-to-date general ledger printout. In the previous example, software would print out only $10,000 in the line item for the Annual Dinner income.

This FAQ was written by Jan Masaoka, Executive Director of CompassPoint Nonprofit Services.

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How Do We Account for Pledges?

How Do We Account for Pledges?
What Pledges Should Be Recorded?
What Are the Accounting Entries for Recording Pledges?
How Do We Account for Uncollected Pledges?
Reporting Issues

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How Do We Account for Pledges?
A pledge is a promise, either written or verbal, to make a contribution at a later date. For example, a donor may pledge to make contributions totaling $10,000 over the next three years. In another example, a donor may pledge to make contributions of $50 each month through payroll deduction for the upcoming year. Pledges may also involve non-cash contributions, such as a pledge to donate artwork at the end of next year.

By showing Pledges Receivable on the Balance Sheet, a nonprofit organization shows the amount of money it can reasonably expect to receive in the future in pledged contributions. In the past, organizations have had some leeway in the timing of recognizing pledges as income. In 1993, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 116, Accounting for Contributions Received and Contributions Made, that set down firm guidelines for pledge accounting.

What Pledges Should be Recorded?
A pledge must be bona fide to be recorded in the accounting system. Some indicators that a pledge is valid include written evidence created by the donor using words such as ìpromise,î ìagree,î or ìbinding,î or whether the pledge appears to be legally enforceable.

Pledges are either conditional or unconditional. An unconditional pledge is a promise by a donor to give a gift to the nonprofit in the future. The nonprofit does not need to meet any specific requirements before receiving the gift, and there are no other conditions stipulated by the donor. The examples at the beginning of this article illustrate unconditional pledges. Statement 116 asserts that unconditional pledges must be recorded in the financial record when they are made.

A conditional pledge is contingent on the occurrence of an uncertain future event. For example, a donor might promise to contribute $1,000 if the organization obtains a matching gift of $2,000 from new sources. Conditional pledges are recorded on the books only when the condition is met, so this pledge would not be recorded as revenue until the matching gift is obtained. (Once a condition has been met, in the above case when a matching gift has been obtained, the pledge becomes unconditional, and is recorded.) Prior to meeting donor-imposed conditions, conditional pledges are included in the footnotes to the financial statements.

What are the Accounting Entries for Recording Pledges?
Suppose that at the end of the 1994 fiscal year, you have two unfulfilled pledges: one is a pledge to make a gift of $1000 during the next year; the second pledge promises gifts of $2,000 per year in each of the next three years, for a total of $6,000.

The end-of-year journal entry to record these unconditional pledges is:

Pledges receivable	$7,000
Contributions Receivable		$7,000

To record newly received unconditional pledges

When the pledge payment of $1,000 is received in 1995, the entry is:

Cash	$1,000
Pledges Receivable		$1,000

To record receipt of a pledge

It is important to note that the $1,000 is recognized as revenue in 1994, and not in 1995 when the cash was actually received.

In an example of a conditional pledge, a donor may pledge $25,000 to renovate a half-way house on the condition that the building is purchased. This pledge would be mentioned only in a footnote until the nonprofit buys the building. At that point the pledge would be recorded and recognized as revenue.

How Do We Account for Uncollected Pledges?
Accounting for collectible pledges is similar to accounting for uncollectible accounts receivable. For example, suppose $20,000 in unconditional pledges were made to your organization during the year and your experience indicates that, on average, 20 percent of these will not be collected. An expense account can be established called ìAllowance for uncollectible pledges.î The following journal entry would be made at the end of the year:

Uncollectable pledges expense	$4,000
Allowance for uncollectable pledges		$4,000

To record estimate of uncollectable pledges

The allowance account would subtract from the value of pledges receivable on your balance sheet:

Pledges receivable	$20,000
Less: Allowance for uncollectable pledges	4,000
Net pledges receivable	$16,000

Reporting Issues
The question has been posed that implementing these guidelines could lead an organization to show a ìsurplusî when, in fact, the income is pledges that have not been received. This is a concern that was noted by one member of the Financial Accounting Standards Board in a dissenting opinion, noting that he is ìtroubled by the potential for misunderstanding of financial information resulting from the requirement. Organizations, particularly those that rely heavily on annual pledge drives, will report large increases in net assets if promises are recorded.î He is concerned that the amounts will be regarded as surplus resources or otherwise misinterpreted by financial statement users.

At the time this article was written, the FASB guidelines have just been implemented by nonprofit organizations. Over the next few years, through experience and FASB rulings, the practical implications of the guidelines will become clear.

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How should we invest our short-term cash balances?

Determining How Much to Invest and for How Long
Who should We Invest With?
Checking and Savings Options with Immediate Cash Availability
Certificate of Deposits and U.S. Treasury Savings Options

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Careful management of short-term cash balances can add to an organization's current income and provide the basis for an investment program which will benefit the organization in the future. Even small balances can be invested to earn some interest.

Organizations with significant assets to invest should consider the services of a portfolio manager, a finance professional at a brokerage firm, bank, or other financial institution. Frequently a member of your board can provide advice on how to invest or where to seek help.

Determining How Much to Invest and for How Long
The investment of funds in the short-term is one aspect of short-term cash flow planning and cash management. (See Financial Management FAQ 18: What Is Cash Flow and How Should We Manage It?) As part of the annual budget process you will want to determine as accurately as possible the amount of cash inflow and cash outflows, as well as their timing. The cash flow budget should give you a good idea of when you will have surplus cash to invest.

Generally speaking, the longer funds can be committed to an investment the higher the percentage return will be (assuming the same amount of risk.) For example, cash balances in a checking account may earn little or no interest while cash invested in a risk-free six month treasury bill can yield significant interest. Therefore, it is to your advantage to identify cash which may be invested for a longer time once you have determined your cash needs and are confident that they are covered.

Who Should We Invest With?
It is worth comparing services and yields from a variety of financial institutions before making your selection. Some banks offer special services to nonprofits. Others may charge higher fees because they offer services which smaller nonprofits are unlikely to take advantage of.

Checking and Savings Options with Immediate Cash Availability
An interest-bearing checking account and/or a savings account should be considered in order to earn some return on monies as they flow in and out of the organization on a daily basis. Terms vary widely, but a short discussion with a board member, banker, financial advisor, or broker should help you sort it out quickly. Some donors, especially government agencies, require that interest earned on their monies be returned to them.

When considering an interest-bearing account you should consider the net cost incurred from the combination of interest and other fees, which may include monthly service charges, per check fees, electronic transaction charges, and other fees resulting from insufficient funds and returned checks. An interest-bearing account is advantageous only if your average balance is sufficient to avoid fees, such fees are waived automatically for you, or the interest generated from your balance is consistently greater than the fees charged to maintain the account.

Banks offer a variety of checking and savings instruments. Typically higher interest is paid on those accounts requiring higher minimum balances. When deciding what type of account to open, you will want to consider the following factors:

• 
  
• Bank Fees
  Review the entire list of bank fees, not just the minimum balance fee.
  
• Daily Balance
  Ask whether fees are computed on an average versus minimum daily balance. On a minimum daily balance basis, you are penalized for falling below the required minimum balance for even one day, regardless of your balance for the month.

You might also look into a sweep account with your bank. In this arrangement, you maintain a predetermined amount in your checking account. At the close of each business day, the remainder is then swept automatically into a savings account or other account that may yield higher interest. If your organization could benefit from such an arrangement, be sure to discuss options with a number of banks as the level and type of security offered can differ widely among banks. This service may only be available to nonprofits with substantial cash to invest.

The Federal Deposit Insurance Corporation (FDIC) insures up to $100,000 of depositor funds in a single bank, whether funds are in a checking, savings or other account. Some instruments available through a bank may not be covered. These include certificate of deposits (see below) and money market funds,. Money market funds are mutual funds holding a portfolio of securities, often with a minimum balance of $1,000 or more. These funds are usually available on demand, which means you can withdraw them by writing a check from your account. While there has never been a default, money market funds are subject to some risk. Money market investments can be made directly with the fund or through a broker.

Certificates of Deposit and U.S. Treasury Savings Options
Some investments, such as Certificates of Deposit (CD's) offer higher, fixed rates on funds deposited for a specified period of time. Before selecting such a savings plan or investment, your organization should seriously review its cash flow needs to determine whether assets can be set aside -- inaccessible -- for a long period. Substantial penalties for withdrawing funds from a CD before the due date are customary. In addition, some CD's may not be covered under FDIC insurance.

U.S. Savings Bonds offer more savings with higher returns for investment terms from six months to five years or longer. These bonds and notes can be purchased in various denominations for as little as $75.

U.S. Treasury Bills (T Bills) and U.S. Treasury Notes yield an even greater return than savings bonds, but have higher minimums. Treasury bills have $10,000 minimums and maturity dates of less than one year. Three- to six-month issues are available weekly and one year issues are sold monthly. Treasury notes have a maturity from one year to thirty years. Treasury Bills and Notes can be obtained directly from the Federal Reserve Bank nearest you, or from commercial banks and brokers. Again, you should consider how long you can set aside organizational funds without jeopardizing your organization's cash flow.

Other federal agencies issue bonds and notes, such as Fannie Mae (Federal National Mortgage Agency) or TVA (Tennessee Valley Authority) bonds. For additional information on these and other government investment options, contact your banker, financial advisor, or a knowledgeable board member.

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What is the board's responsibility in investment?

The board of directors of a nonprofit organization has a responsibility to safeguard the organization's assets, and to ensure that funds are used to further the organization's goals. In addition, the board must ensure that donor designations are honored, and that cash and other investments are managed wisely.

Specifically, the board should review three areas related to investments:

Cash Management

Cash management refers to ordinary transfers, usually of small amounts, between the checking account and other liquid accounts such as savings accounts. For example, if an organization anticipates having excess cash for a few months, the organization may open an account that earns more interest and temporarily hold cash there. (See Financial Management FAQ 16: How Should We Invest Our Short-Term Cash Balances?)

While these tasks are typically managed by staff, the board has a responsibility to oversee cash management and periodically review staff work. In most boards, the finance committee meets periodically with finance staff to review cash management guidelines and practices.

Endowment Funds (now called permanently restricted net assets)

Endowment funds, also called permanently restricted net assets, are created when donors designate contributions to a fund where the principal amount of the gift (the amount of the contribution) will not be spent, but will be maintained in perpetuity, for the purpose of producing income for the organization. In a term endowment fund the donor has specified that, after a stipulated passage of time or after the occurrence of some event, the principal amount may be spent as well. Most endowment funds specify that the principal will be held in perpetuity, but that earnings on the principal may be used for the organization's operating expenses.

The board's key responsibilities with endowment funds are to ensure that the principal is maintained and that the endowment is invested wisely. Assets held in the endowment fund (cash, stocks, bonds, land, works of art, etc.) should be managed prudently, according to guidelines which the organization has adopted for management of the funds. When organizations need cash, either because of an ongoing deficit or short-term cash deficits, they are tempted to borrow from endowment funds. Any such loans from the endowment fund should be approved by a formal vote of the board and a repayment schedule should be established. Because such loans put the principal of the endowment fund at risk, they should be discouraged.

It is the responsibility of the board to establish guidelines for the management of the endowment fund. These guidelines are typically discussed by the finance committee, which makes recommendations on policy to the board. Some of the most important guidelines to establish are the following:

• Shall the principal be maintained at face value or should the endowment be managed so that the value of the endowment increases at the rate of inflation?
  
  For example, if an organization has an endowment fund valued at $2 million and the earnings are used for current purposes, over time the endowment funds purchasing power will be reduced, although it will still show on the books at $2 million. Some organizations choose to reinvest an amount of the earnings equal to inflation in the endowment fund, in essence defining maintaining the principal as the principal adjusted for inflation.
  
  This is sometimes achieved by adopting a spending rule. For example, some organizations assume long term inflation at four percent and average portfolio return at nine percent, and thereby adopt a rule to spend five percent of the average market value of the endowment over the next three years.
  
  
• Shall gains on contributed, non-cash assets be treated as additions to principal (and, therefore, to be held in perpetuity), or as income (and, therefore, available for current expenditure)?
  
  For example, imagine an organization that receives a contribution of ten shares of stock, valued at $1,000 each for a total of $10,000. A year later, the organization sells the stock, now valued at $1,100 a share, for a total of $11,000. Must the organization now keep $11,000 in perpetuity, or can it keep $10,000 in the principal, and take $1,000 into income for current purposes? (In some cases a donor may place restrictions on the contributed assets such as specifying that a donation of stock cannot be sold.)
  
  
• How often will we withdraw the cash resulting from interest income from the portfolio and into the checking account of the general operating fund?
  
  Some organizations choose to take the earnings from the principal out of the investment accounts only once a year. Others pull out the earnings quarterly, or even monthly. Of course, the longer the intervals between withdrawals, the more income will be realized (because the income will be earning interest, too, until it is withdrawn).
  

Maximizing Income Through Prudent Investment

Whether assets belong in an organization's general fund, its endowment fund, or other fund, these assets should be invested wisely. Key decisions the board should make related to investments are:

• 
  
• Should we hire a portfolio manager or investment advisor, or make our investment decisions?
  
  Organizations with substantial assets often hire a portfolio manager. Organizations with fewer dollars to invest usually rely on the expertise of a board member or the finance committee.
  
  The portfolio manager, typically employed at a bank, brokerage, or an investment advisory firm, is responsible for making in vestment decisions for the organization. The portfolio manager will meet with the finance or investment committee to learn about the organization 's financial objectives and other concerns, and then make investment decisions throughout the year to meet those objectives. The portfolio manager should give the organization a monthly or quarterly written report which shows all the trades made in the period, the investments at the end of the period, and the value of each investment.
  
  Portfolio managers and investment advisors are generally paid on a retainer basis (a flat monthly fee) for their services, although some are paid as a percentage of the portfolio and others by commission on trades (the latter creates an incentive to make frequent transactions). Great care should be taken in selecting a portfolio manager and the finance or investment committee should routinely review the manager's performance in detail (usually by making comparisons to the returns in the financial markets and the returns on mutual funds which have similar investment objectives as the organization), just as they should when working with other professionals such as auditors and attorneys.
  
  Some organizations that have identified and agreed on an investment strategy choose to invest directly in a mutual fund that with similar investment objectives, rather than hire a portfolio manager.
  
  
• Should we create an investments committee?
  
  Organizations with little investment activity often choose to have their finance committees oversee investments. Some organizations with substantial investments choose to create a second committee to oversee investments. One common arrangement is for the investments committee to be chaired by an experienced member of the finance committee, and to include both other board members as well as non-board members, with board members comprising a majority of the investment committee. Having non-board members on the committee allows the organization to use the expertise and perspectives of individuals who may not have the time or other qualifications to be members of the board.
  
  In some cases, the investments committee or the finance committee makes specific investment decisions themselves, such as to move funds from Treasury bonds into mutual funds, to sell a particular stock, etc. In other cases, the committee selects and meets regularly with the portfolio manager to review investment decisions, and if necessary, recommends changing to a new manager.
  
  
• What guidelines should we establish for the investments committee or for the portfolio manager?
  
  The following questions are examples of concerns that boards take up in investment management. Often these questions are discussed primarily in the investments and/or finance committee, where committee members are more likely to be familiar with financial terms and the implications of financial decisions. In some organizations these questions are left to the investments or finance committee, while in other organizations proposed guidelines are brought to the whole board for approval. The answers to these questions will change over time as the organization's needs change; the appropriate committee must be in touch with board concerns, as well as with the following questions.
  
  
• Is our primary objective short-term earnings or long term equity growth?
  
  An investment that provides higher returns may not grow as much in equity. For example, a stock with relatively high dividend income may not increase significantly in its par value. Conversely, a piece of real estate may not provide much rental income, but over time may increase greatly in value and could be sold at great profit. Organizations with large portfolios will want a diverse portfolio that balances investment types; other organizations may choose different objectives as their program plans and cash needs change.
  
  
• What level of risk is acceptable to our organization?
  
  In general, the higher the expected return on an investment, the higher risk of losing the principal. Some organizations may feel comfortable only with investments that are virtually risk-free (despite low returns), such as savings accounts within FDIC-insured limits or U.S. Treasury bills and notes. Such low-risk investments typically are expected to earn less than higher risk investments such as stocks or money market funds. But if the company or the money market funds goes bankrupt, the organization may lose its investment entirely.
  
  
• Should we establish any non-financial guidelines for investments?
  
  Some organizations specify a preference for stocks in locally owned companies; one drug/alcohol abuse organization specified that no investments be made in companies that manufacture alcoholic beverages. Socially responsible investing is an example of utilizing non-financial guidelines.
  
  
• How quickly must our investments be convertible to cash?
  
  For example, do we want a certain percentage of funds liquid, that is, convertible to cash within, for example, five days?

These guidelines only touch on the important and often complex questions that boards must address in effectively managing investments. Most boards delegate their responsibilities to the finance committee in both oversight of staff work and setting financial guidelines. The finance committee typically brings major policies to the board for approval, and makes annual or quarterly written reports to the board on how cash and investments are being held, and on earnings performance during the previous period.

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What is cash flow and how should we manage it?

Projecting Cash Flow
Useful Strategies for Adjusting the Timing of Cash Flows
A Sample Cash Flow Budget

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"Cash flow" management refers to the need to have cash come in -- flow in -- at the right times, so that it is available to flow out as needed. Everyone knows that if an organization has more expenses than income, sooner or later it will find itself in trouble. However, even if income matches or exceeds expenses in a given year, the cash fro m the income may not arrive in time to pay the bills as they come due. A cash shortage can be very disruptive to your ability to carry out your mission. To avoid disruptions of business or to take advantage of temporary cash surpluses, cash flow can and should be projected, monitored, and controlled.

Projecting Cash Flow
Projections of receipts and expenditures, which comprise cash flow, are typically developed as part of the budget process, so that you can anticipate and develop strategies for funding the shortages or investing the surpluses. (Many of these strategies are described later in this response sheet.) Cash flow projections follow a format similar to your budget's. For each month, anticipate how much money you will receive and how much you will spend in each category.

To try this for the first time, you must look at your organization's prior year's checkbook as a basis for your cash flow projection for the coming year, adjusting for any anticipated changes that will affect the timing and amount of payments and deposits. These changes might include when your programs are offered, what programs are offered, new funding sources or expiration of previous funding, increases or reductions in interest rates, etc. While your new cash flow projection will largely correspond to your budget, some cash flow may come in from receivable from the prior year, cash may go out for payments made for last year's bills, and some income and expenses for the current year will be delayed until next year and, therefore, would not be included in the current year's cash flow budget.

As the year progresses, cash flow projections can be updated. By comparing budgeted cash flows to actual deposits and expenditures, and understanding the nature of any variances, you can strengthen your ability to accurately anticipate cash flow in the future.

Note: A cash flow budget or projection should not be confused with a financial statement called "Statement of Cash Flows." The statement describes changes in cash from year-to-year due to operating surpluses or deficits, makes adjustments for non-cash items such as depreciation, and shows increases or decreases in accounts payable an d accounts receivable. This statement is usually prepared by your auditor along with other financial statements during the audit. (See Financial Management FAQ 25a:What Financial Statements are Nonprofits Required to Issue? for further information.

Useful Strategies for Adjusting the Timing of Cash Flow
In a simple example, imagine an organization with no cash in the bank and a balanced budget, with $10,000 in revenue and $10,000 in expenses. If the income is received first, the organization will be able to spend it down as expenses are incurred. If, however, the expenses come in before the income, the organization cannot pay its bills until the cash is received. In this case, the organization has a problem with the timing of cash flow rather than a shortage of revenue or an excess in expenses.

There are common strategies for dealing with the timing of cash flows, whether it is a cash shortage or a cash surplus.

• Meeting a Projected Temporary Cash Shortage
  In order to meet a projected temporary cash shortage, you may want to consider any of the following strategies:
  
  • Obtain a loan, usually from a bank or an individual such as a board or staff member.
  • Arrange for a line of credit from a bank.
  • Speed up the collection of receivables (money owed to you).
  • Move up the fundraising event or campaign you are planning.
  • Finance the purchase of equipment by leasing it or paying for it over time.
  • Liquidate investments.
  • Delay payments to vendors. This strategy is commonly followed in the corporate sector. Nonprofits are often reluctant to delay payments for fear of damaging the public trust or disappointing the vendor, who may be another small business person in the neighborhood. When you must delay payments to vendors, it is often advisable to explain the situation to them carefully, and let them know when they will be paid and how much will each payment be. You may even consider alerting vendors that bills incurred at certain times of year will always be paid. For example, you may experience a cash flow shortfall during the summer. You could negotiate up front with vendors that bills will be paid within thirty days during most of the year, but within ninety days during the summer.
    
• Taking Advantage of a Projected Temporary Cash Surplus
  To take advantage of a projected temporary cash surplus, your organization may:
  
  • Make short term investments in certificates of deposit, money market funds, or U.S. Treasury Bonds.
  • Buy supplies on sale that you will use over the course of the year.

   

In addition to reviewing your organization's revenue and expense budget, the board should review the organization's cash flow budget. The review should also include any measures related to managing cash flow which involve commitments on the part of your organization such as loans or revised terms with vendors.

The Helpful Organization: Sample Cash Flow Budget

	Total Budget	January	February	March	April	May	June
EXPECTED REVENUES
Government Grants	$35,000				12,000	4,000	16,000
Foundation Grants	50,000		5,000		7,500	15,000
Individuals	12,000			1,500			30,000
Fees for Service	55,000	3,000	4,500	4,500	5,000	5,000	3,000
Total Revenue	152,000	3,000	9,500	6,000	24,500	24,000	49,000
EXPECTED REVENUES
Salaries & Fringe Benefits
Executive Director	38,000	3,167	3,167	3,167	3,167	3,167	3,167
Program Directors	50,000	4,167	4,167	4,167	4,167	4,167	4,167
Secretary	27,000	2,250	2,250	2,250	2,250	2,250	2,250
Rent	12,000	1,000	1,000	1,000	1,000	1,000	1,000
Supplies	11,000	5,000					6,000
Telephone	3,300	300	250	300	500	350	250
Postage	2,500	150	150	150	1,500	150	150
Copying	2,950	100	100	100	1,000	100	100
Total Expenses	146,750	16,134	11,084	11,134	13,584	11,184	17,084
NET INCOME	5,250	<13,134>	<1,584>	<5,134>	10,916	12,816	31,916
Cash on Hand - Beginning	2,648	2,648	<10,486>	<12,070>	<17,204>	<6,288>	6,528
Ending Cash Available(Before Loan Activity)	7,898	<10,486>	<12,070>	<17,204>	<6,288>	6,528	38,444
Loan	0	12,000	0	6,000	<10,000>	<8,000>	0
Cash After Loan Activity	7,898	1,514	<70>	796	1,712	6,528	38,444

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How much cash should we hold in reserve?

For the sake of long-term organizational and operating stability it is often desirable to build a reserve of cash to accommodate the following situations:

• Cash flow shortages which arise when expenses fall due before the income to pay for them is received.
  
  Factors which contribute to cash flow shortages in a balanced budget include seasonal or irregular cash flows (e.g., a summer camp or a theater company which receives most of its cash in a few months of the year, but have to pay bills year round), delays in collecting fees for service, and delays in grant payments or contract reimbursements.
  
  This type of cash flow shortage can usually be uncovered by realistic and careful cash flow budgeting. Questions frequently asked during this process include:
  
  • How much do you usually need to borrow to meet payroll and other ongoing expenses during the course of the year?
    
  • How often do you have to delay payments to vendors? How much are those bills?
    
  • How late is your government reimbursement each month? What is the average outstanding amount at any given time?
    
    
• Cash flow shortages which are caused by the unpredictability of delivering services which are part of the organizationís basic mission.
  
  For example, the Red Cross, which is in the disaster ìbusinessî needs an enormous reserve to accommodate years when earthquakes, floods, and fires all hit at the same time. Money saved for unexpected problems is sometimes called a ìcontingency fund,î and can be calculated either as a percentage of annual expenses or as a percentage of a key fundraising event if you have one. The more past experience you have to rely on when making contingency calculations, the more accurate they are likely to be.
  
  
• Cash flow shortages which are caused by unexpected emergencies, such as the withdrawal of a key funder or the loss of a key asset.
  
  Examples of unexpected emergencies include a fire destroys your site, your heating system needs to be replaced, etc. There is no easy or sure way to predict these kind of cash needs. Factors which contribute to these kinds of emergencies include the stability of funding sources (in general, fees for service or from sale of products and membership dues are considered more predictable and stable than grants and contributions) and the predictability of expenditures (if you have old equipment or other fixed assets there is a higher probability that something will go wrong ìunexpectedlyî).
  
  The more thought you give to anticipating these kinds of emergencies, the easier it will be to cope with them. The types of questions asked to anticipate these situations vary from organization to organization. Some examples include:
  
  • If the fall fundraiser is rained out, how much do you need to tide you over until you can try it again in the spring?
    
  • If a fire destroys your theater and you want to move the play to another venue how much will it take to keep the staff and actors on payroll during the transition? How much will additional rent and publicity costs amount to?
    
  • How many months would it take your organization to get back on its feet in case of disaster? What are your monthly core operating expenses?
    
    
• Cash is needed to start a new program or take advantage of an unexpected opportunity which will significantly contribute to your mission.
  
  You might want to determine what it would cost to implement a pilot project, allowing you to test the concept and show some preliminary results to potential funders.
  
  In addition to a reserve for operating expenses, some organizations may build a reserve for an endowment fund or save money towards a large capital purchase (such as a building or computer equipment.)

Each of these areas should be considered by your board and senior staff to determine how much of a cash reserve is desirable for your organization. There is no one answer to how much of a reserve is ìrightî for nonprofits because the answers to the questions noted above will vary from agency to agency. You might consider each of the points raised above and determine how much of a reserve is needed for your organization. The following example illustrates how to establish an operating reserve goal:

Example 1 - The Helpful Organization

The Helpful Organization has had to borrow $5,000 from the board president for the past two years in order to meet cash flow shortages over the summer. In addition, its current government funder has been predicting cuts of 5-16 percent sometime in the next two years. Its current grant is $35,000.

The Helpful Organization also hopes to start a family literacy program on the weekends which will complement its after-school tutoring program for high school students. One semester of the program is likely to increase its expenses by $7,000. Given these factors, the Helpful Organization might set the following reserve goal:

Cash flow	$ 5,000
Guard against reduced funding - 16% x $35,000	$ 5,600
Investing in new program	$ 7,000
Operating reserve goal	$17,600

Another organization might include in its calculation some percentage of its annual operating expenses. Recommendations on ìhow much is enoughî vary from source to source, ranging from no reserve (from some funders) to up to two yearsí worth of expenses (the maximum acceptable to the National Charities Information Bureau.). You want to balance prudent management, taking into account the factors noted above, with putting your assets to work to serve the community. If you perform the calculations above and your reserves significantly exceed your anticipated needs, it is probably time to discuss how to invest more of those funds into programs serving the community.

Building a reserve requires an operating surplus, or ìprofitî from unrestricted sources during the year to provide extra, or reserve cash. Even nonprofit organizations are legally entitled to show an operating surplus. They may not use that surplus to benefit any member or officer of the corporation, but must use the surplus for their designated mission to the community. Cash reserves do not need to be held in separate accounts. To indicate that the board has set aside money as a cash reserve for operations, the unrestricted net assets on the balance sheet might be divided as follows:

Assets	$35,429
Liabilities	$12,226
Unrestricted Net Assets	$23,203

Board designated reserve	$15,000
Undesignated portion	$ 8,203

An operating reserve, whether it is designated as shown above or simply an accumulated fund balance, is likely to have some impact on your fundraising. Some funders may question your need for their contribution if you have had surpluses from previous years. You will need to explain your policies regarding your cash reserve(s), what factors you considered and why the reserve is there. This will often alleviate a funderís concern that you are accumulating cash at the expense of the people you serve.

In summary, you will need to develop a policy which articulates how much is enough to guard against emergency, invest in new programs, replace or improve capital assets, smooth out cash flows, and put the rest of your cash to work for the community.

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What are the differences between nonprofit and for-profit accounting?

Accounting for Contributions
Capitalizing and Depreciating Assets
Use of Cash- and Modified Cash-Basis Accounting
Functional Expense Allocation
Implications of the Differences between Nonprofit and For-Profit Accounting

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Anyone familiar with generally accepted accounting principles and practices will find most accounting for nonprofit activity to be very familiar. There are, however, some significant differences which include:

• Accounting for Contributions
  
• Capitalizing and Depreciating Assets
  
• Use of Cash- and Modified Cash-Basis Accounting
  
• Functional Expense Classification

Accounting for Contributions
Nonprofits which qualify for tax exempt status under section 501(c)(3) of the Internal Revenue Code are entitled to receive contributions that are tax deductible to the donor. Since this is unique to the nonprofit sector, there are no equivalent procedures for handling contributions in for-profit accounting. Special procedures have been established for handling the following types of contributions:

• Pledges (Promises to Give) In 1993, the Financial Accounting Standards Board (FASB) issued the Statement of Financial Accounting Standards No. 116, Accounting for Contributions Received and Contributions Made. This Statement sets down firm guidelines for pledge accounting, requiring that legally enforceable, unconditional pledges be recorded in the accounting records. An unconditional pledge is one which is not contingent on some uncertain future event, such as a matching grant from another donor.
  
  
• Donated Materials and Services ( In-Kind Contributions) FASB Statement No. 116 guidelines also requires that nonprofits account for contributions of most goods (with the exception of works of art and other items held in museum collections). In addition, volunteer time must be included in the financial statements when either:
  
  1. the volunteer time results in the creation or enhancement of non-financial assets, such as volunteer labor to renovate a child care center; or
     
  2. the services volunteered are specialized skills, such as those provided by accountants, nurses, electricians, teachers, or other professionals and craftsmen.

  
  
  

• Special Events and Membership Dues People who pay to attend fundraisers (such as dinners, auctions, fashion shows, bake sales, etc.) often receive a tangible benefit in return (a meal, a performance, etc.) Similarly, membership dues may entitle individuals to use facilities, receive services, etc. The portion of the special event charge or membership dues which represents the fair market value of the benefit received is not tax deductible to the donor. Some minimal benefits are excluded from this rule.
  

In addition, the accounting profession has established guidelines for responsibly tracking monies which have been restricted by the donor for a specific use (e.g. buying a new building, starting a new program, adding to the endowment, etc.). How these monies are tracked and reported depends on the nature of the donor s restriction, what conditions, if any, the donor has imposed on the organization before it can actually receive or use the money, when the restrictions are met, etc.

Capitalizing and Depreciating Assets
As in for-profit accounting, nonprofits are required to record the purchase of long-lasting, substantial property and equipment (such as computers, vans, buildings, etc.) as assets in the financial records, and to charge a portion of the cost of those items in each year in which they have a useful life. This process is called capitalizing and depreciating fixed assets. While all businesses, including nonprofits, are required to record depreciation of assets, some assets in the nonprofit sector receive special treatment. These include museum collections, historical buildings, library books, zoo animals, etc.

Donated items that are added to collections that are held for public exhibition, protected and kept unencumbered, and subject to the policy that, if sold, the proceeds are used to acquire equivalent replacements for the collection, do not have to be recorded as re venue and are not recognized as formal assets in the financial statements.

Use of Cash- and Modified Cash-Basis Accounting
Many small nonprofits use cash-basis rather than accrual-basis accounting to record expenses and revenues. This means that they only record revenue when the cash is received, and only record expenses when they are paid. Some nonprofits use a modified-cash basis of accounting. They will record payroll taxes withheld from employees or large revenue or expense items on an accrual basis. This means recording revenues when they are earned and expenses when obligations are incurred. Most businesses track all expenses and revenue s using accrual accounting.

Functional Expense Allocation
Nonprofits are required to report their expenses by what is known as their functional expense classifications. The two primary functional expense classifications are program services and supporting activities. Supporting activities typically include management and general activities, fundraising, and membership development. Practices vary widely from organization to organization in the nonprofit sector as to how expenses are categorized by functional areas.

Implications of the Differences between Nonprofit and For-Profit Accounting
Because of these few, but significant, differences between nonprofit and for-profit accounting, you will want to select your al personnel, financial advisor, or auditor carefully. The degree to which you receive contributions requiring special handling, or purchase property and equipment covered by special regulations will determine whether you need an accountant who specializes in nonprofit accounting.

In addition, it is important to remember that financial information for nonprofits is interpreted differently from for-profit financial statements. The following is quoted from What a Difference Nonprofits Make: A Guide to Accounting Procedures, 1990, Accountants for the Public Interest:

• Meaningful evaluations and comparisons of nonprofit performance almost always prove difficult and complex. While the profitability of two businesses can easily be calculated, it is much harder to compare the effectiveness of two counseling centers to see which is doing a better job of helping the mentally ill. Without the standard of profitability, it is also difficult to compare the job performance of nonprofit staff and managers.
  
  Since the beneficiaries of nonprofits often cannot afford to pay for services, organizations frequently lose money on every sale. As a result, an increase in the number of clients or customers may paradoxically increase the likelihood of a financial crisis. On the other hand, turning a profit may mean that a nonprofit agency has turned away clients, perhaps including the most needy. To determine a nonprofit's success you must refer to its goals: these are the group's self-determined replacement for the bottom line of profit-making. The board can measure [a nonprofit's] success by comparing the results achieved with the results sought.
  
  This points to the importance of a clear mission statement as well as regularly updated short- and long-term goals that reflect the purpose of a volunteer agency. It also underscores the need to include service statistics in conjunction with financial statements. In this way, board members can begin to grapple with the complex issues of efficiency and effectiveness as their organization pursue s its stated goals.
  
  
  Return to List of FAQs
  

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  What internal controls are needed for cash disbursements?
  
  Segregation of Duties
  Check Signing
  Internal Accounting Controls Checklist
  

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  According to Price Waterhouse's booklet, Effective Internal Accounting Control for Nonprofit Organizations: A Guide for Directors and Management, the objective of internal controls for cash disbursements are to ensure that cash is disbursed only upon proper authorization of management, for valid business purposes, and that all disbursements are properly recorded.
  
  While it is impossible to guarantee that these objectives will be met at all times for all transactions, the following practices provide reasonable assurance that they will usually be accomplished.
  
  Segregation of Duties
  Segregation of duties means that no financial transaction is handled by only one person from beginning to end. For cash disbursements, this might mean that different people authorize payments, sign checks, record payments in the books, and reconcile the bank statements. If your organization is a small nonprofit, managed by volunteers and possibly one staff person, this principle can be hard to put into practice. You might consider having one person, such as the paid staff member, sign checks and assign a different person, such as the board treasurer, to review disbursements, bank statements, and canceled checks on a monthly basis.
  
  Authorization and Processing of Disbursements
  You will want to develop policies regarding who in your organization can authorize payments. Some organizations designate this function solely to the executive director to ensure that a single person is paying attention to monies going out of the organization. In other cases, a department head might authorize purchases for that department, as long as they are within the department's budget. In most organizations, once the board approves the budget, it does not need to authorize individual purchases within that budget. However, unbudgeted purchases would require additional approval. Also, in very small organizations, the board treasurer or board president may be asked to authorize all purchases. Even larger organizations have policies requiring the board to authorize significant expenditures, such as purchases for computers or other assets. It is important to agree and formally define what constitutes a significant expenditure and how these purchases will be handled.
  
  All disbursements should be accompanied by adequate documentation, in the form of receipts or an invoice. Cash withdrawals should never be made via Automatic Teller Machine (ATM) cards.
  
  Managing Restricted Funds
  Restricted contributions are a form of revenue unique to the nonprofit sector. Money which has been restricted by the donor for a specific use (such as buying a new building, starting a new program, building an endowment, etc.) should only be used for the purpose for which it has been given. However, most nonprofits find themselves tempted to borrow against restricted monies when facing a cash shortage. In cases where the funder clearly prohibits such borrowing, such action clearly violates the funder's trust and instructions and may lead to revocation of the grant. In other cases, donors allow temporary borrowing as long as the money is replaced within a certain period of time, usually within the grant year.
  
  Ultimately, it is the role of the board to ensure that the organization fulfills its obligations to donors. Therefore, in cases where borrowing against restricted funds is permitted, the board should establish policies which describe the circumstances under which such borrowing is allowed. These policies might include how often borrowing may occur, who may authorize the interfund loan, and how much can be borrowed (such as a percentage of the total grant). In addition, a repayment plan should be established and the board should be advised regularly on the status of any interfund loans.
  
  Check Signing
  There is some debate regarding the number of signatures required on a check. In many cases, it is useful to require two signatures on checks, especially for purchases over a certain amount. This amount will vary with the organization's budget; your accountant may be able to help you determine how much is significant. Even though checks require two signatures, three or four people might have check signing authority to ensure that two signers are available to make disbursements. The number of authorized signers should be kept to a minimum, while ensuring that daily business is not unnecessarily hampered.
  
  The purpose of this internal control is to make sure that there are deliberate decisions made about who to pay, how much to pay, and when to pay bills. If you habitually have one or more checks that are pre-signed by one of the two required signatories, it defeats that purpose. If more than one signer is not regularly available, and this inhibits your ability to meet your obligations, you might consider having an imprest checking account. This means that the board establishes a policy regarding the amount of money which can be available in the checking account at any one time, say $500. All other money is kept in a separate account which the check signer does not have access to. The check signer is allowed to pay bills until that amount is substantially depleted. At that time, the treasurer or other board members may review the disbursements and make sure that they are within the guidelines established by the board. Once these disbursements have been reviewed and accepted, the authorized board representative then transfers enough money to bring the imprest account back to its $500 maximum balance.
  
  Seek to balance your internal accounting control in such a way as to ensure public confidence and maintain the integrity of your financial systems and assets, without unduly inhibiting your ability to get on with your work.
  
  Internet Accounting Controls Checklist
  The following questions reflect common internal accounting controls related to paying bills. You may wish to use this list to review your own internal accounting controls and determine which areas require further action.
  
  • 
    
  • Are all disbursements, except those from petty cash, made by pre-numbered checks?
    
  • Are voided checks preserved and filed after appropriate mutilation?
    
    
  • Is there a written prohibition against drawing checks payable to Cash ?
    
    
  • Is there a written prohibition against signing checks in advance?
    
    
  • Is a cash disbursement voucher prepared for each invoice or request for reimbursement that details the date of check, check number, payee, amount of check, description of expense account (and restricted fund) to be charged, authorization signature, and accompanying receipts?
    
    
  • Are all expenditures approved in advance by authorized persons?
    
    
  • Are signed checks mailed promptly?
    
    
  • Does the check signer review the cash disbursement voucher for the proper approved authorization and supporting documentation of expenses?
    
    
  • Are invoices marked Paid with the date and amount of the check?
    
    
  • Are requests for reimbursement and other invoices checked for mathematical accuracy and reasonableness before approval?
    
    
  • Is a cash disbursement journal prepared monthly that details the date of check, check number, payee, amount of check, and columnar description of expense account (and restricted fund) to be charged?
    
    
  • Is check-signing authority vested in persons at appropriately high levels in the organization?
    
    
  • Are the number of authorized signatures limited to the minimum practical number?
    
    
  • Do larger checks require two signatures?
    
    
  • Are bank statements and canceled checks received and reconciled by a person independent of the authorization and check signing function?
    
    
  • Are unpaid invoices maintained in an unpaid invoice file?
    
    
  • Is a list of unpaid invoices regularly prepared and periodically reviewed?
    
    
  • Are invoices from unfamiliar or unusual vendors reviewed and approved for payment by authorized personnel who are independent of the invoice processing function?
    
    
  • If the organization keeps an accounts payable register, are payments promptly recorded in the register to avoid double payment?
    
    
  • If purchase orders are used, are all purchase transactions used with pre-numbered purchase orders?
    
    
  • Are advance payments to vendors and/or employees recorded as receivables and controlled in a manner which assures that they will be offset against invoices or expense vouchers?
    
    
  • Are employees required to submit expense reports for all travel related expenses on a timely basis?
    
    
    Return to List of FAQs
    

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    What is petty cash and how should we handle it?
    
    Sample Petty Cash Voucher
    Establishing a Petty Cash Fund
    Petty Cash Internal Controls Checklist
    

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    Petty cash allows you to make small purchases or reimbursements, in cash, for items such as stamps, office supplies, parking, etc. The board or senior management should develop a policy of how much money should be available in cash, and a maximum expenditure which can be paid with petty cash. For example, you may establish a petty cash fund of $100, and have a policy which says that payments for items costing over $15 must be made by check rather than reimbursed through petty cash. The fund should be enough to cover petty cash expenditures for about a month. If it is too small you will have to constantly replenish the funds, and if it is too large it means you have cash on hand which could be more safely kept in your bank account.
    
    The petty cash fund should be kept in a locked box or drawer. Auditors recommend that only one person, called the custodian, have access to this cash, and that person be responsible for all petty cash activity. To disburse petty cash funds, the organization will need to buy or develop petty cash vouchers for documenting each transaction, and determine who in the organization can approve petty cash payments. In some cases, this will be the director; in others, petty cash may also be approved by department heads or the petty cash custodian, within guidelines established by the board.
    
    A Sample Petty Cash Voucher
    
    Petty Cash Voucher Date: ________________ Amount: $ _________________
    
    _______________________________________________ Dollars
    
    For: ___________________________________________________
    
    Account No: ____________________________________
    
    Paid to: ________________________ Signed: ____________________
    
    Approved by: _____________________________________
    
    
    Establishing a Petty Cash Fund
    Once the board has determined (with staff input) how large a fund is needed, write a check to the petty cash custodian (not to cash) to establish the petty cash fund. For example, if you have a $100 petty cash fund and Mary Robinson is the petty cash custodian, write a check for $100, payable to Mary Robinson, Petty Cash Custodian. Mary then cashes the check and places the monies in a locked box or drawer.
    
    To reimburse someone (in this example, Roberto Diaz) for a small purchase, Mary should obtain proof of purchase from Roberto, usually a receipt from the store, post office, etc. Roberto must complete a petty cash voucher, detailing the nature and reason for the purchase. After the voucher has been approved by the appropriate person, Roberto is reimbursed for his expenditure. A sample petty cash voucher is provided under Attachment 1. However, most stationery stores sell pads of petty cash vouchers if you do not want to design your own.
    
    In some cases, the organization may permit an advance from petty cash to cover an upcoming purchase. For example, if the office manager is going to the post office to mail an overnight package, he or she may be authorized to take $20 from the petty cash fund with the stipulation that he or she return with a receipt and change. In this case, the office manager completes a voucher for a $20 advance, approved by a designated staff person. When the office manager returns he or she completes an accurate voucher for the final postage amount, attach the receipt, and return the change to the custodian.
    
    Once the fund is substantially depleted, the petty cash custodian adds up the vouchers and assigns them into appropriate categories (e.g., postage, printing and copying, office supplies, etc.) The total of receipts plus cash available must equal $100 in order to prove that all money has been accounted for. When the account has been balanced, a check is written (in accordance with the check authorization procedure established for all disbursements,) again payable to the petty cash custodian, for the exact amount of the vouchers/receipts, bringing the fund back to its original balance of $100.
    
    Therefore, in the example described above, Mary totals the receipts in the petty cash box and determines that they fall into the following categories:
    
    Postage (4 receipts) $32.50
    Printing/Copying (1 receipt) $11.50
    Office supplies (2 receipts) $26.95
    Total receipts $70.95
    
    In addition, Mary confirms that there is $29.05 in cash remaining in the petty cash box. A check for exactly $70.95 is written, payable to Mary Robinson, Petty Cash Custodian, to bring the fund back up to $100. This method of maintaining a constant amount in petty cash through a combination of cash and receipts is called an imprest system. The petty cash vouchers should be stapled to the summary of expenses prepared by Mary and filed away so they are not reimbursed a second time.
    
    When entering this transaction into the accounting system you increase postage, printing/copying and office supplies expenses, and decrease cash:
    
    Postage $32.50
    Printing/Copying $11.50
    Office supplies $26.95
    Cash - checking $70.95
    
    Notice that you do not post the expenses to an account called petty cash. This way, at the end of the year, you have a true picture of your expenses, which is more helpful for future planning than a lump sum in a petty cash line.
    
    Petty Cash Internal Controls Checklist
    The following questions reflect common internal accounting controls related to petty cash. You may wish to use this list to review your own internal accounting controls and determine which areas require further action.
    
    
    • Is an imprest petty cash fund maintained for payment of small, incidental expenses?
      
      
    • Is there a limit to the amount that can be reimbursed by the petty cash fund?
      
      
    • Is supporting documentation required for all petty cash disbursements?
      
      
    • Is a petty cash voucher filled out with supporting documentation, name of person being reimbursed, and proper authorization?
      
      
    • Is access to petty cash limited to one person who is the fund custodian?
      
      
    • Are unannounced counts of petty cash made by someone within the agency other than the fund custodian?
      
      
      Return to List of FAQs
      

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      What internal controls are needed for payroll?
      
      Payroll Service Bureaus
      Payroll Internal Controls Checklist
      

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      According to Price Waterhouse's booklet, Effective Internal Accounting Control for Nonprofit Organizations: A Guide for Directors and Management, the objective of internal controls for payroll are to ensure that payroll disbursements are made only upon proper authorization to bona fide employees, that payroll disbursements are properly recorded and that related legal requirements (such as payroll tax deposits) are complied with.
      
      Each employee should have a payroll/personnel file, containing updated salary, benefits, employment status, and withholding information, as well as beginning date of employment and termination date, when applicable. A personnel manual should describe the organization's policies, established by the board, regarding vacations, holidays and sick leave. Records should be kept for each employee to ensure that these policies are being followed. Accountants recommend that the organization retains these records for six to seven years after the employee has been terminated (and possibly longer if that employee participates in a pension plan.)
      
      The time sheet is the most common tool used to document employee hours (including overtime) and authorize payments to employees. Time sheets can be designed to incorporate information regarding vacation, sick leave, and holidays. Government funders often require time sheets to document employee effort for their grants or contracts and all other duties they perform. Time sheets are usually submitted by the employee to his or her immediate supervisor for signature, and may also be reviewed periodically by senior management. Ideally, the person authorizing an employee's hours does not also prepare the paychecks.
      
      Payroll checks should be written in keeping with the procedures for all other cash disbursements (see Financial Management FAQ #21, What Internal Controls are Needed for Cash Disbursements?). Additional segregation of duties related to the payroll function include having someone other than the payroll check signer:
      
      • Hold unclaimed paychecks.
        
        
      • Review the payroll register and post payroll to the general ledger.
        
        
      • Review payroll-related tax withholding, deposits, and reporting. This is an especially important function for the board, since board members may have personal liability for payroll taxes that have not been properly deposited with the appropriate government agencies.
        
        
      • Distribute year-end tax summaries (W-2 s) to employees and responding to inquiries regarding W-2 s.
        
        
      • Many organizations choose to have a separate checking account for payroll that is used for issuing paychecks and paying government withholding and other taxes related to payroll. A payroll register, listing who was paid, how much, withholding amount, and check number is maintained, either as a subsidiary journal if there is a separate payroll account, or as part of the cash disbursements journal when payroll is integrated with other cash disbursements in a manual system. Some organizations require that employees sign the employee register to acknowledge receipt of their paycheck.

      
      
      Payroll Service Bureaus
      Because of the number of transactions involved with the payroll function, many nonprofits choose to take advantage of the many low-cost payroll service bureaus available to manage payroll activities. These services bureaus prepare payroll checks for salaried and hourly employees, quarterly reports of payroll, FICA and Medicaid liabilities and withholding, and year end W-2 and W-3 reports of annual salaries. In addition, you may choose to have them deposit taxes with the appropriate government agencies. Since payroll service bureaus offer a range of services, from advising on payroll issues to providing the full range of payroll activities, you can select those services you need and can afford. Payroll service bureaus are able to offer their services relatively inexpensively due to the large number of clients they have. Even nonprofits with under five employees may find it worthwhile to have the significant paperwork and attention to regulations associated with the payroll functions handled by these specialized professionals.
      
      It is important to note, however, that your organization retains final responsibility for accurate and timely reporting and depositing of taxes when using a service bureau. Therefore, it is important to review each payroll check and report. However, the service bureaus also have some liability, and will work with you to resolve any problems with government agencies resulting from incorrect or late filing and deposits due to their error. Errors are not uncommon with payroll services, and they do take staff time and attention to resolve. In addition, a payroll service bureau cannot perform the internal control functions related to time sheets and reviewing payroll records. However, many nonprofits with limited staff time find that using a service bureau saves time and reduces errors, late fees, and late night worries about IRS confrontations.
      
      Payroll Internal Controls Checklist
      The following questions reflect common internal accounting controls related to payroll. You may wish to use this list to review your own internal accounting controls and determine which areas require further action.
      

      • Are detailed time sheets required to document employee hours, including overtime?
        
        
      • Are time sheets signed by the employee s immediate supervisor authorizing payment for work?
        
        
      • Are employment records maintained for each employee that detail wage rates, benefits, taxes withheld each pay period, and any changes in employment status?
        
        
      • Are payroll-related taxes (federal income tax, state income tax, employee and employer share of social security, and other taxes) withheld and paid to federal and state agencies on a timely basis?
        
        
      • Do the executive director and board treasurer review all the payroll tax returns?
        
        
      • Do written policies and procedures exist for accounting for vacations, holidays, sick leave, and other benefits?
        
        
      • Is a list of all payroll checks written, with appropriate withheld taxes, maintained either through the cash disbursement journal or a separate payroll register?
        
        
      • Is a separate payroll bank account maintained?
        
        
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        What is an internal accounting control system and how can we make ours effective?
        
        Developing an Internal Accounting Control System
        The Accounting Procedures Manual
        Maintaining Effective Controls
        

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        Internal accounting control is a series of procedures designed to promote and protect sound management practices, both general and financial. Following internal accounting control procedures will significantly increase the likelihood that:
        
        • financial information is reliable, so that managers and the board can depend on accurate information to make programmatic an d other decisions
          
          
        • assets and records of the organization are not stolen, misused, or accidentally destroyed
          
          
        • the organization s policies are followed
          
          
        • government regulations are met.

        
        
        Developing an Internal Accounting Control System
        The first step in developing an effective internal accounting control system is to identify those areas where abuses or errors are likely to occur. Many accountants can provide you with a checklist of areas and questions to consider when you are planning your system. Price Waterhouse's booklet, Effective Internal Accounting Control for Nonprofit Organizations: A Guide for Directors and Management, includes the following areas and objectives in developing an effective internal accounting control system:
        
        

        • Cash receipts
          To ensure that all cash intended for the organization is received, promptly deposited, properly recorded, reconciled, and kept under adequate security.
          
          
        • Cash disbursements
          To ensure that cash is disbursed only upon proper authorization of management, for valid business purposes, and that all disbursements are properly recorded.
          
          
        • Petty cash
          To ensure that petty cash and other working funds are disbursed only for proper purposes, are adequately safeguarded, and properly recorded.
          
          
        • Payroll
          To ensure that payroll disbursements are made only upon proper authorization to bona fide employees, that payroll disbursements are properly recorded and that related legal requirements (such as payroll tax deposits) are complied with.
          
          
        • Grants, gifts, and bequests
          To ensure that all grants, gifts, and bequests are received and properly recorded, and that compliance with the terms of any related restrictions is adequately monitored.
          
          
        • Fixed assets
          To ensure that fixed assets are acquired and disposed of only upon proper authorization, are adequately safeguarded, and properly recorded.

        
        
        Additional internal controls are also required to ensure proper recording of donated materials, pledges and other revenues, accurate, timely financial reports and information returns, and compliance with other government regulations.
        
        Achieving these objectives requires your organization to clearly state procedures for handling each area, including a system of checks and balances in which no financial transaction is handled by only one person from beginning to end. This principle, called segregation of duties, is central to an effective internal controls system. Even in a small nonprofit, duties can be divided up between paid staff and volunteers to reduce the opportunity for error and wrongdoing. For example, in a small organization, the director might approve payments and sign checks prepared by the bookkeeper or office manager. The board treasurer might then review disbursements with accompanying documentation each month, prepare the bank reconciliation, and review canceled checks.
        
        The board and executive director share the responsibility for setting a tone and standard of accountability and conscientiousness regarding the organization's assets and responsibilities. The board, usually through the work of the finance committee, fulfills that responsibility in part by approving many aspects of the internal control accounting system. Common areas requiring board attention include:
        

        • Check issuance
          The number of signatures on checks, dollar amounts which require board approval or board signature on the check, who authorizes payments and financial commitments, etc.
          
          
        • Deposits
          How payments made in cash (for admissions, raffles, weekly collection plate, etc.) will be handled, etc.
          
          
        • Transfers
          If and when the general fund can borrow from restricted funds, etc.
          
          
        • Approval of plans and commitments before they are implemented
          The annual budget and periodic comparisons of financial statements with budgeted amounts, leases, loan agreements, and other major commitments.
          
          
        • Personnel policies
          Salary levels, vacation, overtime, compensatory time, benefits, grievance procedures, severance pay, evaluation, and other personnel matters.

        
        
        The Accounting Procedures Manual
        The policies and procedures for handling financial transactions are best recorded in an Accounting Procedures Manual, describing the administrative tasks and who is responsible for each. The manual does not have to be a formal document, but rather a simple description of how functions such as paying bills, depositing cash, and transferring money between funds are handled. As you start to document these procedures, even in simple memo form, the memos themselves can be kept together to form a very basic Accounting Procedures Manual. Writing or revising an Accounting Procedures Manual is a good opportunity to see whether adequate controls are in place. In addition, having such a manual facilitates smooth turnover in financial staff.
        
        Maintaining Effective Controls
        The executive director is commonly responsible for overseeing the day-to-day implementation of these policies and procedures. Due to the number of detailed requirements involved if your organization receives government funding, there should be one person in the organization (possibly the grant administrator) with the responsibility of understanding and monitoring those specific regulations and compliance factors.
        
        The auditor's management letter is an important indicator of the adequacy of your internal accounting control structure, and the degree to which it is maintained. The management letter, which accompanies the audit and is typically addressed to the board as trustees for the organization, cites significant weaknesses in the system or its execution. By reviewing the management letter with the executive director, asking for responses to each internal control lapse or recommendation, and comparing management letters from year to year, the board has a useful mechanism for monitoring its financial safeguards and adherence to financial policies.
        
        As your nonprofit changes and matures, and your funding and programs change, you will need to periodically review the internal accounting control system which you have established and modify it to include new circumstances (bigger staff, more restricted funding, etc.) and regulations (such as receiving federal awards with increased compliance demands.)
        
        

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        What financial reports do management and the board need?
        
        What reports do we need to prepare and how often?
        Who prepares these reports and who should review them?
        

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        Because each nonprofit organization faces different financial issues and has different resources to bring to financial functions, each organization will choose a different set of regular financial reports to prepare and analyze. At different times an organization will need different reports to provide information to support its decision making.
        
        What reports should we prepare and how often?
        The answer will depend on several factors, including the extent to which the organization is financially stable, the degree and extent to which the financial picture changes during the period, the availability of cash to meet financial obligations, the availability of staff or other professionals to prepare reports, etc.
        
        A mid-sized human service organization in reasonably good shape financially might consider the following schedule of reports:
        
        Monthly Reports
        • Statement of Position (Balance Sheet)
          What is our financial health? Can we pay our bills?
          
        • Statement of Activities (consolidated) showing budget to actual information
          What has been our overall financial performance this month and to date?
          
        • Departmental Income and Expense Statement showing budget to actual information
          How does actual financial experience compare with the budget? Is specific action called for, such as limiting expenses in certain areas? Does experience indicate a change in the budget is appropriate?
          
        • Narrative report including tax and financial highlights, important grants received, recommendations for short term loans, or other means of managing cash flow
          An executive summary of financial highlights, analysis, and concerns.

        
        
        Quarterly Reports

        • Fundraising Reports; actuals vs. projections for donations; status report on all foundation proposals.
          Are fundraising results on track?
        • Cash flow projections for the next six months
          Do we anticipate a cash surplus or shortage?
        • Payroll tax reports
          Have payroll tax reports been submitted on time and tax deposits been made?
          
        • Fee for service report showing number of fee-paying clients and revenue against projections?
          Are we servicing approximately the same number and type of clients as we had anticipated? If not, what action or change is appropriate?

        
        
        Annual Reports

        • Annual Federal forms, including 990 and Schedule A; State Reports
          Has the organization fulfilled its reporting responsibilities to federal and state governments?
        • Draft financial statements for year: Statement of Activities; Statement of Position; Income Statement for each program. Aggregated financial statements with narrative showing key trends
          Focus: Internal management decision-making. What was our financial performance over the past year? In what ways and for what reasons was performance different from the budget? What financial implications must be taken into account when planning the upcoming year?
        • Audited financial statements for the entire organization, including Statement of Position, Statement of Activities, Statement of Cash Flows, Statement of Functional Expenses
          Focus: External accountability and financial disclosure to funders and the public
        • Management letter from the auditor
          What recommendations has the auditor made related to the accounting system, internal controls, and financial planning?
          

        
        Who Prepares These Reports and Who Should Review Them?
        In a small nonprofit the board treasurer or outside accountant/bookkeeper might prepare the financial information for all in-house financial statements, and work with the executive director to prepare the narrative with financial highlights to be presented to the board. A controller or finance director would prepare these reports in a larger organization. The program director, if you have one, would ordinarily prepare the quarterly fee-for-service report. Similarly, the director of development would prepare the quarterly fundraising report.
        
        The executive director reviews all reports prior to presenting them to board members to ensure that the financial information makes sense and can be translated into issues and opportunities facing the organization. In addition, key staff members such as program directors and the director of development should have the opportunity to review income and expense reports for the whole organization.
        
        When the board is large enough to include a finance committee, that committee reviews all financial statements and reports on financial activity to the full board. In a smaller nonprofit, the executive director might report first to the board treasurer, who can then keep the full board apprised of the organization s financial status.
        
        The finance committee will often review the numbers in greater detail than the full board. The full board may be better able to respond to aggregated information with important financial trends and issues highlighted in an accompanying narrative report. While each board member should have the opportunity to review organization-wide income and expense reports to understand the impact their department's activities have on the whole organization, members who are inexperienced at reading financial statements may get lost in overly detailed statements. To help the board fulfill its oversight function, it is important for the executive director and the finance committee to present the information in as clear and concise a manner as possible.
        
        The audit and management letter are addressed directly to the board of directors because of its oversight function. Typically, the auditor works with the finance staff to prepare federal and state reports and may be included at board meetings during which presentations are given.
        
        

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        How do we interpret our financial statements?
        
        Financial Indicators from the Statement of Activities (Income Statement)
        Financial Indicators from the Statement of Position (Balance Sheet)
        Financial Indicators from More than One financial Statement
        Samples of Vertical Analysis and Horizontal Analysis
        Financial Indicators Using Information from more than One Financial Statement
        

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        Readers of financial statements can learn a great deal about the health of a nonprofit organization by examining the numerical information presented. In particular, financial information helps readers:
        
        
        • Measure the organization's efficiency, using factors such as:
          • Units of service produced compared to costs
            
          • Fundraising income compared to amounts spent on fundraising
            
          • Net income in a fee-producing program compared to the fees received

          
          
          Evaluate the adequacy of financial resources, often through:
          

          • Liquidity ratios, such as the current ratio
            
          • Comparison of total liabilities or total assets with net assets (formerly called fund balance)
            
          • Cash flow projections

          
          
          Seek significant financial trends by:
          

          • Vertical analysis (looking at a simple line item as a percentage of total revenue or expense)
            
          • Horizontal analysis (comparing prior periods with the current period)

        
        
        For different organizations, different numbers will have different meanings. For example, imagine an organization that shows an operating deficit for the year of $20,000. Is that a red flag? In a small organization with few reserves, such a deficit may indeed indicate serious over-spending of failure to generate revenue. In a large organization, $20,000 may represent less than one percent of revenue and may not be significant. Yet another organization may be purposefully spending down cash reserves on an important program and this "deficit" may represent that decision. For still another organization, a loss of $20,000 may not be a concern by itself, but because it represents the third consecutive year of deficits, does cause concern.
        
        Ratios, too, have different meanings in different situations. For example, a new organization may find it spent 90 percent of its dollars on fundraising. In an established organization, such a ratio would certainly be a red flag. But on closer look, this new organization's services are delivered by volunteers, and the only paid staff they have is a fundraiser.
        
        Just as a fast food chain and an airline are in different businesses with different financial indicators, a specific ratio will mean something different in different types of nonprofits. There are different red flags for arts organizations than there are for human service organizations, and different red flags for organizations that rely on donations than for organizations that rely on individual fee payments.
        
        In several cases, ratio analysis is used to evaluate the organization's financial health. Ratios are a tool for comparing numbers representing different aspects of an organization's financial status. The value of the tool is in identifying which numbers to compare, and determining what the comparison might indicate. Although accountants have determined certain standard ranges for these ratios within some nonprofit industries (arts, libraries, human service agencies, etc.), it is most important to identify the trends in your own organization and analyze changes over time. Therefore, instead of giving specific ranges in the following examples, this article indicates the likely significance of a "high" or "low" relationship between the numbers compared in the ratio.
        
        Financial Indicators from the Statement of Activities (Income Statement)
        
        Surplus or deficit
        If income is greater than expenses within a given period, say a year, the organization has generated a surplus. If expenses are greater than revenue, the organization experiences a deficit for the period. There is no rule that says organizations should have surpluses, deficits, or break even. Typically nonprofits budget to break even. However, organization may deliberately decide to spend down their cash reserves (expandable net assets) for a specific purpose such as starting a new program. Doing so results in an operating deficit, but one which is planned. Similarly, if a nonprofit has determined that it needs a cash reserve for specific future purposes (cash flow, investing in a new program guarding against future declines in funding, etc.), the Statement of Activity should reflect an operating surplus. An "unplanned" surplus, deficit, or even a break even position should be analyzed to determine its causes and to plan for the implications.
        
        Budget to Actual for Revenue and Expense
        Perhaps the most commonly used financial indicator is a comparison of budgeted revenue to actual revenue, and budgeted expense to actual expense. These comparisons are made on both a monthly and a year-to-date basis. Significant variations from budget should be investigated to see whether new projections should be make based on actual experience, and/or whether managerial intervention is appropriate.
        
        Samples of vertical analysis and horizontal analysis
        If you would like to receive a sample vertical analysis and horizontal analysis, contact the Support Centers of America at (415) 974-5100. When Web software universally supports advanced formatting, we will make sample forms available on our Web site.
        
        Functional Expense Ratios
        When completing Federal Form 900, nonprofits must report expenses functionally, broken down into the categories of Program , Management and General Activities, and Fundraising. Donors and agencies who evaluate nonprofit performance, often look to see that most of your organization's funds are being used for programmatic purposes. However, different sources recommend differing practices and policies for allocating expenses among the functional expense categories. As a result, it is important to develop consistent guidelines within your own organization to determine which of your expenses go to program support, and which to management and general activities or fundraising.
        
        Some functional expense ratios are:
        Take Program Expense and divided by Total Expense
        If high, most of the expenses are related to program. Relatively little is spent on management or on fundraising.
        
        Take Fundraising Expense and divided by Total Expense
        If high, a large percentage of expenses are spent on fundraising efforts. Prospective donors may draw the conclusion that too high a portion of their contribution will be spent on fundraising, rather than on program services.
        
        Financial Indicators from the Statement of Position (Balance Sheet)
        
        Short term liabilities coverage ratio (quick ratio)
        Will there be enough cash to pay bills in the immediate or near future? Add together all assets that can be used to pay bills over a specific period of time, such as one month or three months and compare this with the bills that must be paid within that same period of time.
        
        Take Cash + Unrestricted Investment + Accounts Receivable and divided by Current Accounts Payable + Current Accruals
        If high, there may be too much in cash, some could be earning more if invested. If low, you may be in danger of a cash flow crisis, not enough cash to pay pressing bills.
        
        Current Ratio
        Will cash flow be adequate to pay bills over the next year?
        
        Take the Current Assets and divide by Current Liabilities
        If high, Same as above. Caution: Even if current ratio is adequately calculated for the year, there may be periods within the year where there is an inadequate cash to pay bills.
        
        Deffered Revenue or Net Temporarily Restricted Assets
        Deferred revenue traditionally refers to cash which has been received for some restricted condition which has not yet been met. Under the new Statement of Financial Accounting Standards No.116 issued by the Financial Accounting Standards Board (FASB), most of these funds will be held not as deferred revenue, but as an addition to temporarily restricted net assets.
        
        To determine the ratio, take the Deferred Revenue and divide by the Cash + Savings - or - take the Temporarily Restricted Net Assets and divide them by the Cash + Savings.
        
        If deferred revenue or temporarily restricted net assets exceeds cash and savings, you may be spending restricted cash for purposes other than those which the funder intended, or using monies designated for future purposes (such as magazine subscription fulfillment) to meet current expenses.
        
        Financial Indicators Using Information from More Than One Financial Statement
        
        Fund Balance Ratio or Unrestricted Net Assets Ratio
        The fund balance ratio, now called the unrestricted net assets ratio, measures the amount of unrestricted, spendable equity to the organization's annual operating expense.
        
        To determine the ratio, take Expendable Unrestricted Net Assets and divide them by Annual Expenses.
        
        If low, the organization has little unrestricted, spendable equity available to meet temporary cash shortages, an emergency, or deficit situation in the future. This may be the case even in organizations with significant unrestricted net assets, if the major portion of equity is tied up in fixed assets.
        
        Days Receivables
        The days receivables ratio measures the average number of days it takes to collect on a sale or service performed for a fee. This ratio is useful to organizations which earn significant portions of their revenue from fees charged to clients or from product sales.
        
        To determine this ratio take the Accounts Payable times 365 days and divide by purchases.
        
        If high, payments taking longer than 30 or 60 days are inconsiderate and may result in friction with community vendors. In addition, the organization may be incurring additional costs as a result of late or deferred payments (e.g., late fees, interest expense, etc.). A very long days payables ratio or a sudden increase in days payable may indicate an inability to pay bills.
        
        Failure to Produce Financial Information
        In order to assess the financial health of your organization, timely and reliable financial information must be available. Lack of adequate financial information may indicate that not enough time is available from staff or outside contractors to perform the accounting function, that staff needs more training in financial statement perpetration, or that financial systems need to be improved.
        
        Final Comments
        Ultimately, the most important performance measure of a nonprofit is not to be found in financial statements at all. To determine "success," a nonprofit must measure progress against its goals. For example, perhaps an organization has set as a goal providing 200 terminally ill patients with hospice care over twelve months. Determining how many patients were served and at what cost is not difficult. But these calculations show how efficient the has been - not how effective the group has been at providing compassionate, professional care for these patients. It is important to remember that financial indicators are powerful tools for nonprofit managers, when used in pursuit of meaningful goals.
        
        

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        How do we prepare for an audit?
        
        Choosing an Auditor
        What Information is Needed for the Audit?
        When Does an Audit Begin?
        

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        Choosing an Auditor
        A nonprofit's audit is addressed to its board of directors, who have ultimate financial accountability for the organization. The board's finance or audit committee should recommend an auditor for approval by the full board. If you do not have an appropriate board committee, the director or an individual board member can bring a recommendation to the board.
        
        While there are many criteria you may consider when selecting an auditor, the following are usually important considerations:
        
        
        • Experience in the nonprofit sector
          Since there are some differences between for-profit and nonprofit accounting and in how financial statements are interpreted, an auditor who has other clients in the nonprofit sector is likely to be more helpful and efficient.
          
          
        • Experience with other nonprofits in your area of work
          You may want to consider an auditor experienced with similar agencies who knows the specific reporting requirements of your primary funding sources.
          
          
        • Training in General Accounting Office (GAO) Standards
          If you are required to have an audit which meets government standards, your auditors must fulfill GAO s continuing education requirements.
          
          
        • References for the audit firm and the auditor
          In addition to experience, you are looking for indications that the auditor has the technical expertise, communication skills, and flexibility to conduct your audit in an efficient and effective manner. A good working relationship with your auditor will help ensure that the audit goes smoothly.
          
          
        • Fee
          In those states where it is permitted, you will want to compare bids from auditors regarding the fees they charge to do the work you require. Pro-bono (free) audits are rare and nonprofits are cost sensitive. However, fees can be a tricky measuring stick for choosing an auditor. There are some outstanding auditors who work with nonprofits for a reduced fee. A firm may produce a lower bid the first year to get your business and then significantly raise the fee in subsequent years. Auditors who do not have the necessary experience with nonprofits may take longer to produce the audit, causing them to raise the audit fee in later years. They may also prepare a less complete report which has less value to the board and the public. Also, they may require nonprofit staffs, who are typically overburdened, to do even more work in preparing for the audit. Finally, some auditors who charge a lower fee do not provide the organization with a management letter detailing areas of weakness in the accounting system. This letter is an important management tool, of benefit to both the board and staff.
          
          On the other hand, an expensive audit does not guarantee an excellent product. Your goal will be to get the reports and advice that you need and can understand for a reasonable fee.
          

        
        There are differing recommendations regarding changing auditors after you have established a relationship with one individual or firm. Auditors argue that, if you are getting the information you need from your audit and are satisfied that the reports are complete and usable, it is unwise to start over with a new auditor. Management consultants reply that, after a period of a few years, auditors may be unable to provide the organization with fresh insights. In addition, bidding out the audit may provide an incentive to your current auditor to maintain reasonable fees. It may be useful to talk to one or two other qualified auditors every few years to determine whether the upheaval of working with a new auditor will be offset by better quality, lower fees, and/or new perspectives.
        
        What Information is Needed for an Audit?
        To prepare for your audit ask your auditor what information you will be required to provide. Many auditors prepare a list of those records which they will need to examine, forms which you will need to complete, and questions you will need to answer. Complete, accurate, and accessible records and other information prepared well in advance of the audit will help ensure that the process goes smoothly and more quickly, reducing the financial and emotional cost of an audit.
        
        While the following is not a complete list, it is representative of the information an auditor is likely to require:
        
        

        • Confirmations
          A confirmation is an independent statement which supports the financial information in your records. Auditors will ask you to prepare confirmation letters on your letterhead (they will provide the format) to your bank(s), funders, attorney, people, and organizations you owe money to and who owe you money to confirm the amounts reflected in your books. Confirmations are mailed by and returned directly to your auditor to ensure their credibility.
          
          
        • Evidence of Internal Controls
          The auditor will either meet with staff members or request that they complete a questionnaire documenting the procedures related to spending and receiving money and other resources, complying with laws, donor restrictions and regulations, maintaining property and equipment, and recording financial information in the books.
          
          
        • Documentation.
          The auditor will request a number of schedules (lists) of information related to the following:
          
          Assets
          
          • Accounts Receivable -- Who owes you money, how much, when it was due?
            
            
          • Property and Equipment (Fixed Assets) -- When acquired, how much you paid, how long they are expected to last, how much they are depreciated each year, and how much has been depreciated to date?
            

          
          Note: Many nonprofits ask their auditors to maintain this schedule for them and to prepare the annual calculation of depreciation.
          
          Liabilities
          

          • Payables -- Who you owe money to, how much you owe each individual/organization? Copies of invoices or loan agreements.
            
            
          • Deferred Revenue -- If you have deferred any contributions due to donor conditions or restrictions, provide the information noted under Grants and Contributions, in the Revenue section below.
            

          
          Revenue
          

          • Grants and Contributions--Funder/donor names and addresses, grant period, grant amount, when received, restrictions, and copies of the grant letters and grant applications. In the case of individual contributions, your auditor will specify which donors to include on this list based on a minimum level of contributions they will establish for you based on your overall budget and total contributions.
            
            
          • Donated services and materials--You may be required to place a dollar value on contributions of certain services and materials. Prepare a list of these donations to discuss with your auditor.
            
            
          • Special events and benefits--Show income and expenses, and documentation for the value of goods or services which donors received (and, therefore, are not included in the tax-deductible portion of their payment.)
            
            
          • Documentation--such as contracts and invoices, names and addresses, registrations, etc. for fees from memberships, tuition, performances, and other services.
            
            
          • Inventory--If you sell tee-shirts, books, or other products, keep a record of sales throughout the year so that beginning inventory can be reconciled with inventory at the end of the year.
            

          
          Expenses
          

          • Payroll records, including federal and state tax returns related to payroll, vacation records.
            

          
          Smaller nonprofits rely on their auditors to prepare many of these schedules based on information they give to the accountant. You can save on the cost of your audit by preparing the majority of these schedules internally, using staff or board volunteers, rather than asking the auditor to prepare them.
          
          

        • ADDITIONAL INFORMATION
          In addition to the schedules noted above, be prepared for the auditor to review the following items:
          
          • Board minutes
            
          • Leases and other contracts
            
          • Bank statements, bank reconciliations, checkbooks, and canceled checks
            
          • Financial files for paid bills and deposits
            
          • Components of the accounting system -- chart of accounts, journals and ledgers, printouts if the system is computerized, trial balance, etc.
            
          • Budget for the fiscal year being examined
            

          
          Finally, you will want to consider the non-financial aspects of the audit. The staff should understand what is involved in an audit, that it is a routine examination of financial and other information, and that they may be asked a few questions in relationship to that examination. You should assign one person to be the audit coordinator. In a small nonprofit, that may be the bookkeeper or executive director. In a larger organization, it may be the finance director. The audit coordinator should have access to all in formation the auditors may need, and should plan to be available to the auditors while they are on-site. In addition, some thought should be given to setting aside a physical location for the auditors so they can work efficiently.
          

        
        When Does an Audit Begin?
        Most organizations select an auditor prior to the end of their fiscal year. About the time your fiscal year ends, you will want to meet with your auditor to determine what information will be required for the audit. If your financial management system is reasonably well organized, the audit can usually begin within two months of the end of your fiscal year. However, new government funding and other complicating factors may extend the amount of time needed to prepare for the audit.
        
        

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