Nonprofit Bookkeeping and Accounting Overview

Transcription

1 Nonprofit Bookkeeping and Accounting Overview The following activities should occur regularly as part of the yearly accounting cycle. The accounting cycle includes bookkeeping, generating financial statements and analyzing information from the statements. Basic Bookkeeping Activities Bookkeeping is basically recording various financial transactions. Bookkeeping activities can often be done by someone who's doing basic clerical work in the organization. Often, the board treasurer can help you develop and carry out your bookkeeping system. Fiscal Policies and Procedures Manual (or Accounting Procedures Manual) The board develops and authorizes a set of procedures for how the organization manages its finances, including how the following activities are carried out by your organization. The board treasurer usually coordinates the board's responsibility for the manual, including its regular review and update. The board and chief executive should make every effort to ensure compliance to the procedures in the manual. Type of Accounting System and Recording of Financial Transactions Accounting starts with basic record keeping (or bookkeeping). When your organization is just getting started, your bookkeeping system will probably be based on what's called a cash basis accounting system, rather than accrualbasis system. Many organizations, when starting out, use the cash basis system and a checkbook to track transactions. In the "memo" portion of the checkbook, they note if the amount depicted on the check is an expense or revenue, and where the amount came from or is going to. As your organization grows, you'll begin using ledgers to track transactions, for example, you'll post cash receipts to a cash receipts journal and checks you write to a cash disbursements journal. As your nonprofit grows and as you begin using the accrual method, you'll likely need more types of journals, for example, a Cash Receipts Journal, Cash Disbursements Journal, Payroll Journal, Accounts Receivable Ledger, Accounts Payable Ledger, Sales Journal, Purchases Journal and General Ledger. (In an accrual basis system, you post entries when you earn the money and when you owe it. Small organizations usually do not have the resources to use an accrual based system. However, financial statements are prepared on an accrual basis. As a compromise, many organizations use the cash based basis to record entries in journals, but get help to convert to an accrual based basis to generate financial statements.) You can do postings using a single entry or double entry method. Double entry works from a basic accounting equation "assets = liabilities + capital". The double entry method makes sure that your books are always in balance. Every transaction has two journals entries, a debit and a credit. Each transaction affects both sides of the equation. Each posting might refer to accompanying documents that you keep in a file somewhere. For example, postings about cash receipts might refer to invoices that you sent to a client which prompted them to write checks to your organization (checks which you posted as cash receipts). For example, postings about cash disbursements might refer to invoices that were sent to your organization which prompted you to write checks (checks which you posted as cash disbursements.) When you make a deposit to the bank, you'll file the bank's deposit receipt in a file. Manual or Automated Accounting System Your record keeping system will be based on a manual system (where you make entries and total them by hand) or a computer system. You might even choose to outsource your record keeping system to another business that manages your bookkeeping activities (along with other financial management activities) for you. Soon you may evolve to using a computer based system, which greatly automates entry of transactions, updating of ledgers, generation of financial statements and financial analysis (more on these later), and generation of reports needed for filing taxes, etc. The only drawback to using a computer is that you might underestimate the 1

2 importance of knowing how your accounting processes really work that's an advantage of doing the bookkeeping yourself, if only for a few months. You should also generate your own financial statements and financial analysis at least for a couple of months. Having this knowledge and experience helps you develop an instinct for getting the most out of your financial resources. Accounts and Chart of Accounts You'll post each entry according to the category, or account, of the transaction. Each account will be associated with an account number. These numbers are referenced when developing your financial statements (more on those later). You'll refer to a chart of accounts which will tell you what account number to use when you post an entry. You can design your own chart of accounts, including coming up with your own account numbers. The chart usually have five areas, including assets, liabilities, net assets (or fund balances), revenues, and expenses. The account numbers you come up with should depend on the particular kinds of revenues and expenses you expect to have most frequently. However, nonprofits have to report account activity according to the classifications functional (or programs) and natural (or supporting). Program transactions are those directly related to providing services to clients, members, etc. Supporting transactions are those in common to all programs, for example, general management costs, etc. It's not always easy to know which transactions belong to which category! We'll also talk more about managing program budgets back in the topic Basic Guide to U.S. Non Profit Financial Management, after we've reviewed the rest of the information on this page. Budgets (Financial Forecasting) You'll have an operating (or annual budget), which shows planned revenue and expenses, usually for the coming year. Budget amounts are usually divided into major categories, for example, salaries, benefits, computer equipment, office supplies, etc. You might also have cash budgets, which depicts the cash you expect to receive and pay over the near term, for example a month. You also might have capital budgets, which depict expenses to obtain or develop, and operate or maintain major pieces of equipment, for example, buildings, automobiles, computers, furniture, etc. Development of the budgets is usually driven by the chief executive. In the case of corporations, the board treasurer can take a strong role in developing and presenting the budget to the rest of the board. The board is responsible to authorize the yearly budgets. You should develop a program budget, that is, a budget for each major service you provide to clients. For example, a transportation program, a child care program. Many nonprofits have more than one program. It's critical to plan and track financial costs for each program. As much as possible, nonprofits should strive to minimize overhead or administrative costs, that is, costs to support the resources that support the entire organization and all programs, rather than just one program. Examples of administrative costs are rent for a building, office supplies, labor costs for personnel who support the central office or more than one program, insurance, etc. It's wise to develop a program budget that allocates indirect costs to programs. There are several methods to do this. We'll also talk more about these methods back in the topic Basic Guide to U.S. Non Profit Financial Management, after we've reviewed the rest of the information on this page. Usually, each month (during trial balancing more on that later), you'll update your budget report to include actual revenue and expenses. Then you can compare your planned revenue and expenses to your actual revenue and expenses. This will give you a good idea whether your operating according to plan or not, including where you need to cut down on expenses and build up on revenue. Petty Cash You'll have a lot of small, recurring expenses that you'll need to pay right away, for example, to buy a computer power cord, stamps, etc. You'll probably work from a petty cash fund. You might establish this fund by writing a check to your organization, and noting on the check that it goes to the "petty cash" fund. You'll withdraw from the fund by filling out a voucher that describes who took the money, how much, for what and on what date. 2

3 Trial Balances Usually, once a month, you'll do trial balancing. Often, the board treasurer can help with this activity. This activity usually starts by totaling the entries from the journal(s) into a general ledger. (As your business grows, you may use other types of ledgers, too, for example for equipment, payroll, etc.) When using double entry accounting, you'll add up totals on both sides of the ledger to make sure that total debits equal total credits. You'll make sure that the individual postings and totals are correct by comparing each to its accompanying documentation. For example, your recording of cash disbursements will be compared to your bank's monthly checking statement that indicates what checks you wrote over the month. Your recording of cash disbursements will also be compared to accompanying invoices and other forms of billing to your organization, to verify there was a need for each check that was written to pay bills. Internal Controls You will have various forms of internal controls to ensure the business is following its plans, minimize the likelihood of mistakes, avoid employee thefts, etc. There are a wide range of internal controls. For example, you'll be careful about whom you hire. You might have authorization lists about who can access which areas of the building, types of information, etc. As mentioned above, you'll carry over totals to various financial reports, including your budget, to see if your financial activities are according to plan or not. To minimize employee theft, the business's mail will be opened by one person who logs in each check that is received. This person will be someone other than the person who deposits the checks to the bank. Disbursements of large amounts, for example, over $500, may require a secondary signature, for example, from the board treasurer. Another form of financial control is an audit. An audit is a comprehensive analysis, by a professional from outside the organization, of your financial management procedures and activities. The auditor produces a report, with a variety of supplements, that indicate how well your organization is managing its resources. Some nonprofits are required to have audits. It's usually good practice to have an audit, whether you're required to or not. Financial Statements In order to know how your organization is doing, you'll do some ongoing financial planning and analysis. In this planning and analysis, you'll likely use your bookkeeping information to produce various financial statements, including a cash flow statement, statement of activities and a statement of financial position. Your cash flow statement depicts changes in your cash during the year. Your statement of activities (known as the income statement before) depicts the changes in your assets over the past year. This statement is particularly useful to tell you if you are operating with extra money or at a deficit. This gives you a pretty good impression of your rate of revenues and spending. It signals areas of concern, as well. Your statement of financial position depicts the overall value of your organization at a given time (usually at the end of the year), including by reporting your total assets, subtracting your total liabilities and reporting the resulting net assets. Net assets are reported in terms of unrestricted, temporarily restricted and permanently restricted assets. Funders often want to see the statement of financial position. (You'll learn a lot more about financial statements, including examples, later on back in the topic Basic Guide to U.S. Non Profit Financial Management). 3

4 Financial Analysis By themselves, numbers usually don't mean much. But when you compare them to certain other numbers, you can learn a lot about how your organization is doing. For example, you can compare the planned expenses depicted on your budget to your actual expenses in order to see if your spending is on track. Another form of comparison is by using ratios. A ratio is a comparison made by mathematically dividing one number by the other. For example, nonprofits are expected to keep administrative costs down in order to make more money available for programs. Dividing a program's expenses by your total expenses indicates the amount of administrative overhead to run your program. The interpretation of results from various types of comparisons depends on the nature of the nonprofit. For example, an association might expect to spend far less on administrative overhead than would a social services agency during their first year. You'll learn a lot more about financial analysis back in the topic Basic Guide to U.S. Non Profit Financial Management. Financial Reporting The types and frequency of reports depend on the nature of the nonprofit and its situation. For example, if the nonprofit is in some sort of crisis, the board may require frequent reports. Your board should require regular financial reports at each board meeting. When your organization is just getting started, the chief executive will prepare and present financial reports to the board. However, as the organization develops, a board treasurer will likely take a strong role in helping the chief executive to present financial information to the board. The finance committee, led by the board treasurer, ensures that financial reports are complete and helps present them to other members of the board. The board may require a statement of financial position and statement of activities at each meeting. They also may request descriptions of finances for each program or of affordability for upcoming, major initiatives. They may request information prior to filing taxes. They will certainly need to see any results from financial audits. You'll learn a more about financial reporting back in the topic Getting an Accountant, If Needed You might choose to do the basic bookkeeping activities yourself. You should get an accountant initially to help you set up your bookkeeping system, generate financial statements and do some basic financial analysis. Quick Overviews of Bookkeeping / Accounting Bookkeeping and accounting is all about identifying, organizing and reporting your financial transactions. Scan this information to further clarify your understanding of bookkeeping and accounting. 4

5 Critical Issues in Financial Accounting Regulation for Nonprofit Organizations Setting Up Your Chart of Accounts What should our chart of accounts include? Unified Chart of Accounts Deciding to Use Cash Basis or Accrual Basis for Accounting What is the difference between cash basis and accrual basis accounting? What is the difference between the cash basis and the accrual basis of accounting? What is petty cash? Deciding Which Expenses Are Direct and Indirect (Overhead) How do we develop functional expense classification? How can we allocate indirect costs to programs? Can a cost be both a direct cost and an indirect cost? What If You Earn Revenue Not Directly Related to Mission? What is the unrelated business income tax? How Do You Account for Fundraising Expenses and Donations? How to account for donated goods Addressing Financial Controls and Risk Management There are certain practices that you should consistently follow to ensure that financial transactions are consistently recorded in an accurate fashion. These controls also help to minimize risk, including employee theft. What is an internal accounting control system and how can we make ours effective? What internal controls are needed for cash disbursement? What internal controls are needed for payroll? Insurance Information for Nonprofits Risk Management Information for Nonprofits Risk Management on Boards of Directors Managing Program Finances Usually, there are two major types of costs to consider: indirect costs and direct costs. Indirect costs are sometimes call "administrative" or "overhead" costs, for example, costs to run the central facility. Direct costs are those that fund resources which directly produce services to clients, for example, supplies and materials for books provided to clients. Usually, the lower your administrative costs, the more it looks like your resources are going directly to services to clients. In addition, you may have restricted grants (that is, grants that are dedicated for certain programs), which require you to report monies spent on overhead and directly on the program. Therefore, it's wise to track carefully how much money each of your programs requires to operate and how much revenue it generates, as well. A major challenge is to analyze how much of the indirect costs are associated with each program. How can I determine my program costs easily? How can we allocate indirect costs to programs? How do we develop functional expense classification? 5

6 Managing Cash Flow As a new or small nonprofit, your biggest challenge is likely to be managing your cash flow probably the most important financial statement for a new business is the cash flow statement. The overall purpose of managing your cash flow is to make sure that you have enough cash to pay current bills. Nonprofits can manage cash flow by examining a cash flow statement and cash flow projection. Basically, the cash flow statement includes total cash received minus total cash spent. Cash management looks primarily at actual cash transactions. (Note that nonprofits must file a financial statement called Cash Flow Statements or Statements of Cash Flow this statement is not the same as a cash flow budget.) What is cash flow and how should we manage it? How much cash should we hold in reserve? How Should We Invest Our Short Term Cash Balances? What is petty cash and how should we handle it? What is the Board's Responsibility in Investments? How Do you manage and Reconcile Your Bank Account Budget Deviation Analysis You learned above that a budget depicts what you expect to spend (expenses) and earn (revenue) over a time period. Budget deviation analysis regularly compares what you expected, or planned, to earn and spend with what you actually spent and earned. The budget deviation analysis can help greatly when detecting how well you're tracking your plans, how much to accurately budget in the future, where there may be upcoming problems in spending, etc. A budget deviation analysis report might include columns with titles: Planned for Month Actual for Month Difference (planned minus actual) % Deviation (Difference x 100) 6

7 Financial Statements In order to know how your nonprofit is doing, you'll do some ongoing financial planning and analysis. In this planning and analysis, you'll likely use your bookkeeping information to produce various financial statements, including a cash flow statement, statement of activities and a statement of financial position. What Financial Statements are Nonprofits Required to Issue? Statement of Activities (Income Statements) These statements include much money you've earned (your revenue) and subtracts how much you've spent (your expenses), resulting in the total of your unrestricted net assets. The statement of activities includes how much money you've earned (your revenue) and subtracts how much you've spent (your expenses), resulting in how much you've made money (your profits) or lost money (your deficits). Basically, the statement includes total sales minus total expenses. It presents the nature of your overall profit and loss over a period of time. Therefore, the Income Statement gives you a sense for how well the nonprofit is operating. Statement of Financial Position (Balance Sheets) Whereas the statement of activities depicts the overall status of your profits (or deficits) by looking at income and expenses over a period of time, the balance sheet depicts the overall status of your finances at a fixed point in time. It totals your all your assets and subtracts all your liabilities to compute your overall net worth (or net loss). This statement are referenced particularly when applying for funding. Statement of Financial Position Balance Sheets Statement of Financial Position (Purpose, Key Numbers, Assets, Liabilities, & Stockholders' equity) Financial Reporting The types and frequency of reports depend on the nature of the nonprofit and its situation. Banks might want reports to verify financial strength to pay back loans. Foundations, individuals, or other donors may want reports to verify that donations are being spent as expected by the foundation or donor. The Internal Revenue Service will want certain reports when filing yearly tax forms. Annual Reports 7

8 Reporting Requirements The IRS requires most tax exempt organizations to submit an annual information report, the Form 990 and its relations, which includes a significant amount of financial reporting. The report requires tax exempt NPOs to complete an object revenue & income statement, with particular categories specified (e.g. salaries, postage, rental revenue), a balance sheet, with particular categories specified (e.g. cash, accounts receivable), a statement of functional expenses, in which all expenses are allocated to either program services, fundraising, or operations, and a report of expenses segregated by individual program service (e.g. educational mailings, a seminar program), a support schedule that details the organization's sources of revenue, with particular categories specified (e.g. charitable donations, membership fees, investment income). Because the IRS provides specific categories and classes into which revenue and expenses must be allocated, any organization that does not build its accounting system around these categories and classes would face serious hurdles preparing its annual IRS report. This provides in part a de facto basic standard for NPO financial reporting. Fortunately, most of the categories given in the revenue & income and the balance sheet are standard accounting categories. Other aspects of the reporting requirements are more complex than would be required in small commercial businesses, but are not foreign to larger commercial operations. The report of expenses for individual program services roughly corresponds to divisional accounting methods, for tracking expenses incurred by different segments of an organization's total operation. Also, while the categories of income the IRS requires to be delineated are specific to nonprofit organizations (i.e. public contributions, unrelated business income), a fine resolution analysis of income sources is typical in large corporate financial accounting. As in that case, the various classifications of income are necessary because the IRS requires different treatment of the income classes for determining taxes. Unlike in commercial reporting, the IRS also uses these revenue classifications to help determine if an NPO will retain its tax exempt status recognition. Some important classifications of revenue for NPOs are discussed further below under "Revenue." However, commercial accounting typically does not face the additional requirement that all expenses be assigned to either program services, fundraising, or operations classification. In other words, every expense will have at least two and possibly three labels. First it will have an object expense label, e.g. a printing expense. Second, it will have a functional expense label, e.g. if the printing expense was associated with activities that advance the organization's nonprofit mission it would be labeled "program services" rather than as a fundraising or operations expense. Finally, all program services expenses will be labeled with the particular program service project for which it was incurred, e.g. an educational program to promote AIDS prevention. The term "fund accounting" is commonly used to refer to the complete segregation of revenue and expenses into "funds," each of which typically corresponds to an individual program service area. Such fund accounting is commonly required by granting agencies. Inferior accounting software is sometimes able to provide for two but not three labels, and therefore may be unsuitable for nonprofit organizations. However, there are sometimes methods for stretching weaker software into NPO usability. The specific meanings of "program services," "fundraising," and "operations" are further discussed below under "Expenses," since these are critical for IRS and other public reporting requirements. If an organization's financial accounting system does not or cannot assign these types of labels to income and expenses as required, completing the annual IRS report becomes an extremely arduous task, and adherence to financial standards required by regulators and granting agencies may be impossible. Fortunately, a wide variety of popular accounting software systems are available that have been designed to satisfy these needs. If the nonprofit organization uses an adequate accounting system, sets up its categories and classifications in line with the IRS reporting requirements, and assiduously labels all revenue and expenses appropriately, then completing the IRS annual report is a relatively painless matter. 8

9 State Reporting To ensure that all organizations report similar transactions uniformly, many states require that contributions, gifts, grants, etc., and functional expenses be reported according to the AICPA industry audit guide, "Not For Profit Organizations," supplemented by the National Health Council's "Standards of Accounting and Financial Reporting for Voluntary Health and Welfare Organizations." Fortunately, the IRS annual information report is structured in accordance with these guidelines, and therefore states will typically accept a completed IRS report as the organization's financial report. However, it is useful for NPO staff and advisors who have financial responsibilities to be familiar with these guidelines. As described below in the section on "Published Guidelines," these form a significant portion of what are considered Generally Accepted Accounting Principles (GAAP) for NPOs. Requirements for Grant Recipients Organizations that receive federal grants have an additional set of financial accounting regulations to follow, which are established by the Office of Management and Budget (OMB) in a set of published circulars. These provide detailed instructions for determining how to categories specific costs, as well as indicating which types of costs may be funded by federal grants and which the organization must pay for through other means. The OMB circulars are further discussed under "Published Guidelines" below. Furthermore, organizations may be required by granting agencies to obtain a financial audit, which is a detailed examination of the organization's financial practices and records by an independent third party. The OMB and AICPA both publish auditing standards that are commonly used. Additional references addressing nonprofit organization audits are listed below. Published Guidelines There are three major bodies that issue standards for nonprofit organization financial accounting, and some supplementary guidelines that are commonly referenced, which regulators typically relay on for determining if an NPO is conducting its finances responsibly. The standards bodies are the Financial Accounting Standards Board (FASB), the American Institute of Certified Public Accountants (AICPA), and the U.S. Federal Office of Management and Budget (OMB). The FASB is the primary standards issuing body for nonprofit organizations in the U.S. However, this hasn't been the case for very long, and at this time it has developed only a limited set of "Statements of Financial Accounting Standards" for NPOs, although two are critical ones. These are No. 116, "Accounting for Contributions Received and Contributions Made," and No. 117, "Financial Statements of Not for Profit Organizations." Unfortunately, the complete text of these is not available online, since the FASB sells printed versions as a fundraising mechanism. The AICPA publishes the primary guide to GAAP for nonprofit organizations, the "Not for Profit Organizations Audit & Accounting Guide." It also releases its own standards, called "Statements of Position." The most recent, and controversial, is SOP 98 2, "Accounting for Joint Activities Accounting for Costs of Activities of Not for Profit Organizations and State and Local Governmental Entities That Include Fund Raising." Further discussion of joint costs allocation is presented below. The OMB develops standards and guidelines specifically for NPOs that receive federal grants. However, even if an organization doesn't currently receive such revenue, there are few that wouldn't like to be able to at some point. Therefore, some familiarity with the OMB guidelines can be useful. Unfortunately, they are rather arcane and picayune, and not something most people would choose to read if they had a choice. The potential size of many federal grants is typically the primary motivation for doing so. In addition to the standards and guidelines developed by official bodies, several works by other organizations have become valuable tools for administering financial accounting operations. Of particular note are the National Health Council's "Standards of Accounting and Financial Reporting for Voluntary Health and Welfare Organizations," and the United Way of America's "Accounting and Financial Reporting: A Guide for United Ways and Not for Profit Human Service Organizations." Several book publishers have recently released guides to GAAP standards for NPOs. These essentially combine the various standards and guidelines issued by official standards bodies into a more unified form. As such, they are very useful for obtaining a complete picture of the commonly accepted accounting practices, and make good desk 9

10 references for accountants. They are not especially written for people other than accounting specialists. Fortunately, there are also various books targeted to nonspecialist NPO managers, which provide a suitably detailed introduction to accounting principles both general and unique to NPO operations. As described earlier, the IRS and various standards and guidelines require revenue to be assigned within a specific set of categories. The most important of these for most nonprofit organizations are revenue from public support and from exempt purpose activities. These are described more fully below, along with a short discussion of other revenue and unrelated business income tax (UBIT). Correct assignment of revenue to the appropriate category is critical for most NPOs, since the IRS uses this information as a primary means of determining qualification for taxexempt status. The most detailed and significant guide for nonprofit administrators to assigning revenue to the various typically required categories may be found in the instructions for the IRS Form 990/990EZ. These are further amplified by various written IRS releases, such as IRS Revenue Procedures statements. The other standards and guidelines described here are generally followed by the IRS when developing its own regulations. Revenue From Public Support Federal law defines several types of nonprofit organizations that qualify for recognition of federal tax exempt status. The type most people usually think of when the term "nonprofit organization" is used, is the publiclysupported public charity, which is actually just a small segment of the nonprofit sector in terms of assets or revenue. A key qualification for this NPO type is the fraction of its revenue that comes from public support. For example, other related NPO types for which public support isn't critical are private foundations, and charities supported by exempt purpose activities. Public support usually takes one of three forms. One is direct public support, which is usually charitable donations by individuals, private foundations, and businesses. Although always classified as public support, this revenue may only be counted toward an organization's "public support percentage" (used to determine tax exempt recognition) to a limited extent, based on the organization's total revenue. This is to prevent an organization from serving as a tax shelter for a limited group. Instead, direct public support must come from many individuals contributing amounts that are relatively small compared to overall revenue. Other common forms of public support are indirect, the two major sources being from governments and from publicly supported granting agencies (including other publicly supported public charities, and public foundations). This support is also considered to come from the general public, but via an intermediary. This form of public support is particularly valuable to publicly supported public charities because the full amount may be applied to the public support percentage used to determine tax exempt recognition. Revenue From Exempt Purpose Activities Simply stated, exempt purpose activities are those that directly advance the organization's stated mission. This mission must be stated and described in the organization's application for tax exempt status recognition as submitted to the IRS, and the IRS refers back to this application to determine which activities are exempt purpose ones. As described above, federal law defines various types of tax exempt organizations, one of which is the set for which exempt purpose revenue is a primary means of support. There is a specific set of requirements that this class of tax exempt organization must meet to retain its exempt status recognition. Organizations may modify or redefine their missions, but doing so requires that the IRS be notified. Also, there is a broad set of revenue generating activities for which their classification as exempt purpose activities or otherwise is ambiguous. The IRS may consider such activities as exempt purpose ones or not, depending on the details of the organization's mission statement and description, and how the IRS has treated such revenue in the past. 10

11 Other Revenue (and UBIT) There are many other potential sources of revenue for nonprofit organizations besides public support and exemptpurpose activities. Examples include special fundraising events, membership fees, interest and investment income, and other unrelated business income. "Unrelated" in this sense refers to revenue that doesn't fit any of the other specified categories, and which comes from activities that are unrelated to the organization's exempt purpose activities because they aren't considered to directly advance its mission. The IRS defines a specific set of categories of income other than public support and revenue from exempt purpose activities. Any income that can't be assigned to any of these categories is considered unrelated business income. Unlike other sources of NPO revenue, unrelated business income is taxed at normal corporate income tax rates. This assessment is called unrelated business income tax (UBIT). Other resources addressing UBIT issues are listed below. Expenses Just as income must be correctly assigned to specific categories, expenses must also be properly labeled. A unique aspect of NPO accounting is the "third label" that must be attached to all expenses, marking them as for program services, fundraising, or operations. Although states have historically tried to establish laws specifying the required allocation that NPOs must make among these (e.g. a maximum fundraising expense percentage), these have been struck down by the U.S. Supreme Court as unacceptable restrictions of the organizations' rights. However, there is no doubt that the costs of fundraising and operations, which don't directly promote the organization's mission, are of interest to donors and other supporters. Organizations with low fundraising and operations expenses are typically considered to be more efficient and to make better use of their assets. Accordingly, the IRS requires that expenses be allocated between these classifications and that information be made public. In short, rather than try to legislate specific percentages, regulators now encourage the public to examine the relative expenses among organizations that they might support, and make their own judgments. The details of how to allocate expenses under the three categories are presented in detail in the instruction for the IRS Form 990/990EZ. Other standards and guidelines may amplify and expand these explanations. In particular, the AICPA's SOP 98 2 addresses the issue of accounting for activities that fit in part under more than one classification (so called "joint costs"). Program Services Expenses Program services expenses are those amounts specifically expended in support of activities that directly advance the organization's nonprofit mission. In other words, if an organization exists to promote the development of a cure for AIDS, amounts spend in grants to AIDS researchers is a program services expense. Funds spent to raise donations that will eventually go to grants, and funds spent to pay for the organization's office, only indirectly support the nonprofit mission, and therefore do not qualify as program services expenses. A particular class of program services, public education, are often tied to fundraising purposes, and this is further discussed below under joint costs allocation. Fundraising Expenses Fundraising expenses are those amounts used to bring in additional revenue, typically (but not only) through public donations. An example of fundraising expenses are the costs of printing and mailing to the general public flyers that encourage them to support the organization's mission by sending a donation. As such mailings often include educational material that advances the organization's mission, such costs are sometimes treated as program services expenses in part, a subject further considered below under joint costs allocation. Operations Expenses Operations expenses are those that don't clearly fit under either program services or fundraising expenses (nor in part under both). Examples of operations expenses are the salaries for senior staff who aren't specifically responsible for only fundraising or a particular exempt purpose activity, the cost of a staff office, and any legal or accounting fees that can't be clearly assigned to any particular program. 11

12 Joint Costs Allocation In 1998, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position 98 2, "Accounting for Costs of Activities of Not for Profit Organizations and State and Local Governmental Entities That Include Fund Raising." SOP 98 2 is effective for fiscal years beginning on or after December 15, SOP 98 2 focuses on expenses associated with certain joint activities, which in part serve a fund raising function, but also have elements of program services or operations. For instance, the expenses associated with an educational mailing that also includes an appeal for donations might be jointly allocated between program services and fundraising expenses. The greater extent one can assign a cost to the program that truly incurred it, the more accurate the organization's financial records and reports. Joint costs allocation is unfortunately an area where NPOs sometimes use questionable financial practices, such as arbitrarily dividing up and spreading most or all of their actual fundraising and/or operations costs in their financial reports among their various program services in order to make it appear that they have very low fundraising and overhead costs. That contrasts with legitimate accounting procedures for accurately assigning a particular program service (or fund or grant) its true share of the operations and overhead costs. Accordingly, SOP 98 2 prescribes the conditions under which costs may be split between fundraising and other activities. If the conditions are not met, then the entire amount must be treated as a fundraising cost. Because these conditions are quite strict, many organizations have objected to SOP 98 2, but it is likely that its acceptance will lead to more accurate accounting and greater public financial accountability by nonprofit organizations. Resources that provide further information about SOP 98 2 and joint costs allocation are listed below. Excess Benefits Transactions (Intermediate Sanctions) Excess benefits transactions are a relatively new area of nonprofit financial concern. Historically, the IRS had only one tool it could use when an organization acted in a manner inconsistent with its nonprofit mission: to strip it of its tax exempt status recognition. This was sometimes considered overly draconian for minor infractions, but the IRS had no other mechanism to encourage compliance. The "intermediate sanctions" laws were therefore devised to give the IRS more discretion in these matters. These are "intermediate" because the provide less of a punishment than being stripped of exempt recognition. A major part of the current set of intermediate sanctions regulations concerns "excess benefits transactions." These are expenditures by a tax exempt organization that are suspect primarily because they either appear to be or in fact are a misuse of the organization's funds. In order to maintain the public trust in NPOs that receive tax exempt recognition, particularly those for which donations are tax deductible, the IRS serves as a public watchdog for improper practices by organizations it regulates. The IRS has only recently released its proposed intermediate sanctions regulations for excess benefits transactions, which implement federal laws passed several years ago. The regulations are complex and in some parts highly disputed. It is likely that at least some modification of the proposed regulations will occur before the final regulations are released. However, the regulations once released will apply retroactively to when the associated laws were passed in This is one of the main reasons why many NPOs are particularly upset about the proposed regulations. Not following the proposed regulations as written may dangerously expose an organization to the risk that its current and recent activities will subject it to sanctions when the final regulations are released, yet parts of the proposed regulations are quite contentious and may be changed. The issue of excess benefits transactions and the intermediate sanctions rules in general, are far too complex to be presented succinctly here. The reader is encouraged to explore some of the other resources available on this subject. 12