Nonprofit vs. For-Profit Accounting
When starting a company, one of the first decisions you need to make is whether the business should be a for-profit company or a nonprofit organization. For some founders, the answer is immediately obvious. It makes sense for a company that wants to make money to be a for-profit business. For a company with a social component, such as a business that produces a product or provides a service that enhances the greater good, the answer might be less clear.
Understanding the differences between for-profit businesses and nonprofit organizations can help you decide which one best suits your company. One way to get a better grasp of the differences is to look at how nonprofits compare to for-profits, especially with accounting practices.
For-Profit vs. Nonprofit Organizations
When a business earns a profit, it brings in more revenue than it spends. One common misconception about the differences between a for-profit and a nonprofit company is that a nonprofit doesn’t earn more than it spends or doesn’t have money remaining at the end of each quarter. The definitions of a for-profit and a nonprofit business are a little more complicated than that. Take a closer look at what it means to have a for-profit business or a nonprofit organization:
What Is a For-Profit Company?
A for-profit company is a business that exists to earn money. For-profit businesses aim to bring in more revenue than they spend to benefit the owners or investors or provide a financial incentive to their employees. In some circumstances, the owners or managers of a for-profit company might use the extra revenue to build or enhance the business.
For-profit companies earn money by selling products or services. For example, a clothing brand will sell clothing and a for-profit attorney will sell their legal services.
One thing worth noting is that although a for-profit business has the goal of earning money, it can also have an additional mission or social component. For example, a clothing brand might aim to reduce the fashion industry’s environmental footprint by producing more sustainable or recyclable garments. An attorney might provide legal services to help those in need. Earning a profit then helps those companies and individuals achieve their goals.
Common Examples of For-Profit Companies
A few examples of for-profit companies include:
- Restaurants
- Retail stores
- Attorneys
- Technology service providers
- Automobile manufacturers
- Consulting firms
- Construction companies
- Real estate companies and developer
What Is a Nonprofit Company?
A nonprofit company is not necessarily a company that doesn’t earn a profit. A struggling business can’t simply decide to be a nonprofit because it is earning less than it’s spending. Instead, the term “nonprofit” means that the goal of the company extends beyond earning money. Nonprofits have a mission and typically seek to benefit the public or further a particular cause.
Compared to for-profit companies, nonprofits have certain tax advantages. Often, nonprofits apply to be 501(c)(3) organizations, which exempts them from paying certain taxes. A 501(c)(3) organization is usually a charitable organization, meaning the service or product it provides benefits the greater good somehow. To earn tax exemption, the organization needs to have at least one of the following purposes:
- Religious
- Scientific
- Literary
- Educational
- Prevention of cruelty to children
- Prevention of cruelty to animals
- Testing for public safety
- Encouraging amateur sports competition nationally or internationally
- Charitable, such as defending human rights, eliminating discrimination or advancing science and education
Common Examples of Nonprofit Organizations
Some common examples of nonprofit organizations are:
- Colleges and universities
- Hospitals
- Performing arts organizations
- K-12 literacy programs
- Organizations that aim to end childhood hunger
- Humane societies
- Adult education programs
Who For-Profit vs. Nonprofit Companies Serve
Nonprofit and for-profit organizations typically differ when it comes to their users and needs or who they aim to serve:
- The public: Nonprofit organizations typically need to benefit the public in some way. Any profit earned by the organization gets directed back into the organization to further its cause and mission. All accounting information about a nonprofit organization needs to be freely available to the public to review.
- Stakeholders and investors: Often, for-profit companies have stakeholders and investors who own a share of the business and who have an interest in how it is doing and its financial situation. If the business earns a profit, the investors earn a portion of the profit based on their stake in the company.
- Members: Not-for-profit organizations often exist to meet the needs of their members. A social club or credit union provides services that benefit the people who sign up. Any additional revenue earned by a not-for-profit gets cycled back into the organization to help it better serve its members.
Accounting Differences Between For-Profit and Nonprofit Organizations
How you handle your company’s accounting will differ depending on whether you apply for for-profit status or to be a nonprofit. Take a closer look at some of the major accounting differences between for-profit and nonprofit organizations.
1. Tax Status
Tax status might be the difference that comes to mind first for many people when they think about for-profit versus nonprofit companies. A nonprofit organization that qualifies for 501(c)(3) doesn’t have to pay federal income taxes. Whether the organization has to pay state or local taxes depends on its location. Many nonprofit organizations also don’t have to pay property tax or sales tax.
If an organization has tax exemption under IRS section 501(c), it does need to file Form 990 each year. The public can access the information on Form 990 to see how a nonprofit organization manages its finances.
Form 990 can influence a potential donor’s decision to give money to an organization or not. Suppose the form reveals that an organization is spending a significant portion of its revenue on overhead and a small portion of its income on fulfilling its mission. A donor might decide not to give money to the company.
In contrast to nonprofit organizations, for-profit companies need to pay federal income tax, state and local taxes where applicable and sales and property tax. The type of tax return a company needs to file and when it needs to file its returns depends on the corporate structure. A sole proprietor, for example, files Form 1040 and Schedule C each year. Corporations get taxed on their profits and need to file Form 1120 with the IRS.
Although for-profit companies do pay taxes, many can reduce their tax obligation through deductions. Deductions reduce the value of a company’s taxable income, lowering its tax bill.
2. Balance Sheet vs. Statement of Financial Position
Whether they are answering to investors or the public, for-profit and nonprofit companies need to prepare financial statements. The format of the financial statements differs based on whether a company is for-profit or nonprofit.
Nonprofit organizations typically prepare a statement of financial position. A statement of financial position, or SOP, provides a snapshot of an organization’s finances at a particular point. A statement of financial position includes:
- The organization’s assets: An organization’s assets are what it owns or has. Examples include cash and money in savings and investment accounts, furniture and equipment, valuables such as artwork, prepaid expenses, long-term investments and investments in endowment funds. Grant money that an organization has won but hasn’t yet received and money it has loaned others can also count as assets.
- The organization’s liabilities: Liabilities are what an organization needs to pay to others. Examples of liabilities include accounts payable to vendors or service providers, loans the organization is repaying, payroll and credit cards or lines of credit.
- The difference between the two: The difference between an organization’s assets and liabilities is its net assets. Net assets can be unrestricted, meaning a company can use them whenever and however it wishes. If assets are restricted, a company needs to use them for a particular purpose, such as paying a particular employee’s salary. Temporarily restricted assets have restrictions set by the donor, which can be fulfilled within a short time.
For-profit companies’ financial statements include balance sheets, which they usually prepare every quarter. A balance sheet looks a lot like an SOP, but there are some key differences. You’ll typically find the following on a balance sheet:
- Assets: Like an SOP, a balance sheet lists a company’s assets, or the value of what it owns, such as cash on hand, real estate, furniture and equipment, accounts receivable and investments.
- Liabilities: A balance sheet will also include the value of a company’s liabilities, such as its debts and accounts payable. Liabilities can be long-term, such as a 10-year loan, or short-term, such as bills the company needs to pay by the end of the month.
- Shareholders’ equity: Another way to describe shareholders’ equity is the company’s net worth. This net worth is the amount investors initially put into the business that the company decides to retain at the end of the year rather than pay out to investors. A company’s assets should equal its shareholders’ equity plus its liabilities.
3. Income Statement vs. Statement of Activities
For-profit and nonprofit companies have different ways of reporting their income and expenses. A for-profit company will create an income statement known as a profit and loss statement (P&L). It should include the following:
- Sales and revenue: Sales and revenue are examples of income a company might earn during a quarter, such as the value of products or services it sold.
- Operating costs and expenses: Operating costs and expenses can include the cost of the goods a company sold, bank fees, rent, office expenses, advertising costs and marketing expenses.
- Net income: Net income is sales and revenue minus operating costs and expenses. If a company has a positive net income, it has a profit for the quarter. If the net income is negative, the company has a loss.
- Other sources of income: Other sources of income a company might include on its P&L include interest income or income from investments.
- Other expenses: Other expenses might include costs not directly related to the cost of running the company, such as taxes or penalties the company has to pay.
A nonprofit’s statement of activities is very similar to a P&L statement. The statement lists a nonprofit’s revenue during a period, such as a quarter. It also lists the organization’s expenses during that time and shows the difference between the two. A statement of activities will usually include:
- Revenue: A nonprofit’s sources of revenue can include donations from individuals, grant funding and funds released from restricted endowments.
- Expenses: Expenses include operating costs, fundraising costs, management costs and program costs.
- Change in net assets: The change in net assets is the difference between revenue and expenses during the quarter. It can be positive if there is more revenue than expenses or negative if the nonprofit brings in less than it spent.
4. Net Assets
How an organization handles and classifies its net assets, or the value remaining after subtracting expenses, differs depending on whether a company is for-profit or nonprofit. Nonprofit organizations need to classify their net assets into three categories:
- Restricted: Also called permanently restricted, restricted funds or assets are amounts of money that an organization needs to invest in perpetuity, usually in a trust or endowment. The money usually needs to be used for a single purpose. For example, restricted assets might fund a chair position in a department or pay for a particular program offered by a nonprofit.
- Temporarily restricted: Temporarily restricted assets are often earmarked for a particular reason, such as paying for a new wing at a hospital or getting a literacy program off the ground. They usually need to be used during a specific time frame.
- Unrestricted: An organization is free to use unrestricted funds whenever and however it would like, as long as the use of the assets helps the organization fulfill its mission and purpose.
Handling net assets as a for-profit company involves calculating total assets minus liabilities. The remainder is the company’s profit.
5. Financial Reporting
While both nonprofit and for-profit organizations prepare financial statements, each only focuses on specific attributes. For instance, nonprofit organizations may record attributes based on accountability more than for-profit companies. This is because nonprofit companies should mainly use their funds for the purpose and mission of the organization rather than for business processes that improve profitability.
Nonprofits can prove this by ensuring their financial statements reflect clear accountability with clear classifications for all donations to ensure accurate records and easy tracking. Due to the different types of restricted funding, nonprofits may be unable to create a set budget, making their financial reporting system more complex than for-profit financial reporting.
It’s also important to note that updated financial reporting for nonprofit accounting revised the equity section to account for revenue transactions as either with or without donor restrictions. Donor restrictions are either by time or purpose. This newer standard includes expanded descriptions of expense allocations, makes the reconciliation between the direct and indirect method of cash flows unnecessary and introduces a brand-new disclosure for liquidity, which is not required for for-profit companies.
6. Revenue Recognition
It is essential for nonprofit organizations to make the different income and funds easy to recognize. Nonprofits need to categorize their grant income or donations as “without donor restrictions” or “with donor restrictions.” Categorization allows them to distinguish the specific purposes of designated funds, ensuring that they are used transparently and appropriately.
Additionally, while for-profit companies may report revenue and associated costs in the same accounting period, nonprofit organizations may only recognize revenue when it is earned or realizable. For example, if the nonprofit received a pledge that is certain and irrevocable, they may record the amount in their financial statements before the donor finally pays the cash.
Additionally, all companies must assess all of their major revenue streams that are subject to the new five-step analysis of exchange revenues called ASC 606, but nonprofits must also adopt a new revenue pronouncement for non-exchange revenues (grants and contributions) called ASU 2018-08. While ASU 2018-08 is primarily for not-for-profit organizations, they also apply to any business that makes or receives contributions of cash or other assets. These two new revenue pronouncements require expanded footnote disclosures and assessment documentation by company management.
7. Fund Accounting vs. Single Accounting System
For-profit organizations typically record all their financial transactions using a single accounting system. For-profit companies do not need to separate their funds based on their purposes because their primary goal is to generate a profit for the shareholders and owners. Companies can also do this because their customers are unlikely to request a report on what their payment went toward, as a donor for a nonprofit would.
Nonprofits generally use a fund accounting system that helps separate different financial resources for specific programs and purposes into separate funds. This accounting system allows nonprofit organizations to improve financial performance in different aspects of the business and maintains accountability for all funds. For example, they can track program funds, general funds and restricted funds independently. This also allows them to accurately report and prove to donors that their payments go exclusively toward the organization’s purpose.
8. Profits vs. Surpluses
Another difference between for-profit and nonprofit companies is their ability to reinvest and distribute profits. For-profit organizations typically have the freedom to distribute the profits they generate to owners and shareholders or reinvest them into the business. This is especially relevant to larger businesses. Publicly traded companies may also incorporate profit maximization to make the highest profits possible.
In contrast, when a nonprofit incurs more revenue than expenses, it is known as surplus rather than profit. In most cases, a nonprofit will reinvest the excess revenue into the organization to further impact its mission, and it typically won’t have owners or shareholders to distribute the funds to.
If a nonprofit wants to receive more revenues than expenses, it can implement a reserve policy. Nonprofits can tailor this to their unique working capital, risk and future opportunity needs.
9. Cash Flow Statement
While both for-profit and nonprofit businesses use cash flow statements, they use them in different ways. Their cash flow statements are similar in that they both show how money moves in and out of an organization within a specific time period. They record the starting balance for that period, where the cash was received, how it was spent and the ending balance.
A business will typically have a positive cash flow if the statement shows that it can effectively fund its operations, pay down debts and meet its obligations. This shows that the company is financially healthy and implements effective cash management strategies.
Because small to mid-sized businesses and new businesses may take more time to adjust to liquidity than larger companies, a cash flow statement is crucial for for-profit businesses to help them keep track of negative cash flow periods and what’s causing them.
Conversely, consistently high cash balances may harm a nonprofit organization rather than improve it. For instance, if a nonprofit were to receive various large cash donations each month, potential donors may prefer to donate their money elsewhere rather than have their money sit in the company’s bank account for months before they can use it to impact their mission.
Accounting for Not-for-Profit Organizations vs. Nonprofit Organizations
Often, people occasionally use the phrases nonprofit and not-for-profit interchangeably. It’s worth noting that there are some subtle differences between the two. While a nonprofit typically serves a charitable purpose or has a mission that enhances the public good, a not-for-profit company doesn’t need to do so. A not-for-profit instead operates to serve its members. The revenue it does earn goes back into meeting its goals and running the organization in general. For example, a social club or sports team can qualify for not-for-profit status.
One key difference between the two is that a nonprofit is usually a business and typically does seek to earn more revenue than it spends. Not-for-profits are usually recreational organizations. They can often apply for tax-exempt status, but the IRS isn’t likely to recognize them as organizations eligible for 501(c)(3) status.
Still, not-for-profit and nonprofit businesses may still be obligated to follow many of the same compliance regulations. For example, they may both need to keep a detailed record of the past three years, register for solicitation in all states and maintain updated public company bylaws.
How is nonprofit accounting different in terms of financial reporting? While nonprofit organizations are required to make their operational and financial records public, some not-for-profits may be allowed to keep this information private if they prefer it. Even so, they may get better results by sharing this information with members.
Unique Accounting Challenges for Nonprofit Organization Accountants and Bookkeepers
While nonprofit and for-profit organizations face unique challenges, accountants and bookkeepers working with nonprofits may experience specific challenges related to strict financial reporting standards and regulations. Here are four key challenges they may encounter and possible solutions for making nonprofit accounting more manageable.
1. Liquidity Footnote
Nonprofits must review the new liquidity footnote in detail. Are the Financial Assets Available for General Expenditures negative, or appear low? When compared to the Statement of Functional Expenses, how many days of expenses does it represent?
Nonprofit management have been concerned that if a potential donor thinks this number is too high, it may impact future donations. Other nonprofit management have worried if the potential donor thinks the number is too low, it may question the financial governance of the organization.
Since this footnote is still relatively new, financial statement readers’ reactions to it are still evolving. The key is educating the reader through utilization of the qualitative portion of the footnote to explain as much as possible about the organization’s liquidity management.
In these cases, it may be beneficial to consult with an accounting service provider on the most effective way to explain the company’s liquidity management in a way that is easily understandable, enhances transparency and displays the organization’s trustworthiness.
2. Understanding Nonprofit Regulations and Uniform Compliance
It is essential for bookkeepers and accountants to have a thorough understanding of nonprofit accounting standards and regulations and remain up to date with these standards. For example, if an organization receives over $750,000 of federal funds, they are required to perform a Single Audit, which is an independent compliance audit. These are audit procedures in addition to the financial audit, which will test federal grant expenditures for proper internal controls around financial reporting and grant compliance. Any findings in this area will be a part of the public record.
In addition to this, they’ll need to ensure they file all the relevant financial statements and tax returns and follow regulatory compliance, such as implementing accounting and cybersecurity software, performing risk assessments and doing regular recordkeeping and periodic monitoring. Fortunately, service providers may help nonprofits with tax planning and preparation and software consulting services.
3. Grant Management
Nonprofit personnel need excellent organization and attention to detail skills when managing grants. Accountants need to ensure the nonprofit uses grant funds according to their grant agreements and accurately record how the organization uses these funds.
4. Tracking and Reporting Restricted Funds
The stipulations for revenue recognition conditions and timing can often be complex. This means accountants must carefully analyze revenue recognition and accurately match it with program and project performance to avoid misreporting issues.
Work With Marshall Jones for Expert Accounting Advice
Whether your company is for-profit or nonprofit, working with Marshall Jones Certified Public Accountants And Advisors helps you get your books in order. Our team of CPAs and advisors can help you prepare your monthly or quarterly P&L statements or statements of activities. We can also help you clean up your accounting records and recommend secure accounting software and training. Learn more about our outsourced accounting services, or contact our experts today for more details.
