Many who want to start a nonprofit organization know very little about nonprofit accounting, and there are some real traps you can fall into if you don’t understand the basics. I’m going to explain one important concept, and I’ll try to make it interesting by including references to donuts and ale.
Let’s say you want to start a simple business making and selling donuts. A friend loans you $100 to buy some ingredients. You now have $100 and you owe $100. Accountants would say you have assets of $100 and liabilities of $100. What you have minus what you owe is what your business is worth (in this case zero). Accountants call this amount “equity”. (That’s the accounting term, not the “let’s be fair, inclusive, and respectful to underrepresented communities” term currently playing a major role in many organizations.)
So, we could say H is what you have, O is what you owe, and W is what your donut business is worth. Let’s say it using algebra:
H - O = W
Or we could say your assets minus your liabilities is the equity:
A - L = E
I can remember this by saying “HOW do you make ALE?” That’s concept is called the accounting equation, and it’s the most fundamental rule of accounting. It tells you how much your for-profit business is worth.
Ok, let’s go from dollars back to donuts. At this point, we have:
H - O = W A - L = E $100 - $100 = $0
Your business is worth zero at this point, so you go to the store, buy $50 worth of ingredients, whip up a batch of donuts using your own equipment in your own kitchen, and sell them to a neighbor for $100. Now you have:
H - O = W A - L = E $150 - $100 = $50
That is, your business is now worth $50! Keep buying ingredients, selling donuts, and you’re on your way to paying your friend back. Your equity (or worth) will go up and up, and you’ll become a zillionaire. Whatever you do, don’t let your equity go below zero. That would be bad!
Let’s move on to nonprofit accounting, and I’m sorry to say it’s weirder, less intuitive, and perhaps more boring than what I’ve covered so far.
We have the same story, except now your friend donated $100 to your organization instead of loaning it to you, so you owe nothing. That is you start with:
H - O = W A - L = E $100 - $0 = $100
After you buy your ingredients, make and sell your donuts for $50, and you have this:
H - O = W A - L = E $150 - $0 = $150
From a capitalist’s point of view, this looks way better than the for-profit scenario above. But now, I need to introduce a change or two to better reflect the nonprofit reality.
Terms like “worth” and “equity” imply that the business has an owner, but a nonprofit doesn’t have owners, so we have to throw these terms away. Instead, nonprofit accountants use the term “Net Assets”, so the nonprofit accounting equation looks like this:
A - L = NA
See how boring that got? No ale. Not even any words that make it easier to remember. Fortunately, we’re still in the donut business.
Oh, and one other thing. When the donor gave you the money they said “Here’s $100. Use it to buy yourself a new deep fat fryer.” Nonprofit accounting rules call this a “restricted donation,” and you are now required to either buy the deep fat fryer, or refuse to take the money. That is, the donor had some “strings” attached to the donation. So, if you take the money, you need to track it as “Restricted Net Assets” (and separate it from any “Unrestricted Net Assets”).
Now you have $100 in restricted net assets, so this is what things look like:
A - L = RNA + UNA $100 - $0 = $100 + $0
Unfortunately, you cannot go buy any ingredients for your first batch of donuts since all your money is committed to the purchase of a deep fat fryer. So you spend $100 on that piece of equipment instead, and now you get this*:
A - L = RNA + UNA $0 - $0 = $0 + $0
Yep. You’ve used up your restricted money, but now you have no cash to buy the ingredients with, so you need to go back out and raise more money in order to start up your activities. Of course, you now have a deep fat fryer, which is good, but that may not have been your first priority.Restricted donations can cause a lot of “hoop jumping” when starting a nonprofit organization. Click To Tweet
Essentially, it’s important to try to get as much restriction-free money in the door as possible, so you have the leeway to do whatever is necessary to run your operations.
When it comes to foundation and corporate grants, this can be a major issue, since many of them comes with “strings attached,” and finding unrestricted grants can feel like searching for the Golden Fleece.
It’s also important to understand how promising to do something specific with donated funds can make donations of cash restricted when they don’t need to be. Saying “Please help us by donating money to buy new office furniture” can create a restriction on the donation, but saying “We have lots of needs, like office furniture. Please help with a donation” will not.
It’s also important to understand all the costs involved in delivering your services, including things that may seem tangential or unrelated to your main work from the perspective of prospective donors. This helps you create a compelling story that can help you pitch your idea to potential funders, a story that will let them be excited about giving you unrestricted funds, or at least restricting those funds to things you actually need.
Hopefully, this is a story that isn’t as boring as these nonprofit accounting rules. I suggest grabbing a donut and a pint of ale and thinking about how these things are made while crafting that story.
* Real accountants know there’s more to it than this, since the equipment you bought could still be an asset, but let’s forget that for now and keep it simple.