Financial Management of Not-for-Profit Organizations

Financial Management of
Not-for-Profit Organizations
Introduction Contents
Introduction...................... 1
Financial management of not-for-profits is similar to financial management in the commercial sector in

many respects; however, certain key differences shift the focus of a not-for-profit financial manager. A for- Budgets........................... 1

profit enterprise focuses on profitability and maximizing shareholder value. A not-for-profit organizations Asset Management.......... 5
primary goal is not to increase shareholder value; rather it is to provide some socially desirable need
The Use of Fund
on an ongoing basis. A not-for-profit generally lacks the financial flexibility of a commercial enterprise
Accounting....................... 7
because it depends on resource providers that are not engaging in an exchange transaction. The
Summary........................ 10
resources provided are directed towards providing goods or services to a client other than the actual
Bibliography................... 10
resource provider. Thus the not-for-profit must demonstrate its stewardship of donated resources

money donated for a specific purpose must be used for that purpose. That purpose is either specified

by the donor or implied in the not-for-profits stated mission. The management and reporting activities

of a not-for-profit must emphasize stewardship for these donated resources. The staff must be able to

demonstrate that the dollars were used as directed by the donor. The shift to an emphasis in external

financial reports on donor restriction has made the use of fund accounting systems even more critical.

Budgeting and cash management are two areas of financial management that are extremely important

exercises for not-for-profit organizations. The organization must pay close attention to whether it has
enough cash reserves to continue to provide services to its clientele. Cash flow can be extremely

challenging to predict, because an organization relies on revenue from resource providers that do not

expect to receive the service provided. In fact, an increase in demand for a not-for-profits services can

lead to a management crisis. It is difficult to forecast contribution revenue in a reliable manner from year

to year. For that reason, the control of expenses is an area of increased emphasis. Budgeting therefore

becomes a critical activity for a not-for-profit.

Budgets

Budgets are the organizations operating plan for a fiscal period. They express, in monetary terms, the

boards and staffs decisions regarding how the organization will fulfill its stated purpose. The board

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 Financial Management of Not-for-Profit Organizations
and staff decide what programs will be undertaken for the upcoming fiscal year. The staff then allocates The budget, once adopted,
resources to ensure that those programs are delivered. The budget charts a direction for allocating should be used by the
and maximizing the use of resources. Ideally it also identifies any financial problems that could arise in staff as a management
the coming year. In addition, the budget should provide indicators for gauging staff performance and tool to gauge operational
give staff goals to reach and steps to achieve them. Methodical tracking and classification of program performance. An effective
expenditures enhance managements ability to report on service efforts and accomplishments. budget should establish
criteria that would signal
Budget planning issues management if a change
is needed or if a course of
The scope and size of a not-for-profits programs and asset base dictate the complexity of its budgets. In
action should be refined
its most complete form, a budget is a compilation of the plans and objectives of management that covers
or altered.
all phases of operations for a specific period of time. If a goal of an organization is to build working

capital, it might want to project a budget imbalance of revenues over expenses. However, building too

much of a surplus too aggressively might indicate to users of financial statements that the organization

is not effectively carrying out its stated purpose. Program priorities should be balanced in an effective

budget. The not-for-profits management must allocate its capabilities and resources to impact the

maximum number of the intended audience or beneficiaries. Not-for-profit organizations that charge for

their services might not be able to easily increase their prices for their programs.

Lead-time for grant requests and multiyear programs must be factored into the budgetary planning

process. The financial manager of a not-for-profit must prepare the budget to ensure adequate funds

for programs slated to be run over a period of time longer than the average budget cycle. The budget,

once adopted, should be used by the staff as a management tool to gauge operational performance.

An effective budget should establish criteria that would signal management if a change is needed or if a

course of action should be refined or altered. A budget that is updated for new situations enhances its

value as a monitoring system. As unforeseen conditions arise, the budget should be tailored to respond

to those conditions. Staff and management accountability is an aspect of budgeting; responsibility should
be associated with those that are actually capable of realizing the goals. Without active awareness and

participation of those carrying out the organizational mission, a budgets usefulness is diminished.

Zero-Based versus Incremental budgeting

Zero-based budgeting incorporates the planning process for setting organizational objectives as part

of the budgeting process. An organization starts from zero by assuming that no program is necessary

and that no money need be spent. Programs that will be continued have to be proven worthy as well as

fiscally sound every fiscal year. Zero-based budgeting involves an orderly evaluation of all elements of

revenue and expense. Each program must be examined to justify its existence as well as its effectiveness

as compared to alternative programs. Programmatic priorities should be established. Each cost center

should be challenged to prove its necessity. Each cost centers contribution to the overall organizational

objective should be measured. Goals and objectives should be clear as well as quantitatively measurable.

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 Financial Management of Not-for-Profit Organizations
Incremental budgeting treats existing programs and departments as pre-approved, subject only to A thoroughly planned
increases or decreases in financial resources allocated. A not-for-profits historical costs are the usual and implemented budget
base from which budget planning starts. The focus is on the changes anticipated over or under last enhances the likelihood
years numbers. The planning process is considered complete and program priorities as established. The that a not-for-profit will
organization must decide whether its budget is to be based on measurable and predictable statistics or be financially successful.
only on good guesses. A comprehensive budget
is a tool that translates
Types of Budgets abstract goals into
controllable parts. It
The basic budget is a comprehensive look at the entire organizations overall projection of the revenues
stipulates performance
or financial support and its expected expenditures. Specialized or supplemental budgets can provide
goals for the upcoming
a specific focus on fragments of financial activity germane to individual programs or revenue centers.
year.
An example of a supplementary budget is the quantification of membership goals for a given year.

This portion of a budget guides the business offices cash flow projections as well as the development

offices annual goals and objectives for fund-raising activities. The program department might be affected

throughout the year as membership projections are matched up with the actual membership numbers.

Useful potential budget reports include:

Annual, quarterly or monthly projections of income and expenses for the entire organization as well

as of each of its divisions, departments, and branches

Revenue projections by type contributions, tuition, fees for services

Individual project, department, branch or other cost center projections

Service delivery costs by patient, student, member or client; potential capital additions building

or equipment acquisition

Cash flow short and long term

Historic and projected fund-raising event revenue and expense

Book store, pharmacy or resale shop sales if applicable

Staffing models

A thoroughly planned and implemented budget enhances the likelihood that a not-for-profit will be financially

successful. A comprehensive budget is a tool that translates abstract goals into controllable parts. It

stipulates performance goals for the upcoming year. The planning and preparation process leading to a

budget forces the organization to set priorities and to narrow its choices. A budget can facilitate coordination

and cooperation between the various programs and financial departments. Periodic budget comparison to

actual financial performance can reveal problems and should allow the board and staff to respond quickly

to changing financial conditions. The budget provides a measurement of financial performance in relation to

the not-for-profits expectations; it guides financial decision-making over the course of a fiscal year. There is

a natural tendency to emphasize cost control because of uncertainty, and the presence of such controls can

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 Financial Management of Not-for-Profit Organizations
stifle creative responses to a change in demand for an organizations services. The board and senior staff The six stages of capital
should provide leadership as to the usefulness and flexibility of the budget. The budgeting process and the budgeting include
subsequent use of the budget as a touch point for financial performance should not overshadow the ability of identification, search,
an organization to respond to the pace of rapid societal change. information acquisition,
selection, financing, and
The master budget coordinates all of the financial projections in the organizations individual budgets in
implementation and
a single organization-wide set of budgets for a set time period. It encompasses both operating decisions
control.
and financing decisions. Operating decisions focus on the acquisition and use of scarce resources.

Financing decisions focus on how to get the funds to acquire resources. The use of rolling budgets

ensures that a plan is always available for a specified future time period by adding a month, quarter or a

year in the future as the month, quarter or year just ended is dropped. A rolling budget continually forces

management to think concretely about the coming 12 months regardless of the month at hand.

Steps in preparing a budget

The revenue budget is generally the starting point in a budget planning process because program delivery

will depend on the forecasted level of revenue. The second step is program or project budget how

much should be offered to support the estimated level of service revenue. Fund-raising goals will also

determine programmatic service levels because service revenues alone will not necessarily finance

all program offerings. How much money the development office plans to raise over the fiscal year will

determine the extent of current and future program offerings.

Capital Budgets

Capital budgeting is the process of making long-term planning decisions for investments. Poor long-term

decisions can affect the future stability of an organization because it is often difficult to recover money

tied up in bad investments. Good long-term decisions help an organization to extend its reach into the

community and to expand the services it provides.

The six stages of capital budgeting include identification, search, information acquisition, selection,

financing, and implementation and control. The identification stage involves distinguishing which types

of capital expenditure projects are necessary to accomplish organizational objectives. The search stage

explores several alternative capital expenditure investments that will achieve organizational goals. The

information acquisition stage considers the predicted costs and consequences of alternative capital

investments. In the selection stage, projects are chosen for implementation.

There are several methods that can be used for the selection process. The discounted cash flow method

measures cash inflows and outflows of a project as if they occurred at a single moment in time. This

method recognizes the time value of money by discounting the future cash flows back to the proposed

date of capital investment. Then the initial cash outlay measured in todays dollars is compared to

tomorrows inflows of cash also measured in todays dollars. Thus the measurement compares apples

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 Financial Management of Not-for-Profit Organizations
to apples. After the budget is
developed, the not-
The net present value method uses the required rate of return that is the organizations minimum
for-profit must focus
acceptable rate of return on an investment. It is the interest rate organizations could expect to receive
on smoothly financing
elsewhere for the same level of risk. The present values of the cash inflows and outflows are calculated at
current operations by
the organizations cost of capital. These values are then summed to determine the projects net present
making the most efficient
value. If the value is positive, the project should be accepted. If an organization is considering more than
use of current or liquid
one capital investment, the projects with the highest net present value should be chosen. funds, and by maximizing
available and obtainable
The third option is to measure the internal rate of return. The internal rate of return is the discount rate at
resources to enhance
which the present value of the cash inflows equals the present value of the cash outflows on a particular
return on the resources
project. The internal rate of return is that discount rate that makes the net present value equal zero. The
or capital.
three calculations the discounted cash flows, the net present value and the internal rate of return

tell an organization something slightly different about the proposed capital investment. When evaluating

such an investment, all three methods should be used on each alternative investment. The organization

should select the investment that provides the greatest rate of return across all of the measurements.

Project funding is obtained in the financing stage. Sources of funding can be internally generated cash or

through debt from the capital markets. The implementation and control stage puts the project in motion

and provides for ongoing monitoring of investment performance.

Asset Management

A not-for-profits resources or assets are best managed from the going concern perspective, which

assumes no limitation on the organizations future existence. Management must be sure that the

organization has sufficient liquid assets available to finance current operations. The goal is to maintain

an optimum balance between available assets and invested or growing assets. Operating in a fiscally

solvent fashion means that the organization must be able to pay its debts in a timely manner and
meet other financial responsibilities. After the budget is developed, the not-for-profit must focus on

smoothly financing current operations by making the most efficient use of current or liquid funds, and by

maximizing available and obtainable resources to enhance return on the resources or capital. Maximizing

resources involves analyzing the costs and benefits of various sources of not-for-profit revenues. Two

possible sources of income are business income and planned gifts. Business income earned by a not-for-

profit must be segregated between that earned in pursuit of its mission and that from activity undertaken

simply to make money.

Cash flow planning

Cash is a vital resource for a not-for-profit organization. To maintain financial viability, the organization

must have enough cash to pay its bills. Accrual basis financial statements can report an excess of

revenues over expenses but this does not necessarily mean that there is cash in the bank. Cyclical and

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 Financial Management of Not-for-Profit Organizations
seasonal fluctuations also have an impact on an organizations cash. Cash inflows and outflows for most The total return concept
not-for-profits typically fluctuate throughout the year. This increases the importance of the budgeting is a relatively new
process because obligations must be met on a timely and consistent basis. The organization must plan concept in endowment
ahead for those periods when cash inflow tends to be less than cash outflows. Postponing expenditures management. Any
or accelerating constituent billings are two options for solving the problem. appreciation in asset
value used to be treated
Once the annual operating and capital budgets are authorized, they can be converted into cash flow
as an addition to principal;
budgets to verify the availability of resources and to highlight times of lower than expected cash flow. The it is now thought of as
process includes estimating when collections on year-end receivables will occur; calculating the normal income.
time lag between invoicing or billing for services or pledges and the actual receipt of cash; and charting the

expected expenditure of cash according to the month payment is due. Then factor in the expected capital

expenditures, sales of assets, borrowing, debt repayment and other financing transactions. A model cash

flow budget reflects a policy decision to maintain a minimum cash level. Organizations need to plan from

day one to build working capital reserves equivalent to at least several months of operating expense. When

excess cash reserves have accumulated, the organization must plan for temporary cash investments to

maximize the return on those resources. As much money as possible should be kept in federally insured,

interest bearing accounts to maximize an organizations yield on its cash. Short term investments of excess

cash should be chosen to balance maximization of interest earned with emergency access to the invested

cash. Some options are certificates of deposit, treasury bills, and money market accounts.

Once cash reserves exceed the amount needed for one operating cycle, longer-term investments need to

be evaluated. Investment policies must weigh the permissible level of risk to the organizations resources

in relation to expected returns. Any equity or debt investments chosen will depend on the boards written

investment policy. If the not-for-profit is a trustee on a charitable remainder trust, then it is under a duty to

the ultimate beneficiary to invest and manage the funds of the trust as a prudent investor would, in light

of the purposes, terms, distribution requirements and any other circumstances of the trust.

Under common law, the not-for-profit owes a fiduciary duty to its contributors and grantors to use gifts

for the purposes for which the funds are given. A mechanism for tracking donated money and its use

must be in place. Many organizations achieve this by isolating restricted gifts. There can be additional

accounting expense associated with a restricted gift. Grant expenditures often require very specialized

reporting to granting agencies.

Endowment Management

Not-for-profit managers and board members face numerous questions when making endowment

management decisions. How many years must the endowment remain restricted? Can the funds be used

for another purpose in a time of crisis? Are realized gains treated as current income? Is the endowment

principal defined as its original sum or is it the original sum plus all appreciations less declines in

underlying values? Do the original endowment creators wish the original asset to be retained? Can it be

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 Financial Management of Not-for-Profit Organizations
sold? If sold for cash, is there any restraint on the way the cash may be reinvested? Must it be offered to Other fund balances,
a particular person first before the not-for-profit can sell the original asset? including those arising
under agreements with
The total return concept is a relatively new concept in endowment management. Any appreciation in
trustees under bond
asset value used to be treated as an addition to principal; it is now thought of as income. The Ford
indentures and those
Foundations study of 1969 The Law and Lore of Endowment Funds stated:
designated by the
Prudence would call for the retention of sufficient gains to maintain purchasing power in the face of
organizations governing
inflation and to guard against potential losses, but, subject to the standard that prudence dictates, the
board for the purchase,
renewal or replacement of
expenditure of gains should lie within the discretion of an institutions directors.
property and equipment
In addition, many states have adopted the Uniform Management of Institutional Funds Act (UMIFA). The should be classified as
act sanctions the inclusion of gains (realized and unrealized) in currently expendable income alongside unrestricted net assets.
dividends and interest. Therefore, total return is now reported on the Statement of Activities. The National

Association of College and University Business Officers (NACUBO) advocates this policy. The AICPA

Auditing Guide for Not-for-profit Organizations provides that the governing board may make a portion

of realized, and in some cases unrealized, net gains available for current use. The unexpended increase

or decrease in value (appreciation) of the securities remaining in the investment portfolio is reported as

temporarily restricted funds under Financial Accounting Standard 117.

The Use of Fund Accounting

Fund accounting is a method for recording resources whose use may be limited by donors, granting

agencies, governing boards, or other individuals or entities or by law. Each fund consists of a self

balancing set of asset, liability, net asset, revenue and expense accounts. Fund balances or net assets

should be classified on the statement of financial position as unrestricted, temporarily restricted and

permanently restricted net assets based on the existence and type of donor-imposed restrictions. Using

a fund accounting system allows an organization to segregate financial resources between those dollars
immediately available for ongoing operations and those dollars intended for a donor specified use. In

addition, a fund accounting system provides an audit trail as the dollars are spent for their intended

purpose and thereby released from the restriction.

Receivables and payables between fund groups are not organizational assets or liabilities. A statement

of financial position must clearly label and arrange those interfund items to eliminate their amounts when

displaying total assets or liabilities. For external reporting purposes, a fund balance may have to be

divided among more than one net asset class.

Operating Fund

Also known as the unrestricted current fund, this fund is used to record organizational activity that is

supported by resources over which governing boards have discretionary control. The principal sources

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 Financial Management of Not-for-Profit Organizations
of unrestricted current funds are unrestricted contributions from donors; exchange transactions with

members, clients, students, customers and others; and unrestricted investment income. Resources are

used to help meet the costs of providing the organizations programs and supporting services.

Restricted Current (Restricted Operating or Specific Purpose) Funds

These fund types are used to record organizational activities that are supported by resources whose use

is limited by external parties to specific operating purposes. Principal sources of restricted current funds

are contributions from donors; contracts; grants and appropriations; endowment income; and other

sources whose resource providers have stipulated the specific operating purpose for which the resources

are to be used. Fund balances of current restricted current funds represent net assets held for specified

operating activities that have not yet been used. A portion of the fund balance that represents amounts

contributed with donor-imposed restrictions should be classified as temporarily restricted net assets.

Fund balances representing amounts received with limitations other than donor imposed restrictions,

such as contractual limitations, should be classified as unrestricted net assets. Any portion of the fund

balance that represents an unearned revenue resulting from an exchange transaction should be reported

as a liability.

Plant (Land, Building, and Equipment) Funds

Some not-for-profit organizations record plant and equipment (and resources held to acquire them)

in a plant fund or funds. A plant fund may be a single group of accounts or may be subdivided into

some or all of the following sub fund account groups: unexpended plant funds, funds for renewal and

replacement, funds for retirement of indebtedness and investment (or Net investment) in plant funds.

Unexpended plant fund balances and renewals and replacement fund balances represent net assets that

have not yet been used to acquire, renew or replace plant and equipment. Retirement of indebtedness

fund balances represent net assets held to service debt related to the acquisition or construction

of plant and equipment. Any portion of those fund balances that represents amounts received with
donor imposed restrictions should be classified in the Statement of Financial Position as temporarily or

permanently restricted net assets depending on the nature of the restriction.

Other fund balances, including those arising under agreements with trustees under bond indentures and

those designated by the organizations governing board for the purchase, renewal or replacement of

property and equipment should be classified as unrestricted net assets. Unless the organization has a

formal policy for recognizing an implied time restriction on long-lived assets, these designated resources

would be classified as temporarily restricted net assets.

Investment-in-plant fund balances represent assets invested in plant and equipment less any liabilities

related to those assets. These fund balances should be classified as permanently restricted net assets

to the extent that donors have imposed restrictions that neither expire by the passage of time nor can

be fulfilled nor removed by actions of the organization, or the proceeds from the ultimate sale or disposal

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 Financial Management of Not-for-Profit Organizations
of contributed assets must be reinvested in perpetuity. Amounts representing property and equipment Some not-for-profit
acquired with unrestricted resources or with resources whose use is limited by parties other than donors organizations use loan
should be classified as unrestricted net assets. funds to account for
loans made to students,
Loan Funds
employees and other
Some not-for-profit organizations use loan funds to account for loans made to students, employees and constituents and those
other constituents and those resources available for loan purposes. The assets initially made available for
resources available for
the loans may be provided by donors or various governmental and other granting agencies or designated
loan purposes.
by governing boards. Fund balances of loan funds represent net assets available for lending. They should

be classified as temporarily or permanently restricted if they carry donor-imposed restrictions. They are

classified as unrestricted if they are board designated. Any portion that represents a refundable advance,

such as under a governmental loan program, should be classified as a liability.

Endowment Funds

There are generally three kinds of endowment. A permanent endowment refers to amounts that have

been contributed with donor-specified restrictions that the principal be invested in perpetuity; donors may

also restrict the income from these investments. A term endowment is similar to permanent endowment,

except that at some future time or upon the occurrence of some specified future event, the resources

originally contributed become available for unrestricted or purpose-restricted use by the entity. Quasi-

endowment is a term for resources designated by an entitys governing board to be retained and invested

for specified purposes for a long but unspecified period.

Fund balances of endowment funds represent net assets for which various limitations exist on the

resources invested and, in some cases, on the income generated by those resources. Fund balances

that represent term endowments for which the principal must be maintained for a specific period or must

be used at the end of the term for a specified purpose should be classified as temporarily restricted
net assets. Fund balances that represent quasi-endowments or other amounts designated by the

organizations governing board should be classified as unrestricted net assets unless donor imposed

restrictions are imposed on their use.

Annuity and Life-Income (Split Interest) Funds

Annuity and life income funds may be used to account for resources provided by donors under various

kinds of agreements in which the organization has a beneficial interest in the resources but is not the

sole beneficiary. Examples include charitable remainder and lead trusts; charitable gift annuities, and

pooled life income funds. Fund balances of these funds represent a not-for-profits beneficial interest

in the resources contributed by donors under split interest agreements. If any of these resources will

become part of the permanent endowment when the agreement terminates, they should be classified as

permanently restricted net assets.

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 Financial Management of Not-for-Profit Organizations
Agency or Custodian Funds

Agency or custodian funds are used to account for resources held by the not-for-profit organization as an

agent for resource providers before those resources are transferred to third-party recipients specified by

the resource providers. The not-for-profit entity has little or no discretion over the use of these resources.

Assets always equal liabilities in agency funds. No net assets are reported.

Summary

The budgeting process and the ongoing management of cash and other assets are two critical areas

of focus for not-for-profit financial managers. This focus is dictated by the overarching stewardship

obligations of a charitable organization that receives money from the public to meet a perceived societal

need. Fund accounting is a method that assists the organization in segregating donated money by time

and purpose restriction as stated by external resource providers donors, granting organizations and

governmental entities. Fund accounting systems today can be set up to mimic either traditional fund

accounting principles or to categorize transactions along FAS 117 reporting lines. It is a challenge for a

for-profit commercial system to track the flows of money between funds as time and purpose restrictions

are met. Either way, the management of a not-for-profit using a fund accounting system should consider

two things: the reporting needs of day-to-day financial management and the ability to effectively

demonstrate stewardship of donated resources.

Bibliography

Anthony, Robert N. and David W. Young, Management Control in Not-for-profit Organizations, Richard D.

Irwin, Inc., Boston, MA, 5th Edition, 1994.

Blazek, Jody, Financial Planning for Not-for-profit Organizations, John Wiley & Sons, Inc., New York, NY 1996.

Horngren, Charles T., George Foster, and Srikant M. Datar, Cost Accounting: A Managerial Emphasis,
Prentice Hall, Upper Saddle River, NJ, 9th edition, 1997.

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