2021 FAQs for Nonprofit Accounting: Internal Controls, Functional Expenses and Donor RecordsIn an effort to centralize evergreen content for easy reference by the nonprofit community, Friedman is consolidating material from past Nonprofit Advisor articles, along with previously unpublished insights, in a series touching on frequently asked questions involving nonprofit accounting, financial reporting and tax compliance. The first entry into the series touches on three key aspects of nonprofit accounting: internal controls, functional expenses and donor records.
Internal Controls – Frequently Asked Questions
Why are internal controls necessary?
Implementation of internal controls prevents the misuse and misdirection of assets and builds the foundation for generating information crucial for financial reporting and tax compliance.
Properly implemented internal controls are essential for deterring fraud, misappropriation of assets or fraudulent financial reporting. The “Fraud Triangle,” is a model used to explain the factors contributing to fraud and consists of three components: motivation, opportunity and rationalization. Motivation may be personal financial pressure (misappropriation) or the need to boost results to meet an organizational goal (fraudulent financial reporting). Opportunity is created by a lack of oversight (infrequent internal reporting to the board) or unimpeded access to resources (check signing authority coupled with responsibility for reconciling the bank account). And, because most people don’t think of themselves as crooked, rationalization is the bad actor’s ability to excuse the fraud. It is important to understand the concept of the Fraud Triangle to assess where your organization’s internal controls may fall short.
What types of procedures can be implemented to improve internal controls?
A few suggested procedures include:
- Adopt workflow systems and software to replace handwritten approval documentation and record the formal approval of transactions, with automated or email approvals archived for future reference.
- A bank lockbox can be utilized for cash receipts.
- Segregate duties to avoid the authorization, custody, recording and reconciliation of transactions by one individual.
- Include a presentation of internal accounting reports at each board meeting and document the discussion in the board meeting minutes.
- Compare actual results to budgeted results on a regular basis.
There are technological solutions that can help add oversight, reinforce existing protective processes or introduce new ones, such as:
- Set limits relating to the access and use of credit cards that will ensure purchases are properly authorized.
- Control exposure and risk by setting a low maximum on the organization’s line of credit.
- Designate a process or technology for the oversight and approval of expense reimbursements, and use technologies to automate this process.
- Design controls over human resources and payroll processes using technologies that automate authorizations and approvals and establishes checks and balances.
How do I know if my controls are working?
Test, test, test. Consider what you are testing, and refresh your tests as necessary, when procedures change or the means of tests become familiar. Make sure that the tests you run are designed to identify:
- Expenditures are authorized routinely
- Funds are received when expected and deposited timely
- Donors are acknowledged and donor information is protected
- Electronic files are secured from corruption, theft or loss
- Access to data and systems are limited to only those who need it
- Access to financial assets (bank and investment accounts) is properly secured and limited
Functional Expenses – Frequently Asked Questions
Why are functional expenses important?
The three functional classifications – program, management and general, and fundraising – can also be thought of as departments. Many organizations will have further differentiation within the program department, as costs associated with individual programs need to be captured and reported to the funding source for the program. Direct costs for each functional classification should be easy to identify. It becomes tricky when determining the allocation of indirect and overhead costs between program(s), management and general, and fundraising. Nonprofit organizations need to understand the reasoning and basis for allocating those costs.
How does the organization calculate the allocation of indirect and overhead costs?
When done accurately and consistently, cost allocations provide a realistic picture of the total cost of different programs and the supporting services: management and general and fundraising. This information becomes critically important as nonprofit organizations work to stretch reduced resources and determine whether they must discontinue certain programs. In addition, many nonprofit organizations are required to report reimbursable expenses annually to funding sources. How the organization reports these expenses has a direct impact on the bottom line and potentially impact fundraising decisions.
How can the organization ensure functional expenses are correctly reported?
Before a nonprofit organization performs functional allocations, accounting for expenses within the natural classification (salary, office expense, travel, etc.) needs to be accurate and can be documented as part of the expense approval process. Spreadsheets outside of the accounting software package may need to be developed to support entries recording allocations between the various functions. The “department” financial statements that result should then be compared to approved budgeted amounts and variances analyzed.
What are functional expense allocation best practices?
- Documenting the functional allocation plan in writing. It is important that the methodology for allocating expenses can be easily communicated to the organization’s governance board, the independent auditors and financial statement users. By documenting the plan in writing, it is easier to substantiate the plan’s reasoning and update as needed.
- Identifying the type of expense transactions that are directly allocated to one of the functional categories, or those that need to be allocated amongst several categories. Further, if there are multiple program service offerings, it is important to identify the type of expense transactions that are directly or indirectly allocated to each program. Accurate cost allocation between programs is important for grant reporting purposes and for determining the overall success of a particular program.
- Maintaining timesheets for individuals whose responsibilities include tasks that fall into more than one functional category or program. The time sheets should reflect the amount of time in a given week (or month) that the individual spends on program type services, administrative services and fundraising services. It is important that the individual maintaining the time sheets understands the definitions of the functional categories and the difference in programs.
- Overhead costs, including rent and utilities, can be allocated based upon the square-footage that each of the three functional categories occupies.
- Establishing a chart of accounts within the accounting system that includes each of the functional classifications facilitates the allocation process in an efficient manner.
- Remaining consistent with the functional and cost allocation plan. Special exceptions to the plan should be minimal.
- Reviewing the allocation methodology at least annually. It is not uncommon for the funding stream of nonprofit organizations to change or for there to be a change in the make-up or responsibility of personnel. Assess the allocation ratios and compare with the ratios of similar organizations.
Donor Records – Frequently Asked Questions
Why does a nonprofit organization need to maintain donor records?
Donor records are essential to maintain for a variety of reasons, such as donor engagement, financial reporting and tax compliance.
Nonprofit organizations can’t engage their donors if they don’t keep records that show who their donors are. There are many different types of donor data base products available that are designed to track donors by name, address and contributions made. Good donor records are part of robust internal reporting policies and procedures.
Recording donor engagement
Donors need to maintain acknowledgements to document the tax deductibility of their contributions. Nonprofit organizations should automatically send acknowledgements that include the information required by the Internal Revenue Service.
Donor engagement includes much more than sending out acknowledgements, such as sharing outcomes and outputs from valuable program services and coordinating with the development department to encourage current giving and cultivating planned gifts.
Financial reporting and disclosures
Contributions can be conditional or unconditional, restricted by time or purpose, or unrestricted. Each of these types of contributions can come in a number of different vehicles. Financial reporting requires disclosures related to major donors and restrictions. Donor’s conditions and restrictions on contributions will impact how the contribution is recorded and reported.
There are complex tax compliance requirements to be met by not-for-profit organizations as well that require:
- Reporting aggregate contributions by donor annually
- Reporting aggregate contributions by donor groups that are statutorily related on a rolling five-year basis that exceed 2% of total contributions
- Issuing acknowledgements to donors
Whether your nonprofit is just getting off the ground or revisiting some of its policies and procedures, you may need an expert’s insight. If you have any questions about any of the topics covered in this inaugural edition of Nonprofits – Back to the Basics, contact us today. Don’t forget to subscribe to Nonprofit Advisor so you can get the next edition of this series as soon as it’s available.