Financial Management for NPO

I. Introduction
“Ten years ago, management was still a dirty word for those involved in nonprofit organizations. Nonprofits prided themselves on being free of the taint of commercialism and above such sordid considerations as the bottom line… Today, nonprofit organizations have learned that they need management and leadership even more than business does…” (Montana and Petit, 2009)

The years when “management” was a prohibited word in nonprofit organizations are long gone. Nowadays, nonprofit leaders are starting to realize what an essential role financial management plays in NPOs. Moreover, as the number of nonprofit organizations around the world keeps rising, more nonprofit leaders and managers have aimed to develop their skills in financial management. As a matter of fact, the nonprofit sector is one of the fastest-growing sectors around the world: just in the United States there are 1.5 million nonprofit organizations and growing, employing one in 10 American employees.
In this paper, we will look at: 1) the financial management process, 2) the importance of financial management for nonprofit organizations, 3) financial management for nonprofits organizations.

II. What is Financial Management?
One of the most accepted definitions of financial management was given by Kuchal, stating that “Financial Management deals with procurement of funds and their effective utilization in the business” (as cited in Paramasivan & Subramanian, 2008).
Konrad and Novak (2000) set the steps of the financial management process as follows: planning, budgeting, organizing, controlling and evaluating. 1. Planning
2. Budgeting
3. Organizing
4. Controlling
5. Evaluating
1. Planning
2. Budgeting
3. Organizing
4. Controlling
5. Evaluating

Figure 1. Financial Management Process. This figure illustrates the different steps of Financial Management.

Basically, the financial process is quite simple: the first thing that needs to be done is to plan the activities that need to be completed. It’s in this step when the organization sets goals and objectives, and decides how these objectives will be achieved. Once the plan is approved, the organization has to develop a budget or expenditure. Budgeting has to be done by relying on financial information about past performance and the organization’s future plans. It’s important that the organization sets realistic goals and budgets, to make sure that the objectives are achieved.
After this, organizing and controlling have to be done, to track the progress and to make sure that everything is done according to what was agreed upon. After completing all of these steps, it’s important to evaluate, to be able to measure how effective the project was and to make sure that all of the objectives were achieved.

III. Financial Management: The Difference Between Non-Profit Organizations & Profit Organizations
In many aspects, financial management of not-for-profits is very similar to financial management in the private sector. However, there are still certain key differences that have a considerable impact on the financial and accounting methods for each organization. * Goals. A for-profit enterprise focuses on profitability and maximizing shareholder value. A nonprofit organization’s primary goal is not to increase shareholder value; on the contrary, the goal of nonprofits is to provide a socially desirable need. * Tax Exemption. For-profit organizations must pay taxes on their net income, but this is not true for nonprofits if they are exempt from taxes. If a nonprofit's goal is to increase the welfare of society, then governments help this cause by minimizing the nonprofit organization’s costs as much as possible. It is these differences between the two types of organizations that can have a big impact on each type's accounting methods. * Balance Sheets. Most for-profit organizations prepare a balance sheet every quarter, listing the company's owner's equity with all of the company’s assets and liabilities. Nonprofit organizations have no owners, so the organizations’ balance sheet will be completely different than the balance sheets of a profit organization. Instead, most of the ‘balance sheet’ will only be a focus on the organizations’ assets and liabilities. Accountants then scrutinize net assets to assess the financial size of the nonprofit. * Financial Flexibility. A nonprofit organization’s financial management and a for-profit organization’s financial management are very different in a very important aspect: a nonprofit organization usually lacks the financial flexibility that a for-profit organization has. For example, a nonprofit organization has to provide evidence of the donated resources – that the money donated for a specific purpose was actually used for that purpose. The importance of demonstrating that the money was used as intended has made the use of financial management in NPOs even more critical.

Figure 2. Differene between For-Profit and Nonprofit Organizations.

IV. The Importance of Financial Reporting for Nonprofit Organizations
Financial reporting in nonprofit organizations should be done both internally and externally.
A. Internal Financial Reporting
Internal financial reporting is of extreme importance in a nonprofit organization. Internally, the organization’s staffs are both creators and users of financial reports. This staff collects the appropriate data, manage the associated information systems and create financial reports. Managers are responsible for financial integrity, risk, quality, program delivery and other key internal responsibilities and use these to fulfill their responsibilities and meet organizational goals.
There are some financial reports that have to be submitted to the board and/or board committees. Financial reporting to the board of an NPO tends to follow a natural cycle: * The budget for the coming year (prepared by management, usually influenced by, but not identical to, management’s year-end estimates from the preceding year and other information) * Audited financial statements for the previous year (issued usually in the first or second quarter of the next fiscal year) * Internal in-year financial statements to report on actual results compared to the budget, often including projected results to year.

B. External Financial Reporting
Nonprofit organizations also have to do external financial reporting. NPOs have many stakeholders and each one has an interest in the financial affairs of the organization. All stakeholders are interested in some areas such as the protection of the assets entrusted to the organization and the efficient and effective use of the organization’s resources in the accomplishment of its goals.
These are some examples of stakeholders and their interests in the financial affairs of nonprofit organizations: * Funders (for example, governments or foundations) want assurance that their contributions to the organization have been used in accordance with the funding submission and subsequent approval, * Donors (particularly major donors) want assurances that their contributions have been applied according to their wishes, * Members have an interest in how their fees have been deployed and more generally in how the organization is performing.

All nonprofit organizations have the duty to report all of the above to its stakeholders. Financial statements and other financial reports are communication tools that the organization uses to meet the information needs of its stakeholders.

V. Financial Statements for NPOs
In order to be able to effectively do financial reporting, whether it is to inform stakeholders or to monitor in-year results, it is necessary to provide financial statements. These financial reports, or financial statements, summarize all financial transactions of the organization and showing its assets, liabilities, net assets, revenue, public support and expenses. Despite having many different ways of reporting finances, two of the most important financial statement typically includes: * Statement of Financial Position (or Balance Sheet) * Statement of Activities
Because these two statements are vital to understand the organization and its financial position, it is important that managers pay special attention to these two financial statements. A. Statement of Financial Position
The Statement of Financial Position, sometimes called the “Balance Sheet”, is one of the basic financial reports which indicate the resources of an organization and how they are financed. Taken at a point in time, the statement demonstrates Assets equal (i.e., balance) the sum of Liabilities and Net Assets.
The statement of Financial Position will show an organization’s: * Assets — Assets are all the things owned by the NPO or owed to the NPO. Examples of owned items are cash, short or long term investments, buildings, furniture and even vehicles. Owed assets are typically accounts receivable, where money is to be received in the future. An example of assets owed is program fees that have been committed, but not yet received. Another example are prepaid expenses where the NPO will receive services in the future for amounts already paid. * Liabilities — Liabilities, commonly called accounts payable, are amounts that the NPO owes to outside parties, where money will be paid out in the future. Current liabilities are those liabilities that are due within the accounting year, such as accounts payable, accrued salaries, and current portion of long-term debt. Long-term liabilities are those liabilities that are due during the following accounting years, such as portion of long-term debt due in subsequent years. * Net Assets – Net assets is the difference between what is owned by the organization and what is owed by the organization. In other words: Net Assets = Assets – Liabilities. Net Assets can be thought of as the amount that is available for the organization to use in the future to continue its operation and achieve its goals.

The Statement of Financial Position organizes assets and liabilities in order of liquidity. Current assets and current liabilities are typically listed first, being items that are available (assets) or need to be paid (liabilities) within the coming year. Below current assets and current liabilities are long-term assets and long-term liabilities. These long-term items are not expected to become cash or require payment (or be otherwise used) within the next year. Ordinarily, the organization will have more assets than liabilities, and what is left over — the net assets — are shown below the liabilities, to balance the equation. B. Statement of Activities
As stated before in this paper, a nonprofit organization’s primary purpose is not to profit from its activities, on the other hand, its main purpose is to provide programs to meet certain social needs. Because of this, nonprofit organizations usually issue a Statement of Activities, instead of issuing the Income Statement that for-profit businesses issue.
The Statement of Activities reports the organization’s financial activities over a period of time, such as the most recent year. In other words, the statement of activity shows income minus expenses, which results in a profit or in a loss. Moreover, it reports all the income the organization has received during the year, and identifies amounts temporarily or permanently restricted by donors.

The statement of activities shows: * Sources of revenue and public support by category (for example, it categorizes government contracts, fees for services, foundation and corporation grants, contributions, interest income, etc.) * Expenses by functional classification (for example, it classifies by administration, fundraising, membership development, program A, program B, etc.) * Change in net assets (for example, the difference between income and expense) by net asset classes (i.e., unrestricted, temporarily restricted & permanently restricted)

VI. Internal Control
Nonprofits, like all organizations, are vulnerable to theft and misguided use of funds for unauthorized purposes. Because of this, there are internal control procedures designed to improve the quality of information and reduce the possibility of error, fraud, and mismanagement. These procedures actually assist management in achieving the organization’s goals.
The purpose of internal controls is: * To ensure the reliability of financial records. Managers and nonprofit leaders depend on accurate financial information to make financial decisions. Program planning is influenced by the financial performance of the program and demonstrated in the financial statements. * To safeguard the organization’s assets. Money and the physical assets of an organization can be stolen, misused, or accidentally destroyed unless they are protected by adequate controls. * To promote operational efficiency. Controls within an organization reduce unnecessary duplication of effort and guard against misallocation of resources. * To encourage adherence to management policies. Management establishes certain procedures and rules to encourage the pursuit of the organization’s goals. With the proper controls in an organization, we can ensure that staff adheres to such policies.

The internal control system may vary depending on the size of the organization. In an organization with very few employees, in which the manager of the organization can actually provide direct supervision, then few controls are needed. However, in a bigger, more complex organization, more controls will be needed to ensure the reliability of the financial records and safeguard the organization’s assets.
Although internal controls can vary according to the size of the organization, there are a few fundamentals that all internal control systems should have. The elements of an effective internal control system include: * Segregation of duties — All responsibilities in the organization should be divided among different employees, to reduce the opportunity for committing fraud or unintentional errors. * Board and staff accountability — The organization has to have clear definitions of responsibility and clear lines of authority. * Record keeping and information systems — Maintenance of accurate financial information, with appropriate supporting documentation and authorizations. * Audit trail — A means by which a transaction can be followed from either end: from the original source document to the final record or from the final record to the original source document. * Policies and procedures — Written operating policies and procedures such as personnel policies, and accounting policies and procedures. It’s not enough to only implement these policies and procedures, but they should be checked and updated at least once a year. * Evaluation mechanisms — The internal controls system in the organization should be evaluated and updated periodically to be effective.

Once again, depending on the size, number, and nature of transactions in a nonprofit organization, controls may be variously distributed. In a small organization, some overlap of duties will be necessary. A key principle is the “segregation of duties”; one staff person should not handle a financial transaction from beginning to end. As a matter of fact, the most effective procedures are those that have the greatest segregation of duties, because the more people involved in the process, the less likely it is that an error or mismanagement of funds will occur.
If implemented correctly, having internal controls in an organization are necessary and helpful. However, these controls do not guarantee that funds will not be stolen or misused. Management has to be careful to control all aspects of the organization to prevent misusage of funds and theft.

VII. Conclusions
Nonprofit organizations continue to grow and expand around the globe. The days in which nonprofits and management were never used in the same sentence are long gone. Nowadays, nonprofit organizations face considerable pressure to report its day to day finances and to demonstrate how it effectively used its donated resources.
Because of this pressure, it is now more important than ever for nonprofit organizations to have an effective financial management process. It is the nonprofit organizations manager’s job to use effectively use the financial information provided to them. In the long run, this financial information will help to guide operations to make the best possible use of the organization’s financial resources, to help achieve organizational goals.