Financial Management of For-Profit and Nonprofit Organizations

by
Kamilah A’Vant
Submitted to
MGMT 640 9040

November 13, 2011

EXECUTIVE SUMMARY This paper will outline the similarities and differences between for-profit organizations and nonprofit and organizations. Many view for-profit and nonprofit companies as very different business organizations; however they have many commonalities. Both for-profit and nonprofit organizations are corporations. As a corporation, both are legal enterprises created to operate and transact business. Corporations hire employees to manage day-to-day activities and act in its best interests. For-profit and nonprofit companies work to control spending, find ways to bring in revenue, operate under organizational structures and utilize accounting practices to track and report how efficiently assets are used. Nonprofit organizations fall under a large umbrella in respect to size and mission. The environment under which they do business helps set them apart from for-profit companies. Nonprofit companies have a great need for their services, face cuts in funding and capital limitations. In this paper I will focus on the financial management techniques used by for-profit and nonprofit companies. I will address the following questions:
• What are the sources of funds available to for-profit and nonprofit companies?

• Is there a conflict between the mission and bottom line of nonprofit companies?

• What types of control functions and governance mechanisms face for-profit and nonprofit companies?

• What financial reporting is used by for-profit and nonprofit companies?

To help illustrate some of the issues, I will use affordable housing providers as an example of how a nonprofit organization operates. Before affordable housing provider can fulfill their mission and develop more affordable housing, they have to find revenue streams such as obtaining organizational and growth capital. By understanding the challenges, funding resources and creating a solid financial plan, nonprofit housing developers can find success in making affordable housing available.

INTRODUCTION For-profit and nonprofit organizations have a number of common characteristics. They have similar organizational structures, make financing decisions to raise capital, establish strategic planning as part of their business model, and use accounting and financial reporting systems to evaluate performance. There are also differences between for-profit and nonprofit organizations. They have different stakeholders which shape their business agendas. Unlike for-profit organizations, nonprofits often face scarce resources and funding challenges. The financial management techniques used by nonprofit affordable housing agencies is a good illustration of the operation of a nonprofit organization and will be discussed below.
THE CORPORATION In the eyes of the law, a corporation is considered a person. It is a legal entity authorized under a state charter and separates liability from individuals that own it (Parrino & Kidwell, 2009). A corporation makes money from selling goods or offering services with the goal of making a profit. Corporations hire directors, officers or members to manage its daily operations. The employees are agents of the corporation and have the responsibility of carrying out the mission or strategic plan of the organization. Managers must establish comprehensive planning, budgeting and performance management processes in place to insure the success of a corporation. Many corporations have a hierarchical organizational structure with various function areas. These different parts of the corporation are all interconnected and work together to fulfill the mission or plan. This includes the finance, marketing, production and human resources. Financial managers must consider the financial strategy of the accounting or treasury function when making decisions (Parrino & Kidwell, 2009). Raising money to operate is critical to run a business. Both for-profit and nonprofit companies are corporations. They have stakeholders, operate under governing boards, find ways to raise capital and use financial reporting and accounting systems to evaluate their performance. Since a corporation operates to make profits, it must maintain financial records to explain how it performs in accordance with GAAP guidelines (Parrino & Kidwell). Nonprofits also wants to generate revenues, however that money is spent to pay for routine operational expenses such as salaries, rentals space and other administrative costs.
FOR-PROFIT ORGANIZATIONS Financial management of for-profits companies is similar to financial management in the commercial environment (Blackbaud, 2011). In a corporation, stakeholders are stockholders and employees make financial decisions that will act in the best interest of the corporation to maximize the firm’s stock price (Parrino & Kidwell, 2009). Successful for-profit entities naturally focus on methods that lead to surplus (Wilson, 2011). Making money is the typical mission of a for-profit company. However, because of recent publicized scandals, many companies are taking their corporate responsibility seriously and incorporating ethics in their business decisions (Parrino & Kidwell). The board of directors is corporate governing body of a for-profit company. It creates and shapes the creation of a company’s image, setting financial decision and the overall agenda. As stated by O’Shannassy, 2010, board of directors are charged with representing stockholders interests, setting strategy and top executives are responsible for implementing them (cited by Ireland & Hitt, 1999). There have been many studies that debate the role of a company’s board and how involved it should be in management activities. A board should be focused on performance, focusing on questioning, criticizing, refining and enable the strategy to be carried out by professional managers (O'Shannassy, 2010). Setting strategy-making and governance continues to be an evolving bargain between corporate boards and CEOs, where often power and influence is used. (O’Shannassy). Recently, there has been criticisms of boards claiming they are ineffective, unwilling to make hard decisions, and lack independence as CEO’s often serve as chairs of the board and exert an undue influence on the agenda (Parrino & Kidwell, 2009). When a for-profit business looks for ways to create value for a customer, the source of revenue comes from consumers who are willing to pay for a product they want (Foster, Kim & Christensen, 2009). There are a number of ways a for-profit company raises money. Businesses determine the need and then utilize then find best resource available. In order to raise money quickly a business will likely to the stock market. By going to investors in capital markets, a company can make a debt offering by selling bonds or a equity offering issuing new shares, such as IPOs (Parrino & Kidwell). Other ways to get money is by bank borrowing, government loans or obtaining venture capital. These typically take longer to process and are considered as a secondary option or when looking for financing in the long-term. Strengths, weaknesses and overall performance of company can be evaluated by analyzing its financial statements (Parrino & Kidwell). CPA’s will prepare a for-profit company’s financial statements, that include the balance sheet, income statement or statement of operations, statement of retained earnings, statement of cash flows and statement of stockholders’ equity. A firm’s balance sheet provides a snapshot in time how a company is operating (Parrino & Kidwell). The income statement shows how much profit has been made between two points in time (Parrino & Kidwell). A statement of retained earnings is not always required but is prepared to if a company has a net income or loss or when a company’s board of directors pays a cash payout from one accounting period to the next (Parrino & Kidwell). To find out all cash flows that have occurred over a calendar year a firm prepares a statement of cash flows (Parrino & Kidwell). A statement of stockholders’ equity show how much capital was earned by a company when it exchanged its stock (Parrino & Kidwell). Financial statements are analyzed in many ways and there is no one way better than others. It is important to use audited financial statements, those prepared by a CPA, over a period of at least three years (Parrino & Kidwell). An analysis of trends can be used to see how different ratios have changed, increased or decreased, over time (Parrino & Kidwell). Besides performing a trend analysis, benchmarking is a way to analyze performance of companies in an industry and looks at how one company performs against its competitor. Benchmarking compares companies that produce the same goods compete in the same markets and are the same size (Parrino & Kidwell).
NONPROFIT ORGANIZATIONS Nonprofit organizations are created to address an ongoing need in society (Blackbaud, 2011). Often their mission is based upon what they hope to contribute to the community or correcting a deficiency. There is often a tension between a nonprofits mission and financial results (Allsion & Kaye, n.d.). This is because the bottom line, which influences many strategic decisions, does not always work in the best interest of stakeholders (Allison & Kaye). A nonprofit organization stakeholder is a benefactor. Some benefactors may include funders, donors and the community. It has been stated by Allison and Kaye (n.d.) that “passion for mission is a great source of strength for nonprofit organizations. The institutionalized impulse to "change the world" has brought about important advancement in American society. As a strength, the passion for mission taps incredible creativity, energy and dedication for the work of an organization. However, zeal for the mission can lead staff, board and volunteers to discount "business" realities…” A nonprofit's single-minded, mission driven nature, can result in financial neglect, especially during periods of growth (Wilson, 2011). In order to balance both mission and financial stability, a nonprofit should place equal emphasis on financial viability using solid reporting mechanisms and the pursuit of its mission (Wilson). Nonprofit boards of directors have authority over organizations they govern and have the responsibility of making it a success (Allison & Kaye, n.d.). They operate similar to for-profit board of directors. Some of the roles of the board include setting the nonprofits agenda and direction, making sure it has adequate financial resources, set strategies, monitor management and provide oversight (BoardSource, 2010). A nonprofit organization generally lacks the financial flexibility of a for-profit because it depends on resource providers that are not engaged in a commercial transaction (Blackbaud, 2011). Since much of the resources provided are from donors to provided goods or services for a specific purpose, the nonprofit organization must demonstrate that funds are used for that purpose (Blackbaud). The purpose is either specified by the donor or implied in the nonprofit’s mission and management must report accurately the use of the funds (Blackbaud). Nonprofits biggest struggle is raising money. Creating a framework to bring in funds to nonprofits is a challenge and nonprofits must be careful not to make their funding models too general or too specific (Foster, Kim & Christensen, 2009). Many nonprofits raise money by fundraising. There are other sources of funds nonprofits receive and their often depend on the type of nonprofit organization. Nonprofits can get funds from the government or federal agencies or the private sector. Private sector donations are often in the form of grants and awards from foundations. Performance evaluation is important for a nonprofit organization. Many funders or donors want to know how they money has been spent and make sure it was used as directed. Nonprofits will use an independent public accounting firm to prepare financial statements which are similar to for-profit companies. They reports will be presented to the board of directors. They will provide a statement of financial position, statement of activities, a statement of functional expenses and a statement of cash flows (Averkamp, 2011). The statement of cash flows is the same for both for-profit and nonprofit companies. The statement of financial position is similar to a balance sheet. It details an organization’s assets and liabilities, when the assets turn to cash and when liabilities have to be paid (Averkamp, 2011). A statement of functional expenses reports expenses by their function and by the nature or type of the expense and a statement of activities shows the amount of revenue and expenses according to changes in net assets (Averkamp, 2011) Unfortunately, many nonprofits do not have consistent methods of recording and presenting their financial positions (Finkenstaedt, 2009). This is because internal accounting practices for nonprofits follow the preferences of their major funding sources (Finkenstaedt). Therefore, the information reported and the format of financial statements varies significantly from one organization to another (Finkenstaedt). Additionally there are few standards or benchmarks for nonprofit accounting. This presents a problem from a certified public accountants standpoint as everything is subjective. As a result, no systematic requirements exist and there is no standard format for preparing audited financial reports for nonprofit companies (Finkenstaedt).

NONPROFIT AFFORDABLE HOUSING PROVIDERS Nonprofit housing agencies, often called affordable housing providers, were created to meet the housing needs of those without the financial means to obtain housing in the traditional real estate market. Their mission is based on the fundamental right for all citizens to live in affordable, safe, decent housing, combat homelessness and break the cycle of poverty (Wilson, 2011). Ultimately, the government outsources the responsibility to create affordable housing on the state and local level. Specific requirements are established for nonprofits to receive funding, such as a using a request for proposals (RFP) process for the selection of contractors when constructing housing developments (Foster, Kim & Christensen, 2009). These nonprofit housing organizations provide homeownership opportunities to first-time homebuyers using Federal Housing Administration sponsored programs such as Fannie Mae, Freddie Mac and veterans loans (Finkenstaedt, 2009). This enables affordable housing communities to be created in both rural and urban areas, providing rental units for families, those with disabilities and the elderly. By making programs and services that help rebuild the whole community and position their residents for success, nonprofit affordable housing providers have been able to accomplish their missions (Finkenstaedt). Nonprofit developers have increased their production and expanded their social development goals (Finkenstaedt). Many directors of these organizations have adopted market-based business approaches to carry out their missions (Finkenstaedt). There are many highly trained, talented and knowledgeable people who manage nonprofit agencies. These skilled leaders are result-oriented, as a result many nonprofits companies report high levels of annual production with strong balance sheets as evidence of their efficiency (Finkenstaedt). Many managers at nonprofit companies could run a for-profit Fortune 500 company. They have the track record and are known in their industry, possessing professional qualifications and technical expertise that rivals their for-profit real estate counterparts, but unfortunately they lack the liquidity needed to sustain such growth (Finkenstaedt). Affordable housing providers face limited cash resources, a cumbersome fundraising process, long periods of delayed funding, and other inefficiencies which quickly prevent them from accomplishing their mission (Finkenstaedt). The majority of loans, grants, subsidies, and tax credits are limited to one particular project (Wilson, 2011). As a result, nonprofit affordable housing development has access to a limited supply of capital (Finkenstaedt, 2009). Affordable housing development requires the ability to raise large sums of capital for projects and withstand long periods of deferred revenue because it takes a long time to complete a building project (Wilson, 2011). There has been a number of ways to attempt to resolve funding issues. One way is labeled “organizational capital.” It is different than conventional project financing that for-profit developers obtain from banks, as conventional financing is long term and usually secured by real estate. Organizational capital can be compared to venture capital, corporate debt or equity (Finkenstaedt, 2009). Organizational capital is available a few forms. “Working predevelopment capital” is in the form of a loan or line of credit, “working capital for general operations” is a mix of short-term lines of credit, loan, “program related investments” or (PRIs) are long-term, flexible, below-market rate debt instruments that are granted by foundations, and “growth capital” is a package of financing consisting of PRI, debt similar to equity financing and mezzanine debt (Finkenstaedt). Startup organizations or small, local nonprofits do not qualify for organizational capital (Finkenstaedt). Only disciplined and well established housing providers that have proven records of financial discipline, stability within the organization, a consistent growth of their balance sheet, a committed management team and ability to adapt to market changes can qualify for these forms of financing (Finkenstaedt). Tracking and accounting for monies received from the federal government and other donors is important. Nonprofits are subject to strict reporting requirements due to receiving these funds. The Department of Housing and Urban Development (HUD) routinely audits affordable housing providers that receive federal funds. Additionally, staff must be able to prove that a donors money were used as directed (Blackbaud, 2011). Grants from foundations or other donors have their own restrictions and often emphasize the use of external auditor reports such as those prepared by a CPA firm (Blackbaud). Nonprofit housing providers’ financial position is evidenced in its financial statements. However, all nonprofits housing providers are different. They operate on different fiscal calendars and report developer fees in various ways (Finkenstaedt, 2009). In addition, they utilize a range of methods to value real estate assets and receivables and different ways of presenting historical performance (Finkenstaedt). Therefore it is hard to benchmark them against an industry standard. These details must be made clear in the statement of findings of the audit report to prevent a skewed financial picture of how the organization is operating.
CONCLUSION
There are many similarities between for-profit and nonprofit corporations and how operate their businesses. The boards of directors oversee corporations, having the responsibility of setting the mission, strategy and direction of the company. Management staff has to satisfy stakeholders and customers. They face operational challenges as they try to find ways to increase revenue and their future financial performance. Nonprofit affordable housing providers is an example of an organization seeking ways to obtain financing, handle board of directors and the communities expectations to produce housing. Their financial performance is documented by certified public accountants providing detail of its operations.

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