Accounting at Governmental and Nonprofit Organizations
The differences in the accounting between for-profit organizations, on one hand, and governmental and nonprofit organizations,1 on the other, start with their organizational mission statements: For-profit organizations are primarily about making money and return on investment.2 Governments and nonprofit organizations are set up to provide specific services (e.g., national defense, international trade, health care, a clean environment, policing, schooling) for a targeted group of constituents, and the services are often difficult if not impossible to express in monetary terms.
This chapter will briefly review some of the key differences between the accounting treatment required in for-profit organizations and that of governmental and nonprofit organizations. An overview of financial analysis for governmental and nonprofit organizations will also be provided.
Accounting for Governmental Organizations
A governmental annual report, called a comprehensive annual financial report (CAFR), has a very similar and often identical structure to that of a corporate annual report. It begins with an introduction in which the governmental unit sets out its mission statement and then discusses and analyses events of the past year. This is followed by a Balance Sheet and Statement of Activities (analogous to an Income Statement), along with details of individual smaller governmental units (called funds). The Notes to the Financial Statements provide details of the accounting choices that were made. There is often supplementary and statistical information, and there is usually an audit report (sometimes done by a public auditing firm but usually done by a separate unit of the government). The accounting also closely follows the accrual accounting approach used in for-profits.
At its core, accounting for governments is meant to provide constituents with the ability to determine a government’s effectiveness on three key issues:
1. Interperiod equity: Whether revenues currently being collected are sufficient to pay for the services currently being provided (as opposed to future generations paying for current consumption).
2. Budgetary and fiscal compliance: Whether the resources being provided to the government are used according to the rules set out by its constituents.
3. Effectiveness: Whether the cost to provide the services is reasonable (or at least comparable to similar governmental organizations).
The shareholder equivalent to governmental organizations are citizens, residents, and taxpayers. Naturally, many others like suppliers of goods and services (including lenders) will also be interested in understanding what the governmental organization owns and controls, what it owes to others, as well as how funds flow in and out of the organization. Thus, much of the accounting for a governmental organization is similar to that of a for-profit organization.
A key difference in accounting for governments is that the distinction between assets and liabilities may be blurred. For example, a national park could be considered an asset in one sense, as the government owns it, but it can also be considered a liability, as it produces little or no revenue and the government is required by statute to maintain it. Also, how an asset can be used is often limited (e.g., renting out the White House for private affairs is not allowed), and the amount and timing of liabilities can often be changed by government fiat (e.g., social security benefits). Finally, there is no clear ownership (e.g., individuals cannot buy and sell units of citizenship).
The basic accounting equation providing the Balance Sheet for governmental organizations is:
Assets = Liabilities + Fund balance
As in the for-profit world, each item is separately measured and if the Balance Sheet does not equate it means there was an error in the accounting process.
Governmental Funds
There are many different types of funds or subunits of governmental organizations (analogous to divisions or departments in for-profits). Some examples include:
• A general or unrestricted fund contains all the resources and obligations that are not in other types of funds.
• A special revenue fund is one restricted to a specific purpose (e.g., to pay for national defense).
• A debt service fund is one restricted to pay the interest on the principal of a specific debt issue.
• A capital projects fund is one restricted to pay for long-term assets (e.g., to pay for a school or road).
• An enterprise fund is one with which the government engages in business-like activities (e.g., a town swimming pool that pays for itself through memberships).
• An internal services fund is one in which the government sets up a business-like activity to provide goods or services to other governmental units (e.g., accounting or computer services).
• A trust fund is one in which the government administers the fund for the benefit of private, nongovernmental parties.
• An agency fund is one in which one governmental unit (e.g., the federal government) administers the fund for the benefit of another governmental unit (e.g., a state).
Accrual versus Modified Accrual Accounting
Accounting for governmental organizations also requires some form of Income Statement to show cash inflows (revenues) and outflows (expenses or expenditures).3 The method for recording these cash flows is typically the accrual method or a “modified accrual” approach. The details of why there are differences and how they are done is presented below.
As in the for-profit world, the period reflecting the cash inflows and outflows is a key element of accounting. For government-wide financials, this will be done on a basis almost identical to the for-profit world. For funds, the period chosen for cash flow measurement is based on when the government is entitled to the revenues or obligated for the expenses.
Remember, the fundamental principal of accrual accounting in a for-profit organization is to recognize revenue in the period in which it is “earned” and then match expenses to the same period if possible and, if not possible, match them to the period when the expenses are incurred. By contrast, governments have it the other way around. Governments typically figure out what they want to do, how much funding they require to do it, and then how to obtain the required funding. Thus, the inflows and outflows for government funds often have little or no direct relationship between their revenues and expenditures.
One solution would be to base all governmental accounting transactions on the actual flows of cash. This would essentially mean using a cash basis of accounting by recording economic events when cash is received or paid. The problem with this approach, as in the for-profit world, is that it provides those in charge of governmental organizations with the ability to manipulate the presentation of accounting data by altering the timing of cash flows.
Instead, the two solutions used are the accrual concept and something referred to as a “modified accrual” approach.
The accrual approach is used in the government-wide (CAFR) reports. It limits managerial discretion and follows widely held accounting principles.
Governments also use a “modified accrual” approach, a decision driven by the nature and timing behind governmental cash flows. In this approach, only events with a current (i.e., short term) economic impact are measured and recorded. This is a combination of cash and accrual accounting and is normally used in accounting for funds.
When Is It (Recorded as) Revenue?
Governments collect cash with both exchange and nonexchange transactions:
Exchange transactions: Similar to when for-profits charge prices or fees for goods or services (the postal service, sewage, and water).
Nonexchange transactions: Imposed taxes (property taxes, fines), derived taxes (based on sales of goods or services by a business or on business or personal income), mandated transactions (generally from one governmental unit to another), and voluntary transactions (people do give gifts to the government).
As with for-profits, revenue cannot be recognized unless it is measurable. However, unlike for-profits, governmental organizations generally recognize revenue for the various funds not when they are “earned” but rather when they become available to finance the current fiscal period’s expenditures. This means revenues are generally counted if they are collected in the current period (following the cash basis of accounting) or expected to be collected shortly after the current period.
What constitutes “shortly after the current period”? In the United States, the rule is within 60 days of the end of the current fiscal period. Note that this 60-day period is required for property taxes and optional for other taxes (i.e., in deciding in what period to include tax revenue for nonproperty taxes, a governmental unit could use either the 60-day rule or the cash basis, as described in its Notes to the Financial Statements).
Discounts given for early tax payment are considered revenue reductions, not expenditures. Taxes paid in advance are treated as liabilities (cash up and a liability called “tax collected in advance” up) and then recognized as revenues in the period to which they relate.
How is the sale of a long-term asset treated? For funds, any cash received from the sale of a long-term asset is treated as pure revenue (there is no gain or loss on sale) because the funds do not include long-term assets on its Balance Sheets. Essentially cash is increased and a revenue called “other financing source: sale of long-term asset” is increased.
For government-wide statements, the sale of a long-term asset is treated similarly to how it would be treated in a for-profit firm: with an increase in cash, the removal of the long-term asset from the Balance Sheet, and with the balance as a revenue or expenditure.
When is it (Recorded as) an Expense?
Governmental funds generally do not use the term “expense” because expenses have a consumption-oriented focus. That is, with accrual accounting, expenses are generally a reduction in net economic resources either matched to revenues or recorded in the period incurred. By contrast, governmental fund accounting, using a modified accrual approach, is more payment (as opposed to consumption) oriented. This means the reduction in financial resources is recorded when the asset is acquired, cash is paid, or the liability is incurred (an exception is usually made for the unmatured principal and interest on long-term debt, which is recorded when it is due).
Governmental organizations generally recognize expenditures as they do revenues. This means they follow the accrual method, and recognize expenditures as incurred, for government-wide statements and the modified-accrual method, if paid in the current period or shortly after the current period, for funds.
For example, consider how governments record the payment of governmental employee salaries. A pure cash basis would record the expenditure in the period when paid, while both the accrual and modified accrual methods would record the payment as incurred (because the payment is made either during or shortly after the current fiscal year). But what about vacation pay? Imagine an employee is entitled to four weeks of vacation a year but does not take it and instead accumulates the vacation pay to a future year. Would the governmental unit record the amount of vacation owed to the employee as an expenditure and liability in the current fiscal year? Yes for the government-wide statements. No for the fund statements (unless the fund was expecting to pay the vacation days very early in the next year). This means that if a government fund has many employees with lots of accumulated vacation days (and thus accumulated vacation pay owed to them), there is a mismatch in the revenues and expenditures as well as an unrecorded liability.
Regarding the purchase of short-term assets (various types of inventory), governmental fund accounting provides a choice between using the accrual method (but generally only using first-in-first-out or the average method) and using the purchase method (recording the purchase when made, as opposed to when the items are received under the accrual method or when paid for under the cash method). For government-wide (CAFR) reports, the accrual method is used.
Regarding the purchase of long-term assets, the accrual method is used for government-wide (CAFR) reports. In contrast, a cash basis (expenditure when purchased) is used for governmental funds, which means there can be a dramatic difference in the statements of governmental funds that rent instead of purchase long-term assets.
Short- and long-term liabilities are recorded as in the for-profit world on government-wide statements. For governmental funds, long-term liabilities are not included and only certain short-term liabilities are included. Thus, the accounting for governmental funds is fairly close to a cash basis of accounting.
Accounting for Nonprofits
Nonprofits prepare their financial statements—the Statement of Financial Position (i.e., Balance Sheet), the Statement of Activities (i.e., Income Statement), and the Statement of Cash Flows—using the accrual method of accounting.
Although nonprofits do account for their resources in separate funds, these are normally not shown to the general public. Rather, like for-profits, all their activities are normally combined into one overall statement with perhaps some additional information on specific activities.
One key difference in the accounting between for-profits and nonprofits is that nonprofits must classify whether there are any restrictions on the use of their assets. Nonprofits must report what portion of their fund balance (assets less liabilities) is unrestricted, temporarily restricted, and permanently restricted. That is, nonprofits must disclose the funds they received from donors without restrictions as well as those which can only be used in certain specific ways, for certain specific purposes, or in certain specific amounts (e.g., only the earnings on the donation can be used but not the amount donated itself). The presentation of this information in the Statement of Financial Position (i.e., the Balance Sheet) is left to the organization, which can decide to present it in separate rows or columns.4
A second difference is the recording of contributions as opposed to other revenue-generating transactions where goods or services are provided by the nonprofit (e.g., selling branded clothing). Often payments to nonprofits involve a combination. For example, when joining a museum, the fee paid may include both a gift to the museum but also unlimited free access. In these cases, the nonprofit must determine and allocate each portion of the contribution.
Another interesting revenue issue for nonprofits is pledges or promises made by donors for future contributions. Most nonprofits would not record these as contributions until made, as they are normally not enforceable if the donor changes their mind. However, nonprofits are allowed to include pledges in the period in which the pledges are made, but only in those cases where the nonprofit has sufficient past experience to predict the likelihood the pledge will actually be received (this is somewhat analogous to a for-profit accounts receivable and allowance for doubtful accounts).
An offsetting revenue and expenditure issue occurs when services used by the nonprofit are donated. In this case, U.S. rules mandate they be included in both revenue and expenses when they are both of a professional nature (e.g., legal services) and something the nonprofit would have otherwise had to pay for. Thus, the donated value of someone serving food at a soup kitchen would not be included because even though it may be something the nonprofit would have otherwise paid for, it is not a professional service.
Another offsetting revenue and expense occurs when donations are made to a nonprofit with a requirement that they be passed on to another organization. These are treated in a similar fashion to the governmental accounting for trusts. Both the contribution and offsetting expense are normally not recorded.5
How about long-term donated gifts such as buildings or collectibles? Long-term assets such as buildings must be valued and included both as a contribution and an asset that then must be accounted for in the same fashion as in a for-profit firm (i.e., reduced over time). For long-term collectibles, nonprofits can choose to exclude them in certain cases (i.e., exclude them by not listing them as contributions and assets to be reduced over time).6
Assessing the Performance of Governmental and Nonprofit Organizations
Many elements of ratio analysis used in examining for-profits also apply in understanding the performance and effectiveness of governmental and nonprofit organizations. However, there are also differences in assessing organizational performance due to the different missions of the organizations, how revenues are generated, how expenditures are incurred, and the organizational form.
Using the same categories as in for-profits:
1. Profitability: Governments and nonprofits do not generate profits, but they can generate surpluses or deficits.7 Unlike for-profits, where a larger profit is generally better, governments are often required to operate with a balanced budget. That is, governments are not supposed to (and often not legally allowed to) run deficits (deficits mean current citizens or residents are overconsuming at the expense of future citizens or residents), while large surpluses are seen as overtaxation. By contrast, nonprofits can have surpluses when they are building up funding and have deficits in times of need. Thus, rather than profitability, governments and nonprofits are evaluated on the level of any surplus or deficit compared to the level of services provided. That said, the rate of growth in government or nonprofit revenues versus expenditures (a ratio also used for for-profits) may be a useful additional ratio.
2. Activity or efficiency: With for-profit firms an examination of days receivable, days inventory, days payable, and asset turnover over time and in relation to other firms can indicate how well a firm is being run. For governments and nonprofits some measure of their cost effectiveness in delivering services is required. This may be much harder to measure and often cannot be done directly from the financial statements. Consider the difference in trying to compute the unit cost of providing national security, health care, transportation, educational services, and so on. This is clearly much more subjective than computing the amount of inventory held per dollar of revenue. Thus, benchmarking across governmental units and nonprofits is critical to determining effectiveness. However, even when this data is available it remains highly subjective. For example, one key metric often used in evaluating nonprofits is the percentage spent on administrative fees (e.g., anything over 35 percent is considered excessive). However, this fails to account for the differences in organization size. A nonprofit that is run in the state of Maine is probably much smaller than one run in the state of New York, and even if the former is well run it is likely to have a much higher percentage of administrative fees than the latter.
3. Liquidity or short-term financial stability: This is the ability to pay debts as they come due in the next year. Similar ratios to those used by for-profit firms can be used, and it can also be helpful to add days cash on hand (cash equivalents/monthly expenses) and bills outstanding to monthly expenses (accounts payable/monthly expenses).
4. Leverage or long-term financial stability: This is an assessment of whether the organization will be able to repay its debts over the long term, and similar ratios to those used by for-profit firms can be used.
5. Other ratios: Similar to the for-profit world, a wide range of other metrics can be used, including changes in the number of employees, the nature of management, and so on. However, when evaluating long-term revenues and expenditures for governments and nonprofits, different metrics should be considered. An evaluation of a for-profit firm will include the evaluation of its products, markets, and competitors. By contrast, additional demographics are required to evaluate governmental and nonprofit organizations. For example, a municipality may look at the number of students it will have to educate over time when it is planning the building and operations of its school system. The growth (or shrinkage) in required programs and services as well as some revenue concentration (revenue source/total revenue) ratios may be included in order to evaluate these additional demographics.
6. Benchmarking: As with for-profits, benchmarking is done using trends over time, comparison to strategic plans and to budgets, as well as comparisons to similar organizations. These benchmarks are also often available from various societies (e.g., The Association of American Colleges), special groups that provide data (e.g., Charitywatch.org), as well as rating agencies (the same ones that provide ratings in the “for-profit” world—Standard and Poor’s, Moody’s Investor Services and Fitch).
The Bottom Line
Differences in the accounting for governmental and nonprofit organizations compared to the accounting used at for-profit firms stem from their different missions. For-profits are primarily about making money (in additional to social and environmental concerns), while governments and nonprofits are supposed to be about providing goods and services to a targeted audience. Accounting at for-profit firms follow the accrual method. Accounting for government-wide and nonprofit organizations use a similar approach with a slightly altered financial presentation (e.g., there are no owners or profits), while governmental funds (i.e., budgetary units) use a modified accrual approach.
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1Many people refer to charitable organizations as nonprofits or not-for-profits. For simplicity, they are referred to as nonprofits here.
2One view of a for-profit organization is that management should focus on increasing the wealth of the owners. Another view is the firm has a duty of care to stakeholders beyond simply the owners. This latter view includes what is called “triple-bottom-line” accounting which encompasses financial, environmental, and social goals.
3The Financial Accounting Standards Board (FASB) develops accounting and reporting standards for nongovernmental organizations. The Governmental Accounting Standards Board (GASB) develops accounting and reporting standards for governmental organizations (state and local governmental entities). The FASB and GASB are private, nonprofit organizations whose boards are composed of seven full time members, who sever all ties with their former organizations, and who serve for up to two five-year terms. Both the FASB and GASB are subject to oversight from the Financial Accounting Foundation (also a private, nonprofit organization).
4Nonprofits are allowed to include restricted contributions with unrestricted contributions in cases where the restriction is met in the same period a contribution is given to the organization.
5An exception occurs if the nonprofit has the power to decide to which other organization to give the funds or when the funds will go to a related organization.
6The collectibles must be held for public exhibition, education or research; must be unencumbered and preserved; and if sold the proceeds must be used to purchase other collectibles.
7A deficit, or deficit spending, is the amount by which expenditures (total outlays) exceed revenues (total receipts) in a given year. This is different from the amount of debt, which is the amount owed by the governmental or nonprofit organization. For example, for the fiscal year ending September 30, 2015, the United States had a deficit of $520 billion (total gross receipts of $3.33 trillion versus total net costs of $3.85 trillion) with an accumulated deficit of $18.2 trillion (total assets of $3.2 trillion versus total liabilities of $21.4 trillion, of which $13.2 trillion is the nation’s debt, $6.7 trillion is owed for future benefits to federal employees and veterans, and $1.5 trillion is other liabilities).