Understanding and Applying GAAP for Nonprofits: FAQ Guide
Monday, February 5, 2024
Nonprofit accounting is unique in both its purpose and execution. While for-profit organizations orient their accounting practices around the goal of turning a profit, nonprofits’ main goal in accounting is financial transparency with donors, stakeholders, and the government. This allows these organizations to remain tax-exempt and use their revenue to effectively further their missions.
However, there is a set of accounting standards that all organizations are expected to follow, known as the Generally Accepted Accounting Principles (GAAP). In this guide, you’ll learn everything you need to know about why these principles are important and how to apply them at your nonprofit. We’ll answer the following frequently asked questions about GAAP:
- What are the Generally Accepted Accounting Principles?
- Who developed GAAP?
- Why do nonprofits need to comply with GAAP standards?
- How can I apply GAAP for nonprofits?
GAAP is a foundational accounting concept that all nonprofits should be familiar with. If you have any questions or need help implementing GAAP standards at your organization, make sure to work with an accountant who specializes in nonprofit work, as they’ll be best equipped to navigate the complexities of your organization’s accounting situation. For now, let’s get started by reviewing the principles that comprise GAAP.
What are the Generally Accepted Accounting Principles?
The Generally Accepted Accounting Principles—commonly known as GAAP—are a set of agreed-upon accounting standards that provide a framework for recording and reporting financial information. They ensure consistency and comparability in financial management among all organizations in the United States, both for-profit and nonprofit.
The 10 GAAP standards are as follows:
- Principle of Regularity: GAAP-compliant accounts adhere to established rules and regulations.
- Principle of Consistency: Financial reports are created according to consistent standards.
- Principle of Sincerity: Accounting practices are conducted accurately and impartially.
- Principle of Permanence of Methods: Financial reports are prepared using standardized procedures.
- Principle of Non-Compensation: All aspects of an organization’s performance—both positive and negative—are reported with no prospect of debt compensation.
- Principle of Prudence: Reported financial data is not influenced by speculation.
- Principle of Continuity: Asset values are reported under the assumption that the organization’s operations will continue.
- Principle of Periodicity: Financial reporting schedules are divided into standard accounting periods, such as fiscal years, quarters, and months.
- Principle of Materiality: Financial reports fully disclose an organization’s financial situation.
- Principle of Utmost Good Faith: Everyone involved in the accounting process is assumed to be acting honestly.
These principles apply to all types of organizations, but they’re especially useful for nonprofits because, like nonprofit accounting in general, one of their main purposes is to promote accountability.
Who developed GAAP?
Since GAAP first came about in the early 20th century, it has been a collaborative effort to create, update, and maintain. The primary organizations involved include:
- American Institute of Certified Public Accountants (AICPA). This organization, which administers the CPA certification exam and establishes various accounting and auditing requirements, laid the foundation for GAAP.
- Financial Accounting Standards Board (FASB). A private-sector organization created for the primary purpose of accounting standardization, FASB has been in charge of keeping GAAP up-to-date since the organization was founded in 1973.
- Securities and Exchange Commission (SEC). This federal government agency regulates the market and protects investors, meaning it’s the most involved organization in maintaining GAAP on a national level.
- State governments. Individual states also help uphold GAAP through the reporting regulations they set forth, although each government does this slightly differently. Check the IRS requirements for your state to stay up-to-date on this aspect of compliance.
Although the primary goal of GAAP—ensuring consistency, comparability, and transparency—has stayed the same over the 100-plus years of its existence, accounting practices have evolved as technology has become more prevalent. So, GAAP has also had to evolve, and multiple organizations in different niches of accounting continue to guide that process to ensure it’s holistic.
Why do nonprofits need to comply with GAAP standards?
While the main benefit nonprofits gain by following GAAP is focusing more deeply on the accountability aspect of accounting in light of donor and stakeholder concerns, that isn’t its only purpose. Here are some additional reasons why your organization should implement GAAP standards:
- Complying with legal requirements. Although GAAP isn’t a legal regulation in and of itself, the principles inform many of the legal guidelines nonprofits have to follow. For instance, despite being tax-exempt, nonprofits still have to file an annual tax return (IRS Form 990) because of the Principles of Consistency and Periodicity.
- Establishing credibility. Reporting your finances in good faith and according to standardized procedures helps external parties see your nonprofit as a professional, trustworthy organization. The accuracy and thoroughness of reports required by GAAP deepen that confidence.
- Aligning with grantmaker and auditor expectations. If your organization applies for grants or undergoes financial audits, the grantmakers and auditors you work with will assume that you comply with GAAP and assess your nonprofit’s information accordingly. It’s much easier for them and for you when this is the case since you’ll have to include disclaimers on all of your grant or audit materials if not (which may negatively affect grantmakers’ opinions of your nonprofit).
- Standardizing organizational financial management. GAAP also provides a good framework for allocating, recording, and overseeing your nonprofit’s finances to most effectively further your mission. That way, all of the internal and external financial professionals you work with—your CFO, your treasurer, your bookkeeper, and your accounting team—will be on the same page about these activities.
To begin implementing GAAP, sit down with the above financial professionals and anyone from your leadership and fundraising teams who can provide insight into your nonprofit’s everyday resource use so you can create a comprehensive financial action plan together. Once you’ve started following this plan, check in with your team regularly to identify what is going well and where there is room for improvement.
How can I apply GAAP for nonprofits?
The action plan you develop may involve creating or updating a variety of financial policies, procedures, and documents for your nonprofit. However, there are five key ways you should make sure GAAP standards are being followed:
Use the Accrual Accounting Method
In an accrual accounting system, your nonprofit will record revenue when it’s pledged and expenses when they’re incurred. This is in contrast to a cash accounting system, which records revenue and expenses only after the money has changed hands.
Because accrual accounting includes both financial commitments and cash flows, it provides a more complete picture of your organization’s situation as required by GAAP. It also makes filing your Form 990 easier since you’d have to include a disclaimer and do additional calculations if you used the cash accounting method.
Properly Recognize Different Types of Revenue
Nonprofits make money from various sources, such as individual donations, grants, investments, and corporate contributions. Each of these types of revenue should be recorded separately in your accounting system to ensure consistency and materiality when it comes time to report your revenue.
Some contributions have additional requirements for how to recognize them in your accounting system for GAAP compliance. For instance, the monetary value of in-kind gifts is recorded as both a debit and a credit to note that you received it, but the amount of cash your organization has hasn't changed.
Honor Donor Restrictions on Funding
Some of the revenue your nonprofit receives will be restricted, or set aside for specific purposes by the contributor. This most often happens with major gifts and grant funding because donors and grantmakers want to ensure their significant contributions will be used to further aspects of your mission that align with their values.
To act sincerely and in good faith, your organization needs to honor your commitments to use those funds as the donor or grantmaker intended. Plus, these contributors have the right to sue your nonprofit for misuse of funds if you don’t respect their official wishes—another way GAAP and legal requirements for nonprofits align.
Allocate Expenses by Function
Generally speaking, there are two ways your organization can allocate expenses in its budget. The first method is based on the type of payment you’ll make to cover each intended cost, referred to as natural expense allocation. The second method, functional expense allocation, is based on how each expenditure impacts your mission.
The three categories of functional expenses are:
- Program costs, which are directly related to the activities that further your mission.
- Administrative costs, which are essential for your nonprofit to operate (such as paying utility bills and compensating your staff).
- Fundraising costs, which are associated with running giving campaigns, planning events, and marketing your nonprofit.
While all three types of expenses are necessary to achieve your goals, your nonprofit should be spending much less on its administrative needs and fundraising than it does on its programs. Allocating your expenses based on these categories allows you to see exactly how much of your funding goes toward mission-related activities and how much is being used to run the organization, allowing for the full transparency that GAAP calls for.
Compile Financial Statements
Since many of the GAAP standards have to do with reporting, ensuring your nonprofit creates accurate financial statements each year is the most essential aspect of compliance. These statements organize and summarize data in consistent ways to provide different insights into your organization’s financial situation.
Under GAAP, both for-profit and nonprofit organizations are required to compile these three financial statements:
- Income statement or statement of activities. These terms are interchangeable, although for-profit organizations prefer the former and nonprofits tend to use the latter. This report outlines your organization’s revenue, expenses, and net assets to provide actual numbers that you can compare to the predictions in your budget for a given fiscal year.
- Balance sheet or statement of financial position. This statement is also compiled annually and referred to by two interchangeable names. It breaks down your assets, liabilities, and net assets to provide a snapshot of your organization’s financial health, which is especially useful if you’re planning for growth.
- Statement of cash flows. Both for-profit and nonprofit organizations use the same term for this statement and typically compile it monthly. It shows how cash moves in and out of your organization through operating, investing, and financing activities to help you stay on track with your spending and fundraising.
There is also a fourth type of financial statement that is unique to nonprofits, known as the statement of functional expenses. This report divides your organization’s expenses into the functional expense categories we outlined previously to demonstrate how your funding is being used to further your mission.
GAAP is one of the most fundamental concepts for nonprofit accounting, so you need to know what it entails to manage your organization’s finances effectively. Use the information and application tips above to get started, and don’t hesitate to reach out to nonprofit accounting experts (like the team at Jitasa!) with any questions or concerns that come up along the way.
For more information about GAAP and its applications for nonprofits, check out these resources:
- Fund Accounting 101: The Basics and Best Practices. Dive deeper into the unique accounting system nonprofits use to transparently track their funds and honor their donors’ wishes.
- Nonprofit Chart of Accounts: How to Get Started + Example. Discover the ins and outs of the chart of accounts, a key nonprofit accounting resource for GAAP compliance.
- How Do Nonprofits Make Money? Making Nonprofits Profitable. Explore the different revenue streams your nonprofit may have as part of its funding model and learn how to properly account for each one according to GAAP.