Financial Management of Not-for-Profit Organizations

Overview of Nonprofit Financial Management

Generally, financial management of not-for-profit organizations is similar to financial management in the for-profit sector in several respects. Nonetheless, there are several major differences that produce a distinct focus for nonprofit financial managers. In the commercial sector, for-profit enterprises primarily focus on maximizing shareholder value and overall profitability. By contrast, not-for-profit organizations have the basic aim of providing a socially desirable service on a continual basis rather than increasing shareholder value ("Financial Management of Not-for-Profit Organizations," 2011).

The difference in focus between for-profit and not-for-profit organizations arises because the latter does not have the financial flexibility of a commercial enterprise, since it is dependent on resource providers who are not engaged in an exchange transaction. As a result, the resources provided are channeled toward offering goods and services to clients rather than to the resource providers themselves.

Key Financial Management Exercises

Because provided resources are directed to clients rather than to resource providers, not-for-profit organizations are required to demonstrate stewardship of those resources. This means that finances donated for a particular purpose must be used for that purpose, and the organization's staff must show that funds were used as directed by the resource provider. However, the purpose of provided resources may not always be specified by the donor; it may instead be stated in the organization's mission. In essence, the main goal of financial management in not-for-profit organizations is to demonstrate stewardship of donated resources as specified by the provider or as stated in the organization's mission. The use of fund accounting systems has become even more critical because of the shift toward external financial reporting on donor restrictions.

To achieve their financial management objectives, not-for-profit organizations must attend to several important exercises. The two most significant are budgeting and cash management. Through these exercises, the organization must critically assess whether it has adequate cash reserves to continue offering services to its clientele. Cash flow can be extremely difficult to predict, however, since these organizations depend on revenue from resource providers who do not expect to receive the services in return. This difficulty means that organizations can face a management crisis when demand for their services increases. Moreover, estimating contribution revenue reliably on an annual basis is challenging, which heightens the need for strong expense control. Budgeting and cash management are therefore crucial for controlling expenses in not-for-profit organizations.

Another important exercise is accountability, which is one of the core financial management standards. Because several methods exist for implementing financial management systems, an organization should select the method best suited to its scale and scope of operations ("Financial Management Guide," 2008). As part of financial management standards, not-for-profit organizations should establish accounting structures that provide accurate and complete information about all financial transactions. In addition to ensuring that actual expenditures are comparable with budgeted amounts, organizations should maintain accounting records on a current basis, including monthly reconciliation.

Not-for-profit organizations should also protect all grant property — whether cash or physical assets — and ensure that it is used only for authorized or specified purposes. This can be achieved through internal control standards such as the immediate recording of cash receipts, reconciliation of bank accounts, and entrusting petty cash to a single custodian. Internal controls should be accompanied by effective audit standards that keep the organization in a state of audit readiness, meaning that records related to the financial and programmatic aspects of grants are consistently available for review. The final exercise is effective financial reporting through appropriate reporting standards, which promote timely submission of reports to resource providers and enhance organizational accountability.

Budgeting in Nonprofit Organizations

Budgets are an essential part of an organization's financial management because they represent the operating plan for a given financial period. Financial statements express decisions about how the organization will accomplish its stated objectives in monetary terms. Through budgeting, the organization's staff and board determine the programs and activities to be carried out in the upcoming financial year, then allocate resources toward ensuring those programs are delivered.

For not-for-profit organizations to develop a reasonable, understandable, and accurate budget, they must have practical knowledge of relevant terminology and accounting standards (McMillan, 2010, p. 1). Accounting periods for these organizations may include a calendar year running from January through December, a fiscal year that does not begin at the calendar year's start, or a short period defined by the organization itself.

Not-for-profit organizations also face budget planning challenges related to the complexity of their programs and asset base. Since budgets compile management plans and objectives across all operational phases for a specified period, program priorities must be balanced to produce an effective budget. This requires management to allocate capabilities and resources so as to reach the maximum number of intended beneficiaries.

The budgetary planning process must account for lead times associated with multiyear initiatives and grant requests. The financial manager should prepare a budget that ensures sufficient funds are available for activities scheduled beyond the average budget cycle. Once adopted, the budget should serve as a management tool for evaluating operational performance. It should also be updated to reflect new circumstances and unforeseen conditions. After adoption, the organization should use periodic reports to compare budgeted revenues with actual revenues and budgeted expenses with actual expenses (Zietlow, Hankin & Seidner, 2011). Financial management proficiency depends on an organization's ability to improve its budgeting and financial reporting processes.

There are two major types of budgeting used in not-for-profit financial management. The first is zero-based budgeting, which incorporates planning for objectives as an integral part of the budgeting process. In this approach, the organization starts from zero by assuming that no activity or program is automatically necessary and that no expenditure is predetermined. Every element of revenue and expense is evaluated systematically, and each program must be proven worthy and financially sound for each financial year. This means every program must justify its existence and demonstrate its effectiveness relative to alternative programs. As programmatic priorities are established, the cost center of each program is examined to verify its necessity in relation to the organization's overall objectives.

By contrast, incremental budgeting treats current programs and departments as pre-approved, adjusting resources based on increases or decreases from the prior period. Historical expenses serve as the baseline for budget planning, and the focus is on expected changes above or below the previous fiscal year's figures. Program priorities are considered settled, and the organization must determine whether the budget should rest on measurable and predictable statistics or on reasonable estimates.

Regardless of which budgeting approach is selected, the organization should ensure that an effective budget is developed. A thoroughly planned and executed budget increases the likelihood of financial success, and a comprehensive budget translates abstract objectives into controllable, measurable units. In general, the budget communicates the performance goals for the upcoming financial year.

Budget preparation in a not-for-profit organization is primarily driven by policy decisions (McCarthy, Shelmon & Mattie, 2012). Although the organization's treasurer may be the best-qualified person to work with the financial figures, he or she is not necessarily involved in policy decisions. As part of the budgeting process, the organization should appoint a budget committee composed of individuals responsible for policy decisions, while delegating detailed cost estimates and revenue projections for individual programs to appropriate staff members.