The Single Biggest Problem With Nonprofit Accounting Rules

There are a number of problems with nonprofit accounting rules.

When I say problems, I mean accounting rules that actually make it more difficult to read and understand a set of nonprofit financial reports.  If you have worked in the nonprofit world long enough, this statement should come as no surprise.

The biggest offender is the rule regarding the timing of revenue recognition with multi-year grants.  This rule says that if your nonprofit organization receives a multi-year grant award, and assuming there are no conditions attached to it, all the revenue is recognized in your financials in the first year.  The revenue may be broken down between restricted and unrestricted, but in total it is all recognized upfront.

This is best shown with an example.

Imagine your organization receives a letter from your favorite foundation awarding you a $300,000 grant to support your main program over the next three years (i.e. $100k per year).  There are no conditions attached to this grant.

Over the three-year term of the grant, your total revenue and expense associated with this grant will look like this:

                       Total      

Revenue      $300,000

Expense      $300,000

Net                            $0

So far, so good.  However, when we break this down year by year, we see the following:

                        Year 1        Year 2         Year 3           Total    
Revenue      $300,000                 $0                   $0     $300,000

Expense      $100,000     $100,000      $100,000     $300,000

Net               $200,000   ($100,000)   ($100,000)                 $0

Note that the totals in both tables above are the same.  However, in Year 1 it looks like the organization has a windfall profit of $200,000.  In years 2 and 3 it looks like the organization has a loss of $100,000 each year.  We know intuitively that the organization is getting $100,000 each year and is spending $100,000 each year, but that is not what the financial reports seem to be saying.

Multi-year grants such as this make it difficult for nonprofit boards and management to understand and interpret their results.  This is further complicated when we consider the impact of the restricted and unrestricted portions of these funds.  (The different types of restrictions will be discussed in a future blog.)

This accounting rule also creates difficulties when budgeting.  How do you prepare your budget for year 2 or year 3?  You will be receiving $100,000 in each of those years from the foundation, but if you put that in your budget, won’t you be double counting revenue that was already recorded in year 1?  But if you don’t include that money, then won’t your budget look like your program is running at a deficit when in fact it is not?

Let me know if you would like me to discuss some solutions to this dilemma in a future blog.

Moral of the story:  almost all nonprofit organizations share this frustration with the accounting rule pertaining to revenue recognition with multi-year grants.  The good news is that there are ways to deal with this when presenting financial information and when budgeting that make your information easier to understand.

Comments welcome.

Eric Fraint, President and Founder
Your Part-Time Controller, LLC