Let’s start out this topic of accounting for churches with two quotes. The first is from Charlie Munger, Warren Buffett’s business partner for over four decades. Charlie once said,
Proper accounting is like engineering. You need a margin of safety. Thank God we don’t design bridges and airplanes the way we do accounting.Charlie Munger.
This quote signifies the importance of understanding accounting principles but emphasizes that too often organizations forget to build in the margin of safety when it comes to their accounting. When improper accounting techniques are used or organizations budget with a break-even mentality, the financial health of the church is in jeopardy. Church accounting should use an engineering approach to the margin of safety, and be able to withstand loads that are greater than expected.
The second is from Charles Scott, a professor from Yale University who said it more simply this way,
Creativity is great – but not in accounting.Charles Scott.
We applaud our children when they are creative. However, in accounting creativity is not only unacceptable but can get you into legal trouble. Even worse, churches can lose donors when proper accounting procedures are not followed. Churches should be above reproach as we discussed in this four-part series — church fundraising blog post.
Mistake #1 — Creative Accounting
Some creative accounting methods may not be illegal per se, but they fail to provide a “true and fair” overview of the organization’s finances. In other words, they are technically permitted, but in general, frowned upon. Let’s give an example of creative accounting.
Inflating property values
A long-standing accounting principle is to report the ‘cost’ of a fixed asset such as a building. Cost, in accounting terms, is what you paid for it. While CPAs could enter appreciation into the accounting ledger they will use a separate sub-account, thus keeping the original cost and appreciation separate. They don’t adjust the original cost in this scenario. Using two accounts the balance sheet shows the original cost and appreciation on separate lines, providing transparency.
In creative accounting, only one line item is used- the fixed asset. In doing this, the original cost of the building purchased possibly decades ago- is combined with the present-day value. thus losing the original cost which will impact reporting.
Mistake #2 — Churches Must Use Fund Accounting
Church accounting is quite different than its counterpart, for-profit accounting. Church accounting concentrates on accountability, not profitability. The accountability principle in church accounting is called fund accounting. For-profit accounting doesn’t use funds since they are focused on making a profit only.
The funds typically represent missions within the church and show church leaders how each mission is functioning financially. For example, is the Haiti mission financially stable and is it fulfilling its purpose(s)? To understand mission accountability, the church has to keep the financial transactions for the Haiti mission separate from the General fund. Designating transactions within a fund, allows for separate reporting and accurate information to be provided to church leaders.
Think of fund accounting more like each mission functioning as a separate company, with it’s own set of accounts. The Haiti Mission fund can report exactly how much money they currently have, how it was earned, and how it was spent. The church leadership can then review each mission’s accounting ledger separately, thus giving the leaders a drilled down view of how that mission is performing without seeing all the other missions intertwined.
Mistake #3 — Not Maintaining Designated Funds
By Maintaining designated donor funds the church ensures transparency, accountability and honesty. Beyond these important values, there’s also the FASB requirement that states, churches must keep designated monies separate from the undesignated monies. FASB (Financial Accounting Standard Board) is the organization that issues accounting standards that all government entities like the SEC, IRS and so on follow. Churches need to stay compliant with FASB guidelines.
Why is it important to keep the monies separate?
Money given to a designated fund can only be used for that particular purpose. If the church collects money to remodel the main congregational room, via designated fund, they are NOT allowed to use that money to resurface the parking lot. The proper church fund accounting software allows designated funds and undesignated funds to exist within the same system, but keep separation between them.
One drawback of having several designated funds is that donations towards undesignated funds may decrease. This happens when donors are giving a lot of their resources to a designated fund like a building remodel, thus ignoring the undesignated General fund that keeps the lights on. Churches should be careful about how many designated funds are allowed at a time.
Mistake #4 — Improperly Classifying Transactions
There’s an old adage about data entry that states “garbage in, garbage out”. When entering accounting transactions properly assigning the account is crucial. Having a wrong disbursement will mess up the reporting 100% of the time. Unlike horseshoes where close will gain you points, accounting transactions have no such leeway, it’s either right or wrong.
Let’s use an example of processing a refund to see how easy it is to get a transaction wrong. Most of the time when depositing money into the bank account, a revenue account is used. However, a refund is not revenue. Why isn’t it revenue? Revenue is new money the organization has received. A refund is money you had already spent, but are now receiving back, due to an overpayment or return. This is not new money, thus not recorded as revenue. It’s important the organization does not overstate a revenue account because of a refund.
How to process a refund
The refund has to go against the original expense account used when the money initially left the organization. By using the same expense account, it decreases the expense that paid the bill. This helps the church know how much they truly spent on any particular line item giving them a more accurate financial picture and better reporting.
Additionally, the organization needs to ensure the fund used on the return is also the same fund as the original purchase transaction. In other words, if the General fund initially spent the money, then the General fund should receive the refund.
Think of the old budget method using envelopes. Before computers, people would put money into envelopes as a way to budget. We can relate this to non-profits. In this analogy, the envelopes are the funds. When using this budget method, you go to the grocery store with $150.00 cash, and you spend $140.00, leaving $10.00. When you come back home you wouldn’t put the $10.00 in the gas or dining out envelope. The leftover $10.00 would go in the grocery envelope (i.e. the fund).
How to process loan payments
Another example of an inappropriate account designation is when making a loan payment and the transaction debits an expense account and credits the checkbook. A transaction like this actually has three disbursements, the checkbook, an expense account, and a liability account. Because it is a loan, the transaction must debit the liability so the amount owed is reduced. The interest amount is also debited- using an expense account. Lastly, the checkbook must be credited for the full amount of the payment.
Non-profits not only have to make sure the account assignment is correct, but they must also make sure they are selecting the appropriate fund used for all transactions. When the wrong fund is used, it does not end well for reporting. Reporting will always be wrong.
Mistake #5 — Failing To Reconciling Checkbooks
Reconciling checkbooks is HUGE. Why is it so important? Because this one not only catches mistakes but also possible embezzling and fraud. Checks should be written by one staff member while the reconciliation process is completed by another. This is called, “Separation of Duties” which we’ll talk about in mistake #6.
When a person is reconciling the transactions within the accounting system to their bank statement, several irregularities can be corrected. For example, transposing numbers is easy to do. A check written out for $120.00 but entered as $102.00, creates an $18.00 discrepancy. Automatic withdrawals- or EFT transactions could easily be missed along with bank interest and fees. To ensure accurate account balances, bank accounts must be reconciled.
Mistake #6 — Failure To Have Separation Of Duties
This mistake is easily made within churches due to their trusting relationships with staff, board members, and volunteers. There should be individuals that are in charge of depositing money but those same individuals shouldn’t be writing checks. Likewise, the person writing checks shouldn’t be reconciling the checkbook.
Whenever it comes to money, organizations should put in place internal controls to correctly account for the money. This rule is overlooked at times. Particularly when smaller churches don’t have a large number of volunteers. If this is the case, then other internal controls must be in place to ensure a separation of duties exists when it comes to donations (i.e. the church’s revenue).
Why is separation of duties so important?
The stakes are pretty high when trying to keep an organization on the straight and narrow. When an organization drifts from this path because of inconsistencies or worse, embezzling, organizations typically end up losing money. Often, they end up closing their doors when money from donations is used incorrectly.
Mistake #7 — Keeping Multiple Checkbooks Instead Of Funds
Another mistake is using multiple checkbooks for funds. Before the creation of fund accounting software, churches would use multiple checkbooks to keep their money separated — ie designated vs undesignated. The major problem with this is that checkbooks aren’t a double-entry system, thus reporting was a nightmare.
Another issue, is that it would take a lot of effort to combine each checkbook’s numbers into one coherent report since the ‘numbers’ spread out across several different checkbooks. If the church had four checkbooks how would the bookkeeper bring in the expenses and revenues from the different checkbooks into one report? Typically this is where a spreadsheet comes into play for churches. After entering transactions into the checkbook they would have to go update the spreadsheet to get a report for the month-end meeting.
What about checkbook reconciliations?
Given the same scenario of having four checkbooks, the church has quadrupled the monthly work for the bookkeeper. The bookkeeper would have to reconcile all these checkbooks each month. Fund accounting software uses one checkbook and has multiple funds keeping the money separated within that one checkbook. This allows for faster reconciliations, less paperwork, and less time needed to complete the work.
Accounting For Churches Summary
The seven mistakes above aren’t the only ones churches can make. Think of this as a shortlist to start thinking about how to avoid these mistakes and others. Many times these mistakes creep in slowly without anyone realizing it. An example of this is increasing a property value as discussed in mistake #1. This mistake comes down to doing just one entry wrong, possibly by a well-meaning volunteer bookkeeper. Because this is an asset account, this mistake carries forward on the books into all future years. Other mistakes like #7, the church simply opens up another checkbook not realizing what that really means. Most of the time the church board is trying to solve an immediate need of keeping money separated and not looking at the long-term issues.