TLDR
Boards that cannot read financial statements cannot exercise fiduciary oversight. Funders that cannot read your financials will ask questions that delay grant renewals. These 13 questions explain what each required nonprofit financial statement shows, what auditors look for, and how to present the most common difficult results — a deficit year, a qualified opinion, a significant restricted net asset balance — to audiences who did not study nonprofit accounting.
A foundation program officer reviewing a renewal application requested the applicant’s most recent audited financial statements. What she received was a set of statements using “temporarily restricted” and “permanently restricted” terminology — the pre-2018 FASB framework. The statements were either several years old (a red flag) or the auditor had failed to update the presentation (also a red flag). The renewal went on hold while the nonprofit’s Executive Director explained the discrepancy. The grant was eventually approved, but three weeks were lost to a question that accurate financial statements would have prevented.
Financial statements are the first thing sophisticated funders and board members read. These 13 questions address what each statement shows, what changes since 2018 affect every nonprofit’s presentation, and how to explain the results that require explanation.
Implementation realities and migration notes
Mid-sized nonprofits in this category typically inherit a tangle of restricted-fund histories: federal pass-throughs, state agency contracts, family-foundation grants, and partner funding stretching back many years. Migrating that history cleanly is not optional — auditors and program officers will ask questions that require a year-by-year reconstruction. Implementation timelines run six to ten weeks for organizations that scope the data inventory before signing. Cutting corners on migration to chase a fast launch usually surfaces gaps during the next single-audit cycle, and the cost of fixing those gaps after the fact is meaningfully higher than doing migration right at the start.
Plan accordingly, and require any vendor on the shortlist to demonstrate restricted-fund handling, grant tracking, and donor record migration on a representative sample of your actual historical data before you sign. Vendors that decline to demo on real data are filtering you out for a reason. The demo on your data is where the gaps surface — both the gaps in the vendor’s product and the gaps in your existing records that you will need to clean up regardless of which system you choose. Use that demo to set realistic expectations with the board and the audit committee about timeline and scope before contracts get signed.
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Frequently asked
Frequently Asked Questions
What financial statements does a nonprofit produce?
Under FASB ASC 958, nonprofits are required to produce four financial statements: (1) the Statement of Financial Position, which shows assets, liabilities, and net assets at a point in time; (2) the Statement of Activities, which shows changes in net assets — revenues, expenses, and gains and losses — for the period; (3) the Statement of Functional Expenses, which presents expenses by both natural classification (salaries, rent, supplies) and functional classification (program services, management and general, fundraising); and (4) the Statement of Cash Flows, which explains the change in cash and cash equivalents through operating, investing, and financing activities. These four statements, taken together with the notes to the financial statements, constitute a complete set of financial statements under GAAP. Nonprofits do not produce a statement of retained earnings — there are no retained earnings in a nonprofit; the equivalent is the change in net assets shown in the Statement of Activities.
What is the Statement of Financial Position?
The Statement of Financial Position is the nonprofit equivalent of a balance sheet. It presents, as of a specific date, the organization's total assets (cash, receivables, prepaid expenses, investments, fixed assets), total liabilities (accounts payable, accrued expenses, deferred revenue, long-term debt), and net assets (the difference between total assets and total liabilities). Net assets are divided into two classes: net assets with donor restrictions (funds that donors have restricted to specific purposes or time periods) and net assets without donor restrictions (funds available for general organizational use, including board-designated reserves). A funder reviewing this statement is primarily looking at: (1) the organization's liquidity — how many months of unrestricted operating expenses are covered by liquid unrestricted assets; (2) the composition of restricted net assets — what restrictions exist and when they are expected to be released; and (3) the liability structure — whether the organization has significant deferred revenue, loans, or contingent liabilities.
What is the Statement of Activities?
The Statement of Activities shows changes in net assets for a period — typically a fiscal year. It presents revenues (grants, contributions, program service fees, investment income), expenses (program services, management and general, fundraising), and other items (gains and losses on investments, transfers) for each net asset class separately. The bottom line is the change in net assets for the period — the nonprofit equivalent of net income. Key line items unique to nonprofits: (1) contributions and grants, which may be classified as with or without donor restrictions at the time of receipt; (2) 'net assets released from restrictions,' which records the reclassification of restricted funds to unrestricted when donor conditions have been satisfied — this line must appear gross, showing the full amount released; (3) in-kind contributions, recorded at fair value. The statement does not show a single 'profit or loss' figure — it shows how net assets in each class changed and why.
What is the Statement of Functional Expenses?
The Statement of Functional Expenses presents expenses in a matrix: natural classifications (salary and benefits, occupancy, supplies, professional services, depreciation, etc.) as columns, and functional classifications (each program service, management and general, fundraising) as rows. It answers the overhead question: for every dollar spent, how much went to programs versus administrative costs versus fundraising? Watchdog organizations (Charity Navigator, GuideStar) use this data to calculate program expense ratios. Many grant funders review it as part of proposal due diligence. The statement requires a documented cost allocation methodology — joint costs (like a mailing that is both programmatic and fundraising) must be allocated according to the criteria in FASB ASC 958-720-45. An undocumented or inconsistent allocation methodology is a common audit finding and a source of management letter comments.
Why does our Statement of Activities look different from a for-profit income statement?
Three structural differences explain most of the confusion. First, revenue is not just revenue — it is divided between net assets with donor restrictions and net assets without donor restrictions. A $500,000 grant that is restricted to a specific program appears as restricted revenue, not as an addition to your operating budget. Second, the 'net assets released from restrictions' line has no for-profit equivalent — it shows the reclassification of restricted funds to unrestricted when the conditions are met, which is why the same dollar sometimes appears twice (once as restricted revenue when received, once as a release when spent). Third, the bottom line is 'change in net assets,' not 'net income.' An organization with a positive change in restricted net assets and a negative change in unrestricted net assets has surplus in restricted funds and a deficit in operations — two very different financial situations that one bottom-line number would obscure.
What does 'net assets released from restriction' mean?
'Net assets released from restriction' is the accounting entry that records the reclassification of donor-restricted funds to unrestricted when the donor's conditions have been satisfied. A $75,000 grant restricted to workforce development is initially recorded as revenue in net assets with donor restrictions. Each time workforce development expenses are incurred, an equal amount is 'released from restriction' — recorded as a revenue item in net assets without donor restrictions and a deduction from net assets with donor restrictions. This release entry ensures that the Statement of Activities shows: in the restricted column, where restricted gifts went; in the unrestricted column, what resources funded program delivery. If your organization runs on a simultaneous release election (recognizing restricted contributions as revenue in the period they are spent), you will never see a restricted net asset balance on your Statement of Financial Position for these grants — the receipt and release happen in the same period.
How often should we produce financial statements?
For board governance: monthly financial statements for Executive Director and Finance Committee review, including at minimum a Statement of Financial Position and a year-to-date Statement of Activities compared to budget. Monthly statements allow early identification of budget variances and cash flow problems — quarterly board reporting is too infrequent to prevent problems, only to document them after the fact. For grant compliance: grant-level budget-to-actual reports monthly, more frequently for grants approaching their period-of-performance end date. For external reporting: annual audited financial statements are the standard for most grant funders and state reporting. Some funders require quarterly unaudited financial statements as part of grant reporting. Organizations with revenues above $1M should have a finance committee that reviews monthly financials and reports exceptions to the full board.
Do our financial statements need to be audited?
It depends on revenue size, state law, and grant requirements — and usually, all three apply simultaneously. State law: most states require audits for nonprofits with revenues above $500,000–$1,000,000; some require a review (less rigorous than an audit) at lower thresholds; a few require audits below $500,000. Check your state's nonprofit reporting requirements. Federal grant requirements: any organization expending $1,000,000 or more in federal awards in a fiscal year must have a single audit (2 CFR 200.501, updated 2024 threshold effective for fiscal years ending September 30, 2025 or later). Funder requirements: many foundations require audited statements as a grant condition or in applications for awards over $50,000–$100,000, regardless of state law. An organization can be below the state audit threshold and still be required to have an audit by a specific funder. Review your grant agreements and your state's requirements annually.
What is the difference between cash basis and accrual financial statements?
Cash basis financial statements record revenue when cash is received and expenses when cash is paid. Accrual basis financial statements record revenue when earned and expenses when incurred, regardless of cash timing. GAAP requires accrual basis for nonprofit financial statements. The practical difference matters most for: (1) grant revenue — a cost-reimbursement grant where you spend in December but receive reimbursement in February shows the expense in December and the revenue in December under accrual, correctly matching them; under cash basis, the expense appears in December but the revenue appears in February, creating a misleading picture; (2) accounts payable — under accrual, invoices received but unpaid at year-end are liabilities on the Statement of Financial Position; under cash, they disappear; (3) grant fund balances — cash basis fund balances are often wrong at any date where reimbursements are pending. Auditors convert cash basis books to accrual basis for the audit, which adds cost and time.
What does a funder look for in our financial statements?
Program funders reviewing financial statements focus on: (1) operating reserves — the unrestricted net asset balance relative to annual operating expenses; three to six months of liquid unrestricted operating reserves is the standard threshold for financial health; (2) program expense ratio — the percentage of total expenses spent on program services (70% or higher is generally considered acceptable; below 65% invites scrutiny); (3) revenue diversification — concentration in one funding source (more than 30–40% from a single funder) is a risk factor; (4) the presence and nature of restricted net assets — specifically whether previous grants to this funder were fully expended or whether there are unexplained carryover balances; (5) audit opinion type — a qualified opinion or adverse opinion on the financial statements, or a finding specifically related to grant compliance, will delay or prevent grant renewal. Major gift prospects examine many of the same factors.
What is a clean opinion vs. a qualified opinion?
An unqualified (clean) opinion means the auditor has concluded that the financial statements present fairly, in all material respects, the financial position and results of operations in conformity with GAAP. It is the standard favorable result. A qualified opinion means the auditor has taken exception to one or more specific aspects of the financial statements but has not found the overall statements to be misleading — the statements are fairly presented 'except for' the identified matter. A qualified opinion signals a GAAP departure or a scope limitation and should be explained to funders proactively. An adverse opinion means the auditor concluded the financial statements do not fairly present the financial position — this is rare and serious, and will typically trigger funder notifications and board action. A disclaimer of opinion means the auditor could not obtain sufficient evidence to form an opinion — usually due to a scope limitation. Funders commonly request your audit opinion letter specifically to determine which type of opinion was issued.
How do I explain a deficit year to the board?
Start with what kind of deficit it is. A change in net assets without donor restrictions that is negative — an operating deficit — means the organization spent more than it received in unrestricted funds and drew down operating reserves. That is a substantive financial risk requiring a corrective plan. A change in net assets with donor restrictions that is negative means restricted grants were spent down faster than new restricted grants were received — not necessarily a problem if unrestricted operations are healthy. A combined negative change in net assets where the operating fund is positive but a restricted fund had a large release from restriction that created a mathematical negative change is a presentation artifact, not a real deficit. The board needs to understand which of these three situations they are looking at. The questions to answer: Was this deficit planned or unexpected? What is the organization's liquidity position after the deficit? What specific actions are being taken to return to surplus — and on what timeline?
What changed about nonprofit financial statement presentation in 2018?
FASB ASU 2016-14 took effect for fiscal years beginning after December 15, 2017 — calendar year 2018 for most nonprofits. The primary changes: (1) the net asset classification system changed from three classes (unrestricted, temporarily restricted, permanently restricted) to two classes (with donor restrictions, without donor restrictions) — eliminating the distinction between time-based and perpetuity restrictions on the face of the statements, with expanded note disclosures providing the detail instead; (2) the Statement of Functional Expenses became required for all nonprofits, not just voluntary health and welfare organizations; (3) new required disclosures for liquidity — organizations must now disclose the availability of financial assets to meet general expenditures within one year of the balance sheet date; (4) enhanced endowment disclosures, including amounts and composition of underwater endowment funds; (5) investment return presentation was simplified. If your financial statements still use 'temporarily restricted' or 'permanently restricted' terminology, they are not in compliance with current FASB ASC 958 requirements.