Imagine one of your nonprofit’s vendors emails you an invoice. Your bookkeeper prints the invoice and files it away to be paid.
A week later, the vendor sends you an automated reminder about the invoice. Without realizing the invoice has already been filed, a volunteer prints out the statement. Since there’s no system to check invoice numbers, you end up paying the same bill twice.
Without proper expense and accounts payable documentation, your nonprofit risks double-paying bills. But the stakes go up with other types of documentation, a lack of which might mean losing funding, jeopardizing tax-exempt status, breaking funder trust, and more. This guide will review the risks of poor financial documentation, empowering your staff to keep clear records at all times:
- Frequently Asked Questions About Nonprofit Financial Documentation
- 5 Potential Risks of Poor Financial Documentation for Nonprofits
Frequently Asked Questions About Nonprofit Financial Documentation
What types of financial documentation should nonprofits maintain?
There are several different types of financial or adjacent documentation nonprofits should maintain, including:
Governance Documents
While not technically financial documents, documentation related to your nonprofit’s governance verifies your organization’s tax-exempt status. These documents include:
- IRS Determination Letter, which proves your 501(C)(3) status and may be necessary for grant applications and state tax exemptions
- Articles of incorporation and bylaws, which explain how your organization runs
- Board meeting minutes, which are official records of financial and other board decisions
- State tax exemption certificates, which prove sales tax exemptions in different states
Income and Revenue Documentation
These documents allow for proper revenue recognition:
- Grant agreements that describe important terms and conditions, including how you can spend grant funds
- Donor letters or other accompanying correspondence that conveys any restrictions donors have imposed on their contributions
- Deposit slips and scans that prove when money hits your bank account
- In-kind donation acknowledgments that provide records of non-cash gifts
Expense and Accounts Payable Documentation
In contrast, these documents allow you to track money flowing out of your organization:
- Vendor invoices and monthly statements
- Itemized receipts for credit card purchases
- Forms W-9, which collect tax information from consultants, contractors, freelancers, and other vendors
- Service contracts and lease agreements
Payroll and HR Records
Payroll is typically one of a nonprofit’s largest expenses and requires significant documentation:
- Timesheets, which are especially important for showing which programs employees worked on for government grants
- W-4s and state tax forms, so you know how much federal income tax to withhold from employee paychecks
- Benefit enrollment forms that prove which employees agreed to reductions for health insurance or retirement benefits
Review and Reconciliation Reports
This type of documentation demonstrates how you manage funds:
- Bank and credit card statements and reconciliations, which prove that your books match the bank
- Investment statements and reconciliations, which report on your investment transactions, holdings, gains, and losses and verify balances
While these types of documentation are standard across the nonprofit sector, this list is not exhaustive, as charitable organizations produce various financial documents.
How long should nonprofits keep these documents?
How long your nonprofit should keep financial documents depends on the document type. Core documents, like your articles of incorporation, bylaws, IRS determination letter, and board minutes, should be retained permanently.
Other documents might have their own associated retention guidelines. For example, YPTC’s W-9 for nonprofit guide explains that you should keep W-9s on file for at least four years so you can answer any questions from the IRS about independent contractor payments.
State laws might also dictate how long you should keep certain documents. For instance, in Georgia, you must keep internal and external audit reports for at least five years.
5 Potential Risks of Poor Financial Documentation for Nonprofits
1. Loss of Tax-Exempt Status
Perhaps one of the largest risks of poor financial documentation is the potential to lose your tax-exempt status. While poor documentation doesn’t necessarily cause tax-exempt status revocation, it can lead to it.
Let’s take a look at situations in which inadequate documentation can result in tax-exempt status loss:
- Failure to file Form 990 for three consecutive years. If your nonprofit fails to file Form 990 for three years in a row, it will automatically lose tax-exempt status. Typically, organizations miss filings because of cracks in their organizational continuity. For example, if the staff member typically in charge of the Form 990 filing process leaves your nonprofit and doesn’t document their IRS login credentials, your organization may fail to file and not even notice until it’s too late.
- Failure to pass an IRS audit. The IRS may audit a nonprofit to confirm that it’s using funds appropriately to support its mission and reporting these resources accurately. If you can’t produce documentation like receipts, grant agreements, and board minutes to prove that expenses are mission-related, the IRS may reclassify them as non-exempt, leading to the loss of your tax-exempt status.
- Private inurement. If insiders, such as board members, leadership, or founders, personally benefit from your nonprofit’s funds, you may lose tax-exempt status. For instance, if a founder uses the company card for a mix of personal and business travel but loses the receipts, they can’t prove which payments were business-related, and the IRS may consider these transactions private inurement.
2. More Expensive, Complex Audits
The cost of a nonprofit audit depends on several factors, including the amount of time the auditor spends and the complexity of your nonprofit’s finances. Missing documentation can consume more of your auditor’s time, leading to higher costs.
Plus, failing to maintain proper documentation creates more work for your staff both before and after the audit. When you don’t stay audit-ready, you’ll be scrambling to get all the required documents in order, which can harm staff wellbeing, and afterward, they may need to spend significant time implementing the auditor’s recommendations.
3. Grant Reductions
When you propose and apply for a grant, you typically attach a budget for how you’ll spend grant funds. Then, in the final grant agreement, the funder will finalize this budget, the payment schedule, and any reporting requirements.
Without adequate documentation, such as invoices, contracts, or proof of payment, previously agreed-upon expenses may become disallowed costs. If you can’t substantiate expenses, funders may deny reimbursement or ask you to return the money if it was given in advance, causing your nonprofit to lose out on mission-critical funding it worked hard to secure.
4. Restricted Fund Commingling
In addition to not being able to prove that you spent restricted grant or individual funds for mission-related expenses, poor documentation may also cause you to actually mismanage those funds.
For example, let’s say a donor contributes restricted funds specifically for your nonprofit’s elementary school mentoring program. If you don’t keep clear records of this restriction and the associated expenses for your mentoring program, you may accidentally spend the funds on another program or even overhead.
Donors or grantors who contribute restricted funds may request financial reports proving your compliance with their wishes. However, even if funders don’t explicitly ask for proof, it’s good practice to proactively share impact reports that demonstrate responsible fund use. Failing to use restricted funds according to donors’ intent can break funders’ trust and risk your relationships—or even result in legal action.
5. Vulnerability to Fraud
Poor documentation creates more opportunities for fraud. For instance, if you don’t keep credit card receipts and match them to your credit card statements every month, it creates temptation and opportunity for staff members to slip in their personal expenses. Alternatively, without records and inspections of your office’s physical assets, like computers and cell phones, you may not notice when one goes missing.
Additionally, if you suspect fraud later on, you won’t have the evidence you need to file an insurance claim or pursue legal action. That’s why consistent documentation and implementation of internal controls, such as separating financial responsibilities and conducting physical asset checks, are essential for strong financial management.
While maintaining financial documentation takes a little extra effort, it’s a habit well worth the investment. Inform your team of these risks so they’re aware of the gravity of this practice, and implement policies that necessitate clear recordkeeping to prevent these issues.
