If you are struggling to understand a nonprofit balance sheet and other financial statements, then this post is for you! And it’s especially for you if you are not a “numbers person.”

Chances are you’ve looked at your organization’s profit and loss report and never thought much about the balance sheet. If that’s the case, you may be using the wrong accounting framework.

We have noticed in working with clients that people often relate to accounting the same way they relate to their checkbook. In this framework, money going out is an expense and money coming in is income.

Accounting should be this simple, right?

Problems with the Checkbook Framework of Accounting

However, within the checkbook framework of accounting, it becomes confusing to record transactions.

Take, for example, credit card charges. How do you code an expense for $100 in supplies if you haven’t paid anyone any cash yet? It would be nice to include that expense in the profit and loss statement based on the date of the purchase. But what often happens is the expense is entered into the books when the credit card is paid, which could be a month or more later!

Other transactions that cause much confusion don’t impact income or expense at all such as:

• The payment of a security deposit for a special event venue (This isn’t an expense; you’re going to not wreck anything so you’ll get that money back, right?)
• The return of the security deposit (See what we mean?)
• A cash withdrawal to create a petty cash fund for a special event (This is never an expense; it’s just you moving the organization’s money around.)
• A transfer from PayPal to the checking account (Again, no income or expense here; just moving more money around.)

These transactions don’t “feel” like income or expense. Yet, for lack of a different way to understand them, one side of the transaction is coded to increase or decrease cash (that’s the easy part) while the other side of the transaction is coded to an income or expense account, thereby affecting the profit and loss report.

As an example, a transfer from PayPal to the operating account gets entered as a deposit to the operating bank account and the other side of the transaction is coded to Miscellaneous Income. Or Contributions. Or even Uncategorized Income. (Cue the accountant groaning.)

“Oh wait. There are two sides to each transaction? But my checkbook just lets me add and subtract. Why do I have to worry about another side of the transaction?”

Stick with us and we’ll show you. It all comes down to three buckets.

 Introducing the Three Bucket Framework

While the basic accounting framework is not terribly complex, it’s becoming apparent that there’s a lot more going on than just income and expenses. Think of the accounting framework as having three buckets: Assets, Liabilities and Net Assets.

The Three Bucket Framework encompasses the balance sheet as well as the profit and loss report. You see, income and expenses found on the profit and loss report belong in the Net Assets bucket.

Each bucket contains accounts for transactions affecting that bucket as listed below.

The Assets Bucket

The Assets bucket includes things you own, both tangible and intangible, such as

• Cash
• Pledges receivable (promises from donors to make gifts in the future)
• Expenses you’ve paid in advance, such as insurance premiums
• Money owed to the organization, such as an employee advance
• Investments
• Physical assets like a building, computer equipment or vehicles

The Liabilities Bucket

The Liabilities bucket includes amounts you owe, such as

• Payments due to vendors for services provided or goods received (accounts payable)
• Credit card charges for supplies where the credit card issuer has not been paid yet
• Payroll earned by employees but not yet paid

The Net Assets Bucket

The Net Assets bucket holds all the income and expenses of the organization. Net assets increase when the organization receives income and decrease when the organization incurs expense.

The three buckets fit into the following basic accounting equation:

Assets = Liabilities + Net Assets

Let’s walk through a quick example:

The organization receives a $100 donation which increases cash, an asset on the balance sheet. The other side of the transaction is an entry to Contributions on the profit and loss report. The $100 of income flows from the profit and loss report into the Net Assets bucket on the balance sheet keeping it in balance:

$100 increase in assets = $0 change in liabilities + $100 increase in net assets

See how easy that is?

The for-profit business term for net assets is equity. Since no one owns a nonprofit organization, we use the term “net assets.”

If you use a checkbook framework to understand accounting, you are only working out the Net Assets bucket. There are two other whole buckets you can use! The Three Bucket Framework beats the Checkbook Framework any day of the week.

More Examples Using the Three Bucket Framework

Paying a Security Deposit

Take the first example above – paying a security deposit for an event venue. A security deposit is not an expense because you will get that money back after the event (assuming no damage!).

To record the payment of a $500 security deposit, think in terms of which buckets are affected, then which accounts within each bucket. In this example, the Assets bucket is impacted because a check will be written to the venue for the amount of the deposit, reducing cash and impacting the bank cash account in your accounting system. (Usually the bank cash account in your accounting software is named for the specific bank, such as Wells Fargo Checking.)

The other account affected is another Asset account called Security Deposits. This transaction simply increases one asset account, Security Deposits, by $500 and decreases another asset account, Cash, by $500. The three buckets of Assets = Liabilities + Net Assets remain in balance.

Making a Credit Card Charge

How about the credit card charge for supplies? No cash is impacted at the time of the charge, but you have obligated the organization to pay money in the future. Which buckets are affected?

The purchase increases credit card debt so the Liabilities bucket is affected, specifically the Credit Card Liability account. (Usually this account is named for the credit card, such as Amex.)

What other account is affected? You have an expense for supplies. Therefore a Supplies Expense account would also be impacted, which is part of the Net Assets bucket.  In this example the Liabilities bucket increased and the Net Assets bucket decreased by the amount of the charge. Hence the three buckets of Assets = Liabilities + Net Assets continue to remain in balance.

Remember to use all the buckets at your disposal when trying to make sense of accounting. There are only three of them and they always maintain the same relationship to each other:

Assets = Liabilities + Net Assets

Links to Other Resources

To help you get more familiar with the accounts inside of each of these three buckets, here are links to our posts on common accounts in the chart of accounts

Chart of Accounts Grand Tour Wrap Up – for links to posts on income and expense accounts that feed into Net Assets on the balance sheet

Biggest Bookkeeping Secret – for links to posts on balance sheet accounts

Also here is a link to a great explanation by the Greater Washington Society of CPAs on the Statement of Financial Position (the name for a nonprofit balance sheet prepared using Generally Accepted Accounting Principles).

For now we hope we’ve given you the big picture. By using the Three Bucket Framework, you will be able to make sense of the financial story behind any transaction!