The accounting and financial management literature on nonprofit organizations is in considerable agreement that such organizations need adequate financial surpluses for a variety of reasons. Herzlinger and Nitterhouse, for example, identify three reasons: (1) to replace assets because asset values are reported at cost rather than at their substantially-higher replacement value, (2) to help finance expansion because an organization cannot rely entirely on borrowing to finance its expansion, and (3) to protect against uncertainties and variability in earnings. 1
Similarly, Suver, Neumann and Boles, focusing specifically on the needs of healthcare organizations, 2 argue that a nonprofit organization must earn a surplus to meet its “total financial requirements,” which include costs of doing business and staying in business. Costs of doing business include the cash needs associated with growth. Costs of staying in business include the need to replace fixed assets as they become obsolete or wear out.
As a result, a nonprofit organization, especially one that has significant plant, equipment, and other fixed assets (such as a hospital, a museum, a university, or a port authority), or one that is growing rapidly, needs to earn a surplus. It must do so to “... avoid the erosion of its real capital and its ability to continue to provide the volume and quality of services desired by the community it serves.” 3
In sum, the relevant literature on nonprofit management and accounting has established the fundamental principle that a nonprofit organization must generate a financial surplus. That surplus must serve four purposes:
- Assist the organization to obtain the funds necessary to replace assets that wear out or become obsolete.
- Finance the cash needs associated with a growth in conjunction with its charitable or nonprofit purposes.
- Provide the funds necessary to expand and diversify fixed assets for expansion its charitable activities.
- Protect the organization from fluctuations in revenues from year to year, and from general economic and other uncertainties surrounding its ongoing operations.
These requirements are not unique to nonprofit organizations. What distinguishes a nonprofit from a for-profit organization is the absence of “owners” or “investors.” As a result, nonprofit organizations do not need a surplus to provide a return to its owners. Apart from this distinction, however, an organization that wishes to remain in business, or that wishes to expand its operations, needs a surplus for one or more of the above four requirements.
Failure to understand these requirements and their implications has led many observers to suggest that the term “nonprofit” implies there should be a zero surplus. Nothing could be further from the truth. Nevertheless, there is an important question to be answered about whether the surplus of a given nonprofit organization is “reasonable.” This question can be addressed from the perspective of each of the above four requirements.
REQUIREMENT #1. FIXED ASSET REPLACEMENT.
The surplus requirements associated with replacing fixed assets (principally plant and equipment) arise because, at some point, all fixed assets wear out or become technologically obsolete. Because of inflation, their replacement cost usually is more than their initial cost.
Some have argued that sufficient funds would be available for fixed asset replacement if their depreciation were “funded,” i.e., if an equivalent amount of cash were sequestered each year in a special fund dedicated to fixed asset replacement. However, funded depreciation would be sufficient only if there were no inflation. In an inflationary economy, the inflation base is the asset’s purchase price, whereas the earnings on the funded depreciation come from a base that is only a small fraction of the asset’s purchase price. This phenomenon . . .
1 Herzlinger, Regina E., and Denise Nitterhouse, Financial Accounting and Managerial Control for Nonprofit Organizations, Cincinnati, Ohio, South-Western Publishing Co., 1994, p. 152. See also Ziebell, Mary T., and Don T. DeCoster, Management Control Systems in Nonprofit Organizations, San Diego, Harcourt Brace Jovanovich, Publishers, 1991; and Young, David W., “Nonprofits Need Surplus Too,” Harvard Business Review, January-February 1982.
2 Suver, James D., Bruce R. Neumann, and Keith E. Boles, Management Accounting for Healthcare Organizations, 3rd edition, Chicago, Healthcare Financial Management Association and Pluribus Press, Inc., 1992.
3 Seawell, L. Vann, Introduction to Hospital Accounting, 3rd edition, Dubuque, Iowa, Kendall/Hunt Publishing Company, 1992.