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9 Common Internal Controls Your Nonprofit Should Have

Failure to understand internal control when identifying risks was the reason major issues come up at nonprofits 40 percent of the time, according to data from a AICPA Peer Review Program Study. Making sure your accountants and consultants understand remote monitoring and management (RMM) and internal controls is vital.

The best practice is to document internal controls so that there can be a complete risk assessment. The issues of internal controls and risk were discussed during the recent AICPA Nor-For-Profit industry conference in National Harbor, Md. The session presenters were Melissa Galasso, CPA, director, audit professional practices, in the Charlotte, N.C., office of Cherry Bekaert and Kris Ray, industry technical leader for Plante Moran in Southfield, Mich.

Internal control is designed, implemented and maintained to address identified business risks that threaten achievement of any of the entity’s objectives that concern reliability of financial reporting, effectiveness and efficiency of operations and compliance with laws and regulations.

Internal controls can provide only reasonable assurance that things won’t go sideways, according to the presenters. The reality is that human judgement can be faulty and that mitigates the controls, they said.

The Committee of Sponsoring Organizations has an integrated framework for internal control, the components of which are: Control Environment; Risk Assessment; Information and Communication; Control Activities; and, Monitoring.

Even the smallest of organizations have internal controls of one form or another, according to the presenters.

The 9 Common Internal Controls include:

  1. Strong tone at the top
  2. Leadership communicates importance of quality
  3. Accounts reconciled monthly
  4. Leaders review financial results
  5. Log-in credentials
  6. Limits on check signing
  7. Physical access to cash, Inventory
  8. Invoices marked paid to avoid double payment
  9. Payroll reviewed by leaders.

The NonProfit Times

 

What you should know about preparing your Schedule of Expenditures of Federal Awards (SEFA)?

Not-for-profit organizations often seek out grants and other awards in order to provide the necessary funding for their programs. It is important to know the source of all grants and awards as well as the requirements of the U.S. Office of Management and Budget’s (OMB) Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards, Final Rule (Uniform Guidance). In this article we will explore a small but very important part of the Uniform Guidance requirements: The Schedule of Expenditures of Federal Awards (SEFA).

What is the SEFA and How is it Used?

In its simplest form, the SEFA is a financial statement schedule that lists an organization’s expenditures of federal assistance for the fiscal year by federal agency, grant number and amount. It is the organization’s (auditee’s) responsibility to prepare a complete and accurate SEFA, which is a key component of the reporting package required under the Uniform Guidance. The SEFA is also used by external auditors to determine the required procedures and test work under the Uniform Guidance.

How to Accumulate the Data for the SEFA

Every grant and award received needs to be evaluated in order to determine the funding source.  A checklist or standard intake form should be used to document every individual grant/award (even those that do not appear to be federally sourced). This process may involve some research, as the funding source may not be obvious in the grant/award paperwork.

  • All grants/awards should be reviewed in detail to determine if they contain any special provisions (for example, some awards require they be treated as major programs, even though they might not otherwise qualify as such).
  • If the grant/award contains federal funding, the organization will obtain the following: name of the federal agency, award period, Catalog of Federal Domestic Assistance (CFDA) number.
  • The grant/award should also be researched to determine if it is part of a cluster (including research and development) or a federal loan program.
  • If the grant/award is passed through to/ from a subrecipient, the organization will obtain the pass-through entity identifying number.

Gathering this information is time consuming, and obtaining the name and contact information of the program manager can be invaluable.

Prior to the grant/award becoming operational, the organization should review the OMB Compliance Supplement’s Matrix of Compliance Requirements. For every federally funded grant/award, personnel should be assigned for each area of compliance. Expenditures must be tracked for each individual grant/award. The accounting system must be set up to capture this information, and individuals must be established to assign expenses to each grant/award.

How to Prepare a Complete and Accurate SEFA         

If the organization has a good system of accumulating data for grants/awards, preparation of the SEFA should not be difficult. It is simply a matter or organizing the data in the appropriate format. The draft SEFA should be reviewed for the following:

  1. Are all awards sorted by federal program and agency?
  2. If received through a subrecipient, is the name and number of pass-through entity included?
  3. Review Uniform Guidance for clusters of awards. Are the federal programs within that cluster all separately identified within the cluster?
  4. Are Research and Development awards totaled by federal award?
  5. Are total federal awards excluded for loan or are loan guarantee programs included?
  6. Are total federal awards provided to subrecipients by program totaled?
  7. Are the required footnotes to the SEFA prepared?
  8. If any non-federal awards are included in the SEFA, are they clearly segregated and designated as non-federal awards?

Where are Some Useful Resources?

Organizations are encouraged to review the 2017 and 2018 Uniform Guidance Compliance Supplements located at Whitehouse.gov. The AICPA’s Government Audit Quality Center provides a free resource center for auditees.

Please contact us to help you with the requirements of the Uniform Guidance. We can assist you early in the process at an organizational level. This will help assure a smooth and successful process to manage your federal funds and the related compliance requirements.

Nonprofit Treasurer Roles and Responsibilities

When you think about it, it’s a bit inaccurate to refer to your organization as “nonprofit.” In fact, money is rarely far from the minds of your organization’s leaders. At least, it shouldn’t be.

Like your for-profit counterparts, you can’t succeed without maintaining sound fiscal health. That’s why the title of “treasurer” is so much more than an honorific. By watching over your organization’s “treasure,” the person holding that position facilitates the accomplishment of the nonprofit’s greater goals.

The role in a nutshell

The treasurer generally is charged with overseeing the management and reporting of the organization’s finances. In a large nonprofit with accounting staff and a chief financial officer, the treasurer will usually head a finance committee that reports to the board of directors. He or she focuses mainly on reviewing internally prepared financial reports and evaluating financial policies and procedures.

By contrast, in a smaller organization with no internal accounting staff, the treasurer may need to get down in the trenches — writing checks and making deposits, managing and safeguarding funds and maintaining financial integrity. Where applicable, he or she also might oversee outside bookkeepers, tax preparers, fundraisers and investment advisors.

Regardless of the organization’s size, the treasurer typically shepherds the development of the not-for-profit’s financial policies, such as those for investing, borrowing and cash reserves. And he or she presents regular treasurer’s reports to the board of directors. These can range from a simple “dashboard” to more detailed information.

Specific areas of concern

The treasurer must ride herd over several different areas. Depending on the organization’s resources, the treasurer’s degree of involvement will vary. He or she might take on the following duties personally or just provide the necessary oversight to confirm that staff is handling them appropriately.

Budget. The annual budget represents the financial map of the organization’s goals and how it plans to achieve them in the coming year. The treasurer should present the budget for board approval, being realistic about both revenues and expenses. He or she also should review current reports frequently for variances between actual and budgeted figures and determine the reasons for those discrepancies.

Financial reports. The board relies on the treasurer to provide timely and accurate financial information to support its decision-making. In addition to financial statements, the treasurer might supply information on financial ratios and trends that describe the organization’s current and projected financial status.

Compliance. Complying with relevant laws and tax regulations is a top priority. Among other things, the treasurer should work with your CPA and keep a calendar of reporting and filing deadlines to avoid late fees, penalties and the reputational damage they can bring.

Risk management. The treasurer also should coordinate with your CPA and insurance agent to regularly perform assessments that identify and mitigate risks to the organization’s assets, data and confidential information. You might have risks, for instance, related to the use of volunteers in money-handling positions. Mitigation could include internal controls designed to deter and detect fraud.

Audit. Once your nonprofit reaches a certain size, its books should be audited annually by an independent CPA. The treasurer should review the results and recommendations — asking questions where appropriate — and present them to the board.

The right person for the job

With so much responsibility, it’s clear that not just anyone can function well in the treasurer position. You need to be very selective about candidates’ qualifications.

For starters, the treasurer must have a demonstrable financial literacy, including a thorough understanding of the particular financial reports and accounting practices used by nonprofits. He or she also should possess an attention to detail, adherence to deadlines, patience, curiosity and recordkeeping skills. A passion for the cause also is valuable, as the treasurer needs the motivation to make, and keep up with, the ample time commitment required for the job. It helps, too, if the treasurer has some people skills — a grumpy introvert may not work well with staff and other board members.

The bottom line

Although the specific duties treasurers perform will vary depending on the not-for-profit’s circumstances, the importance of the job does not. Without a qualified treasurer performing proper oversight, your organization’s financial health will be in jeopardy. Investing in a thorough search for the right person will pay off in the long run.

Is a merger right for you?

In the wake of the new tax law and other developments, many nonprofits are looking for ways to solidify their financial footing — including the possibility of merging with another organization. But a merger isn’t something to be entered into lightly. It’s a big step that requires careful planning and consideration.

Possible structures

The term “merger” is a bit of a catchall, and your organization may opt to pursue a different type of collaboration. In an actual merger, all the assets and rights of one organization transfer to the surviving organization. And the former nonprofit no longer exists as a legal entity. Notably, the surviving organization assumes all the merged-out organization’s liabilities. There are several other popular ways to combine forces:

Consolidations are like mergers, except that both organizations are dissolved, and an entirely new entity is created that assumes all assets and liabilities of both former organizations. The new entity will need to apply for tax-exempt status.

In an asset acquisition, one nonprofit acquires identified assets — and possibly liabilities — of another. When dealing with two nonprofits, you could simply structure the transaction as a gift from one to the other. This approach usually is permitted if the transferring organization’s creditors are either transferred, or paid in full, before it dissolves.

Alternatively, two nonprofits could enter into a parent-subsidiary arrangement. The “parent” doesn’t own the other organization. But it takes control, for example, by serving as the sole voting member of the subsidiary’s board or having the right to appoint the board members. Notably, though, the parent doesn’t assume the subsidiary’s liabilities. Each organization continues to function individually, with separate IRS filing obligations and boards of directors.

The parent-subsidiary arrangement — also known as an affiliation of nonprofits — can be implemented by amending the subsidiary’s articles of incorporation and bylaws to describe the parent’s control. If the arrangement doesn’t work out as hoped, it can be reversed simply by amending the documents again. The organizations usually also enter an affiliation agreement that addresses a variety of topics, such as the subsidiary’s activities.

State nonprofit corporation acts generally govern the processes and requirements for each of these transactions. Both state and federal laws must be considered when structuring the combination.

Due diligence

Each nonprofit should conduct a thorough investigation into the other organization’s history, finances and operations before entering into a collaborative agreement. Neither party can afford to take due diligence lightly — the board members for the nonsurviving organization have a fiduciary duty to obtain reasonable assurances that the surviving organization can properly steward the nonsurvivor’s assets postmerger.

The organizations should exchange a wide range of information, including corporate documents (for example, charters, bylaws and policies); financial statements and audit reports; and fundraising records and donor lists. They should also share third-party contracts, including grants and other funding; HR records; and meeting minutes.

Moreover, the two organizations should look at IRS determination letters and filings; documentation of exemptions from property, sales and other state or local taxes; real estate records; and current and pending litigation. Due diligence can be performed in phases so that more confidential or sensitive information isn’t exchanged until further along in the process, as the combination becomes more likely. Final approval must come from each organization’s board of directors and possibly its members.

Potential costs

Nonprofits often consider collaborations for financial reasons. But the process can come with significant costs, some of which aren’t always obvious. Potential expenses include:

  • Staff time, severance pay and professional fees (attorneys, accountants and consultants),
  • Audit and filing fees,
  • Rebranding and replacement of promotional materials,
  • Moving expenses and infrastructure upgrades,
  • Lease and loan buyouts, and
  • Lost funding.

Other possible staff-related costs could include a need to increase some salaries to achieve organizationwide pay parity. This could happen if one of the nonprofits paid its employees significantly more than the other did.

Don’t forget to report

Most nonprofits that end their operations by merging with another nonprofit must inform the IRS by filing a final Form 990, 990-EZ or 990-N. It must be filed within four months and 15 days of the organization’s termination. Certain states also require notification to the state attorney general or other appropriate office. Keep in mind that a merger can be complex.

FASB proposes moving back effective date for lease and other new accounting standards

The Financial Accounting Standards Board (FASB) recently voted unanimously to propose a delay to the effective date for the implementation of the new lease accounting standard, ASC 842, for non-public business entities. The proposed delay in the effective date is until January 2021, which provides an additional year to privately held companies to comply with the new lease rules.

Additionally, the vote proposed delays to other recent standards updates including credit losses, derivatives, and long-duration insurance contracts. For credit losses and long-duration insurance contracts, the proposed delay could potentially also apply to nonprofits and smaller reporting companies as the FASB seeks to re-define its reporting entity buckets in relation to implementation dates of its future standards.

Refresher on lease accounting

The existing lease accounting standard, Leases (Topic 840), requires companies to record lease obligations on their balance sheets if the arrangements are considered financing transactions, such as rent-to-own contracts for buildings or vehicles. Few arrangements get recorded, however, because U.S. Generally Accepted Accounting Principles (GAAP) give companies leeway to arrange the agreements to look like simple rentals. If an obligation isn’t recorded on a balance sheet, it makes a business appear less leveraged than its reality.

After nearly a decade of debate, the FASB issued Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). The new standard calls for major changes to current accounting practices for leases. In a nutshell, companies will be required to recognize on their balance sheets the assets and liabilities associated with rentals, such as offices, factories, airplanes and heavy equipment. The effects of the new standard are expected to be pervasive, because businesses rent anything from forklifts to photocopiers to recycling bins.

ASU No. 2016-02 defines a lease as a contract (or part of a contract) that conveys the right to control the use of a rented asset for a specified period in exchange for consideration. The concept of control is a key change from the definition of a lease. It means that the customer has both the right to realize substantially all of the economic benefits of the asset and the right to direct the asset’s use.

Most existing arrangements that currently are reported as leases will continue to be reported as leases under the new standard. In addition, the new definition is expected to encompass many more types of arrangements that aren’t reported as leases under current practice.

Delayed implementation

The new standard took effect for public companies, employee benefit plans, and non-for-profit conduit bond obligors in January 2019, and was intended to take effect for private companies for reporting periods beginning after December 15, 2019. However, the AICPA asked the FASB for a delay earlier this year in light of the overlap with the implementation of the new revenue recognition standard and the struggles public companies have incurred thus far in complying with the new lease accounting rules.

The additional year will allow for further educational opportunities for private companies and other organizations that anticipate a major disruption when implementation arrives.

If you have questions on how this delay will affect you and your company, please reach out to us.

New rules clarify accounting for grants and contributions

When the Financial Accounting Standards Board (FASB) released new rules for revenue recognition in 2014, contributions were specifically excluded. Now the FASB is offering further guidance in its Accounting Standards Update (ASU) No. 2018-08, Not-for-Profit Entities (Topic 958): Clarifying the Scope and Accounting Guidance for Contributions Received and Contributions Made.

The new rules likely will result in more grants and similar contracts being accounted for as contributions than have been under current Generally Accepted Accounting Principles (GAAP). So, if you haven’t learned the new rules yet, now is the time!

What prompted the new rules?

The new rules reflect the FASB’s stance that nonprofits have taken inconsistent approaches when characterizing some grants and contracts as exchange transactions (reciprocal) rather than contributions (nonreciprocal transactions). Organizations also have acted inconsistently when distinguishing between conditional and unconditional contributions, according to the standard-setting agency. For example, some nonprofits account for government grants as contributions while other organizations account for them as exchange transactions.

These issues came into the spotlight in the wake of the FASB’s new revenue recognition standard. Contributions generally are reported in the period the pledge or commitment to donate the funds is received. But exchange transactions will be subject to the revenue recognition rules, including robust disclosure requirements.

Is it a contribution?

When characterizing a grant or similar contract, a nonprofit must evaluate whether the “provider” (the grantor or other party to a contract) receives commensurate value in return for the assets transferred. If so, the transaction is an exchange transaction.

The ASU makes clear that “the provider” isn’t synonymous with the general public. Thus, indirect benefit to the public because of the asset transfer doesn’t constitute “commensurate value received.” Execution of the provider’s mission or the positive sentiment from acting as a donor also doesn’t equate to commensurate value received.

If the provider doesn’t receive commensurate value, the nonprofit must then determine if the asset transfer represents a payment from a third party for an existing transaction between the nonprofit and an identified customer (for example, Medicare or a Pell Grant). If so, the transaction isn’t a contribution and other accounting guidance would apply. If not, it’s a contribution.  If the contribution is considered unconditional, it is recognized into revenue immediately.

Is it conditional?

Whether a contribution is conditional affects when the revenue is recognized. This ASU explains that a conditional contribution comes with 1) a barrier the nonprofit must overcome to receive the contribution, and 2) either a right of return of assets transferred or a right of release of the promisor’s obligation to transfer assets if the condition is not met. An unconditional contribution is recognized when promised or received. However, a conditional contribution isn’t recognized until the barriers to entitlement are overcome.

To assess whether the nonprofit must overcome a barrier to receive the contribution, it should consider the following indicators:

  • The inclusion of a measurable performance-related barrier or other measurable barrier (for example, raising a certain amount of matching funds),
  • Limits on the nonprofit’s discretion over how to conduct an activity (for instance, a requirement to hire specific individuals to run a new program), and
  • A stipulation that relates to the purpose of the agreement (excluding administrative tasks and trivial stipulations, such as producing an annual report).

Depending on the circumstances, some indicators might prove more important than others. No single indicator will determine the outcome.

Effective dates

The new rules impact agreements for most nonprofits who are resource recipients for annual reporting periods starting after December 15, 2018. For organizations who are resource providers the new rules apply one year later. Early adoption is permitted. 

Using Ratio Analysis to Manage Not-for-Profit Organizations

Thousands of CPAs work in the not-for-profit sector, and thousands more volunteer as members of the governing boards of not-for-profit organizations. There is little in the academic background or experience of many accountants, however, to prepare them to analyze and evaluate not-for-profits. University courses in not-for-profit accounting emphasize the recording of transactions and the preparation of financial statements, rather than the evaluation of financial and operational effectiveness. Board members without substantial accounting expertise are even less equipped to interpret not-for-profit financial reports.

Because not-for-profit organizations exist for purposes other than earning a return for equity investors, measures commonly used to evaluate commercial enterprises are not well suited for evaluating them. Furthermore, although they are commonly represented as a single class of organization, great variety exists in the mission and finances of not-for-profit organizations. While many not-for-profits rely heavily on contributions, others derive most of their revenues from the sale of services or membership dues. Because of varying missions and funding sources, there are no sector-wide norms to guide managers and board members.

It is often difficult for not-for-profit managers and governing boards to plan for the organization’s financial future because of a reliance on contributions and the lack of predictability of demand for their services. The future can be daunting if a not-for-profit does not have a strong grasp on its financial position. A not-for-profit can, however, help maintain its financial sustainability by following prudent financial management standards and monitoring financial ratios. Financial management standards help a not-for-profit monitor its budget, cash flow, resource utilization, and revenue sources. This article’s focus is on the use of financial ratios in trend analysis and benchmarking to improve the effectiveness of management and boards charged with monitoring not-for-profit organizations, specifically those not-for- profits that file Form 990. Financial ratios can help determine if a not-for-profit has sufficient resources and determine if it is using those resources efficiently to support its mission. Ratios are useful because they express underlying financial relationships as a single value, allowing comparisons across time and among entities of varying size.

Not-for-Profit Ratios

Investors, creditors, and analysts routinely use ratios to evaluate commercial enterprises. Because many of these ratios focus on profitability measures, their usefulness in guiding not-for-profit managers is limited. Historically, discussion of financial ratios among not-for-profits has focused on spending ratios: program, fundraising, and management expenses as percentages of total expenses. Donors in particular employ these measures to evaluate the extent to which their contributions support mission-related activities. There is ongoing discussion in the not-for-profit literature suggesting that being overly focused on spending measures can have unintended consequences. Sector leaders have called for greater attention to measuring operational effectiveness; others contend that measures of financial position are necessary to assess liquidity and sustainability. Responding to this demand, FASB standards now require greater disclosure related to liquidity.

The authors contend that not-for-profit managers and boards should actively measure and evaluate not just spending ratios, but also measures of liquidity and operational effectiveness. The selection of a set of ratios to monitor is challenging because not-for-profit missions vary extensively, as do their sizes and the industries in which they operate. The most accurate statement that may be made about the choice of ratios to monitor is that no single set of ratios is suitable for all not-for- profits. The management team of each not-for-profit should consider its needs and select a set of ratios to measure that address its particular concerns. Regardless of the specific ratios selected, two characteristics make ratio analysis more useful:

  • Trend Analysis. Within an organization, the value of ratio analysis lies in directing management’s attention to areas of changing conditions. Therefore, it is important to measure and report financial ratios across time. Once agreed upon, the selected ratios should be consistently measured and presented to the governing board within each financial report so that trends can be identified. The authors’ recommendation is that financial reports provided to the governing board contain five years of ratios.
  • Benchmarking. No generally accepted ideal or target levels exist for ratios. The desirable level for a given ratio is a matter of judgment and will vary according to the circumstances facing each organization. Ratios are generally evaluated against a benchmark rather than a theoretically optimal value; these benchmarks are typically calculated as an average value from a comparison group. Therefore, in addition to agreeing upon a set of ratios to measure and monitor, each not- for-profit should also agree on a comparison group of five to ten peer organizations. Ideally, this group would consist of well-managed not-for-profits of similar size and mission.

Because many ratios focus on profitability measures, their usefulness in guiding not-for-profit managers is limited.

For purposes of illustration, the authors present a set of eight ratios that are likely to be useful to a variety of not-for-profit organizations. The ratios represent the three broad areas of liquidity, operations, and spending. It also computes average values for these ratios for over 200,000 not-for- profits, divided into five categories by entity size, using information available from the IRS website.  Exhibit 1 describes the ratios, what they measure, and how they are calculated.

Ratio; Formula; Averages by Size of Not-for-Profit Liquidity Ratios Days cash on hand: Measures the number of days of expenses that can be covered from existing cash and cash equivalents. Generally, higher values indicate a stronger liquidity position, although there is both a benefit and an opportunity cost to holding cash reserves.; (Cash + cash equivalents) ÷ [(Total expenses – depreciation expense)/365 days]; Total assets Average value; $100,000 to $500,000 123 days $500,000 to $1,000,000 146 $1,000,000 to $10,000,000 99 $10,000,000 to $50,000,000 76 >$50,000,000 57 Months of spending: A less extreme measure of liquidity than days cash on hand since it assumes receivables can be collected to sustain operations. Generally, higher values indicate a stronger liquidity position.; (Current assets – current liabilities + temporarily restricted net assets) ÷ [(Total expenses – depreciation expense)/12 months]; Total assets Average value $100,000 to $500,000 4.22 months $500,000 to $1,000,000 5.24 $1,000,000 to $10,000,000 3.84 $10,000,000 to $50,000,000 3.35 >$50,000,000 2.42 Operating Ratios Savings indicator: Measures the net revenues that are retained by the organization as a percentage of expenses. Generally, not-for-profit organizations must maintain some surplus to replace existing facilities and extinguish debt. This ratio should be evaluated in the context of the anticipated needs of the organization.; (Revenues – expenses) ÷ Total expenses; Total assets Average value $100,000 to $500,000 4.5% $500,000 to $1,000,000 6.0% $1,000,000 to $10,000,000 4.3% $10,000,000 to $50,000,000 4.5% > $50,000,000 9.6% Contributions and grants: Measures the extent to which revenues are received from donors and grantors. Since this ratio measures the organization's dependence on voluntary support, high values indicate less diverse revenue sources and greater susceptibility to economic downturns.; Contributions & grants revenue ÷ Total revenue; Total assets Average value $100,000 to $500,000 59% $500,000 to $1,000,000 56% $1,000,000 to $10,000,000 47% $10,000,000 to $50,000,000 34% >$50,000,000 15% Fundraising efficiency: Indicates the amount of contributions raised for each dollar of fundraising cost. Higher values indicate greater fundraising efficiency.; Total contributions (other than government grants) ÷ Fundraising expenses; Total assets Average value $100,000 to $500,000 $16.94 $500,000 to $1,000,000 $16.47 $1,000,000 to $10,000,000 $11.45 $10,000,000 to $50,000,000 $11.93 >$50,000,000 $12.86 Spending Ratios Program service expense: Measures expenses incurred on mission-related programs as a percentage of total expenses. Donors generally view higher values as desirable since this represents resources that are being directed to mission-related programs.; Program services expenses ÷ Total expenses; Total assets Average value $100,000 to $500,000 85.3% $500,000 to $1,000,000 86.1% $1,000,000 to $10,000,000 85.2% $10,000,000 to $50,000,000 86.2% >$50,000,000 86.8% Management expense: Measures management and general costs as a percentage of total expenses. Donors generally view higher values as undesirable since this represents resources that are not being directed to mission-related programs.; Management and general expenses ÷ Total expenses; Total assets Average value $100,000 to $500,000 12.3% $500,000 to $1,000,000 11.7% $1,000,000 to $10,000,000 12.6% $10,000,000 to $50,000,000 12.3% >$50,000,000 12.4% Fundraising expense: Measures fundraising costs as a percentage of total expenses. Donors generally view higher values as undesirable because these represent resources that are not being directed to mission-related programs.; Fundraising expenses ÷ Total expenses; Total assets Average value $100,000 to $500,000 2.5% $500,000 to $1,000,000 2.2% $1,000,000 to $10,000,000 2.2% $10,000,000 to $50,000,000 1.6% >$50,000,000 0.8%

Because commercial businesses are reluctant to share detailed financial information with competitors, developing suitable benchmarks can be very challenging. In contrast, not-for-profits are aided in this process by the I RS’s requirement that tax-exempt organizations file a Form 990 and it be made publicly available. Many notfor-profits post their Form 990s to their websites or make them available through organizations such as Guidestar. In addition, the I RS website provides annual extracts of Form 990 data; users may download financial information for all tax-exempt organization filings in a given year. Form 990 contains much more detailed financial information than is typically available in corporate financial statements and includes a wealth of nonfinancial information, including information about organizational governance and employee compensation. A list of potential ratios and the lines on the Form 990 where the information can be found appears in the article, “Why So Many Measures of Nonprofit Financial Performance? Analyzing and Improving the Use of Financial Measures in Nonprofit Research” (Christopher Prentice, Nonprofit and Voluntary Sector Quarterly, August 2016, http://bit.ly/2GlwUHX (http://bit.ly/2GlwUHX)).

Liquidity ratios.

The “days cash on hand” ratio measures the number of days of expenses that could be paid from existing cash and cash equivalents. Depreciation is removed from total expenses (denominator) since it does not require a cash outlay. Higher values indicate a stronger liquidity position. The “months of spending” ratio represents a longer planning horizon since it assumes receivables can be collected to sustain operations. Because the ratio removes current liabilities and donor-restricted resources from the numerator, it closely parallels the liquidity management disclosures that are now required of not for-profit organizations.

Both ratios indicate whether the not-for-profit has a sufficient “cushion” of cash and near-cash resources (often described as liquid resources—assets that can be quickly converted into cash) to meet organizational expenses as they come due. Many organizations have a policy of maintaining cash reserves equal to two or three months of expenses; higher values indicate a stronger liquidity position, suggesting that the not for-profit is better prepared to address periodic declines in revenues or unexpected expenses. Several factors influence the desired level of financial liquidity. Larger organizations and those with more predictable expenses and more diverse revenue sources may maintain lower levels. In addition, organizations relying on donated goods, such as food banks, can operate with lower levels of liquidity since those goods (rather than cash) are the source of the bulk of their average monthly expenses. As is the case with many financial ratios, maximizing either of these ratios comes at a cost. While reserves in the form or cash or short-term investments may make the organization financially secure, these resources could also be used in programs that further the organization’s mission.

Operating ratios.

The “savings indicator” ratio expresses the annual surplus (or deficit) of revenues over expenses and should be evaluated in combination with the liquid funds indicators. Improving liquidity ratios requires an organization to increase its annual savings; similarly, a governing board that is comfortable with its liquidity may spend a greater proportion of its resources, driving the savings rate to zero, or even a negative value, for a short period. A common misunderstanding about not-for- profits is that operating surpluses (i.e., savings) are undesirable. In most not-for-profits, accounting surpluses are necessary if equipment and facilities are to be enhanced, debt retired, or liquidity maintained.

The “contributions & grants” ratio indicates the organization’s reliance on external support. Very high values indicate the absence of a diverse revenue stream and a funding model that depends upon donations and grants. This ratio is particularly tied to the not-for-profit’s industry; religious and public broadcasting charities rely heavily on donations, while many larger organizations have multiple sources of revenue, including program revenues, charges for services, and member dues. For example, hospitals receive most of their revenue from patient services, and professional associations rely on membership dues. These not-for-profits typically report low values for this ratio.

Many organizations have a policy of maintaining cash reserves equal to two or three months of expenses; higher values indicate a stronger liquidity position.

“Fundraising efficiency” is the average dollar amount of contributions raised for each dollar expended on fundraising. Values less than $1.00 indicate the cost of fundraising exceeds its benefits. Charity Watch advises a minimum level of $2.85 for most charities. As with most ratios, care must be exercised in its interpretation. Fundraising capacity may take several years to develop, with the result that fundraising appears more expensive as an organization is building capacity. For this reason, studies find that smaller organizations dedicate higher proportions of their budget to fundraising than larger entities (e.g., Patrick Rooney, Mark Hager, and Thomas Pollak, “Research about Fundraising and Administrative Costs,” Giving USA Update,2003, http://bit.ly/2G2qQCw (http://bit.ly/2G2qQCw)). It is also important to recognize that the ratio is an average and not a marginal return. This distinction becomes important if development activities are evaluated on the basis of this ratio. In such a situation, notfor-profits may forego productive fundraising efforts for the purpose of keeping the ratio artificially high, thereby leaving money on the table that could have been used to further the organization’s mission. Fundraising opportunities should not be rejected merely because the expected pay-back is less than the current average.

Spending ratios.

The next three ratios all measure a given category of expense as a percentage of total expenses. Conventional wisdom is that expenses incurred for program services are good, while expenses incurred for management and fundraising are undesirable. Because accounting standards require expenses to be classified with the categories of program, fundraising, and management and general, the three ratios must sum to 100% for any given organization.

Because these ratios are relatively easy for non-experts to interpret (e.g., how much of each dollar is spent on programs), they are widely reported by the media, not- for-profit watchdog organizations, and not-for-profits themselves. Ample evidence exists that these ratios are widely used by governing boards, granting agencies, and donors. While these ratios are industry standards, they are also often misused. Because of the prevailing perceptions, incentives exist to shift costs to the program category and thereby improve the desirable ratio while decreasing the other two. To address abuse, accounting rulemaking bodies provide standards for the allocation of joint costs.

The “program service expense” ratio is the proportion of expenses incurred for purposes of the organization’s mission. It does not measure program effectiveness, only the extent to which available resources are directed toward the organization’s mission. The Better Business Bureau’s Wise Giving Alliance recommends a minimum threshold of 65% for this measure. Charity Watch uses a grading system ranging from A+ (> 90%) to F (<35%), with 60% or greater required for a satisfactory rating.

“Management expense” may be the most commonly misinterpreted ratio. Sometimes called “administrative expense,” it includes expenditures for training, planning, internal controls, and organizational governance. Training employees and volunteers, safeguarding assets, and assuring responsible governance are all desirable things, but the conventional view of this ratio is that higher values are undesirable. In addition, the costs associated with securing government grants and complying with grant requirements are classified as management and general expenses and can significantly affect this ratio, particularly among smaller not-for-profits. As organizations grow in size, they require more layers of management for institutional control. Yet while the amount spent on administration increases with notfor-profit size, management expense as a percentage of total expenses may remain constant or even decline, depending upon economies of scale.

“Fundraising expense” is the proportion of total expenses devoted to development activities, and together with management and general expense is commonly described as “overhead costs.” Substantial empirical evidence exists that investments in overhead vary with the size and nature of organizations (Rooney et al 2003), but that increased overhead spending contributes to organizational performance. For example, a study by the Urban Institute’s Center on Nonprofits and Philanthropy (Getting What We Pay For: Low Overhead Limits Nonprofit Effectiveness, 2004, https://urbn.is/2X8svNX (https://urbn.is/2X8svNX)) found charities that spend too little on overhead are less effective. In response to these and similar findings, the chief executives of the Wise Giving Alliance, Guidestar, and Charity Navigator jointly authored a letter to donors alerting them to the “overhead myth” and encouraging greater attention to not-for-profit performance, transparency, and governance.

Curtis Klotz proposed adoption of a new reporting model for not-for-profit expenses to overcome the inherent limitations of current reporting (“A Graphic Re- visioning of Nonprofit Overhead,” Nonprofit Quarterly, Aug. 16, 2016, http://bit.ly/2FeaZ3x (http://bit.ly/2FeaZ3x)). Until accounting standards or the format of Form 990 are changed, however, the existing expense categories and reporting will persist. Because of the visibility of these spending ratios and their importance to donors, management and governing boards should continue to monitor them. But it is important to recognize their inherent shortcomings and not base strategic decisions exclusively on the ratios.

Use of Ratios to Evaluate a Not-for-Profit

In this section, the authors calculate the eight ratios for an example not-for-profit organization for purposes of illustrating how ratios may be used in both trend and benchmarking analyses. The organization chosen was a Young Men’s Christian Association (YMCA) from a moderatesized U.S. city. YMCAs are easily comparable because each community’s YMCA is separately incorporated—and thus prepares its own Form 990—and they have relatively uniform missions, organization, and activities. The information necessary to calculate the ratios presented here took less than two hours to collect using the free section of Guidestar’s website; this suggests that once a not-for-profit selects a set of peer organizations, the annual investment necessary to obtain relevant benchmarking data is not significant.

Exhibit 2 (https://www.nysscpa.org/news/publications/the-cpa-journal/article-detail?ArticleID=12842#T2) presents ratios for the selected YMCA over a five-year period. Longitudinal analysis permits the identification of trends and highlights aberrations. During the past four years, the selected YMCA has consistently maintained a cash balance of approximately 2½ months of spending and an overall liquid net asset balance of approximately 3½ months.

Ratio; Current Year; Year 4; Year 3; Year 2; Year 1 Liquidity Ratios Days cash on hand; 67 days; 70 days; 81 days; 69 days; 128 days Months of spending; 3.3 months; 3.3 months; 3.9 months; 3.5 months; 5.7 months Operating Ratios Savings indicator; 8.6%; 3.9%; −0.9%; 2.8%; 1.3% Contributions and grants; 18.6%; 12.0%; 8.6%; 10.4%; 10.9% Fundraising efficiency; $7.00; $4.30; $2.70; $3.30; $2.10 Spending Ratios Program service; 87.6%; 87.5%; 86.6%; 86.7%; 85.5% Management and general 9.5%; 9.6%; 10.2%; 10.1%; 9.0% Fundraising 2.9%; 2.9%; 3.2%; 3.2%; 5.3%

One benefit of trend analysis is that it identifies deviations in the ratios, such as the unusually high liquidity values in Year 1. A 46% decline in cash from Year 1 to Year 2 would almost certainly merit investigation. In this case, the organization had undertaken a capital campaign in Year 1, resulting in high cash balances, which were expended for long-term assets in Year 2. The presentation of five years of ratios provides a context for unusual amounts; presentation of only two years of ratios (Years 1 and 2) would likely leave the governing board uncertain about which year was abnormal.

Among the operating ratios, the savings indicator exhibits the greatest year-to-year fluctuation. Although negative savings (deficits) are not sustainable in the long run, not-for-profits may experience occasional deficits. In this case, the YMCA held expenses constant over a three-year period (Year 2 to Year 4), and the deficit reported  in Year 3 was attributable to a 20% decline in contributions that year. Because the savings indicator returned to positive in the subsequent year, the one-year deficit should not be of particular concern to the governing board.

Exhibit 2 (https://www.nysscpa.org/news/publications/the-cpa-journal/article-detail?ArticleID=12842#T2) also highlights the interrelationships among financial ratios. The decline in contribution revenue in Year 3 caused the deficit reported for the savings indicator as well as a decline in the contributions and grants and fundraising efficiency ratios. Conversely, contribution revenue increased nearly 70% in the current year, causing all three operating ratios to increase.

The purpose of a benchmarking analysis is to evaluate the current position of a notfor-profit with respect to similar organizations and to identify areas for improvement. The value of benchmarks as an evaluation tool is dependent upon the selection of an appropriate peer group. Not-for-profits vary widely in mission, activities, and funding sources, and benchmarks developed from disparate organizations are likely to be of marginal value. In many instances, not-for-profit managers will be able to identify organizations with similar missions. Trade associations and networking opportunities provided by industry conferences and meetings may also be useful in identifying peers.

Exhibit 3 (https://www.nysscpa.org/news/publications/the-cpa-journal/article-detail?ArticleID=12842#T3) presents the current year financial ratios of the selected YMCA and average values for a sample of 10 peer YMCAs. To ensure comparability, the peer YMCAs are from similarly sized cities within the same geographic region; geographic proximity contributes to comparability since real estate, utilities, and other costs vary across regions. Ratios were calculated for the peer institutions using information from their Form 990s. Exhibit 3 (https://www.nysscpa.org/news/publications/the-cpa-journal/article-detail?ArticleID=12842#T3) presents both average values and ranges of values for the peer group.

 Ratio; Example Not-for-Profit; Average for Peer Group; Range of Peer Group Liquidity Ratios Days cash on hand; 67 days; 51 days; 11 to 71 days Months of spending; 3.3 months; 3.1 months; 0 to 9 months Operating Ratios Savings indicator; 8.6%; 3.6%; −3.3 to 14.3% Contributions & grants; 18.6%; 15.9%; 3.7 to 40.8% Fundraising efficiency; $7.00; $12.00; $3.10 to $44.50 Spending Ratios Program service; 87.6%; 84.6%; 74.8% to 94.7% Management and general; 9.5%; 13.4%; 3.9% to 22.1% Fundraising; 2.9%; 2.0%; 0 to 5.4%

With regard to liquidity, the selected YMCA is very close to the peer group average for the months of spending ratio and has a cash position near the top of the peer group distribution. The operating ratios are also close to the peer averages. Although the selected YMCA has a higher-than-average contributions and grants ratio, it is not high in an absolute sense, with most revenues continuing to come from program fees and membership dues. The fundraising efficiency ratio is less than the peer group average, but well above the minimum recommended by charity watchdog groups. Finally, the spending ratios are close to peer averages. Overall, both the trend and benchmarking analyses suggest nothing is out of the ordinary in this year’s liquidity, operating, or spending ratios. Accordingly, the governing board could better use its members’ time discussing strategic matters affecting the future of the organization rather than past financial results.

Using Benchmarks and Ratios to Their Fullest

The requirement that all tax-exempt organizations complete and make available their Form 990s provides access to a wealth of financial information about peer organizations at minimal cost. In some cases, it may be desirable to develop multiple benchmarks. For example, colleges and universities commonly develop benchmarks for both peer and aspirant institutions. Doing so enables organizations to evaluate how well they are doing and what is required to move up to the next level.

Financial ratios can be useful tools for those in charge of monitoring a not-for-profit’s financial position and operations. Ratios are not a goal in themselves, however, and care should be taken in their interpretation. Conventional wisdom regarding desirable levels for some ratios may be unsupported by empirical data. For example, not-for-profits often feel pressured to lower overhead ratios, even though research shows that investment in overhead is often critical to overall not-for-profit mission success.

Each not-for-profit faces unique circumstances, and pursuit of a given strategy may improve one ratio while worsening another. It is also important for boards to understand that resource providers monitor the organization’s ratios. Management should anticipate and be prepared to address the concerns of donors and grantor agencies regarding the organization’s financial position.

CPA Journal, May 2019 Issue

By Kaitlin Cashwell, Paul Copley, PhD, CPA and Michael Dugan, DBA

 

 

 

 

 

 

2019 Review of Non Profit Accounting Systems

CPA Practice Advisor, Mary Girsch-Bock, April 16, 2019

According to the National Center for Charitable Statistics (NCCS), there are currently more than 1.5 million nonprofit organizations registered in the U.S. While the vast majority of these organizations are registered as public charities, the number also includes private foundations, chambers of commerce, and civic leagues.

While their missions may vary greatly, one thing these organizations share is the need to manage funds properly. This can include everything from applying for and managing grant funding, to tracking both donors and donations adequately. Membership driven organizations need to be able to track members, invoice members when membership fees are due, and maintain an accurate member list. Those that run programs regularly need to be able to handle event registration and keep track of everyone who has registered.

If that isn’t enough, these same organizations also have to be able to do the things that for-profit organizations do such as process journal entries, pay vendors, record payments, send out invoices, pay employees, and reconcile bank statements.

Many smaller nonprofit organizations make the mistake of thinking that regular accounting software is adequate. And while it’s possible to make it work, the more a nonprofit grows, the greater the need for a system that is designed to track the information that needs to be tracked.

Of course, finding the nonprofit software that is best for your client’s organization can take some time. If the organization has a large number of donors, they’d likely want that capability in any product that they choose. Likewise, if their organizational funding source is primarily from grants, they should be looking for a program that includes the ability to manage multiple grants.

Another issue to look at is deployment options. While some nonprofit software applications can be accessed from anywhere, others are designed to be installed on a desktop or network system. . Of course, cost can also be an issue, particularly for smaller nonprofit organizations with a limited budget.

All of these issues will need to be considered when looking for a software product that will work best for your client’s needs. And the best place to start is by taking a look at the nonprofit reviews that are included in this issue:

Abila MIP Advance

 AccuFund for Nonprofits

 Aplos Fund Accounting

 Araize Fast Fund

Blackbaud Financial Edge NXT

 Cougar Mountain Denali FUND

Fund E-Z Nonprofit Accounting  

GMS Grants Management Systems

QuickBooks for Nonprofits

Serenic Navigator

Tangicloud for Nonprofits & Government

 Xero Nonprofit Accounting

The reviewed products vary widely in both cost and functionality, with some of the products best suited for smaller nonprofits that have less stringent needs, while others provide just about every feature and functionality possible.

To make it easier, we looked at specific features and functionality in each of the products listed above, including chart of accounts structure and customization, grant management capability, fundraising and donor management capability, and even whether a mobile app was available. A Features chart accompanies the reviews, allows you to quickly view which features and functionality are found in each product. We also advise readers if a free demo is available, since trying out the product can be extremely useful when in the market for a new software system. Finally, pricing considerations come into play for most nonprofit organizations, since many have a limited budget available, so we’ve made every effort to include product costs in the review.

The bottom line is that nonprofit software can help an organization work more efficiently while they continue their mission to make this world a better place. We hope that the reviews included in this issue help in some way towards finding your client’s organization the product that works best for them.

Financial Technologies & Management provides our software evaluation to help you select the best nonprofit accounting system for you.  Also, we sell and implement the industry leading solutions which include MIP Fund Accounting, MIP Advance, AccuFund,  and Araize.  I would suggest you review our article “why your Nonprofit should consider using Nonprofit Accounting Software?” to start your review.  Please contact us before you contact any software vendors for us to best serve your review of Nonprofit Accounting Systems and Software.

12 Characteristics of Financially Healthy Nonprofits

12 Characteristics of Financially Healthy Nonprofits

Every director and board member of a nonprofit would like to have a large endowment, reserve cash in the bank, and a surplus at the end of every year. Unfortunately, most of us know that this might be a dream instead of reality. Without these tangible signs of financial strength, how can you know if your organization is financially healthy?

Financial health is about more than just reserves and endowment balances. Having a large budget or complex accounting system doesn’t always result in good management and longterm success. Just as our personal health depends on our behavior, so the financial health of a nonprofit depends on management behavior – policies and practices.

Even though there may be occasional deficits, or periods of tight cash flow, the following character- istics are good signs that your organization will be financially healthy over the long-term.

  1. Board of directors and management hold themselves responsible for long-term stability in both programs and financial performance.
  2. Board members understand their roles and responsibilities in financial matters.
  3. A realistic and well-considered budget is prepared and approved by the board.
  4. Budgets are prepared in tandem with planning for programs and operating needs.
  5. Management and board are committed to managing with the goal of an operating surplus each year.
  6. Consistent, accurate, and timely financial reports are prepared and analyzed by qualified individuals.
  7. Management and board monitor financial results as compared to the budget and modify programs and activities in response to variances.
  8. Management realistically plans and monitors cash flow so as to be able to meet obligations.
  9. Financial policies are in place that establish, or have specific plans to establish, an operating reserve to finance cash shortfalls and program growth.
  10. Policies are established for major financial decisions and adequate and appropriate internal controls.
  11. Management is committed to compliance with all required legal and funder reporting.
  12. The board and management regularly review short-term and long-term plans and develop goals and strategies for the future.

It is important that you strive to achieve each of these characteristics to insure your organization’s financial health and long-term sustainability.

Please let us know if we can help you improve in any of these areas.

Is Diversification of Revenue Good for Nonprofit Financial Health?

By MARK A. HAGER AND CHIAKO HUNG

This article comes from the spring 2019 edition of the Nonprofit Quarterly.

As in any field, nonprofit management has its little truisms: Boards make policy and staff members carry it out. Hire an independent facilitator for strategic planning. Always thank your volunteers. One of the most often-quoted truisms is that nonprofits should seek as much diversity in their revenue streams as possible. Turns out that some truisms are truer than others, and anybody handing out absolute rules is probably trying to sell you something. There’s no substitute for understanding the ins and outs of an issue and then smartly applying them to your own situation. What blossoms in one situation might crater in the next.

The basic principle sounds good: depending on one primary source of income can be risky, especially if that source begins to head south, so it makes sense to hedge your bets—right? Indeed, the decree that more types of revenue—or more revenue streams—is always good has been around for a long time. Each revenue type (and source) comes with its own levels of reliability, constraints, and costs, and all may not align appropriately with the organization or its stakeholders or other revenue sources. Many types of revenue streams may need a runway where they may cost more than they bring in for a period of time. Some need a different kind of organizational capacity than what exists. Some may draw you off course or create reputational issues. Some revenue streams might soften with the economy, while others do not.

Examples of this kind of complexity are everywhere. Picture a thrift shop that lives and dies purely on individual contributions, which we might call a concentrated portfolio. In contrast, the homeless shelter across the street may also rely substantially on individual contributions but also benefit from a foundation grant, county government sponsorship, and earnings from a social enterprise (a café staffed by shelter residents). We might say that the shelter has a diversified portfolio. And that’s always good, right?

Not always, no. Perhaps the government grant does not pay full costs of the service required to fulfill it, and therefore requires otherwise precious unrestricted money to supplement a specific contract. And perhaps the social enterprise demands more than its fair share of staff attention— producing more angst than cash. The fact is that every revenue source requires some transaction costs: money, time, and attention. Every revenue source has its own level of restriction, from complete to none at all, and this affects autonomy and adaptability. The thrift store can do what it wishes with the money it makes within the confines of the nondistribution constraint—unless, of course, it loses money or operates on a very thin margin. Its revenue is not likely to decline with the economy—in fact, the opposite is true. All of these details about the nature and behavior of various revenue streams matter to the health of the overall operation, complicating the question of whether or not diversification is needed.

The decision to pursue additional revenue streams is a vital question of strategy for any nonprofit. So, you might not be surprised to learn that dozens of university faculty members who study nonprofit organizations have been studying the value of revenue diversification for decades. But how useful has this been for practitioners? We reviewed all this research for a paper recently published in Nonprofit and Voluntary Sector Quarterly, and you might not be surprised to learn that the findings are messy and conflicting.1 When we say that revenue diversification matters, what exactly are we saying it matters for? “Financial health” might mean revenues, or revenue growth, or volatility. It might mean assets, or asset growth. It might mean operating margin, or fundraising spending, or program spending, or even survival. Different researchers study different outcomes among different types of nonprofits in different places with different research methods, and *boom* they get different results and draw different conclusions. Sometimes revenue diversification is helpful to financial health, sometimes it makes no difference, and sometimes it is harmful. Given these conflicting results, it falls to you to figure out your situation for yourself.

Luckily, this rich thread of research has spawned a number of arguments about why revenue diversification might be helpful or harmful. That’s what we want to present for you here, so that you have what you need to make your own strategic decisions in your nonprofit organization. An important starting point is to dispel the notion that revenue diversification is uniformly (always, every time) a good thing. Sometimes it’s not. Turns out the pros and cons are about even on the revenue diversification question. Let’s dig in.

Pro: Flexibility

If you know anything about the revenue diversification arguments, you might call this the standard textbook declaration on the pro side. Maybe the future is going to be stable and predictable, and your one revenue stream will provide the resources you need to pursue your mission. But the
future is unknown! Two kinds of uncertainty threaten to upset the applecart at any time. One is large-scale environmental change: a hurricane, or a recession, or civil unrest could radically shift what you need or what you have coming in. The other is more personal: your revenue line could just dry up. Shifts in tax policy make people think twice about their charitable gifts, foundations change their giving priorities, governments move their contracts to your competitors, and social enterprises fail. We know these things happen, and it’s not hard to imagine them happening to us.

The argument, then, is that more (and ideally unrelated) revenue streams give us the flexibility to weather shifts of all kinds. If you get all your money from government contracts and that contract is terminated, you may be sunk. If you get half your money from government contracts and half from private grants, loss of the contracts is serious but not necessarily fatal. Revenue diversification can give you options when the ground shifts beneath you. We say it allows you to “hedge against uncertainty.”

Con: Risk and Vulnerability

Hager saves a little money each month: It grows in his savings account—not much, but it grows. Hung saves a little money each month: He invests it in mutual funds—sometimes the market produces big returns, and sometimes it cuts into his principal. Maybe Hung will end up with more savings than Hager after a few years, but Hager sleeps better at night.

Modern portfolio theory helps us think about how to balance our tolerance for risk with our desire for greater returns. The investment choices with the greatest potential for gains are the same ones with the greatest potential for loss. These same ideas apply pretty well when making decisions about whether to pursue new revenue streams or not. Some revenue streams are more volatile or harder to maintain than others. Every time we pursue a new revenue option, we increase the complexity of our portfolio. We introduce risks that might cost us money in the long run—or at least a few nights of sleep.

Single-revenue streams, especially when the future is going to look much like the past, are safe and stable, just like savings accounts. However, the future is looking less and less like the past. Most of us now understand that we have to be prepared to adapt. Many read reliance on one revenue source as vulnerability, and, therefore, risk, and that makes good sense. But adding revenue streams adds complexity and new risks—ones that we often cannot fully calculate or appreciate as we enter into them.

Thus, diversifying requires at the very least a sober look at all the pros and cons of that particular income stream, including assessments of start-up costs, capital needs, and risks and consequences of worst possible scenarios. You may also need a special dashboard—or additions to your dashboard—so that the board can measure the costs-versus-benefits proposition. Without this forethought, you might end up in a worse financial position than if you chose not to diversify. The competence of your management team plays a big role here, and only you can gauge the likelihood that you will end up ahead.

Pro: Autonomy

The great advantage here is the freedom to call your own shots. Having money above what is needed for subsistence provides a lot of freedom, and needing money is a source of “constraint.” You have certainly seen examples of this: Private foundations do what they want, while their grantees have to toe the line.

Read any of the scholarship on revenue diversification, and there’s a fair chance you will see references to “resource dependence,” which means that money (or the ways to procure it) influences how organizations behave. Nonprofits that get all their money from government contracts—say, to provide mental health services for some part of their state—do not have much autonomy. The American Civil Liberties Union, with its recent huge influx of donor dollars, has a great deal of autonomy. The difference, again, is in the type of restrictions written into the type of revenue.

Revenue diversification has the potential to provide autonomy and all the advantages that come with that, since the nonprofit is not beholden to a single master. Whether many masters is better than one master is an open question, but diversification can provide freedom when one or another revenue stream places constraints on operations. The ability to call your own shots is essential; otherwise, nonprofits just vend services for the people holding the purse strings, and might stop representing their missions, boards, and broader stakeholder communities.

Con: Crowd-out of Private Donations

Crowd-out is one of those unanticipated problems that might come with—or might complicate—diversification of income streams. Put simply, crowd-out means that donors or purchasers might adjust their decisions due to their views on your other resource acquisition efforts. An example is the art museum attendee who declines to respond to a fundraising appeal because he believes his support obligation was met when he purchased the coffee-table book as he passed through the gift shop. Consequence: the museum cleared $15 profit on the book purchase, but lost out on a $150 donation.

Most of the research on crowd-out focuses on the statistical relationship between government contracts and private donations. A mental health agency might strategize that a public fundraising campaign would provide it more latitude and autonomy, and even the ability to innovate.
However, people may not be willing to contribute because they perceive the agency to be amply funded (by the government contracts) and therefore not in need of their contribution. Right or wrong, you can’t blame the donor for making that leap.

Blind revenue diversification carries these kinds of unanticipated problems. Because the revenue streams are part of a portfolio, they can interact with and influence each other. In isolation, a given revenue stream has a certain potential for revenue gains. Taken together, those potentials may be lowered. If they are lowered enough, they may well not be worth pursuing or will need to be pursued in a more limited, experimental way.

Pro: Community Embeddedness

Community embeddedness refers to your street credibility. Do potential clients or patrons know about you? Do they see you as legitimate? Do potential collaborators think about you when opportunities arise? Embeddedness is one part visibility, one part credibility, and one part networking. Some people call it social capital—the more that key stakeholders see you as a player, the more embedded you are in the community. Not every nonprofit needs this kind of embeddedness in order to serve its mission, but many crave it nonetheless.

One important way that organizations interface with community is through their efforts to acquire resources. An organization with a prominent fundraising campaign might be well known among the part of the public that cares about its mission but invisible to foundations, other nonprofits, government, local businesses, or the more general public. While diversifying revenue streams can have unanticipated downsides, a potential “extra” upside is exposure to new dimensions of the community. An organization well known to local grant makers might gain unique connections and increased reputation through the development of a social enterprise. Community connectedness might increase your penetration of mission, but community embeddedness might pay other benefits as well. For one, nonprofits with greater community embeddedness tend to live longer than more isolated nonprofits. Social capital pays, and revenue diversification can be a pathway to such embeddedness.

Con: Increased Administrative Costs

We mention risk and the potentials for crowd-out above, but the costs associated with (and capital required for) competently pursuing new revenue streams is too often overlooked by decision makers. If your organization has put time and effort into really good fundraising, that doesn’t instantly translate into expertise in grantwriting, or investments, or sales. Expertise is one thing, but sunk and ongoing administrative costs in management systems are another. Contracting often carries the highest such costs, with administrative time required for application, monitoring, and reporting. A good fundraising program requires pricey software and a sustained effort. Earned-income ventures require products and physical spaces and bear the risk of market failure.

A nonprofit with a concentrated revenue portfolio can streamline its spending and maximize the resources it passes to programs. In contrast, diversification requires specializations and different administrative apparatuses across the various approaches. If administrative costs stray onto the sensibilities of donors, those donors might even reduce their commitments to the organization. The increase in administrative outlays and the signals this may send to stakeholders are complexities that board members and other top managers do not always fully appreciate. Don’t get us wrong: we think nonprofits should spend more on vital administration, including information technology, human resource management, and resource development. But the problem is that your patrons may not agree with that. As always, nonprofits have to balance their progress with the demands of those who hold the purse strings.

Can decades of academic research tell you whether you should diversify your revenue streams or not? Sadly, no: the results are mixed and difficult to sort out. However, what it can do is outline the issues you and your board should consider when the question arises. Strategy, expertise, history, commitment, cause, and revenue mix differ from case to case, with a million different permutations. It depends. Study your own case, think through the ramifications, talk to everyone involved, and make your best calls without paying undue attention to an overly simplified prescription. Hopefully, flexibility, autonomy, and community embeddedness are around the corner.
Note

1. ChiaKo Hung and Mark A. Hager, “The Impact of Revenue Diversification on Nonprofit Financial Health: A Meta-analysis,” Nonprofit and Voluntary Sector Quarterly 48, no. 1 (February 2019).

“Is Diversification of Revenue Good for Nonprofit Financial Health?” draws on the NVSQ article, with permission