Outsourced Accounting

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

 

 

Budgeting must be more flexible in uncertain times

By Jim Simpson, CPA and Director, Financial Technologies & Management

A strong budget is an essential element for any nonprofit organization to achieve financial leadership. Superior budgets, though, have written plans about the core activities to include strategic, organizational, and program goals and how they will be financed.  A superior budget must be monitored and managed in light of the political and economic realities and the increased uncertainties we are all facing.

Most financial leaders focus too much time on budget variance analysis and not enough time on anticipating or planning for the future. By anticipating or planning, organizations can focus on what’s upcoming regardless of its budget cycle or fiscal year-end. A budget can be complemented with rolling forecasts to better anticipate upcoming financial results.

Budgets also need to include cash flow projections, which maybe outside of the finance departments capacity or capabilities. Financial leaders must have a direct role in developing useful cash flow projections and assumptions with frequent, detailed analysis.

Financial sustainability can only be achieved with a well-prepared and continuously monitored budget. Conversely, a poorly developed budget can diminish mission focused activities opportunities and threaten long-term success.

It is important that each of the following budget process practices is used to develop the budget.

  • Draft revenue and expense budget to attain strategic, organizational and program goals. It is important to break expenses into variable expenses, fixed expenses, incremental expenses and indirect expenses for administration and facilities.  It is important that any new initiatives are approved and deadlines established before they are undertaken.
  • Modify budget with budget team input to ensure everyone understands and approves the revised draft budget.
  • Implement budget to communicate budget, assign management responsibilities, implement in accounting system, monitor and respond to changes to the budget. It is important that you document budget decisions including writing down all budget assumptions.
  • A budget should be implemented with monthly distributions to anticipate the changes to monthly revenues and expenses based on timing and seasonal program activities.
  • A budget may need to be broken out for donors without restrictions and donors with restrictions to insure that there are sufficient resources to actually fulfill the donor restrictions.
  • A budget should add a contingency or cushion to take into consideration the unknown.   The less predictable your budget it, the more contingency you may need to have.    A contingency of 5% of your non-personnel costs is typical and may need to increase if your funding or costs are not predictable.

Any unfavorable budget deficits need to be evaluated to determine if it is just a timing difference or an actual deficit. Shortfalls created by deficits need to be solved by budget adjustments or strategic choices to absorb a shortfall. An organization can determine timing or actual deficits by reviewing the budget to see if it had planned for or not.

Your budget deficits should consider what funding may become available, whether to utilize reserves, utilize unrestricted funding, or reduce expenses.  If funding is disappearing, can we replace the funding, should we reduce or eliminate an ineffective program, or can we reinvest into more effective or sustainable programs.  You should create various budget scenarios so you have various options about how to meet budget deficits.

In contrast to traditional budgets, a flexible budget may include a range of scenarios or a shorter time frame, or both. Three scenarios at a minimum should be prepared: best, worst and expected cases.

A bare bones worst-case budget will show you exactly which expenses are crucial to your organization.  Prepare your flexible budget in shorter or longer time increments from the annual budget cycle.

It is important the you strike the right balance in your development of flexible budgets.

  1. Worst-case budget – It will include realistic income and your core expenses.  The realistic income is committed funds and conservative fundraising estimates.  The core expenses would include essential expenses with no expansion of services.
  2. Expected-case budget – It will include optimistic income and incremental expenses.  The optimistic income will include uncertain funding estimates.   The incremental expenses would be the additional expenses to be incurred if new funds are secured.
  3. Best-case budget – It will include the fundraising goal revenue and projected expenses.  The fundraising goal revenue includes the combination of the realistic and optimistic income.  The projected expenses includes the combination of he core and incremental expenses.

It is important that an accompanying cash flow projection be developed to accompany the accrual based budget.  A cash flow projection will help to foresee cash flow problems a plan for solutions even if an organization has a balanced or surplus budget.

Flexible budgets and Cash Flow Projections will provide you with additional tools to help ensure your organization remains financial stable despite an uncertain future.

Key Goals for Financial Stability

  • Diversify Revenue so you are no too dependent on any one funding source and look for ways to accelerate cash flows
  • Allocate indirect costs to programs to insure all program costs are covered
  • Develop Staff versatility and adaptability to work in different program areas
  • Develop and maintain an Endowment to support financial operations
  • Maintain one to three months reserves to allow for program growth and cover short-term deficits
  • Keep track of financial results and how you are doing to keep organization financially stable
  • Monitor cash flow projection at least monthly to determine how long the organization can survive without additional funding

Let us know how we can help your organization develop the financial tools it needs to grow and remain financially stable.

Beyond the Debits and Credits: A Management and Governance Checklist for Implementing FASB ASU 2016-14

Beyond the Debits and Credits: A Management and Governance Checklist for Implementing FASB ASU 2016-14

 The time has come to dive into the details of how to implement FASB Accounting Standards Update (ASU) 2016-14, Presentation of Financial Statements of Not-for-Profit Entities. For that purpose, you can’t beat a good checklist. While there are several checklists available online to assist you with the financial-statement-presentation aspects of ASU 2016-14 implementation, this checklist addresses the governance side of implementation. What needs to be considered from a process perspective; what needs to be communicated and to whom?

The checklist is divided into the five key areas:

  • Classifying net assets
  • Reporting investment returns
  • Reporting expenses by function and nature
  • Preparing the statement of cash flows
  • Preparing disclosures about liquidity and availability of financial assets

Each section contains a high-level overview of the requirements, followed by questions that management should consider when implementing the standard as well as steps that may be taken to ensure that your board understands the implications.

Net Asset Classification

ASU 2016-14 replaces the three classes of net assets – permanently restricted, temporarily restricted and unrestricted –with two classes – net assets with donor-imposed restrictions and net assets without donor restrictions. To ensure that there is no loss of information, the standard requires not-for-profits to provide information about the nature and amounts of donor restrictions on net assets, as well as the amounts and purposes of net assets that have been designated by the governing board.

Amounts by which endowment funds are underwater will now be reported within net assets with donor restrictions rather than in unrestricted net assets. In addition, organizations will be required to disclose their policy for spending from underwater endowments and the aggregate original gift amounts of underwater funds, along with the fair value of those funds.

The policy option to imply a time restriction that expires over the useful life of donated long- lived assets will no longer be available. Instead, absent specific donor stipulations, restrictions on capital assets will be released when the asset is placed in service.

 

Considerations Yes/No Actions Required
1. Should current classifications be reviewed to ensure accuracy?    
a) Are processes in place to ensure that donor restrictions have been released appropriately?    
b) Are there unidentified balances in temporarily restricted net assets that should be examined?    
2. Does the organization have board designated net assets?    
a) Are the purposes for which the net assets are designated still appropriate?    
b) Has the board’s approval of designated amounts been adequately documented?    
3. Does the organization have endowment funds that are underwater?    
a) Are systems and processes in place that enable identification of underwater funds?    
b) Will the transfer to net assets with donor restrictions adversely affect ratios or covenants?    
c) Is the organization’s policy for spending from underwater endowments still appropriate and adequately documented?    
4. Does the organization have a policy to imply a time restriction that expires over the useful life of donated long-lived assets?    
a) What is the potential effect of releasing from restriction net assets to which that policy has been applied?    
5. Does the organization’s chart of accounts need revisions to support the net asset changes?    
Considerations for Board Communication
1. Explain the new net asset categories.    
a) Review terminology changes.    
b) Illustrate how the changes will affect statement presentation.    
2. Describe any impact of underwater endowments on net asset balances.    
3. Describe any impact on net asset balances if policy to imply a time restriction on donated long-lived assets is currently being used.    
4. Reaffirm prior board decisions.    
a) Review existing board designations.    

 

b) Ensure policy for spending from underwater endowments is still appropriate.    
5. Discuss additional costs associated with changes.    
a) Additional audit fees    
b) Necessary system and/or process changes    

Reporting Investment Returns

Under ASU 2016-14, investment returns will be presented net of external and direct internal expenses in the statement of activities. The current requirement to disclose the amount of netted investment expenses has been eliminated. In addition, NFPs will no longer be required to display the investment return components (income earned and net realized and unrealized gains or losses) in the rollforward of endowment net assets.

 

Considerations Yes/No Actions Required
1. Identify the costs, if any, that are being netted today.    
a) Do costs currently being netted meet the definition in the standard?    
b) Will any additional costs need to be netted?    
2. Consider how to communicate any significant changes in net investment revenue reported in the financial statements.    
a) Who needs to communicated with?    
b) What is the best means of communicating (i.e., in person, by email, other)?    
3. Will a change in net investment return have any adverse consequences that should be addressed prior to implementation?    
a) Debt covenants    
b) Regulatory requirements    
c) Other    
4. Does the organization produce other reports that should be revised to provide consistent information?    
Considerations for Board Communication
1. Explain the new requirement for netting investment expenses.    
2. Identify any changes to the current amounts, if any, being netted.    
3. Describe any impact on net investment return to be reported in the financial statements and any adverse consequences of the change.    

Reporting Expenses by Function and Nature

ASU 2016-14 requires an analysis of total expenses by both their function and nature in a single location either on the face of the statement of activities, as a schedule in the notes to financial statements, or in a separate financial statement. To the extent that expenses are reported by other than their natural classification (such as salaries included in cost of goods sold or facility rental costs of special events reported as direct benefits to donors), they must be reported by their natural classification in the functional expense analysis. For example, salaries, wages, and fringe benefits that are included as part of the cost of goods sold on the statement of activities should be included with other salaries, wages, and fringe benefits in the expense analysis. External and direct internal investment expenses that have been netted against investment return may not be included in the functional expense analysis. Enhanced disclosures about how costs are allocated among functions are also required.

 

Considerations Yes/No Actions Required
1. Determine the best format for presenting the expense analysis:    
a) On the face of the statement of activities?    
b) In the notes to the financial statements?    
c) As a separate statement (i.e., a statement of functional expenses)?    
2. Are the current functional expense classifications still appropriate?    
a) Are there too many?    
b) Are there too few?    
c) Is any renaming necessary to accurately depict what is included in a specific function?    
3. Ensure functional classifications are being accurately captured in the financial statements.    
a) What processes are in place to ensure that expenses are properly classified?    
b) Is a review of the classification necessary to ensure accuracy?    
4. Are expenses by natural classification being properly captured?    
a) What processes are in place to ensure expenses are properly recorded?    
b) Are employee reimbursements in accordance with the organization’s policy?    
5. Are the current natural expense classifications still appropriate?    
a) Are there too many?    
b) Are there too few?    

 

6. Are current allocation methodologies appropriate?    
7. If comparative years are presented, should the expense analysis be presented for the current year only or for all years presented? (Note: NFPs that previously were required to present a statement of functional expenses do not have the option to omit prior-period information.)    
Considerations for Board Communication
1. Discuss how this analysis may differ from the similar analysis required on the IRS Form 990.    
2. Identify any additional costs anticipated in preparing the disclosure (i.e., costs to review existing functional expenses).    

Statement of Cash Flows

ASU 2016-14 allows an organization to present cash flows from operating activities using either the direct or indirect method. If the direct method is chosen, the indirect reconciliation is not required, but may still be provided if desired.

Considerations Yes/No Actions Required
1. Determine which presentation method is best for the organization.    
2. If contemplating a change:    
a) Consider recasting current statement into the new format.    
b) Identify any system changes needed to support the new format.    
c) Determine if any process changes will be necessary.    
d) Decide whether to include the indirect reconciliation in the financial statements.    
Considerations for Board Communication
1. Discuss the pros and cons of each format and get input on the board’s preference.    
2. Consider preparing statements in each format and highlight differences.    
3. Identify any additional costs associated with making a change.    

Disclosures about Liquidity and Availability of Financial Assets

The new standard requires not-for-profits to disclose both qualitative and quantitative information about liquidity and availability of resources as follows:

  • Qualitative information that communicates how the organization manages its liquid resources available to meet cash needs for general expenditures within one year of the balance sheet
  • Quantitative information that communicates the availability of the organization’s financial assets at the balance sheet date to meet cash needs for general expenditures within one year of the balance sheet The availability of a financial asset may be affected by its nature; external limits imposed by donors, laws, and contracts with others; and internal limits imposed by governing boards.

These disclosures can take many forms depending on the relative liquidity of an organization’s resources, donor-imposed restrictions on those resources, internal board designation of resources, and so on.

Considerations Yes/No Actions Required
1. What is the message the organization wants to convey?    
a) Does the organization have ample resources to fund activities over the next 12 months?    
b) Are there significant restrictions or internal designations limiting the use of resources?    
c) What additional sources of liquidity are available?    
2. Identify the best way to present the message:    
a) Text only?    
b) Tables and text?    
3. Identify current procedures around board designations.    
a) Are procedures formally documented?    
b) Does the board delegate authority for designation of net assets?    
i.   Is the delegation documented?    
ii. Are the levels of delegation still appropriate?    
4. Review current policies.    
a) Will any new policies be required?    
i.   Net asset designation policy?    
ii. Operating reserve policy?    
b) Do existing policies need updating or formalizing?    
5. Are system changes needed to easily capture information for disclosure?    
6. Does the organization’s chart of accounts need revisions to support the disclosure?    

 

7. Do current processes need to be modified?    
8. Are any new processes necessary?    
9. If comparative years are presented, should the liquidity disclosures be presented for the current year only or for all years presented?    
Considerations for Board Communication
1. Explain the disclosure requirements.    
2. Discuss the best presentation for achieving desired transparency.    
3. Recommend any policy changes or additions.    
4. Discuss any additional costs anticipated for preparing the disclosures.    

Source: “Beyond the Debits and Credits: A Management and Governance Checklist for Implementing FASB ASU 2016-14,” American Institute of Certified Public Accountants, Not-for-Profit Section.

Nonprofit Cash Flow Management: Day-to-Day Liquidity

In recent years, the concept of the “business model” has gained a great deal of currency within the nonprofit sector, with nonprofit leaders as well as grantmakers and other stakeholders focused on understanding and improving the business and financial underpinnings of how organizations deliver on their missions. Discussions of the nonprofit business model often include considerations of things like cost to deliver services, mix of sources of funding, and key drivers of financial results.  Discussions of financial stability and sustainability often focus on the overall health of the balance sheet and (accrual-based) operating results. While these are all essential elements to understanding an organization’s finances and business model, such conversations sometimes miss one critical component of any business—namely, day-to-day liquidity. This article will discuss ways in which cash flow impacts—and is impacted by—the way a nonprofit organization does its business.

Cash flow is simply the mix—and timing—of cash receipts into and cash payments out of an organization’s accounts. It is where the numbers on budget spreadsheets and financial reports translate into the reality of money changing hands. And as such, it is a very specific lens on the reality of a business model—one that takes into account not just what an organization’s revenues and expenses look like, but when they come and go.

Managing cash flow, therefore, is primarily a question of when—when we pay our staff, when this bill is due, when the grant payment will come in. And as there are many varieties of nonprofit business models, each one has a particular bearing on many of those whens.

Nonprofit business models have two main components: what kinds of programs and services nonprofits deliver, and how they are funded.  For nonprofits, the latter component is a bit more complicated than for our colleagues in the for-profit world, for whom the answer is (nearly) always “by selling them to customers.” Of course, this isn’t to say that cash flow is perfectly smooth or friction less even in the for-profit sector, only that the range and variety of funding models for nonprofits (including not just “customers” but also third-party funders such as foundations, governments, and even individual donors) adds additional complexity.

Each component of the nonprofit business model—the delivery model and the funding model—has implications for organizational cash flow that should be understood for effective financial planning. We’ll look at each one in turn before discussing some strategies for addressing the almost inevitable occasions when the cash flowing in doesn’t match the cash flowing out.

What Do We Do?

 “What do we do?”—what kinds of programs and services an organization delivers (and how it delivers them)—is really a more high-minded way of asking, “What do we spend our money on?” (Granted, some services may be delivered by volunteers or use donated goods, but money is still necessary to pay managers and fund operations.) Really understanding “what we spend money on” will also generally give us a good idea of “when we spend it.” For example, a performing arts company that does four productions a year will have a fairly steady base of ongoing expenses, with spikes during the periods when productions are being prepared and staged. An emergency relief organization may have its baseline of operating expenses, with sudden (and unpredictable) surges of cash needs in response to a local hardship or disaster. A social service organization may have very predictable and consistent monthly cash outlays: payroll every two weeks, rent on the first of the month, invoices on the fifteenth and thirtieth. In each case, the cash flow demands are inherent in the business model.

Job one for cash flow management, then, is to understand the timing of cash needs—the magnitude and due dates of an organization’s bills.    Again, the “what do we do” side of the business model is the guide. If what you do is relatively stable, consistent, and predictable (as in the social service organization example), your cash needs likely will be as well. If what you do is predictable but not consistent (as in the performing arts company with productions at various points throughout the year), you know to plan for the surge in cash needs when the programming picks up. If what you do is unpredictable (as in the disaster relief agency), you will need cash available to deploy at a moment’s notice.

The examples above only take into account normal operations—businesses also need cash at certain points for longer-term investments like moving to a new space or buying a building. And while a major investment like that wouldn’t happen without a solid plan, there are also the occasional random but significant expenses like facility repairs. Again, the business model tells the story of the cash needs: while the social service organization may not be making capital purchases beyond a new set of computers, a housing development organization may need enough cash for major real estate purchases or construction of buildings. However large or small the investment, at the end of the day it means cash flowing out of your account.

How Are We Funded?

 Wouldn’t it be nice if the biggest task were simply thinking through one’s program delivery model to identify when the cash will be needed, and then turning on the tap to make it flow? Unfortunately, cash doesn’t work like a tap (and in fact, we have to have cash to keep water flowing). While the ideal case scenario is that cash comes into an organization at a similar volume and velocity to how it goes out, in reality nonprofit funding streams very often don’t work like that. In fact, an organization with a balanced (or even surplus) budget can still end up running out of cash due to timing mismatches. Looking at the “how are we funded” side of the business model can give us a better sense of what to expect in terms of cash inflows and of what to do if they don’t line up with the “what do we do” side. Each type of income stream tends to have particular implications and challenges for cash flow, so a business model built primarily around one type of funding will need to understand and plan for those implications and challenges.

A revenue-side business model that we see posing one of the biggest challenges for cash flow management is funding from government (particularly state and local) sources. In general, contracts with government entities pay for services only after the services are delivered, forcing the service-providing nonprofit to cover the initial outlay of cash to deliver those services. This is actually fairly typical of any business (for example, a retailer has to front the cash for inventory before generating income from sales; a professional services firm delivers services to clients prior to invoicing and collecting cash), but it is often compounded in the case of government funding by bureaucratic delays in registering contracts or processing invoices and payments. In some extreme cases, we have seen gaps of several months or more between an organization’s disbursement of cash to deliver contract services and collection of cash under the terms of the contract. In the absence of other revenue streams or other ways of accessing cash (about which more later), nonprofits in situations like this can face true cash flow crises.

Earned income from nongovernment sources—for instance, ticket sales for a performing arts organization—brings some of the same challenges, although (ideally) without the additional bureaucratic delays sometimes inherent in working with government. Even so, cash outlays typically happen in advance of cash collection—performances are rehearsed and sets are built before the audience buys tickets. This means that an organization needs cash to finance those costs that will later generate revenue back into the organization. (Any sort of prepayment on earned income—for example, advance ticket sales for performances or advance payments or retainers for service delivery—can help to fund the initial cash outlays.)

Cash from contributions and donations doesn’t come with the bureaucratic delays of government funding or the up-front outlays required to generate earned income. But organizations whose revenue model is primarily driven by voluntary contributions often face another reality of managing cash, which is that cash inflow can be very concentrated at a particular point (or points) within the year. For example, an organization that generates a significant portion of its income from an annual gala-type fundraiser may have an event in spring whose receipts may have to carry it much of the way until the next spring. Another may see much of its cash come in from an annual campaign timed to take advantage of end- of-year holiday (and tax write-off) giving. Nonprofits with highly concentrated cash inflow can exist in something of a “feast or famine” mode— flush when the money is rolling in but concerned that it will have to carry all the way until next year, or at least the next campaign.

Support from foundations and institutional philanthropy has its own implications for cash flow. On the positive side, grants are generally paid at the start of a funding period rather than following the delivery (and costs) of programs and services. On the negative side, grantmaking calendars can vary considerably from a nonprofit’s own programming calendar, so there can still be periods when ongoing program or operating costs have to be financed from other sources. Another relatively common characteristic of foundation support (and a cash flow consideration unique to the nonprofit sector) is its restriction to particular programs or activities, meaning that a condition of a grant is that its funds be used only for a specified purpose. So, what may look like readily available cash to meet current needs could technically be a set-aside for expenses weeks or months down the road.

Each side of the nonprofit business model—what and how we deliver, and how we fund it—helps set expectations about the timing of cash into and out of the organization’s accounts. But, particularly given the fact of nonprofit life that our “customers” and “payers” are often different entities, there’s only so much we can do to line up that timing to smooth out cash flow. If it does happen to line up perfectly, it’s probably due more to coincidence (or miracle) than conscious effort. So, once we establish solid expectations for what our business model means in terms of the timing of cash going out and coming in, the task is how to manage the many and inevitable instances when the timing doesn’t line up.

Balancing Cash In and Out

Regardless of the nature of our business model, or of how well we plan, there will inevitably be periods in which more cash is going out of an organization than is coming into it. This is most obvious during a start-up phase, when the initial investments made in (or loans made to) a new organization are essential to meeting cash needs before income generation kicks in. But even for an established organization in a relatively steady state, “you have to spend money to make money” (and generally in that order) is a rule of business. So, how do we meet our cash needs in those times when there is not enough coming in from operations?

Before discussing that question, one critical point: It’s true that in almost any business, there will be times when cash coming in doesn’t cover the full need for cash going out. That may be because of certain timing issues inherent in the organization’s business model—slow payments for services delivered under a government contract, say. But it may also be because there’s simply not enough revenue in the business model to cover the expenses of operating the business. If the issue is a temporary cash shortage, then an organization’s leaders will know (or have a reasonable sense of) when the situation will be back in balance, with sufficient cash coming in to cover expenses. If the issue is a more permanent imbalance, what may be presenting as a cash flow problem (i.e., a matter of timing) is in reality a broader business model problem—not just a disconnect between when money is coming in versus going out, but between how much money is coming in versus going out. If an organization’s overall business model is in deficit and out of balance, cash flow problems will certainly exist, but not ones that can be resolved by the methods discussed further down. In those cases, cash flow problems are just a symptom of the bigger challenge of overall revenues not being enough to cover expenses; treating that situation as a matter of cash flow timing will only delay and intensify the necessity to address the deeper need to increase revenues and/or decrease expenses.

On the flip side, an apparently healthy cash balance doesn’t necessarily translate to cash fluidity. For instance, particularly in organizations that have multiple streams of funding for individual programs (where, as alluded to earlier, some money is restricted to certain activities), it is easy to lose track of the purposes for which each stream may be used. You may have enough money to run the program, but the money may end up being spent in ways other than what each funder requires. To make a bad situation worse, such mistakes can be punishable by a requirement to repay, making future cash even harder to come by. Thus, in nonprofit finance, cash is not fungible like it is in most for-profits: you cannot necessarily take it from one overfunded function and devote it to another that is underfunded. This can be confusing to boards—and also, too often, to unschooled executives. Such mistakes with government contracts and other forms of restricted funding can have serious high-profile repercussions for your long-term financial health and cash flow.

With that major caveat out of the way, let’s turn back to the question of how to address timing issues when last month’s collections are lower than this month’s bills. The most basic (and important) solution is drawing on an organization’s own cash reserves, which supply the working capital to keep current on payroll, rent, and other expenses. Having a cushion of a few months’ worth of expenses built up in the bank account provides the liquidity necessary to avoid being at the mercy of each day’s cash receipts to determine which bills to pay. Cash reserves are a good indicator of a nonprofit’s overall financial health and sustainability, but from an even more practical perspective they are an essential resource for managing cash flow and payment schedules.

Unfortunately, development of a robust cash reserve can be a significant challenge for many organizations. While financial surpluses and accumulations of reserves should always be a goal of budgeting and financial management, some organizations’ business models make this particularly challenging. For instance, heavily government-funded social service providers face a Catch-22, in that expense reimbursement contracts cannot by definition operate at a surplus, yet the typically slow pace of cash receipts makes it particularly important to maintain a significant cash reserve. What options exist in such cases?

For any business unable to meet cash needs with its own resources, it must meet them by borrowing from someone else’s resources (that is, taking on debt). To meet operating cash needs in the absence of adequate cash reserves, a nonprofit can turn to a line of credit as a “floatation device” to meet the temporary imbalance between available cash and expenses due. We stress the word temporary here to echo the important point made a few paragraphs back: that lines of credit should be used only to address a timing discrepancy between payment of expenses and receipt of cash.

Without a reasonable and relatively specific understanding of when the cash will be available to repay the line of credit, an organization is at risk of using credit to fund an operating deficit—and, of course, exacerbating the deficit with the interest expense associated with the debt!

That said, credit lines used responsibly can be a useful and vital tool for cash flow management, particularly for those organizations whose business models entail slow collection of major receivables or long gaps between cash infusions. We typically recommend that organizations in those situations secure a credit line at least as a safety net, since using credit is generally a better course of action than delaying payment of expenses that are critical to the functioning of the organization. And, as a general rule, it’s much easier to secure a line of credit before it’s needed than it will be when and if the situation becomes urgent. Of course, credit doesn’t come free, and organizations using lines of credit must also plan and budget for interest expenses and any other transaction costs associated with taking on debt.

If neither reserves nor credit are options in a cash crunch, nonprofits may be forced to resort to less appealing means of riding out the storm. These may include measures such as approaching funders for accelerated or advanced payments (here again, it would be critical to show that the problem is only one of timing mismatch in order to avoid raising a huge red flag to a funder) or delaying payment of certain noncritical vendors. An even less appealing option would be a loan from a staff or board member, which could raise conflict-of-interest concerns. Probably the worst-case scenario is delaying payroll for some or all staff, which could jeopardize the organization’s programs as well as potentially raise legal issues. Far better to understand your business model and budget, and plan in such a way as to establish a solid cash cushion for the lean times.

Cash Management across an Organization

The challenges and consequences nonprofit organizations face with respect to cash flow are to a large extent inherent in the business models those organizations operate with—what kinds of programs and services they deliver and the way(s) they are funded. But this isn’t to say that nonprofit leaders are purely at the mercy of the business model; understanding the way the model impacts cash flow is the first step toward planning for and managing it. While it may be impossible to ensure that cash is coming into the organization exactly on time and on target to keep things on automatic pilot, it is certainly possible to plan for those times when it isn’t, and to take advance measures to be sure that bills (and staff) are paid on time.

In this effort, it helps to take a team approach. While one person or department (finance) will be in charge of the central cash flow projection tool, effectively planning and managing cash requires input from across an organization. Program and human resources staff have the most insight into the timing of expenses. The fundraising team knows the most about timing of grant payments and donor gifts. Contract managers can set expectations about reimbursement schedules. Team members working on earned income projects can estimate billing and collections. Ultimately, all of this information should flow to the CFO to project and plan for any potential shortfalls (or, in the happy event of significantly more cash than necessary, to park it in safe short-term investments). Staff across the organization may also be asked to help manage challenges as well—perhaps by rethinking timing of certain expenses or working on accelerating collection of cash from donors or customers. Being informed, strategic, and collaborative in cash flow management can help to ensure that a nonprofit’s long-term strategy isn’t derailed by avoidable—if inevitable—short- term obstacles.

Source: Cash Flow in the Nonprofit Business Model: A Question of Whats and Whens by Hilda H Polanco and John Summers, Nonprofit Quarterly, February 13, 2019

7 steps to planning a successful not-for-profit audit

Year-end financial statement audits serve a valuable purpose in helping maintain the financial integrity of not-for-profit organizations so they can successfully complete their missions. These audits can be more effective and less challenging with a little bit of preparation and planning on the part of the not-for-profit management and finance team.

This preparation starts with your accounting system, because everything you do on a monthly basis will pay dividends as you gear up for your year-end close and the audit. Chances are your accounting system is very good for everyday things, such as processing customer/donor billings, receiving payments, paying bills, and making payroll. And you probably do other things every month in the normal course of your monthly closing cycle, such as review and reconcile various accounts.

Having these processes in place provides a good start in preparation for your year-end audit.  There are 7 planning steps to help your year-end audit be successful:

Analyze, review, and reconcile significant balance sheet accounts. Use a roll forward schedule to capture all the account activity. You and your auditor can agree as to the exact form and layout of the schedules to ensure they serve the dual purposes of the year-end close worksheet and audit schedule:

Beginning balance + additions – reductions +/- adjustments = Ending balance

Completing the schedule ensures that the account balances roll forward from the prior year end to the current year end, which provides assurance that the income statement effects of the changes have been properly recorded.

The following balance sheet accounts (and related income statement accounts) that you will want to reconcile and roll forward. Be sure to add other accounts to meet your organization’s unique needs.

Balance Sheet to reconcile and roll forward include Cash, Investments, Account Receivable, Pledge Receivable, Prepaids, Property and Equipment and related accumulated depreciation, Accounts Payable, Accrued Expenses, Deferred Revenue, Debt including capital lease obligations, and Net Assets.

Meet with your auditor to confirm the audit plan and timeline. Be sure you both come away with a clear understanding of the who, what, when, where, how, and why for each step of the audit process all the way to delivery of the final reports. The result of these efforts will be a matrix of roles, responsibilities, and dates that you both agree to uphold. Review all the audit confirmations, schedules to be prepared, documents to be pulled, and other support functions your organization will provide to the auditor. Ask for items that can help reduce your work in preparing for the audit.

Talk to your internal accounting team. Discuss the expectations, concessions, adjustments, and accommodations needed to make the year-end closing plan work. Build some contingency time into your planning, as the unexpected has an uncanny way of sneaking into even the best of plans.

Inform others in your organization about what to expect. Share your plan outside of the accounting department. Talk about what to expect from your team and the auditors when they arrive on-site. Now is a good time to reserve space for the auditors and ensure that adequate electrical outlets, internet service, photocopying/scanning, and other resources needed by the audit team will be ready and waiting when they arrive.

Finish recording all the activity for the year. Before closing your fiscal year, post the accruals and adjustments necessary to put your books fully on GAAP basis of accounting. The objective at the finish is to have a closed general ledger that will need no adjustments by your auditor. As part of the closing process, you will be completing all the roll forward schedules and account reconciliations, adjusting depreciation, recording all payables and receivables, adjusting bad debt allowances, and so on. Be sure to perform a final check of roll forward schedules to be sure they agree with final general ledger balances.

Have everything ready for the audit team when they arrive on-site. If possible, try providing items as they are completed, which will give your auditor a chance to review them in advance, potentially saving time for you and your auditor.

Don’t forget to communicate. Kindness and communication throughout the year-end closing process will produce the best results, minimize stress, and make life more pleasant for all. Be sure to build in breaks and a little downtime to help everyone maintain a healthy balance and perspective as you work together through what can be a bit overwhelming at times

Source: “7 steps to planning a successful not-for-profit audit”  AICPA CPA Insider, April 24, 2017, Tim McCutcheon, CPA

An Executive Director’s Guide to Financial Leadership-Includes ED Finance Cheat Sheet

There is an important distinction between financial management and financial leadership. Financial management is the collecting of financial data, production of financial reports, and solution of near-term financial issues. Financial leadership, on the other hand, is guiding a nonprofit organization to sustainability. This is the job of an executive director. He or she is responsible for developing and maintaining a business model that produces exceptional mission impact and sustained financial health. To do that successfully, the executive director has to be ever mindful of essential nonprofit business concepts and realities. The following is a guide to this way of thinking for an executive —a summary of what we see as the eight key business principles that should guide financial leadership practice.

1.   Activate Your Annual Budget

Strong annual budgeting is an essential element of financial leadership. The best annual budgets align to an annual plan—a written narrative that all staff and board understand about the core activities the organization will undertake in the coming year and how they will be financed. If the budget includes as-yet-unidentified income, which is standard for many organizations, that amount should be clear to all board and staff along with the plan to raise the funds during the year.

Achieve a net financial result. A classic mistake executives make is allowing staff to spend all year on budget when income is not coming in as expected. In fact, it is critical to emphasize to your staff that an annual budget is a plan to reach a net financial result—to yield a specific surplus or to invest a specific amount of the organization’s reserves through a planned deficit.  Whichever the financial goal for the year, if the organization is not running on pace to achieve that net financial result, then even budgeted expenses should be questioned and reconsidered. The budget is never permission to spend when income is not coming in as planned.

Anticipate the future. Given that many organizations raise funds and encounter new risks and opportunities throughout the fiscal year, it is important not to stay overly focused on budget variance analysis to the exclusion of rolling analysis of your anticipated financial position.  Budget variance is the difference between budgeted and actual results for a given period. While it is useful to understand why predictions were off, it is just as important to be actively anticipating the future. We see too many executives and boards focused on “hitting the budget” rather than anticipating and intentionally shaping their financial futures beyond the current fiscal year. Fiscal years are arbitrary units of time; in reality, the decisions we make—and the consequences of deferred decisions— live on well beyond the fiscal year. For this reason, we recommend that organizations build the habit of rolling financial projection.

Commit to financial projection. At least quarterly, the management team should evaluate what they are learning about current and possible revenue streams, shifts in programming, and strategic opportunities, and there should be a means to capture that up-to-the moment thinking in a financial projection. Midway through the fiscal year, we recommend adding a projection column to the income statement, so that for the rest of the year it includes year-to-date actuals, year-to-date budget, and a column for management’s current projection of where the organization is likely to end the year. Even better, the projection can roll into the “fifth quarter”—that is, across the arbitrary finish line of the fiscal year and into the first quarter of next year.

2.   Income Diversification . . . or Not

Income diversification is often touted as a tenet of sustainability—the idea being that having all of your eggs in one basket is by definition riskier than having them in multiple baskets—or in this case, multiple revenue streams. In fact, nonprofit business models vary considerably by field or service type.

Determine the degree of diversification you  need. Income diversification is more possible and more necessary in some models than in others. For instance, community mental health services are likely to be heavily government funded, and once a nonprofit has established a successful track record of providing these services, that government funding may remain in place for years. Even though the organization is technically dependent on one set of government contracts, it may not be in a riskier position than another kind of nonprofit struggling to raise small amounts of money from individuals, corporations, and foundations, for instance. The reliability and competitiveness of your revenue streams dictate the degree of diversification that you need.

Determine risk. Income diversification carries some real risks. Evidence shows that more revenue streams don’t necessarily mean greater annual surpluses or organizational scale. To attract new revenue streams, an organization has to develop and sustain new capacities. As nonprofit finance expert Clara Miller has noted, “Maintaining multiple, highly diverse revenue streams can be problematic when each requires, in essence, a separate business. Each calls for specific skills, market connections, capital investment, and management capacity. Only then will each product attract reliable operating revenue, pay the full cost of operations, and deliver results.”  And a recent analysis of high-growth nonprofits by the consulting firm Bridgespan Group found that 90 percent had a single, dominant source of funding. Bridgespan concluded that organizations get to scale by specializing in a certain type of funding, and that diversification, and thus risk management, happens by “securing multiple payers of the same type to support their work.”

3.   Make Cash Flow Your Priority

Most financial reports are historical documents, useful to verify what has already happened and compare to budgets and plans.

Develop a cash flow projection. For looking forward, one of the most important tools is a cash flow projection. Executive directors need to know how the organization’s cash flows, and what to do if the cash doesn’t flow. Unless your organization has built up a substantial base of operating cash, any nonprofit can run into cash flow problems. What causes them? A variety of factors, including seasonal fundraising, annual grant payments, reimbursement-based contracts, and start-up costs for new programs.

Anticipate—and resolve—cash flow issues. Cash flow projections require knowledge and judgment that the accounting department may not have. Because of this, executive directors need to have a direct role in developing useful cash flow projections, agreeing on the assumptions to use, and reviewing the projections carefully. The earlier you anticipate cash flow issues, the easier it is to address them. As a first step, assess whether the cash flow shortfall is a problem with timing or is an indication of a deficit. The strategies used to solve the cash flow problem should match the cause of the shortfall.

Manage your shortfalls. Timing problems can be prevented by managing the timing of payments and receipts, improving internal systems, or arranging for a line of credit. Shortfalls caused by deficits need to be solved by budget adjustments or strategic choices to absorb a near-term shortfall. All of these options need the input and support of senior management. Managing cash flow is not a one-time activity. Insist that projecting and discussing cash flow every month or quarter become routine practice.

4.  Don’t Wish for Reserves—Plan Them

 “Building a reserve” is on the top of the financial wish list of just about every executive director. It’s an understandable goal—just read the preceding section about cash flow and you’ll understand why. Having a cushion of cash that can absorb an unexpected delay in receiving funds, a shortfall in revenue for a special event, or unbudgeted expenses can stabilize an organization. Nonprofits that have built up a good cash cushion have had options and opportunities during the recession that have allowed them to respond to reduced income and increased demand more strategically and carefully than those organizations with few extra dollars in the bank.

Achieve a surplus. Wishing you had reserves is not the same as planning for reserves. But where do reserves come from? For most nonprofits, reserves are built up over time by generating unrestricted surpluses and intentionally designating a portion of the excess cash as a reserve fund. On rare occasions a nonprofit will receive a grant to create an operating reserve fund. So step one in planning for reserves is to develop realistic income and expense budgets that are likely to result in a surplus. Step two is to make sure that achieving a surplus is a priority that is understood and supported by staff and board members.  For some organizations, there is an earlier step, too. They have to stop operating with deficits before they can even dream of having a reserve.

Determine your reserve goal. How much should you have? While there are some rules of thumb, generic target amounts don’t take some important variables into account, such as the stability of ongoing cash receipts. A commonly used reserve goal is three to six months’ expenses. At the low end, reserves should be enough to cover at least one payroll, including taxes.

Manage your cushion. Once a nonprofit has been able to build a reserve, using it must be intentional and strategic. Using reserves to fill a long-term income gap is dangerous. A cash cushion allows you to weather serious bumps in the road by buying time to implement new strategies, but reserves should be prudently used to solve temporary problems, not structural financial problems. To maintain reliable reserves, it’s also important to have a realistic plan to replenish them from future surpluses.

5.  Rethink Restricted Funding

 There is an ongoing debate among grantmakers about whether general operating funds are a better investment strategy than programmatically restricted grants. And frustration with funding restrictions is a common refrain among nonprofit executives. But at times this debate gets oversimplified to a notion that all restricted money is bad and inherently compromising of organizational sustainability, when this is not the case. As an executive, what you need to be concerned with is not whether a grant is restricted but what it is restricted to. A restricted grant for a program central to your desired impact and that covers a robust portion of that program’s cost is functionally the same thing as general operating support— it is funding a core piece of the work that you do. The two qualifiers are key, though: you are doing something that the organization would do anyway, and you are getting paid fairly to do it. What you need to avoid is chronic reliance on grants and contracts that pull the organization in unaligned directions or that refuse to pay fairly for the promised outcomes.

Develop effective grant proposals. Your development of sophisticated grant proposals is essential to incorporating restricted funding in your business model effectively. Take a very broad view of any program you are proposing for funding by including as direct costs such elements as hiring program staff, marketing and outreach to clients, staff professional development, and program evaluation. These are the kinds of organizational expenses that directly benefit programs but for which we too rarely charge our investors. If you believe that program evaluation is essential to monitoring effectiveness of outcomes, it’s your obligation to force the issue with funders who classify the cost as “overhead.” Incorporating sophisticated language in your proposal narratives that links staff development to program design to strong program outcomes sets the stage for a budget that includes these critical expenses. Restricted funding from foundations and corporations that genuinely understand and value your organization’s work can be a very sustainable revenue stream if you are very selective about which funders to pursue, and if you pursue them with well- conceived programs and accompanying budgets.

6.  Staff Your Finance Function

Put simply, too many executives have not staffed their finance function properly, and they pay the price with chronically underdeveloped financial systems, low-grade financial reporting, and the lack of a trusted partner with whom to do analysis and projection. In Financial Leadership: Guiding Your Organization to Long-Term Success, co-authors Jeanne Bell and Elizabeth Schaffer describe three functional aspects of the finance function: transactional, operational, and strategic. The transactional are the clerical tasks that support the accounting function, such as copying, filing, and making bank deposits; they require someone with excellent attention to detail and exposure to basic accounting principles. The operational are the range of accounting functions, such as paying bills and producing monthly financial statements; they require someone with strong nonprofit accounting knowledge, including managing grants and contracts. And the strategic are the systems development, financial analysis, planning, and communication about the organization’s financial position; they require what we think of as CFO-level knowledge and skills.

Determine your optimal staffing approach. Every organization needs all three functions, but organizational size and complexity will determine how much time each requires and the optimal staffing approach. In general, it is income that makes nonprofits more or less complex. A $10,000,000 organization that gets all of its money from individual donors requires a very basic accounting system, while a $2,000,000 organization with government contracts and restricted foundation grants requires a very robust accounting system. As an executive, you seriously jeopardize your organization’s funding and reputation if you maintain inadequate systems for tracking contract and grant dollars—it’s a true nonnegotiable. If you have these funds in your business model, you should assume that you will need to fund a very experienced, senior finance staff role.

Invest in contract consultants. So how does an organization with limited resources adequately attend to all three finance functions? Increasingly, we are seeing executives pair contract consultants with staff in the finance function. For instance, a small or midsize nonprofit might invest in an excellent full-time staff accountant who can handle the operational functions expertly and provide oversight to an administrative generalist—such as an office manager, who handles the transactional functions during the 50 percent of her workweek that is directed to the accounting function. Then the executive contracts with a CFO-level consultant who spends fifteen hours per month answering any questions the staff accountant may encounter, doing financial analysis for the management team and board finance committee, developing budgets and projections, and so forth. This way, the executive has a strategic financial partner without creating a fixed staffing cost that she can’t afford. Board members, including the treasurer, have a role that is distinct from the staff finance team. The executive needs an uncomplicated relationship to her finance team so that she can direct them in developing the analysis and reporting she needs as the organization’s financial leader.

7.  Help Your Board to Help You

Boards have a governing role in assessing and planning an organization’s finances. In too many cases, though, executive directors expect their boards to stay high-level and strategic without equipping them for the role. It is the executive director’s responsibility to provide the board with information that is appropriate to members’ roles and responsibilities.

Design your financial reports thoughtfully. The board is responsible for short- and long-term planning of the organization, and its members must ensure that systems are in place for effectively using resources and guarding against misuse. The board has legal responsibility for financial integrity but board members are not the accountants, so don’t inundate the board with pages of detailed accounting records and then wonder why the board can’t see the “big picture.” Boards need analysis and interpretation more than they need the numbers.  There is no one-size-fits-all financial report. Reports must be designed to communicate information specific to the organization’s size, complexity, and program structure in a format that matches the knowledge level and role of board members.

Understand how boards use financial

information. The format and content of reports for the board should be determined by their intended purpose. Boards actually use financial information for four distinct purposes: compliance with financial standards, evaluation of effectiveness, planning, and immediate action.

Compliance. Most nonprofits do pretty well with providing the board with financial reports that comply with the board’s legal fiduciary role to know how much the organization has received and expended. Historical financial reports, audits, and 990s are the common reports.

Evaluation. For the board to evaluate how well the organization has used financial resources, different information is needed. Comparisons are needed to measure progress toward goals, assess the financial aspect of programs, and consider financial strategies.

Planning. When the board is engaged in planning to project future needs and changes or to develop budget guidelines, they need a big-picture understanding of the organization’s history and of the external environment and financial drivers.

Taking Action. Sometimes the board needs to make a key financial decision to implement a strategic plan, react to a sudden change, or respond to an opportunity. In order to make a wise but timely decision, the board needs to understand the background and situation and scenarios based on one or two possible actions. And form should follow function: before developing financial reports for the board, ask what type of actions or decisions the board will need to make, and provide them with the right amount of information and analysis in a format that fits the purpose. Don’t ask your board to maintain a top-level focus on strategy while submitting financial reports better suited to the auditors.

8.   Manage the Right Risks

 To reduce and manage risks, most nonprofits develop policies and procedures for each area of the organization. The facilities manager maintains controls over keys, access, and insurance coverage. The finance director assures appropriate segregation of duties, internal controls, and checks and balances. Program managers compile information and data to run background checks, keep licenses up to date, and maintain required reporting. If we put them all together in a binder, these policies make up the organization’s risk management process.

Assess your organization’s risks holistically. If each area assesses and formulates its own risks, who is responsible for deciding which risks have the most magnitude and impact on the organization? Put another way, if a nonprofit decided that at least one of its policies had to be eliminated for some reason, how would you decide which one the organization could do without? For example, which of these possible events pose the greatest risk to the organization’s ability to achieve its mission, programmatic, and financial goals: theft of a laptop computer, loss of confidential client data on that computer, or damage to the organization’s reputation if client data were made public?

 

Consider enterprise risk management. Many nonprofits do a better job of managing the risk of a small theft than they do of identifying and reducing these other two, much greater, risks. Enterprise risk management (ERM) is a term that your auditors may have brought up recently. ERM is essentially the process of assessing all of the risks that the organization faces with a comprehensive, enterprise-wide view and making decisions about managing risk in the same way. An ERM process considers both risks that are evident today and those that are will emerge as operational and strategic plans are implemented. Some organizations need to complete a formal, extensive internal assessment with a staff team and outside consultants. Smaller organizations can complete their own organization-wide review of risks through brainstorming and discussions. The most important step is to start thinking about all the parts as a whole. In the case of the stolen laptop, for example, too much emphasis on limiting access to the office on weekends might have led a program staff member to store confidential data to take home to complete a needed report. Balanced together, these risks would probably have been managed differently than if looked at separately.

With the big-picture view of the organization always in mind, the executive director is the right person to advocate ERM by asking members of his or her team to think beyond their own area to the wider enterprise.

What’s old is new again. These principles are both longstanding practices and emerging trends for nonprofits. Some of these business principles are undoubtedly familiar to you. Others may run counter to what you may believe to be a “best practice.” Executive directors learn that leading a nonprofit requires a constant balancing of current needs, external demands, and long-term vision. Financial leadership is fundamental to the role and cannot be fully delegated. These principles will help executive directors adapt to the demands of the changing environment and maintain the balance needed for mission impact and sustained financial health.

The Executive Director’s Finance Cheat Sheet

A SUMMARY OF THE EIGHT MUST-DO’S FROM THIS ARTICLE . . .

  1. Develop your annual budget with a commitment to its net financial result—whether surplus or planned deficit—and then adjust spending during the year if income is not coming in on pace to yield that net Then, complement your annual budget with rolling financial projections that incorporate your most current information about probable future financial results.
  1. Diversify your income cautiously, ensuring you have the capacity to develop and sustain the programmatic and operational requirements of attracting each new resource type
  1. Develop cash flow projections along with the budget and rolling projections so that you can anticipate any cash flow problems well in advance, when you have more
  1. Plan goals for financial reserves based on your typical cash flow cycles and risks and incorporate reserves into all financial plans and Be sure to foster a financial culture for staff and board that promotes the importance of a regular operating profit or surplus.
  1. Pursue restricted funding from those foundations and corporations that understand and value your organization’s mission and particular strategies for achieving impact. When pursuing restricted funding, develop proposal narratives and accompanying budgets that link staff development to program design to superior outcomes, including all related costs as direct.
  1. Ensure that your finance function is always properly staffed; if necessary, use a mix of staff and expert contract consultants to achieve this.
  1. Discuss expectations for financial roles and responsibilities with board leadership to create accountability and information flow that matches the size and life stage of the Make sure to invest time in developing meaningful financial report formats for the board that reinforce organizational strategies and goals and support the board in fulfilling their responsibilities.
  1. Introduce the concept of enterprise risk management to your team and initiate an internal assessment of a full range of risks.

Source: “An Executive Director’s Guide to Financial Leadership”.  Nonprofit Quarterly

What’s your nonprofit tax IQ?

What should your organization know about Nonprofit Taxes?  Aren’t nonprofit organizations exempt from nonprofit tax issues except employment related taxes?   The answer is no, but many organization’s make this assumption.  With limited accounting and finance staff, there is a tendency to rely too much on other professionals for this knowledge.   It is also important to develop internal capacity to deal with nonprofit tax issues as the board and management are ultimately responsible.  If these nonprofit tax issues aren’t dealt with proactively, they can take significant effort and resources to resolve later, reducing your ability to serve others.   Keep in mind that just because an organization has received tax-exempt status from the federal government does not mean it is exempt from state and local taxes, property taxes, sales taxes, payroll taxes, or other taxes.

The following is some basic nonprofit tax knowledge:

  • Form 990 – The Internal Revenue Service Form 990.
  • Independent Contractors – Make sure they are issued an IRS Form 1099-MISC at year end. More information on the Form 1099’s can be found on the IRS website:  IRS.GOV     You must issue Form 1099-MISC to each person who you have paid at least $600 for services and rents and Corporations are generally exempt from this requirement which is why you need to obtain a W9 from each vendor before you pay them.
  • Health Care Tax Credit – There has been a health care tax credit available for smaller nonprofits with 25 or fewer employees starting in 2010.
  • Property and Utility Taxes – If your organization owns a building, are you sure you are exempt from property and utility taxes?
  • Sales and Innkeeper Taxes – If your organization purchases items, are you sure you are exempt from sales and innkeeper taxes.
  • Federal Payroll Taxes – Nonprofits must comply with both federal and state payroll reporting requirements. Federal Tax Withholding, Social Security Taxes, and Medicare Taxes must be deposited through the Electronic Federal Tax Payment System (EFTPS).  The frequency with which deposits must be made depends on the size of the payroll, and may be semi-weekly, weekly, semi-monthly or monthly.  In addition, the organization must file a Form 941 on a quarterly basis.  Keep in mind that Board members should be especially aware of potential personal liability for payroll taxes.  Federal law requires someone is the “responsible party” and is personally liable for payroll taxes which could be the board member.
  • Unemployment Taxes – In Indiana, a nonprofit employer of 3 employees are less should be exempt from State Unemployment and most are exempt from Federal Unemployment
  • Other – For Charitable Gaming, do you follow these laws and have systems to be in compliance. For fundraising events, what steps are you taking to minimize facility fees?  For merchandise or publication sales, what are you doing to minimize any fees or taxes?  Did we file our annual report with the secretary of state office?  Are we providing written acknowledgement for gifts over $250 and provide the fair value of any goods or services in exchange for a $75 or larger donation?

More Information – At the end of the article will go into more detail about how to stay in compliance and avoid taxes and penalties.  What are you doing to make sure you are paying no penalties and taxes and staying in compliance.   If this nonprofit tax issues aren’t dealt with proactively, they can take significant effort to resolve with significant resources allocated to compliance.  Additionally, these taxes and penalties increase your cost and ability to serve others.

The Internal Revenue Service Form 990-Keep in mind the different filing thresholds which include Form 990-N Electronic Notice (e-Postcard) for organizations with gross receipts of $50,000 or less.  Form 990-EZ threshold is gross receipts of $200,000 or less and Total Assets at the end of the tax year less than $500,000.  Organizations with $200,000 or more in revenue or $500,000 of assets will file the full Form 990.  Form 8868 (extension) may be filed electronically or in paper form.  The IRS Annual Report noted the following common issues:  private benefit and inurement, no filers, political activities, employment tax issues, and organization’s not operating as required by exempt status.

The health care tax credit is a great contribution to smaller nonprofit to offset increasing health insurance costs.  It maybe difficult to qualify if the employer contributions to health insurance are not enough or the average salary of your employees exceeds $50,000.

For property, utility, innkeeper, and sales tax exemptions, you need to make sure that you meet the proper filing requirements.     A nonprofit organization must register for a sales tax exemption by filing Form NP-20A, available online at http://www.in.gov/dor/3506.htm  Form ST-105 is used by nonprofits for sales tax exemptions including the 10 digit state tax ID.   The Sales Tax Information Bulletin #10 lists out the nonprofit sales tax exemption.  Form ST-200 is used for each account to exempt sales taxes from utilities.  GA-110L can be filed to claim a sales tax refund relating to utilities for the current and prior 3 years.  For property exemptions, you need to file Form 136 on the even years along with Form 103 and Form 104

For IN state unemployment, you are no longer exempt once you employ four or more individuals for a day for 20 weeks during the calendar year. There is no minimum dollar amount associated with this qualification.  You may opt to become a reimbursable employer, as opposed to an employer paying premiums.

Our firm provides tax preparation and consulting services so please contact us if we can help your organization.

Common Form 990 errors for Nonprofit Organizations

Many Forms 990 are prepared incorrectly or incompletely.

Because the Form 990 is a public document — nearly all are posted on GuideStar.com and many organizations post them on their websites — it is important that the Form 990 be prepared completely, correctly and consistently.

An incorrect Form 990 could reflect negatively on the organization when reviewed by possible donors, the community or even the media. More importantly, an incorrect Form 990 might be viewed as an incomplete filing by the IRS, subjecting the organization to late filing and other penalties even though a Form 990 was filed.

Here are some of the most common errors we have encountered.

Missing the deadline. The 990 is due on the 15th day of the 5th month after the organization’s year-end.  That means May 15th for calendar year organizations and November 15th for organizations with a June 30th year-end.  There is a 6-month extensions available but this has to be filed by the deadline.  Final deadline after all extensions is November 15th for calendar year-end organizations and May 15th for June 30th organizations.  Late filing fees can be as high as $50,000.  Failure to file for 3 consecutive years results in loss of exempt status.  If the organization has unrelated business income, it must file an extension for the 990 and a separate extension for the 990-T.

Filing an incomplete return.  The IRS can consider an incomplete return as never filed in which case late filing penalties up to $50,000 can apply.  Missing schedules is one of the most common reasons for incomplete returns.  Listed below are some of the most common schedules.  Keep in mind that some schedules only apply to organizations filing a 990 and some schedules apply to both the 990 and the 990-EZ.

  • Schedule A – Required of all public charities
  • Schedule B – Required of organizations that received donations of $5,000 or more from a donor
  • Schedule C – Lobbying activities are reported in this schedule
  • Schedule D – Most common reasons for filing this schedule are fixed assets, endowment funds, escrow funds, and/or audited financial statements.  Endowment funds includes those administered by someone else such as a community foundation.  An example of escrow funds is security deposits from building tenants.
  • Schedule G – Required if the organization had over $15,000 in expenses for professional fundraisers (not employees) or if it had over $15,000 in gross income from either fundraising events or gaming activities.
  • Schedule I – Required if the organization gave more than $5,000 in grants and contributions to other organizations or individuals in the United States.  Schedule F is completed if the grants were given to organizations or individuals located outside of the United States.
  • Schedule M – Required if the organization received over $25,000 in donated non-cash contributions.  Common mistake is not realizing that donated stock is considered a non-cash contribution.
  • Schedule R – Required if the organization was related to any other organizations or if it owns 100% of a disregarded entity.

Voting members of the governing body.

Line 3 of Part I asks for the number of voting members of the governing body.  This should be the number as of the end of the organization’s year end.  For a calendar year organization, this is the number of voting board members at December 31.  This number should never be more than the number of board members listed in Part VII.  Part VII should include the name of any individual that served on the organization’s board at any time during the fiscal year.  There may be individuals listed in Part VII that were not board members as of the last day of the organization’s year but served earlier in the year.

New significant programs.

Line 2 of Part III asks if the organization took on any significant program services during the year which were not listed on the prior form.  Nonprofits need to check this box yes and provide a description for any new programs that began during the year.  When an organization applies for tax-exempt status, it must describe its program services in its application for exemption.  It is important the nonprofit notify the IRS of any new programs so that the IRS can ensure that these new programs coincide with the organization’s exempt purpose.  The IRS may be able to challenge any new programs as unrelated which could result in unrelated business income taxes.

Policies.

Part VI asks if the organization has various policies in place.  Nonprofits will not lose their exempt status simply because they do not have these policies in place; however, it is best practices to have them.  Two of the questions address provisions of the 2002 Sarbanes-Oxley Act.  Although most provisions of the Sarbanes-Oxley Act apply to public companies, two provisions apply to nonprofit organizations – a whistle-blower policy and document retention and destruction policy.  In addition, if a nonprofit is required to file Schedule L, Transactions with Interested Persons which reports financial transactions or arrangements between the organization and disqualified persons, there should be a conflict of interest policy in place.

In-kind.

Donated services and facilities should not be recorded in Part VIII as revenue or in Part IX as expenses.  Items such as donated advertising or the use of materials, equipment or facilities are recorded in the organization’s financial statements prepared using generally accepted accounting principles but they are excluded from Form 990.

FORM 990, PAGE 1, PART I

Page 1 of Form 990 includes summary information relating to the organization and creates a first impression for the reader.

Organizations should consider a concise description that fits in the allotted space on the first page, so the reader can gain a clear idea of the organization’s most significant activity without searching through the voluminous disclosures in Schedule O.

Part I of Page 1 also includes summary information regarding the number of voting board members, employees and volunteers. Unpaid board members are considered volunteers for purposes of reporting the number of volunteers on Page 1.

Organizations with unpaid board members often fail to count them as volunteers on Form 990.

FORM 990, PART VI

Total members of the governing body and total independent members of the governing body are often counted incorrectly on Form 990.

The IRS instructions ask for the total number of voting members of the governing body, which may not be the same number listed in Part VII of Form 990.

In addition, the concept of independent members of the governing body is defined differently for purposes of Form 990 completion. Often, members of the governing body who are compensated for services performed outside their service as a board member, as well as members of the governing body who have interested person transactions reported on Schedule L, are counted as independent board members in error.

Business and family relationships often are not disclosed as required in question 2. Exempt organizations that have large numbers of board members — more than 20 — or are located in rural areas are likely to have a business or family relationship with fellow board members. This question is often answered “no” in error.

FORM 990 PARTS VIII & IX

While reporting revenue and expenses of an exempt organization should be routine, many times items of revenue or expense are not properly reported. Common reporting issues include:

  • Reporting fees paid for services rendered (contract services) incorrectly.
  • Contributions and revenue reported in the incorrect column.
  • Security sales, fundraising and/or gaming events not reported properly.
  • Incorrect or lacking allocations of a reasonable amount of expense to either management G&A or fundraising expense.

SCHEDULE A PUBLIC CHARITY STATUS

Schedule A reports the public charity status of an organization. Many times, organizations select the wrong public charity type in Part I. For organizations classified as publicly supported, one of the public support tests included in Part I or Part II must be completed.

These computations often are completed inaccurately with incorrect amounts reported throughout. A common error is the omission or incorrect computation of excluded support on Line 5 of Part II or Line 7 of Part III.

SCHEDULE L TRANSACTIONS WITH INTERESTED PERSONS

Schedule L reports a variety of transactions with interested persons. Many organizations define interested persons too narrowly and only inquire as to possible transactions with board members.

Interested persons are defined differently depending on the type of transaction reported on Schedule L, and inquiries regarding these transactions should include not only officers, directors and trustees but also key employees, highest-paid employees and, in some cases, certain donors.

Organizations should take care to inquire about interested-person transactions regarding all interested persons.

Once a transaction with an interested person is identified, the organization reports certain information in Schedule L. Business transactions tend to be the most often reported transaction on Schedule L. Part IV requests the name of the interested person (and not the ODTKE), the relationship and amount of the transaction. In many cases, the ODTKE of the organization is reported in error as the interested person.

SCHEDULE O MISCELLANEOUS DISCLOSURES

Schedule O is used to provide required disclosures based on the answers to certain questions contained in the core form of Form 990. The disclosures range from expanded program service descriptions and internal Form 990 review processes to availability of certain documents for public access and compensation-setting processes.

Often the disclosures are incomplete, not updated for current reporting information or so lengthy the purpose of the disclosure is lost to the reader.

Care should be taken to read each disclosure to ensure it answers the question or describes the issue completely, correctly and concisely.

Please contact us to review your current Form 990 for any errors or let us prepare your Form 990 and we will make sure you comply with the IRS requirements.  Also, we work with our clients on a daily basis so we typically know the organization very well which also contributes to a better prepared return with little effort from our busy clients.

 

 

Common Financial Statement Errors for Not-for-Profit Entities

The following series is a listing of some of the financial statement errors found in Not-for-Profit organizations.   I have broken it down by the different financial reports.

The Statement of Financial Position which is commonly referred to as a Balance Sheet may have the following financial statement errors:

  • Display of current/noncurrent assets without displaying current/noncurrent liabilities when a classified statement is used.
  • Improperly including items in cash and cash equivalents, such as cash held or other assets that are restricted or not available for current use.
  • Failure to report cash, contributions receivable, and other assets that are restricted for a long-term purpose separately from unrestricted cash and cash equivalents, contributions receivable or other assets.
  • Recording deferred revenue for amounts received under a “grant” instead of recording temporarily restricted revenue in circumstances where the “grant” is, in substance, a temporarily restricted contribution and not a true cost-reimbursement arrangement.
  • Improper reporting of beneficial interests in assets or net assets held by others, such as in the instance of an entity transferring assets to a community foundation and naming itself beneficiary.
  • Failure to distinguish between operating leases and capital leases and apply the proper accounting under the circumstances. A capital lease is recorded as both an asset and a liability on the statement of financial position. An operating lease is not reported on the statement of financial position and is expensed as incurred.
  • Missing one or more of the required totals: total assets, total liabilities, total net assets, permanently restricted net assets, temporarily restricted net assets, and unrestricted net assets.

The Statement of Activities which is commonly referred to as an income statement or statement of revenues and expenses may have the following financial statement errors:

  • Improperly releasing temporarily restricted net assets that are subject to both a time and purpose restriction when one, but not the other, restriction is met.
  • Reporting revenues from exchange transactions as increases in restricted net assets. Only those revenues related to contributions with donor-imposed restrictions can result in restricted net assets.
  • Reporting amounts receivable under a cost-reimbursement contract/grant as temporarily restricted (may be legally limited as to use, but it is an unrestricted activity for which unrestricted costs have been incurred).
  • Recording amounts as a receivable under cost-reimbursement contract/grant for which costs have not been incurred.
  • Failing to properly classify revenue transactions (or portions thereof) as contribution or exchange transactions.
    Improperly including expenses in temporarily or permanently restricted net assets. Expenses should decrease unrestricted net assets.
  • Erroneously reporting just one program service function when the NFP has more than one major class of program services. For example, an NFP may have programs for health or family services, research, disaster relief, and public education, among others.
  • Failure to recognize contributions of services that meet the recognition criteria or recognizing
    contributed services that do not meet the criteria as discussed in paragraphs 16-17 of FASB ASC 958- 605-25.
  • Not reporting contribution revenue for gifts-in-kind (free or below-market rent, services provided by another organization, donated supplies, donated media, and so on.)
  • Not reporting costs of soliciting contributions, including costs of soliciting contributed services that do not meet the recognition criteria, as fundraising costs.

The Statement of Cash Flows may have the following financial statement errors:

  • Failing to display donor restricted capital-type contributions (permanently restricted gifts, gifts restricted for acquisition of property) as a financing activity.
  • Failing to display information about noncash gifts for endowment or property, plant and equipment purposes.
  • Failing to disclose indebtedness incurred for the acquisition of assets as a noncash activity.
  • Netting amounts for purchases and sales of property, plant and equipment.
  • Improperly reporting unrestricted contributions that were subsequently designated by the governing board for long-term purposes as a financing activity rather than an operating activity.
  • Failure to report as investing activities the cash flows from purchases, sales, and insurance recoveries of unrecognized, noncapitalized collection items.

The Statement of Functional Expenses may have the following financial statement errors:

  • Failing to include certain expenses in the statement (for example, expenses netted against revenues or non-operating expenses).
  • Failing to include the statement when one is required (voluntary health and welfare entities).
  • Management and general expenses are inappropriately or completely reallocated to other functional categories. For example, costs associated with soliciting funds other than contributions, including applications for and administering certain grants and contracts, are allocated to program services or fundraising activities.
  • Within the listing of natural expenses in a Statement of Functional Expenses, including a function or program line item. For example, within the listing of natural expenses listing the line item “grant expenses” which might have already been allocated such items as payroll, occupancy and supplies.

The Notes to the Financial Statements may have the financial statement errors:

  • Failing to include the required disclosure for summarized financial information.
  • Failing to disclose an adequate description of the organization’s activities, including each major class of
  • Failing to disclose the capitalization policy for property, plant and equipment.
  • Failing to disclose discount rates used in present value measurements, such as in measuring unconditional promises to give or split-interest agreements.
  • Failing to disclose information about the nature of temporary or permanent restrictions on net assets.
  • Failing to disclose information about the programs or activities for which contributed services were used.
  • Failing to present reclassifications which are in effect corrections of errors as restatements. However when reclassifications are not corrections or errors, failing to describe the nature of reclassifications made to prior-year amounts to conform to current year presentation when such reclassifications are significant, even if such reclassifications had no effect on the prior year’s change in net assets.
  • Failing to disclose total fundraising costs. When a statement of functional expenses is presented and certain fundraising costs have been netted against revenue, such netted costs need to be included in total fundraising costs.
  • Failing to disclose total program expenses if the components of total program expenses are not evident from the details provided on the face of the statement of activities (for example, if cost of sales is not identified as either program or supporting services).
  • Failure to disclose material related party transactions as set forth in FASB ASC 850-10. Related parties include, but are not limited to, the following: officers, board members, founders, substantial contributors, and their immediate family members; members of any related party’s immediate family; parties providing concentrations in revenues and receivables; supporting organizations; financially interrelated entities; or other entities whose officers, governing board members, owners, or employees are members of the NFP’s governing board or senior management, if those individuals have significant influence to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.

We hope you find this list helpful as your review and evaluate your current financial statements.   The notes to the financial statements are typically only included in the audited financial statements which means the organization is typically unaware of these disclosures.  We work with our clients on a daily basis to review and update the financial statements on a regular basis so let us know if you would like us to review and update your financial reports.