The following article is provided courtesy of Cathedral Consulting Group, LLC, a Milwaukee-based firm that helps small and mid-sized nonprofit organizations and private companies to grow their enterprises through the implementation of best practices. As growth requires vision for tomorrow and an awareness of today’s needs, Cathedral works alongside clients to identify their organizational needs and to implement both long-term and short-term beneficial strategies.
Perhaps no single operational practice is more impressive to a donor than having timely, accurate financial statements. It is a reflection of professionalism and accountability.
Successful individuals – that is, your donors – are usually skilled at reading financial statements and find them to be the most important measure of the health of an organization. In fact, most major donors care just as much about the state of your financials as they do about the impact you are making or the service you are providing.
This article addresses the basics of understanding nonprofit financial reporting.
The financial process begins with bookkeeping. When an organization is just getting started, its bookkeeping system is often simply an excel spreadsheet, a checkbook register, and an online bank statement. Typically not reviewed until tax season, these spreadsheets are then collected and sent to the accountant, who then returns them in basic statement form and files the 990.
Most organizations, however, keep their records in Quickbooks or a similar accounting software. For some, the software is not much more functional than a spreadsheet and a bank register. This is because they keep their books on a cash basis, instead of accrual as explained below.
Larger nonprofits may have a bookkeeper or a full finance department. While this is helpful, professional staff does not ensure timely, accurate financials.
A good board treasurer can be a great resource in this area. While the nonprofit may not be able to afford highly trained accountants, a board treasurer with an accounting background can be well utilized and will help set up and maintain your financials.
Since all board members have a legal fiduciary responsibility for the finances of the organization, it is important for the board to seek a treasurer that will be active in the organization and willing to provide sound advice on bookkeeping and financial reporting.
Cash versus Accrual Accounting Methods
The cash-basis accounting method is perhaps the most familiar to nonprofits, because of its ease and similarity to a checking account. When cash is received, income is recorded and when an expense is paid, an expense is recorded. The weakness in this method is in its simplicity – as a nonprofit organization grows, its financial statements will get more complex. Eventually, something will need to be accrued, whether it’s a pledge or note payable. Not adapting to the complexity can lead to incomplete and misleading financial statements – most specifically the lack of Accounts Payable and Accounts Receivable. The question of Accounts Receivable is especially important in a nonprofit, for whom pledges (donations promised but not yet paid) are essentially an asset that, in the cash accounting system, cannot be recognized.
Accrual-based accounting represents all accrued, or “recognized,” income and expenses, regardless of the status of actual receipt or payment. The easiest way to understand this is to see the various financials exchanges of your enterprise as a series of promises. This comes in the form of pledges on the revenue side, and in the form of invoices for services on the expense side. In an accrual-basis system, you post entries as the promises are made. This is of particular importance with the expense categories, as many bills need to be deferred for cash flow purposes. Full accrual accounting allows you to keep track of the liabilities within the structure of a financial report.
Because it is so hard to avoid the need to accrue pledges and invoices, many small to mid-sized nonprofits do their bookkeeping a hybrid part cash-basis, part accrual system. The result is a set of financial reports that are more complex and difficult to understand than anything produced by straight accrual accounting.
THE THREE BASIC FINANCIAL STATEMENTS:
1.) Income Statement/Statement of Activities
The Income Statement or Statement of Activities summarizes the activities of the organization over a period of time – monthly, annually or quarterly. It begins by showing total revenue – usually broken up by category or project. Organizations should use a reasonable level of detail in categorizing revenues and expenses. At minimal, revenues must be categorized as follows for the IRS each year:
1. Public support: Donations considered to come from the general public. This includes individuals, private foundations, businesses, government, and publicly supported granting agencies.
2. Exempt-purpose activities: Activities that directly advance the organization’s stated mission such as arts groups who sell tickets, schools that charge tuition, etc.
3. Other Revenue (and UBIT): This category includes the miscellaneous revenue received from unrelated business income (income that does not fall into any other category). UBIT represents revenue that is taxable because it is not related to the exempt activity of the organization.
While an accurate revenue report is important, the expense side of the Income Statement is scrutinized more carefully by donors. Categorized expenses are a unique aspect of nonprofit accounting. Donors, board members, and anyone else with an interest in the organization will typically judge an organization’s efficiency on the allocation of their expenses among the following three categories:
1. Program: Expenses that specifically and directly advance the mission of the organization (e.g., food provided at a homeless shelter);
2. Fundraising: The costs of raising donations (e.g., marketing efforts that request donations); and
3. Operations: Expenses that don’t clearly fit under either program or fundraising expenses (e.g., accounting fees).
Note that some expenses may be split up into different categories, such as salaries and rent. Make sure that all employees keep detailed track of their time spent on program and record it as such so that not all salaries are counted as operations. Taking a few minutes a day to record where time was spent will ease the categorization process, and provide the level of detail and documentation donors, accountants, and the IRS desire.
2.) Balance Sheet/Statement of Financial Position
The Balance Sheet or Statement of Financial Position is a snapshot of the organization’s financial condition at a given time. It describes what an organization has (assets), what it owes (liabilities), and the difference between the two (fund balance).
Assets are listed in order of liquidity. Current assets come first, and include cash and cash equivalents that can be converted into cash within twelve months. This would include cash in the checking account, inventory and accounts receivable, for example. Fixed assets come next, and include items like equipment, land & buildings.
Liabilities are listed by commitments due with those due soonest listed first. Current liabilities include those that need to be repaid within twelve months such as accounts payable, short-term loans, and grants payable. Long-term liabilities include mortgages, loans, or restricted assets.
Fund Balance is the nonprofit substitution for Equity. For nonprofit organizations, the fund balance is your leftover cash (profit). The difference is that profit is not taken out of the organization and distributed to the owners, because there are no owners in a nonprofit organization. The money stays in the organization, and is generally labeled as Retained Earnings or Net Fun Balance. Net Fund Balance is often broken down into three categories: Unrestricted, Temporarily Restricted and Permanently restricted.
3.) Statement of Cash Flows
When financial statements are kept in full accrual, they should be accompanied by a Cash Flow Statement. A Cash Flow statement begins with the Net income or loss for the period, then adds or deducts operating, financing and investing activities. The cash flow statement adjusts your accrual-based Income Statement and Balance Sheet back to a cash-based statement, providing you with valuable information on where cash was spent over a given period of time.
Once you have become proficient at producing the three basic financial statements each month (Statement of Income, Statement of Financial Position, Statement of Cash Flows) it is imperative that the statements are reviewed and discussed. The Executive Director, the Board Chair and Board Treasurer are the key leadership responsible for ensuring the fiduciary integrity of the organization. This is best done through a monthly discussion and analysis of financial statements.
The benefits of this monthly review will help your organization to stay on budget, identify opportunities and target inefficiencies. Get involved with the preparation, production and analysis of the financial statements of your organization, and learn them inside and out. An Executive Director who understands and takes responsibility for the financial statements is a blessing to the organization. The benefits will be reflected within all areas of your organization – program, operations and fundraising.
For specific guidance available to help leaders in nonprofit organizations manage from their financial statements, stay on track with fundraising, and keep their organization strong and growing, please visit http://www.cathedralconsulting.com/nonprofit-services
Peter Giersch is a Managing Director and Virginia Zignego is a Senior Associate at Cathedral Consulting Group, LLC. For more information, please visit us online at www.cathedralconsulting.com