Kenneth Cerini
June 8, 2020
Governance

Understanding Financial Reporting for a Board Member

Most Board members are not expected to be nonprofit financial experts, but they should have a basic understanding of the information in the financial statements that is presented to them. Having a basic understanding will help them better govern a nonprofit and allow them to better understand an organization’s financial position, cash flows, and results of operations. This is important, as it is the role of the Board to ensure that the organization’s funds are used prudently and that the organization is fiscally sound enough to fulfill its mission. By having better fiscal insight, Board members are better able to read and interpret financial reporting, and ask the necessary questions of the organization’s internal fiscal staff as well as the external auditors.

To have a basic understanding of the financial statements, a Board member should be familiar with the common components of financial statements:

Statement of financial position (balance sheet)
Statement of activities (profit and loss)
Statement of functional expenses (required for some health and welfare organizations)
Statement of cash flows
Footnotes

The Independent Auditors’ Report is shown before the financial statements. This report provides the period under audit, the responsibility of the auditor and management for the audit of the financial statements, and the auditors’ opinion.

An unmodified opinion is what agencies are striving for, but what is an unmodified opinion?

The purpose of an audit is to opine on the information presented in the financial statements. Once the audit of the financial statements is complete, the auditor will give an opinion as to whether the information presented in the financial statements is in accordance with accounting principles generally accepted in the United States of America, better known as “GAAP.” An unmodified opinion is a “clean” opinion in which the financial statements are presented in accordance with GAAP and the information presented in the financial statements is not materially misstated.

What are GAAP-based financial statements?

To be in accordance with GAAP, typical not- for-profit financial statements must include the statements and footnotes noted above.
The amounts presented on the financial statements are recorded on the accrual basis of accounting (revenue recorded when earned and expenses are recorded when incurred), as opposed to the cash basis (revenue recorded when received and expenses recorded when paid). Many smaller organizations maintain their books throughout the year on the cash basis and convert to the accrual basis for their annual audit..

A Board member should be familiar with the information that is presented in the financial statements.

The statement of financial position has three categories:

Assets – Most common assets of an organization include cash, investments, accounts receivable, prepaid expenses, and fixed assets. The assets are presented in order of liquidity (how fast the asset can be converted into cash). Current assets are those assets that are generally expected to be available for use within a one year cycle (such as cash, receivables, and prepaid expenses) and long-term assets are those that cannot be used in the near term (such as property and equipment and restricted cash).
Liabilities – Represent the current (generally due within one year from the statement of financial position date, such as accounts payable, and current debt obligations) and future (such as long- term debt and contingencies) obligations that the organization is expecting to meet through the use of its assets. In essence these are liens, or anticipated liens, against an organization’s assets.
Net Assets – The difference between total assets and total liabilities. It represents the portion of the assets that the organization owns (not allocated for a liability).

Net assets fall into two categories: without restriction (also includes net assets that are designated by the Board for specific uses) and with restriction (includes temporarily restricted and permanently restricted).

Restrictions on net assets are created by the donor. Temporarily restricted net assets can be restricted as to time and/or purpose and will be considered “released from restriction” once the restriction(s) has been met. Permanently restricted net assets generally are held in perpetuity (Board may have some control over this depending on the wording in the donor’s gift) and typically the earnings from the principal amount can be used for general operations or temporarily restricted for a specific purpose.
Net assets will increase or decrease based upon the results of its operations as reflected on its statement of activities.

The statement of activities includes:

Support (contributions, grants, and net fundraising income) and revenue (fees for services and program service revenue).
Net assets released from restrictions, which represents the use of an organization’s restricted net assets. The amount is reflected as an increase to net assets without restrictions and a decrease in net assets with restrictions under support and revenue. The concept of net assets released from restriction is that once a purpose or time restriction is met, usually through the use of the funds, these resources are no longer restricted and should be included in net assets without restrictions.
Expenses, subtotalled by program, general and administration, and fundraising. These amounts will agree to the totals reported on the statement of functional expenses.
Some people think that a nonprofit cannot make a profit. A nonprofit is a business, just like any other business, and it should strive to create appropriate “profitability” and establish adequate reserves to develop strong fiscal viability.

The statement of functional expenses reports the natural classification of the expenses (e.g. payroll, fringes, rent, etc.) that were spent on the organization’s programs, general and administration, and fundraising activities. Many donors focus on this schedule, because they are interested to see what percentage of an organization’s expenditures are spent by the organization in a program service capacity (program service percentage). This is particularly important for organizations receiving significant NY State originated or pass-through funds as Executive Order 38 limits the amount of general and administrative costs that can be funded by the State to no more than 15%.

The statement of cash flows reconciles the beginning of the year cash balance to the end of the year cash balance. The cash activity is separated by three types of activities: operating, investing, and financing. The statement of cash flows combines the statement of financial position and the statement of activities to help you to better understand the sources and uses of cash within an organization.

Footnote Disclosures:

The footnotes disclose information about the organization, its programs, significant accounting policies, detailed information on significant accounts, and commitments and contingencies. The footnotes are an important aspect of the financial statements as they add a better understanding as to the detail behind the numbers on the statements.

In addition to the information presented on the financial statements, Board members should be familiar with certain key benchmarks, trend analyses, and ratios that will help them to better understand the meaning and impact of many of the numbers on the financial statements. This information is often looked at by funders, banks, and other users of the financial statements to assess the organization’s fiscal health. If these ratios are not strong, it could impact an organization’s ability to obtain funding. The most common trend analyses and ratios include the following:

Liquidity – shows the organization’s ability meet its financial needs in the next fiscal year:

Is measured by working capital (current assets less current liabilities) and current ratio (current assets divided by current liabilities). You want to have at least positive working capital.
It measures the ability of an organization to meet its current obligations with the current assets it has available. Banks like to see a current ratio of approximately 1.5 to 1.

Days in Cash:

The number of days the organization can operate with its cash balance (as of the statement of financial position date) without bringing in any additional resources.
Depending on how an organization is funded, an appropriate days in cash figure could range from 45 days (organization with a consistent monthly funding stream) to as much as a year (an organization with one big annual fundraising event or appeal). Understanding days in cash can provide a quick insight into whether or not an organization is having, or is going to have, cash flow issues.

Days in Accounts Receivable:

The number of days it takes an organization to collect on its receivables. Depending on the type of funding an organization receives, a Board member would want to see the number ofdaystobenomorethan45andtoseethe days decrease over time, or at least remain consistent. Days in accounts receivable is typically more relevant for organizations that rely on regular revenue streams (such as fees for service or regular government vouchers) than those that are more fundraising-driven. If an organization’s days in receivables are greater than its days in cash, the organization may have cash flow issues if a line of credit is not in place.

Trend in Net Assets:

A Board member would want to see the organization’s net assets increase over time, or at least remain fairly consistent. A steady or continuous increase in net assets means the organization is operating efficiently (i.e. programs are appropriately run and expenses are controlled). Growth in net assets typically means better cash flows and better liquidity.

Expendable Net Assets:

It’s important when looking at an organization’s net assets that you also understand if those net assets are available for use by the organization. Too often, organizations have significant levels of net assets, but they are still having difficulty meeting their day-to-day obligations. Expendable net assets takes an organization’s net assets, removes long-term assets (e.g. property and equipment, security deposits, restricted resources), and adds back debt related to the removed assets. This will really hone in on the level of expendable or usable net assets the organization really has. After all, you can’t pay your staff with bricks from your building.

Program Trend Analysis:

A significant measurement of an organization operating effectiveness is based on the success of its programs. It’s important to see if a program is profitable, break-even (i.e. deficit-funded, where the organization is reimbursed for the expenses already paid to run the program), or operating at a loss.

Program trend analysis will be unique from agency to agency, depending on the organizations’ operations and funding sources. Some examples include:

Total program revenues less expenses (this could be in total or by funding source).
Sources of revenue (what percentage of an organization’s revenue is coming from each revenue stream) help to identify concentrations in revenue.
Revenue and/or expense per unit of service.
Trends in units of service (important for fee-based revenue streams).

Fundraising Event Profitability:

The profitability of an organization’s fundraising event(s) is measured by the total revenue raised from the event less the total expenses associated with the event. This measurement can assist in determining if an event is worth continuing or should be modified to potentially generate more income. A good rule of thumb is you would like your events to generate at least three times the related expenses.

Program Service Percentage:

This represents the percentage of every dollar that is spent on running the organization’s programs. The higher the percentage, the more dollars targeted to program activities. The nature, size, and funding sources of your organization will all impact your program service percentage. Larger organizations, government funded organizations, and health and welfare organizations all tend to have higher program service percentages.

By having a better understanding of your organization’s finances, by being more engaged in financial discussions and by understanding the impact of the financial information, you can identify concerns or opportunities early on. This will put you in a better position to help steer the organization forward and ensure that it is able to maximize its organizational impact.

Download the full guide for Nonprofit Board Members