Staying Competitive with Accurate, Timely Financials

The rising competition for donated funds has forced charities to increase the level of professionalism they demonstrate to foundations. Perhaps no single operational practice is more impressive to a donor than to have timely, accurate financial statements.

Why do financial statements matter so much? Think about by what means your donors made so much money that they can afford to give large chunks of it away. In the vast majority of cases, it was a matter of financial acumen and careful management of resources. Financially successful people are hard-wired for numbers. They love reading financial statements. 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.

Competition

74% of nonprofits make under $499,999 and make up a mere 2.3% of expenses. The important take away is that small to mid-sized nonprofits are in competition against the big-budget nonprofits for donation dollars. And the larger nonprofits have a much greater need and more resources to go after them. The competition is fierce.

Like the local hardware store competing against a neighboring Lowe’s or Home Depot, your small to mid-sized nonprofit is competing for donations, and you are up against the heavily funded, highly resourced, financially solid, well-marketed nonprofit organizations. Don’t feel threatened by this, because there is plenty of room to squeeze your organization into sight of many donors. But, keep your competition in mind when approaching them. Donors look at your programs, but more importantly they look at your organization as a whole. They are well aware that each element of a nonprofit organization – program, operations, and fundraising – is dependent upon financial feasibility. In this resource, we discuss how to obtain financial feasibility, what the numbers on your financial statements mean, and the significance of solid, timely, accurate financial statements.

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 rushed through at the end of each month. Typically not touched until tax season, these spreadsheets are then collected and sent to the accountant, who then returns them in basic statement form. This is bookkeeping at its simplest. Some of you wish that bookkeeping could be this easy forever.

There are several key reasons why bookkeeping must advance to proper financial reporting. The most important are accountability to the donors and IRS, as well as clear decision-making tools for Executive Directors. If ever there were a need for rigor and discipline, it is in your financial reporting. Donors not only appreciate thorough financial reporting, more than ever before they are starting to require it. As the IRS is the organization that ensures your tax-exempt status, it is important that documentation abides by their stated guidelines. But pleasing donors and keeping the IRS at bay is not all that proper financial documentation will do. Through proper creation and analysis of financial statements, nonprofit organizations can become more effective with their services, programs, and operations.

For small nonprofits, a good board treasurer can be a great resource. A board treasurer with an accounting background can be well-utilized and will help set up your nonprofit for financial success. Since board treasurers have a legal fiduciary responsibility for the finances of the organization and ensure financial policies and procedures, it would be wise to seek a board 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. 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. Let’s say your organization year-end is 12/31. You spent all year working to get a large foundation grant in and finally in November you get “the letter” – your organization has been approved for a $500,000 grant, and funds will be dispersed on 1/15 of next year! If you are on strictly cash-basis, then you can’t include this very large grant in your financials at all. In an accrual-basis system, you post entries when you earn the money and when you owe it.

Many small to mid-sized nonprofits do their bookkeeping a little unconventionally in this part cash-basis, part accrual-basis system. Small organizations often underestimate or don’t quite understand the importance of moving to an accrual-based system as the organization grows. As a compromise, many organizations use cash basis to record entries in journals, but get help to convert to an accrual- basis to generate financial statements at year end.^[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. Organizations whose primary revenues are from exempt- purpose activities are liable for a specific set of IRS regulations and requirements.
3. Other Revenue (and UBIT): This category includes the miscellaneous revenue received from special fundraising events, membership fees, interest and investment income, and other unrelated business income (income that does not fall into any other category). Keep in mind that unrelated business income is taxed at normal income tax rates using the assessment called unrelated business income tax (UBIT).

While an accurate revenue report is important, the expense side of the Income Statement is scrutinized more carefully by donors. Listing expenses is easy – the tricky part is properly categorizing each expense. Categorized expenses are a unique aspect of nonprofit accounting. According to muridae.com, states have historically tried to establish laws specifying the required allocation that nonprofit organizations must make, e.g. a maximum fundraising expense percentage). These have been struck down by the U.S. Supreme Court as unacceptable restrictions of the organizations' rights. Even though the government cannot control the percentage of spending in each category, they almost don’t have to.

Donors, board members, and anyone with an interest in the organization will typically judge an organization’s efficiency on the allocation of their expenses among these three categories:

1. Program: Expenses that specifically and directly advance the mission of the organization. Ex: Food provided at a homeless shelter
2. Fundraising: The costs of raising donations Ex: marketing efforts that request donations. This could also be a joint cost.
3. Operations: Expenses that don’t clearly fit under either program or fundraising expenses. Ex: Accounting Fees

Joint costs are expenses that are split up into different categories, such as salaries and rent. We recommend that all employees keep detailed track of their time spent on different activities.  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.

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 and owes, divided into Assets, Liabilities and Fund Balance.

Assets

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. Cash in the checking account, Inventory and Accounts Receivable, for example. Fixed assets come next, and include items like equipment, land & buildings. Net assets are often broken down into three categories: Unrestricted, Temporarily Restricted and Permanently restricted assets.

Liabilities

Liabilities are listed by commitments due. 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

Fund Balance is the nonprofit substitution for Equity, although some nonprofits still use the term “Equity.” In a for-profit business, this is the section where profits are divided up between retained earnings and shareholders. 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 nobody owns a nonprofit organization. The money stays in the organization, and is generally labeled as Retained Earnings.

By construction, the Fund Balance will be the offset of difference between assets and liabilities. Therefore, a proper Balance sheet should show: Total Liabilities + Fund Balance = Total Assets

Cash Flow Statement

The cash flow shows exactly what is evident by its name – where the actual cash goes, over a given period of time. By subtracting the beginning balance sheet with the ending balance sheet of a specific period, the difference indicates the changes that will be reflected in the cash flow statement. A Cash Flow statement begins with the Net Income or Loss, then adds or deducts non-cash operating activities. For example, the balance sheet shows depreciation expense, yet no cash is actually utilized to pay this expense, so the adjustment is made in the Cash Flow statement. Adjustments are also made to reflect changes in Inventory, Accounts Receivable and Accounts Payable. 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 exactly, over a given period of time.

The Cash Flow statement is divided into three sections:

1. Cash from Operating Activities. For most nonprofit organizations, this section of the cash flow statement is the heaviest. Any operating revenues received or expenses paid for operating reasons are included here. It is important here to separate the restricted grants from unrestricted funds.
2. Cash from Investing Activities includes purchases or sales of assets, such as equipment, and investments. Also included in this section is the investment you made with endowment gifts.
3. Cash from Financing Activities includes cash paid or received from creditors of any sort, and often donations with long-term donor restrictions, such as a donation towards your endowment fund.

If your numbers look weak and poorly accounted for, donors will know. At the Giersch Group, we recommend a monthly 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 knows their financial statements will not go unnoticed by donors and members of your board. The benefits will be reflected within all realms of your organization – program, operations, fundraising and oversight.

NOTE: The Giersch Group offers General Executive Counsel to help leaders in nonprofit organizations manage from their financial statements, stay on track and keep their organization strong and growing. This service involves a monthly meeting that addresses financials, operations, and fundraising concerns an affordable price.

[1] McNamara, Carter. "Basic Guide to Nonprofit Financial Management." Free Management Library (SM). Authenticty Consulting. Web. 20 May 2010. http://www.managementhelp.org/finance/np_fnce/np_fnce.html 

For more information, please visit the Giersch Group at www.gierschgroup.com or contact us at prosper@gierschgroup.com.