March 2007 NEWSLETTER: Financial Literacy for Not-for-Profits
"Financial Literacy for Not-for-Profits"
This newsletter is a free service to the North American not-for-profit community from William Harper Associates. Its focus is on helping organizations that do good, do better ... by helping Not-for-Profit Boards and managers improve their understanding of financial management and reporting concepts, and implementing practical, effective financial controls and processes.
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March 2007: Financial Literacy for Not-for-Profits
This month's Financial Literacy Newsletter answers the following questions:
1. Should we change our budget as our plans change?
2. What does the auditor's report really mean? and
3. Term of the Month - What is GAAP?
Should we revise our budget as our plans change?
Recall that your budget is simply the financial expression of your business plan. It reports on the dollar/financial aspect of your plans. And, as we all know, plans change. So, should the budget be changed along with the plan?
The short answer to this question (like so many …) is "yes", and "no". So, let's look at some of the reasons for revising your budget, and some of the reasons for NOT revising it, and try to come up with rules of thumb for what to do.
TO CHANGE …
For many people (and this includes many accountants), actually producing one budget per year is quite an accomplishment in itself … the idea of revising it, producing another budget for the same period, is really quite daunting. So, why would we?
1. Legislation, regulations, or funders require it. If it's a requirement, by law or funder condition, that's usually the end of the argument. But, remember that budgets typically serve multiple purposes for your not-for-profit. If a revised budget is needed for one purpose (e.g. to support a funding arrangement), that doesn't necessarily mean you have to use it for every purpose (e.g. managing your operations). You do have to keep straight which document is for which purpose, of course!
2. It keeps the Board up to date. Major changes in circumstances (e.g. loss of a major funder and the resultant termination of a program) can have a pervasive effect on an organization, and occasionally it's difficult to see all the effects of a change. A new budget may be needed to reflect the new reality and understand what the new plans mean to the organization. Less dramatic changes are often better presented as variances from the existing budget, however, so that the Board and management can still maintain their focus on where they want to head.
3. It's the most realistic view of where we are going. There is another concept that needs to be introduced here, and that is the concept of a forecast. Just like a weather forecast, a financial forecast is simply our best prediction of what is going to happen. And, that may well be different from what we planned to have happen! In more sophisticated environments, separate forecasts are prepared, particularly as the end of the year (and next year's budgeting) approaches. This provides valuable information for imminent planning activities, that a budget is just not designed to provide. If you feel the need to update budgets with actual and anticipated information, you are probably best advised to do this, but label it for what it is: a forecast.
OR, NOT TO CHANGE …
1. Well, it IS a lot of work! You bet! Make sure the value added from this exercise exceeds the effort put into it.
2. It's confusing to the Board and others looking at various reports. Yes, it can be, especially if you revise it more than once during the year. The key is to clearly label every document you prepare (a good idea anyway …), and double check that everyone is (literally) on the same page.
3. It hides the very changes that we need to focus on. If we revise a budget to take into account everything that varies from one budget presentation to the next, it can get very difficult to keep in mind just what those variances were, why they occurred, and what we should be doing about it.
4. It undermines accountability and performance measures based on the original budget. Holding people accountable for accomplishing what they set out to do is an important part of achieving your mission, and moving the yardsticks every few months really can obscure the targets, objectives and remaining challenges to meeting them.
So, what's to be done? Our recommendations are as follows:
I) Don't revise a budget for a period unless there have been truly pervasive, dramatic changes that serve to render the existing budget (and plan) completely irrelevant.
II) If you need a specific-purpose budget that varies from the approved budget (either in presentation or content), then a) label it conspicuously with the special purpose that it is for; b) limit its distribution to the relevant recipients; and, c) prepare a reconciliation between the special-purpose and approved budgets so you can always zero in on why they differ.
III) Remembering that the budget is only the financial representation of the operating plan, be willing to prepare and present a forecast statement to show your best estimate of the results of upcoming operations, and label it clearly as such.
IV) If there are numerous differences between the budget and actual results, prepare a variance analysis that explains why things are different from the plan, and focusing on which variances are temporary/timing related, and which are permanent differences.
Having a practical planning, budgeting and reporting process in place makes these steps manageable (if not actually easy!). William Harper Associates has broad experience in helping not-for-profits implement cost-effective, practical processes - call us for help!
What does the auditor's report really mean?
When you look at your organization's annual financial statements, they sure do look different from what you've seen (or should have been seeing!) every month during the year. For one thing, right at the front, there's a page from the auditor that never seems to change from year to year (even though they invoice your NPO every year!). Sure, you read the words on the page, but you're probably still wondering just what that report really means.
Is it a guarantee of some sort? A clean bill of health for the organization? Or, is it more like an insurance policy (someone to sue if something goes wrong)? Well, it's none of these things, actually, so what IS it saying?
Even though it's no panacea, it does mean something, and it does say a number of useful things. For example, you can generally read into the auditor' report the following statements (unless the report actually says something to the contrary!):
- we (the auditors) are independent. That is, we don't have a financial or other interest in the organization (beyond our audit fee) that would influence what we say;
- we are financial experts. We are (almost always) Chartered Accountants, and have the education, training and experience to do this work, and we follow a code of ethics and other professional standards in doing it;
- we had access to all the organization's records and people in doing our work. This means that their work was not limited by not being able to see certain things or talk to certain staff members. They could inspect and question everything they needed to in their work;
- we conducted an audit of these financial statements. An audit is a series of tests and procedures to assess the financial statements; it's not preparing the statements (though auditors will often do that too); it's also not looking at every transaction that makes up the statements;
- we have formed a professional opinion about the financial statements. And, it's just an opinion, not a guarantee, and not a statement of fact;
- our opinion is that the financial statements
- present fairly - the statements give a fair indication about the organization's financial position and results of operations. So, if the statements show a huge loss and deficit, for example, that's a problem and the problem is reflected in the financial statements!
- in all material respects - the statements aren't to-the-penny-perfect; they are "materially" correct. That is, they give an overall reasonable picture, but a specific figure may or may not be precisely correct.
- the financial position and results of operations - the statements reflect these specific results, not any others.
- in accordance with GAAP (see definition below) - the statements have been prepared in accordance with a particular set of standards.
The auditor's report doesn't say anything about how efficient the organization is; about how effective its internal financial systems and controls are; about whether the organization is on budget, or acting in accordance with its plans and mission; or a host of other things. What it does do is tell the reader that they can rely on the financial statements to tell them what financial statements are meant to tell them.
Term of the Week - What is GAAP?
GAAP, or Generally Accepted Accounting Principles, is the framework used in preparing "general purpose financial statements". Let's look at each part of this phrase:
"Generally Accepted" - the framework is used by most preparers and readers of financial statements. In other words, it is the common language of accounting.
"Accounting" - accounting is the process and system by which transactions are recorded and presented. It describes the way that the monetary effect of transactions are recorded in the organization's accounting records and then summarized and presented in financial statements.
"Principles" - the framework describes the relatively high-level concepts and guidance for preparing and presenting financial statements, not specific, detailed rules. This is surprising to anyone who has looked at (or picked up!) a set of accounting text books or the CICA Handbook (which is the authoritative source for GAAP in Canada). Even though there are hundreds upon hundreds of pages, there is still considerable "room" in these principles for interpretation and variation in how to apply them.
GAAP, then, is the common language for preparing and presenting financial statements that, like the English language, still leaves a lot of room for variations in its use. Future Financial Literacy newsletters will explore this area further.
William Harper is a Chartered Accountant with many years experience in preparing, interpreting and auditing financial statements. William Harper Associates can help you demystify the financial reporting process and improve your communications to your stakeholders. Call us!