April 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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April 2007: Financial Literacy for Not-for-Profits
This month's Financial Literacy Newsletter answers the following questions:
1. What should I look for in our monthly financial statements?
2. What is a Balance Sheet? and
3. Term of the Month - What is an accrual?
What should I look for in our monthly financial statements?
If you are on the Board of a not-for-profit, you should be receiving interim (generally monthly) financial statements. But, if you're like many volunteers, month after month, it all starts to look the same, and it's not really clear what you should be focusing on. Of course, the answer will vary from one organization to the next. But, let's talk about a few common areas to look at.
First off, let's take a quick tour through the information that you are likely looking at (or should be!). For sure, the main thing you will have is an income statement, sometimes called a profit and loss ("P&L") statement, or statement of revenues and expenses. You may also have a balance sheet, statement of cash flow, and more detailed schedules by program or activity. But, today we will focus on the main course, the income statement.
Down the left side
This statement shows what your organization has earned ("income", such as donations, member dues, interest income, etc.) and what expenses have been incurred ("expenses", such as salaries, rent, supplies, and many, many other things) over some period of time. The various types of income and expense are generally listed down the left side of the page, usually starting with income, followed by expense. They may be listed alphabetically, from largest to smallest, or in some other (or no!) order. So where should you focus?
To answer this question, we suggest that the first thing to do (before you even look at the statement), is to ask yourself, "What do I expect to see on this statement?" Did your organisation pay salaries and rent last month? Did you expect to receive certain types of funding? Did you have a major event or program running in the month? Consider what you expect to be happening in the organization, and then look for the financial impact of those things. Use the statement as a check against your expectations and knowledge about the organization's activities.
Many figures will stay more-or-less the same each month, as you would expect: salaries, for example. Seeing these figures stay the same confirms your expectations about operations. If you see salaries increase, however, this should be a trigger to ask: did we hire a new person? Did we increase salaries? On the other hand, if you know that you hired a new staff member, did the salary figure increase as you expected? Make sure that the numbers reflect your understanding, and use the numbers to improve your understanding of what is happening in the organization.
Other figures will naturally go up and down from period to period. These fluctuations may reflect seasonal trends, program activity levels, or some other factor - again, consider what you know about the organization and what you expect to see happen. If the numbers don't confirm your expectations, ask. You will either improve your understanding, or identify issues in the statement - both good things.
Across the top
The headings across the top will generally include actual results for the current month and the year-to-date, probably similar headings for the previous year (comparative information), and possibly budget information for some or all of these periods. There may also be calculated information such as variances (i.e. the difference between this year and last, or actual and budget columns) or percentage change.
Remember that year-to-date ("YTD") information runs from the beginning of your organization's fiscal year. This may be the calendar year, but it may be some other period as well. It's important to know this period, and reflect on what has happened within the organization since that time.
The budget columns should reflect budget information that has been reviewed and approved by the Board. Be careful, if your organization revises budget numbers, that you understand which set of numbers you are looking at. (Last month's newsletter discussed the issue of revising budgets.) It is sometimes useful to think of the budget as your target - if the budget figures get revised, now you've got a moving target!
Variances are often presented as "favourable" or "(unfavourable)" - remember that this reflects the accountant's view, or more properly, a financial view of these words. Anything "favourable" leaves more money with the organization; anything "unfavourable" leaves less money with the organization. Even though spending money on our mission is what we are all about - and therefore you might think it's favourable to spend more money on our mission - from a financial perspective, this term means something quite different. It all relates to the effect on our bottom line in this context.
Some problems to watch out for
Not all numbers are created equal! Keep in mind the limitations of the numbers you are looking at:
- current month numbers reflect a very short period of time - one month. It is very easy for the timing of transactions to be off by just a few days, and have a relatively huge impact on current month numbers. Something as simple as the timing of being approved for a grant can throw these numbers off by a big amount.
- budget numbers, as we always stress, are simply the financial expression of the operating plan. And, plans, by their nature, are never as precise as the actual results. We tend to budget some amounts evenly over the year, for example, even though we know that we won't actually incur the cost evenly. But, in doing our planning (i.e. our budget), we don't know precisely (and probably don't care …) when every single amount will be spent.
- small numbers are … well … small! And, so, a tiny change in a small number can look more significant than it really is. Keep a focus on the big numbers - the ones that can really cause problems for your organization.
- percentage figures can be really misleading. Again, small numbers can create huge percentages that really don't mean much, whereas some small percentages might mask bigger problems. If, for example, salaries are three-quarters of your expenses, then a 4% increase instead of the planned 2% can spell big financial trouble.
Putting it all together
As we said at the outset, what you need to focus on will depend on your organization and its circumstances. But, here are a few rules of thumb that may prove helpful, especially if you are new to looking at your organization's monthly statements:
- think about what is going on in your organization and what you are expecting to see, before you even pick up the statements. Look for amounts that confirm your expectations, and for amounts that challenge them;
- focus more (though not exclusively) on the amounts that are normally your bigger items - large grants, major fee categories and events, as well as major types of expenses. These are where big problems, if they exist, can hide. It may also be where big improvements could be made;
- tend to look at the year-to-date figures, since they smooth out very short-run fluctuations and timing issues;
- compare the results to budget, since it will highlight where you are straying from your plans;
- ask about numbers that aren't clear, or that include several items grouped together (for example, "administration expenses" is not a very explanatory caption). Ask what exactly goes into figures that are not self-explanatory.
Finally, if the statements don't paint a reasonable picture of the organization's finances, get the statements changed. Demand more detail, or less; demand comparative information, and budget information; insist on captions and groupings of information that are clear, sensible and revealing. The accounting for your organization should be an effective communications tool - it should tell a story - and if it isn't, you should insist on changing the accounting.
William Harper is a Chartered Accountant, and has broad experience in making financial information tell the real story. Contact us for help.
What is a Balance Sheet?
The Balance Sheet is more clearly called the Statement of Financial Position. It shows what the financial position of the organization is, at a certain, specific point in time. It shows the "Assets" (i.e. the things that the organization owns, or has rights to), "Liabilities" (i.e. the amounts that the organization owes to others), and - what's left - the organization's equity (i.e. its net worth), which all "balance" at any point in time.
Some assets (most "current assets"), like cash and amounts receivable, are recorded at their true current value - it's the amount in the bank, or the amount that will be paid to the organization. Other assets are generally recorded at their original cost, less depreciation. For example, if your organization bought a truck for $10,000 a few years back, that $10,000 will be recorded as the cost. This cost amount will be reduced by depreciation, to reflect that the truck is being used by the organization. Maybe your organization has recorded $7,000 of depreciation, so the "book value" (i.e. the value of that truck in the accounting records, or books) is $3,000. That doesn't mean the truck is worth $3,000, though. If you sold that truck today, you might get $1,000, or you might get $5,000. Long-term assets, like buildings and vehicles, are recorded at this "net book value", which may or may not be close to their current "real" value.
Finally, some assets (like the organization's reputation, its name recognition or "brand", and so on) are not recorded in the financial statements at all. These assets can be the most significant ones of all.
Liabilities, on the other hand, are mostly recorded at their current value - the amount that will have to be paid by the organization. (There are exceptions to this rule, like all accounting rules, but it is a good rule of thumb for most smaller organizations.) However, some amounts will have to be paid out soon ("current liabilities"), while others may not be paid, at least in full, for many years (e.g. a mortgage).
The equity is what's left over, the assets minus the liabilities. Since not all assets (and, occasionally, not all liabilities) are shown at their current values, however, the equity amount is not generally what the organization is really worth. It really is the "balancing" figure.
The equity section of the balance sheet is also where some organizations show restrictions placed on the organization by donors of funds, or by the organization's own Board of Directors. These restrictions show that the equity is not totally free to be used as the organization sees fit. For example, a donor may have required that funds donated be used only for certain purposes or that they not be used at all, except to generate investment income. And, Boards will often place restrictions on equity, for example, to indicate that a certain amount is being retained in the organization to provide for its future financial health, or is being saved for a future capital expenditure.
As a final comment, note that some organizations go beyond even this type of restriction, and use a system of "Fund Accounting", where the entire balance sheet (and other statements, too) are split out into various groupings of activities (for example, an operating fund, a building fund, and so on) - this can become very complex, and a full discussion is beyond the scope of this article. Don't be shy, however, about asking management or your bookkeeper what all the accounts really mean.
Term of the Week - What is an accrual?
Accrual is an accounting term which means that items are recorded as of the dates that transactions occur, rather than when cash changes hands. For example, if you buy office supplies and the store gives you an invoice that you will pay later, this transaction would be "accrued" on the day of the purchase (i.e. when you receive the supplies), rather than on the day you pay the invoice. Between these dates, the amount would be shown as "accounts payable", meaning that the organization owes this amount to the store during that time. (On the flip side, the store records this as a sale when you take the supplies, even though they haven't been paid, and they record "accounts receivable".)
Another example would be where employees have worked, but haven't yet been paid. The amount of wages they've earned but not yet been paid would be shown as an "accrued liability", even though there is no invoice for this amount.
Accrual accounting is generally considered to be more accurate than "cash accounting", since the results are not affected by the timing of when bills are paid (which can be easily controlled).
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!