Most Not-for-Profit boards of directors don’t really know what to expect from the organization’s Chief Financial Officer (CFO) when he/she reports. Most CFOs report a rather vanilla version of the not-for-profit (NFP) organization’s latest financial statements, as produced by the organization’s accounting software. Most could do much better!
These comments and suggestions represent a truly 3rd party perspective, quite possibly insensitive to what individual boards and not-for-profit organizations would most appreciate. Nevertheless, consider the following suggestions as ruthlessly oblivious and insensitive to what any particular board has seen before and with what it would be comfortable.
Summary of CFO Board Reporting Recommendations
For most Boards and their reporting CFO, consider the following recommendations for accounting and financial reporting (and consequently, to board financial reporting):
- Accrual Reporting – Adopt full accrual accounting and reporting,
- Major Expense Aggregation Reporting – Regularly allocate major groups of expenses (such as personnel and facilities expenses) to appropriate functions or programs (such as conference, other programs, and supporting functions),
- Comparative Reporting – Always present comparative financial statements, as well as actual vs. budget reporting,
- Functional Reporting – Use the accounting software functional accounting feature to report separate income statements on a functional or program basis,
- High Level Reporting – Provide a summarized income statement that consolidates class reporting at a high level in order to provide a correspondingly high level perspective, to facilitate high level decision making,
- Dashboard Reporting – Supplement each board report with a “dashboard” of critical monitors of overall financial health, and
- Trending Issues Reporting – Supplement each board report with a list of “issues” that, from the CFO’s perspective warrants board level attention, discussion, and possible resolution. Associated with each list of issues, also propose, for board consideration, tentative board resolutions for consideration and action, should the board decide to act.
Note that prior to any board meeting, the CFO should confer with the Treasurer to make sure that he/she is reasonably comfortable with this reporting agenda, and fully comfortable with presenting the dashboard, list of issues, and tentative resolutions. The financial statements could be reported by either the CFO or the Treasurer, depending upon Treasurer preference and financial statement familiarity.
Many NFP organization CFOs report their organization’s financial statements on the cash basis of accounting. People understand the importance and relevance of cash-in-the-bank, so CFOs often leverage the perception that cash basis reporting represents the most understandable form of financial reporting.
Accountants typically hold a different perspective, and consequently go somewhat crazy when trying to understand and/or explain cash basis accounting. As opposed to wanting to always assess current financial position and operating results based upon what is currently in the bank, accountants prefer to assess these things based upon what what actually happened. For example, if an organization invoiced an amount to a customer or member, then the recoding of that transaction should be booked and reported as an event in the year in which it was either invoiced, or the period to which it related or will relate. Similarly, when a an organization makes a purchase on credit, then that purchase should be booked in the period in which it occurred. Therefore, according to accrual accounting, expenditures should be reflected as expenses in the period to which they relate.
Consider the way many NFP organizations book convention transactions and the way that an accrual based accountant would book them. An organization that used accrual accounting would always account for and report all convention income and expense in the period in which a convention takes place. The fact that deposits on a convention hotel, for example, might have been paid a year ahead of time, would not deter from recognizing that deposit as an asset on the prior year’s balance sheet, and a convention expense for the year in which the convention takes place. In addition, an organization should book late paying convention expenses and late received convention income that might be paid or received in the following year in the year in which the convention took place, using a balance sheet placeholder to offset cash when cash is actually paid or received in the following year. Thereby, the board would review a more accurate portrayal of convention profitability or loss. The use of full accrual accounting would dispel confusion resulting from timing issues, otherwise created through cash basis accounting.
Quite often, organizations take an overly simple approach to reporting income and expenses on financial statements by simply listing their expense accounts in alphabetical or descending amount order. The problem with this type of reporting is that it fails to provide the reader of financial statements the opportunity to easily understand closely related groups of expenses that could make financial decision making easier and more responsive to what an organization needs to accomplish. NFP organizations should consider grouping natural expense accounts by their similarity of occurrence. For example, compensation expenses typically represent the greatest cost of doing business. Aggregation of payroll expenses that include salaries, wages, contract employees, payroll taxes, workers’ compensation insurance and other employee benefit expenses should be grouped and subtotaled so that the financial statement reader can easily see what the total cost of employment is. Similarly, the cost of occupying a facility often constitutes the second most costly part of doing business. Equipment and facility expenses should similarly be grouped and subtotaled. An organization should similarly group other account aggregations, depending upon what makes the most sense and facilitates decision-making the best.
However, when people work, they often work on multiple programs and support functions. An employee might spend some of his/her time working on convention business, some on membership communications, some on other specific organization programs, some on administrative affairs, and perhaps even some on fundraising or communicating with potential donors. Therefore, even though an NFP board would likely be interested in knowing how much money is spent on personnel, it also would likely want to know how that time is divvied up so that a true picture of total convention and other expenses and associated profitability could be assessed. NFP expenses should be allocated between programs and support activities to present natural expenses on a functional basis.
Expense allocations could be handled either of two ways. First, actual expenses as they are incurred could be directly allocated between the programs and supporting functions to which they relate. Second, actual expenses could be aggregated and then allocated functionally. An NFP organization would need to devise a reasonable method of allocating costs between programs and supporting functions so that an activities statement would show not only total personnel costs, but also their allocation to what they were really invested in.
The IRS requires a form of expense allocation when it asks that all expenses be broken down between program expenses, administrative expenses, and fundraising expenses on an NFP organization’s Form 990 – Return of Organization Exempt from Income Tax. In fact, Form 990 also requires that total expenses for each of the largest programs be reported in total near the front of the tax return.
Comparative Financial Statements
An NFP CFO should always present to the board, or anyone else, at least two years’ worth of financial statements, so that the reader can easily see how the most current year numbers compare with the most recent prior year’s numbers. Understanding how income and expense is trending is critical to allowing decision makers to make adjustments to operations, if necessary, in order to be able to accomplish strategic objectives in the context of relevance.
In addition, an NFP board should annually develop (or approve) a budget. Comparative financial reporting should also include a comparison of actual activity results against budgeted results.
Every NFP board should regularly (annually, bi-annually, or xx-annually), create or update a long-range financial projection, consistent with any long-range strategic plan that the organization may have adopted. Annually, the board should then compare the current year’s actual financial statement results with its long-range financial expectations or strategic objectives.
Program and Functional Reporting
Generally Accepted Accounting Principles (GAAP) stipulate the kind of reporting that is appropriate for financial reporting, which might be different than for management reporting. Financial reporting refers to reporting that is generated for reading by external users. GAAP addresses financial reporting. Management reporting refers to reporting that is generated for an organization’s internal use. Management reporting is not standardized, and therefore is not addressed by GAAP.
A private sector (or, for-profit sector) statement of activity is generally structured as follows:
Aggregation of “natural expense” accounts (such as compensation, supplies, etc.), #1
Aggregation of natural expense accounts #2, etc.
Note that the list of expense aggregations can be quite long. For small companies, they sometimes don’t aggregate at all, but simply list each and every expense account balance (see similar comments under Allocations.
GAAP requires four different reports for not-for-profit organizations, at a minimum, to satisfy accounting and reporting standards. In addition, a fifth report, often appended to the income statement, reconciles net assets at the end of the prior year with net assets at the end of the current year. Note that activity reporting for the not-for-profit sector is a bit more complex than for the private sector. Whereas the private sector relies simply upon a statement of activity (income statement), the not-for-profit sector relies upon both a statement of activity as well as a statement of functional expenses.
A not-for-profit statement of activity is generally structured as follows:
Program A expenses
Program B expenses (if applicable), etc.
Notice that the listing of expenses is rather short, and emphasizes total expenses on a programmatic basis as well as a supporting services basis. (Supporting services generally refers to administrative and fundraising expense aggregations).
A not-for-profit statement of functional expenses is generally structured as follows:
|Natural expense #1|
|Natural expense #2, etc.|
Note that natural expense aggregations are broken out in a columnar fashion by program and supporting service category. The totals of each column are the same as the expense lines on the statement of activities.
What is significant about not-for-profit financial reporting is that there is a heavy emphasis upon programmatic breakouts of expenses. In general, it is thought that a not-for-profit financial statement reader needs to know how program expenses are broken out, and how they total. Organization efficiency is generally determined by dividing program expense totals by total expenses. Higher ratios indicate higher measures of efficiency, which is critical to any organization seeking grant funding.
GAAP allows flexibility in structuring the statement of functional expenses. Therefore, when clients structure their statement of functional expenses, they are allowed to take the liberty of not only reporting expenses, but also associated income. Thereby, each program can be more easily measured according to its contribution to, or detraction from, overall profit.
Accounting software often allows income and expenses to be associated with functions, which in effect can be viewed as programs or support service categories. Therefore, organizations are given the flexibility to report this way. Therefore, if an NFP organization were to fully allocate expenses across functional categories, then it could produce a separate income statement for each program. This can make discussion and analysis easier, because each functional financial statement can be reviewed and discussed separately, and with its own focus.
Every NFP organization, using guidance from its CFO, should devise a method for allocating expenses, initially accounted for according to their natural classifications, and then allocated across functional categories in a fair and reasonable manner. Then, its CFO should report this way to the organization’s board of directors.
A High Level Perspective
No matter how complex an organization’s accounting and reporting might get, a board of directors always requires a simplified financial overview, so that it is not immediately dragged into the details of accounting minutia. Board members are typically not financially literate, so financial reporting needs to be simplified. However, even if every board member was a financial expert, a board (as a decision making body) still needs to be able to see the big picture in order to gain perspective, before diving into more detailed review and analysis of financial affairs.
Therefore, a separate “big picture” financial statement should be created outside of its accounting software, perhaps using spreadsheet software or some other template, in order to present a summarized picture of both the balance sheet and statement of activities.
Every CFO should present to his/her board of directors a financial dashboard. This dashboard would need to be created, but would routinely present key financial data (maybe about a half dozen or less) about how the organization is doing. Examples of dashboard reporting items might include the following;
- Liquidity (cash or near-cash financial position),
- Debt coverage ratio (commonly used by lenders and included in loan covenants),
- Reserves, as a percentage of a year’s worth of operating expenses (many organizations like to maintain a measure of their financial stability in the context of possible “dry” seasons),
- Restricted net assets, as a percentage of total net assets (restricted net assets tend to tie the hands of NFP organizations and their boards),
- Program expense ratio (measure of efficiency, critical to sources of grant funding, other contributors),
- Compensation (or other key sensitive account aggregation) as a percentage of total expenses,
- Key program profitability,
- Key budget variances,
- Other measures considered sensitive to the financial health of the organization.
Even high level financial statements often make non-financial board members loose interest. But, if the CFO routinely presented a dashboard of key financial measures, and then gave an overall grade, perhaps along the lines of either a rating on a scale of 1 to 10, and/or in terms of a green vs. yellow vs. red light rating, the non-financial oriented board members could more easily fulfill their fiduciary financial duties right along with the more financially literate board members.
Even after a dashboard of key financial indicators is presented, there are always “issues” that arise that don’t fit the routine of financial reporting, that deserve highlighting, commenting upon, and board discussion or consideration. These should be reported each board meeting as part of a routine presentation item, even when there aren’t any key issues. The CFO should not leave it to the board to identify key issues just by reviewing the dashboard or financial statements, because key issues also involve issues that are on the horizon, that are emerging, or that might be historical in nature but are “under-currents” rather than immediate “big deals”. The board can always override the CFO’s assessment, but at least if the CFO presents his/her perspective on key issues, the board then has the opportunity to opine or chime in on their significance.
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Hopefully, this analysis and outline of appropriate NFP board level financial reporting can be helpful in structuring your NFP board’s fulfillment of fiduciary responsibilities.
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