Understanding Nonprofit Financial Statements
Financial statements can seem daunting, especially for new nonprofit board members. Yet, financial oversight is a fundamental board duty. Every director needs a basic understanding of the organization's finances and how to interpret its financial statements. This session demystifies these reports and clarifies key concepts like fund accounting, tailored for board members in the U.S. and Canada.
The Board's Role in Financial Oversight
Budget Approval
Review management's proposed annual (or multi-year) financial plan. Ensure it aligns with strategic priorities and includes realistic income and expense projections. Understand major revenue streams (grants, donations, fees) and expense categories (programs, administration, fundraising). Challenge assumptions before approving the budget, which then authorizes the Executive Director (ED) to operate within its parameters.
Financial Monitoring
Regularly (at least quarterly) review financial reports comparing actual results to the budget, typically including the Income Statement and Balance Sheet. Identify and inquire about significant variances (e.g., lower-than-expected donations, higher program spending). Prompt management to explain variances and outline corrective actions if necessary. This ongoing monitoring helps prevent year-end surprises and ensures solvency.
Statement Acceptance
Formally accept key financial statements, particularly the annual audited statements if an independent audit is conducted (common for larger U.S. nonprofits and Canadian charities above certain thresholds or as required). The Audit or Finance Committee typically liaises with auditors before the full board approves the audited statements as part of its fiduciary responsibility.
Ensuring Proper Accounting & Controls
Confirm financial statements adhere to relevant standards (U.S. GAAP ASC 958 or Canadian ASNPO/IFRS). Understand the basis of accounting (cash vs. accrual) and verify that qualified personnel prepare the statements. Ensure robust internal controls (e.g., segregation of duties, dual signatures for checks) are implemented to prevent fraud and errors, and oversee management's response to any issues raised by auditors (often in a management letter).
Overseeing Regulatory Filings
Review crucial public documents like the U.S. IRS Form 990 or ensure a board member signs the Canadian T3010 charity return. Verify these filings are accurate and submitted on time to avoid penalties or loss of charitable status.
Financial Policy Development
Establish and oversee key financial policies, such as investment policies for reserves or endowments, operating reserve targets (e.g., maintain 3 months of expenses), and guidelines for using restricted funds. Monitor management's adherence to these policies.
All board members need financial literacy, not necessarily expertise. Don't hesitate to ask clarifying questions. Effective oversight involves prudence, transparency, and fulfilling the duties of care, loyalty, and obedience, mitigating potential personal liability and contributing to the organization's financial health and strategy.
Where Do the Numbers Come From?
Accounting System & Chart of Accounts
Transactions (donations, bills, payroll) are recorded in accounting software (like QuickBooks, Sage) using the organization's chart of accounts—a structured list of asset, liability, net asset, revenue, and expense categories. Financial statements summarize these categorized transactions. Most nonprofits use the accrual basis (recording revenue when earned, expenses when incurred).
Preparation & Reconciliation
Statements are prepared internally by staff (ED, bookkeeper, Finance Director/CFO), sometimes presented in simplified "dashboard" formats for boards. These reports derive from the accounting system's general ledger. Crucially, internal records must be reconciled (e.g., matching book cash balances to bank statements) to ensure accuracy. Outdated reconciliations are a red flag.
Accruals, Non-Cash Items & Event Reporting
Accrual accounting means statements include non-cash items like Accounts Receivable (money owed to the org), Accounts Payable (bills owed by the org), and Depreciation (allocation of asset cost over time). Understand that these impact the bottom line but not necessarily immediate cash flow. For events like galas, note both gross revenue and related expenses to assess net fundraising results.
External Verification (Audits)
Many nonprofits undergo an annual audit (or review/compilation) by an independent CPA firm. Auditors verify the financials and may propose adjustments. An "unqualified" (clean) audit opinion indicates the statements fairly present the financial position according to accounting standards (GAAP/ASNPO). Reviewing audit adjustments can highlight areas for internal improvement.
Accounting Standards (US/Canada)
U.S. nonprofits follow FASB GAAP (ASC 958), classifying net assets as "with" or "without" donor restrictions. Canadian nonprofits often use ASNPO, which features similar concepts like restricted/unrestricted fund balances. While technical details vary, both provide established rules ensuring financials aren't arbitrary. Board members should ask for explanations if accounting rules lead to counterintuitive results (e.g., deferred revenue).
In essence, financial statements summarize categorized transactions based on established accounting rules, prepared by staff and often verified by auditors. Board members should "trust but verify"—review the statements critically and ask questions to connect the numbers to organizational activities and ensure sound financial governance.
How to Read Key Financial Statements
Balance Sheet (Statement of Financial Position)
This shows the organization's financial health at a specific point in time (e.g., Dec 31). Equation: Assets = Liabilities + Net Assets.
Assets: What the organization owns or is owed.
- Key Lines: Cash, Accounts Receivable (pledges/grants owed), Investments, Prepaid Expenses, Fixed Assets (property/equipment, net of depreciation).
- Board Focus: Is cash sufficient? Are receivables collectible? Note fixed asset values are book value (cost less depreciation), not market value.
Liabilities: What the organization owes.
- Key Lines: Accounts Payable (unpaid bills), Accrued Expenses (e.g., unpaid salaries), Deferred Revenue (funds received but not yet earned), Loans Payable.
- Board Focus: Are payables growing (potential cash issue)? Understand debt terms. Note deferred revenue signifies future obligations.
Net Assets (or Fund Balances/Equity): The cumulative difference between assets and liabilities (Assets - Liabilities).
- Key Lines: Typically broken down into Without Donor Restrictions (unrestricted, usable for any purpose) and With Donor Restrictions (restricted by donors/grantors for specific purposes or time). May also show board-designated funds (internally restricted).
- Board Focus: Is total net assets growing or shrinking? What's the composition? High restricted net assets limit operational flexibility. Calculate liquidity ratios (e.g., Current Ratio = Current Assets / Current Liabilities) and months of operating reserves (unrestricted liquid assets vs. monthly expenses). Negative net assets signal insolvency.
Income Statement (Statement of Activities/Operations)
This shows financial performance over a period of time (e.g., Jan 1 - Dec 31). Equation: Revenues - Expenses = Change in Net Assets (Surplus or Deficit).
Revenues and Support: Income sources.
- Key Lines: Contributions/Donations, Grants, Program Service Revenue, Investment Income, Special Event Revenue, In-kind Contributions. U.S. GAAP may show releases from restrictions.
- Board Focus: Compare actual vs. budget for major categories. Note revenue diversity and reliability (recurring vs. one-time). High dependency on single sources poses risk.
Expenses: Costs incurred.
- Key Lines: Often shown by function (Program Services, Management & General, Fundraising) and/or by nature (Salaries, Rent, Supplies).
- Board Focus: Compare actual vs. budget. Analyze key ratios (e.g., program expense ratio). Ensure functional expense allocations are reasonable and comply with standards. Payroll is often the largest item.
Change in Net Assets (Surplus/Deficit): The bottom line.
- Board Focus: Is there a surplus or deficit? Consistent deficits require action (cut costs or increase revenue). Understand if deficits are planned (e.g., using reserves). Focus on the operating surplus/deficit (excluding unusual items).
Cash Flow Statement
Shows how cash moved during the period through Operating, Investing, and Financing activities. Useful for understanding discrepancies between accrual-based profit/loss and actual cash changes. Positive operating cash flow is generally desirable.
Practical Tips: Look for summary dashboards highlighting key metrics (cash levels, budget variance). Read explanatory notes. Ask management to clarify anything unclear. The goal is to confidently answer: "What is our current financial health and performance?"
Understanding Fund Accounting
Purpose
To ensure money restricted by donors or grantors is used as intended
Restrictions
Externally Restricted vs. Internally Designated funds
Presentation
Internal reports by fund vs. consolidated statements
Why It Matters
Compliance, Financial Clarity, Strategic Planning, Donor Reporting
Fund accounting is a method used by many nonprofits to track resources designated for specific purposes, emphasizing accountability.
Purpose: To ensure money restricted by donors or grantors is used as intended. It divides resources into separate "funds" (e.g., General Fund, Building Fund, Scholarship Fund), each with its own self-balancing set of accounts. This prevents accidental misuse of restricted money.
Restrictions: Funds can be Externally Restricted (by donors/grantors for specific programs, time periods, or endowments) or Internally Designated (by the board for specific purposes, like reserves; the board can potentially undesignate these). Honoring external restrictions is a legal and ethical imperative.
Presentation: Internal reports might show financials broken down by fund (e.g., columns for General, Restricted Fund A, etc.). Audited statements often consolidate this into Net Assets With and Without Donor Restrictions (U.S. GAAP) or similar categories under ASNPO (Canada). Boards need to understand both the segmented and consolidated views.
Why It Matters to Boards:
- Compliance: Prevents misuse of restricted funds, a serious breach potentially leading to liability. Ensures donor intent is respected.
- Financial Clarity: Reveals the organization's true operational flexibility (e.g., large bank balance might be mostly restricted). Prevents misinterpreting financial strength.
- Strategic Planning: Informs decisions about program funding needs (e.g., anticipating the end of a restricted grant) or allocating surpluses (e.g., creating a board-designated reserve).
- Donor Reporting: Provides the basis for accurately reporting back to funders on how their specific contributions were used.
Example: A $100k donation for equipment (restricted) and $100k for operations (unrestricted) are tracked separately. The Equipment Fund shows the purchase and any remaining restricted balance. The General Fund shows operating activities. This transparency ensures the $100k restricted donation isn't inadvertently spent on salaries.
Essentially, fund accounting underpins nonprofit stewardship. Board members must grasp it to correctly interpret financial reports, ensure compliance, and make informed strategic decisions. Understanding fund balances helps assess true liquidity and resource availability.
Nonprofit Board Governance Guide
This comprehensive guide breaks down nonprofit governance into eight essential sections.
Whether you're new to board service or a seasoned leader, you'll find valuable insights.
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