KEY ACCOUNTING INDICATORS, FUNCTIONS, REGULATORY, GOVERNANCE AND TAXES
Sound nonprofit financial management is one of the biggest keys to success for any nonprofit organization. Whether you have one employee or 1,000, your organization will need accurate bookkeeping and committed, credible oversight. With those in place, you’ll be in a better position to maintain your 501©(3) status, raise and manage necessary funds, and protect the resources needed to deliver on your mission.
There are no magic rules that apply to all nonprofits. Type and size of organization, sources of revenue, and the length of time your organization has existed are just a few of the factors to consider. That said, there are several common measures that can be helpful in assessing the financial health of your nonprofit organization:
- The quick ratio ([current assets – inventories]/current liabilities) indicates your organization’s ability to meet short-term obligations. As a general guideline, a quick ratio of 1 or more is good.
- The debt ratio (total debt/total assets) indicates the proportion of debt relative to assets. A high value can suggest liquidity problems and, just as it would for an individual, may be perceived as a risk by creditors. A debt ratio of 1 or less is good.
- The defensive interval ratio ([cash + marketable securities]/[operational expenses/365]) measures the number of days an organization can operate without having to tap into long-term (fixed) assets. This lets you know how long your cash reserves will last. Most experts recommend maintaining enough cash on hand to cover three to six months of operating expenses.
It should be noted that in addition to standard financial analysis, an examination of your organization’s sources of revenue (e.g., grants, individual donations, fees for service, etc.) relative to total revenue can also be useful. This will help to identify opportunities to diversify revenue streams and assess potential areas of risk, such as if a large portion of funding is coming from only one source.
What steps are involved and what role does the board play?
Your operational budget is the foundation from which all of your work will be carried out. It allows you to establish benchmarks, gauge financial health from one year to the next, and determine priorities.
Here are some key steps in developing your budget:
- Establish your budget period (one year, multiple years).
- Review program achievements and financial performance for the prior year.
- Set program and organizational goals for your budget period.
- Estimate expenses, including: Fixed costs such as staff, rent, taxes, utilities, etc., variable costs that fluctuate based on activity level (e.g., the cost to vaccinate more clients in a health clinic would fluctuate based on the number of clients and environmental factors such as a flu outbreak) and incremental expenses, which occur when a particular action is taken (e.g., when a certain amount of money is raised, a new program will be launched).
- Estimate anticipated revenue.
- Plan for needed cash flow and development of cash reserves.
- Adjust to align expenses and revenue.
Your board of directors should be called upon to comment on and approve your organization’s budget each year. From there, it becomes a tool for monitoring progress and determining areas for refinement, if necessary. Your budget should also be provided to the board at quarterly meetings, along with comparisons to the prior quarter and prior year, and projections for the remainder of the year.
As a reminder, when it comes to planning your budget, be conservative. It’s easy to say how much money you’d like to raise, but it’s far more important to be practical about what can be raised. That way you’ll be setting realistic goals for your staff and managing everyone’s expectations, including your own.
Adapted in part from Finance Manual, by Jan Masaoka and Jude Kaye.
While many aspects of nonprofit and for-profit business accounting are similar (such as the tracking and reporting of income and expenses, and payroll taxes), there are significant differences. These arise out of the nonprofit organization’s duty to drive its resources toward its mission. For example, nonprofits are required to itemize expenses across management (general and administrative), fundraising, and program areas. These are called “functional expenses” and the IRS requires that they be reported.
The requirement for nonprofits to report functional expenses also highlights the importance of a cost allocation plan. This basically means establishing a system that defines how you will allocate expenses across the various functional areas and to specific programs. For example, let’s say that those involved in administrative functions take up 20 percent of your office space. You might then allocate 20 percent of an expense like paper to the administrative functional area.
A cost allocation plan can be extremely useful in determining how much a program or activity actually costs and, done accurately, it gives a clearer picture of the organization’s finances. There are several acceptable methods – such as applying direct/indirect costs, and allocations based on percentage of payroll or physical space used (as in the example above). Frequently, a combination of these methods will be appropriate. Consult with your accountant to determine the approach that best suits your organization.
Other key aspects of interest to nonprofits are outlined by the Financial Accounting Standards Board (FASB), a nonprofit organization authorized by the Securities and Exchange Commission to set accounting standards in the United States. Of particular importance is the FASB’s Statement of Financial Accounting Standards No.116, which defines:
- Revenue in the form of contributions: These standards establish how and when to recognize that revenue has been earned. They include standards for the accounting treatment of unrestricted and restricted funds, donated goods, in-kind contributions, pledges and the like.
- Value of donated services: This establishes standards for when it is necessary to record donated services (i.e., volunteer time) in the organization’s financial statements. According to the FASB, services to be recognized include those that “(a) create or enhance nonfinancial assets or (b) require specialized skills, are provided by individuals possessing those skills, and would typically need to be purchased if not provided by donation.”
Another area that’s important to nonprofits, while rarely affecting for-profits, is the reporting of restricted contributions. While the amounts of restricted contributions are reported on a nonprofit’s 990 tax return, donors will typically require much greater detail about the use of restricted funds. This serves to inform the donor that the conditions of the gift have been (or are being) met, and enables staff to track what funds remain available for the restricted purpose.
The basic financial reports of a nonprofit organization include:
- Statement of financial position (also called a balance sheet): This summarizes the assets, liabilities and net assets of the organization at a specified date. It’s a snapshot of the organization’s financial position on that date.
- Statement of activity (also called an income and expense statement): This reports the organization’s financial activity over a period of time. It shows income minus expenses, which results in either a profit or a loss.
- Statement of cash flow: This summarizes the resources that become available to the organization during the reporting period and the uses made of such resources. It’s especially useful in real-time because it reports income that has been received and expenses that have been paid. A statement of projected cash flow is helpful for the board and organization to be able to anticipate any shortfalls for planning purposes.
- Statement of functional expenses: Reports all expenses as related either to program services or to supporting services. Expenses under program services are shown divided among the various programs. Expenses under supporting services are generally divided between (1) management and general expenses and (2) fundraising expenses.
While these reports are extremely important in terms of understanding your organization’s financial health and conveying that information to your board, you’ll also find that these types of reports will often be required by funders when applying for grants.
Other reports, depending on your organization’s needs, are: government information returns, payroll tax returns, reports to funders, management reports, budget monitoring reports, and analysis of statements and investment reports.
A detailed list of financial reports for nonprofits, and related definitions can be found in Financial Statements of Not-for-Profit Organizations, by the Financial Accounting Standards Board (www.fasb.org).
There are also a few accounting basics you should keep in mind. A qualified bookkeeper can help you to ensure reports are prepared properly and in a timely manner. He or she can also help to reconcile bank statements on a monthly basis, which is critical, and lend support and key information during budget development.
At its best, the term “audit” usually sparks apprehension. While it can refer to contract monitoring, internal review or external management review, a lot of people think immediately of an IRS review.
In actuality, a financial audit most commonly refers to an independent review of an organization’s financial books. Usually conducted annually, it’s really just a part of a reliable checks-and-balances system to make sure everything is in order. Here, we address whether a nonprofit needs an audit or other independent review of its financial condition.
First, it’s important to know if an annual financial audit is required of your organization by the federal government or by your state. These standards vary considerably. The federal government requires any organization receiving federal funds of more than $500,000 in a year to undergo a “Single Audit,” which generally covers the year/program in question.
State governments typically regulate the independent-audit requirement based on income – whatever the source. For example, in Pennsylvania, nonprofits that receive more than $300,000 in funds must file an audited financial statement with the Department of Revenue. In California, gross receipts totaling more than $2 million carry a similar requirement. Some states require an audited statement simply by virtue of fundraising there, regardless of where an organization’s headquarters may be located.
Given these variations, it’s best to consult an experienced attorney or accountant to determine the specific needs of your organization.
Another factor to consider is the requirements of funding sources. In addition to the requirements of federal and state governments, some funders may require an independent audit as a condition of funding.
If you do determine that an audit is beneficial (or required), it’s important to know that it must be prepared by a licensed independent certified public accountant (CPA). Once engaged, an auditor performs a series of selective tests that provide a basis for judging whether the financial reports can be relied upon.
Auditors will examine, among other things, bank reconciliation, selected restricted donations (to see that they were handled and recorded properly), and grant letters (to see that receivables are accurately stated). In addition, the auditor reviews physical assets, journals, ledgers and board minutes. Based on this investigation, the auditor issues a formal opinion about the accuracy of the financial reports.
If you do undergo an audit, you’ll also want to establish an audit committee within your board of directors. These committees are typically responsible for selecting (or approving the selection of) an auditor, reviewing the auditor’s outputs, and meeting with the auditor pre- and post-audit to address any issues or questions. Audit committees also frequently have ongoing responsibility for the organization’s overall financial oversight and internal financial controls.
All tax-exempt organizations must file certain reports with federal, state and local authorities. Because of distinctive state and local requirements, it’s important that you consult with your legal counsel and accountant to ensure that the necessary paperwork is being filed for your organization.
That said, at the federal level, you’ll definitely need to file one of the following:
- Form 990, Return of Organization Exempt from Income Tax, or
- Form 990-EZ, Short Form Return of Organization Exempt from Income Tax
- 990-N (e-postcard) for exempt organizations that normally have less than $50,000 in gross receipts
See Legal for more information regarding these forms and requirements in the state of California.
In terms of paying taxes, exempt organizations are exempt from income taxes, but they are still required to pay payroll taxes. Typically these are withheld from employee paychecks and paid quarterly. Be sure to file and pay on time. Willful failure to pay is a felony under federal law and the interest and penalties for late filing can add up quickly.
The IRS provides an Exempt Employer’s Toolkit (www.irs.gov/charities/article/0,,id=172794,00.html), which includes all of the forms that must be filed by organizations that have employees.
In addition to federal requirements, you’ll need to file payroll taxes with your state and, in some cases, locally. Check with your state’s Department of Revenue to determine when and where to file payroll taxes.
Another factor to consider at the state and local level is the need to collect sales tax. If you engage in the sale of taxable goods and services, you may have to collect and remit sales tax. Check with the Department of Revenue in your state to determine whether this applies to you and, if so, the required process.
What does the Sarbanes-Oxley Act have to do with it?
An independent audit is one form of internal financial control, but it’s important to put ongoing procedures into place as well. This helps to safeguard an organization’s assets and enhance reliability of its financial records. Internal controls are designed to provide assurance that transactions are properly authorized and recorded, accountability over assets is maintained, and access to assets is limited to authorized individuals.
In 2002, in response to corporate accounting scandals, the federal government passed the American Competitiveness and Corporate Accountability Act (more commonly known as the Sarbanes-Oxley Act). In brief, the Act compels corporate boards to monitor and be responsible for their companies’ financial transactions and auditing procedures. In other words, it regulates their financial controls.
Why does this matter to your nonprofit? The Act itself doesn’t apply to nonprofits, but there are a number of provisions that you might consider voluntarily adopting, particularly as they relate to board oversight and committees, disclosure, document retention and audits.
Another very important reason that this Act may be relevant to your nonprofit is that it inspired a number of state laws that do apply to nonprofits, such as the California Nonprofit Integrity Act of 2004 which addresses registration of a charity, financial reporting, auditing and other areas relevant to a nonprofit’s finances and management.
In addition to familiarizing yourself with applicable state laws, following are a few key areas you’ll want to consider as you develop your internal controls:
- Organizational budget, size and objectives
- Board and staff involvement in finances
- Establishment of audit and/or finance committees
- Organizational structure and governance
- Segregation of duties
- Recordkeeping and recording systems
- Authorization protocols
- Periodic board review
- Cost-benefit analysis (e.g., is the cost of the proposed system aligned with the benefits of implementation for your particular organization?)
When is it advisable to have one and why is it important?
Any organization that invests assets should have an investment policy. This is a document that outlines your overall strategy for investing, your short and long-term goals and the process by which investment decisions are made.
The board of directors needs to make two critical decisions in regard to investment policies: asset allocation (commonly referred to as diversification) and spending parameters. These decisions will provide insights into an organization’s investment practices, its historical return on the investments, its asset allocation and its compliance with the Uniform Prudent Management of Institutional Funds Act (UPMIFA).
Following, you’ll find a list of questions the board of directors should answer in setting investment policies for your organization:
- Does your organization have an investment policy statement? If so, when was it last updated? Does it meet your objectives and needs? Is it consistent with the UPMIFA and state law?
- What is your return goal over the period of your plan?
- What is your current spending rate (percentage of endowment transferred to operating fund)?
- What is your projected contribution level and liquidity needs?
- From whom has the organization received endowments, grants and contributions?
- Is there a board committee responsible for investments? How often does it meet?
- How do you currently monitor investment performance? What investment performance benchmarks are used?
- Have you evaluated the cost of your investment managers?
- What is your current asset allocation in the organization’s portfolio?
- What are the organization’s attitudes toward risk and returns within the portfolio?
- Are your investments subject to any unusual regulations?
- Have you adopted a policy regarding investments in companies that may conflict with your mission?
- Has the organization transferred cash and investments to any related organizations?
- Who manages the portfolio and are any unique skills required of the portfolio manager?
The 990 is the primary federal return for tax-exempt organizations. In 2008, the IRS released its first major revision in more than 20 years. The reason, according to the IRS, is that the old form “failed to reflect the changes in the law and the increasing size, diversity, and complexity of the exempt sector.”
While there are changes to most tax forms every year, when you hear about the “new 990,” people are generally referring to the 2008 overhaul.
So what’s new? Here’s a quick summary:
- The addition of a section on governance, including requests for information on the governing body, management practices, and disclosure policies, such as in the case of a conflict of interest.
- Revisions to the way executive compensation is reported, along with transactions with “interested persons,” such as board members and independent contractors.
- New definitions of officers, directors, trustees and key employees.
- The addition of thresholds and exceptions for organizations required to file certain reports. This is designed to reduce the reporting burden for many organizations.
- Revised filing amounts (i.e., gross receipts and assets) for organizations eligible to file the 990-EZ.
- The addition of an annual electronic filing requirement for tax-exempt organizations normally with annual gross receipts of less than $25,000. These organizations are not required to file a 990 or 990-EZ, but must file a Form 990-N, Electronic Notice (e-Postcard).
- Reduction of required attachments; addition of new schedules. Financial reporting, fundraising, gaming activities (such as a charity-run bingo game) and treatment of endowments and art collections are just a few of the items covered in the new schedules.
Cash reserves (in this case, meaning cash on hand or more formally, “operating reserves”) are critical for any organization. Most experts recommend maintaining enough cash on hand to cover three to six months of operating expenses. However, this is a generalization and may not apply to all organizations.
It’s important to consider your own unique circumstances. For example, an organization that relies largely on fees for service or has long-term contracts in place may not need six months of reserves. For a newly launched organization, six months is likely unrealistic, but could be an important goal. Whatever your nonprofit’s situation, it’s widely agreed that all organizations should have an absolute bare-minimum of one month’s reserves.
Moving toward the development of a cash reserve fund is not unlike building up your own personal savings account. You need to look at where revenue is coming in, where it’s allocated (for example, monies earmarked for rent or restricted donations won’t be helpful here), and where it can be drawn upon to bolster cash reserves. Sometimes, you need to tighten your belt.
There are a few primary places from where a nonprofit can draw off funds to strengthen the cash reserve: fees for service, individual donations, general operating grants and fundraising events. As you develop your budget, consider how much funding is coming from these or other relevant sources and begin to siphon off a percentage for your cash reserves. Establishing a benchmark, say 10 percent, can be helpful in prioritizing other areas of your budget in ways that can help meet that goal.
You won’t get to six months’ reserves overnight, but progress can be made relatively quickly.