I find this all fascinating on a policy level, and I’m happy to talk about these kinds of questions over a glass of wine (yes, I know how to have fun).  What happens, though, when theory about state policy meets daily reality at nonprofits that deliver public services? It’s not theoretical anymore. In Minnesota we have a very real case study as a result of an accounting shift for the state public education budget. Charter schools, a type of public school, have been scrambling for two years to manage the cash flow crisis caused by one of the shifts. State aid to public schools is paid beginning in July in even amounts over the year based on the number of students enrolled and attending school.  The state started “shifting” some of the education aid payments to future years to reduce the budget hole. What had been a 10% shift, called the holdback, has been increased twice in the last two years to help address the state’s budget problems. In the 2009-2010 school year 27% of state aid was deferred to the next year. For the current school year the shift is 30% of state aid.  Because of the state’s continuing budget difficulties, the payment shift seems likely to stay in place for years to come.

Earlier this year Nonprofit Assistance Fund, Minnesota Association of Charter Schools and Charter School Partners conducted a survey of Minnesota’s charter schools to understand how charter schools responded to the funding shift, including the availability of credit, the cost of borrowing, and impact on school operations and education services.  This week we released a report on the results of the survey to bring attention to this clash of policy theory and cash flow reality.

Highlights

• Charter schools have used every tool available to them to manage their cash flow, including internal fund balance reserves, renegotiating lease terms, budget cuts, loans from commercial banks, nonprofit loan funds, outside supporters and affiliates, and sale of receivables.
• Given that traditional school districts have taxing authority and a state guarantee of any loan, districts can typically receive loans with a 1% or less interest rate. Charter schools, who do not have these financing mechanisms in place, have faced obstacles to accessing credit and must pay between 6% to as high as 23% in loan fees (includes interest, fees and legal expenses).
• A gross inequity exists between traditional school districts and charter schools as to how the holdback impacts their respected operations.
• A 30% holdback is unsustainable for many charter schools in Minnesota and unless this is addressed, solid, high-performing charters will be at risk of ongoing financial instability.

Recommendations to reduce the inequity

The report recommends three possible policy changes that could address the inequity and help resolve cash-flow gap financing issues for charter schools, including:

1. Reduce the holdback for charter schools from 30% to 15%.
2. Provide a state-backed, low-interest loan pool.
3. Improve access to private capital (market rate loans) via a state-authorized ‘written assignment’ to banks.

You can read the release and the State Education Funding Shift Has a Disparate Impact on Minnesota Charter Schools report here.

This is just one case of the impact of state accounting schemes. There are many others all over the country. The solution isn’t simply a matter of GAAP accounting. If not through accounting, Minnesota, Connecticut, and 46 other states still have a hole to fill. It’s important to remember that theory quickly becomes reality when it hits the ground.

I’ve told the story many times about my first job at a nonprofit. I was a receptionist at an arts organization (a long time ago). The board of directors discovered that payroll taxes had not been paid for many months. The financial situation was dire and the board took extreme action. All but two staff members were laid off or furloughed, the board took over all financial matters, and a major budget reduction was implemented. They had to have someone answering the phones (this was long before voice mail and email), so I kept my job. After the immediate crisis was over I was asked to take on some financial tasks and eventually became business manager. That firsthand experience with the impact of unpaid tax liabilities is forever seared on my brain. It’s the worst way to solve a cash flow problem ever.

Here’s how it happens – slowly and silently. Cash flow is tight and when taxes are due, the director/business manager/accountant holds off on the payment “until the grant check comes next week.” The check comes, but other obligations are due. Pretty soon it’s time for payroll again and cash flow is still tight. By the third payroll, the unpaid taxes are starting to add up to more than can be paid all at once. Meanwhile, the landlord, vendors, and contractors are calling to remind our intrepid manager that payments are due. The IRS doesn’t call, though. This is one of the most insidious parts. People often choose to pay low priority bills before urgent obligations because of relationships, annoying phone calls, or emotions. The IRS doesn’t take action to demand payment of delinquent taxes for quite a while. When they do, the matter is immediately urgent and expensive and becomes the #1 priority for the organization.

As an example, this article from North Carolina, Nonprofit’s IRS bill tops $850K, describes a mental health agency that had their state funding cut by 23%. They reduced their budget but also had serious cash flow delays. As stated in the article, “they fell behind in making payroll tax payments.” It appears from the article that the agency financed their budget deficit by deferring tax payments. Ultimately, the IRS filed a lien and the situation became a crisis so severe that the agency ultimately closed in July 2010. When they faced the state budget cuts and delays, the statewide mental health agency had to make some tough decisions. It’s really unfortunate that they chose delayed payroll taxes to “manage” their finances.

If you need another reason to stay current with payroll taxes, share the article Not Paying Your Taxes? Your Board Could Be Personally Liable from Nonprofit Quarterly with your board members. The article lists seven lessons learned from payroll tax cases.

Lesson two: Virtually any alternative – including taking on additional debt, restructuring, downsizing, and filing for bankruptcy – is better than failing to remit withholding taxes to the government.

That’s a pretty harsh lesson, but it underlines the severity of consequences of this financial choice. The worst one.

Part of the value comes when you pull together all the pieces to have the form completed. The new 990 requires information about mission, program accomplishments and costs, board members and key staff, policies and governance practices, compensation, fundraising, finance, and much more. While many nonprofits rely on their audit firms to complete the 990, most of the required information is not financial and must be supplied by various departments or staff of the organization. The second part of the value comes from continuing to use the 990 as a communication and analysis tool. Here are four suggestions.

As an organizational tutorial

Read the whole 990, front to back. New managers, board members, emerging leaders, or anyone else on staff who wants to know more about the organization can get a complete overview of the organization by reading the complete form including all of the schedules. This assignment will also help you identify any questions or sections that need to be clarified or completed more thoroughly.

As a financial analysis tool

The 990 contains a complete financial report in a standard format. The new form expands the financial information, particularly the income section, to provide more complete data. Most financial analysis steps can be conducted using the 990. To make it easier, Nonprofits Assistance Fund created a new tool that we call the “990 Decoder.” Transfer the three financial pages from the Core Form onto this spreadsheet and you will generate a familiar looking Balance Sheet and Income Statement and a page of six standard nonprofit financial ratios. These can easily be used for comparison with other years or with other, peer nonprofits. Just “decode” their 990, too. We’re happy that the Minnesota Council on Foundations likes to decode 990s, too.

As a source of comparable compensation data

A month ago we were fielded a number of requests for help from board members of nonprofits who were responsible for obtaining information about executive director compensation from comparable organizations. In many cases, salary surveys fit the bill, such as the thorough review that Minnesota Council of Nonprofits compiles. Another simple approach is to create your own peer group of 4 or 5 nonprofits that are of similar size and type of service. Compile a custom comparison by using Guidestar to collect compensation data from your peers’ IRS 990s. Compensation is usually listed in Part VII on page 7. Guidestar registration is easy and free for the basic search. The information will be at least a year old, but as we told the board members we talked with, no one got much in the way of salary increases last year anyway.

As a communications tool

One of the unique features of the 990 is the Program Accomplishments section that is now the second page of the form. Hopefully you have taken advantage of the opportunity to communicate specifically what activities you completed, who you served, and how this work had an important impact in the community. Take an hour or so and read the Program Accomplishments for your nonprofit and then read the section for a few other organizations that you admire. How well did they communicate their work? How did you do? Learn from other organizations and look for ways to promote your 990 as another communications tool. Post it on your website (along with you audit, please).

Don’t let the IRS 990 sit around gathering dust. Give it a workout and help both your organizations and the nonprofit sector show the value of transparency and accountability.

• It tells you nothing about the impact the charity has on the people it’s trying to help.
• It discourages charities from investing in tools and expertise that would make them more effective.
• The rules for determining overhead costs are vague and every charity interprets them differently.

Hooray! I’ve been one of many voices speaking out on this problem for a long time, most recently in the post Donors and Overhead: Maybe They Don’t Care. This step by some of the most prominent national watchdogs, especially Charity Navigator, is huge. Ken Berger, CEO of Charity Navigator, elaborated on his own blog:

We do concur with the fundamental truth that the most critical dimension in evaluating a nonprofit has to do with achieving meaningful results.

Charity Navigator has been criticized for relying too heavily on the overhead ratio and other simplistic measures for their rating system. Berger has been blogging about their plans to shift to a more comprehensive approach, and this announcement is a breakthrough.

This feels like a gamechanger because now we can stop arguing about whether overhead is an accurate measure of charity performance. It’s not. Clearing that hurdle doesn’t get us to the finish line, though. Everyone in the nonprofit sector should cheer that the watchdogs are encouraging donors to review the impact and effectiveness of nonprofits – but how? There is not a single, simple alternative method to evaluate the effectiveness of all nonprofits. It’s essential for nonprofits to invest some time and brainpower to figure this out.

The organizations behind the press release have their own approaches:

• Consumer reviews: The personal experience approach of Great Nonprofits relies on a broad network of people who are involved with nonprofits to submit comments and ratings. Users of the website can search and browse for stories that interest or inspire them. Think of this as the Amazon reader reviews or TripAdvisor comments equivalent for nonprofits.

• Experts: Philanthropedia, on the other hand, relies on panels of experts in four different fields to pool their knowledge and assessment of which nonprofits are the “top” in effectiveness. Their “mutual funds” of nonprofits can become your vehicle for giving. In some ways this is a global, scaled up version of how we’ve used the local United Way.

• Data: GiveWell has a laser focus on reliable research and evaluation at nonprofits to support anecdotal stories or claims about impact. Read about their low opinion of the way nonprofits currently evaluate effectiveness. If better quality outcomes supported by good evidence is needed, then GiveWell will be there pushing us all.

Whatever approach you trust or endorse, get to it now. It will take us a long time reverse course for all the donors, advisers, and institutions that have used the program cost ratio as a stand-in for value. You’re going to have to offer some other data to replace it. Make it mean something. Ken Berger of Charity Navigator issued this call to action:

The nonprofit sector must get its act together and make sure it is really helping provide meaningful change in communities and peoples lives. It is life or death for many of those we serve whether we are effective or not. So let’s work together to measure, manage and deliver what is really important to make our world a better place.

Transparency

In December 2007 I wrote about Transparency and Financial Information:

I would strongly suggest that nonprofit organizations make the effort to make usable financial information available on their website. The IRS 990 is already a public document, so it seems like the obvious tool for financial disclosure. However, I think we should go past the 990 to share better information, especially since everyone seems to agree that the current version of the IRS 990 is overly complex, confusing, and very difficult to use. A better solution would be having the audited financial statement easily available on the website.

Guidestar recently published The State of Nonprofit Transparency Report, which included these findings:

A high percentage (93 percent) of nonprofits are embracing the Internet to disclose information about their programs and services.

Only 13 percent posted their audited financial statements on their Web sites. The results of our survey show a reluctance to disclose audited financial statements publicly. Although not all nonprofits obtain audits of their financial statements, our survey sample reflects organizations of the size for which an audit is both prudent and a necessary tool for assessing management’s financial capabilities and the organization’s financial health.

Let’s hear it for more audits online!

Mergers and Strategic Collaborations

In June 2008 I suggested Speed Dating for Nonprofits:

No one would say that mergers are the right answer for every nonprofit, but if you do think that joining forces would make sense and help your organization maintain stable services, where do you find your mate? I think I’ve found the answer – speed dating for nonprofits! Speed dating is an organized event to help singles meet a number of people in one evening with the intent of finding one or two for an actual date.

I’m excited that MAP for Nonprofits and the MACC Alliance for Connected Communities have organized a Speed Dating event on May 20^th to explore strategic partnerships.

Low-profit, Limited Liability Corporation (L3C)

And in May 2008 in Where For-Profit and Nonprofit Meet I was excited about the new hybrid Low-profit, Limited Liability Corporation (L3C) that had been adopted in Vermont.

The idea is to create businesses that can attract some private capital, bolster that with more patient philanthropic or socially motivated investment, and result in value to the community (jobs, housing, local revitalization) and a below-market return to investors. This structure is not a fit for every nonprofit, or even for every social enterprise. The L3C is all about raising capital, and when the need for capital is significant, this is worth considering.

This post continues to attract readers and questions. The most common confusion is about the fit for nonprofits that need subsidy (i.e. grants and contributions), rather than capital. The L3C is designed for capital but doesn’t offer any incentive for contributions. For more information, the experts on the L3C are Americans for Community Development. We’ll explain this new hybrid form at the May 14^th meeting of the Social Enterprise Network.

Since the post was written several other states have adopted the model, with others in the legislative process. I’m hoping that Minnesota can get on the bandwagon in the next year.

Last December I posted an entry in response to a Wall Street Journal column by Sally Beatty in which I chafed at her observation that charities were not accountable enough about how they used donated funds. She said:

“It’s time to make sure our gifts are being used as intelligently as possible. Instead of showering hard-earned dollars on charities and hoping for the best, we need to demand clear, detailed information on the results of their efforts. We ask the government and public corporations to be transparent and accountable. Charities should meet the same standard.”

It seemed that a lot of business leaders held this same view of nonprofits. It seems like a good time to revisit this notion and ask about whose standards of accountability to use now.

In the past few months we heard about the three page proposal from the Secretary of the Treasury asking for a $700 billion check to intervene in the financial meltdown (that ended up to actually be a blank check). The bailouts have continued, leading columnists like Floyd Norris of the New York Times to shout, Accountability needed with bailouts. Most recently, when executives of the Big Three automakers struck out with a request for their own bailout, House Speaker Nancy Pelosi said:

“It’s all about accountability and viability. Until we can see a plan where the auto industry is held accountable and a plan for viability on how they go into the future — until we see the plan, until they show us the plan, we cannot show them the money.”

Ask any nonprofit executive director or grant writer to guess how far they would get with a foundation or government agency if they submitted a three page request, or if they sat down at a site visit without a detailed project plan, budget, and evaluation outcomes. The answer is, not far.

Here’s a suggestion for how the nonprofit sector can contribute to the bailout – we can teach workshops and classes on accountability for government agencies and public corporations. Maybe it’s a new earned income opportunity.

Next lesson: Action must be taken. One of the most interesting dynamics in nonprofits is the relationship and shared authority of executive directors/CEOs and their board of directors. We could debate infinitely the question of who is really in charge. In day to day life, most nonprofits find a way to make it work if they have assembled and hired the right people, agree on roles, and know how to share and use information. There are times, though, when the board needs to assert its real and legitimate authority to make a big decision – to take action in the face of urgent needs for the nonprofit and its mission. In Lesson Number 1, I said that asking questions is one of the board member’s most important roles. I will state here that I think the primary role for board members, especially board chairs, is to know when they need to take action, and then to do it. I think this is an urgent issue right now because I have often seen the sometime dire consequences of reluctant, slow decisions. Too often, board members who have been expected to be good supporters and cheerleaders can’t seem to change gears and be the leaders they need to be. If the board’s practice has been to ask for more information and then defer decisions to the next meeting, and then the next, then real problems can grow while the options shrink.

The need to step up and take action is always applicable, but it seems to be more urgent right now. If income sources are less reliable, or costs are harder to identify and match with impact, then boards simply must ask questions and then follow up with real decisions – and real governance.

What do you think about these Accountability Lessons?  Do you have an example where asking tough questions and then taking action led to positive change? Or do you have lessons learned that may be helpful to others?  I invite you to share your experiences in the comments section.

• Time Horizon – Funds that may be needed within a few months must be invested in highly liquid, safe investments. This is the most common type of investment fund for most nonprofits, composed of operating funds and reserves. In order to be assured that the funds will be available as needed, the investment choice must be readily available. The recent financial news has even raised red flags about some short-term investments – see my earlier post It’s 10 AM, do you know where your cash is?.

• Risk Tolerance – One of the fundamentals of investing is the balance of risk versus return. Investments with a higher return almost always also come with higher risk. The key question for nonprofit leaders and boards is to understand how much risk is involved and to decide if they can accept the risk. As an example, if the funds to be invested represent the balance of a large program grant that will be spent over the next year, then the organization can’t afford to risk the loss of any of the funds. A permanent endowment fund, on the other hand, is usually invested in a diverse portfolio that includes more risk in return for a higher long-term return.

• Responsibility – The nonprofit’s board of directors is responsible for overseeing this balance of risk and return for the health of the organization and any legal requirements. In order to fulfill this responsibility the board must act as prudent and loyal stewards of the organization’s assets. The board may decide to employ professional staff or outside advisers to manage the investments if the amount if large enough.  At minimum, the board needs to adopt and follow an investment policy. I highly recommend a booklet from BoardSource, Minding the Money: An Investment Guide for Nonprofit Board Members.

In this economic environment, every nonprofit needs to take a look at their investments and understand any risks that may have been taken for granted. It’s better to spend some time now and avoid surprises later.

It seems that every article includes a comment by either the director or board chair that identifies the current economic downturn as the cause of the financial problems. The next time you read something similar, consider the possibility that, in some cases, “it’s the economy” might be a masking a different story.

By doing a little financial detective work, I’ve found that some of the nonprofits that identify the current economy as their problem have actually been operating with deficits for several years. They spend more than they bring in – and eventually it catches up with them. Checking this out requires a few steps. Access to IRS 990s on Guidestar is a gift for this kind of research. Page 1 (Part I) of the 990 reports all income and expenses and the resulting surplus or deficit. Because this section consolidates all unrestricted, restricted, capital, and endowment activity, though, it isn’t helpful in reporting the operating results. Page ahead to Part IV, the balance sheet, and look at Line 67 – Unrestricted Net Assets. If the organization had an operating surplus, this balance will increase from the beginning to the end of the year. If they had an operating deficit, then the balance will decrease.

There are a wide range of reasons and circumstances that result in operating deficits. Recurring and unmanaged operating deficits are the number one red flag of financial problems and raise questions about ongoing viability. If deficits recur, the management and board must take the time to understand the causes and make needed changes in income and expenses. Raising money is challenging in every economic environment, especially during a downturn. Make sure you can distinguish between the economic, management, and program considerations that result in deficits and take the steps needed to address each one.

Jeanne Bell at CompassPoint wrote a wonderful column about surplus and deficit planning, Nonprofit Budgets Have to Balance: False!. She asks strategic questions about budgets:

Instead of “How can we make the budget balance?” the annual budgeting cycle should begin with the question, “What financial outcome does our organization want or need this year?”

I can’t think of a single nonprofit that would answer that question by saying, “Our desired financial outcome is to run out of money and close our doors.”

This complex balancing act between supporting and governing is discussed in the article Why Boards Don’t Govern available from CompassPoint. One point raised in this article is the importance of creating an atmosphere and culture at board meetings that encourages questions and disagreements. I know in financial matters, many board members feel like second-class citizens because they are not the “financial” board members. The fact is that if they have a question, or if something doesn’t make sense, they need to feel free and encouraged to ask the question. It just might be the question to unlocks the truth.

There was no telling what people might find out once they felt free to ask whatever questions they wanted to. (Joseph Heller, Catch 22).