Balancing the Mission Checkbook

How do you know what you don’t know? Someone asked this question last week in a workshop on the topic of board oversight and some high-profile problems. It’s such a great and critical question. There’s been a swirl of conversations in the last week or so about financial problems and governance issues at a number of nonprofits, both local and national. No matter what the details are, questions have been raised in every situation about the board’s role – what did they know, when did they know it, and what did they do? But what’s the first step for the board, since they are relying on reports from the staff and have little or no access to the raw information. Boards that ask for lots of details are accused of micro-managing and not trusting the staff. So how do you know what you don’t know? There has to be a balancing act between accepting reports at face value and asking questions that go beyond the information presented. I think that there’s an art to asking good questions – my favorites generally start with either “Why…?” or “What if…?” (I actually have those two words up on the wall in my office). Speaking last night to a group of people who had recently joined boards of nonprofits, I suggested that asking questions is their primary job. It’s great if they get an answer that makes sense. However, the role of governing requires further action and follow up when the answer doesn’t make sense, or when the answer is “Don’t worry about it,” or “I’ll find out later.” The distinction between hyper-questioning and prudent questioning depends on circumstances, but in every one of these recent governance and financial situations there were some “why” questions that needed to be asked and then carried through.

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).

In the midst of the big fundraising season of the year, I’m wondering about how much nonprofits really want to be open and forthcoming about their financial information. With all the talk about accountability and transparency, I don’t see a lot of evidence of easily available, freely shared financial information from most nonprofits. While I realize that I have a unique (and probably unusual) interest in financial information, I think that it’s important to walk the walk of transparency.

The Panel on the Nonprofit Sector, convened by Independent Sector, just released their report, Principles for Good Governance and Ethical Practice: A Guide for Charities and Foundations. The report lays out 33 practices “that should be considered by every charitable organization as a guide for strengthening its effectiveness and accountability.” Number seven on the list reads:

A charitable organization should make information about its operations, including its governance, finances, programs and activities, widely available to the public. Charitable organizations also should consider making information available on the methods they use to evaluate the outcomes of their work and sharing the results of those evaluations.

In the longer description of ways to implement this practice, the panel suggests an annual report and using websites to make available information such as the IRS 990 and other financial statements.

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. Many nonprofits already do this, but most do not. I checked the websites of six organizations in Minnesota that I have supported financially in the last few years. Of these six, one had their audit posted, three had a detailed annual report but no audit or 990, and two had no financial information that I could find. Why not post the audited financial report?

I recommend a look at the financial section from the website of The San Diego Lesbian, Gay, Bisexual, Transgender Community Center. In addition to posting their annual report and audit, The Center devotes a page to describing their financial management commitments and policies what a great a model of financial transparency.

In just a few days the comment period will end for the IRS proposed changes to Form 990. Since these proposed changes will impact every nonprofit organization that is required to file a 990 (nonprofits with revenues over $25,000) it will be worthwhile to pay attention to the comments and the IRS’ process for considering and responding to the input received. IRS hopes to have the changes finalized and a new 990 form in place for the 2008 tax year and they have a mountain of comments to digest if they want to stay on schedule. Many commentators, in fact, are urging the IRS to delay the implementation date of all or parts of the new form to allow time for more review and discussion of the impact of this major change. Comments are available for review on the IRS web site. Many state and national organizations have convened their members and constituents to analyze the draft and submit thorough comments, including Independent Sector and the National Council of Nonprofit Associations. Read these comment letters to get a sense of the analysis and feedback to the IRS.

Form 990 has not had a major overhaul in many years. The need for a change is widely accepted, and summarized well in the IRS background paper on the redesign: “The current 990 has not kept pace with changes in the sector and the law. Because of its history of ad hoc revisions, the current form neither adequately describes the filing organization nor provides a basis for comparing an organization with its peers.” The proposed redesigned Form 990 consists of a 10 page core form for all filers, and 15 separate schedules that will be required only of those nonprofits for which the information applies. This format will hopefully be much easier to read and keep related information together instead of scattered on different pages and schedules. It is very different, though, and will require learning a new structure and format.

The core form begins with a summary page with the organization’s mission and activities and several key points about activities, governance, and key financial information. While comments are generally positive about the summary page, there are concerns throughout the proposed form about questions that reach into what might be called best practices. Management and governance practices are developed to respond to an individual organization’s structure, community, financial situation, and activities and any simple yes and no questions can easily be misinterpreted without sufficient context. The comments reflect this concern over and over again, on questions about compensation, conflicts of interest, and audit committees.

The 15 proposed schedules range from supplemental financial information that will be required for most filers to schedules for tax-exempt bonds or foreign activities that would apply to a small percentage. There are several proposed schedules that will require new reporting for many organizations such as non-cash contributions and gaming and fundraising events. Some of these will necessitate additional recordkeeping and could be onerous. Hospitals have commented en masse requesting a delay of the implementation for a new schedule regarding community benefits and charity care.

I suggest you pay attention to this change as it goes through review and any further drafts or discussion. A clearer, more easily understood Form 990 will be good in the end, but will require much effort along the way.

We’re more than halfway through the year – how’s your budget holding up?

It’s pretty common to review the financial reports for the first six months of the year and notice some clear trends when you compare the actual results for income and expense lines to the budget. Differences between the plan and the results are to be expected, but if the variances are really large, it might be reason to consider a mid-year budget modification. At the very least, big variances are a signal that your process for developing the budget might need some improvement.

Variances from budget are normal, of course, since it’s unlikely that the staff or board of a nonprofit will know with certainty and within a few dollars what each income and expense item will be. Expenses are easier to predict since they are under management’s control (more or less). Income, on the other hand, is harder to predict since there are many different types of income and so many external factors. That is precisely why a good budget process is crucial.

Mid-way through the year is a good test of the reliability and value of the budget process that you use. Signs that you have problems with budgeting are: widespread and inconsistent variances; ignored or excused materials variances; accounting problems that don’t allow you to monitor actual compared to budget; or flawed significant assumptions.

One budget problem that can rear its head at this point in the year is when budgets for either grants or contributions were plugged in when the budget was created. It feels good in December when a balanced budget is approved, but it really hurts in July when you see that balanced budget evaporate because the numbers were made up.

If you look at the mid-year financial report and see big differences between budget and actual and you want to avoid repeating this problem next year, start thinking about how to get everyone committed to having a reliable, useful budget. Some of the reasons budgets fail are:

• Lack of support for the budget development
• Weak or undeveloped assumptions, especially for income items
• Lack of oversight of initial decisions and priorities
• No buy-in from program staff who will be responsible for the budget
• No input from development staff about realistic fundraising goals
• Starting at the last minute and rushing to get the budget completed
• Emphasis on minor details rather than macro factors (good numbers for telephone expense but no attention to changes in funder guidelines or contract terms)
• Lack of accountability

How do I develop a good budget? Just do the opposite of everything on the above list. Another resource is an article we wrote in the style of the troubleshooting guide at the back of your DVD manual – Troubleshooting Your Budget.

I’ve had several discussions lately with board members of nonprofits on financial management topics that had an odd, disconnected feel to them that I couldn’t pinpoint at the time. One was about operating reserves and how much was the ideal amount to have in reserve – 3 months, 6 months, or a full year’s expenses? Another was about how to determine the best mix of income sources for a nonprofit that has grants, government contracts, and fee income. In both conversations I asked the board members my favorite question: Why? This is a set up, of course, since I think that reasonable reserves are valuable to have, and that understanding the sources of income is a key to financial health. The “Why” question has to be asked when financial matters are considered without any connection to the nonprofits’ mission - that’s the disconnect. The purpose of these particular queries had more to do with creating a financial model and satisfying the board members’ perception of their role than with improving the nonprofit’s ability to serve its community. Finding the balance is very hard, though, and we have few guides.

Nonprofit Quarterly has been one of those guides recently with their spring issue titled “Revenue is Destiny”. I enjoyed reading a preview of the summer 2007 issue, especially this excerpt from an interview with Richard Brewster, executive director of the National Center on Nonprofit Enterprise. NCNE “helps nonprofits make wise economic decisions”.

NPQ: What should boards focus on if they are concerned about long-term sustainability?

RB: This may be counterintuitive, but the central question is the quality of the program. In other words, the worst threat to nonprofit sustainability is if your program is crap. A nonprofit’s only reason for keeping going is to change people’s lives, communities, the environment, and so on for the better. If a nonprofit is not making the biggest difference it can with the resources available, it is being wasteful. From an economist’s perspective, it is not putting its resources to best use and is inefficient. I’d find it odd to apply the word sustainable in any really meaningful way to such an organization.

I love the directness of this comment. Why should nonprofit directors and board members be concerned about their financial and economic condition? As a tool to deliver good programs to change communities and lives, both today and in the future.

If you’ve ever felt that your executive director, program managers, and board members just don’t “get it” when you talk about financial reports, maybe it’s because you gave them the wrong information. I don’t mean that you are using inaccurate financial reports, but that you may be providing the wrong information all together. There is no such thing as one size fits all in financial reports, but most of the advice and guidance on nonprofit financial reports cover the same generic materials – how to read a balance sheet, income statement and audit. Does this mean that reading a financial report is the best preparation for financial decisions? Is that what you need the executive director, program manager and board members to do – to understand how to read the report? Or do you need them to know how to use the information to develop plans, monitor progress and make decisions? If you want the latter, then you need to take a look at what financial information is provided and how it’s provided.

I think there are six distinct steps in using financial information well. Each step is necessary and follows a clear sequence.

1. Produce accurate reports
2. Understand the information
3. Analyze the information through variance review, comparisons and ratio analysis
4. Interpret the information in the context of the organization’s situation, plans and goals
5. Communicate the information
6. Use the information for decisions and planning

Think about how your organization uses financial information – most of us jump directly from step one to step six. Without discounting the importance of the first two steps (a big accomplishment for most small nonprofits), the analysis, interpretation and communication are essential for really wise decisions. So who should be responsible for these different parts of the process? Are you expecting your board members and program managers to complete their own analysis and interpretation? I shared this concept with a CFO the other day and he stopped suddenly and said “what you’re saying is there is a difference between data and information”. Yes – the financial staff should strive to provide valuable information, not just accurate data. Ideally, the financial staff is responsible for the first three steps, and the fourth and fifth are completed in coordination with management and program staff.

If you take the time to really evaluate how you provide and use financial information – and diagram these six steps – you can easily create a better process for providing exactly the financial information needed for the organization. For a longer article about how boards need to use financial information, read Reporting Financial Information to the Board from the Nonprofits Assistance Fund’s financial management resource library.