Balancing the Mission Checkbook

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.

But what if your nonprofit doesn’t have audited financial reports? Does this item listed in the grant proposal form mean that you should rush out and hire an audit firm – or that without an audit you’ll never get a grant? Probably not – but you should understand what an audit is, why the foundation includes this on the checklist, and what alternatives you have. I’ve been asked this question many times by both nonprofit directors and foundation program officers. The short answer is this – no, you don’t have to have an audit for the majority of grant applications. Most foundations do not want to require a small nonprofit to spend $5,000 or more for an audit just to apply for a grant. In some cases, the cost of the audit would actually exceed the amount of the grant! Requirements for nonprofit audits depend on how funds are raised and various state and federal grant requirements, but the threshold for most nonprofits defined by the Attorney General in Minnesota is $350,000 in income. What the foundation really wants – and needs – is financial information that they can rely on. An audit is the ideal, but there are alternatives.

It’s helpful to first understand what a financial audit is – and what it isn’t. An audit report is a financial report prepared according to accounting standards and an accompanying opinion of a CPA that they have reviewed and tested the information and determined that it is accurate. This is called a “clean” opinion. The reason that funders like to see audits is because of this opinion about the accuracy of financial reports. It’s important to understand that the audit is completed using the financial reports prepared by the organization, not by the auditor. (In fact, the auditor cannot prepare the financial reports and then turn around and issue an opinion letter about them.) An audit is not an assessment by a CPA that the nonprofit is in a good financial position. Making that assessment is up to the organization’s staff and board and any outside users of the financial reports.

So without an audit, how can you provide accurate and reliable financial information that is acceptable to a current or potential funder? Go back to the description of what an audit is: a financial report prepared according to accounting standards. Without an audit you won’t have an opinion letter, but you can provide an accurate year end financial report including an income statement and a balance sheet. In order to do this, the financial manager or treasurer will have to prepare a “final” financial report for the year and have it available in a standard accounting format. It’s great if you create a PDF version that can serve as the definitive version. Along with this report, send your IRS 990 form to demonstrate that you have complied with the requirements for reporting and accountability. The 990 should be accurate, the information reported should agree with the financial report, and it should be timely. The executive director and development staff person or volunteer should be able to read and discuss both of these reports at a site visit or phone call.

I recommend an article in the current issue of Nonprofit Quarterly, “Absent the Audit: How Small Nonprofits Can Demonstrate Accountability Without One”, by Jeanne Bell and Steve Zimmerman. The authors suggest that there are three key functions of an audit for a small nonprofit: generating donor and constituent confidence, ensure compliance with accounting standards, and prevent or catch fraud. They propose a number of ways that small nonprofits can fulfill these same functions with a printed annual report, open communication of a summary version of year end results and the annual budget, and a timely, correctly prepared IRS 990. The article also includes some good advice about using a board treasurer or volunteer to help assure accurate reports and the importance of internal controls for any sized nonprofit.

How important are financial ratios? I’ve had several very lively discussions recently about the value of using financial measurements, specifically ratios, to assess the financial health of nonprofit organizations. The appeal of ratios is that they are so tangible and certain, which makes them seem very reliable - especially compared to attempts to evaluate management strength or program effectiveness.

I will confess that I’m a finance person and I love financial analysis the way other people love mystery novels – I can follow the clues and tell a story from the numbers. So I’m surprised that I find myself in these discussions taking the devil’s advocate role that ratios are valuable only at certain times and with a lot of conditions. Used as a generic measure, ratios can potentially even mislead. To prove my case, consider the value of the “program service ratio” in evaluating nonprofits. This is the percentage of total expenses that are spent on program services rather than general and administrative and fundraising. Whenever someone attempts to impose a standard ratio that all nonprofits should use, we all bray about how different organizations are depending on their size, years of operation, field of service, client base, etc, etc. I agree with all of those arguments against a single standard and use the same reasoning to argue that ratios are valuable only when used in the right context and with the right information.

The first law of quality financial analysis – always use the right comparative information. Financial information by itself is just a list of numbers on paper. The understanding comes when it is compared – to the budget, the previous year’s reports, a set of goals, a peer organization or industry averages. Ratio analysis follows the same law. Yes, you should calculate ratios to analyze financial information, but then the ratios must be used with the right comparative information. There is no single “current ratio” for all nonprofits, but there is probably a good one for your nonprofit. A small nonprofit with few bills can have a strong current ratio compared to a larger organization with a larger budget, but that doesn’t tell us that one organization is in better financial shape.

After making an argument about the shortcomings of ratios, let me switch sides and offer a resource for ratio calculations.  Analyzing Financial Information Using Ratios has just been posted on our website as part of our Financial Management Resources. It includes an overview of ratios, definitions and descriptions and an excel worksheet for the calculations.

When I argue that ratio analysis is not a complete and reliable method to assess financial health, I have to offer some alternatives. How can we assess nonprofit financial health? What IS financial health? In a word, financial health is stability - the confidence that the organization will be able to serve its community and clients in the future. I can think of only three universal signs of stability that can apply to all nonprofits: reliable revenue, managed expenses and adequate cash. Pretty simple, and even these have to be understood in the context of the organization. Measuring and assessing these three components can take the form of ratios, trend analysis, comparisons with peers, budgets, plans or history. They are the fundamental financial levers that build stable operations. If you are interested in going through an in-depth analysis of your organization’s financial picture, with an emphasis on the types and reliability of income, consider attending Minnesota Council of Nonprofits’ workshop: Planning for Financial Sustainability on May 8th.