Questions every not-for-profit board should ask about the finances

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The COVID-19 crisis highlighted the importance of financial literacy in not-for-profit organisations. When the whole board has a sound understanding of how the finances work, the organisation is well equipped to promote and fulfil its mission, regardless of external events and global economic conditions.

This help sheet arose from a webinar held on August 3, 2020, in which Our Community staff Lisa Jennings (executive director of learning and education, ICDA) and Michelle Eddy (director of finance, Our Community) gave a general presentation and then answered questions posed by webinar attendees from across Australia.

Finance
The webinar, Questions your Not-for-Profit should be asking about finances, was run during Not-for-Profit Finance Week.

You can watch a recording of the webinar here.

In the 45-minute webinar recording – and in this accompanying help sheet – you’ll learn:

  • The questions you should be asking and the reports you should be seeing
  • How to read, understand and act upon financial papers
  • How to build financial matters into decision-making processes.

This help sheet provides responses to questions and comments that arose during the webinar but were not addressed live because of time constraints.

1. Where does depreciation of assets come in?
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Rather than immediately expensing the cost of the asset in the profit and loss statement, generally the cost of the asset is added to the balance sheet, represented as a non-current asset. This is to reflect that the asset will be held and used over a number of periods, not just the current period in which it was purchased.

We use depreciation to expense the cost of the asset over its useful life, which in turn decreases the value of the asset on the balance sheet. This spreads the cost over a number of profit and loss periods and provides a more realistic view of the profit/loss during the periods in which the asset is used in the organisation.

2. Cash flow statements are usually done by audit on an annual basis. Is that sufficient or should they be prepared, say, quarterly?
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It really is dependent on the size and needs of your organisation and what the users require. That said, and especially in the COVID-19 climate, cash flow is very important and can make or break an organisation.

The cash flow statement helps us understand how operations are running by showing where money is coming from and how it is being spent. It is an important report that helps to determine the liquidity of the organisation (its ability to meet its short-term obligations).

Preparing a cash flow statement quarterly would be very helpful in enabling management and the board to make better decisions and to spot any downward trends such as declining cash flow from operating activities, and whether there is enough cash to fund operating expenses and debts. I personally think it should be done at least quarterly, but it is entirely up to the board and management and how often they wish to review the cash flow statement.

3. Benchmarking your finances against those of other organisations in the same sector can be an important tool for boards, but how do you get that information?
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Check out these resources used for benchmarking:

4. Can you be more specific about how to record grant monies?
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As per the AASB standards for NFPs, “Revenue from grants and donations will be recognised where any associated performance obligation to provide goods or services is satisfied, and not immediately upon receipt.”

How it is recorded, then, depends on what the grant will be spent on. If it will be spent on a recognisable asset (such as construction of a building), then the grant received should initially be recognised as a liability rather than income. The liability is then recognised as income when the entity satisfies its obligation to construct the building (or purchase the asset).

If the grant is spent on something that will not be recognised as an asset (e.g. a grant for research), then the grant should be immediately recognised as income and not as a liability.

5. Why are huge accrued expenses considered a red flag on the balance sheet? What can be considered “huge”?
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Accrued expenses are future amounts the organisation will be required to pay for goods and services that have already been delivered but have not yet been paid or invoiced for; e.g. where wages or utilities have been used for the month, but the payment has not been made or invoice hasn’t been received by the end of the period.

These expenses are current liabilities, meaning they will need to be paid in the short-term, so the consideration here comes back to cash flow requirements. I can’t really attach an amount to what is considered “huge” as this will vary depending on the size of entity. However, organisations need to ensure they will have sufficient cash flow to cover any accrued expenses, which are often looked over or “forgotten” in favour of trade creditors.

6. Should a bank loan should be broken up into current and non-current liabilities for reporting purposes?
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Yes, there should be a portion classified as “current”. If the bank loan is due within the next 12 months then the whole amount would be considered a current liability. However, if the loan was due in, say, three years, only the instalments or principal portion that is due within the next 12 months would be classified as a current liability and the remaining would be considered a non-current liability.

7. Because our organisation is small and we have a largely positive cash flow, we usually budget for the year and not month by month, so we compare actuals to last year and what portion of the budget is used. Do you think we need to change this practice?
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I always say “If it ain’t broke, don’t fix it.” However, in these unusual times, if your cash flow has changed, then perhaps your board needs to collectively make a decision on whether they would like more frequent reports.

Monthly budgets are good to pick up on expected or planned income/expense variations that might get missed if you’re only looking at the annual figure. For example, if you receive a certain payment every year in March, you could have this as an income line item in the budget for March. When reviewing the budget compared with actuals, if you see that this expected amount was not received, you can look into it straight away and hopefully get it resolved and paid in the next month rather than waiting to analyse the variance at the end of the year.

Budgeting monthly can also be more helpful if your organisation has busy and slow months/seasons. Because income and expenses may not be consistent each month, you can budget in expected higher costs during busier seasons and lower costs during quieter months, which may help you to identify areas for costs savings – i.e. budgeting for lower direct costs in quieter months so that you have room to move in busier months.

8. Can you point to sections of the Corporations Act or the ACNC standards that show that management are compelled to provide finance information to the board and not be lacklustre in providing information, especially finance information?
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I think I can see where you’re going with this, but you need to remember that the board employs the CEO (or manager, administrator etc), and one of the main tasks of the CEO is to oversee the provision of adequate financial reporting to the board.

So, it’s not a matter of “throwing the book” at the CEO (from the Corporations Act or ACNC or anywhere else) – this may just lead to squabbling about what is “adequate” and what is “lacklustre” reporting. The fact is the board must receive the information it needs from management to be able to make good financial decisions and steer the organisation successfully. If the board as a whole is not happy with the standard of the financial reports it is receiving, it needs to take the steps required to ensure that it does. Different boards will require different levels of detail. For the board to get what it needs, it may need to manage the CEO’s performance, or even let them go if they refuse to comply.

This is important, because it’s the board that is most likely going to end up in court if things go wrong, not the staff (unless it can be proved that the staff members are acting fraudulently). Remember: the buck stops with the board.

9. Equity equals assets minus liabilities plus retained equity – is that correct?
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Equity includes retained profits/earnings and can also include reserves (asset revaluations) and capital injections from members.

Your statement is almost correct in that equity does equal assets minus liabilities. However, retained profits (opening balance plus or minus the current year net profit/loss) form part of the equity of the organisation.

10. If our organisation has revenue only from grants, can we ever generate an operating profit?
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If the only revenue your organisation receives is from grants, you are operating under a defined budget, and will need to acquit the funding you have received in the way that you said you would in your grant application. If you have money left over, you will temporarily see that you have an operating “profit”, but that shouldn’t last long. You will need to contact your funder, and make arrangements either to pay the money back, or to find another creative way to use the money which still meets the guidelines of the original grant or funder, with their agreement.

Just a note here – if your only funding is from grants, I suggest you should be looking very seriously at trying to diversify and seeking funding from areas, such as sponsorships, donations, crowdfunding, memberships/alumni, special events or sales. This will ensure you will still be able to survive if the grants dry up.

11. What responsibility do board members have if they are hanging on and don't have the ability to read and don't want to do further training?
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As per the webinar, the legal duties of a board member are:

  • Duty to act bona fide in the best interests of the company
  • Duty to exercise powers for proper purposes
  • Duty to retain discretion
  • Duty to avoid conflict of interest
  • Duty to avoid improper use of position in the company
  • Duty to use of confidential information appropriately
  • Duty to avoid related-party transactions
  • Duty to understand requirements around payments to directors
  • Duty of care, skill and diligence
  • Duty to prevent insolvent trading.

If a board member is refusing to engage with the finances, they are clearly in breach of a number of those duties. They are liable for any financial (or other) decisions the board makes, whether they contribute or not. A reminder of that is sometimes enough for recalcitrants. ICDA has a really useful set of help sheets which could help you here:

Overview of your board responsibilities
https://communitydirectors.com.au/help-sheets/overview-of-your-board-responsibilities

Overview of your financial obligations
https://communitydirectors.com.au/help-sheets/overview-of-your-financial-obligations

Dealing with difficult board members
https://communitydirectors.com.au/help-sheets/dealing-with-difficult-board-members

The main point of difference between the profit and loss statement and cash flow statement is that the cash flow statement captures all cash inflows and outflows, which can include things that won’t be shown in your profit and loss, such as loan repayments, or asset purchases (which are generally a balance sheet item and then depreciated). Similarly, the profit and loss statement can capture income and expenses that are non-cash movements, such as donations in kind or leave accruals, or there might be timing differences between when the cash is paid and when it is recognised in the profit and loss. For example, a supplier invoice dated 29 June 2020 but paid when due on 29 July 2020 will be included as an expense in the June 2020 profit and loss statement (and the supplier will appear as a creditor on the balance sheet), but it will not appear on the cash flow statement until July 2020.

Equity includes any profit reserves the organisation might have accumulated. At the end of the period, the net profit/loss is added/subtracted from the opening reserve balance, leaving the closing balance of accumulated reserves.

13. Why is there a GST on funding amounts if you're a NFP?
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If your NFP has a turnover of more than $150,000 per annum you are required to register for GST, and may then be required to pay GST on the funding you receive. The ATO provides a very useful summary of this, with case studies: https://www.ato.gov.au/non-profit/your-organisation/gst/grants-and-sponsorship/

14. How can an external auditor help the board in understanding the financials? This might be a good independent source of information and feedback.
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Yes – agreed. Depending on the size of your organisation, you may or may not be required to undertake an external audit by law (check with your regulator here). However, it’s a good idea for smaller organisations to do this every so often if they can afford it, even if they are not legally required to. Auditors look through in-depth accounting information in order to ensure that the reporting is a true representation of an organisation’s financial position, and can help assess risk. They can also help board members spot potential internal oversight or unethical behaviour.

15. When receiving donations via PayPal etc should I record net proceeds, or gross payment and fees?
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I suggest recording the gross amount as income and the fees as an expense to arrive at the net amount banked, as this is the actual transaction that is occurring.

16. Is JobKeeper a grant? How should it be recorded in the financial statements?
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Yes, JobKeeper payments are considered government grants, and such payments should be recorded as “other income” in the financial statements.

If your entity is required to prepare general purpose financial reports, please note that there are certain income recognition timing considerations to be aware of, dependant on whether your entity is for-profit or not-for-profit: https://www.ato.gov.au/General/JobKeeper-Payment/Not-for-profits-and-charities/

17. Charities coming in for criticism are challenged that they should use reserves before campaigning; often these funds are tagged- What is the best way of showing /demonstrating this to the satisfaction of donors?
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Usually charities will use notes in their financial statements to provide justification for their levels of reserves and what they consider to be an appropriate level of reserves.

The statement of changes in equity shows the movement in retained earnings, and funders can review this to determine whether the closing balance of reserves is in line with the charity’s justification.

Charities should retain an appropriate level of reserves for a “rainy day”, and to enable them to carry out their strategic plan (in line with their purpose), and to ensure their financial stability.

When campaigning, a charity should make it clear to funders that any profits will be (and must be) used in the pursuit of the purpose of the charity. This might entail adding to the reserves in order to maintain financial stability and carry out strategic plans. Knowing that the charity has purpose, not profit, at the forefront of its mind may help to put funders’ minds at ease.

More information
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For even more questions and answers about the finances, download our free guide: Damn Good Advice for Board Members: Twenty-five questions a not-for-profit board member needs to ask about the finances.

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