Nine Changes You Didn’t Expect for Your Nonprofit Financial Statements

July 2015: Catherine M. Pennington, MBA, CPA, CGMA; Renner and Company, CPA, P.C.

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It’s been over twenty years since we were introduced to temporarily and permanently restricted net assets. We’ve also gotten used to columnar formats on our statements of activities and a certain amount of freedom in determining the definition of “results from operations.”

I hope you aren’t too attached to these items because it may all change. The Financial Accounting Standards Board, FASB, has spent the past two years working on a variety of changes to nonprofit accounting and reporting. Their central mission was to improve the current net asset reporting requirements, address inconsistencies in establishing and reporting intermediate measures of operations, address inconsistencies in information reported about expenses, and clarify misunderstandings about the statement of cash flows, particularly operating cash flows.

The current status of the FASB project is an Exposure Draft, Not-For-Profit Entities (Topic 958) issued April 22, 2015 with comments due August 20, 2015. The implementation for these proposed changes is not scheduled for several years; however, the FASB wants practitioners and not-for-profit entities to spend that time working on the implementation of these changes.

Let’s take a look at what is proposed in the Exposure Draft.

Change #1 – Results from Operations

The Exposure Draft requires two intermediate measures (subtotals) of operations to be presented on the face of the statement of activities associated with changes in net assets without donor restrictions (we’ll talk about those next). These two measures are aimed at current operations from carrying out the entity’s mission. The difference between the two measures is that the second includes a new concept, internal transfers, from board designations, appropriations or other self-imposed limits on assets.

Change #2 – Dropping to Two Types of Net Assets

Classes of net assets will be reduced to two: those with donor restrictions and those without. We’ll no longer have to distinguish between temporary and permanent restrictions. Changes in net assets will be reported for these two classes of net assets as well as a total.

Change #3 – Indirect Method is No Longer an Option

Not-for-profit organizations will be required to present the statement of cash flows on the direct method of reporting.

Change #4 – Changes in Operating vs. Investing Cash Flows

Certain cash flows will be classified differently than they are currently classified. For example, cash flows from interest and dividends on investments are currently classified as operating cash flows but under the new guidance interest and dividends (other than from programmatic loans) will be classified as cash flows from investing.

Change #5 – More Information on Unrestricted, Designated Net Assets

The new proposed new standard requires additional disclosures on governing board designations, appropriations and similar transfers including imposition and removal of restrictions. These disclosures would include a description of the purpose, amounts, types of transfers, and qualitative and quantitative information about end-of-period balances of board designations of assets without donor restrictions.

Change #6 – New Disclosures on Liquidity

Additional disclosures will be required regarding the management of liquidity and quantitative as of the reporting date about financial assets available to meet near-term demands for cash including demands resulting from near-term financial liabilities.

Change #7 – A Statement of Functional Expenses Won’t be Required But…

Disclosure will also be required of the methods used to allocate costs among program and support function.

Change #8 – Investment Income and Expense Will be Shown Net

Investment income will be reported net of external and indirect internal investment expenses.

Change #9 – No More Allocation of Net Asset Releases Over Time

Not-for-profit organizations will be required to use the placed-in-service approach for reporting expirations of restrictions on gifts or cash or other assets used to acquire or construct a long-lived asset.

The comment period for this Exposure Draft expires August 20, 2015. If you are interested in these changes and how they will affect your organization or your clients, I recommend reading the actual document and considering a response to the Draft. The final Standard may differ from this Exposure Draft but we will learn more about it in the coming months.

Would You Drive Blindfolded?

February 2015; Joan M. Renner, CPA, CGMA; Renner and Company, CPA, P.C.

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Introduction

No one would ever drive blindfolded.  However, your organization’s internal financial statements may be leading you to do just that.  It’s a challenge to staff all the finance functions an organization needs on a limited budget.  Organizations may inadvertently squeeze out the important controllership function, leaving management and the Board with misleading internal financial statements.  Below we will explore some examples that illustrate why controllership matters and discuss some solutions for ensuring that you are leading your organization with timely and accurate financial information.

The challenge

In smaller associations and charities, especially those with a limited budget and staff size, a few individuals wear many hats.  One accountant is called upon to serve as both bookkeeper and controller and the CEO usually takes on the budgeting and reporting duties of a CFO.  When this happens, the important middle layer of the accounting function can get squeezed out—with unfortunate results.  Board members can be looking at financial statements with positive net income all year, only to see big adjustments when year-end reconciliations are done.

Accounting is like a layer cake

To understand why this happens, it helps to understand the three layers of accounting; operational, controllership and strategic.  In large organizations, these functions are performed by different individuals with different skills and compensation levels.  The finance office is staffed with full-time accountants at each functional layer, like a layer cake.  Smaller organizations can’t afford to pay for the whole cake, so they often opt for just buying one layer—basic accounting.

Operational accounting–recording transactions

Experienced operational accountants, or bookkeepers, accurately conduct and record basic transactions, paying the bills, depositing collections and handling payroll.  There are basic systems for these types of transactions; accounts payable, accounts receivable and payroll.  The systems record the transactions on the books as they are conducted, resulting in basic financial data.  At this point, the financial statements can be printed out, but they really only consist of raw data.

Controllership—making sure recorded balances are right

The mid level of accounting is controllership.  The controller looks at the raw accounting data that resulted from the system transactions, like paying bills, depositing income and paying payroll.  The controller uses personal initiative, skills and specialized accounting knowledge to review the accounts to see if they are accurate, and to see if they are recorded on the accrual basis in accordance with generally accepted accounting principles.  Most bookkeepers also do basic controllership such as performing bank reconciliations and making adjustments as needed.

Just what are reconciliations and adjustments?

The controller reviews recorded account balances for accuracy at month-end by preparing schedules, or workpapers, that support the accuracy of the material balance sheet accounts, and selected income and expense accounts.  Sometimes, recorded balances are compared to outside data such as a bank statement or line of credit balance.  This process of determining what the recorded ending balances should be is referred to as “reconciliation”.  Sometimes the controller finds that transactions need to be reclassified or that accruals or deferrals need to be recorded into, or reversed out of, the current period.  In that case, the controller makes an “adjustment” to the books.  Without these month-end reconciliations and adjustments, the Board could be looking at financial statements that are misleading.

Strategic accounting—using accounting data

At the top level of the finance function, the CFO, or CEO in smaller organizations, reviews actual amounts compared to budget, presents financial statements to the Board, recommends appropriate courses of action, and prepares next year’s budget.  For the accounting function to provide accurate financial information for management decisions and Board oversight and governance, the financial information must be reasonably accurate.  Without the controllership level making sure the financial statements are right, management and Board members can be steering the organization while blindfolded.

How bad could it be?

Here are some scenarios that can happen when the Board makes decisions based on raw financial data:

Unexpected expenses.  All year, an association’s statement of activities showed positive net income of $20,000.  This seemed to be a result of a profitable special event early in the year.  At year-end, it was discovered that a large hotel deposit made in the prior year for the special event, was still sitting on the balance sheet in prepaid expenses, and was never adjusted into special event expenses of the current year.  Once the $30,000 prepaid expense was adjusted to the current year, the association’s supposed net income turned into a net loss of $10,000.  Because the prepaid account was not reviewed and adjusted during the year, management and the Board were steering the association while blindfolded.

Disappearing income.  All year, a charity’s statement of activities showed positive net income of $20,000.  This seemed to be a result of good collections from corporate sponsors early in the year.  At year-end, it was discovered that three large corporate sponsor contributions had been recorded as receivables at the end of the prior year, and were still sitting on the balance sheet as accounts receivable.  When the sponsor money was collected in the current year, it was counted as income instead of relieving the receivables—effectively double counting the income.  Once the $30,000 of collections was taken out of current year income and applied against accounts receivable, the association’s supposed net income turned into a net loss of $10,000.  Because the accounts receivable account was not reviewed for accuracy during the year, management and the Board were steering the charity while blindfolded.

Floating income.  At year end, an organization’s statement of activities showed positive net income of $200,000.  This seemed to be a result of an increase in grant activity late in the year.  At year end, it was discovered that three large grant receipts were recorded as grant income when they were actually unspent advances of grant money to be used next year to pay allowable costs.  When the $300,000 of grant advances were taken out of current year grant income and recorded as deferred income, the organization’s supposed net income turned into a net loss of $100,000.  Because the deferred income account and the recorded grant income and expenses were not reviewed for accuracy during the year and adjusted properly, management and the Board were steering the organization while blindfolded.

What to do?

Nonprofit Execs and Board members should take steps to educate their fellow organization leaders about the nature and importance of controllership.  It’s difficult to convince Board members that controllership is needed unless you can explain clearly what it is and what it does.  The above scenarios can serve to illustrate that inadvertently skipping timely controllership has the unintended consequence of steering the organization while blindfolded.

Fortunately, organizations do not have to hire a separate full time employee for each layer of the accounting cake.  Part-time and outsourced controllership is available to make sure the organization’s books are reconciled and adjusted on a timely basis.  By engaging part-time help for the controllership function, the nonprofit effectively buys a slice of each layer of the cake in just the amount needed.

Conclusion

No one would drive blindfolded.  However, nonprofit Execs and Board members who make decisions based on raw financial data may be doing just that.  Without the important controllership function, internal financial statements can be misleading.  Fortunately, organizations can outsource controllership and get just the amount of services needed.  This will allow smart nonprofit leaders to take off their blindfolds and steer the organization with timely and accurate financial information.

©2015 Renner and Company, CPA, P.C., all rights reserved.

Anti-Fraud Controls

February 2015, Joan M. Renner, CPA, CGMA, Renner and Company, CPA, P.C.

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Introduction

An association loses $900k from unauthorized disbursements…a housing agency loses $30k from diverted income…another association loses $5 million in fake vendor scheme…  These news stories about nonprofits victimized by embezzlement are enough to cause a nonprofit Executive or Board member to lose sleep.  No nonprofit leader ever wants to read that their organization has become the next victim.   Sadly, the Association of Certified Fraud Examiners (ACFE) says the typical organization loses 5% of revenues each year to fraud.  If you’re a $1 million nonprofit, that’s an estimated $50,000 each year.  In its 2014 Report to the Nations, the ACFE used survey results to paint a clear picture of a typical fraud.

  • The median loss from a fraud is $145,000,
  • the fraud usually lasts 18 months,
  • it’s usually an embezzlement, and
  • the smallest organizations suffer disproportionately large losses from embezzlement.

The survey went on to state that having anti-fraud controls can reduce fraud losses and shorten fraud duration.  In this article, we will explore some recent frauds ripped from the headlines, and discuss steps you can take to develop the right anti-fraud controls for your organization.

Here are a few frauds where perpetrators exploited their job duties for personal gain:

$900k lost from unauthorized disbursements:  In November 2014, a former association CFO pleaded guilty to embezzling more than $928,000 from a San Francisco trade association from 2007 to 2014.

How did he do it?  The CFO used the access to the association’s bank accounts and books that his employer gave him.  As CFO, he had complete control over all aspects of the association’s finance function including keeping the books, authorizing payroll, and paying bills.  He wrote checks payable to himself and payable to “cash” totaling more than $550,000.  He made unauthorized purchases of more than $250,000 on the association’s credit cards, and he put an overpaid acquaintance on the payroll.

How did he conceal it?  He just omitted the fraudulent transactions from the books and the financial statements he sent to the Board.  He made false entries on the books to cover up his personal charges.

$30k lost from diverted income:  In December 2011, a former director of a nonprofit housing agency pleaded guilty to diverting more than $30,000 of rent money from tenants of the nonprofit into his own bank account during 2008 and 2009.

How did he do it?  The housing director used the access to tenant rent collections that his employer gave him.  As director of property management, he collected rent money from tenants, but instead of handing it in to the agency, he deposited it into his personal bank account.  He even moved an unauthorized tenant into a vacant unit and set up a post office box to collect that rent as well.

$5 million lost in fake vendor scheme:  In November 2013, a former administrative assistant pleaded guilty to embezzling more than $5 million from her association employer from 2005 through 2013.    

How did she do it?  The administrative assistant’s duties included processing vendor invoices, even approving some invoices.  In addition to the valid invoices she processed, she submitted false invoices from real organizations.  Because signed checks were returned to her after signing, the administrative assistant made sure that the checks from the fake invoices went to her own bank accounts that she had set up using names similar to the real vendors.

She also submitted invoices to the organization from her own business, called FCI, which did no work for the organization.  She left these payments off her budget reports.  FCI turned out to be the bridal shop she owned, Fabulous Concepts, Inc.

Eventually, after a call from the perpetrator’s bank, her employer discovered her fraud.  The association said they were “truly stunned” and referred to the perpetrator as a “long-time, trusted employee” who had “exploited every gap in their system” using “deception and coverup”.  The association further said they would “apply the lessons we have learned from this experienced, as well as share them with others in the nonprofit community.”

With headlines like these, nonprofit leaders know they can’t rely on good intentions to protect their organizations.  However, small organizations may not know how to address fraud risks with limited budgets and small staff size.  It is clear that nonprofit managers and Board members need to take action to get ahead of the curve with appropriate anti-fraud controls.

Developing Anti-Fraud Controls

Anti-fraud controls are procedures an organization implements to prevent or find and correct fraudulent transactions.  Anti-fraud procedures are not one-size-fits-all.  In designing the right policy, management and Board members must balance the cost and restrictions related to internal controls with the protection and accountability they offer.

Here are some concepts and steps that will help nonprofit managers and Board members design and evaluate anti-fraud procedures that are right for an organization:

  • Understand that anti-fraud controls are the responsibility of management and the Board.   It is their fiduciary duty to safeguard the assets of their organization.
  • Understand that anti-fraud controls may be more important in the nonprofit environment than they are in a Board member’s own business. Business owners may take risks with their own money, but in the nonprofit environment, the general public expects a high degree of accountability.
  • Make controls a Board priority. Some Boards dismiss anti-fraud procedures as unattainable or inefficient, presuming that organizations should just do the best they can when it comes to internal control. This approach can leave the organization open to fraud. Remember that all Boards are expected to carry out their fiduciary duty, even in situations where resources and/or staffing is limited.
  • Implement an annual assessment of anti-fraud controls. Management will inspect the organization’s transaction processes annually, identifying any new risks and updating anti-fraud controls. Read and update your policies and procedures document for each area such as disbursements, receipts and payroll. Ask “how could someone steal money in this area, and if they did, how would we find out?” Enlist the assistance of outside accountants to help with this review as needed. Management will report the results of this process to the Board.
  • Look for new ways of doing things that offer increased anti-fraud controls. For example, instead of allowing someone to pay bills electronically on a system that requires no further approval to release disbursements, switch to paying bills using an online banking platform that requires a second level of approval.
  • Small organizations may need to enlist Board members to help with anti-fraud controls. If a second employee is not available to review and approve a transaction, a Board member may need to step in to review and approve. Online processes make it easier to log in and oversee transactions.

With frauds like these in the headlines, nonprofit leaders are aware that no organization is immune.  Smaller organizations may not know how to address the risk of fraud given their limited resources.  Using the points above, nonprofit managers and Board members can develop anti-fraud controls that address fraud risks in a way that is best for the organization.

©2015 Renner and Company, CPA, P.C., all rights reserved.

 

Tax Extender Bill Renews Donors’ Charitable Rollovers from IRA Accounts – Through December 31, 2014.  

December 2014, Joan M. Renner, CPA and Hope Covington, CPA, Renner and Company, CPA, P.C.

There’s good news and then there’s bad news.

The good news is that the Tax Extender Bill is on the President’s desk and is expected to be signed any day. It renews the tax benefit allowing your donors to make a charitable contribution to your organization directly from their IRA accounts.  This is important news for charitable givers and charities alike.  The provision in the Bill is retroactive to transfers already made during 2014.

The bad news is that the provision expires, December 31, 2014.  It’s worth your while to be sure your donors know this benefit is available and what they can do to take advantage of it.

How Charitable IRA transfers work:
Most people know they can volunteer or write a check to the charities they wish to support, but they might not realize there is another way.  The Tax Extenders Bill extends the qualified charitable distribution provisions for 2014. This allows donors to donate directly from their IRAs to qualified charities. If you have donors who are age 70 ½, they are probably eligible for tax savings by donating to your charity directly from their IRAs.

How To Use This Information for Your Charity

Proactive Charities will want to get this information to their donor base and potential donors as soon as possible. The provision currently expires December 31, 2014, so don’t delay.

    • Review the information below and determine if you have contributors or potential contributors who are age 70 ½.
    • Educate your donors and potential donors about this tax benefit. Include it in a special appeal letter or notice. Suggest that they consult with their individual tax advisors regarding the tax benefit that may be available to them by making their contributions to your organization directly from their IRAs.
    • Encourage your donors and potential donors who wish to do so, to contact their IRA trustees and provide transfer instructions as described below.

The Basics: IRA Required Minimum Distribution

The IRS will not allow taxpayers to maintain retirement funds indefinitely. Once taxpayers reach age 70 ½ they must take required minimum distributions from their IRAs. You may have
donors that do not need these distributions, and do not want to increase their tax by taking them. There is no way around taking the distribution, but there is a way to avoid the tax.
Taxpayers who donate their distribution directly to a qualified charity may exclude the distribution from their income.

How Donors Benefit from Qualified Charitable Distributions

  1. The IRA distribution contributed to charity never hits taxable income. Required minimum distributions usually increase adjusted gross income, affecting taxable income in a number of ways. Higher income increases limits on itemized deductions. Higher income also raises the amount of social security benefits subject to tax. IRA distributions donated directly to charity are excluded from income. This results in a lower adjusted gross income, and possibly lower taxable social security benefits, and lower tax.
  2. The charitable donation income limits do not apply. Taxpayers are usually only allowed to deduct up to 50% of their adjusted gross income in charitable contributions. Donors who take taxable IRA distributions and then choose to make charitable contributions
    have to consider that those contributions are only deductible up to 50% of adjusted gross income. Donors who make their charitable contributions directly from their IRAs exclude the entire  contribution from tax.
  3. There’s no need to itemize deductions to benefit. Taxpayers can only receive a benefit from charitable contributions if they itemize their deductions on Schedule A of their individual returns. However, an amount donated directly from an IRA can be excluded from adjusted gross income. In this case, if the donor does not have enough deductions to qualify for itemized deductions, they still get a benefit without having to itemize.
  4. If an individual has an inherited IRA and they have reached age 70 ½ then they can still take qualified charitable distributions from the inherited IRA.

How Donors Can Maximize Contributions

A donor is allowed to exclude from gross income up to $100,000 for qualified charitable distributions made each year. Spouses may each contribute up to $100,000 for qualified charitable distributions from an IRA.   Therefore on a joint tax return there could be a total of $200,000 excluded from adjusted gross income. If donors also contribute additional amounts besides those distributed from their IRA, those additional amounts may be included on Schedule A of the 1040 as charitable contributions. The additional contributions may not exceed 50% of their adjusted gross income without considering the $100,000 allowed for IRA distributions. Therefore, on a joint return an individual may exclude $100,000 for each spouse from their adjusted gross income for IRA distributions and then also contribute to charity up to 50% of their adjusted gross income.

How to Donate

Donors should contact their IRA trustee and have them transfer the money directly to the charity.  The trustee can issue a check in the name of the charity and allow the donor to deliver it to the charity. The distribution cannot be made payable to the individual, it must go directly from the IRA trustee to the charity.

Tax Reporting

Donors will receive a Form 1099‐R from their IRA trustee for distributions made in 2014. Qualified Charitable Distributions will be included in total distributions but will be excluded from taxable distributions. “QCD” should be listed next to the taxable amount so that the IRS is aware there are amounts that were excluded from tax as a result of a charitable distribution deduction.

Taxpayers will report total IRA distributions on the first page of their individual returns where it says IRA distributions and the taxable portion will be listed on the next line. The taxable portion is the total amount of IRA distributions that were not donated to charity. The charity should provide a receipt to the donor. The donor must keep this receipt with his or her records to support the contribution.

Summary

If you have donors who are age 70 ½ they may be receiving required minimum distributions from an IRA. If they’re already contributing to your charity, it’s likely that you can save them some tax by suggesting that they make their donations directly from their IRA accounts. Proactive charities will want to get this information to their donor base and potential donors as soon as possible. Your donors will appreciate the information. The provision currently expires December 31, 2014, so don’t delay.

© 2014 Renner and Company, CPA, P.C. All Rights Reserved.

Alert To Virginia Corporations Regarding Solicitations

FROM “VIRGINIA COUNCIL FOR CORPORATIONS”
(11/25/2014)

The State Corporation Commission has received inquiries recently about unsolicited mailings directed to Virginia corporations from Virginia Council for Corporations, 7330 Staples Mill Road, #402, Richmond, VA 23228-4122. The Commission posted an alert in  December 2013 about similar solicitations to Virginia corporations from Corporate Records Service, whose Richmond, Virginia address is identical to the address for Virginia Council for Corporations.

The mailings from Virginia Council for Corporations include an official-looking document titled “2014 – Annual Records Solicitation Form” and instructions for completing the form. The Solicitation Form includes an offer from Virginia Council for Corporations to prepare “corporate consent records in lieu of meeting minutes” for a fee of $125. PLEASE BE ADVISED that the Solicitation Form is neither required by Virginia law nor authorized by the Commission, and it will not be accepted for filing with the SCC.

The Solicitation Form looks somewhat like the annual report form prescribed by the State Corporation Commission and mailed to corporations of record in the Clerk’s Office of the SCC. Some corporations have confused the Solicitation Form for the  Commission-prescribed annual report.

A search of the Commission’s business entity records in the Clerk’s Office revealed no information about a company with the name Virginia Council for Corporations.

Any corporation that has questions about the solicitation or form is encouraged to obtain advice from its lawyer or business advisor. Also, the Clerk’s Office can be contacted at (804) 371-9733 or 1-866-722-2551 (toll-free in Virginia) for information about corporate annual report and other business entity filing requirements under Virginia law.

 

Nonprofit Operating Reserves – Good Governance for Tough Times; Part II of III

/wp-content/uploads/2014/10/nonprof-op-reserves2.pdf” target=”_blank” rel=”noopener”>[1] concluded that your Operating Reserve target should be expressed as an Operating Reserves Ratio.    Your ratio can be either a percentage of annual expenses, or a number of months of expenses.  Your organization’s own potential emergency needs affect the percentage of annual budget or the number of months’ expenses you need in your Operating Reserve.

The Operating Reserve target is a minimum standard the organization should strive for to maintain its financial health.    There is no need to establish a maximum, as the other competing demands of the organization will preclude the temptation to overinflate the Operating Reserve.   The Better Business Bureau Wise Giving Alliance does recommend that no more than three time the past year’s expenses be maintained in all types of reserves, although their definition of reserves includes more than just the Operating Reserve.  For example, their definition includes opportunity reserves, to be used for new programs and building reserves for expansion of existing facilities.

The Nonprofit Operating Reserves Initiative Workgroup, which was comprised of a number of individuals with extensive experience in the nonprofit industry, recommended a minimum Operating Reserve of 25%, or three months of annual operating expenses, and this is in addition to any other types of reserves.

What Should Your Board Do?

Whatever your target, it must be approved by the organization’s Board.  In any nonprofit organization, it is the Board’s responsibility to monitor and evaluate the organization’s financial health, and management’s responsibility to implement policies to achieve the Board’s goals.  Establishment of the Operating Reserve target is a key step for the Board to take in ensuring the future financial health of the organization.

Operating Reserves should be governed by a comprehensive, Board-approved policy that includes criteria for spending the reserve.    If the policy requires Board approval for withdrawals, the Board must be prepared to meet quickly to authorize access to the Operating Reserve in an emergency.   The time needed for the Board to respond to an emergency may influence the size of the Operating Reserve target.

Another issue for the Board is implementing corrective action when the Reserve falls near or below the target level.   To do this, the Board needs to have regular status checks on the level of the Operating Reserve, and may want to develop a plan that can be quickly put into place should the need arise.

Next Steps With the guidance above, you should be able to help your organization identify the Operating Reserve target that is right for you, and help your Board approve an appropriate Operating Reserve policy.

In the final part of this series, I will address methods for funding the Operating Reserve and polices for governing the safeguarding and spending of an Operating Reserve.

© 2014 Renner and Company, CPA, P.C. all rights reserved.

 


[1] Nonprofit Operating Reserves Initiative Workgroup was established in 2008 to

examine the need for Operating Reserves within the nonprofit community.

The results of their work can be found at Operating Reserves White Paper 2009 PDF

Charitable Deduction Documentation Requirements – How to Help your Donors Get Their Deductions

/wp-content/uploads/2014/10/char-ded-req.pdf” target=”_blank” rel=”noopener”>

Nonprofit Operating Reserves – An Issue Whose Time is Now; Part I of III

Washington Monument March 2012, Catherine M. Pennington,
CPA, CGMA, Senior Manager, Renner and Company, CPA, P.C.
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Those of us who work in the nonprofit world know that our entities are very different from our for-profit brethren. Nonprofits focus on the mission, not the “bottom line.”   They are generally self-funded and normally have no owners to support the organization through tough times. While our mission is constant, our funding is not. This combination of factors leads us to examine the need for Reserves.

Reserves are often loosely defined, roughly calculated and frequently unfunded. They can be donor restricted, board designated or created by a windfall of funds left over from operations. In other words they are often unintentional, and not specifically created or defined.

In 2008, a group of associations, charities, charity rating agencies, and nonprofit professionals formed The Nonprofit Operating Reserves Initiative to address the need for Operating Reserves for all levels of nonprofit organizations. Their whitepaper, “Maintaining Nonprofit Operating Reserves, An Organizational Imperative for Nonprofit Financial Stability”, defined the concept of Operating Reserves and includes many of the concepts discussed here.

In a series of three articles, we will examine Nonprofit Operating Reserves.   This first article will focus on understanding of Nonprofit Operating Reserves and why they are necessary.   In the second article, we will address how to determine the amount of reserves that are necessary and, finally, we will discuss ways to fund Operating Reserves and develop policies governing their use. We hope that by the end of the third article, many more nonprofit organizations will be working to define and establish the Operating Reserves that will help support and sustain their mission.

Why Do We Need Reserves?

In 2011, the Nonprofit Finance Fund, a leading community development financial institution, researched the funding status of nonprofits and found that the majority are undercapitalized.   Their 2011 State of the Sector Survey found:

  • 60% had less than three months of cash available,
  • 28% reported that they had one month or less of operating cash,
  • 10% had no cash.

Without any available cash, nonprofit organizations may have serious difficulty meeting their normal working capital operating needs, much less weathering economic downturns.   In addition, they are often unable to take advantage of preferred pricing due to an inability to purchase supplies on a regular schedule.

This crisis in funding severely handicaps nonprofits in their ability to be effective in accomplishing their mission.     As an industry, we must recognize the need to create sustainability in our organizations and one way to do this is to create Operating Reserves.

Operating Reserves can be defined as the portion of unrestricted net assets that Boards designate for use in financial emergencies. It does no good, however, for these net assets to be invested in buildings, furniture and equipment.   Operating Reserves need to be funded in readily accessible cash.

Day to day working capital is not the same as Operating Reserves.   Working capital is used to meet your normal obligations through your operating cycle which is generally one year.   There are ups and downs to this cycle and working capital on hand must be sufficient to meet your organization’s needs during the lean parts of the cycle; not just the flush periods. Operating Reserves are emergency funds you hold in addition to your working capital.

Many charities with a traditional mindset accept their crisis in funding as status quo. Before dismissing the idea of Operating Reserves as a luxury item, consider how Operating Reserves would add to your ability to carry out your mission by:

  • Enabling continued operations during downturns,
  • Providing evidence that management is prudent, forward thinking and committed to reliable program delivery,
  • Making the organization more attractive to employees,
  • Adding flexibility to respond to both emergencies and opportunities,
  • Creating sustainability for members or clients.

This last point is probably the most important of all the reasons to have an Operating Reserve and is best illustrated through an example:

Let’s say a preschool/daycare center provides its services to low-income families and is largely funded through local government subsidies. A natural disaster occurs in the area and a number of the parents lose their jobs. Because they no longer have two working parents, the families are not eligible for the subsidies and must withdraw their children from the school. As enrollment falls, the school is no longer viable and closes. After a few months the local economy recovers and the parents can again find work, but are unable to find affordable child care because the school has closed.

In this instance an Operating Reserve may have enabled the school to sustain its mission by remaining open until the economy recovered.

Charity rating agencies understand that an organization with funds in reserve is better positioned to carry out its mission than an organization without reserves. Some charity rating agencies give higher marks to nonprofits that hold one to three years of expenses in reserve.

Associations, even those that hold long-term reserves, also need to consider the need for Operating Reserves. Unforeseen events can lead to meeting cancellations, cancellation penalties and loss of income. Long-term reserves may not have the liquidity to meet emergency needs. Associations need to hold a portion of their reserves in investments that can be accessed quickly without incurring capital losses and disrupting long-term asset allocations.

Next Steps

Now is a good time for forward thinking Board Members and nonprofit executives to begin discussing the Operating Reserve concept, and how it relates to the needs of their organization.

To read more about the Operating Reserves concept, access The Nonprofit Operating Reserves whitepaper at: http://www.nccs2.org/wiki/images/3/3c/OperatingReservesWhitePaper2009.pdf.

Summary

Operating Reserves are not a luxury but a necessary component of sustaining the mission of charities and associations alike. They are Board designated and separately funded with liquid assets and are held in addition to the organization’s normal working capital. Forward thinking Board Members and nonprofit execs should embrace the Operating Reserve concept and consider the advantages it would bring their organization. In the next newsletter I will discuss methods to determine an adequate amount of Operating Reserves.

 

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