In addition to the notes from the Jossey-Bass Handbook, you should familiarize yourself with the resources provided by the Nonprofit Assistance Fund (https://nonprofitsassistancefund.org/resources/tools). Throughout your career, you will find them the go-to organization if you have questions about financial issues.
Ch. 19 Accounting and Financial Management, Robert Anthony & David Young
There are two types of accounting—financial accounting (provides information to outside parties and is subject to outside audit) & managerial accounting (provides information to an organization’s managers and is normally not shared outside the organization). This chapter focuses on financial accounting; the next one focuses on managerial accounting. Read this chapter slowly! There is nothing magical or particularly difficult about accounting—the math is simple algebra, the chapter does a good job of expressing the terms in common English. But for most of you this is a new and different way of thinking (double-entry bookkeeping and accrual accounting are not the way you manage your personal checkbook). You will not “get it” from a quick skimming of the chapter; but you can get it from a careful reading and re-reading (and my notes should help).
i. Assets & liabilities are reported as with for-profits; but “equity” is treated differently because there are no investors (stockholders)
ii. “Retained earnings” are called “net assets” or “fund balance” and are comparable to “operating capital” in the private sector.
iii. Contributions are called “endowment” if cash or cash equivalent, or “contributed plant” if tangible property.
iv. Contributed capital should be accounted for separately from operating capital.
i. By the accrual concept, revenue is recorded when it is earned and expenses when they are incurred.
ii. Actual collection of revenue may come months later (in the meantime, the revenue is considered “accounts receivable”)
iii. Actual expenses may not be paid until months later (in the meantime, the expense is considered “accounts payable”)
i. Sales revenue
ii. Membership fees
iii. Pledges—counted as revenue in the year to which the pledged contribution applies
iv. Operating contributions—when an event has both revenue and expenses, both should be reported in the same accounting period (they should be “matched”). Advance payments should be reported as a liability on the balance sheet and labeled “unearned revenue.”
v. Endowment earnings: Many nonprofits calculate endowment earnings on a “spending rate” basis, rather than reporting actual earnings as operating income. In this approach, a fixed rate (usually 5 percent) is recognized as revenue for operation purposes, because:
1. Dividends on common stock do not reflect real earnings
2. Part of the increase in the value of an endowment should be returned to the principal, since the purchasing power of an endowment is eroded by inflation (a $1,000,000 endowment will purchase less in 10 years than it does today).
3. A fixed rate of revenue provides a more predictable flow for managerial purposes.
i. Recognize four basic terms which describe different stages in the withdrawal of equity in accrual accounting (in cash accounting—sometimes called “checkbook accounting—change in equity occurs when disbursement is made; this does not conform to GAAP, but is sometimes used by smaller organizations):
1. Encumbrance—an obligation is incurred (e.g., an order is placed)
2. Expenditure—good or services are received (inventory increases; accounts payable increases)
3. Expense—resource is consumed (inventory is decreased; equity is decreased). For personnel costs, expenditure and expense are simultaneous, but not for long-lived assets and inventory.
4. Disbursement—cash paid out (cash decreases; accounts payable decreases)
iii. Long-lived assets & depreciation: If expense for long-lived item is recorded at purchase, net income will not be measured correctly. Instead, expense should be spread over the anticipated life of the purchase (“depreciation”).
iv. Debt service: Interest is an expense of the period in which it is paid. Technically, principal repayment is not. However, if depreciation is not booked, booking the entire debt service payment could have roughly the same effect.
v. Contributed services: Ordinarily, volunteer time is not entered as either a revenue or an expense. However, by the “rule of reprimand,” if management has control over the activities of the volunteer that time can be booked at the going wage rate.
vi. Fringe benefits: Pension, health care, leave pay, holiday pay should all be charged, even if the actual disbursement will not be made until many years in the future. This is often overlooked in many accounting systems.
i. Operating Capital Maintenance:
1. If revenue is fixed, limit expenses to available revenue
2. My choose to retain some net income
a. To recoup previous losses
b. To provide funds for expansion
c. To acquire or replace fixed assets
d. To create a reserve for contingencies
3. May choose to operate at a loss (use accumulated equity) to meet an unusual need
ii. Generational Equity: Each generation affected by an entity should provide enough revenue to meet the expenses of the service it uses from that entity.
i. Expenses on an operating statement may be classified by element (salaries, supplies, etc.) or by program.
ii. If program reporting is used, administration costs and fundraising should be a separate program items.
iii. If expenses are incurred jointly for two or more programs, the expense is allocated among the programs.
iv. If revenues can be identified with programs, they too may be classified by program.
i. Financial accounting focuses mainly on operating performance. Non-operating transactions are reported in separate funds.
1. Contributions for operating purposes are revenues.
2. Capital contributions are not revenue; they are direct additions to equity.
3. A capital contribution does not affect the measurement of net income as reported on the operating statement!
ii. Financial Statement (Balance Sheet) Presentation:
1. Assets = Liabilities + Equity
2. Each fund is usually reported as a separate column on the balance sheet
3. Operating fund is sometimes called “general fund” or “current fund”
4. By definition, revenues, expenses, and net income apply only to operations, so there is no operating statement for endowment or plant funds.
5. “Statement of Changes in Fund Balance” is a summary of the flows through the various funds
iii. Endowment Fund
1. Legal endowment: Gift permanently restricted so only investment income can be used for operations
2. Board-designated endowment: Gifts not restricted, but designated by Board for investment rather than operations (Board may reverse this decision at a later time).
iv. Plant Fund
1. Donated assets are recorded at fair market value at the time received; subsequent increase in market value is not reflected in accounts.
2. Depreciable assets should be depreciated
v. Other types of funds
1. Restricted operating funds: grants & contracts, etc.
2. Other nonoperating funds: loan fund, pension fund (required by law if self-funded), sinking fund, etc.
1. “Funding depreciation”—transferring cash from operating fund to plant fund to offset depreciation
i. Revenues increase operating equity, and expenses decrease it. Both should be reported in the accounted period to which they are related, in accordance with the realization and matching concepts.
ii. Contributed capital is added directly to equity, and is accounted for separately from operating transactions
i. The asset side of the balance sheet contains those items that an organization owns; the liability and equity side shows how the assets have been financed.
ii. The Operating Statement (Balance Sheet) shows an organization’s profitability (excess of revenues over expenses); Statement of Cash Flow shows how the organization has managed its cash—whether it has acquired more fixed assets or more current assets, and how they were financed.
i. Profitability Ratios
1. Profit Margin = Net Income/Revenue (How much of each dollar in revenue received get turned into net income)
2. Return on Assests (ROA) = Net Income/Total Assets (How much the value of assets increases--should be at least as high as the inflation rate)
3. Return on Equity (ROE) = Net Income/Total Equity [Fund Balance] (useful for investors; not used much for nonprofits)
ii. Liquidity Ratios (ability to convert noncash assets into cash)
1. Current Ratio = Current Assets/Current Liabilities (varies, but should be at least 2.0)
2. Quick Ratio = (Cash + Marketable Securities + Net Accounts Receivable) / Current Liabilities (eliminates inventory, prepaid expenses and other items not readily converted into cash; answers the question of whether you could pay all debts if called in today; sometimes called the “acid test.”)
3. Average Days Receivable = Net Accounts Receivable / (Revenue/365) (average number of days needed to collect an account receivable)
4. Average Days Inventory = Inventory / (Cost of Goods Sold/365) (average number of days that inventory remains on hand before being sold; if no inventory is held, use supply income—total expenses less salaries & depreciation)
iii. Asset Management Ratios
1. Asset Turnover = Revenue / Total Assets (how much revenue is earned for each dollar invested in assets)
2. Fixed-Asset Turnover = Revenue / Total Fixed Assets (used for capital-intensive organizations, assesses relative productivity of plant & equipment)
iv. Long-Term Solvency Ratios
1. Debt-Equity Ratio = Total Liabilities / Equity [Fund Balance] (measures use of external funds to supplemental internal funds
2. Leverage = Total Assets / Equity [Fund Balance] (variation on debt/equity ratio)
3. Long-Term Debt-Equity = Noncurrent Liabilities / Equity [Fund Balance] (over time, will reveal reliance on long-term debt to finance asset acquisition)
4. Debt Service Coverage = (Net Income + Depreciation + Interest Payments) / (Principal Payments + Interest Payments) (measures ability to meet debt service obligation)
i. Industry Standards
ii. Historical Standards
iii. Managerial Standards
i. Accounting Issues—some accounts depend on estimation rather than actual values. These should be listed in the “notes to the financial statement,” along with any extraordinary items (unusual or nonrecurring financial events)
1. bad debts
2. inventory (obsolescence, spoilage, shrinkage and accounting convention—LIFO vs. FIFO—can lead to overestimation of value)
3. accumulated depreciation
ii. Financial Management Issues—accounting relates to validity or accuracy of the figures in a financial statement; financial management focuses on the meaning of those figures.
i. Principle of “OPM” (Other People’s Money)—Leverage allows an organization to finance more assets than would be possible if it relied only on its own equity. In turn, this allows it to deliver more services (and earn more revenue).
ii. Creates “financial risk”—exposure due to debt repayment demands (as opposed to “business risk,” which is uncertainty of annual cash flows.
i. In economics, in a purely competitive model excess profits entice new organizations to enter the market and increase the supply of goods and services until the price falls to an equilibrium point where all the players earn a normal profit (“excess profits” are said to be “squeezed out”).
1. In accounting, profits are operating resources used to finance asset acquisition.
2. Organizations could substitute long-term debt for surplus in acquiring assets, but only up to the point that the debt service obligations are about as great as the annual cash flow.
ii. Surplus and Growth
1. An organization experiencing growth in revenues requires increasing cash, whether or not it invests in new fixed assets.
2. Cash outflows that take place between acquisition of inventory and collection of accounts receivable must be financed somehow. Possibilities include:
b. Slowing growth
c. Shortening the collection period for accounts receivable
d. Shortening the inventory holding period
e. Extending the period for accounts payable
f. Generating new equity (through surplus or through donations)
iii. How Much Surplus Is Needed?
1. ROA or ROE?
a. ROE = ROA x Leverage (and ROA = Profit Margin x Asset Turnover)
b. By using leverage, an organization can transform a low ROA into a high ROE; but this is no guarantee that assets can be replaced as they wear out.
2. ROA needs to be at least as high as inflation, and higher if the organization needs to expand its asset base.
3. Further, the need for cash arises from three factors:
a. Profit margin
b. Changes in current assets (especially accounts receivable and inventory)
c. Changes in current liabilities (especially accounts payable)
i. Strategic Assessment
1. What are this organization’s critical success factors?
2. What are the important (and tricky) accounting issues for this organization?
ii. Accounting Issues
1. Identify relatively large numbers and consider whether change in accounting policies would affect them
2. Read the notes
3. Distinguish between book value and market value
iii. Financial Management Issues
a. How does this organization generate a profit?
b. How do the ratios compare to the conclusions from the strategic analysis?
c. Is the organization earning a sufficiently high return on assets to counteract inflation?
a. Is the organization generating cash from operations?
b. What are the sources of cash?
c. What is the “business risk”
3. Asset Management
a. How does the asset turnover compare to expectations?
b. How is the organization managing current assets?
4. Long-Term Solvency
a. How has this organization structured its debt?
b. How much leverage does this organization have?
c. What kind of debt service coverage does this organization have?
d. What does the environmental assessment indicate about the future for this organization?
© 2004 A.J.Filipovitch
Revised 28 July 2004