Explain the Use of Strategic Management

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| Part V: Financial Performance Future and Prolog

Good organizations assess their performance periodically, typically at the end of the year or early the following year when data are due to be reported anyway. Even though a nonprofit corporation may not have to file a Form 990, if it is incorporated the state may require an annual report of some form as it does other corporations. These provide a basis of assessing performance. There are other bases as well, prin- cipally the organization’s financial statements. Part V is not only about using the fi- nancial statements for this assessment but for planning and forward-looking pur- poses. Given its obligations and objectives how much does the organization need, how much must it earn, what levels of expenditures can it afford, what are its endow- ment requirements?

Bryce, Herrington J.. Financial and Strategic Management for Nonprofit Organizations, Fourth Edition, Walter de Gruyter GmbH, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/ncent-ebooks/detail.action?docID=4810136. Created from ncent-ebooks on 2022-01-12 17:02:32.

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DOI 10.1515/9781501505713-018

Chapter 17 The Financial Performance and the Strength to Continue

This chapter is about the use of financial statements as a tool of management rather than on accounting rules, ratios and procedures. The first part of the chapter discusses the basic statements and how they are used. This is followed by mock dialogues (a board meeting) illustrating how these statements can be used by the manager to evalu- ate its asset and debt management, its revenue, expense and cash situation. This chap- ter is basic to all types of nonprofits—charities and associations alike. It is definitely not about calculating ratios. Calculating is not what managers do. But they must know what story steers them in the face.

What top managers learn to do is not to calculate numbers, but to be able to tell gather their essentials on sight. This doesn’t happen simple because one is smart or committed.

Here are some pointers: 1. Each financial statement tells a story 2. One does not have to be an accountant to get the story line 3. The story line is based on what has happened and allows an informed manager

to see what needs fixing, what resources are available, what resources are needed

4. The manager without this information is “managing” an organization he or she does not know

Financial Statements as An Aid to Management

Budgets are financial plans indicating the level at which the nonprofit plans to oper- ate, how its resources will be allocated among various programs within its mission, and from where those dollar resources are expected to come. Budgets have no legal force in nonprofit organizations and they are usually never audited.

This is not so with the other financial documents that will be studied in this chap- ter. These documents are audited, they have some legal force, and unlike the budget they are made up of actual numbers rather than projections or estimates and, if they are, the latter the method used as to be described and consistent with generally ac- ceptable accounting rules.

These documents have legal force in the sense that to propagate them knowing that the numbers are wrong is an act of misrepresentation with serious legal conse- quences; for example, if those figures are used to support financial transactions. It is

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528 | Chapter 17: The Financial Performance and the Strength to Continue

these financial statements, not the budget that creditors and donors to the organiza- tion often require. They are also often required by sponsors of programs. While spon- sors may ask for a budget of the program they expect to support, they usually also ask for a picture of the overall financial condition of the organization to be sure that they are not pouring their dollars into a sinking ship. These documents also give manage- ment an early warning of impending financial disaster and signal the possibilities of financial opportunities. Finally, they are the bases for annual financial reporting to governments and for evaluation by watchdog agencies. We begin with the balance sheet.

The details of financial statements differ among types of nonprofits and within any given type partly by the rules and partly by the kinds of transactions conducted. But the basics are roughly the same and generic. Hence, we use generic statements placing “what you should know” in the text and the discussion for your focus.

The Balance Sheet or Statement of Financial Position

The balance sheet (Table 17.1) is a statement of the financial position of the nonprofit on a given date, in this case, December 31, 2017. This balance sheet as presented as- sumes that the nonprofit sells a product in a related business. It also assumes that there are no donor restrictions on its use of funds. Many associations and 501(c)(3) organizations fall into this category. We shall deal with donor restrictions later.

As a basic rule, the information in the balance sheet is divided into three major categories: assets, liabilities, and fund balances. The amount of funds and the use of which was restricted by donors must be shown. The amount that is temporarily re- stricted must be separated from the amount that is permanently restricted. Thus, the balance sheet also tells the manager how much discretion he or she has over the as- sets of the organization and how much, if any, is restricted temporarily or perma- nently by donors.

Table 17.1: Example of a Balance Sheet of a Nonprofit Corporation, December 31, 2017, or Statement of Financial Position*

Current Assets Current Liabilities

Cash $ 1,000 Current notes payable $ 8,000 Membership 50,000 Accounts payable 600 (minus allowance for uncollectable)

(5,000) Wages and salaries 55,500 Deferred revenues 700

Marketable securities 5,000 Total current liabilities 64,800 Receivables 400

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The Balance Sheet or Statement of Financial Position | 529

Current Assets Current Liabilities

(less uncollectable) (40) Inventory 900 Supplies 500 Prepaid items 1,000 Total current assets 53,760 Long-lived assets Long-term investments 3,000 Long-term debt 1,000 Property and equipment 8,000 Total liabilities 65,800 (less accumulated depreciation)

(800)

Leasehold improvements 3,000 Funds balance; excess (deficit) of assets over liabilities

5,260 Deferred charges 1,500 Other long-term assets 2,600 Total long-term assets $17,300 Total liabilities and fund

balance $71,060

* Assuming zero restrictions of any kind.

Current assets include: 1. Cash and accounts on which checks may be drawn 2. Marketable securities (treasury bills, certificates of deposit, repurchase agree-

ments or any security with a fixed date, usually no more than a year for its re- demption)

3. Membership fees showing the amount that may not be received as members fail to pay

4. Prepaid items such as insurance when payments are made in advance, usually to cover the current year’s costs

5. Supplies: paper, pencils, pens, whatever is consumable in the work process 6. Accounts receivable: payments expected from others for goods or services ren-

dered minus the uncollectable 7. Inventory: the stock of goods and services the organization has to sell

Since all claims are not collectible because some clients do not pay, the accounts re- ceivable should be adjusted to reflect the uncollectable. The same is true for pledges. All other assets are listed at fair market value except that marketable securities (stocks and bonds) are either listed at fair market value or cost, whichever is lower. Inventory may be listed according to the latest or earliest price of the item making up the inventory.

Fixed or long-term assets include items such as:

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530 | Chapter 17: The Financial Performance and the Strength to Continue

1. Building and equipment—these items are listed at cost and the depreciation on them is shown in an accumulation account just below their entry on the balance sheet. The cost (the amount paid for it by the organization) minus the deprecia- tion is known as the book value of the asset.

2. Deferred charges—advance payments by the organization for goods and services that will not be delivered to it during the year.

3. Copyrights and leasehold improvements—long-term leases on real property whereby the nonprofit maintains the property and remodels it as if it were the owner.

The total assets owned by the organization are the sum of the current and long-lived or fixed assets. In the balance sheet shown in Table 17.1 this amounts to $71,060. Some balance sheets will separately show intangible assets, such as copyrights and trademarks, to be differentiated from physical assets such as land and buildings.

Other major areas of information in a balance sheet are liabilities of the nonprofit and funds balance. Liabilities are claims against the nonprofit and may be divided into current and long-term claims. Current liabilities include: 1. Current notes payable—payments to be made this year. These might be short-

term notes or the current portions of long-term debt that are payable in the cur- rent year, such as mortgage payments to be made this year.

2. Accounts payable—payments due creditors who have extended goods and ser- vices to the organization.

3. Wages and salaries—payments to the employees for services rendered and ac- crued vacation time.

4. Deferred revenues—amounts received but not yet earned by the nonprofit. The nonprofit may receive subscription dollars for a publication not yet produced and distributed. Such revenues are said to be deferred and create a liability or claim of the subscribers against the organization until such time that the goods or ser- vices are produced and delivered.

Long-term liabilities include debt and other obligations such as long-term leases that must be paid to others in future years. (Note that the current year’s amortization of debt is listed as current liability.) Total liabilities are the sum of long-term and current claims. For this organization on December 31, 2017, they are $65,800.

The difference between total liabilities (current and long term) and total assets (current and fixed) is the fund balance, which may be an excess or a deficit. This non- profit has an excess of $5,260. In the case of associations this amount may be called, “funds balance and membership equity.” Its liabilities are less than its assets. A defi- cit is easy to spot, since it is usually placed within parentheses ($5,260).

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The Balance Sheet or Statement of Financial Position | 531

Managerial Use of The Balance Sheet

The balance sheet tells how financially sound the organization is on a specific date. We know from Table 17.1 that as of December 31, 2017, the assets of this organization exceed its liabilities. For most uninformed observers, this nonprofit is economically sound. If it had to close down tomorrow it could meet all of its liabilities and still have $5,260 left over. But there is more to the story.

Liquidity and Cash Management A balance sheet can give other critical information about a nonprofit. It tells how liq- uid or solvent the organization is on the date the balance sheet was prepared. Can the organization pay its current bills? Does it have sufficient cash or liquid assets that it can sell easily in order to raise enough cash to pay its current liabilities? In short, is the organization solvent? This organization is not.

There are several ways to use the information in the balance sheet to determine how liquid or solvent the organization is. One test is the size of the net working capi- tal. This is the difference between current assets and current liabilities. The larger the net working capital, the greater the liquidity. The net working capital for this organi- zation is a negative of $11,040. This is the amount by which its current liabilities ex- ceed its current assets. It cannot pay its bills this year. It must borrow, sell assets, raise more funds, or use a combination of these. An existing line of credit can back up low working capital.

Another way of expressing the same dilemma in which this organization finds itself is to calculate the current or the working capital ratio. This is the current assets divided by the current liabilities for each year in question. Ratios are better than ab- solute numbers for making comparisons. The ratio for 2000 was 0.286, meaning that the assets were about 83 percent of the liabilities. The organization was 17 percent short of just covering its debts, including paying its employees.

Liquidity is also measured through what is called a quick ratio or acid test. In- stead of using all current assets, as is done in calculating working capital, only cash and assets that are easily converted to money (those that have a fixed redemption date, preferably in the current year) are used. In the balance sheet of Table 17.1, this would include cash, marketable securities, pledges (minus the expected uncollect- able), and accounts receivable (minus the uncollectable). The amount, $51,360 in this example, is divided by the current liabilities ($64,800). The ratio is 0.792. It is worse than the working capital ratio. The amount of money or near money the organization has is $51,360, but it is 20 percent short of what it needs to pay its current debt. The amount of cash or near cash the organization has must be viewed in terms of the cur- rent claims against it. Can it pay the monthly bills?

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532 | Chapter 17: The Financial Performance and the Strength to Continue

Note that we speak of monetary assets—cash and assets easily converted into money—and not just cash. As we have discussed under Liquidity and Cash Manage- ment, a large amount of cash on hand is not necessarily good. The excess cash could be invested in marketable securities, thus earning interest for the organization. How- ever, a shortage of cash portends a serious solvency problem if the organization does not have marketable securities that it could readily sell to raise the needed cash. Like the working capital, the quick ratio is a warning signal. There is no magical level that is good or bad. Obviously, however, the lower the cash or working capital relative to the current liabilities, the greater the risk of insolvency.

Here are some illustrations of the use of working capital or quick ratios. Suppose the organization has a current ratio of 2:1 and the assets that yield this ratio are prin- cipally receivables, only half of which are collectible. How liquid is this nonprofit? Not very. The true ratio, given the uncollectible receivables, would be closer to 1:1. The lesson: No ratio, no matter how high, is better than the quality of the assets be- hind it.

Would you be willing to lend a nonprofit money if its quick ratio is less than 1 or its working capital is negative? You probably would not without substantial collat- eral, because a negative working capital figure or a quick ratio that is less than 1 is a sign of probable insolvency because current liabilities exceed current assets.

As a matter of fact, short-term borrowing would not help because it increases cur- rent liabilities by the amount of the debt and interest, thus increasing the demand for cash. But long-term borrowing may be helpful. It increases long-term rather than cur- rent liabilities and provides cash that increases current assets. The debt ratio of this organization (long-term debt divided by total assets) is .014. Not bad. Over the long run the organization is not overleveraged in excess debt relative to its assets. But still, would you want to make the loan? How will the organization pay the interest and the principal? One possibility would be to use the long-term loan to meet its current obli- gations and begin to restructure its balance sheet so that it will avoid the same di- lemma in the future.

One way of restructuring the organization is to increase revenues from its busi- ness. Another way is to sell some of its assets; still another is to increase gifts and contributions. In all cases, the objective of the organization should be to increase its cash or near-cash items. To illustrate, a gift in the form of a building would not help. It increases fixed assets rather than current assets. Furthermore, if a debt is assumed or if there are current operating costs exceeding current revenues from the building (a negative cash flow), the situation is worsened.

Similarly, a gift that is restricted may not help. To illustrate, suppose that the or- ganization has a cash shortfall. It gets a gift of $1,000,000 from Isaac Simon Perez, but this gift is restricted to the building fund. These dollars, whether received in cash or deferred, cannot be used to meet current expenses unless the restriction can be legally broken.

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The Balance Sheet or Statement of Financial Position | 533

The Limits of Liquidity Ratios on Measuring Liquidity

Liquidity ratios are a quick measurement of liquidity. And, as we have demonstrated above they can also be misleading if the manager does not appreciate a larger fact: What matters in liquidity is the ability to have access to cash when it is necessary. An organization can operate for a very long time if it has credit facilities. A credit facility is an arrangement that gives the organization access to cash when it needs it. They are used very heavily throughout the private sector. Here are three: 1. Perhaps the simplest form of a credit facility is a credit card. An organization may

have several credit cards but the use of them should be controlled. 2. A revolving loan is an account. This is sometimes called a “revolver” it is a loan

which has a limit but which allows the user to withdraw and repay as its discre- tion and pay interest only on the amounts outstanding at the time. Thus, the user controls the interest expense at the set or variable interest rate agreed upon, and the amount available as each repayment refurbishes the pool and is again avail- able at the borrower’s discretion.

A letter of credit is another form of credit facility, but one that may be best suited for a larger nonprofit or for large project expenditures. A letter of credit is issued by a lender and vouches that the lender will pay up to some limit an organization’s bill incurred and billed during a specific period of time. Letters of credit are portable so that the organization can use them with any third party that it chooses that is not prohibited by the lender.

Sophisticated corporations and nonprofit organizations use these and other credit facilities to bolster their liquidity ratios. Pending reforms in FASB will require a reporting and discussion of these techniques as they are used by the organization.

Equity and Debt Management

The balance sheet also tells us something about the claims others have against the organization. Liabilities are claims against the organization. The total liability, $65,800, is roughly 60 percent of the total assets, $71,060. This debt ratio may be too high for a nonprofit.

Let us explain. Large nonprofits such as hospitals, universities, and housing that raise money in the bond market, as for-profit firms do, receive credit ratings, and so what is a good debt ratio depends on the rating systems view. Therefore, there is a market discipline to the debt ratios of these nonprofits.

With other nonprofits, such wide market discipline does not exist, so it is more imperative that market discipline be internally imposed. The amount of debt that can be carried, whether by a household, firm, or nonprofit, depends on several factors:

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534 | Chapter 17: The Financial Performance and the Strength to Continue

the cost, the use, and, what is most critical, the level and steadiness of earnings. Debt, short or long, must be paid according to schedule.

Debt that generates income is superior to debt that does not; that is, debt for an investment is better than debt for a consumer good. The organization that has a high steady monthly income, after all operating expenses are accounted for, is in a better position to carry debt than one that has an erratic or low net revenue flow. It is pre- cisely these latter organizations that tend to suffer short-term cash flow problems that generate more debt, because their current assets fall below their current liabilities. The need for controlling debt becomes imperative. This should begin by monitoring the debt-to-equity ratio and keeping it low (below 30 percent). It should also be done by monitoring the revenue, support, and expense statement (which we shall be dis- cussing) to be sure that the debt, whatever its size, can very easily be covered because of a large and dependable net cash flow. We refer you to the discussion in this book about matching fixed costs with permanent income.

Pledges and Receivables

Pledges and receivables can be an illusion the manager need avoid. The problem is that a fraction of them may never be collected or collected on time even if the promise is made by a reliable person. For example, the decline in the stock market caused many promises of pledges not to have been met or met on time because of the decline in stock prices. To a donor a stock with negative value is not worth giving and a stock still with positive value may have declined so much that the incentive to make the gift declines, Accounting for pledges and receivables require some discounting for the probability that some amount will not be received. One strategy for reducing this probability is to have donors and purchaser use credit cards or cash—if feasible.

Accounting for Financial Assets and Liabilities on the Balance Sheet

Financial assets and liabilities on the balance sheet are subject to three different lev- els of valuation for the balance. Some are measured at level 1. At this level, it is pre- sumed that the asset value could be easily determined. One simply has to open the newspaper and find the price of a stock. Level 2 recognizes that the value of some financial assets has to be indirectly determined but the determination is possible us- ing standard methods that are transparent—finding the present value. Level 3 recog- nizes that more intricate methods may be necessary to find and to report a value of an asset or liability in the balance sheet. When these are used, the accountant must explain so that it can be replicated by the curious. It helps the management to know which of these three methods or the composition of the three that is used in reporting

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Statement of Support, Revenues, and Expenses or Statement of Activities | 535

its liabilities and assets. The choice of what level to use is determined by the auditor, the accountant and the rules of accounting and not left to the discretion of manage- ment. Nevertheless, an awareness (as from what is stated in the notes of the financial statement) helps the management in its thinking about the “actual” or realizable value of the financial assets on the balance sheet—aside from the fact that some of the assets and liabilities may be volatile.

Historical Measures, Depreciation and Realizable Value

Another managerial hint in using the balance sheet is the realization that the value of some fixed assets especially real estate is likely to be understated because the bal- ance sheet will show them at their historical cost and may also show an adjustment for depreciation—even if the market value of the asset has increased.

Restrictions on Asset Use and Newly Proposed Measures Not all of the net assets on the balance sheet may be available to the discretion of the management at the time the balance sheet is presented. Some are permanently re- stricted by donors for some time and/or specific use; others are temporarily restricted by the donor and can only be used for any other purpose or any other time when the restriction has expired. Only that which is unrestricted by the donor is available to the discretion of management at the current time barring that there are no other re- strictions especially by the trustees or some other agreement such as the covenants (restrictions) that may be imposed by a lender. When this fact is coupled with the discounting of pledges and receivables, the management at the moment could very well have substantially less available to it than may be implied in typical and com- monly used ratios and financial analysis techniques.

Newly proposed accounting procedures by FASB will do away with the temporary restriction and require the nonprofit to report all restrictions quantitatively and qual- itatively. These may be done in the notes—how much, why, how, and the conditions that these funds may be available for operations.

Statement of Support, Revenues, and Expenses or Statement of Activities

Another important financial statement for nonprofits is the statement of activity or statement of expense, revenues, and support, as shown in Table 17.2. This is an an- nual statement produced by the nonprofit and is analogous to the income statement of a for-profit firm. The statement is a year-end depiction of the financial operation of

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the organization during a year. Again, we assume that this organization has no donor- imposed restrictions on its funds.

The support and revenues of the organization may include: 1. Fees from admissions to events 2. Government contracts, state, local, or federal 3. Gifts and grants from institutions and from individuals 4. Membership fees (if applicable) 5. Investment income (dividends and interest) on marketable and long-term

securities 6. Net realized investment gains or losses from the sale of the securities 7. Royalties; that is, income from permitting others to use logos, trademarks, and

other copyrighted materials 8. Revenues from sales of publications and the like

Table 17.2: Statement of Support, Revenues, and Expenses of a Nonprofit Corporation, January 1, 2017, to December 31, 2017*

Support and Revenue** Admissions $ 2,235 Government contracts 20,000 Gifts and grants 230,000 Membership 38,000 nvestment income 10,000 Net realized investment gains (losses) 4,000 Royalties 1,000 Revenue from sales 5,000

Total $310,235 Expenses Programs 290,000 Supporting services 48,000 Cost of sales 1,000

Total 339,000

Fund balance at beginning of period (30,000)

Fund balance at end of period $279,235

* Assuming no restrictions on the use of funds. ** If this were a 501(c)(3), the entry would show public support, with a subset of contributions.

The statement does not show that these revenues and support (except the govern- ment contract) are restricted to a specific fund or use, which I shall say more about later. Generally, these revenues and support are available for use by the organization

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Statement of Support, Revenues, and Expenses or Statement of Activities | 537

as it sees fit in the conduct of its mission. This nonprofit had unrestricted support and revenues during the year January 1, 2017, to December 31, 2017, of $310,235, minus the $20,000 for government contracts. Contracts are restricted to the performance of a specific task.

There are also expenses. For nonprofit organizations, expenses are generally classified by function or program, general administration or supporting services, and the cost of sales (items sold in a business). This organization had a total operating expense of $339,000. Its operating expenses exceeded its revenues and support by $28,765. It operated in the red.

This operating deficit had nothing to do with the related business that yielded sales of $5,000, for the cost of such sales was $1,000, giving a gross profit (defined as the difference between the two) of $4,000. As these businesses become larger, it will be important for the organization actually to itemize costs such as insurance, wages, rents, and interests that are specifically attributed to the business as for-profits do. A more accurate measure of the profitability of the business can then be obtained.4

This organization has two strategies available to it. It can seek to bring its ex- penses into line or increase its revenues and support. This latter approach would work only if the organization increases its unrestricted funds. Funds restricted by do- nors for other purposes cannot be applied to general operations.

An organization can sustain a deficit and still survive. The question is, How long? A special class of revenues and support is called capital additions. These are re-

ceipts, usually in the form of endowments, the use of which are restricted by the do- nor. The restrictions are expressed in the agreement that leads to the gift, bequest, or contribution. The use of the funds may be restricted in several ways. The restriction may apply to specific purposes, such as the construction of a building. The restriction may require the passage of time or the occurrence of an event before the restriction is lifted. The restriction also may be permanent—a stipulation that the funds (and earn- ings they’re from) can be used only as specified.

The capital additions include: 1. Restricted gifts received during the year 2. Net investment income earned on these gifts and similar ones received earlier 3. Gains or losses realized from the sale of assets related to these restricted gifts

Managerial Use of the Statement of Support, Revenues, and Expenses The most basic use of this statement is to determine whether the organization oper- ated efficiently during the year. To do this, we must distinguish between operating and capital performance. Each has its bottom line.

This organization operated at a deficit ($28,765). It spent more than it took in for current program and support activities. The interpretation of deficits and surpluses depends on the facts and circumstances. Every organization can expect a deficit to occur now and again over its lifetime. The objective should be to have surpluses in

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538 | Chapter 17: The Financial Performance and the Strength to Continue

both the operating and capital accounts every year, as long as the organization is car- rying out its mission satisfactorily. Surpluses provide savings for financing the future and are an indication of the ability to pay off debt.

A nonprofit that conducts many programs may strategically plan for surpluses in one or more of them as a way of financing or subsidizing other programs. A full-blown revenue statement would enable management to distinguish between these two.

It is important to recognize that the statement of activity gives hard facts predi- cated on reasonable accounting practices, not estimates as in the budget. The data on the statement of activity can therefore be used to compare the actual with the pro- jected figures shown in the budget. The statement of activity thus tells whether the organization operated efficiently, met its budgetary targets and limits—and how. Moreover, as we can see here, the statement of actual activity, if used properly, would also form the basis for budgetary targets. This organization needs to review its reve- nue and expense performance and set new, achievable budgetary targets on each if it is to escape the fate now facing it. This organization would benefit from the discus- sion of setting targets in this book.

The statement of activities, when compared over several years, gives a picture of the trend toward the diversification of income and support. Is the organization be- coming more or less dependent on admissions or fees? Is this a good trend? Is it sus- tainable? Which expenses are rising faster, which programs? Why? Is this what we want?

Comparative Statement of Activities

There are differences between the income statement of a for-profit firm and the state- ment of activity of the nonprofit and it is not whether the one has a bottom line and the other does not. The revenues of a firm are earned from the sale of goods or services (called revenues from operation) or from the earnings on investment or the sale of assets (called other or extraordinary or nonrecurring revenues). For-profit firms do not get support from deductible gifts and contributions.

In many nonprofits, this support is the only meaningful form of income. In oth- ers, there are both contributions and earned revenues. It is the ability to rely on con- tributions that permits the nonprofit to operate and sell its goods and services below market price. The price might even be zero, indicating that the nonprofit does not charge at all. It can do this because of its reliance on gifts and other contributions. A for-profit cannot do the same. It must operate at or above market price because it must bear all costs and provide a fair rate of return to its investors.

At the risk of being repetitious, another difference between for-profit and non- profits is in the bottom line. The income statements of for-profits normally end with an entry that is called net income. This is the bottom line because it shows whether the organization operated at a loss or a gain during the course of the year. If there is

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a gain, that amount can be retained by the firm, distributed to the shareholders in the form of dividends, used to purchase other assets, and used to pay off debt at the dis- cretion of the board of trustees.

A nonprofit has as its bottom line “funds deficit or excess,” or a similar phrase. Note that for both a for-profit and nonprofit, the possibility of having a positive or negative bottom line exists. Either may have a surplus (called a profit in a for-profit firm) or a deficit (called a loss in a for-profit firm). The major difference is in the use of the surplus or profit. Of all the possible uses, one does not pertain to nonprofits: Nonprofits may not distribute their surplus to individuals or use it other than to foster their mission. Of all the possible ways of dealing with a deficit, the one that cannot be used by nonprofits is that they cannot issue shares of stocks but they may rely on gifts. Just the reverse is true of a for-profit firm: They may raise additional funds by selling stocks but cannot rely on gifts.

A final difference between the for-profit and nonprofit statement of activity is that the former will have an allowance for taxes whereas the latter, unless a private foundation or the operator of an unrelated business, would not normally have such a line item.

Statement of Changes In Financial Position

The principal purpose of the statement of changes in the financial position of the or- ganization is to show how resources were acquired and how they were used during the year and, consequently, why the organization finds itself in either a favorable or unfavorable financial position at the end of the year. Unlike a budget, it is not a pro- jection of the sources and uses of resources. It is an actual accounting of major re- source uses and acquisition during the fiscal year of the organization. And, unlike a budget, this statement is subject to audit.

The statement of changes in the financial position of the organization also differs from the balance sheet. The latter describes the financial status of the organization at a point in time. The former shows the flows that contributed to the attainment of that financial status. In short, what are the major financial flows that resulted in the pic- ture portrayed in the balance sheet? Both statements are subject to audit.

The statement of changes in the financial position of the organization differs from the statement of activities just analyzed. The latter shows the dollar expenditures of each set of activities by type of expenditure (salaries, rent, supplies, and so on) and the sources of revenues by type. The latter focuses on broader categories of resource flows.

Sometimes the statement of changes in financial position may be combined with the statement of activities. Instead of a statement of changes in financial position, an organization may report a statement of changes in working capital. This latter state- ment merely shows the changes in current assets and liabilities that the organization

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experienced during the year. A statement of changes in financial position is broader than a statement of changes in working capital because it includes all major resource flows, not just those in current assets and liabilities.

Managerial Use of Changes in Financial Position

Like all financial statements, the statement of changes in the financial position of the organization contains information in the form of numbers, and the interpretation of these numbers is the responsibility of management. Instead of looking at an example of a statement of changes in financial position, let us focus on some of the major re- source flows that may appear in the statement. What are some of the major uses and sources of financial resources for the nonprofit organization during the course of its fiscal year? What resource flows may bring about a change in its financial position?

Note the use of the word resources. It is intended to imply more than the word cash. Changes in resources may or may not be reflected in the change in cash. This is illustrated below.

Sources of Resources

Here are eight sources of resources for the organization: 1. The operating excesses from the organization’s performance during the year arise

because the organization’s revenues and support from operations exceeded its expenditures. These revenues and support may include sales and contributions that are unrestricted; that is, available to be used for the general operation of the organization. An excess implies that the organization did not spend more than it brought in during the year, so the excess can be used to strengthen its financial position. If the organization operated at a deficit, this too would represent a change in financial position, thus implying, at least in the short term, a weaken- ing of the financial position of the organization.

2. Decrease in inventories (when the organization runs a related business) implies that sales are made. Therefore, a reduction in inventories implies positive change in the financial position of the organization. An increase in inventories, particu- larly if such increases were unintended and merely represent the inability to make planned sales, implies a weakening of the financial position of the organi- zation. The organization is less liquid and had to use its resources to build up unintended inventories, which it has been unable to sell.

3. Increases in deferred amounts (such as unfilled orders for the organizations pub- lications) represent changes in the financial position of the organization. By de- ferring payments or the fulfilment of orders, the organization has more financial resources available to it now. A decrease in these amounts, however, implies that

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payments were made and, therefore, the organization has fewer resources avail- able to it.

4. Returns on the organization’s investments may be from the sales of investments, interest earned, and dividends received from corporations in which it owns stocks. Returns on investments represent a positive increase in the financial po- sition of the organization and an improvement in its ability to advance its mis- sion. However, losses represent a deterioration of the financial position of the organization.

5. Increases in contributions and bequests that are restricted to specific purposes, such as a building fund or a scholarship fund, represent improvements in the financial position of the organization. These are known as capital additions. One aspect of capital additions is that the funds may not be used for operating pur- poses at the time they are given, and their uses are restricted to those stipulated by the donor. Hence, although capital additions improve the long-term financial position of the organization, they may do little to improve its liquidity unless the terms of the gift provide for the transfer of these funds and earnings from them for operating purposes.

6. Sales of the long-term assets of the organization also bring about a change in the financial position of the organization. Such sales bring in cash. This is not to im- ply that selling the assets of the organization is necessarily good. In some cases, it might be a strategy forced by the need to raise cash. But in others, selling long- term assets might reflect a decision that they are no longer needed or they may be divestitures required by law, such as the excess business holding law of pri- vate foundations discussed earlier in this book.

7. The organization deducts depreciation every year in determining whether it op- erated at a deficit or a surplus. But unlike other expenses, the organization does not pay out any money to anyone when it incurs a depreciation expense. Techni- cally, it withholds the amount depreciated to be used to finance the replacement of the equipment or property depreciated. The depreciation is thus a “source” of resources.

8. Recall that when the organization records a depreciation expense, it does not make a payment to anyone such as it does when it incurs a salary or benefit ex- pense. In these latter cases, payments are made. Because no payments are made in depreciation, even though it is deducted as an expense, this deduction repre- sents a source of resources.

9. By acquiring debt (borrowing), the organization increases the amount of re- sources available to it in the short run. At the same time, it increases the claims of others over the future resources of the organization. Debt may be necessary because the organization does not have needed resources. But long-lived assets also are better financed—not by current income but by income the assets gener- ate over their lifetime. If debt is incurred to purchase an asset that appreciates,

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the effect is to increase the total financial resources of the organization by more than the debt.

Uses of Resources

What are some major uses of resources of the organization that result in a change in its financial position? Such uses include the following: 1. Resources may be used to purchase new assets such as buildings and equipment.

To say that such a transaction represents a change in the financial position of the organization is not to imply that the organization is worse off. The organization is merely less liquid, having used its cash to purchase long-term assets. The transaction may have limited effect on the organization’s immediate liquidity po- sition if the purchase is financed totally by long-term debt such as a mortgage. Future liquidity will be affected because the interest and principal on the notes will have to be paid. Whatever method is used to finance the purchase, a change in the financial position occurs.

2. Reductions in short- and long-term debt represent a change in the financial posi- tion of the organization because a reduction in debt implies a payment, that is, a use of the organization’s resources.

3. The purchase of investments such as bonds and certificates of deposit represents the use of cash for the acquisition of an income-producing asset, thus changing the financial position of the organization. This act does not drastically change the organization’s liquidity if the investment is short-term and very marketable.

4. The resources of the organization are also used to the extent of increasing receiv- ables, including pledges of contributions not received. To understand this, con- sider that a receivable, whether it is called accounts receivable or pledges due, is really a payment due to the organization. Technically, that payment is due be- cause the organization expended resources either to create and sell a product or service or to create a situation to which a donor wishes to give. The act of creating the product, the service, or the purpose to which the donor wishes to give could only occur by the use of the organization’s resources. Put another way, the or- ganization’s resources may be used to create a product or service or to create a purpose for giving. If an immediate sale were made or if the donation had been received, this would have represented an increase (a source) of resources. Since no money is received by the organization, technically all the organization has done is expended its resources in expectation of receiving money. It has incurred costs. These expectations are receivables. Where there is a sale, collection is le- gally enforceable; a promise of a gift may not be.

5. The transfer of funds from restricted accounts to the unrestricted operating ac- count (a source of resources), or vice versa (a use or application of resources), is a flow of resources that is unlike the others because it does not represent bringing

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in additional resources to the organization or transferring the organization’s re- sources to an outsider. It is a flow of funds between one set of accounts of the organization and another. The organization thus changes its financial position without necessarily adding or subtracting from the total amount of resources it commands. These interfund transfers are governed not only by accounting prin- ciples but by the legal agreements that set up the funds. For example, the organ- ization may transfer funds from an endowment to the operating fund, either be- cause the terms of the endowment provide for such an amount to be transferred at that time or because the organization is borrowing the funds for operating pur- poses—as long as the terms of the agreement that set up the endowment permit such loans.

Resource Use and Opportunity Costs

Changes in uses of resources are not cost free. To demonstrate, based on the above discussion, we know that building up inventory is a use of funds; therefore, it has a cost. One cost is an opportunity cost because resources could be used for something else. Inventory has other costs, which we shall discuss later. Building up accounts receivable (while there are claims against others) also has a cost. Take the organiza- tion that charges for its newsletters. It can build up readership by building receiva- bles—extending credit by making it easier for people to pay. In the meantime, the organization has to pay its bills and foregoes earnings on the interest it could have received had the payments been received and banked.

Rises in inventories and receivable must therefore be monitored. A rise in receiv- ables, for example, could occur because the organization has a bad collection policy. Bills go out late, there is no follow-up, or the organization extends credit to the wrong people. Such lax management of credit consumes resources. The statement of changes in financial position gives us a clue.

Statement of Cash Flow

Cash-flow statements are statements of sources and uses specifically of cash during a period. The basic categories of cash used by nonprofits are (a) from operations such as cash from clients, fees, and contributions and uses would involve payments to em- ployees, cash purchases of supplies and equipment; (b) from investments which would include dividends and interest, rental income, and royalties while uses would include the purchases of properties and equipment and securities; (c) from financ- ing which would include loans, proceeds from endowments, annuities, marketable securities and uses would involve the payments of annuities to others or the purchase of securities, annuities, or insurance.

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The Accounting Notes and Their Increasing Managerial Significance

As we write, there are proposals for changes in the accounting statements we have just discussed. The accountants will be required to give some explanations and dis- play and they will be allowed to put many of these in the notes to the financial state- ments. I have culled from FASB what these accounting reforms are and proceed to suggest how they will help the nonprofit manager—without an accounting back- ground. They are displayed in Table 17.3.

Table 17.3: Likely Utility of FASB Reforms on Managerial Intelligence

The proposal requires the accounting to: 1. Report operating expenses by nature and by functions in one location so that the manager will

be able to ascertain not only total labor expense, but expense by program, management, and perhaps even keener. Non-operating expenses; e.g., expenses for investment, don't have to be categorized by function.

2. Report the method it uses to allocate expenses across programs and support functions. 3. Distinguish and display cash it receives from operating its mission (including fees, interest and

gifts and contributions, from other cash it receives from elsewhere; e.g., interest it earns from loans to its clients from interest it earns from investments.

4. Report its net assets according to availability—to distinguish between that which is available to the management in the current period from that which is not.

5. The amount of net assets and cash restricted by donors and therefore not available during the current period and some idea of the timing and conditions of their availability for operations.

6. Report and describe the amount and nature of restrictions imposed by trustees. 7. Report investment expense separate from investment performance and the net gain or loss. The

expense should be both those that are internal to the organization and those that are external; e.g., broker fees.

8. Report on both quantitative measures of its liquidity (total financial assets and total financial liabilities due within a specified period of time) and qualitatively how the organization manages its liquidity; e.g., does it have credit facilities—methods of obtaining cash when it needs it.

By the author from: Financial Statements of Not-for-Profit Entities Tentative Board Decisions Reached to Date as of April 7, 2015. http://www.fasb.org/cs/ContentServer?c=Document_C& pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176164459852

General Aspects of Interpretation In using financial statements, the management must know whether the accounting is on a cash or an accrual basis. If it is on a cash basis, all accounting entries represent actual cash receipts or outlays. If the organization is on an accrual basis, there is a definite commitment to pay or to receive payment. The transaction may be completed but no cash has been transferred. In this case, the amounts shown as accounting en- tries represent commitments rather than cash. Small nonprofits tend to operate on a

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cash basis, whereas the larger, more complex ones operate, like for-profit firms, on an accrual basis.

When using financial statements, managers should also be aware that as in budg- ets, vertical and horizontal analyses can be helpful. This is especially true if the data are presented for more than one year. For example, in the support, revenue, and ex- pense statement, a horizontal analysis for more than one year could reveal whether the proportion that each line item contributes to expense or revenues has changed. Similarly, a vertical analysis of the same factors over the same number of years could reveal which line items are growing fastest and which are declining. The question for management is, why? Is this in the best interest of the organization? Is this what we planned in our strategic planning process? Do we need to change our plans?

Using financial statements may also involve comparisons with other organiza- tions. This is not necessary but it is often advisable. In so doing the underlying differ- ences in the organizations ought to be kept in mind. Moreover, when possible, ratios rather than absolute numbers ought to be used to reflect the differences in sizes of the organizations. Because nonprofits tend to be so different from each other and data and accounting procedures are less standardized, comparisons among organizations ought to be done with utmost care.

On the point of standardization of accounting procedures, I reiterate that the ex- amples given in this chapter are intended to highlight concepts. All nonprofits do not use exactly the same accounting procedures or reporting format. The mastery of the information as presented in this chapter, however, should be a firm basis for dealing with individual organizations.

Funds: A Managerial Accounting Perspective

Fund accounting refers to a system of financial record keeping and reporting that is common among nonprofit organizations. The basic characteristics of fund account- ing is that certain accounts must be kept separate, funds cannot be commingled ex- cept in an approved investment pool or through authorized and documented transfer of funds from one account to another, and the financial activity in each separate fund is subject to independent accounting. Inter-fund transfers, the movement of money from one fund to another, must be authorized by the board of trustees. Accounting principles require nonprofits to classify all of their funds into one of three categories: (1) permanently restricted, (2) temporarily restricted, and (3) unrestricted. For inter- nal managerial purposes, other types of fund classifications may be used. We begin with the managerial perspective.

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Managerial Types of Funds

For managerial purposes, funds may be classified as expendable or nonexpendable. Expendable funds are those that may be totally spent. Unexpendable funds are those of which typically only the income to the fund may be spent, but the principal and sometimes the gains from sales of the assets of the funds must be spent so that the fund may have a perpetual life. True endowments are examples of nonexpendable funds.

Endowments, as we discussed earlier are of several types. A university may have an endowment fund for scholarships, land acquisition and building construction, ath- letic purposes and facilities, lectureships, and for professorships. Although we may speak of the endowments of Harvard or Columbia universities to be a certain dollar amount, we are actually speaking of the composite of several separate endowments.

Within any category of endowments are numerous separate accounts. For exam- ple, a modest endowment of $100 million may have thousands of separate restricted accounts. Some are restricted for scholarships, some for academic prizes, and some for financing academic events. Each account represents a specific donor or cause for which a specific endowment has been established, not just a gift but an endowment, that is, a gift that is expected to have a lengthy life whose principal would not gener- ally be spent, but the income of which will be used to support a specific cause speci- fied by the donor or donors.

Each of these separate accounts technically has a balance sheet, an income state- ment, a financial report, and perhaps a statement of changes in financial position. Each must be kept separate and generally bears the name of the donor. The Simon and Myra Bryce chair, the Carlos Gill chair, the Orvin and Sylvia Gaustad chair, and the Mabel and Mary Laporte chairs may be in the same university, but each is a sepa- rate endowment subject to separate accounting. Each is also subject to a separate agreement between the donor and the donee. It is this separate, written legal docu- ment that determines how a fund may be used.

Managers may use another important classification of funds. Funds may be re- stricted or unrestricted. Restricted funds are those that can be used only for purposes that are specified in the agreement at the time the gift was made or the contract was signed. A grant or payment to a nonprofit to provide research on the topic of AIDS uses its restricted funds. An unrestricted fund is one that can be used to finance ac- tivities at the discretion of the board of trustees of the organization. These unre- stricted funds can be used to pay salaries, provide scholarships, make investments, take advantage of unanticipated opportunities, meet emergencies, fund scholar- ships, begin new programs, and finance general activities.

Sometimes the term general fund is used to denote unrestricted funds used for general operations. The term operating funds may include general funds and re- stricted funds used in current operations but for the specifically restricted purpose for which they are given. Hence, in a current year, a university operates using restricted

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funds to finance scholarships and lectures and also uses unrestricted funds for these and other purposes, including salaries and maintenance.

It should be kept in mind that the terms restricted and unrestricted are not syn- onymous with budgeted. An organization may budget $1 million for salaries and ben- efits. What makes the amount restricted is a legal force. A restricted amount cannot be used for any other purpose than those for which it was given. Variations from this intended purpose legally occur only by an act of the board of trustees when it imposes the restriction, the court, and the donor, directly or through a representative. Again, a budgeted amount is a planned or anticipated amount. It is not a legal restriction. There are no legal contracts or consequences from their variations. The misuse of a restricted fund is a violation of a contract and can be subject to both civil and criminal penalties.

The fact that the funds are unrestricted does not mean that discretion is absolute. These funds cannot be used for purposes that contravene the mission of the organi- zation or violate the terms discussed in Part One of this book. Unrestricted merely means that the management may use its discretion about how the funds can be used as long as the use is consistent with the mission of the organization and the terms under which it was given legal and tax-exempt status.

Unrestricted funds come from gifts and contributions of donors and the earnings of the nonprofit. Many nonprofits conduct special campaigns to increase the size of their unrestricted funds. Others obtain unrestricted funds almost exclusively through fees and sales.

In addition to giving the organization fiscal discretionary powers, unrestricted funds also have the advantage that there is no legal ratio of unrestricted to restricted funds that it must maintain. Hence, financially skilful nonprofit management can maintain the support ratios discussed in Chapter 4and still maintain discretion. For example, it is possible to meet the one-third public support test and still have a large percentage, even 100 percent, of the assets of the organization as discretionary. It is possible and customary, for example, to emphasize unrestricted gifts in any contri- bution campaign the organization conducts.

Many nonprofits do run campaigns for unrestricted gifts at the same time that they seek out funds for restricted purposes. They are two different tracks upon which chapters on giving and on soliciting in this book are based.

The previous discussion on fund restrictions, emphasizing managerial use, is summarized in Table 15.3. The accounting requirements will soon follow.

Interfund Transfers by Managers The transfer of money or assets from one fund to another is a formal financial trans- action with at least three requirements: (1) a vote or standing permission from the board to allow such a transaction, (2) permission from the donors or broad language in the terms of the gift to allow such transactions or an act by the court or state, and

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(3) a clear and specific accounting of such transactions in the year-end financial state- ment.

Table 17.4: Summary of Managerial Approach to Funds Restriction and Use.

Type of Fund Use of Funds

Unrestricted Determined by management via budget Board restricted Determined by trustees Expendable Both principal and income spendable Unexpendable Only part of income spendable Donor preference Moral obligation to follow preference Donor restricted Determined by legal contract Expendable Both principal and income spendable Unexpendable Only part of income spendable Contract and grant Determined by terms of acceptance Note: Unexpendable or inexhaustible funds may, by provision of the contract, permit occasional spending of principal. The aim is to avoid this since perpetuity of the fund is the objective.

Interfund transfers occur for several reasons. An expense may be paid from general funds and then recouped from the specific fund to which it belongs. This avoids hav- ing to sell securities to make immediate payments. It also allows parking funds in short-term interest-earning accounts. Sometimes the maintenance of a separate fund is no longer economical, legally or managerially necessary; that is, the objective is satisfied or obsolete. Transfers are frequently made into the current accounts to pro- vide cash to carry on current operations consistent with the terms of restriction. There are also interfund loans to cover cash shortfalls.

Funds as an Accounting Concept: The Meaning and Treatment of Restrictions

For internal purposes, organizations may defer in how they account for and treat funds as a managerial method of classifying resources. Accounting principles, how- ever, require a specific treatment of funds for public reporting purposes. Funds must be classified in financial statements as unrestricted, restricted, or temporarily re- stricted. Here the concept of a restriction refers solely to the restriction imposed by the donor, not the board or the organization.

A donor may make a restriction based on the lapsed or passage of time. For ex- ample, the donor may say that the gift cannot be transferred to the control of the or- ganization for ten years, or twenty years, or some other period. Alternatively, the do- nor may say that the gift cannot be transferred until the occurrence of some event. An

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event may be the death of a person, the completion of a building, or the start of con- structing a building.

A restriction may be permanent or it may be temporary. A restriction that is based on not expending any of the funds until a building has already been constructed is a temporary restriction—assuming that there are firm commitments. A restriction that funds may never be used but in a specific fashion—scholarships for senior tennis fe- male students—is a permanent restriction. If there are neither temporary nor perma- nent restrictions placed by the donor or if these restrictions are already met, the ac- counting must show the funds as unrestricted.

The accounting segregation of restricted funds must appear in the financial state- ments of the organization. The accounting statements, such as the statement of activ- ities and the statement of financial position, show the amount of permanently re- stricted, temporarily restricted, and unrestricted funds. The notes to these financial statements will detail the nature of these restrictions. Again, and by definition, if as- sets or revenues are not restricted temporarily or permanently by the donor (not the trustees), they are by definition unrestricted.

There are six points to bear in mind about the accounting concept restricted: 1. Accounting for donor restrictions occur within the scope of contractual law. The

restriction occurs because the donor (not the trustees) imposed it and the gift was accepted with the promise that the restriction will be obeyed by the management and enforced by the trustees.

2. When in doubt, the organization has to consider the probable intent of the donor in deciding the character of the restriction.

3. This way of segregating funds does not deny the organization the chance to use other methods of classification, such as those described earlier, as long as it is understood that they are for managerial purposes and cannot replace the re- strictions required by accounting conventions.

4. Because the restrictions are contractual, they can only be changed by the donor (or permission given by the donor in the contract transferring the gift) or by the court. When the court relaxes or nullifies these restrictions, it does so through a cy pres decision. Such a decision is granted, not for the convenience of the or- ganization or to relieve it of the burden of conforming, but because the restriction is contrary to public policy or economically detrimental to the organization.

5. As restrictions are satisfied, funds may move from one restricted category to an- other and finally into unrestricted. These interfund transfers are formal account- ing procedures that must be documented in specific ways. See the earlier discus- sion on Interfund Transfers by Managers.

6. Management has full discretion only in the use of unrestricted funds. But these funds may be subject to managerial restrictions by the trustees even though they appear as unrestricted in the accounting statements. Managerial restrictions are thus of two types—those imposed by the donors, and those imposed by the trus- tees—even though only the first appears in the accounting statements.

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Managerial and Solicitation Implications of Restrictions

Some years ago, I sat on a board that was the official issuer of billions of dollars in tax-exempt bonds. The bond consul prepared a draft of the prospectus to describe the bond. It said that all of the income and assets of the organization for which the bond was being issued was pledged to support the bond. I objected. Why? Because assets acquired with other restrictions cannot be used to support a bond unless the contract accompanying the gift permitted such use.

The prospectus had to be amended to show that the use of certain assets was re- stricted and technically could not be pledged in the support of the bond, yet the assets could be reported as part of the overall assets of the organization. Today this problem is lessened by the requirement that the restricted asset totals must be identified in the financial statements.

The list below shows some examples of different types of permanent restrictions. – Illustration of Permanent Restrictions: – Scholarship To support the athletic program – Permanent gift to purchase roses To buy flowers – Gift for purchasing windows For maintenance of building – Purchase science books To purchase books for the library

It should be clear that the accounting rules are more than a technical issue for the manager. Compare all of the above with an outright gift to the same school. Then compare each of the permanent restrictions in the first column with the change in discretion that is attained by a slight change in language in the second column. Yet in both cases the restrictions are permanent.

Consider also what a big difference would have occurred if the language of the gift said that the restriction would be temporary and then the residue would be used by the management to support the organization. The lesson: The amount of discretion, even though stipulated by the donor, is often the consequence of how the idea was presented and eventually worded. The consequence of all this falls on the managers and restricts the ability of the organization to create its own initiatives without seeking specific fund- ing for each and every purpose. See Simon’s Dilemma (Figure 17.2).

Audit

The various sectors in the nonprofit world apply different accounting standards—alt- hough GAAP is the standard. One standard is “Audits of Voluntary Health and Wel- fare Organizations” of the American Institute of Certified Public Accountants; another is Accounting Principles and Reporting Practices for Churches and Church Related Organizations by the Catholic bishops.

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General Characteristics of Audits Audits are done to determine whether the accounting procedures used by the organ- ization conform with the generally acceptable accounting principles (GAAP). The aim of these principles is to be sure that the accounting of the organization is objective, fair, complete, and accurate. These are the four criteria used to judge the accounting practices of the organization.

In assessing the organization’s conformity with these four standards, the auditors look at expenses and revenues of the organization. In investigating the expenses, the auditors seek clear evidence that the expenses were authorized and approved by a responsible person of the management team, are correctly classified by function (pro- gram) or object, are recognized in the correct accounting period, and are justified or supported by documents such as invoices. Auditors are instructed to pay particular attention to the existence of controls over expenditures. These controls include the existence of an organizational chart and a clear line of responsibility for decision making, recording, and monitoring expenses. The auditor may also compare the ex- tent to which actual expenditures deviate from planned or budgeted expenditures. The auditors may also be expected to see whether the factors that are included in the overhead of the organization are properly classified as such or whether they should be classified as part of the direct cost of a specific project. Conversely, they will check to see that items treated as direct costs are properly classified and charged to the cor- rect project. The auditors can be expected to look at operating expenses to be sure that they are properly classified as unrelated or related and that there is compliance with the payment of taxes.

On the revenue side, the auditors will be concerned with the accurate recording of the amounts of revenues, in the proper time period and in the proper classification by type such as fees, gifts, and contributions, income from investments, sales, and so on. The auditors will also check to be sure that there are proper controls set over the receiving of revenues, including the persons who are so authorized, and that there is a chain of command within the organization to control the receiving, recording, and accountability for such revenues. Where applicable, as in the case of endowments, the auditors will assure that accounts are segregated and independently recorded.

Where cash is involved, the auditors may want to be sure that there are physical safeguards for keeping cash and procedures that control and limit petty cash to a rea- sonable amount. Where securities are concerned, the auditor will verify the type and the reasonableness of their reported cost and return.

In carrying out their function, the auditors focus on financial statements, such as the balance sheet, that tell them about the treatment of the assets and liabilities of the organization. They focus on the revenue and expense statements, which tell them about the flow of revenues from various sources and the expenditures of the organi- zation for various purposes. They examine those and other statements that explain how the financial position of the organization has changed over a period that is usu- ally one year. Their only use of the budget is as a standard through which they may

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judge departures from the organization’s commitments, what the organization thought was reasonable, and as evidence that there is some credible attempt to con- trol both the revenues and expenses of the organization.

At the end of the audit, the auditors may render an opinion in writing to the or- ganization. The opinion is divided into a section that describes the scope of the audit, a disclaimer, an explanatory paragraph, and an opinion. The scope tells what finan- cial statements were audited and for what period; the disclaimer tells what was omit- ted from the audit and why; the explanatory statement explains departures or pecu- liar aspects of accounting by the nonprofit and why they may be justified; and the opinion is the judgment of the auditors as to the conformity of the organization with generally acceptable accounting practices. An opinion may be “clean,” meaning that the organization conforms with the GAAP, or it may be “qualified,” meaning that it expresses concern about the practices of the organization.

The Scope The scope statement gives the period and the specific fund being audited, as well as the basis for the audit. Note that the scope is limited to a certain period, but it may also be limited to a particular fund and be conducted for a specific purpose.

The Explanation The explanatory paragraph further defines the scope of the audit. In some cases, it emphasizes that the audit is not of the entire organization, which is not unusual. As we recall, endowments are accounted for separately, and often periodic auditing may be called for in the contract. Alternatively, the audit could have been for the organi- zation in general rather than for a specific endowment alone.

The Opinion In a clean opinion, there are no qualifying statements. The auditors may state: “In our opinion, the financial statements referred to above fairly present.” Take note that the opinion does not use words that imply that the financial status of the organization is strong or weak or precarious. An audit does not make judgments about the financial strength of the organization. Only those who interpret financial statements make such judgments. Note also that the audit does not say that the numbers used by the accountant or bookkeepers for the nonprofit are right or wrong. Even a clean audit does not verify that the numbers are right. An audit gives an opinion about the sound- ness and merits of the procedures and practices used.

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Preparing for An Audit

What is management’s responsibility in preparing for an audit? It varies depending upon the scope of the audit. One of the broadest audits is that done of nonprofit re- cipients of federal assistance.

Circular A–133 of the federal Office of Management and Budgets describes the auditing of programs that are financed by the federal government. It offers a useful protocol for all organizations and managers whether or not they receive such funds. The financing by the federal government may be through cash payments, loans or loan guarantees, cost-reimbursement, the transfer of property or other types of non- cash assistance, or the use of these assets directly by the organization or by its sub- contractors.

The circular sets certain requirements with which the management of the organ- ization to be audited must comply. Management must prepare and give the auditor a schedule of expenditures of federal awards it has received during the period to be audited. Management is expected to disclose to the auditor the terms of the contracts and to demonstrate compliance with these terms. Management is also expected to provide effective internal control over the federal assets, to be able to demonstrate this control, and to provide the auditors with copies of correspondence that are ma- terial to the management of the contract.

In addition, management must also provide all financial documentation includ- ing reports, claims, books, and other records that provide the basis for the financial statements. If there is a pass-through, records pertaining to transfers from and to the nonprofit must be surrendered even if these transfers or communications occurred electronically. If the subcontractor’s auditors have findings, the nonprofit being au- dited must demonstrate that it acted expeditiously upon these findings. It must also reveal all contracts with the subcontractor.

If there were previous audit findings about the organization, these must be sur- rendered to the auditor with a description of any ameliorative actions taken. Changes in internal control that could materially affect the federally assisted program must also be given to the auditor. Of course, the management must always warrant to the truth and accuracy of all these statements and documents it gives the auditor. Failure to comply or to cooperate is sufficient reason for a qualified opinion or a disclaimer and a reason for pursuing the audit. The Circular A–133 audit is not only about ac- counting procedures, it is also about contract compliance and internal control.

Illustration of Managerial Use of Financial Statements

Let us role play. Let us pretend that the board of directors of a nonprofit organization is meeting. We have just entered the room when the board is about to listen to an extensive report by the CEO about the state of the organization at the end of the year

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2004. Notice how the concepts discussed in the past chapters of this book are put into play in a conversation between a smart manager and a board that is doing its duties at a board meeting. There is full participation—across the board. Members try to ex- plore the meaning and implications of what they are viewing for the welfare of the organization. The financial statements are not divorced from planning or from the current or future budgets.

A secure CEO would rarely enter such a meeting without his or her executive staff and would expect them to be able to explain technical matters. In such a meeting, each financial statement has a specific story line. The balance sheet tells about the status of the organization, the income statement about the operations of the organi- zation, and the changes in financial situation about how or through what major trans- actions these changes in the financial status were brought about. In a well-balanced board, a conversation can be conducted without talking in technical tongues. The formality of the conversation enhances its seriousness.

Chairman Eugenia Norman-Ruby: Let us come to order. I would like to ask Victor Alexis, our new CEO and president, to give us a complete rundown on the financial state of our organization. As a board, we are concerned because of the increasing de- mand on our resources, and we brought Mr. Alexis because of his confidence that he could reverse our past few years of deficits. We were all very conscious of the fact that years of deficits would eventually destroy this organization and its ability to carry on its important mission. Furthermore, I remind each and every one of you that part of the duties of a trustee is the duty of care. This implies our unequivocal involvement in the financial health of the organization.

Board Member Delfina Atherton: Does this mean that we can’t snooze through this boring stuff?

Chairman Ruby: Ms. Atherton, I promise you that it will not be boring. It is a legal and inescapable part of our duty as trustees. Mrs. Norma Reginald-Sadie who is chair of our finance committee, Mr. Millett Clifford, chairman of our audit committee, and I, as chairman, have gone over these financial reports that were audited by Ezra, Ford and Chambers a reputable CPA firm with a specialty in our line of work. Ms. Olivia Fibuiel-Innis who was in charge of the audit for the firm is here with us today and so, too, is Mr. Thomas Beckels who is one of our two attorneys.

Discussion of the Balance Sheet Mr. Alexis: Thank you, Mr. Chairman. I would like to ask you to turn to the balance sheet or statement of financial position that we sent each of you in advance of this meeting. We are conscious of the fact that we have a responsibility to inform you, and that is the only way you can exercise your duties properly.

This statement summarizes our financial health as of the end of the past year. It tells us that our assets exceeded our total liabilities—we owned more than we owed. This difference means that we achieved a positive fund balance at the end of the past

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year. Our unaudited report for the past six months suggests that this positive fund balance is growing.

Before we go further into detail, let me call your attention to the bottom lines in the balance sheet. They show that a majority of the assets that we have are unre- stricted funds, followed by those that are temporarily restricted, a substantial portion of which would be released from the donor-imposed restrictions during the year. The remainder are restricted.

Board Member Dorothy Johnson-Bostic: I interrupt to remind the board that the restrictions we imposed last year on the $4 million check that we got from Clark Smythe is reported as unrestricted. He graciously gave the money without restricting how it is to be used. We imposed the restriction. Therefore, while for our managerial purposes we treat it as a restricted amount, for accounting purposes it is unrestricted. Our financial statements report donor restrictions because of the legality of such re- strictions. As a board, we can remove our own restrictions, but we can’t remove a restriction or disobey a restriction that a donor sets.

Vice Chair of the Board Francis Cox-Dylan: That’s an important reminder. I saw some of you look with wonderment at those figures. It is one of those peculiarities of 501(c)(3)s and other organizations that receive tax-deductible gifts. Please be assured that the decision that we made last year about the $4 million is being honored. We have supplied a separate report showing these managerial restrictions and the vari- ances between our actual and budgeted expenditures for the year. We’ll get a chance to question the President about these variances later.

Balance Sheet: Asset Management President Alexis: Let us turn our attention to how we are managing the assets of this organization. How are these broken down? Basically, our assets, as are those of other organizations and associations, are broken down into two large classes—those which we call current because they are readily accessible and those that are fixed or long- lived.

We closed the year with current assets equalling more than $10 million. This number, as all other numbers, should not be held as implying either that that was the average amount we held during the year or that that amount was constant. It changed from time to time, but that is the amount we ended the year with, and it is considera- bly greater than what we had last year.

Board Member Albert Van Horn: Does this mean that you may very well have op- erated with substantially less during the year but closed the year up with $10 million?

Chairman Ruby: That is correct, and the reverse is also true. President Alexis: Thanks. As I was saying, our current assets are broken down

into the usual categories: cash, marketable securities, receivables from sales, contri- butions and pledges, dues, and inventory. Please note that we have decreased the amount we hold in cash. With the market being as good as it is, we have tried to follow

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Mr. Kenneth Sandiford’s recommendation to hold more marketable securities, and that strategy explains the figure—not only do we own more but what we own has ap- preciated considerably. We account for our holdings at their market price at the close of the year. We did well.

Board Member Hector Hogan: I wish to remind the board that the policy to invest more was not the only thing we voted upon. We voted upon setting up a guideline for allocation of our investments among certificate of deposits, stocks, bonds, and treas- ury notes. This diversification will help us to meet our obligations if the market turns down. It is wasteful to carry so much cash as we did. The earnings from these invest- ments will enable us to do our work in the future. Also, because we did not borrow to make these investments, all of the earnings from them—interest, dividends, capital gains, and even the rentals from lending of our securities—are tax-free. They are not subject to the unrelated-business income tax.

If we were a political action committee, however, we would have had to pay in- come taxes on this amount. Furthermore, if we were a 509(a)(2) organization, there would have been a limit to the amount of these earnings we could use to demonstrate that we are publicly supported, and if we were a private foundation, it would affect the amount that we have to distribute annually.

Board Member Winston Oakley: And it would also have increased our need to get in more dues or gifts and contributions so that we can meet our public-support test.

Board Member Thelma Dacosta: By the way, does my association have this prob- lem? I am also on its board.

Board Member Sonia Leslie-Fernandez: Associations also have to worry about setting and following investment policies, unrelated business income, and demon- strating that their membership financial support is a considerable part of their total income. But let us not jump the gun. The fact that these appear in our balance sheet does not imply that we would make these gains when we actually sell. Today’s bal- ance sheet shows the investments that could lead to gains or losses in our income and expense statements next year.

Board Member Joseph Morrell: What is this about inventory? President Alexis: As you know, we carry large inventories of a variety of proper-

ties from personal properties such as uniforms to books that we sell. Since we run a cafeteria, we also carry inventories of food. Clearly, we cannot count each item and value each item every day because we purchase them at different days and some of our inventories perish, some we must sell at a discount after a period of time, some we must dump, and some increase in value. We try to get a value of our inventory taking these factors into account, for example, discounting some for loss of value and using a technique to assume that the value of the last unit of an item purchased is the value of all similar items in our inventory. We could, of course, have used an equally acceptable technique of valuing all similar items by the price we paid for the first of such items. Is this what you are referring to, sir?

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Board Member Morrell: Not exactly. What concerns me is the tremendous growth in inventory. As you know, such a growth is not cost free. There is the ordering or purchasing cost of the items. There is the holding cost, including storage and insur- ance. And there is the risk that the inventory would become damaged or even obso- lete. There is also the question as to whether the inventory increase resulted from our inability to move it, our producing and acquiring the inventory in anticipation of sales this year. You see, an increased inventory is not by itself a sign of progress.

Vice President of Operations Cynthia Edgehill: Your point is well taken, sir. We sought to significantly increase a large part of our inventory in November because we got a good discount and we believed that we can exhaust it in the first quarter of the year with little additional holding cost. Frankly, by the middle of the quarter, most of that inventory should be sold and you would see a reduction in inventory and an in- crease in cash or accounts receivables to the extent that we extend credit that we need to do. Unfortunately, as you are well aware, we did not receive payment for 100 per- cent of the credit that we extended. Thus, our receivables (as incidentally our pledges) must always be discounted for amounts we will not collect.

Chairman Ruby: Please summarize quickly your comments on fixed assets, which is the other category of assets you mentioned, and move along to the liability side.

President Alexis: I shall be happy to do so. We made no major changes in our fixed assets last year. We acquired and disposed of no buildings or equipment, which are the major components to our fixed assets. We do want the members to appreciate, however, that we use the original cost of these assets in our accounting and decrease them by the amount of their depreciation. Of course, we depreciate a building, but not land. Therefore, the accounting data sort of understates the real value of our prop- erties. These, because of a very strong real estate market, are actually higher than shown. We do not know exactly what the values are.

Board Member Violet Gustave Rudolph: I guess we don’t get tax appraisals from the local government, because we are exempt from property taxes because all we use all our properties for is to carry out our mission.

Board Member Rosa Brown: And we don’t pay unrelated-business income taxes either for the very small portion that we rent out to Jocelyn, Sinclair and Scantlebury even though they are a very profitable for-profit firm.

Board Member Dorotea Medford Gibbs: Please remember that the balance sheet simply tells us what we owe and own. These questions about the character of actual earnings, while important and accurate, will have more to do with the income state- ment. In that statement, we will learn how much we actually earned and what the character of these earnings are for tax purposes.

I would like to have the President tell us more about the liabilities. What are the claims against these assets on the right-hand side?

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Balance Sheet: Debt Management President Alexis: Like the asset side, the balance sheet shows liabilities as either long- term or current. As you all know focusing on the liabilities side tells us about our debt and the claims of others against us.

The current liabilities are mostly made up of accounts payable. These are the amounts we owe people who sell us things such as goods and services. Incidentally, it includes our compensation. It also includes our interest payments during the pe- riod. This is both our interest payment to the bank for the line of credit that we took out and the payments to our bondholders—those holding our revenue bonds.

Member Bettina Jones-Maynard: I don’t recall. Didn’t we have to use our accounts receivables and out inventory as collateral for that bank loan?

Chairman Ruby: Yes, we did. They used 80 percent of the value of both on the date that the loan was closed for collateral purposes. Of course, that does not infringe on our use of these in the ordinary course of operation. We still want to move this inventory, get the cash even from those who purchased on credit, and pay the bank.

Board Member Laura Layne-Campbell: If my arithmetic is correct, our current as- sets were five times as large as our current liabilities. If I remember my accounting, this is good because it tells me something about our ability to pay our current debt. That is, for every one dollar in debt at the close of last year we had five dollars’ worth of readily available assets to make such payments had we chosen to do so. Is that correct?

President Alexis: Yes. The arithmetic difference between those two numbers is called the net working capital and the ratio of current assets to current liabilities is called the liquidity ratio. But what impresses me more is the fact that we had suffi- cient cash on hand to meet those liabilities. We wouldn’t have had to sell our securi- ties, depend on a fast sale of our inventories, or hound our customers and members to pay up in order to meet those debts. In short, we managed both our short-term or current debt and our current assets wisely, and we were shrewd enough to get a line of credit to back up our cash position.

Board Member Lord Tomlinson Romero: Let me congratulate the managers on keeping us liquid and afloat. But I am reminded that this is a year-end report. Were we that liquid throughout the year?

President Alexis: Frankly, we almost had a shortfall and were able to get a gov- ernment advanced payment. We also had to draw on our line of credit. It is our insur- ance and our first line of defense so that we do not have to touch our investments or endowment.

Board Member Anita Theopholous: I seem to remember that Mr. Teddy Gillette, our Treasurer, was adamant about our performing in a way that would keep up our credit rating. Have we done so?

President Alexis: Yes. As you know, the purpose of our issuing those bonds was to develop a massive community for the elderly. I have asked our accountants to pre- pare a separate set of financial statements of that project. The balance sheet for that

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project shows that our total debt outstanding is $12 million. That is in the lower left. If you go up to the upper left, it would show that our payment of interests during that period was $157 thousand. Our payment of principal was $100 thousand. These were all current liabilities—claims that our borrowers had against the project over the past year.

Please turn to the upper left of the balance sheet, and it shows the total cash and marketable securities and outstanding rents due as receivables associated with that project alone. That amounted to $800 thousand. Thus, our current assets for that pro- ject were more than three times what we owed our bondholders and more than two times what we owe all of our creditors combined—including the maintenance service. If we look at the income statement, our rents were more than nine times the interest we owed. This index, sometimes called times interest earned, is very favorable.

But that is not all. Our credit rating also depends upon the quality of income. By that I mean its steadiness and dependability. Our account receivable is very low be- cause our renters pay their rents. Moreover, their rents are partly guaranteed by the government. They are steady. Let me add that if you go back to the balance sheet of this project you would discover that the ratio of debt to total assets is less than two percent. The project owns substantially more than it owes.

Board Member Dolores Dudley Trotman: Let me interject to say that the fact that the organization’s overall financial statements are strong also helps. These things tend to impact each other in the minds of the bondholders. Moreover, that such a large part of our income, as we shall soon see, is unrestricted means to the bond- holder that the parent is not only financially strong but has discretion to use those funds to ensure paying off the debt. I am feeling more secure about our debt manage- ment.

Discussion of Liquidity and Liquidity Management Board Member Isaac Perez: With such a healthy working capital number, we must be very liquid.

Board Member Olivia Henry: That is right, we have a healthy, a liquidity ratio be- cause our current assets well exceed our current liabilities—that is—those bills we currently due.

Board Member Isaac Perez: Yes, that is my understanding. Board Member Elaine Simon: Sorry to disappoint you, but that is not necessarily

so even though that is the way they teach it and many textbooks describe it. But any truly experienced CEO will tell you that that is not so and may be misleading. That is why alas the accounting regulatory association is undertaking a change in how those numbers are used to determine the liquidity of an organization.

Board Member Perez: What do you mean by that—liquidity?

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Board Member Elaine Simon: Well, let me explain. The liquidity of our organiza- tion is its ability to put its hands-on cash right now if it needed it. We can't sell off our long-term assets such as real estate and get cash for it tomorrow.

Board Member Perez: I understand but we are not talking about those long-term assets and liabilities.

Board Member Elaine Simon: That is true, but many of the current assets are not as liquid as you may think or the manager may need. Some of the “cash” is our wise investment in certificate of deposits and treasury notes that will mature in six months. We may not collect quickly on some of our receivables or sell sufficient of our inven- tory to have a load of real cash either.

Board Member Margie Watson: But there is a good thing we have going for us and that is that two years ago we established a line of credit that line we can draw on anytime we need it. That too is liquidity and not reflected in those numbers. Also not reflected in those numbers is that several years ago this board had the common sense to impose certain restrictions on what we did with our earnings. Those are not re- flected in the financial statements which only reflect donor restrictions.

Board Member Booze-Wallace: My issue is a little different. It has to do with these restrictions you mentioned. could someone explain?

Board Member Wallace Edward: A donor may place restrictions on the use of his or her donation and that was like a contract once we accepted it. Some of these restrictions were permanent, some temporary and sometimes there would be none at all. I hear that they are contemplating getting rid of the temporary category but we need to report them because they are varying contractual restrictions on our true liquidity.

Chairman Ruby: That is why we attend these meetings to help the board see behind these accounting data that can't speak for themselves. Keep the questions coming?

Discussion of the Income and Expense Statement Chairman Ruby: In the interest of time, let us turn to the income statement.

President Alexis: The income statement tells the source of all of our revenues dur- ing the last period. This includes revenues from our net sales (sales minus discounts and returns), gifts and contributions, contract income, investment income, and in- come from the sale of our fixed assets—if any. There was no sale of the assets. There- fore, there is no income from such sales we have to report on our income statement and no decline from such sales on our balance sheet.

Again, I call your attention to the bottom lines. We operated efficiently. Our rev- enues from operation exceeded all our expenses by four to one. As you are aware, one of your responsibilities would be to decide how that excess is to be used. We shall visit that issue when you set broad guidelines for our next budget or amend this cur- rent budget later in the year.

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Illustration of Managerial Use of Financial Statements | 561

It is important that you note that the majority of funds that came into the organiza- tion from donors was unrestricted. Again, accounting rules require our income state- ment to separate funds that donors restrict the use of permanently from those that are restricted by the donors temporarily or that have no donor restrictions at all. The lack of restriction allows us to exercise discretion and avoid the Simon’s Dilemma.

Fortunately, the format we use for reporting income and expenses segregates those revenues that are considered public support from others. As you may recall, we need to pass a test showing public support and we need to try to achieve that every year.

Also, I do wish you to note that the $5 million promise that has been pledged to us by Sybil of Jamaica, Ltd., is reflected as a receivable. We have not received it, but there are no contingencies or reasons to doubt its receipt. As you know, a promise to give can only be recorded as such if there are no conditions that would reasonably place its receipt in doubt.

Board Member James Smith: Sir, I find it helpful that your statement allows us to look at certain types of expenditures across major categories. We can look at salaries across fund-raising, management, and programs, for example, and we can total up the expenditures on each of these categories. Are there any general rules on the dis- tribution among or between categories that we should be following?

Board Member Enid Jones Debrathwaite: No, there aren’t. I jump to answer the question because we had a strong debate in another organization and came to learn from Attorney Janet Stewart-Williams that even the Supreme Court and the IRS realize that organizations can be so different that to come up with one ratio is unwise. Ex- pense ratios should reflect the operating realities of each activity. Some activities are more labor intensive and involve more skilled personnel than others. We trust that our accounting staff is allocating costs correctly.

Board Member Sylvester Prince: Our job is to use these numbers in the income statement to ask the following questions: (a) Are we producing a surplus for the or- ganization at the same time that we consciously carry out our mission? (b) Is some of the income taxable and are we paying the unrelated-business income tax? (c) Can we control these expenses better? (d) Does the composition of our income stream allow us to pass the support test? (e) Are we allocating costs properly? On this last point, it seems to me that what we have are actual expenditures (not true costs) and that we do not know enough about how indirect costs are allocated across these various groups.

President Alexis: Your points are on target. As you know, indirect cost allocation is important for our survival, our ability to recover the full costs of our activities from those with whom we have contracts, and that the failure to recover these costs will eventually create financial problems. The notes to our financial statement describe the method of indirect cost allocation that we use.

As to the other points you have made, you are correct that the financial results have far-reaching consequences. We must report these in our 990 forms, which are

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made public and which are the bases of IRS decisions about our classification. Part of our financial planning must be to ensure that we meet these tests. I am fully aware that the details of doing so are part of our responsibility as management, and we ap- preciate that the board does not micro-manage these details.

While we report financial results to you today, we calculate these figures through- out the year and use them to develop variances from the budgetary targets that the board sets. Let me emphasize that your question as to whether these operational re- sults actually meet our targets is very much germane and so, too, are your questions about whether they meet our requirements to keep our tax-exempt status or bonding rate or covenants surrounding the outstanding loans. They do. Thanks for your ap- preciation of the fact that the glow of a financial performance is not all there is to what we are about. These financial statements and budgets are instruments for keeping control and guiding the organization. As management, we are constantly comparing them and are accountable to you.

Board Member Roy Wood: Am I correct in concluding that at some point we, as trustees, must look at these results again from what the Form 990 and budgets say?

Chairman Ruby: Your question applies to all financial statements, and we have one more to look at. But I wish to respond affirmatively to your question at this point because the income and expense statement is actually the fulcrum of all financial statements, and it is so easy during the discussion of this statement to become either saddened or overjoyed with the bottom line.

As a matter of fact, I have requested that we obtain a full financial statement for our stores so that we can look at those in detail. We may want to consider subcon- tracting the operations of these stores. I got to this idea from looking at the data for its expenditures and revenues along with the other “program” in this financial state- ment and notice that it is not as financially prosperous for us. Okay, I don’t need to be reminded that we don’t have a profit motive. But neither do we have a pledge to be losing money. A properly constructed subsidiary or contractual relationship would not necessarily change our tax-exempt status or the taxability of the earnings we ob- tain from this enterprise.

Board Member Harry Tait: Some of our new members may be wondering, as I did when I first got on the board, why the income statement can show such an apparent imbalance between our earnings and our taxes. Perhaps we ought to be reminded, Mr. Chairman, that as a tax-exempt organization we do pay taxes on earnings unre- lated to our income. Furthermore, but for the grace of good management, we could have ended up paying taxes on interest, dividends, capital gains, royalties, and rental income if the management were not careful not to violate the rules that make those specific classes of income exempt.

Vice President for Finance and Planning Gooden Walters: We make those consid- erations part of our overall planning. We always have to consider how what we do impacts our financial position but also our tax-exempt status. That is why we retained the tax-law consultants Charlotte, Melvina and Kelly.

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Discussion of Changes in Financial Position President Alexis: Before proceeding to look at the statement of changes in financial position or cash-flow statement, let me expand on the idea of the income and expense statement as the fulcrum—a word used by the chairman. The balance sheet tells us about the status of the organization at the end of an operating period. The income and expense statement tells us about how we operated to achieve that status. These other statements tell us which resources were used during this operation and where they came from.

I may live to regret saying this, but often a board becomes so enamoured with the positive surplus that was achieved without ever asking how it was gotten. Such a sur- plus could be gotten, for example, by selling more bonds because this brings in a heavy cash flow at the time of sale. It could have been gotten by our selling some property, or it could have been gotten because we carried out our mission efficiently. The next statement we are about to discuss, changes in financial position, helps us to understand the sources and uses of resources during the period and to uncover where they came from.

I want to call your attention to the fact that, as in the previous two statements, we report permanent, temporary, and the absence of donor restrictions.

Board Member Harris Soley: I thought that depreciation was an expense. That is what it shows in the income and expense statement. Why are we adding it back in to determine the source of our resources?

Board Member Mitchell Scott: As an accountant, I can tell you that this is common and reasonable. Depreciation is not a cash expense. It is merely a bookkeeping or pa- per expense. No money is ever used up in paying someone for depreciation, therefore, none of the organization’s cash is used. If we didn’t add it back in, we would have implied that the cash left the organization. It didn’t.

This does not mean that depreciation has diminished actual operational im- portance. We actually used up the physical capacity of our equipment—we just didn’t pay out cash in doing so. Because this equipment and building would someday have to be replaced, the board passed a resolution that a “capital replacement fund” be set up and that that be funded partly by a fraction of this depreciation. Again, however, this does not imply that the funds leave the organization. There is just an inter-fund transfer, so to speak. The organization has lost no cash, it merely placed part of it in a different pocket for a rainy day.

President Alexis: This has been an open, not an executive, meeting, and our vis- itors must leave shortly. Let me quickly summarize the sources and uses of our re- sources during the past year. I call your attention at this point to the fact that all our resource uses were consistent with our mission. There were no dividends because that would have been personal inurement and illegal. Further, note that our main re- source was internal—from our own operations. I call attention to inventory because a question was raised earlier about the size of our inventory. Do note that the turnover

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or sale of our inventory was a major source of funds for us, and so was the collection of receivables associated with those sales.

Board Member Polly Veronica Welch: You say that these were major sources. I notice that all sources show decline over the past year and all uses show rises—at least for the assets, and the reverse is true for liabilities. Please explain.

Board Member Gaskin Diaz-Lowe: Let me explain. For assets that decline, say for inventory or receivables, are sources because we sold the inventory we had and got cash or gave credit. Then we collected the credit and we got cash. Similarly, when we sell some of the stocks or bonds we own, we will reduce our holding of these and report that we got cash for them. I hope that this would be more than we paid and we would get a substantial realized gain. As it stands in the balance sheet at this point, the gains are unrealized as we still own the securities. In the case of liabilities, notice just the opposite is true. Notice that our payables went down sharply and that was possible only because the staff used cash to pay off our debt to others. When we pur- chase goods or services on credit we are temporarily using other people’s cash to fi- nance our organization.

Chairman Ruby: Thanks for this discussion. Please remember that we will have to revisit some of these findings when we submit our Form 990, our taxes, and when we prepare our budget. Our budget should reflect the reality of our recent experience.

Discussion of Cashflow Board Member Raymond Braxton: Wow, we did well in moving money in and out of the organization last year. I am especially struck by the contribution and investment numbers and the amount of cash we generated.

Board Member Natalia Wynter: Don't put it that way. We are not money laundering. Board Member Raymond Braxton: But we are taking in cash from the various

sources given and spending it for the various good reasons given. Board Member Natalia Wynter: Yes, but part of the cash we take in this year came

from the tremendous efforts we made in the past. We made for example, a tremendous and expensive effort to court donors over the past two years and raised little then. Now it is paying off for us. We must continue to work hard just to sustain it. Fortu- nately, part of our cash flow for the major repairs we did will not have to be made next year. There can be such jerkiness in cash flows.

Board Member Felicia Conrad: I am aware that the stock market has done very well and that our real estate portfolio has also done well. Over the past years we have averaged an impressive total rate of return. But as we celebrate this, let us not forget that it came with a great deal of effort on the part of our staff, the monetary charges of our agents and for doing business to make such highly rewarding investments.

Board Member Sara Malcom: Thanks for that reminder. I understand that the ac- counting regulatory bodies are interested in having nonprofits reflect these costs even though they may deflate the rate of return, they'll be more reflective of the true costs.

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Illustration of Managerial Use of Financial Statements | 565

Board Member Carlyle Henry: But we need to account for actual cash received and spent and sometimes we can do that directly and sometimes we do that by esti- mating what the cash flow would be in various transactions. In any event, we need to know for operations purposes and also to detect what could be an illegal flow of money or could cause suspicion that that is what we do.

Discussion of Audit and Impact of Financial Statements Board Member Richard Gooding: Mr. Chairman, just before we bring this discussion to an end, I would like to applaud the staff for an excellent job. I note that the financial recording and reporting they have done meet the generally acceptable principles in accounting, and we have gotten a clean audit. I hope that when we audit our endow- ment and when the federal government audits our accounting for their programs that we shall have the same results. I am mindful that these are independent and separate audits. But we need to applaud not only the general management that provides us with outstanding operating performances, but with the management of our finances, and the financial recording and reporting systems. At least we did not get an opinion that our accounts could not be audited because there was no way of tracing expendi- tures or receipts.

Chairman Ruby: I totally agree with you. We often forget that our financial state- ments are public through the Internet and may be used by watchdog agencies and both state and federal governments. The contents of these statements give confidence not only to knowledgeable donors and, therefore, increase our fund-raising yield, but they are also important to foundations and to those with whom we contract. Again, thanks.

President Alexis: Thanks for the fine compliments. But the staff needs to express its own thanks. One of the reasons why our unrestricted funds have grown so much as a percentage of the total is because of our concerted efforts to solicit such contributions. It was just two years ago that this board directed us to focus our soliciting campaign on unrestricted gifts. What happened in the past is that our funds were generally restricted by donors to our most popular and, perhaps, our single best program. But a dynamic organization that is full of imagination does need unrestricted funds, and we have been successful in using the two best sources for us—our revenues generated from our own fees and sales and our campaign that encourages unrestricted gifts with-out detracting from the eminence of our main and best known programs.

The Impact of Transactions Board Member Sandra Cummings: Mr. Chairman, we are grateful for the large gifts that have made our financial statements so much more attractive and for the work the staff has done in increasing the financial efficiency of the organization in general. Because he recognized that large gifts such as the ones we have reported could have

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significant impact on the organization, Mr. Frederico Larson urged this board to cre- ate a subcommittee to look at the possible impact of these gifts on the organization.

As a result, a subcommittee was formed with Mr. Evans Coloute, Ms. Lynnette Benjamin, and me to look at ways to integrate these gifts. Our subcommittee report is not yet due. However, I would like to alert the board to routes of investigation we are now pursuing and to accept any recommendations. First, we are aware that such large gifts, if not balanced by others, could impact our ability to pass the public-support test. Second, we have to avoid being categorized as a private foundation and the do- nors as disqualified persons. Third, should these or similar gifts not materialize, just as they boosted our financial statements this year, we would have to discount them in the future causing a negative picture of our statements. These are just three of the directions, esoteric as they might be, that we are following.

Board Member John Cummerbach: I hope that you would also look at our ability to meet the terms of the gifts—if any. Even though these funds are unrestricted, do- nors can be angered when their gifts are used in certain ways. Unrestricted does not mean disinterested. Furthermore, gifts of the size that we are reporting tend to impact the program direction of the organization even though we would remain within the broad terms of our mission.

Board Member Waite Carr: I hope the ad hoc committee formed to shepherd in the gifts and to consider their integration will soon meet with Mr. Lloyd Sobers’s and Mr. Cedric Ferraro’s committees on strategic planning and budgeting with the aim of asking not only whether these gifts are consistent with our long-range plan, but how we may modify these plans given the new opportunities that arise with these gifts.

Chairman Ruby: I trust that Mr. Sidney Henry has gotten this discussion properly recorded in our minutes.

How Much Do Financial Statements Tell?

Financial statements show the organization’s status at the start and end of a period. They say little about the interim. Financial statements sometimes exclude facts, show them in favorable light, or are dressed to present the best picture of the organization. Sometimes they legitimately give incomplete information. For example, it is not cus- tomary for museums to report the value of their collections. Therefore, a museum’s balance sheet will frequently underestimate its assets.

Depreciation is now expected of all long-lived assets except rare pieces of art and historical assets. But how a nonprofit chooses to depreciate, whether it considers the asset depreciable, is a matter of discretion. Land may be depreciated if its quality is used up, as in farming. But for a building site, its quality remains reasonably constant once construction is completed. Therefore, there may be no depreciation charges shown in the balance sheet.

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Summary and Preview | 567

Similarly, accounts receivables and pledges are not all collectible; how much to report as such and how much to report as uncollectible are matters of judgment based on the history of the organization. Financial statements might be the next best thing to truth. What protects the user and justifies the patience in analyzing them as we have done is not only that they are the best information available. The misrepresen- tation of the facts in these accounts is illegal. The threat of the law constrains false- hood. The threat of an unfavorable audit constrains material incompleteness.

To gain greater uniformity and greater reliability in the interpretation of financial statements of nonprofits, the Financial Accounting Standards Board (FASB) has promulgated some changes. These include requiring most nonprofits to report (1) de- preciation, (2) gifts when they are deemed to be actually received and free of condi- tions, and (3) the value of volunteer services when these services can be priced, such as fees for attorneys because even though these services are not deductible, pricing and including them give a truer picture of the cost of running the organization.

Take a simple case. Frances Williams makes a gift to Gertrude and Louisa School for the Handicapped in the form of a pledge of a $1 million to be provided through the proceeds of a sale of Frances’s mansion. Should the school report this $1 million in its current balance sheet? Should it report it in the year the sale actually takes place? Should it report it in the year the hard cash is received? Each of these projects a dif- ferent financial picture of the organization.

The Notes

The notes to financial statements can provide insight into the meaning of these state- ments. They give explanations, expand on some accounting procedures and content matters, give definitions, and explain procedures commitment. Did you ever want to know whether an organization is a 501(c)(3), (4), (5), or (6) and what type of 501(c)(3), as discussed in Part One? Check the note.

Summary and Preview

This chapter is not about accounting and it is not about reading and interpreting ra- tios. Rather it is about using financial data for managerial assessment of the organi- zation and for decision-making. It assumes that most board members and senior man- agers even of large organizations are not accountants, are not excited about financial statements or of computing numbers, yet they hold a fiduciary responsibility to the financial and operating health of the organization. After introducing certain essential matters of financing and accounting that the manager or trustees cannot escape, it proceeds to show through an extensive discussion of a typical board, they might raise

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the right questions, come to a reasonable conclusion, and satisfy their duty to serve the organization in a beneficial manner.

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DOI 10.1515/9781501505713-019

Chapter 18 Evaluating Old Targets and Setting New Ones

After the financial statements have been explored for financial information, decisions have to be made about how the organization will proceed. Should new financial ob- jectives be set? What should be the new targets? With a good system of reporting in- formation, the board of directors and managers of the nonprofit should have financial statements at regular intervals in addition to more granular supplementary infor- mation using today’s technology. On the basis of this information, financial goals and targets can be modified. These modifications feed right back into the system and, in this sense, financial management is a loop. And this is how some of what we have learned to this point can help: 1. What are the financial requirements of the organization given what it wants to

accomplish? This can be ascertained from the budget. 2. Where will this money come from? The amount that is available internally is as-

certainable from a proper understanding of the financial statements. It will tell the amounts available in cash and other forms of assets now in the organization, the amount that is available for a specific use or over time, the amount by source, and the liabilities the organization may face that would reduce the amount available. A good budget may reflect some of this, but the original source should be the financial statements.

The external sources are the amounts that would have to come into the organization through fund-raising for gifts and contributions, the amount that may have to be bor- rowed, and the amount that would have to be earned.

From these two basic questions, the organization can set (a) its fundraising tar- get, (b) its earnings target, (c) know the amount available from a reading of its finan- cial statements, (d) then determine how much it must borrow to fill the gap, or (e) reduce the ambitious number in its budget and start again.

Periodic evaluations during the fiscal year lead to the setting of new targets or the affirmation of old ones, which themselves will later be reaffirmed or modified. This chapter is about evaluating old targets and setting new ones and the menu of short- term investment strategies that is available in this process. It is also about capital budgeting and endowment planning, both of which involve setting long-range tar- gets and strategies.

Targets may be set for investment, disbursement, and fund-raising objectives, the subjects of this chapter. Setting targets begins by assessing the status of the organi- zation.

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Questions for Evaluating Old Targets

The end of every fiscal period marks the commencement of a new one. A new fiscal year begins at the very moment that the old one ends, thus giving an uninterrupted continuity to the financial function. Having the financial data from the closing period means that the managers of the nonprofit organization are now armed with real data that indicate the actual financial performance of the organization. Management can also assess actual accomplishments. The balance sheet will tell the present situation of the organization: What does it have with which to launch the new year? One way to use these data is to amend or reaffirm old targets. These will be reflected in the new capital and operating budgets. The first step, however, is asking the right questions.

The following are examples of the questions that must be answered in evaluating financial targets: 1. Was the revenue target in the budget met? If not, by how much was it missed and

what was the reason? Does it make sense, in light of recent experience, to con- tinue believing that such a target is reasonable? Should it be increased or de- creased, or should it remain the same? Why? Are we on course?

2. What form and sources of giving showed the greatest increase? Is this a promising new area of emphasis? Is this where the organization has its best shot? In what form of giving did the organization underachieve? What can be done to get greater support from this form of giving or from this sector? What new strategies shall we try?

3. What is the distribution of support by source? Is there too much dependence on one source or form of giving? Should the organization diversify its base of sup- port? Does the mix of support leave the organization in jeopardy of its tax-exempt status?

4. What are the major cost factors in operating the organization? Can anything be done to contain costs without reducing the productivity and commitment of the organization to its mission?

5. What cost factors are rising and at what rate? Why? Is there a less expensive sub- stitute?

6. What cost centers are exceeding their budgets? Why? Was the budget allocation unreasonable? Should these allocations be realigned? Do some centers need less while others need more? What programs should be dropped?

7. Is it time to put some functions on a self-financing basis? Could they survive? Could they provide revenues for the organization?

8. If there is a deficit, how will it be financed? How long can it be sustained before destroying the organization?

9. Is it time to change investment advisors? Is it time to change banks, insurance companies, or the financial committee of the organization?

10. Is there a cash surplus? How can it be used to the best interest of the organiza- tion?

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Questions for Evaluating Old Targets | 571

These questions feed back into the strategic planning process from the interpretation of the hard facts in the financial statements. Once decisions are made about targets for the new year, renewed efforts must be made to raise money and contain costs, gather financial data and interpret them, and then begin the cycle all over again set- ting new targets. The process continues as long as the organization lasts.

Considerations in Setting New Targets

Based on the answers to the preceding questions, the management may set new tar- gets and restrictions.

First, there are policy considerations based on the mission and philosophy of the organization. For example, this organization will not invest in overly risky invest- ments, certain corporations, or countries.

Second, there are legal considerations. New targets should not jeopardize the tax- exempt status of the organization or its charter or place it unwittingly at odds with ethical standards.

A third type of consideration is contractual. Do these targets commit the organi- zation unwisely? Do they threaten existing commitments?

A fourth consideration is the capacity or knowledge of the organization. I hope that this book has broadened the horizon of management. Yet some may not have learned, others will fear, and yet others will reject. The point as noted in the strategic planning chapter is that an organization is constrained not only by what occurs ex- ternally but by its own internal capacity, imagination, and initiative.

A fifth and realistic type of concern is that the organization may simply not have the financial resources to be flexible. It is common for an organization to receive a high percentage of its support in the form of restrictive gifts, grants, or contracts. Hence, the room for discretionary decision making is limited. Ironically, however, it is these very organizations that need to push toward the development of unrestricted money to be used for the general support and development of the organization in the conduct of its growing mission. Recall Simon’s Dilemma (Figure 12.2); this was also discussed in Chapter 15.

Within this broad set of constraints, decisions have to be made and targets set. This chapter gives examples of six common types of financial target-setting problems in nonprofits and shows how they can be resolved.

To set financial targets, the organization has to have a firm vision of what it is and what it can do (Part One), because this vision must fit within these legal boundaries that shape the range of strategies at its disposal. The management will want to con- sider these options systematically (Chapters 17and 18), decide what investments to make (Chapter 16), or how to strengthen their fund-raising activities (Chapters 7 through 10). Management must also know how to control costs and attract good per-

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sonnel (Chapter 13). After these managers have had a chance to implement the pro- grams, they must evaluate the fiscal performance of the organization (Chapters 15, 17, and 18) and then reassess targets, set new ones, and make new investment decisions to help meet the targets. The process is continuous and circular and answerable to the trustees (Chapter 6).

Risks Inherent in Target Setting and in Target Achievement

When setting targets, it pays to be realistic. Events may occur that hinder achieving the target. Some of these may be generated from without and others are generated from inside the nonprofit itself. Nevertheless, they require some defensive contem- plation by the nonprofit. What shall we do, if anything, if the following occurs?

External Examples

1. Inflation is an externally generated risk against the realization of the plans of the nonprofit. If prices rise, costs may increase and reduce the purchasing power of the organization.

2. A fall in the stock market may reduce the net worth of the organization and also reduce the propensity of people to make gifts especially if they are realizing losses.

3. Changes in the tax code may reduce the tax motive for giving and it could also increase the tax liability of the nonprofit if it earns unrelated business income.

4. The entry of a new competitor in the nonprofit's market could challenge its mar- ket share.

5. The relocation of a local supplier or supporter could threaten availability of re- sources.

6. The failure of a collaborator could threaten the continuation of a plan or program.

All of the above could lead to the questions: Is the target achievable? Is it still worth the try?

Internal Examples

1. Insufficiency of staff or loss of key staff persons could threaten the practicality of the plan.

2. A major law suit could derail the plan. 3. An investment that goes sour could divert resources or fail to produce that which

is needed.

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4. Pledges not materializing may short-change the plan or make it unfeasible. 5. Embezzlement of dedicated funds—not uncommon way of depriving a plan of

what it needs.

Threats to Financial Targets:

1. Failure of fundraising to meet its target 2. Failure of pledges 3. Rise in prices of things bought 4. Fall in prices of things sold

Hedges are ways of dealing with financial risks such as the fall or rise in prices. One way to hedge is to buy or sell forward. When the nonprofit buys forward it does so because it expects the prices of what it may want in the future to rise above what it is now. So, it wants to save by buying now but accepting delivery some specified time in the future. If it is the seller, it is doing so because it expects the price to fall and it wants to lock in the amount it could get today.

Alternatively, the nonprofit could decide that rather than buying it will pay for the right to buy (a call) or the right to sell (a put). When options are involved, the party paying for the option is not obligated to act when the date as agreed upon to exercise the option arrives. So, if the nonprofit buys an option, it does not have to exercise the option when the time comes for exercising it, it merely loses the premium it paid to the seller to reserve it for delivery.

Of course, all of the above is done by contract. These contracts go by fancy names such as derivatives, because they have value and they can be bought or sold and their values depend upon whether prices are moving in the direction for which they were bought or in the opposite direction. To wit, if the contract was bought with the expec- tation that the price will rise, and it actually falls, the value of the contract would be lower and if it falls sufficiently, it might be worthless for the nonprofit that bought it because it would be cheaper to buy at the knockdown price—it being lower than the price at the time the option was bought.

What have we said thus far? That setting targets is not done in a vacuum, and that one of the real considerations are the risks associated with not meeting the target set and some ways of preventing or mitigating the loss when targets are not met. With that understanding, we proceed to actually setting targets and strategies for meeting them.

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574 | Chapter 18: Evaluating Old Targets and Setting New Ones

The Treasurer’s Report as A Source of Intelligence for Setting Financial Targets

The treasurer’s report highlights the financial experience and status of the organiza- tion over a specified period. It is given legitimacy by the signature of the treasurer of the organization and (if used externally) may require the signature of each board member and the CEO of the organization. The report may contain the following: 1. A highlight of significant changes in assets—specifically those that are material

to some policy declaration previously made by the board, some change in direc- tion that was taken or that the management deems desirable, or in such assets that are critical to the financial and operating health of the organization.

2. A similar highlight of liabilities—including contingent liabilities (such as law- suits and outstanding pension obligations) that are critical to the organization. This may include the rate of disposing of liabilities or drawing down on the assets created by and to pay off such liabilities.

3. Changes in restrictions or the impact of restrictions on the organization. 4. The investment experience of each portfolio and of the endowment. 5. The liquidity of the organization and its ability to meet upcoming obligations. 6. The meeting of capital campaigns or fund-raising targets and the need to accel-

erate such activities if desirable. 7. Extraordinary claims or receipts of the organization. 8. The results of implementing and monitoring past policy initiatives of the board

so that they may evaluate their decisions. 9. The results of the disposition of certain assets of the organization. 10. Major acquisitions—financial and otherwise—and their impact on the organiza-

tion. 11. New financial risks, credit ratings, and collateral requirements. 12. Board contributions to the organization. 13. Reports of consultants, lawyers, and auditors as they pertain to the financial per-

formance of the organization and status of filings the organization must make requiring the signature of the board or for which it is liable.

14. Changes in bank and other depository relationships. 15. Report on or request for new financial authorizations—who may sign, limits on

amounts, methods to improve cash management, investment policies, and changes in auditors, investment, or financial advisors.

16. The financial outlook of the organization, including opportunities, threats, needs, and targets.

17. Changes in revenue sources, including subscriptions, membership fees, and as- sessments.

A thorough treasurer’s report should increase the trustee’s ability to comply with the duty of care. It should also prepare the trustees by laying the foundation for financial

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The Treasurer’s Report as A Source of Intelligence for Setting Financial Targets | 575

recommendations to be made by the investment advisor, auditor, and CEO. Unlike the mere presentation of financial statements or the mere analysis of such statements, the treasurer’s report tells a story that goes beyond the numbers.

Assessment of Revenue Alternatives

In setting new targets, it is important to reassess the revenue structure of the organi- zation. The following questions would be appropriate: 1. Is the overall revenue stream sufficiently diversified to meet the tax-exempt

requirements if the organization is a 501(c)(3)? 2. Is the overall revenue stream sufficiently diversified to reduce a financial risk? 3. Is the overall revenue stream sufficiently coordinated with cost expectations? 4. Is the revenue stream sufficiently coordinated to meet covenants and other agree-

ments of the contract? Does it impede other contractual agreements? 5. Is the organization exploring all of its most potentially fruitful sources? 6. For each potential source, what is the answer to each of the following?

What is the normal range of its giving or support for the activities in which the nonprofit is eligible?

What would it cost the organization in money and other resources, including time to apply?

Are the funds discretionary? If not, what are the constraints? Can the organiza- tion comply? At what costs?

How long will the funds last? Is the organization penalized for achieving savings if it spends less?

When will cash begin flowing? Will costs be incurred before cash is received? If so, how will cash need be covered?

Can the funds be leveraged? Will the amount received be sufficient to cover indirect and direct costs? What are the risks that promised funds will be recorded but not received?

This last question is important because a sizable promise that has been recorded in the books, but not kept, has the potential effect of causing the organization to show a decline in assets. Such an unkept promise also has the effect of reducing the ability of the organization to make commitments planned on the strength of that promise and could, if large and significant enough, affect the debt rating of the organization. If it is a matched gift, it has the potential effect of having the organization renegotiate a restriction on the match or even losing the match.

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Cash Management and Investment Strategies: Increasing Cash

Having set revenue targets, the next question is, what do we do with the cash? One set of strategies that must be continuously assessed is what to do with the organiza- tion’s money (cash management) so that it might multiply until it is used to meet the organization’s targets. To appreciate the challenges of cash management, it is neces- sary to revisit the sources and uses of cash. Aside from donations and business in- come or membership fees, how does the organization get more cash?

Sources of Cash

In Chapter 15, we looked at sources and uses of cash for detecting the changes in the financial condition of the organization. Now we shift from analyzing past actions to the planning of present and future ones.

A source of cash is the operation of the organization. The organization may operate at a deficit or surplus. To this deficit or surplus, we add depreciation, since it was an expense charged but no cash was actually spent. Hence, two sources of cash are the surplus (the total revenues and support that exceed expenses) and the depreciation.

A third source of cash is the net decrease in all current noncash assets. A decrease in inventory implies that the organization had sales that yielded cash; a decrease in marketable securities implies they were sold for cash. A decrease in accounts receiv- able means that cash was received. A decrease in prepaid items and supplies is a source of cash savings and therefore a source of cash. If the organization had in- creased these current assets instead of decreased them, this would cause a decrease in its cash position. It can only buy more marketable securities or prepay items by spending cash.

A fourth source of cash is the increase in current liabilities. An increase in notes payable implies a loan of cash that would otherwise have been used to pay a bill. An increase in accounts payable means that the organization has increased its cash po- sition by not paying for its purchases. Similarly, an increase in salaries and wages owed implies that the organization has kept cash by postponing the payment of these expenses. If it had paid any of these expenses, its cash position would have de- creased. Expenses can only be paid with cash.

A fifth source of cash is the sale of fixed or long-term assets. The sale of the or- ganization’s furniture, automobile, and building will all lead to an increase in the organization’s cash.

A sixth way to increase cash is to enter into long-term loans. These loans may even be from insurance policies given to the organization or they may be from a lend- ing institution such as a bank. Let us take a deeper look at loans.

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Preparing to Borrow

Organizations should prepare for borrowing by taking certain steps. An organization should: 1. Obtain a resolution by the board authorizing it to borrow. 2. Have its financial statements, tax statements, and filings in order. 3. Obtain, if necessary, a letter of good standing from the state of incorporation. This

is a certificate from the state indicating that it has filed annual reports and taxes as required.

4. Determine whether there are outstanding encumbrances to its going into debt. An outstanding debt may prohibit further bother without the authorization of the creditor.

5. Ascertain whether it will have the cash flow to make debt payments. 6. Determine the length of time for which it needs the loan and match it with its

ability to pay. 7. Decide whether it has collateral for the loan and the extent to which it may wish

to encumber that collateral. Collateral may be accounts receivables, future grants or contract revenues already committed, or contributions.

8. Determine whether the loan would lead to opportunities for self-dealing and de- vise a preventative strategy.

9. Understand, before closing the loan, the conditions under which the loan is being made. These conditions may state what the organization must do to get the money, what it must continue to do while the loan is enforced. This may involve holding cash in the bank, it may require the board making annual restrictions on specific monies, it may even prohibit the organization from making significant increases in salaries. Please note that the breaking of a condition in the contract amounts to defaulting on the loan.

10. Learn what the penalties are. 11. Be prepared to do the annual reporting that may be required. 12. Consider getting a financial advisor, if the loan requires the issuing of a bond or

is sizable. 13. Be prepared to be truthful with the lenders and in applications. Lenders will re-

quire the management of the organization to make certain warranties and repre- sentations. It is a crime to misrepresent the facts and this may be punishable both by jail time and penalties.

14. Be prepared for conditions precedent. These are conditions that the lender may require before the conversation or exercise of the loan may move forward. See item 9 above.

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Events of Loan Default

There are a few concepts that the manager needs to be familiar with in negotiating or accepting a loan. A loan is a contract and breaking of any term of that contract may constitute an event of default. The lender often specifies these “events of default” that the borrower needs to be conscious of when accepting a loan. These covenants (re- strictions and requirements of the contract) may include periodic reports on the or- ganization including the proper filing of a 990 or 990EZ, notification of changes of management, restrictions on certain types of expenditures, the sale or disposition of certain assets or the acquisition of others especially if they are subject to debt or were used as collateral for the loan or to support the analysis for the loan, the discharge or elimination of a guarantor, major civil or criminal judgments against the organiza- tion, misrepresentation on the application and the declaration of bankruptcy or the filing for reorganization.

The lender may also ask for notification of financial problems or the failure to meet certain financial targets set by the lender, or default on any other loans. Some loans, including credit cards, have a cross-default clause which says that a default on any other loan is a default on the one in question. These are measures that the lender takes to protect itself and to give it early warning that something might go wrong with the loan. It gives the lender an opportunity to ask for accelerated repayment or closing the loan down. In addition, where the lender has insufficient information or know that information may change by circumstances it will ask the signer to warrant and to represent certain points—called in the contract “warranties and representations.” Deception on any of these warranties or representations or on the facts of the appli- cation for the loan including deviations from its intended use could be a cause for the lender to declare default.

Default, unlike the average delinquency for which there may be a late payment, is not a trivial matter. Default usually gives the lender certain rights and imposes upon the borrower certain obligations—specified in the contract. Furthermore, a de- fault as described above goes beyond the ability to pay or the actual payment of in- terest and principal. A default may occur because the organization fails to make pay- ments into a reserve required by the lender or pay taxes or filing fees required by the state. Fortunately, every loan is not subject to all of the items discussed here but all of them are possible. It is duty of the trustees and of management to read the loan contract before committing. Most are relatively simple.

Borrowing as A Source of Cash

It is normal for nonprofit organizations, as well as firms, to run into cash flow prob- lems and have to borrow. They also borrow to meet capital projects, such as purchas-

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ing a building or equipment or making leasehold improvements (improvement in of- fice rental space when the lease runs several years). Loans may be for a short or long term. What are the mechanics and strategies?

Short-Term Borrowing

Short-term borrowing refers to loans that are for approximately one year or less. The need for these loans may be indicated when the organization cannot meet current payments, such as for supplies, a month’s rent, payroll—basically payments that are periodic and current. These loans are sometimes called working capital loans and arise most commonly from cash flow or liquidity problems. That is, the organization is not necessarily broke; it simply is not receiving cash at the same time that it has to pay it out, or wisely chooses not to liquidate assets.

Calculation of Interest

When negotiating a loan, it is important to determine how the interest rate is calcu- lated. One way is to calculate the interest in dollars based on a nominal (stated) rate and then add it on to the amount of the loan. The amount “borrowed” is thus the amount asked for plus the interest on it. In short, the amount actually paid will exceed the amount you wanted.

This is a common way of determining interest on installment loans. When this is done, the annual percentage rate (APR) is the important number to know. It may be higher than the annual interest rate quoted and is required to be disclosed by law.

Sometimes the interest is simple. That is, it is calculated and may be paid at the end of the term of the loan. Another form of calculation, called discounting, is to de- termine the interest and subtract it from the loan; therefore, the borrower gets less than requested. Simple interest is the least expensive, but it is not always available.

Which balance is used also makes a difference. Does the interest apply to the bal- ance at the beginning or end, or is it an average of the daily balance during a period? Which will work better for your organization depends on the pattern of borrowing and repayment during the course of the month. See the upcoming discussion on av- erage daily balance in the following section, Lines of Credit.

Sometimes, even though these are unsecured loans (meaning that no collateral is required), the bank may require a compensating balance. This means that the bank requires the organization to keep some total in its checking account at all times, for which it receives no or a lower interest than is being charged for the loan.

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Lines of Credit

The following insert of a line of credit reflects many useful concepts; for example, compensating balances, prime rate plus, and encumbering certain assets as collat- eral. A loan contract is often referred to as an indenture and the conditions under which the loan is made are called covenants.

Again, establishing a line of credit when the organization is in the strongest fi- nancial position is a good strategy. Managing so that the debt does not overwhelm the organization is a necessary strategy.

One way to obtain a short-term loan is to request one, called a negotiated term loan, when it is needed. One problem with this is that the organization most needs a loan when it is also least attractive to a lender and the loan is thus seen as very risky. Second, the term of the loan may be very unfavorable at that time. Third, the situation may be urgent (for example, to meet a payroll) and there just isn’t time. For these reasons, organizations should establish lines of credit when their financial state- ments and outlook are most favorable.

Because cash flow problems are so common, every organization should consider a line of credit for short-term borrowing. Credit cards are a form of such credit, but these generally have such low limits that they cannot be used for major organiza- tional purposes such as payroll. It is therefore good for the organization to negotiate a larger credit line. The question is whether the temptation to use it willy-nilly can be contained. To protect against this, lines of credit should probably require the signa- tures of two authorized persons, just as checks should, when the amount being drawn exceeds, say, $1,000.

The bank is a common source of short-term loans whether they are in the form of a credit card or a line of credit. Basically, the bank approves the nonprofit to draw a check on the bank without having to negotiate a loan each time. Lines of credit are good to have as long as they are not abused. Such loans are negotiated well in ad- vance and are formalized by an agreement that is a promissory note. This note lays down the conditions under which the line is established, how the interest and finance charge will be determined, and the rights of both the borrower and the lender:

This is an agreement between Dylan Bank (the Lender) and Carla Carter Charity, as Borrower, for the establishment and use of a line of credit. This agreement constitutes a promissory note executed under seal, and we may enforce it to the full extent allowed by law for the enforcement of promissory notes. The credit line that the lender makes available to you permits you to borrow on a revolving basis up to the maximum indicated in this agreement. The credit line is secured by . …

Many types of assets may be used to secure a line, for example, inventory, the income from a contract or a grant already awarded the organization, real estate, or equip- ment. When an asset is used as security, the lender gets the right to inspect it and to

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require you to insure and to maintain it so that its value does not fall. The lender also reserves the right to foreclose and to demand that the property be sold when it ap- pears that the loan is not likely to be paid. Under these circumstances, it can also call the loan, demanding full payment. It will demand to receive information if the prop- erty is to be sold by you and may prohibit its use as security for other loans without prior approval. Permission may also be required to move or modify the property.

When the organization’s property is used to secure a loan, be sure that all legal steps are taken to record and free it once the loan has been repaid. In some cases, for example, on real estate in the District of Columbia, papers releasing the property must be filed. Because of the encumbrance, called a lien, placed on the organization’s property or future income, loans must be approved by the trustees.

The lender may also retain the right to assign or sell your promissory note. The sale of your note, normally not a problem, may occur without your knowing it be- cause the terms of the loan will not change and because the lender may continue to service the loan, meaning that you will continue to pay the original lender and receive bills from it. The original lender then passes your payments to the institution to which it sold your loan. This is a common and usually harmless procedure.

The interest rate on lines of credit will normally vary according to some index. One commonly used index, the T-bill rate, is the rate that the federal government is paying to borrow money on a three- or six-month basis. Another index is the prime rate of some major bank, the rate that the major bank is charging its best customers. Usually, a credit line will charge a rate at least one and one-half percentage points higher, that is, the prime plus one and one-half.

Because rates may rise while a loan is outstanding, it is smart to choose a credit line that has a maximum by which it can increase per year and a ceiling. Hence, the contract may say that the rate is one and one-half percentage points above prime but will not rise more than 2 percent per year and will never exceed 21 percent.

But two other concepts are important, partly because they affect your finance charge but also because they are useful information to have in controlling and man- aging your short-term finances. One of these concepts is the average daily balance. Every day the institution calculates the balance in your line of credit by adding what you borrowed that day to the outstanding balance at the beginning of that day and subtracting the amount it received from you as payment. It does every day for the billing period—the period that the bill covers. Let us say that the billing period is thirty days. Then it sums up each day’s balance over the thirty-day period. Since the billing period is thirty days, it divides the total by thirty and that gives the average daily bal- ance. It tells the nonprofit what its outstanding debt was per day on average during the period.

The finance charge for the period is obtained by dividing the annual percentage rate by the number of days in a year, 365 or 366. If the interest rate is 10 percent, di- viding by 365 gives a daily rate of .027. This is the amount of interest your organization paid every day on its outstanding balance for that day during the billing period. By

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adding up all these charges for the thirty-day period, the total finance charge for the period is obtained. In short, you can reduce the cost of the loan to your organization by paying early in the billing period. This would reduce the amount outstanding, as- suming no further borrowing.

Trade Credit

Another form of short-term loan is trade credit. This occurs, for example, when the organization purchases supplies and has thirty days to pay. If it pays within those thirty days, it pays no finance charge. This is free trade credit.

A variant of this involves discounts, say of 2 percent, if the organization pays in ten days or else it has to pay the full amount due in, say, thirty days. The discount lost by not paying within the ten days is actually an interest charge for a loan for twenty days (the 30 minus the 10). So, delaying beyond the discount period implies paying a finance fee.

Every organization should take advantage of discounts to the extent that by so doing a serious cash flow problem is not created. These discounts may also not be worth it if the organization has to liquidate accounts or assets that are earning higher rates than the organization is being charged by the vendor, or if it has to borrow from the bank at an unfavorable rate. In these cases, it is better to wait thirty days. The cost of a bounced check is usually higher than the implicit cost of foregoing the discount.

Advances

One of the least cumbersome ways of getting a short-term loan is through an ad- vanced payment on a contract or grant. Sometimes it is possible to arrange these be- fore the contract or program period. Other times it is done when money is needed. This is not cumbersome, except one should be aware that when money is advanced, interest can be charged and specific performance may be required. That is, repaying the advance may not free the organization from performance should it decide it does not want to go through with the contract. Consider an advance as a retainer. It is also a debt.

The IRS, Trustees, and Officers Not Lenders

An illegal form of short-term loan is borrowing from the IRS. This occurs when payroll taxes are not paid even though collected by the organization. The penalties on the organization, its management, and trustees can be severe. They are all liable. Do not

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use payroll and other taxes to meet short-term obligations. See our discussion in Chapter 6.

Borrowing from trustees or officers of an organization may be convenient but not always wise. It encourages a merging of identities between persons and the organiza- tion they manage. Moreover, when loans are paid back they may give the appearance of self-dealing. Such loans, if they occur, should be documented and should not en- cumber the organization with any promises or obligations beyond repaying the loan; interest should be at or below market rate, should be authorized by the board, and should not violate state law, which may not permit them. Borrowing from trustees or officers should be a very last resort.

Cash Value Insurance

A source of short-term (or long-term) capital can be the cash value of insurance poli- cies donated to the organization. As stated in Chapter 8, these cash values can be borrowed. All that is required is a written request to the insurance company. No col- lateral is necessary because the security the insurance company has is the insurance contract itself. The rates are usually below the commercial rates, and such loans do not have to be repaid. At the time of death, the total amount owed, including accu- mulated interest, is deducted from the face value of the insurance before the proceeds are paid to the organization. Policies more than seven years old are generally best for these purposes if a tax on such loans is to be avoided.

Foundations, Government, and Nonprofit Loan Funds

Occasionally, foundations will provide short-term loans to nonprofit organizations. In some states, nonprofits have another option. Loans are made through state funds or authorities created for making such loans or through community foundations mak- ing loans with terms ranging from thirty days to five years and for amounts ranging from a couple hundred dollars to hundreds of thousands of dollars. The intent is to provide financial stability to nonprofits, particularly small 501(c)(3)s. As is similar in some foundation cases, loan recipients can also receive technical assistance.

Long-Term Loans (Revenue Bonds)

Long-term borrowing occurs principally for long-term reasons, such as the purchase of a building. These are usually secured loans. A common way of securing these loans is by pledging the property owned by the nonprofit, including land, equipment, and building. These can be sold to pay off the creditors or can be assigned to the creditors

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if the organization is unable to pay off the loan or meet scheduled interest payments. But watch for restrictions placed on the property if a gift and be sure that the holding period is met to avoid taxation on the donor.

Long-term borrowing is also secured by the income stream of the project, rather than the project or property itself. Dormitories, hospital buildings, and low-income housing are good examples of uses of long-term borrowing secured by the income stream of the project. These are called revenue bonds. The loans are made because the lenders believe that the income stream (revenues) from these projects will be high enough to pay the interest and the principal on a timely basis. Income from the project is the only collateral. These bonds are attractive to buyers because they do not have to pay income tax on the interest they earn. Accordingly, the cost of borrowing is lower. These bonds are sold on the capital markets just as every corporate board is. See our discussion in Chapter 5.

Any organization that contemplates this type of borrowing will soon learn how important it is to put together a good financial structure for the organization and a good reporting system. These nonprofits must compete with government agencies and corporations in the capital markets and therefore must be able to demonstrate financial stability. People buy these bonds not because of the mission of the organi- zation but because they expect a competitive rate of return after accounting for the tax-free rates.

Leasing is an alternative to long-term borrowing. Basically, the nonprofit needs to compare the cost and advantages of leasing with the costs and advantages of pur- chasing. This type of financing is not for small nonprofits, but is of increasing use by housing authorities, hospitals, universities, and other large nonprofits.2

Borrowing and all the other approaches lead to an increase in the cash position of the organization. Note that the receipt of gifts and contributions is not ignored. As stated under Sources of Cash, an excess from operations is a source of cash. This ex- cess is defined as the amount of all revenues and support (including gifts and contri- butions) minus all expenses. So, the organization does increase its cash by increasing its receipt of gifts and contributions and other forms of support, including business income. But the actual amount of cash available at the end of any fiscal year depends on the timing of disbursements and receipts and their volumes. I’ll say more about this later. But first, what are the competing uses of cash?

Uses of Cash

Here are some of the ways the organization may opt to use its cash, whether it is gained from operations or a loan.

It can increase its fixed assets by buying more or better types of plants, equip- ment, or buildings.

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It can increase its current assets by buying more marketable securities, making more prepayments, increasing inventory, buying more supplies, and financing more accounts receivables.

It can decrease its current liabilities by paying off notes, accounts payable, sala- ries, and wages, and decrease its deferred revenues by spending what it takes to pro- duce and deliver those items for which it has been paid but has not delivered.

It can pay its long-term debt. The organization can also use cash to finance the operating deficit. The fact that

an organization has a deficit does not mean that it does not have to pay bills. The deficit may be financed by using previous years’ cash accumulations or what would have been this year’s cash accumulation.

Alternatively, if there is a surplus, cash could be saved. As we discussed previ- ously under Cash Management and Investment Strategies, holding excess idle cash is usually unwise. But using excess cash to begin a program for which future support has not yet been identified or secured may be equally unwise.

Cash management is a skill. It involves increasing the total volume (sources) and the rate (acceleration) at which cash flows into the organization. At the same time the volume (uses) and the rate (deceleration) at which cash flows out must be prudently tempered to meet the obligations and mission of the organization. Unlike government agencies, nonprofits are not “required” to disburse or obligate their funds at the end of the fiscal period. This is even illegal in federal agencies. Some surplus shown in the financial statements of nonprofits results from expenditures lagging behind re- ceipts. This is good management and it provides cash for short-term investment op- portunities. The lag might be due to time needed to build the organization’s capacity to carry out a program successfully. The gain might be nothing more than interest arbitrage (the interest earned is higher than that due to the delay in paying a bill). Let us look at alternatives for investing excess cash.

Liquidity Versus Investment and Risk Versus Safety

The following steps may be taken once cash is available: First, the board of trustees of the organization may elect to have a part of the cash placed in a restricted fund. This fund may be restricted so that withdrawals can occur only at the discretion of the board or to finance some specific activity in the future. Accumulation of this type is generally no problem for public charities, except it could affect their meeting watch- dog standards. For private foundations, as explained in Chapter 4, any attempt to set aside large amounts of cash should be done only after getting specific authorization from the IRS. Obviously, if accumulation is the choice, holding cash and currency makes no sense. The money ought to be invested.

Second, an amount of cash of approximately six months of the organization’s cash need should be kept in a highly liquid asset that earns interest with a very low

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risk of loss. Negotiable order of withdrawals (NOW) and money market accounts available at banks and through mutual funds are examples.

Third, beyond this amount, cash should be invested so as to stagger maturity dates. That is, some cash should be placed into instruments that have a thirty-, sixty-, ninety, and 360-day maturity. Repurchase agreements (as will be explained), certificates of de- posit, Treasury bills, and commercial paper (short-term loans to corporations) are ex- amples. These instruments pay higher rates of interest than money market accounts but are less liquid.

Ten Considerations in Selecting and Maintaining a Bank Account

The most direct way of dealing with cash is to put it into the bank. The bank debacles of the 1990s and 2007 are reminders that banks are not risk-free. Here are ten rules that should be helpful:

1. Be sure the bank is insured, preferably by the federal government. 2. Determine dollar limits of the insurance and whether the limit is per depositor,

per bank, or per account. 3. Because of items 1 and 2, try to maintain no more than the limit in any one bank—

diversify. If more than this amount must be kept, try to have separate accounts and indicate that each account is being held in your capacity as a fiduciary; it is thus being held for another entity. Using different branches may not help unless they are separately chartered; for example, in different states.

4. Balance checks monthly and check each entry. 5. Compare fees, free checking, and interest payments. They differ among banks. 6. Be sure that your bank will be willing to make a short-term loan, or at least pro-

vide a line of credit. You may need it. 7. Hold money for investment and retirement in a bank different from that holding

money for check-writing needs. This relates to items 1 and 2, but it is also im- portant because the same bank may not be equally good at both.

8. Check the investments of the bank. Some banks are risky. Banks are rated accord- ing to performance and risk exposure.

9. Check the investment and performance of the parent if the bank is a part of a holding company, that is, part of a larger bank family. Children can inherit the problems of their parents.

10. Check to determine whether the bank has a social investment policy compatible with your interests. How much does it invest in the local community? Does it cater to nonprofits?

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Near-Cash Investments

One possible use of cash is to hold it to meet the known cash needs of the organization and to meet emergencies. There is no magic to determine what this amount should be. This depends on the experience of the organization. Aside from putting money in the bank, the organization could buy securities. Bank accounts rise because of the interest earned. A security may earn interest or dividends and rises if buyers bid up their prices and falls if any of these is reversed.

Treasury bills are the lowest-risk securities. They are issued by the U.S. Treasury weekly and carry a three-, six-, or twelve-month maturity. They are sold in $5,000 multiples with a $10,000 minimum required. Repurchase agreements have short (overnight) maturity. A borrower gives security to the nonprofit. When the loan is re- paid, the nonprofit returns the security. The risk of loss of any portion of the invest- ment in commercial paper (a short-term loan to a corporation) can be reduced by buy- ing only the shortest-term papers of the strongest companies. The risk of loss from buying certificates of deposit can be reduced by buying them from institutions cov- ered by federal insurance.

Bonds

U.S. Treasury notes mature in two to five years and are sold in minimums of $1,000 to $5,000. Bonds may be bought from the Treasury, a government agency, state and local governments, or a corporation. Newly issued bonds mature in twenty to thirty years. This is a long time to commit the organization’s money, and although we would like to think of bonds as having little risk, this is not the case. There are risks of de- fault, and there is a risk of inflation, with not only a decline in the real value of the interest earned, but a fall in the bond prices as investors seek to make up for the low interest by lowering the price they will pay for it. Why pay $1,000 for a bond that offers 7 percent, when you can get 10 percent on another bond? Hence, if the organi- zation needs to sell before maturity, it will have to take a loss unless interest rates have declined, in which case it might make a gain as the price of the bond rises to reflect the fact that this bond earns more interest than ones issued at a lower coupon (interest) rate.

Low-grade corporate bonds (rated B or under) pay attractive rates but are highly risky not only of default, but also of loss of principal if the corporation collapses. These are junk bonds. True, bondholders have a claim on the assets of the corpora- tion, but this claim may be long in exercising and may be worthless.

The riskiest of the corporate bonds are subordinated debentures that have a be- low A rating. Subordinated or junior means that claims, in the event of bankruptcy, will be among the last honored. A debenture means that the bond has no collateral behind it. Below A means the firm is not among the financially strongest. These bonds

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pay high interest rates because of their high risk. They, too, are junk. Nonprofits in- terested in these bonds would do well to purchase them through a mutual fund, thereby reducing bond-specific risks.

Another risk that bondholders face is that the bond may be called by the issuers. Bonds are called when the issuer sees that it can issue a new bond at a lower rate of interest. Consequently, a bondholder who is getting abnormally high rates of interest may not have that bond for very long, as it may be called by the issuer. Unfortunately, it is usually impossible to reinvest the proceeds at similarly high rates and low risks because calls occur when interest rates have fallen. The inability to reinvest at a com- parable rate and risk is called reinvestment risk.

Even state and local government bonds have risks. Not all are backed by the full faith and credit of the issuing government. That is, not all are backed by the full taxing powers of the jurisdiction. Those that are reduce the risk of loss of principal invest- ment or interest because the issuing jurisdiction is required by law to fully utilize its taxing powers to pay bondholders. But the fastest growing type of jurisdictional bonds may have no such backing unless it is specifically stated. These are called rev- enue bonds because they are backed only by the revenues from the project (housing, dormitories, hospitals) they finance.

Stocks

Listed stocks are easily marketable because they can be bought and sold every work- ing day unless some special event causes their trading to be suspended. Stocks are highly volatile. Preferred stocks (stocks that are given preference in the receiving of dividends and in the settlement of claims should the business collapse) are less risky than common stocks. The latter has lowest priority in exercising claims if the firm folds and no preference in the payment of dividends. Usually, the dividends paid are low and may be changed at any time by the board of directors of the corporation. Both types of stocks, but especially the common, offer the possibility of appreciation in their prices as the company’s expected earnings are favorably valued by investors. They also have the possibility of decline as they become less favored, and common stocks are more volatile than preferred because, even in a decline, the investor can expect higher dividends from the preferred.

Stocks are dubious investments for some nonprofits because of their long-term perspective, volatility, and the capital needed to diversify among many companies so as to reduce the risk associated with any one (called nonsystematic, idiosyncratic, or diversifiable risks). Moreover, a number of nonprofits and foundations have sizable ownerships of businesses and indeed were originally founded by gifts of stocks in these businesses. Playing the stock market, however, requires a lot more expertise and involvement than some nonprofits have. For many, their involvement should not go further than accepting gifts of stocks and investing in mutual funds.

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Mutual Funds

Mutual funds, other than money market funds, are of all types. There are corporate bond funds, municipal bond funds, energy funds, gold funds, and aggressive com- mon stock funds, bond funds, and emerging markets income funds, to name a few. There is virtually a mutual fund for every investment taste. Mutual funds are market- able in that they can be bought and sold with relative ease. They avoid the need for investment expertise on the part of the organization because they are managed by professional investment advisors.

Mutual funds reduce the risks of losses associated with individual common stocks because they are very large and highly diversified. Even a mutual fund that specializes only in gold will carry the stocks of several firms involved in gold. Mutual funds do not generally invest more than 10 percent of their portfolio in any one com- pany so the individual investor in one of these funds is not overexposed to the risks of collapse by any one company. Mutual funds move faster, slower, or are indexed to move in speed and direction of the general or some specific market. There is a fund for every investment taste.

Partnerships

Investing in tax-sheltered partnerships is another option, but this serves no useful purpose to most nonprofits except pension funds. These partnership interests cannot be redeemed without considerable penalty and only in the amounts and at the times stated in the contract. Moreover, the need of nonprofits for a shelter is less than it is for tax-paying entities, and the use of such shelters may be challenged by the IRS.

The preceding paragraph refers to partnerships for tax purposes. These are very different from the types of partnerships discussed in Chapters 9 and 14, where the partnership is for a productive purpose or for producing rental income, as discussed in Chapters 11 and 18. Several nonprofits engage in the latter types of partnerships. They are common in the nonprofit housing and health sectors.

Buying Guide

Ratings can be used as a guide to determine the investment quality of bonds, com- mercial paper, municipal notes, and stocks. These ratings are not recommendations and they are not forecasts of how well the security will perform in the future. They are evaluations of the financial integrity of the issuer and the issue. In the following, we summarize certain ratings; beginning with the Moody’s rating of corporate bonds. The appropriate rating for most nonprofit bond purchases is designated as invest-

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ment grade—meaning that the bonds are issued, backed or insured to provide a reli- able stream of income for the term of the bonds. These bonds are giving various levels of A rating or are among the top three levels. Speculative bonds pay higher interests but their risks of default are high. The organization may be paying for a flow of income it might not get, Ratings change as economic conditions or the conditions of the issuer or those it depends upon change. The nonprofit should keep check on these ratings as long as the bonds are in its portfolio.

Again, the major purpose of these rating systems as far as the financial manager is concerned is an indication of the investment worthiness of securities. It is often unnecessary, unwise, and sometimes illegal to invest the dollars of a nonprofit organ- ization in a highly risky (below A) security. Another way to reduce risk is to purchase securities that are insured. Even municipal bonds may be insured so that the pur- chaser’s risk is reduced. A good investment strategy is an excellent source of unre- stricted income for running an organization. The earnings can generally be used at the discretion of the management to carry out the mission. Table 18.1 displays some typical investments and their risks.

Volatility of Security

The organization should also be concerned with the degree of volatility or systematic risks; that is, changes in the value of a security as the overall market changes. This feature of a stock or mutual fund can be ascertained by checking out its beta coeffi- cient. The more the beta exceeds one, the more the stock moves (up and down) rela- tive to the market. A negative beta means the stock or fund moves in the opposite direction to the market. With bonds, the duration is the index of volatility. Hence, the more the duration is above one, the more a change in the interest rate would affect the price of that bond. When a small increase in the market interest rate causes a large fall in the price of an existing bond so as to compensate new buyers of these bonds for the lower rate the bond carries on its coupons, the bond is said to have a long duration. These indices, durations and betas, are easily obtained and a diversified portfolio will have a combination of them. In the final analysis, the structure of a port- folio is dependent upon its intended use and the purpose for which it was con- structed. These indices help to coordinate use with market risk. The risk of being in- vested in a single company or industry can be reduced by diversifying the investment portfolio. The latter should reflect investment objectives and risk tolerance.

Setting Up a Portfolio: First Steps

Creating a portfolio involves the following steps. First, the organization needs to have an estimate of the total funds available to it for investment. Then it has to divide this

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sum up into portions that are for the current year, some intermediate periods, and for the distant future. The division into these periods will vary depending upon the budg- eting and program responsibilities of the organization. Some private foundations budget over a two-year period and they must take into account the legal requirement that they distribute the higher of 5 percent of their net investment income or adjusta- ble gross income. See Chapter 4.

Table 18.1: Securities: Their Typical Minimum Maturities and Risks

Securities Typical Minimum Maturity Period

Comments

Negotiable order of withdrawal*

Immediate Low risk, especially if institution is federally insured

Money market mutual fund Immediate Low risk, especially if portfolio is weighted toward U.S. Treasury paper

Repurchase agreements 1–90 days Risk depends on security backing agreement

Commercial paper 20 days or more Risk depends on issuing corporation

Certificate of deposit 90 days Low risk, especially if institution corporation

U.S. Treasury bills 90 days Low risk

Negotiable certificates of deposit

90 days Low risk, but requires large initial amount of $100,000

U.S. Treasury notes 3 years Low risk, but long holding period

U.S. Treasury bonds 30 years Low risk, but long holding period

State and local government bonds

30 years Varying risk depending on issuer; long waiting period

Mutual funds (other than money market)

Immediate Risk depends on investment philosophy of fund

Corporate bonds 20 years Risk depends on issue

Common stocks Immediate Wide fluctuations

Preferred stocks Immediate Fluctuate like bonds; risk of dividend default

Tax-sheltering partnerships Indefinite Risky and redemption depends on terms set in contract; early redemption will lead to losses

Guaranteed investment contracts

3–5 years Fixed interest; should be considered long term

*By law, available only to individuals and nonprofits.

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Some organizations have very strong current needs, but have an endowment that al- lows them to invest over the long haul. Some organizations have program needs that are neatly divided into the short-run, intermediate run, and long run. Hence, the meaning of a period in terms of years depends upon the underlying facts about how the organization operates.

Once this breakdown into periods is determined, a second step will be to decide how to allocate the funds set aside for each period among various types of assets ap- propriate for that period. The most important principle here is that the funds are avail- able when needed and that they are generating income for the organization while be- ing held.

Given this orientation, we can think of the following periods and allocation of funds at the beginning of each period. Allocations will vary upon the risk tolerance of the organization, the rate of return that can be gotten, and the schedule at which the accounts will be drawn down to pay bills. But the availability of a line of credit to the organization to make up for its inability to cash in the assets without loss at the time the money is needed can serve as a good hedge. The short-term portfolio is also de- pendent upon the cash management arrangements the organization can make—and its ability to postpone payments without penalty or at a cost is less than the cost of delaying payments.

Figure 18.1: Funds Needed Within One Year

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Legend: Spending begins with the cash and then the money market, and by the time these amounts are exhausted, the CDs should mature and be ready to enter the spend- ing stream. By the time that amount is exhausted, the commercial paper and Treasury bills should be ready.

Figure 18.2: Funds Needed in Ten or More Years

Legend: Money market accumulates dividends, interest, and capital gains to finance new investments.

In Figure 18.2 most of the portfolio can be put in longer-term assets that are likely to have greater rates of return and more risk. The organization can wait out turns in the market. This kind of allocation is appropriate for a non-exhaustible endowment— one that does not require complete draw-down of the amounts in the funds described in this chapter. This is so not only because of the long holding period it allows, but also because the trustees can set draw-down rates to match the earnings of the port- folio. Hence, in a bad year, the amount that will be drawn will be lower than in a good year.

Once these major broad asset allocations are made, the real technical skill is in determining the choices within each asset class. Which bonds and which stocks? Here are some simple rules that would help the manager: 1. Get a good investment advisor (or preferably separate portions of the account

among several of them). 2. Get a board that is diligent and prudent. 3. Recognize that investment decisions are ultimately that of the board. 4. In general, oppose giving unconstrained rights to investment managers or advi-

sors to make decisions about the portfolio. If an unconstrained approach is desir- able, think of a mutual fund.

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5. Place limits on the amount of the portfolio that can be invested in any one com- pany and sector. Check state law on this. This book discusses these laws in vari- ous places, including in this chapter and in the chapter on trusts (Chapter 8). Most times, a manager would rely on an investment advisor in or outside the or- ganization. The manager must be approved by the board and must report to it.

6. Require the investment manager to give presentations that are understandable. Most investment options that are too technical or too difficult to understand are too risky for those who are being asked to undertake them and who are bound by oaths of prudence and care.

7. Although investment advisors are required to disclose any relationship they or their firm may have with a security or its issuer, it is wise to include that disclo- sure requirement in any contract. Beware of self-dealing when such a relation- ship exists.

8. Do not let a commission come between you and a good deal. In my view, as one who has marketed, served as a trustee for issuers, and also has bought securities, the concern about commission is often misplaced. The investor should ask these questions: Is this deal for me? Does it make me significantly better off even after the commission is paid? Is this a relationship that can serve my information needs beyond this trade? Is there a possibility of a charge of self-dealing by manage- ment or the trustees?

9. Every decision should be prefaced by education and no decision can be so urgent that it cannot wait. The market creates opportunities every day.

10. Make sure that the investment advisor is acquainted with state and federal laws related to the investment of institutional funds.

If the money will not be needed for some time in the future, most of it can be invested in assets that have maturities of one year or more. As one invests in these longer term fixed assets, the risk is that the interest rate will rise above that which the organiza- tion is getting. But because the portfolio is rolling, some of this loss will be reduced as the organization places money at these higher rates.

The opposite risk, discussed earlier, is the reinvestment risk. This refers to the occasion that the nonprofit is getting a higher rate than the market is currently pay- ing. Therefore, the funds that mature can be reinvested only at lower rates. Spreading the portfolio over different maturity periods dampens these types of risk. Figures 18.3 and 18.4 show intermediate portfolios.

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Figure 18.3: Funds Needed in Two to Three Years

Legend: Because cash is not needed for a year to date, the 40 percent can be placed in money market accounts. The CDs will be ready at least six months before the year begins and can join the money market pool. This would provide a strong cash buffer for supporting the longer-term investments.

Selecting Securities and Rebalancing Portfolios

In several places in this chapter we describe concepts that would help the manager in selecting securities. The principal rule to follow is that this is not the manager’s job. A smart manager would exercise his or her duty of care that compels an under- standing of what is going on. He or she will also rest on the law’s protection if the manager relies on the recommendations of a carefully chosen advisor. The trick is to set hurdles and prohibitions. A very simple one is to insist that the primary purpose of the entire portfolio strategy is capital preservation. This is a message understood to mean moderate risk.

The descriptions used in this text in the discussions of volatility of security, buy- ing guides, ranking of securities, and especially in the rebalancing of portfolios (see the next sidebar on pages 562–563) would help the manager understand and partici- pate in the decisions about the securities that will populate the portfolio. There is no advantage to trying to be your own investment advisor, but there is total disadvantage in not understanding.

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Figure 18.4: Funds Needed in Four to Five Years

Investment Pools

Managers of small organizations may wonder whether investment strategies such as those used by larger organizations may be available to them. The answer is yes, through an investment pool. Such pools provide for several organizations to invest as a group. By doing this, they share risks and are able to diversify among several in- vestments, hire an investment advisor, and trade at a lower commission rate.

The National Conference of Catholic Bishops, the United States Catholic Confer- ence, the American Board of Catholic Missions, the Campaign for Human Develop- ment, the Committee for the Church in Latin America, and the Catholic Communica- tion Campaign, for example, have a short-term and long-term investment pool for themselves. This assists them in conducting a wide range of charitable missions here and abroad, including financial support of other charities. Section 501(d) organiza- tions (see Chapter 2) are specifically organized to permit religious organizations to have a common treasury and carry out investments.

Rebalancing Portfolios Rebalancing of portfolios is a way of managing risks. It is also a strategy for preserving past gains and minimizing future losses. Rebalancing involves not only giving a new structure to a portfolio and a new risk profile; it also involves the timing of these changes.

Here are some thoughts that a board of trustees of a nonprofit organization ought to consider in thinking about rebalancing the organization’s portfolios—a process that should be ongoing regardless of what the market does.

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1. Setting portfolio ranges is the duty of trustees. Every organization needs an in- vestment policy. It should be passed by a resolution of the majority of the board of trustees. A vote of the board is also required for resetting the parameters in that policy. A good policy provides ranges that are broad enough to be useful and nar- row enough to be confining. Hence, a policy may say 30 to 50 percent in stocks rather than 30 percent or 30 to 35 percent.

2. A guiding principle of all investment policies and of all rebalancing is prudence and preservation of the assets of the organization. This is the duty of care.

3. The overall policy should reflect diversification across types of assets—such as common stocks, bonds, and money market assets such as treasury notes, short- term certificates of deposits, and checking accounts. Diversification should take into account that within each class of security further diversification is prudent. For example, bonds of different investment grades such as AAA, AA, and A and of different issuers, maturities, and durations (a measure of how volatile the price of the bond is with respect to small changes in the interest rate) are bases upon which bond diversification can be accomplished.

4. Similarly, stocks can be differentiated by industry, the dollar size capitalization of the firms such as small, mid-cap, and large cap or blue chip. An important di- versification can be between preferred and common stocks. The former is usually bought because it provides a more stable dividend.

5. The overall policy should reflect diversification across geographic lines and may well include some global investments. It may also be consistent with the social policy of the organization.

6. The overall policy should reflect the financial needs and capabilities of the organ- ization and the particular purpose of each program. Some activities of an organi- zation might be heavy cash users on a monthly basis; their portfolio needs would require a considerable amount of liquidity. Long-term investments should be considered only after the organization’s liquidity needs are fully satisfied.

7. The trustees must decide how much rebalancing can be done automatically; that is, how much discretion they wish to retain for themselves, and how much they wish to give to their investment manager. In each case, the composition of the portfolio is adjusted as changes occur either through relative growth or decline in one part of the portfolio relative to others. Rebalancing can also occur by changing the formula for distributing new contributions to the overall portfolio.

8. The past is no predictor of the future. An investment mix that worked well in the past may not work well in the future. During periods of great uncertainty, the holding of larger cash or money market assets to preserve past gains, invest as market opportunities arise, and assure liquidity for future needs is not neces- sarily imprudent.

9. The excess holding of cash may create an opportunity cost or loss—the possibility that cash may be held for too long and in too large an amount.

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10. Since index funds (those that are set up to have the same composition of some broader index such as the Russell 5000, S&P 500, or the Dow Jones) sometimes do better than managed funds (those that have portfolios that change at the dis- cretion of managers), the need for continuous rebalancing might be reduced when investments are made according to these indices. This does not eliminate the need to consider rebalancing. But it reduces the range of discretion, since the aim is to mimic the index.

11. Rebalancing is not cost-free even though there may be no charge. Investment managers earn fees when funds are turned over. This should not stop manage- ment from exercising the prudence of rebalancing but it should be considered in assessing the motive or advice to rebalance and the returns from rebalancing.

12. Beware of being a victim of fast-talking investment advisors, fads, and the lure of high returns. At the same time, beware of paying a premium for rights never used. The right to withdraw or to have access is worth as much as the probability that such a right will be exercised. However, a good reason for rebalancing a portfolio is to have access to meet a known future expenditure.

13. There is no substitute for beginning with a thoughtful policy, having patients, and yet recognizing the need to change when that need is clear. For trustees of nonprofits, this is part of the duty of care.

Capital Planning

To top management, capital planning must precede capital budgeting. It should con- tain at least the following considerations: 1. Determine that there is a need that is likely to endure for some time. By definition,

capital projects are long-lived and therefore so should the intensity and quantity of the need.

2. Determine the desirability of the project. Does the need comport with the mission, culture, and philosophy of the organization under current conditions and in the foreseeable future?

3. Determine the feasibility of the project. Can the project, conceived in a manner that is acceptable, be done?

4. Determine alternative cost scenarios within the range of feasibility and desirabil- ity.

5. Determine operating and maintenance costs and inputs. 6. Determine requirements and their costs. For example, a construction project may

pass all of the above tests and the capital budgeting hurdle but be completely handicapped by the inability to get a license or a permit to operate as quickly as desired.

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As a reminder of Point 6, note that most building-related expenditures are subject to zoning laws. This kind of violation occurs much too often and represents bad capital planning. So even though the budgeting may have appeared to have been perfect, if point 6 occurs and endures, the cash inflow projection upon which the capital budget was done would be wrong. The organization will face a financing problem it did not plan to entertain.

Capital Budgeting and Endowment Planning: Setting Targets and Identifying Sources of Capital

The operating budget that we described in Chapter 12 is concerned with the annual operation of the organization. It shows planned inflow and outflow of the organiza- tion’s resources during the course of the coming year. Some organizations, but not many, have a multiyear operating budget. These budgets show the plan for annual operation of the organization for each of the next five years.

A capital budget shows the planned acquisition, disposition, or reconstruction of capital items. A capital item is one that has a useful life of more than one year. Furni- ture, equipment, buildings, automobiles, and computers are examples of capital items. The launching (not operation) of large, flagship, or sustaining programs that are at the core of the mission of the organization should also be considered a capital expense, especially if such programs are associated with endowments or capital ex- penditures such as the acquisition of new buildings or equipment.

Expenditures on capital items are called investments or capital expenditures. These are different from expenditures planned in the operating budget, which are op- erating expenses. An investment is an expenditure on an item that may change in value over time and that is not all consumed or used up in one year. A building is not used up in one year. It has a useful life of decades. But each year, a portion of the building, the computer, or the automobile is used up; that is, there is wear and tear. The dollar approximation of this wear and tear is called depreciation. Because depre- ciation arises as a result of annual operation, depreciation is shown as an annual ex- pense in the operating budget and financial statements of the organization.

Furthermore, once the capital item is placed in service, it requires maintenance, and the principal and interest on the loan used to purchase the asset (mortgage in the case of a building and car loan in the case of an automobile) must be paid annually. These become annual operating expenses.

Capital planning and budgeting require analyses not only of when and how the capital asset will be obtained, but how it will affect the annual operating budget. Two routes through which this impact occurs are by way of maintenance and amortization costs (payment of principal and interest). Another source is through insurance pre-

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miums. Credit and liability insurance premiums must be paid annually; they may in- crease as capital expenditures increase. An additional building means greater expo- sures to liability and credit risk.

From a financial point of view, several questions arise in capital budgeting. Let us put ourselves in the position of the board of directors of a nonprofit organization considering the acquisition of a building. What are some of the questions that may arise?

One question is the source of the required funds. One potential source is through gifts and contributions of money, including a large gift obtained in trust or by running a special gift campaign, that is, a capital campaign.

A second potential source is through the accumulation and setting aside of part of the annual earnings of the organization. Recall that with private foundations, such accumulations must be authorized by the IRS.

A third source of capital acquisition may be the physical gift of a building, which may be used, sold, or leased by the organization. Be reminded, however, that if the building is obtained through a gift and has a mortgage on it, the income from the rental could be subject to an unrelated business income tax and this annual tax pay- ment would affect the organization’s operating budget.

A fourth source that provides the basis for systematic accumulation is deprecia- tion. By depreciating existing assets, an expense is written off current operations. But depreciation does not represent the kind of expense that requires the organization to draw a check. It is a paper expense. Therefore, one way to finance new acquisitions is to accumulate these paper expenses—actually setting aside each year the amount of depreciation so that these amounts may be used to purchase new assets.

A fifth source is debt: Borrow the money. This source would also have an impact on the organization’s operating budget since the principal and interest on the debt must be paid annually.

A sixth source is a leasehold arrangement. This is a cross between a lease (a long- term liability) and ownership. Basically, the owner of the property makes physical changes in the building to suit the specific needs of the nonprofit with the commit- ment from the nonprofit that it would stay for a specific number of years, pay rent according to a specific schedule, and leave a security deposit. In this case, the source of cash for rental payments is a capital fund or the operating revenues of the organi- zation.

As stated earlier in this book, nonprofits may not sell stocks in themselves. There- fore, this source of financing capital projects is not available to them as it is to for- profit corporations. As Chapter 11 describes, a company that they control can issue stocks, or they can sell partnership interests in a project such as the housing case discussed under “Coexistence of Charity and Capitalism” in the next chapter.

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Accumulation and Disbursement Strategies

A related set of questions has to do with the schedule of accumulating the funds needed to acquire the building. For example, the organization could collect all the money it needs in one year or it could collect it over a number of years. How much does it need to collect in each year if it chooses the latter course? How much does it need to collect by the end of the first year if it chooses to collect all the money at the end of that year?

Both answers depend on the rate of interest, for the smart financial manager would invest the collected sum in a safe investment paying a relatively predictable fixed rate. By doing this, the amount that has to be collected, borrowed, or taken from the organization’s savings or shifted from the monies available for the daily operation of the organization would be lessened.

Let us assume that the rate of interest is 10 percent, the planning horizon (the time over which to accumulate the money) is four years, and the amount needed to acquire the building is $5 million. What are some of the alternative targets for accu- mulating the funds?

Present Value of Single Sum One option is to have a fund-raising drive that ends at the end of the first year and to put that money into the bank so that, at 10 percent, it will accumulate the money needed to acquire the building over a four-year period. If the organization can be suc- cessful in doing this, it will be able to avoid debt, shift its fund-raising efforts to an- other program, and avoid using any of its operating income or savings from opera- tions to buy the building. How much must it raise in the first and only year of its fund- raising effort for this strategy to be successful? What is its target amount?

A strategy such as this obviously depends on the amount of money that must be collected in the first year so that when it is invested at 10 percent over a four-year period it will equal $5 million. This is called the present value of a single sum. It is the dollar value of a single amount of money that, if invested, would yield the targeted amount at the end of some specified period (in this case four years) when the rate of interest per year is some specific amount (in this case 10 percent).

This problem can be solved by going to a table such as Table 18.2, which can be found in interest rate books. We look under the column called single payment present worth and the row that applies to four years, and we find a factor .6830. We multiply $5 million by this factor and get $3,415,000. This is the amount that must be raised and invested in the beginning of the first year at 10 percent annual rate of return each year if the $5 million target is to be met by the end of the fourth year. Of course, the board could significantly reduce this amount and still not take the greater risk of look- ing for a higher rate of return if it stretches out the time it has to accumulate the funds.

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If they chose to wait eight rather than four years, their fund-raising target would be (.4665 X $5,000,000) or $2,332,500.

Future Value of a Single Sum Alternatively, the organization may already have a large gift that it can invest in the first year. The question that the board of trustees is faced with is, will this be sufficient when invested at 10 percent over the four-year period to meet our target? Would we have to raise more money? How much more? This type of problem is called finding the future value of a single sum. That is, how much is a single sum invested today at, say 10 percent, worth in the future, say four years? Once we have found the answer to this, we can subtract this amount from our required amount and determine whether we are going to meet, exceed, or fall short of the target.

Table 18.2: Time Value of Money Assuming 10 Percent Interest Factor

Uniform Series

Sinking-Fund Uniform Series

Single Payment Single Payment

Compound Amount

Payment Present Worth

Compound Amount

Present Worth Future Value of

Uniform Series Whose

Capital Recovery

Present Value of

n Future Value Present Value

Uniform Series Future Value Installment to Uniform Series

Years of $1 of $1 of $1 Is $1 Amortize $1 of $1

1 1.100 0.9091 1.000 1.00000 1.10000 0.909 2 1.210 0.8264 2.100 0.47619 0.57619 1.736 3 1.331 0.7513 3.310 0.30211 0.40211 2.487 4 1.464 0.6830 4.641 0.21547 0.31547 3.170 5 1.611 0.6209 6.105 0.16380 0.26380 3.791 6 1.772 0.5645 7.716 0.12961 0.22961 4.355 7 1.949 0.5132 9.487 0.10541 0.20541 4.868 8 2.144 0.4665 11.436 0.08744 0.18744 5.335 9 2.358 0.4241 13.579 0.07364 0.17364 5.759 10 2.594 0.3855 15.937 0.06275 0.16275 6.144 11 2.853 0.3505 18.531 0.05396 0.15396 6.495 12 3.138 0.3186 21.384 0.04676 0.14676 6.814 13 3.452 0.2897 24.523 0.04078 0.14078 7.103 14 3.797 0.2633 27.975 0.03575 0.13575 7.367 15 4.177 0.2394 31.772 0.03147 0.13147 7.606 16 4.595 0.2176 35.950 0.02782 0.12782 7.824 17 5.054 0.1978 40.545 0.02466 0.12466 8.022 18 5.560 0.1799 45.599 0.02193 0.12193 8.201 19 6.116 0.1635 51.159 0.01955 0.11955 8.365 20 6.727 0.1486 57.275 0.01746 0.11746 8.514 21 7.400 0.1351 64.002 0.01562 0.11562 8.649 22 8.140 0.1228 71.403 0.01401 0.11401 8.772 23 8.954 0.1117 79.543 0.01257 0.11257 8.883 24 9.850 0.1015 88.497 0.01130 0.11130 8.985

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Uses of Cash | 603

Uniform Series

Sinking-Fund Uniform Series

Single Payment Single Payment

Compound Amount

Payment Present Worth

Compound Amount

Present Worth Future Value of

Uniform Series Whose

Capital Recovery

Present Value of

n Future Value Present Value

Uniform Series Future Value Installment to Uniform Series

Years of $1 of $1 of $1 Is $1 Amortize $1 of $1

25 10.835 0.0923 98.347 0.01017 0.11017 9.077 26 11.918 0.0839 109.182 0.00916 0.10916 9.161 27 13.110 0.0763 121.100 0.00826 0.10826 9.237 28 14.421 0.0693 134.210 0.00745 0.10745 9.307 29 15.863 0.0630 148.631 0.00673 0.10673 9.370 30 17.449 0.0573 164.494 0.00608 0.10608 9.427 35 28.102 0.0356 271.024 0.00369 0.10369 9.644 40 45.259 0.0221 442.593 0.00226 0.10226 9.779 45 72.890 0.0137 718.905 0.00139 0.10139 9.863 50 117.391 0.0085 1,163.909 0.00086 0.10086 9.915 55 189.059 0.0053 1,880.591 0.00053 0.10053 9.947 60 304.482 0.0033 3,034.816 0.00033 0.10033 9.967 65 490.371 0.0020 4,893.707 0.00020 0.10020 9.980 70 789.747 0.0013 7,887.470 0.00013 0.10013 9.987 75 1271.895 0.0008 12,708.954 0.00008 0.10008 9.992 80 2048.400 0.0005 20,474.002 0.00005 0.10005 9.995 85 3298.969 0.0003 32,979.690 0.00003 0.10003 9.997 90 5313.023 0.0002 53,120.226 0.00002 0.10002 9.998 95 8556.676 0.0001 85,556.760 0.00001 0.10001 9.999

To answer this question, turn to Table 18.2 and look under the single payment com- pound amount. Assume that the amount the board of directors has on hand is $2 mil- lion. What would this amount be worth in four years invested in a manner that yields 10 percent per year? The factor is 1.464. Multiply $2 million by this factor and get $2,928,000. Since $5 million is needed, the board knows that it cannot rely merely on its initial investment. It must raise more money to meet its target.

Future Value of a Uniform Series of Payments The board of directors may conclude that they prefer not to deal with a single sum. Rather, they would prefer to have a fund-raising campaign that is annual and stretches over a four-year period. This has the advantage of being less pressing on them and the staff. They can assume, based on past experience and on their contacts, that they could raise a specific amount of money every year, say $800,000 per year. Would they meet their target if they collected that amount every year and put it into an investment paying 10 percent per year? Would they overshoot their target, fall short of it, or just meet it?

This type of problem requires finding the dollar value that a series of uniform payments made at the beginning of every year for a specified number of years would

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604 | Chapter 18: Evaluating Old Targets and Setting New Ones

be worth on a specific future date. To solve this, we go to Table 18.2 and the column that shows a uniform series compound amount. We see the factor 4.641. Multiply this by $800,000 and get $3,712,800, which is how much $800,000 raised and invested each of four years will be worth at the end of the fourth year. The board will fail to meet its $5 million target unless it raises more money or stretches out the period of raising and investing funds.

Sinking Fund

The reciprocal of the same uniform series of payments problem stated above is a sink- ing-fund problem. In this case, the trustees are less interested in whether they will exceed, fall short, or miss their target. They wish to give a clear and specific annual target to the fund-raising manager. “We have a target of $5 million that we must have in four years. We know that the safest rate of return we can get on our money is 10 percent. To accomplish this, we give you a directive to set a fund-raising target of X number of dollars per year.” The director of fund-raising retorts, “I shall be happy to follow your orders if you could specify how much must be raised each year under the conditions you have set.”

The answer can be found by resorting to Table 18.2. The column entitled sinking- fund payment tells how much money must be sunk into a fund each year if a specific target is to be met over a specific number of years and when the rate is 10 percent. Multiply the factor shown for four years, .21547, by $5 million. The fund-raising team must come up with $1,007,350 per year. Notice that this is substantially lower than the fund-raising target when the money is expected to be raised only in one year (the example given earlier), but to accomplish the objective, the fund-raising campaign must last at the same intensity for four years.

Capital Recovery

The board of directors may follow another option. They may decide that they would rather go out and borrow the money to acquire the building. They know that if they do this they will have to pay principal and interest on the loan each year until the loan is paid off. This is called amortization, the paying off of a debt. They will borrow the entire $5 million. How much will be their annual payment in principal and interest? In other words, how much will the lender charge per year so as to recover the full amount loaned plus the interest charged? This is called a capital recovery problem.

To solve this problem, go to Table 18.2 and locate the column showing capital recovery. The factor is .31547, which when multiplied by $5 million gives $1,577,350. This is how much the organization would have to come up with each year if it borrows the funds at 10 percent and pays off the mortgage in four years. More realistically, it

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may choose a thirty-year mortgage. The factor there is .10608. Multiply it by $5 million and get $530,400, the amount it must come up with each year (its target) to pay off its principal and interest.

Present Value of a Uniform Series

The reciprocal of the capital recovery problem involves finding out how much money the organization could borrow given its capacity to pay a total sum of money each year. Would the amount of money we can afford to pay each year for the next specific number of years be sufficient to pay both principal and interest on our loan so that at the end of that period our loan would be paid off?

In this case, the trustees are willing to commit to a specific annual payment, but only if it would be enough to pay off the principal and interest on the debt. To answer the question, turn to Table 18.2 and the column showing uniform series present worth. Assuming that the organization is willing to come up with $200,000 per year for the next ten years, what size mortgage could it afford assuming a mortgage rate of 10 percent? The factor is 6.144, which when multiplied by $200,000 gives $1,118,800, the maximum mortgage it can afford.

Perpetual Endowment

Once a building is built it has to be maintained for the remainder of its life. It has to be painted, remodeled, refitted with heating and air conditioning systems, and so on. Good planning will involve a strategy not only to raise the funds to construct a build- ing but also to do the maintenance for the life of the building. Once the building is in service, the trustees won’t have to search for funds to keep it maintained. It is a far- sighted and wise strategy. Hence, a good building program may have both an ex- haustible (construction) as well as an inexhaustible (maintenance) endowment in- vested and managed differently for their different purposes.

Since a building could conceivably last forever, the board may well ask, assum- ing that we have a fund of $4 million that we intend to last forever, how much would we have per year to take care of maintenance and repairs if we use just the earnings of the fund for repairs? By using only the earnings, the principal amount we invested in the fund would last forever. It will always be there earning money to pay for the maintenance and repairs. This is called the perpetual endowment problem. Funding scholarships and professorships are of this type.

The answer to this problem is not found in Table 18.2. It is simple. Multiply the principal amount by the rate of interest expected per year and we get the target. If the rate of return on the invested $4 million is 10 percent, $400,000 would be available each year to maintain and operate the building.

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Capitalization Capitalization is the opposite of a perpetual endowment. In capitalization, the board of trustees is asking: How much must we put up in an endowment if we know that the annual cost of repairs and maintenance or of scholarship awards is $200,000 per year? In other words, how much capital must we put in an endowment if we intend to use only the earnings of the endowment so that the principal will last forever, earn- ing the required amount of money we need to do maintenance and repairs or to award scholarships so that we might never have to undertake (unless in an unusual circum- stance) to borrow, use operating funds, or have another fund raiser for this specific purpose?

To answer this question, let us assume that the expected rate of return on the investment is 10 percent. Divide this required amount of $200,000 by 10 percent and get $2 million. This is the target amount by which an endowment would have to be capitalized if it is to yield sufficient money annually to pay for the repairs and mainte- nance of the building.

Disbursement in Practice: Simple Rules and Practices

In practice, trustees are responsible for setting disbursement schedules and proce- dures for capital and endowment funds. Beginning with the foregoing exercise, they set simple rules. Note one thing about all these rules: They aim to have the endow- ment last forever. They also assume that a 10 percent rate of interest is available every year and inflation does not erode the value of the earnings by causing the cost of the repairs, scholarships, or other reasons for withdrawal to escalate. In actuality, these do happen, and so trustees monitor annual performance and requirements particu- larly over withdrawals, which, unlike earnings, they control. How do they do it?

The American Red Cross uses what is known as the total return method for with- drawing and disbursing funds from its endowment. At the beginning of each year, the trustees set a spending or withdrawal rate, called a target withdrawal rate, which is a percentage of the market value of the portfolio at the beginning of each year. Under this method, disbursements to meet this target are made first from net investment earnings of that year. If this is insufficient to meet the target, the rest is taken from cumulative realized gains (the amounts accumulated from the past sale of assets and securities). This preserves the original principal, which grows whenever current in- vestment income equals or exceeds withdrawal needs.

A variation of this approach using moving averages is used by many colleges. It works this way. A policy setting a fixed percentage of 5 percent of the earnings of the past five years is the withdrawal target. This dampens the impact of erratic earnings— when they are in a valley or peak—on how many dollars can be disbursed.

Disbursements conform to contingencies set up by the board or by the grantor of the endowment. To illustrate, some years ago the endowment set up by the National

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Urban League based on a grant from the Ford Foundation, under terms of the grant, prohibited disbursement from the principal for five years. Such terms are based on the calculations that we discussed earlier and are intended to give the endowment an opportunity to grow and to last into perpetuity. The League was permitted to expend, for operational purposes, any net realized gains. The basis for calculating this gain was the dollar value of the endowment when it was started. But it is also required to plow into the endowment over a five-year period cash and securities matching the $4.5 million of the original gift.

Finally, when starting a new endowment, postponing all disbursements may be a good strategy. Accordingly, the board of trustees of some organizations would pro- hibit any disbursements from its endowment until it reached a specific amount.

Preservation of The Terms of Endowment

The law requires that endowments be prudently administered to preserve the intent of the donor and that the trustees act with loyalty toward the public purpose of the endowment. The list of actions given in Chapter 6 that could be cause for suit applies to endowments.

When we say that endowments must be administered by the terms of the con- tracts that create them, we are making reference to law. The borrowing of money that is in an endowment, shifting it to some other use, and closing an endowment are all legally prohibited transactions unless allowed in the endowment contract. Other- wise, the management, trustees, or board can be sued by the donors or their public beneficiaries. To make such unspecified transactions legal, the trustees or board may have to get permission from a court. Such permission is usually granted if a financial crisis that cannot be satisfied in some other manner can be demonstrated; if the pur- pose of the endowment no longer exists or is impracticable, contrary to public policy, or financially infeasible; and when actions required by the endowment would lead to its destruction. Under what the lawyer’s call a cy pres ruling, the court may give au- thority for the funds to be used in some manner other than that stipulated in the con- tract but consistent with the mission of the organization.

To illustrate the need for abiding with public policy, in one case the IRS con- cluded that a charitable trust, though established and functioning for decades, was no longer qualified for tax exemption and its donors no longer qualified for tax de- ductions because the fund’s mission was to aid “worthy white people.” See Private Letter Ruling 8910001.

To avoid these types of problems, attorneys try to eliminate this type of language, which was perfectly acceptable at the time that the trust was set up. Of course, the problem can be reduced when the fund is created by the board of trustees of the or-

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608 | Chapter 18: Evaluating Old Targets and Setting New Ones

ganization by transferring operating surpluses into a restricted fund. Yet it is not un- common that universities and other nonprofits run into serious problems with their own restrictions. Times change.

Some endowments are set up under terms that stipulate that they will not com- mence making awards or cash payments until the passage of some time. This gives the fund an opportunity to grow, establish some critical level based on a calculation of the future value of a single payment, and then make perpetual awards based on the amount that is needed to sustain a perpetual payment of some specific amount.

The terms under which an endowment is established will include accumulation, investment, and disbursement policies. Some of these may have the force of contrac- tual law.

Members, officers, a single trustee or a group of trustees, an individual with re- versionary rights, and the attorney general may sue an organization, its officers, and trustees if restrictions are broken without the authority of the donor or the authority of the court; except trustees of religious organizations in California can in good faith find that the restriction is contrary to public policy and, after making a written expla- nation and decision, remove the restriction.

Time and Risks in Endowment Planning

It should be obvious from what has been said in this section that capital planning and endowment management are related to sustaining the growth and performance of the organization over several years. It has not only to do with buying buildings, equip- ment, and machines but with creating funds that can finance the mission of the or- ganization well into the future.

In all capital planning problems, as we saw above, the pressures on the fund- raising campaign can be reduced by stretching out the time required to accumulate a targeted amount of money or by investing the money in assets that pay a higher rate of return. But a higher rate of return always implies a greater risk. When an invest- ment is risky it must pay high rates so as to attract money. Because securities of the federal Treasury are generally considered to be the lowest risk, a rate approximating their prevailing rate is what should be used as a basis for judging the relationship between risk and return.

Moreover, because the rate has to be presumed to prevail for the length of the planning horizon, the investment that should be made is one that is likely to keep a relatively fixed rate for that period. The accumulated funds should be invested in rea- sonably safe fixed-rate assets that mature at about the time the money is needed. Notes, bonds, U.S. Treasury securities, securities of government agencies, certificates of deposits, even high-grade zero-coupon bonds and municipal bonds are examples.

Stretching out the time reduces the pressures on the fund-raising efforts and may perhaps make the project more realistic. This has to be weighed against other factors.

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Uses of Cash | 609

Stretching out the time increases risk: inflation would cause the cost of the project to rise. If the assets held are fixed rate, then their value will decline or probably will not keep pace with the rise in inflation. Hence, the earnings to finance the project will not keep pace with its rising costs and more, not less, fund-raising will be necessary, and common stocks may be a superior alternative to bonds. If bonds are used in volatile markets it is important to know their duration—a measure of how much the bond price changes as a result of changes in the interest rate.

Stretching out time also risks loss of interest on the part of donors and, in the case of buildings, changes in zoning or building codes that could increase costs. However, stretching out time does have an advantage—feasibility; but as argued earlier, stretching out time is not riskless.

Setting Target Prices, Fees, and Dues

For a nonprofit organization to do well selling its goods and services requires a ra- tional approach to the setting of prices and fees. In this section, I describe some ap- proaches.

Prices and Fees It is essential to note that all prices are eventually determined by the market, some prices more so than others. In a very competitive market, the price or fee that a non- profit will be able to charge will depend on the prices or fees being charged by its competitors. Even in a monopoly situation where the nonprofit sets a price and does not have to worry about competition, market forces will determine how much of that good or service will be sold. If there is no demand for the product, it will not sell. If the demand is limited by a very high price, only a few will be purchased. If the price is low enough and consumers are very sensitive to prices, more will be sold. This is the basic law of supply and demand.

Not only does the market set limits on prices, but so too do the laws and regula- tions from federal, state, or local authorities. For example, where there is rent control, nonprofits may not exceed it unless by special exemption.

In short, whatever the price or fee level set by the nonprofit and whichever of the methods it uses to determine those prices or fees, they must eventually be adjusted to the realities of the market and the law. Therefore, the methods to be discussed may best be viewed as rational ways to determine target prices or fees.

The rational setting of prices and fees means that they should have some rela- tionship to costs. To simplify matters, let us describe the full costs of producing a good or service as composed of (1) direct costs resulting solely from the production of the good or service, and (2) indirect costs only partly related to the production of the good and service. Put another way, direct costs exist only because the good or service is

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being produced. Indirect costs would exist whether or not a specific good is being produced because the organization has to incur costs to exist and to carry on its non- profit mission. See Chapter 12.

Various price or fee targets can be set depending on the amount of the direct and indirect costs the organization wishes to recover. On one level, the nonprofit may set a fee or price that does not meet even its direct costs. It can do this only to the extent that gifts and contributions or some other source of income—for example, member- ship fees, endowment income, business income, or government grants—make up the difference. This is in fact what many nonprofits do. When they set the price of their goods or service at zero (or no charge), they are totally dependent on other sources to pay for the cost of the service they provide.

On a second level, the nonprofit may set a price or fee that only recovers its direct costs. When this is done, less pressure is placed on other sources of income to support that particular activity. These sources would be needed only to cover the indirect costs, a portion of which would exist even if the good or service were not being produced.

On a third level, the price or fee could be set so that the full costs, both direct and indirect, are being covered by the price. In this case, the activity is self-supporting. The other sources of income can be used to advance other missions of the organization.

On yet another level, the price or fee may be set so that the organization not only recovers its full costs (direct and indirect) but more. It can do this by adding a per- centage to its full costs. In the for-profit world, this percentage reflects a gross profit margin. This margin is also permitted to nonprofits. In the General Council Memoran- dum 39346, the IRS concluded that the provision of veterinary service for a fee of cost plus a percentage was not in violation of the tax-exempt status of 501(c)(3) organiza- tions formed to provide veterinary services. Moreover, the IRS concluded that given the facts and circumstances of that organization, the markup did not constitute an unrelated business and therefore it was not taxable.

The significance of this last level of setting a target price or fee is that this extra percentage can be (and virtually must be if it is not to be taxed as an unrelated busi- ness) used to support the advancement of the mission of the organization. Hence, the pricing levels described progress from losses that impose a burden on the organiza- tion to one that provides a legal surplus helping to support the organization in its mission.

Setting of prices or fees does not necessarily subvert or destroy the charitable character of a 501(c)(3) organization or its mission. The fees or prices may be set ac- cording to some means test. Clients are charged according to their ability to pay. Those who cannot pay are served without charge, and the charge rises as the ability to pay increases. In setting rental levels in homes for the elderly, the nonprofit must set the prices so that they fall within the financial reach of a significant proportion of the elderly population in the community. Should a resident not be able to pay, the organization should be prepared to make necessary arrangements to continue to pro-

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Uses of Cash | 611

vide housing even in a housing project operated by another organization. The organ- ization should also operate at the lowest feasible cost. This does not mean that it does not provide amenities, but that the cost of these plus other necessary costs should not become so high that the subsequent price is out of reach of a large segment of the elderly population.

Prices can be set in a deliberate attempt of the organization to meet its mission and to demonstrate public support. The John F. Kennedy Center for the Performing Arts sells tickets at half price to seniors, low-income groups, students, military, and handicapped persons. The cost of doing this is considered by the Center as part of its educational and public service mission. The Metropolitan Museum of Art in New York “suggests” an entrance fee to its visitors on a sliding scale—lower rates for senior cit- izens and zero for children.

Dues Membership dues are prices—the cost to an individual or entity to be a member. For nonprofits, setting these dues should balance the ability to pay with the benefits re- ceived. Partly because of the support rules described in Chapters 3 and 4 and the rules on deductions, as well as for marketing purposes, it helps to separate these two con- siderations.

Accordingly, part of the dues should be based on the average (per person) total cost of running the organization and providing benefits from which people cannot be excluded. This part of the dues should be based on a sliding scale according to the ability to pay. This portion could very well have a value of zero for the least able to pay.

The second component of the dues may reflect benefits received. Hence, we may tilt higher dues to those who receive the greater benefit. For most organizations, this runs counter to the ability to pay and, unlike a firm, a nonprofit should place more weight on the ability to pay.

One way to reconcile this difference is to structure the dues based on the ability to pay. Then take all those benefits that can be priced and make them available to the membership at a price. Hence, there are annual dues according to a sliding scale; but if one wishes to attend a conference or receive a publication, a price is charged. The target dues, like the target price, are subject to market considerations. It will be low- ered if people do not value the organization’s services as highly as it does or cannot pay, in which case the organization will have to return to the point from which we began this book: Whose welfare is it advancing?

Dues, Donations, and Taxation Ruling 407–95–03 of New Mexico makes an unusual but interesting point about the definition of dues and includes a reminder of the importance of state laws. It reads: “Exempted from the gross receipts tax are the receipts from dues and registration fees

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612 | Chapter 18: Evaluating Old Targets and Setting New Ones

of nonprofit social, fraternal, political, trade, land or professional organizations and business leagues. … Dues means amounts that a member of an organization pays at recurring intervals to retain membership in an organization where such amounts are used for the general maintenance and upkeep. … Under the Internal Revenue Code a 501(c)(4) is a civic league or organization. … X is not a nonprofit social, fraternal, polit- ical, trade, labor or professional organization, nor a business league. … The voluntary payment made by the community members do not fall with the definition of ‘dues’. … Therefore, X’s receipts are subject to the gross receipt tax.”

The IRS is also concerned not only about differences in dues—arguing that charg- ing associated members a different dues amount could be unrelated business income (Chapter 10)—but that discounted prices and fees could also be a problem. Therefore, when using a discount for members, be sure that it is reasonable and that the event is financed primarily by the members. If this is not done, the higher rate charged to nonmembers will be construed as personal inurement; that is, the higher rate of non- members was a benefit in the form of a lower rate passed on to the members. Also, be sure that if differential dues are used, these are not subject to the same argument and are not seen simply as a way of increasing revenues. If this turns out to be the inter- pretation, Revenue Procedure 95–21 calls for the reporting of an unrelated business income and a tax on that income. Further, if nonmember fees and charges become a principal source of gross revenues of associations, the exemption can be lost.

Summary and Preview

Many managers are blindsided by the creeping of their organizations toward financial problems. This chapter is intended to help them in reducing the risks of “surprises” by that which could have been foreseen, to set targets for that which they want, and to achieve both of these through informed financial decisions. Management, there- fore, needs to be involved in setting financial targets (without the arithmetic details), financial and strategic safeguards such endowments, and have a basic command of how these work. In short, managerial action is grounded in more than reading finan- cial statements

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