To the uninitiated, annual financial statements can be confusing and intimidating. This article is intended to help financial statement readers understand the content and limitations of financial statements. It should also help with the interpretation of the information contained in the statements. While the article is not a comprehensive guide to reading and interpreting financial statements, it should provide a good introduction to the topic.
Structure of Financial Statements
The annual financial statements of not-for-profit organizations normally include:
- a statement of financial position (sometimes called a balance sheet or a statement of net worth)
- a statement of operations (often called a statement of revenue and expenses)
- a statement of changes in net assets (the term “net assets” is often referred to as accumulated surplus or funds). For many organizations this statement is combined with the statement of operations.
- a statement of cash flows. This is often omitted if information regarding the cash flows for the year is readily obtainable from the other statements.
Audited financial statements include notes to provide additional information about the method of financial statement preparation and about the organization itself. The notes may also include supporting schedules that are cross-referenced to the statements noted above.
The financial statements of seemingly similar organizations may use different titles for the various statements. For example, one organization might have a statement of revenues and expenses while another might have a statement of operations. The purpose of these statements is the same despite the difference in names.
Content of Financial Statements
Financial statements are generally limited to quantitative financial information about transactions and events as opposed to more qualitative statements regarding financial condition and well being. For example, a statement of operations may show an excess of expenses over revenue (i.e. a loss) of $20,000 for the year. The statements will not comment on the future effect that the loss may have on the organization. It is up to the reader to interpret the information.
Financial statements are based on past rather than future transactions and events. Readers often look to historical information contained in financial statements to help predict the future cash flows of an organization. Predictions are, however, not an objective of the statements. Instead, the statements are intended to reflect what has already happened. In the example above, the existence of a loss does not provide sufficient information for a reader to determine if there is a serious cash flow problem or if the loss was an anomaly. The fact that a loss happened should, however, be reason for a reader to question whether a problem might exist in the future.
Financial statements form only a part of the financial reporting of an organization. Other important sources of financial information include annual reports, budgets and funding proposals. Readers wanting more information than that contained in the organization’s financial statements will often be able to obtain it by referring to these other sources.
Objectives of Annual Not-for-Profit Annual Financial Statements
The primary objective of annual financial statements of not-for-profit organizations is to fulfil the information needs of members, contributors (i.e., funders) and creditors regarding the organization’s financial position.
Members, creditors and contributors to not-for-profit organizations are not generally kept informed of daily operations and ongoing finances unless they are members of the board of directors. Members require some form of external communication of the not-for-profit organization’s economic information to determine whether their contributions and fees are being spent as expected. Similarly, a not-for-profit organization’s creditors and funders often need external reports.
Financial statements are used to provide information about:
- what the organization owns and what it owes;
- the changes over the period in what the organization owns and what it owes;
- whether the organization operated at a surplus or a deficit over the period.
Owned or Owing
The statement of financial position (a.k.a. balance sheet or statement of net worth) contains information at a specific date – typically the fiscal year end of the organization – about:
- what the organization owns and what is owing to it (assets);
- what the organization owes (liabilities). This includes amounts owed to others or amounts to be spent on the operations of a future period (e.g. deferred grants).
- the accumulated surplus or deficit from prior years’ operations (net assets/deficit). The difference between the assets and the liabilities is the amount of the net assets/deficit.
The statement provides a measure of the net worth or solvency of the organization. This snapshot of assets, liabilities and accumulated surplus (i.e., net worth) usually includes a comparative snapshot as at the prior year end.
Surplus or Deficit
The statement of operations (a.k.a. statement of revenue and expenses) contains information regarding:
- how much revenue was earned by the organization during the year. This will include both cash received and revenue earned but not yet collected (i.e. amounts receivable).
- the expenses the organization incurred such as those for wages, operating costs, etc.
- the difference between the revenue and expenses, which is the organization’s surplus or deficit for the year.
If the statement of financial position presents a snapshot at the beginning and end of the fiscal year, the statement of operations paints a picture of the year itself.
The statement of operations contains information concerning where revenues come from and how they were spent. The excess (or deficiency) of revenues over expenses is the number that people refer to as the “bottom-line”. This number tells readers whether the organization was able to match its expenses with revenue or if expenses outweighed revenues during the year.
Changes in What is Owned and Owed
The statement of cash flows provides information about how the organization generated and spent its cash during the year. It compliments the first two statements. The statements of financial position and operations provide a snapshot of the financial position of an organization at a specific date and a sense of its economic performance over the period but do not always clearly show why there were changes in assets, liabilities, and net assets. For example, an organization receiving a capital donation to buy a piece of land or a building would not normally reflect that donation as revenue. Instead, it would be shown as an increase in capital assets on the statement of financial position and, typically, shown as a direct increase in net assets. Another example is that of repayment of debt. If an organization pays off a bank loan, that payment is not an expense. It would result in a direct reduction of a liability. In both of these cases the transactions would be disclosed in a statement of cash flows.
Note that for many small operations, the changes in an entity’s assets, liabilities, and net assets can generally be seen from the statement of operations. As a result, many not-for-profit organizations without significant debt, capital assets and deferred grant balances often do not prepare a statement of cash flows.
What Goes into Financial Statements
As discussed above the objective of financial statements is to provide users with an idea of an entity’s financial position, its economic performance over a period and its changes in assets, liabilities, and net assets. We will now take a detailed look at the more common categories that appear in financial statements.
The first section of assets represents the current assets. Current assets comprise cash and other assets (e.g. short-term investments and accounts receivable) that would usually be converted into cash in the normal course of operations within the year.
Cash includes petty cash on hand, and cash in bank and credit union accounts. Note that the cash balance is adjusted for:
- cheques written before the year end that are not cashed until after the year end
- cash deposited in the bank after the year end that was received by the organization before the year end.
These two adjustments ensure that the cash balance represents the actual cash on hand and available to the organization at the reporting date.
Short-term investments include items such as term deposits, guaranteed investment certificates, mutual fund money market holdings, and, in some cases stocks and bonds. It is important to note that, as with all other assets, these investments are recorded at their original cost to the organization. Subsequent gains are not recorded in the accounts. The notes to the statements often disclose market value of the investments. You should read the notes to see if the market value disclosed is greater than or less than the cost amount of the investments recorded in the statements.
If, in the eyes of the organization, an investment has suffered a permanent impairment in value (i.e., has declined in value below the original cost and the value is not expected to recover) then the securities will be written down in the financial statements to the now lower market value. Subsequent increases in market value will not be recognized in the statements.
Accounts receivable are amounts owing to the organization at a specific date for services rendered and goods sold. Examples of accounts receivable are amounts owed by parents for child care fees and workshop fees earned by an organization but not received until after the year end. Accounts receivable may also include other items due to the organization such as GST refunds, interest receivable on investments and grants receivable from government organizations for services rendered by the organization prior to the reporting date.
An important question to ask regarding accounts receivable is: “Will the amounts receivable actually be received by the organization?” An implicit assumption in financial statements is that the amounts included in accounts receivable will be recovered by the organization. Amounts on the organization’s books that are not expected to be recovered are often either fully written off or are offset by an allowance for uncollectible debts.
Inventory comprises goods and supplies (assets) held by the organization for resale. An implicit assumption in financial statements is that inventory can be sold at an amount at least equal to its cost to the organization. A question to ask regarding inventory is: “Is it saleable in the foreseeable future?” If the answer is no, then the inventory should not be included as an asset in the financial statements.
Capital assets are assets held for a period longer than one year and comprise items such as land, buildings, furniture and other equipment. Capital assets are held for use by the organization in delivery of its services and are not intended for sale in the ordinary course of operations. The financial statements reflect capital assets at their original purchase price. The statements do not attempt to disclose fair market value or disposable value or any type of value other than cost. Consequently, while capital assets may be listed at $20,000, that is not to say that they could be sold for $20,000 or that it would cost $20,000 to replace them. The information disclosed is that the assets originally cost the organization $20,000.
Financial statements disclose not only the cost of capital assets but also an item called accumulated amortization. Assets are usually recorded as an expense over a number of years (e.g. three years or five years). This is the accountant’s way of trying to spread the cost of an asset over its useful life. Accumulated amortization is the accounting term that explains how much of the assets have been recorded as an expense since their purchase. The excess of original cost over accumulated amortization of capital assets is termed “net book value”. The net book value of capital assets represents the remaining value of assets to be written off as an expense in future years.
Note that land is not amortized as the usefulness of land generally does not diminish with time in the same way that, for example, a computer does.
Analysis of assets
When reading a balance sheet we recommend that you focus on the following:
- collectability of accounts receivable (i.e. will amount recorded actually be received);
- the difference between the market value of securities/investments and their recorded cost;
- if inventory on hand is saleable in the foreseeable future;
- whether all significant capital assets of the organization are recorded on the balance sheet
- whether the organization plans to or needs to replace capital assets in the future .
Like assets, liabilities are divided into current and long-term categories. Current liabilities are those which are owed and due to be paid within one business cycle, usually a year, such as accounts payable and accrued liabilities and deferred grant revenue. All other liabilities to be paid over a period longer than a year are classified as long-term liabilities.
Accounts payable and accrued liabilities
Accounts payable and accrued liabilities are obligations that have been incurred by the organization before the year end but have not yet been paid. The following are examples of some of the more common amounts payable:
- unpaid salaries and wages at the year end where the pay date does not fall on the year end date
- vacation pay earned but not taken by employees as at the year end
- goods and services such as utilities, food and professional fees that have been purchased and/or consumed by the year end but have not yet been paid for.
Liabilities are generally recorded at the amount that the organization expects to pay to discharge them. If a potential liability exists but it cannot be valued (e.g., in the case of an outstanding item such as a lawsuit whose outcome is in doubt at the year end) then this situation will often be disclosed in the notes to the financial statements. This is yet another example of why you should always refer to the notes when looking at a set of financial statements.
Deferred grant revenue
Deferred grant revenue represents grants received by an organization before the year end where the related expenses have not yet been incurred. As an example consider an organization that receives a salary grant in advance of the year end for salaries to be incurred the following year. The unspent portion of the grant at the year end would be recorded as deferred grant revenue in the liabilities section of the financial statements.
Loans, mortgages and other debt
This caption represents the amount of debt, such as mortgages and multi-year bank loans, owed by the organization to third parities. Again, reading the notes is very important for understanding the impact the debt will have on the future cash flows of the organization. The notes will generally disclose the loan payment terms, interest rates, and, very importantly, the security pledged by the organization. For example, if an organization pledged its accounts receivable and inventory as collateral for a bank loan then this will be disclosed in the notes to the financial statements.
Analysis of liabilities
- Compare current liabilities with current assets. The organization should have sufficient current assets (the sum of cash, inventory, accounts receivable, etc.) to cover its current liabilities. If it does not then you should question how the organization will pay the amounts owing in the upcoming year.
- Review the terms and conditions of loans and other debt to determine whether any large payments are due in the near future.
- Read the notes to the financial statements to determine whether there are any potential liabilities that could not be quantified as at the year end.
The next major caption in a balance sheet is that of net assets. This caption often appears as accumulated surplus (deficit), net worth, or funds. Regardless of the name, in all cases it represents the excess of the book value of what an organization owns (assets) less the book value of what the organization owes (liabilities).
Net assets are often subdivided based on the nature of the restrictions placed on the net assets by an organization’s donors and funders. There are four common subdivisions of net assets: restricted, designated, invested in capital assets and unrestricted.
This caption reflects assets given to the organization on which the funder or donor has placed explicit restrictions. The organization has a duty to use these funds in accordance with the specified purposes or the funds could have to be returned to the contributor. An example would be where donations have been given specifically to fund the purchase of a building. The organization must use the money to buy a building; it could not turn around and spend the money to cover operating or other non-building expenses.
Designated amounts usually represent amounts the organization has set aside to fulfill a specific function. Designated amounts come to the organization without restrictions on their use but are subsequently designated for a specified use by the Board of Directors. A common example would be where an organization notionally or physically sets aside an amount to purchase a new asset such as a building or to repair or renovate an existing asset such as a playground. Designated amounts could also be set aside for possible costs in the event of wind up of an organization or to provide a cushion in the event of unexpected financial requirements.
It is important to note that, unlike funds with externally imposed restrictions, the requirements to spend designated amounts can be changed by the organization without the funds having to be returned to anyone.
Invested in capital assets
This amount represents the net book value of capital assets in the financial statements less the value of liabilities related to those assets. For example, if an organization had a building with a net book value of $1,000,000 against which there was a $250,000 mortgage then the amount reflected as “invested in capital assets” would be $750,000.
What is left over after restricted, designated and funds invested in capital assets are so called “unrestricted” funds. These are funds that can be used for the general operating purposes of the organization. Note that even though use of the funds is classified as unrestricted they must still be used in accordance with the legal mandate of the organization as set out in its incorporating statutes or similar documents.
The amount of unrestricted funds provides an indication of the solvency of an organization; solvency being the ability of an organization both to fulfil its current obligations and fund its future operations for the foreseeable future. For many not-for-profit organizations the combination of the unrestricted and designated net asset items should typically be within the range of one to three months of operating expenses. This is only a very general guideline. There are circumstances that would warrant a level of unrestricted and designated net assets outside of that range. Circumstances include extreme financial uncertainty (which could justify a level of net assets in excess of the range) or, on the other hand, excellent financial stability (which could justify a smaller than average level of net assets).
Analysis of net assets
- Compare restricted net assets with the level of current assets less current liabilities. Does the organization appear to have sufficient resources to cover these specified spending requirements?
- Review the total of unrestricted and designated surplus amounts. Compare this total with total operating expenses. If the combined surplus is less than a month’s worth of operating expenses or more than three months’ worth of operating expenses then you might question whether the surplus is appropriate.
Revenues represent the earnings of an organization during the reporting period. For example, an organization entitled to receive $1,000 in a year for providing services to its community would report the $1,000 as revenue. It is important to note that the revenue would be recorded whether or not the organization actually received the cash. Note that any revenue earned by not received at the reporting date would be included in accounts receivable under current assets in the balance sheet.
Donation revenue usually comprises donations actually received in the year. Donors do not enter into a contract with the organization when making a donation. The revenue is, therefore, generally only recognized in the reporting period in which the donations are actually received.
Pledges to donate that have not yet been honoured by the donor at the year end are generally not set up in the financial statements. Because the pledge agreement is not a legally enforceable contract the organization has no legal way to enforce collection. You should read the notes to the financial statements to see if the organization has a policy of recognizing as revenue donations pledged but not yet received at the year end.
Grants, unlike donations, are generally characterized by a legally binding contract between the funder and the organization. Grant revenue comprises funds earned by virtue of the organization carrying out programs specified by the funder in a grant contract. Revenue earned does not necessarily equal cash received from funders during the year. For example, an organization receiving $1,000,000 in cash before the year end for a program that was only three quarters over by the year end would typically record grant revenue of $750,000 in the statement of operations. The remaining $250,000 would be reflected as deferred grant revenue under the liabilities section of the statement of financial position. Consequently, grant revenue, unlike donation revenue, reflects grants “earned” by an organization and not just cash received.
Analysis of revenues
- Review changes in revenue from last year to this year. Management should be able to explain significant changes if the reasons for those changes are not evident from the financial statements themselves.
- Review accounts receivable in conjunction with revenue. A significant increase in accounts receivable might indicate either problems with collectability of revenue or a significant increase in activity toward the end of the fiscal year.
Expenses during the year represent costs incurred by the organization to carry out its services. Again, as with revenue, it is important to note that expenses will include amounts for services provided or goods received that have not yet been paid for by the organization at the reporting date. Note that unpaid expenses will be reflected as part of accounts payable and accrued liabilities in the statement of financial position.
Salaries and wages
Salaries and wages are typically the single biggest expenditure item for most not-for-profit service-based organizations. Personnel related expenses should include the amount of any pay equity obligation for the year whether or not the organization has actually paid staff their pay equity entitlement. Organizations should also include the expense of unpaid vacation pay over the period if this is a significant item.
Analysis of expenses
- Compare the change in expenses from last year to this year. Review the notes to see if explanations for significant differences are noted.
- Review the notes to the financial statements to determine whether there are potential expenses that have not been recorded because the amounts were not reasonably determinable at the year end.
Statement of Cash Flows
This brings us to a review of the statement of cash flows. This statement is a very important one for organizations with a significant amount of deferred revenue, long-term debt and capital assets. The statement of cash flows categorizes and summarizes the actual cash receipts and cash disbursements for the year. Unlike the statement of operations, this statement excludes the effect of amounts receivable and amounts payable by the organization at the year end. The statement discloses, among other items, cash spent for purchase of capital assets together with cash spent to retire debt.
Cash transactions occurring in the year are typically divided into two captions:
Cash from operations
This caption includes cash received and cash spent during the year on an organization’s operations. For example, if an organization receives a $1,000,000 grant before year end but only spends $750,000 of it by the year end then the statement of cash flows will reflect the full $1,000,000 grant receivable under the caption cash received from operations. Cash used for operations will show the $750,000 in cash spent.
Financing and investing
This caption includes cash received from and cash paid out for investments in the year such as marketable securities, equipment and land and buildings. These items would not appear in the statement of operations as they result from an exchange of one asset for another (i.e. cash for an investment) and are, therefore, not expenses. The statement also includes cash received from or paid to reduce debt. For example, if an organization paid $250,000 to purchase a building, then the full amount of the $250,000 would appear in the statement of cash flows as a building purchase.
Analysis of statement of cash flows
- Take net cash actually received or spent on operations from the statement of cash flows and compare it with the surplus or deficit for the year as recorded in the statement of operations. The two amounts should be similar unless liabilities or receivables have changed significantly over the year. If the two amounts do not closely correlate then ask why. Understanding a discrepancy is especially important when an organization with a healthy excess of revenue over expenses has received significantly less cash from operations. The discrepancy might indicate cash flow problems that could lead to financial difficulties.
The above is a brief overview of the information portrayed by financial statements with a few tips for questions you might want to ask management. We would be happy to hear if you have ideas and suggestions regarding the review and analysis of financial statements of not-for-profit organizations. We will share ideas and suggestions with our readers wherever possible.