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UNDERSTANDING
ANNUAL FINANCIAL STATEMENTS (November 1999) 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:
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:
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:
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. Assets 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 Cash
includes petty cash on hand, and cash in bank and credit union accounts.
Note that the cash balance is adjusted for:
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 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 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 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 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. Accumulated
amortization 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:
Liabilities 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:
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
Net
Assets 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. Restricted 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 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. Unrestricted
funds 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
Revenues 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 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. Grant
revenue 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
Expenses 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
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
Conclusion 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. |
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