Setting the Foundation to Interpret Nonprofit Financial Statements

As a CPA, I am generally focused on the financial health of a nonprofit organization. In working with board members over the years, I’ve heard a lot of the same questions surrounding the financial statements:

• Who is responsible for the financial statements?
• How do I read and understand the details of the financial statements?
• How can I leverage the financial statements to fulfil our mission?

Management is responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP); this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error.

The Auditors’ responsibility is to conduct the audit in accordance with U.S. GAAP. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements, while considering the internal controls relevant to preparing the financial statements. The auditors provide an opinion as to whether the financial statements are materially presented in accordance with U.S. GAAP.

Nonprofit financial reporting contains four main statements:

1. Statement of Financial Position (known as the “balance sheet” for for-profit entities),
2. Statement of Activities (“income statement”),
3. Statement of Cash Flows, and
4. Statement of Functional Expenses.

Equally important to the individual statement are the footnotes to the financial statements, which tell the users of the financial statements the nonprofit’s story over the last year.

The statement of financial position shows the financial condition at a point in time (the nonprofit organization’s year-end). The statement is presented based on liquidity and based on an accounting formula where assets equal liabilities and net assets. Net assets are equivalent to a for-profit’s stockholder’s equity, but as there is no “owner” of nonprofits, the net assets are the excess assets over its liabilities. 

The statement of activities reports the financial results during the reporting period. It presents the revenues and expenses in two columns, those with donor restrictions and those without donor restrictions. The net asset class of “with donor restrictions” are based on the donor-imposed restrictions. Some donor-imposed restrictions are temporary in nature, such as those met by the passage of time or other events. Other donor-imposed restrictions are perpetual in nature, where the resources are to be maintained in perpetuity. As time lapses or purpose fulfilled, the donor-imposed restrictions are released for use. The net effect of revenues and expenses is the change in net assets, referred to as earnings in for-profit entities.

The statement of cash flow reports the cash receipts and disbursements during the reporting period. Cash activity is presented according to its use in operating, investing, or financing activities. The cash effects from the nonprofit’s normal operations of providing services or making and receiving contributions are reflected in operating activities. Supplemental information is shown to represent cash paid for income taxes, interest, or other non-cash transactions.

The statement of functional expenses is only used by nonprofit organizations. Management allocates the expenses by natural classification (wages, occupancy, depreciation, etc.) by the programs and support of maintaining the operations. The breakout of how expenditures are shown allows the nonprofit to monitor expenses and track how much is spent on the nonprofit’s mission, administration support, and fundraising. This statement is reported on the Internal Revenue Service Form 990, required of nonprofit organizations. When considering an organization for donation, many donors check the percentage of programmatic expenses as it highlights how much of their dollar is spent on the organization’s mission.

The footnotes to the financial statements include detailed qualitative and quantitative information. The footnotes start with who the nonprofit organization is, highlighting any major programs or significant operations. Management’s accounting policies are then detailed to explain how the organization records transactions, which may include recently adopted or upcoming accounting standards. The footnotes disclose information on matters not included in the four main statements of the financial statements. Additional disclosures include information for debt and future obligations, details on related party transactions, litigation contingencies, or subsequent events.

This blog was co-authored by Monica Johnson, Nonprofit Director at CLA.

Watch future blogs as we dive into calculating financial and nonfinancial data for key ratios.