Financial Statement Analysis:
The learning objectives of this chapter are to:
Discuss the elements of financial statement analysis, including review of the financial statements, examination of the notes that accompany the financial statements, calculation of ratios, and final assessment;
Explain the parts of a financial statement review, including the audit opinion letter and the individual financial statements;
Explain the importance of examining the notes that accompany the financial statements and discuss the note that focuses on significant accounting policies, as well as other more specific notes;
Define ratio analysis and discuss the role that ratios play in assessing the financial situation of an organization;
Explain the importance of comparing the organization’s ratios with its own ratios over time, as well as those of comparable organizations, and the industry as a whole;
Provide cautions in the use of ratio analysis;
Define and explain a number of major classes of ratios and specific individual ratios that are of value in financial statement analysis; and
Discuss the importance of bringing all of the information together to make a final financial assessment of the organization.
INTRODUCTION:
Chapters 9 to 13, Part IV of this book, focused on reporting results using financial accounting. The role of financial accounting is to gather, summarize, and report information about the financial history of the organization. The financial statements discussed in the preceding chapters are the vehicle used to communicate the results of operations and the financial position of the entity. The focus of this chapter and the next is on how that information can be analyzed to gain additional insight into the financial situation of the organization. This chapter focuses on a general framework for financial statement analysis. Chapter 15 focuses on special concerns in the analysis of the financial condition of governments.
The two chapters also consider other indirect sources and types of information that may be valuable in understanding the finances of an organization. For example, comparison of the organization’s financial results with those of similar organizations can be particularly enlightening. The same is true for comparisons with the organization’s industry as a whole.
There are many potential purposes of financial analysis. Managers must understand the financial situation of the organization to assess its ability to achieve its mission. They will want to understand their organization’s financial position and results so that they can make decisions that will maintain a satisfactory financial situation or improve an unsatisfactory one. Managers also want to compare the financial performance of their organization with similar organizations to learn if perhaps they could improve their organization’s performance.
Donors desire to evaluate organizations to which they are considering making a contribution. Vendors want to understand whether their customers will be able to pay for their purchases. Lenders want to consider the likelihood of an organization being able to repay loans. These represent just a few of the many uses of financial information.
Different users and different uses of information call for different types of information. Some users want an assessment of the likelihood of repayment of a loan due in 20 years. That requires some prediction of long-term solvency. Vendors may only be concerned with short-term liquidity: Will the organization be able to make payments next month for its purchases this month? Before investing in an entity, we may wish to know about its profitability. Before making a donation, we may wish to know how much of the money spent by the organization goes to program rather than support services. The goal of financial analysis is to use financial statements and other sources to gather the information needed to answer questions and make decisions.
For most organizations, the primary focus of financial analysis is on the audited financial statements. The statements themselves are reviewed, the contents of the notes that accompany audited financial statements are carefully considered, and a set of ratios are calculated. The notes to financial statements are critical because financial statements alone are often inadequate to convey all important financial information. The Generally Accepted Accounting Principle (GAAP) of full disclosure requires that notes be used to convey important financial information that the financial statements do not adequately disclose. Ratio analysis compares numbers from financial statements with each other to gain insight from the relationship between the numbers. Finally, all of the information gathered is brought together, and an assessment is made based on the information as a whole.
FINANCIAL STATEMENT REVIEW:
A good place to commence a financial statement analysis is by carefully and thoroughly reading the financial statements and the accompanying notes. Ratios should then be calculated and comparative data should be obtained if possible. Finally, based on a review of all data, an assessment can be made about the financial status of the organization.
In reviewing the financial statements, three overriding concerns are as follows: (1) Is the organization accomplishing its mission? (2) Is the organization financially stable? and (3) Are the results of operations acceptable? By looking at the financial statements, we are not just looking for numbers; we are also trying to gain an insight as to what has happened to the organization and where it is today. The Certified Public Accountant’s (CPA’s) opinion letter and management’s discussion are other elements of an annual report that should be included in the review process.
Trend information often makes analysis easier and more fruitful. If possible, analysis should use financial statements that show more than one year of information. If such statements are not available, the individual annual financial statements from several preceding years can provide comparable data. In reviewing the statements, changes should be noted. If the changes appear significant in amount, one would want to try to investigate them to determine why they occurred and whether they represent a trend that is likely to continue.
The Audit and the Auditor’s Opinion Letter:
A financial audit, or simply an audit, is a detailed examination of the financial statements and financial records of an organization. Audited financial statements are financial statements that have been examined by a CPA. The CPA issues an opinion letter, called the auditor’s report, providing expert opinion about whether the financial statements provide a fair representation of the organization’s financial position and the results of its operations. As an outsider, the auditor provides an independent review of the financial statements. The discovery of fraud is an occasional by-product but is not the primary focus of the audit. The primary focus is on whether the financial statements are in compliance with GAAP and are free of material misstatements.
Note that it is the accountant who is certified (by a state licensing board) and not the financial statements, although often people refer to audited financial statements as the “certified financials.”
In some cases, the auditor is hired to do something less than an audit. Small organizations, including many not-for-profits, are not required to have an audit by a CPA, which can be quite costly. Sometimes such organizations will employ a CPA to perform a compilation or review of financial statements. In a compilation engagement, the auditor is hired to develop a set of financial statements. The auditor takes the information that has been recorded by the organization during the year and summarizes that information into a set of financial statements that report the results of operations and the financial position of the organization. In a review engagement, the organization has prepared the financial statements, and the CPA reviews them for form and accuracy. However, in neither a compilation nor a review engagement does the CPA perform the extensive testing of records and detailed review that are part of an audit. The statements compiled or reviewed may not be referred to as audited or certified financials.
One of the major functions of an audit is to review not only specific transactions but also systems. It is too expensive to review every single transaction and find every error that has been made. Instead, auditors use sampling techniques to determine how often errors are occurring and how large they tend to be. If an unacceptable level of errors is occurring, the auditor works with the organization to improve its internal control systems (see Chapter 8). The auditor will send a letter, referred to as the management letter, to the organization’s management discussing its internal control weaknesses. That letter does not become part of the annual report issued to outsiders.
The management letter, written by the auditor, should not be confused with a separate letter called management’s discussion, which is written by the organization’s management and discusses their assessment of the organization’s performance.
In addition to the management letter, the auditor issues an opinion letter. This letter follows a standard format, with much of the same wording used for many different organizations. The following auditor’s opinion letter for The Fresh Air Fund is provided as an example:
Report of Independent Auditors:
To the Board of Directors of The Fresh Air Fund:
We have audited the accompanying statements of financial position of The Fresh Air Fund (the “Fund”) as of September 30, 2007 and 2006, and the related statements of activities, functional expenses, and cash flows for the years then ended. These financial statements are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
1 Source: The Fresh Air Fund. Financial Statements: Years Ended September 30, 2007 and 2006 with Report of the Independent Auditors. Reprinted with permission of The Fresh Air Fund.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Fresh Air Fund as of September 30, 2007 and 2006, and the changes in its net assets and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
Marks Paneth & Shron LLP
January 9, 2008
The first, introductory, paragraph explains what type of job the auditor was hired to do. Sometimes auditors do consulting or tax work, or are hired to perform a compilation or review. The paragraph indicates that in this instance an audit was performed and indicates the specific financial statements that were included in the audit process. For The Fresh Air Fund the CPA firm of Mark Paneth & Shron LLP2 audited the statements of financial position, as of September 30, 2007 and 2006, and the related statements of activities, functional expenses, and cash flows for the years then ended. Note that since a balance sheet shows the financial position at a moment in time, the letter refers to the statements of financial position as of a particular date, September 30 of each of the years covered by the audit. The other statements provide information on what has happened over a period of time. They are grouped together with an indication that they cover the “years then ended.”
The first paragraph of the letter points out that although the auditor can provide an expert opinion, management holds primary responsibility for the contents of the financial statements. In some organizations, the auditors, in practice, provide a substantial amount of help in compiling the financial statements as part of the audit. Nevertheless, managers must remember that if there are later problems with the information contained in the financial statements, it is the organization’s management, rather than the auditors, who bear the primary responsibility for their content. Regardless of who actually prepares the statements, managers should assure themselves that they understand their statements and agree with the estimates made and the contents of the statements.
The second, scope, paragraph of the audit letter explains the type of work the auditor did to ensure that the financial statements were in compliance with GAAP. Its purpose is to clarify that not every transaction was examined and that immaterial errors were not necessarily found and corrected. The types and extent of examinations that are undertaken as part of the audit are dictated by generally accepted auditing standards that CPAs follow in carrying out their audit.
The third, opinion, paragraph gives the auditor’s opinion on whether the financial statements provide a fair representation of the financial position and results of operations in accordance with GAAP. It is unusual and serious if the statements are not a fair representation (adverse opinion) in the opinion of the auditor. Some auditors condense the information from all three of these paragraphs into one paragraph.
2 LLP stands for Limited Liability Partnership. Generally the partnership business form, unlike corporations, does not limit the liability of its owners. LLP is a legal form of business organization that allows the business to operate as a partnership but provides legal liability protection to its owners.
The reader should also carefully examine any additional paragraphs beyond the standard three, or the one condensed paragraph. In the Fresh Air Fund letter, there are no additional paragraphs. In other instances, additional paragraphs might call the reader’s attention to a particularly important note, such as one regarding a major lawsuit against the organization.
The auditor’s letter often appears to be standard and contain nothing out of the ordinary. Nevertheless, it should always be reviewed as one of the first steps. If it does have anything out of the ordinary, it is worth giving it careful attention. Once the audit letter has been reviewed, the next step in financial statement analysis is to thoroughly review the financial statements. We begin with a discussion of the balance sheet.
The Balance Sheet:
Exhibit 14-1 provides comparative statements of financial position (balance sheets) for the hypothetical Meals for the Homeless. (Note that this is a new example. The numbers in the Meals for the Homeless Financial Statements in this chapter are not the same as those in Chapters 10 and 11.) Comparative financial statements present financial information for more than one fiscal period. Each number on the balance sheet should be examined.
EXHIBIT:
The first section of the balance sheet is current assets. Current assets are the most liquid of the firm’s resources. They generally represent resources that will become cash or will be used up within one year. In Exhibit 14-1, one of the first things we notice is that total current assets have increased from $48,100 to $61,100. At the same time, on the liability side of the balance sheet, we see that current liabilities, which will have to be paid in the near term, fell from $16,000 to $14,000. The increase in current assets during a period when there is a decrease in current liabilities, by itself, is a good thing.
It is important, however, to review critically all numbers rather than just summary ones. Although current assets increased, most of the increase is in accounts receivable. In fact, cash has declined from $3,100 to $100. Even though current assets seem adequate overall, one might question whether the $100 is adequate cash on hand to meet obligations as they come due. Furthermore, the increase in accounts receivable is a concern. If this is the result of increased revenues, then it is a positive sign. However, if revenues have not increased substantially, this is more likely to be indicative of problems collecting receivables. In that case, it may be a flag that a problem exists.
All assets that are not current assets fall into the general category of long-term assets. Prominent among the long-term assets are fixed assets, or property, plant, and equipment. Meals’ long-term assets have declined from $97,900 to $83,900. The largest element in this decline is a $10,000 reduction in equipment, net of depreciation. This indicates that the equipment of the organization is aging faster than it is being replaced. Depending on the specific circumstances of the organization, this might or might not be cause for concern. For example, if Meals had 10 delivery vans and a goal to replace two each year, the purchases of two new vans would offset the depreciation on the 10 vans. Given inflation, the new vans would cost more than the old ones, and we should see equipment gradually rise on the balance sheet each year. However, if Meals has only one van, it would not be surprising to see equipment, net of accumulated depreciation, decline from year to year until the year that the van is replaced.
We also note that investments declined from $12,000 to $8,000. Perhaps investments were sold to provide cash due to a shortfall from operations. If that is the case, it will show up on the cash flow statement. Alternatively, perhaps the market value of the investments has declined. We can look for more clues in the activity statement. Note that the first review of financial statements is a process that tends to raise more questions than it answers.
Long-term liabilities include any recorded liabilities that are not current liabilities. The only long-term liability for Meals is a mortgage. Note that the part of the mortgage that is due in the coming year is shown as a current liability. Overall, the mortgage for Meals has declined from the end of 2011 to the end of 2012. This is a positive indicator. It would be desirable, however, for the long-term liability reduction to be as great as the reduction in long-term assets. That was not the case for Meals.
The last thing we note in the case of the balance sheet for Meals is that although its total assets are approximately the same in both years and the total liabilities and net assets are approximately the same from 2011 to 2012 year-end, the net assets have increased by $5,000 from $114,000 to $119,000. A healthy, thriving organization generally requires at least a modest increase in net assets over time. In sum, Meals has performed reasonably in this area. The details of the increase will become apparent as we review the other financial statements.
The Activity Statement:
The comparative activity statements (sometimes called operating statements, income statements, statements of revenues and expenses, or statements of revenues and expenditures) are shown in Exhibit 14-2. Revenues and support have increased by $9,000 from $169,000 to $178,000. This is a positive sign. However, it is not a large enough increase to explain the $17,000 increase in accounts receivable that was noted when reviewing the balance sheet. This change would therefore warrant further investigation. It is a potential sign of problems with management of the collections process.
Examination of the individual revenue and support items shows that foundation grants are up sharply, by $10,000. However, there is a disturbing decline in contributions to $65,000, down from $73,000. We would want to investigate and determine if this is a one-year aberration or the beginning of an unfavorable downward trend.
EXHIBIT:
Meals for the Homeless Activity Statements For the Years Ending December 31, 2012 and 2011
2012
2011
Changes in Unrestricted Net Assets
Revenues and support
Client revenue
$ 11,000
$ 9,000
City revenue
20,000
16,000
County revenue
10,000
10,000
Foundation grants
60,000
50,000
Annual ball
12,000
11,000
Contributions
65,000
73,000
Total Revenues and Support
$178,000
$169,000
Net assets released from restrictions
Satisfaction of program restrictions (See Note 5)
$ 10,000
$ 10,000
Expiration of time restrictions (see Note 5)
2,000
1,000
Total Net Assets Released from Restrictions
$ 12,000
$ 11,000
Total Unrestricted Revenues and Other Support
$190,000
$180,000
Expenses
Meals
$ 67,000
$ 63,000
Counseling
35,000
34,000
Administration, fund-raising and general
75,000
65,000
Bad debts
4,000
4,000
Depreciation
10,000
10,000
Total Expenses
$191,000
$176,000
Increase/(Decrease) in Unrestricted Net Assets
$ (1,000)
$ 4,000
Changes in Temporarily Restricted Net Assets
Foundation grants
$ 10,000
$ 10,000
Contributions
5,000
2,000
Assets released from restrictions (Note 5)
(12,000)
(11,000)
Increase in Temporarily Restricted Net Assets
$ 3,000
$ 1,000
Changes in Permanently Restricted Net Assets Contributions
$ 3,000
$ 2,000
Increase in Permanently Restricted Net Assets
$ 3,000
$ 2,000
Increase in Net Assets
$ 5,000
$ 7,000
Net Assets at Beginning of Year
114,000
107,000
Net Assets at End of Year
$119,000
$114,000
The accompanying notes are an integral part of these statements.
Unrestricted net assets increased by $12,000 during 2012 due to release from restrictions. It is likely that most of this is the result of having spent money in compliance with restrictions. A note is often provided to explain net assets that are released from restrictions.
Although total unrestricted revenues and support have increased by $10,000 from $180,000 to $190,000, expenses have increased at an even faster pace. It is important to compare the organization with itself over time. The total $1,000 decrease in unrestricted net assets in 2012 is not a large amount. However, we note that the previous year there was a $4,000 increase. The implication is that we are possibly seeing a declining trend developing in the financial results of operations.
Overall, net assets increased by $5,000 in 2012. This is only $2,000 less than the increase the prior year. It is possible that the main change is that more of Meals’ contributions are coming with temporary and permanent restrictions. Note that while unrestricted contributions fell by $8,000 (from $73,000 to $65,000), temporarily restricted contributions rose by $3,000 (from $2,000 to $5,000), and permanently restricted contributions rose by $1,000 (from $2,000 to $3,000). While this helps reduce the sting of the reduction in unrestricted net assets, it is not totally reassuring. Restricted donations do restrict the organization’s use of resources. They do not provide the organization with the same degree of flexibility in directing resources where management believes they are most needed. Management might decide after reviewing these financial statements that a greater effort is needed to raise additional unrestricted contributions.
The Cash Flow Statement:
The cash flow statement focuses on financial rather than operating aspects of the organization. The concern is not with specific revenues and expenses but rather with the general sources and uses of money. The statement provides less information about profitability than the activity statement and more information about viability. It is possible to go long periods without making a profit. However, negative cash flows can create immediate questions regarding continued survival. The cash flow statement can provide some early warning signs when viability problems start to arise.
Sometimes the overall change in cash may seem to be fine, but it turns out that the organization’s routine activities lose cash. Long-term assets are sold or money is borrowed to overcome an operating cash deficit. Unless annual cash deficits from operations can be reversed, the survival of the organization is not ensured. In Exhibit 14-3, we see comparative cash flow statements for Meals for the Homeless for 2012 and 2011. Operating activities in 2012 consumed $10,000 more of cash than they generated. This shortfall was partially made up by selling investments for $4,000 and by receiving contributions that are restricted to long-term investments. Overall cash decreased by $3,000.
The cash decline of $3,000 was only half as great as the decline for 2011, when the cash balance fell from $9,100 at the start of the year to $3,100 at the end. However, the implications are much worse. The 2011 cash decline was the result of acquiring a van, which required a $32,000 cash payment. We can see this in the “Cash Flows from Investing Activities” section of the statement. The purchase of the van required an increase in mortgages of only $9,000 (see the “Cash Flows from Financing Activities” section of the statement). Part of the acquisition was paid for by selling investments and part by lowering the cash balance. A substantial portion of the cash for the van, however, was generated by operations. In 2011, there was $15,000 more cash generated from operations than was used for operations. In 2012, the organization sold nearly as much of its stock investments as it did in 2011 but did not acquire any fixed assets. If the trend from 2011 to 2012 is allowed to continue, it will likely have severe consequences for the organization.
When routine operating activities generate a surplus of cash, the organization is more financially stable and viable than if operating activities consume more cash than they generate. There are times when cash deficits from operations cannot be avoided. Growing organizations often have this problem. Receivables and inventory grow faster than collections can keep up. Even when the deficit is the result of healthy growth, however, caution is needed. Rapid expansion will require, at a minimum, careful planning. There must be a determination of how much cash will be needed from sources other than operations. Agreements from banks or other sources must be obtained to ensure that a cash crisis does not occur. It is far easier to obtain financing while one still has cash than it is if one waits until one runs out of cash.
EXHIBIT:
Meals for the Homeless Statements of Cash Flows For the Years Ending December 31, 2012 and 2011
2012
2011
Cash Flows from Operating Activities
Change in net assets
$ 5,000
$ 7,000
Add expenses not requiring cash Depreciation
10,000
10,000
Other adjustments
Add decrease in inventory
2,000
2,000
Subtract increase in receivables
(17,000)
(2,000)
Subtract decrease in wages payable
(1,000)
0
Subtract decrease in accounts payable
(1,000)
(2,000)
Subtract increase in prepaid expenses
(1,000)
0
Subtract contributions restricted to long-term investments
(4,000)
0
Subtract permanently restricted contributions
(3,000)
0
Net Cash Used for Operating Activities
$(10,000)
$ 15,000
Cash Flows from Investing Activities
Sale of stock investments
$ 4,000
$ 5,000
Purchase of delivery van
0
(32,000)
Net Cash from Investing Activities
$ 4,000
$(27,000)
Cash Flows from Financing Activities
Contributions restricted to endowment
$ 3,000
$ 0
Increase in notes payable
1,000
3,000
Contributions restricted to long-term investment
4,000
0
Increase in mortgages
0
9,000
Repayments of mortgages
(5,000)
(6,000)
Net Cash from Financing Activities
$ 3,000
$ 6,000
Net Increase/(Decrease) in Cash
$ (3,000)
$ (6,000)
Cash, Beginning of Year
3,100
9,100
Cash, End of Year
$ 100
$ 3,100
Supplemental Cash Flow Information Interest paid
$ 1,280
$ 1,600
The accompanying notes are an integral part of these statements.
The Statement of Functional Expenses:
The comparative statements of functional expenses, shown in Exhibit 14-4 for Meals, provide a great deal of detailed information about the different expenses incurred by the organization. One can see the mix between salaries versus materials and the mix of expenses by type of program. One of the most critical relationships to explore on this statement is the relative program service expense versus the support service expense. For 2012, Meals spent $121,000 on program services ($83,000 for meals plus $38,000 for counseling) while it spent $70,000 on support services ($47,000 for management and general plus $23,000 for fund-raising). One must always question whether the support service expenses are too high relative to the program service expenses, which are more directly related to the organization’s mission.
EXHIBIT:
Meals for the Homeless Statements of Functional Expenses For the Years Ending December 31, 2012 and 2011
Program Services
Support Services
Meals
Counseling
Management and General
Fund-Raising
Total
Expenses
For Year Ending 12/31/12
Salaries and benefits
$35,000
$35,000
$40,000
$17,000
$127,000
Food
17,000
17,000
Supplies and brochures
2,000
1,000
1,000
2,000
6,000
Office expenses
1,000
1,000
1,000
3,000
6,000
Rent
13,000
1,000
1,720
1,000
16,720
Interest
1,000
280
1,280
Professional fees
3,000
3,000
Bad debts
4,000
4,000
Depreciation
10,000
10,000
Total Expenses
$83,000
$38,000
$47,000
$23,000
$191,000
For Year Ending 12/31/11
Salaries and benefits
$33,000
$34,000
$36,000
$12,000
$115,000
Food
15,000
15,000
Supplies and brochures
2,000
800
1,000
2,000
5,800
Office expenses
1,000
800
1,000
3,000
5,800
Rent
12,100
1,000
1,700
1,000
15,800
Interest
1,300
300
1,600
Professional fees
3,000
3,000
Bad debts
4,000
4,000
Depreciation
10,000
10,000
Total Expenses
$78,400
$36,600
$43,000
$18,000
$176,000
The accompanying notes are an integral part of these statements.
The amounts spent on different types of expenses should be carefully considered. Also, changes from one year to the next should be evaluated, especially if the amount of the change is large.
Exhibit is the Statement of Functional Expenses for the American Endowment Foundation for the year ended December 31, 2007. Note the extremely high portion of total spending that goes directly for program services ($20,702,979 out of a total of $21,822,344, or 95%). In contrast, the Charity Navigator reported that The Association for Firefighters and Paramedics, for the year ending December 31, 2006, spent $80,530 on program expenses, $239,081 on administrative expenses, and $3,595,480 on fund-raising expenses.3 That comes out to just 2 percent spent on program services.
3 https://www.charitynavigator.org/index.cfm?bay=search.summary&orgid=8222
EXHIBIT:
American Endowment Foundation Statement of Functional Expenses For the Year Ended December 31, 2007
Program Services
Management and General
Fundraising
Total
Grant expenditures
$ 20,403,417
$ —
$ —
$ 20,403,417
Salaries and benefits
180,239
180,239
185,700
546,178
Investment expenses
—
449,147
—
449,147
Miscellaneous expense
22,139
22,139
22,811
67,089
Employee benefits
19,947
19,947
20,551
60,445
Computer systems
19,777
19,777
20,376
59,930
Development
—
10,878
32,633
43,511
Payroll taxes and fees
12,591
12,591
12,973
38,155
Occupancy
9,635
9,635
9,927
29,197
Travel and education
7,967
7,967
8,209
24,143
Legal fees
7,858
7,858
8,097
23,813
Office supplies and expense
5,561
5,561
5,730
16,852
Telephone
4,858
4,858
5,004
14,720
Accounting services
4,060
4,060
4,182
12,302
Insurance
—
8,237
—
8,237
Life insurance expense
—
8,146
—
8,146
Supplies and postage
2,234
2,234
2,302
6,770
Outside services
1,206
1,206
1,244
3,656
Staff development
840
840
865
2,545
Depreciation
—
2,119
—
2,119
Service charges
585
585
604
1,774
Brochures and publications
65
65
68
198
Total expenses
$ 20,702,979
$ 778,089
$ 341,276
$ 21,822,344
Source: American Endowment Foundation. Financial Statements for the Years Ended December 31, 2007 and 2006. May 15, 2008, p. 4. Reprinted with permission of the American Endowment Foundation.
THE NOTES THAT ACCOMPANY FINANCIAL STATEMENTS
Financial statements, in themselves, do not provide a complete picture of the organization’s finances. Audited financial statements all refer the reader to the “notes” that follow or accompany the financial statements. In trying to analyze the finances of an organization, the user cannot simply look at total assets and net income. A thorough reading of the statements provides just a start. The notes that accompany the financial statements are an integral part of the annual financial report. In fact, many analysts prefer to review the notes carefully before even beginning to look at the financial statements.
Financial statements do an excellent job of summarizing a very large number of transactions into a usable form. However, they are limited. Throughout this book, we discuss some of the causes of the limitations. Fixed assets are recorded based on their historical cost adjusted for depreciation. Therefore, the balance sheet does not convey the current fair value of the fixed assets. Inventory may be valued on the financial statements based on a last-in, first-out (LIFO) or first-in, first-out (FIFO) cost assumption. Depreciation can be calculated based on a straight-line or accelerated approach.
The notes that accompany financial statements are designed to provide explanations about choices made, methods used, and anything else the reader needs to understand the financial position and results of operations of the organization. They ensure that the financial report presents a “fair representation of financial results in accordance with GAAP.” That means that all relevant information that a reasonable person who is knowledgeable of GAAP would need is provided. In many cases, the notes are considerably longer than the financial statements themselves.
To provide a sense of the types of notes that are used and the information they provide, a hypothetical set of notes for Meals for the Homeless is provided in the next section. In addition, examples from real organizations are shown. Notes for Meals are shown in italics, with commentary in normal type. Excerpts of notes from real organizations are shown in boxes.
Significant Accounting Policies:
Each organization provides a unique set of notes that apply to its own unique circumstances. However, the notes section generally begins with a statement of accounting policies. This note often has a number of subsections.
NOTE A: SIGNIFICANT ACCOUNTING POLICIES:
Meals for the Homeless (“Meals”) is subject to the requirements of Statements of Financial Accounting Standard (“SFAS”) No. 117—“Financial Statements of Not-for-Profit Organizations.” Under SFAS No. 117, Meals is required to report information regarding its financial position and activities according to three classes of net assets: unrestricted, temporarily restricted, and permanently restricted. In addition, Meals is required to present a statement of cash flows and a statement of functional expenses.
Unrestricted net assets represent that part of the net assets that are neither permanently restricted nor temporarily restricted by donor-imposed stipulations. Temporarily restricted net assets represent the part of net assets resulting from contributions and other inflows of assets whose use is limited by donor-imposed stipulations that either expire by passage of time or can be fulfilled and removed by actions of Meals pursuant to those stipulations. Permanently restricted net assets represent the part of Meals’ net assets resulting from contributions and other inflows of assets whose use by Meals is limited by donor-imposed stipulations that neither expire by passage of time nor can be fulfilled or otherwise removed by actions of Meals.
When a donor restriction expires or the purpose is accomplished, the restricted net assets are reclassified to unrestricted net assets and reported in the statement of activities as net assets released from restrictions.
The preceding note is fairly standard for not-for-profit organizations. However, it is important to include this note since it indicates critical differences from other types of organizations. The first note for Meals continues with some specific policies:
RECOGNITION OF REVENUES AND EXPENSES:
Revenues and expenses are recorded on an accrual basis.
Since some organizations use cash, others use accrual, and others use modified accrual accounting, a note is often included to indicate the basis of accounting. See Box 14-1 for the basis of accounting note for The Fresh Air Fund.
ACCOUNTING FOR CONTRIBUTIONS:
All contributions are considered to be available for unrestricted use unless specifically restricted by the donor. Amounts received that are designated for future periods or are restricted by the donor for specific purposes are reported as temporarily restricted or permanently restricted support that increases those net asset classes. Unconditional promises to give that are silent as to the due date are presumed to be time-restricted by the donor until received and are reported as contributions receivable and as temporarily restricted net assets.
This indicates that when a pledge is made, the organization is not free to spend that money until it has been received. Although the pledge may be legally enforceable and one might consider treating it as current period unrestricted resources, this more conservative approach is being taken by the organization. This information is helpful to a user who might be concerned that the organization might get into financial trouble by spending money based on pledges that may never be collected. See Box 14-2 for the contributions note for The American Red Cross.
DONATED MATERIALS, MARKETABLE SECURITIES, AND SERVICES
BOX 14-1 Basis of Accounting
The accompanying financial statements have been prepared on the accrual basis of accounting.
Source: The Fresh Air Fund. Financial Statements: Years ended September 30, 2007 and 2006 with Report of Independent Auditors, January 9, 2008, p. 9.
BOX 14-2 Contributions
Contributions, which include unconditional promises to give (pledges), are recognized as revenues in the period received or promised. Conditional contributions are recorded when the conditions have been met. Contributions are considered to be unrestricted unless specifically restricted by the donor.
The Organization reports contributions in the temporarily or permanently restricted net asset class if they are received with donor stipulations as to their use. When a donor restriction expires, that is, when a stipulated time restriction ends or purpose restriction is accomplished, temporarily restricted net assets are released and reclassified to unrestricted net assets in the consolidated statement of activities. Donor-restricted contributions are initially reported in the temporarily restricted net asset class, even if it is anticipated such restrictions will be met in the current reporting period.
Source: The American National Red Cross. Consolidated Financial Statements June 30, 2007 (with Independent Auditors’ Report Thereon.) October 16, 2007, p. 9. https://www.redcross.org/pubs/car07/14606D.pdf
Donated food and other materials, and marketable securities are reflected as contributions in the accompanying statements at their fair values at date of receipt. Conditional donations are not considered revenue until the conditions have been met.
A substantial number of volunteers donated significant amounts of their time to Meals’ food services. SFAS 116 requires that donated services be recognized if the services received (a) create or enhance nonfinancial assets, or (b) require specialized skills, are provided by individuals possessing skills, and would typically need to be purchased if not provided by donation. For the years ended December 31, 2012 and 2011, Meals received $80,000 and $72,000 worth of donated services, respectively, that would otherwise have had to be purchased. However, these services (related to cooking and serving meals) do not qualify as skilled services. Thus, no amounts have been reflected in the statements for these donated services.
In not-for-profit organizations, a great deal of labor is provided by volunteers. It is important to indicate the extent to which those volunteers’ services are recorded as both a contribution and an expense related to providing services. See Box 14-3 for Scholarship America’s note related to contributed services.
INVENTORIES:
Inventories are stated at cost, not to exceed market value. Cost is calculated using the last-in, first-out method.
By stating that inventory is not valued in excess of market, the organization is telling the user of the financial statements that if inventories have declined in value, they are shown at the lower value. This is referred to as using the lower of cost or market and occurs because of the GAAP of conservatism. Even though we might charge more for the inventory when we use it, we cannot record it above its cost. If it declines in value (e.g., food spoils), we can record a value lower than cost. An important question, however, is how we determine cost. We could use last-in, first-out (LIFO) or first-in first-out (FIFO). This note indicates that Meals uses LIFO. Since different organizations can use different approaches, this note helps the reader to understand this organization and compare it with others. See Box 14-4 for The American Red Cross inventory note. The Red Cross uses the average cost method rather than LIFO or FIFO.
BOX 14-3 Contributed Services:
A number of volunteers have made significant donations of their time to program and support functions. The value of this contributed time does not meet the criteria for recognition of contributed services, and accordingly is not reflected in the accompanying financial statements.
Source: Scholarship America, Inc. Financial Statements and Supplemental Schedules June 30, 2007 and 2006 (With Independent Auditors’ Report Thereon). September 28, 2007, p. 6. https://scholarshipamerica.org/files/ARSA_07_Financials.pdf
BOX 14-4 Supply Inventories:
Inventories of supplies purchased for use in program and supporting services are valued using the average cost method. Whole blood and its components are valued at the lower of average cost or market.
Source: The American Red Cross, op. cit., p. 8.
PROPERTY, BUILDINGS, AND EQUIPMENT:
Land, buildings, and equipment are recorded at cost, and depreciation over the useful lives of buildings and equipment is charged annually using the straight-line method.
This note distinguishes the organization from organizations that do not depreciate all of their buildings and equipment or that use accelerated depreciation methods. The specific amounts of accumulated depreciation on fixed assets currently owned appear in a note discussed later in this section.
If a user of financial statements is comparing two similar organizations, but one uses straight-line depreciation and another uses accelerated depreciation, one may appear to have higher expenses and lower assets than the other. The user might infer a greater difference between the two organizations than actually exists. By providing information such as this in the notes, the user can make a more meaningful comparison between the organizations. See Box 14-5 for the National Society to Prevent Blindness’s property, buildings, and equipment note.
TAX STATUS:
Meals is a not-for-profit voluntary organization exempt from income taxes under Section 501(c)(3) of the U.S. Internal Revenue Code.
BOX 14-5 Land, Building, and Equipment
Land, building, and equipment are stated at cost or, in the case of gifts, fair market value at date of donation, less accumulated depreciation. Building, equipment, and leasehold improvements are depreciated or amortized using the straight-line method over their estimated useful lives, which are as follows:
Buildings
40 years
Equipment
3–10 years
Leasehold improvements
5–10 years
Source: National Society to Prevent Blindness (Doing Business as Prevent Blindness America) and Affiliates, Combined Financial Statements for the Year Ended March 31, 2007. September 4, 2007, p. 10.
This note is quite important for users of the financial statements. It indicates to creditors that the organization will not have to pay income taxes, thereby removing a competing creditor. When organizations go bankrupt, the Internal Revenue Service (IRS) is aggressive in collecting amounts owed to it. It also indicates to potential donors that their contributions will be tax-deductible.
ACCOUNTING FOR INVESTMENTS:
In accordance with the Statement of Financial Accounting Standards (“SFAS”) No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations,” Meals reports debt and equity securities at their fair value with the related gains and losses included in the statement of activities.
Since investments at one time were reported at lower of cost or market, this is an important policy statement to include. For Meals, Note A concludes with “Use of Estimates.”
USE OF ESTIMATES:
The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of certain assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the period. Actual results could differ.
Many individuals tend to believe that accountants have an ability to be more precise and accurate than is in fact the case. This note’s purpose is to point out to the reader that despite the conventions of GAAP, financial statements remain subjective and subject to uncertainty. See Box 14-6 for the Wildlife Conservation Society’s note regarding its policy for accounting estimates.
Other Notes:
The first note covers a wide range of accounting policies. The remaining notes for the most part focus on a specific issue in somewhat more detail. Where the first note is policy oriented, the remaining notes provide information about specific circumstances or values.
NOTE B: PROGRAM SERVICES:
BOX 14-6 Use of Estimates:
The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosures of contingencies at the date of the consolidated financial statements and revenues and expenses recognized during the reporting period. Actual results could differ from those estimates.
Source: Wildlife Conservation Society and Subsidiaries. Consolidated Financial Statements, June 30, 2007 and 2006 (with Independent Auditor’s Report Thereon). November 19, 2007, p. 8.
The activities of Meals for the Homeless consist of providing meals and counseling services. The meals are provided in soup kitchens throughout the city. Meals also uses vans to deliver food to shelters. Counseling services are provided to assist clients find both temporary shelter and permanent housing.
In 2012, Meals provided 587 meals per day in its 4 kitchens. In addition an average of 147 meals was delivered each day to shelters. Approximately 1,292 individuals are counseled each year. Meals’ services are consumed by both individuals and families.
As a result of Meals’ programs, a number of individuals have the physical strength to continue work or return to work. Others avoid hospitalization from malnutrition. It is the belief of the organization that without its services, a number of its clients would die each year.
See Box 14-7 for the program services note for The Fresh Air Fund.
NOTE C: MARKETABLE SECURITIES:
The market value of Meals investments in marketable securities at December 314 was:
2012
2011
Treasury Bills
$1,000
$1,500
Stocks
2,000
1,500
Total
$3,000
$3,000
It is informative to know the composition of marketable securities and other investments. Treasury bills are very safe investments. High percentages in stock indicate a more risky portfolio. The marketable securities note from the Make-A-Wish Foundation is shown in Box 14-8.
NOTE D: PROPERTY, BUILDINGS, AND EQUIPMENT:
As of December 31, the property, buildings, and equipment owned by Meals consisted of the following:
2012
2011
Land
$ 40,000
$ 40,000
Equipment
70,000
70,000
$110,000
$110,000
Less Accumulated Depreciation
35,000
25,000
Net Property and Equipment
$ 75,000
$ 85,000
BOX 14-7 Program Services
Fresh Air Camping activities consist of escorting and transporting approximately 3,000 children from their homes in New York City to the Fund’s camps in Fishkill, New York. The summer program provides direction, leadership, food, medical care and recreation for two or more weeks at no cost to the children’s families. Included within this program is the Fund’s Career Awareness Camp, which serves approximately 300 children. The camp program fosters critical career-related qualities such as responsibility, cooperation and leadership. Additionally, the Fund’s year-round camping program serves 1,000 disadvantaged teenagers each year.
Source: The Fresh Air Fund. Financial Statements Years Ended September 30, 2007 and 2006 with Report of Independent Auditors, p. 8.
4 The value of balance sheet accounts is given as of a specific point in time. Accountants often refer to a value “at” the date, such as “at December 31.”
BOX 14-8 Marketable Securities
A summary of investments as of August 31 follows:
2006
2005
Equity securities
$31,823,423
$29,885,684
Mutual funds
30,109,975
26,269,677
U.S. Government securities
12,340,462
9,258,421
Corporate bonds
10,083,752
9,962,960
Certificates of deposit
9,077,323
8,155,033
Fixed income
7,594,464
5,864,501
Money market funds
2,908,752
2,816,565
Other
749,902
1,492,081
Mortgage backed securities
359,303
567,067
Total investments
105,047,356
94,271,989
Less investments held for long-term purposes
8,543,844
5,054,642
Investments not held for long-term purposes
$96,503,512
$89,217,347
The net unrealized and realized gains on investments for the year ended August 31, 2006 were $2,749,996 and $839,787, respectively. The net unrealized and realized gains on investments for the year ended August 31, 2005 were $4,760,487 and $688,639, respectively.
Source: Make-A-Wish Foundation of America. 2006 Annual Report. March 5, 2007, pp. 30–31.
From the net amount, we cannot tell how old our equipment is. However, from this note, we can see that we have $70,000 worth of equipment that is about half depreciated. This note therefore gives information that we would not know from looking at the balance sheet. Notice that the information in the notes following Note A provide specific details such as the cost of fixed assets, while Note A and its subparts provide information on the organization’s accounting policies. The fixed asset note for Prevent Blindness America is shown in Box 14-9.
NOTE E: PENSION PLAN
Meals has established a defined contribution plan for all eligible employees, effective January 1, 1992. Employees who have completed one year of service and have attained the age of 21 are eligible for participation. Contributions are discretionary and are determined by the Board of Trustees. The contributions are allocated based on an equal percentage of each participant’s compensation. No employee contributions are permitted. Participants are fully vested after two years of service. Contributions during 2012 and 2011 were $6,000 and $5,500, respectively.
Pension plans can be extremely complicated. There are two major categories: defined contribution plans and defined benefit plans. In a defined contribution plan, the amount required to be put aside by the organization is determined each year. That amount is the organization’s total obligation to the pension plan. Depending on investment experience, the participants will be able to receive larger or smaller amounts upon retirement. In a defined benefit plan, the organization is required to make specific defined payments to participants upon retirement. The risk or benefit of investment experience falls on the organization rather than the participants. The pension note for St. Jude Children’s Research Hospital is shown in Box 14-10.
BOX 14-9 Property, Buildings, and Equipment
Prevent Blindness America’s property and equipment consisted of the following as of March 31:
2007
2006
Land
$ 850,507
$ 850,507
Building
3,229,038
3,218,038
Equipment
3,308,407
3,125,134
Leasehold improvements
359,541
349,790
7,747,493
7,543,469
Less accumulated depreciation and amortization
3,339,428
3,125,805
$4,408,065
$4,417,664
Source: National Society to Prevent Blindness (Doing Business as Prevent Blindness America) and Affiliates. Combined Financial Statements for the Year Ended March 31, 2007. September 4, 2007, p. 10.
NOTE F: CONTINGENT LIABILITIES
There are various lawsuits and threatened actions against Meals, arising out of accidents and other matters, some of which claim substantial amounts of damages. In the opinion of Meals’ management, these lawsuits are either without merit or covered by insurance, and will not result in any material adverse effect on the financial position of Meals.
BOX 14-10 Pension Plan
The Hospital sponsors a defined-contribution retirement annuity plan generally covering all employees who have completed one year of service. The plan requires that the Hospital make annual contributions based on participants’ salaries. Employee contributions to the plan are not allowed. The Hospital’s contributions are 50% vested after two years of service and 100% vested after three years of service. Total contributions to the plan were approximately $12,000,000 and $11,000,000 for the years ended June 30, 2007 and 2006, respectively.
ALSAC sponsors a defined contribution retirement plan generally covering all employees who have completed one year of service. The plan requires that ALSAC make annual contributions based on participants’ salaries. Employees can choose to invest their contributions into the options provided through the plan. Employees become 30% vested in the employer contributions after one year of service and completion of one plan year (July to June); 60% after two years of service and completion of two plan years (July to June); 100% after three years of service and completion of three plan years (July to June). ALSAC contributed approximately $2,416,000 and $1,971,000 to the plan during the years ended June 30, 2007 and 2006, respectively.
Source: St. Jude Children’s Research Hospital, Inc. American Lebanese Syrian Associated Charities, Inc., Combined Financial Statements, as of and for the Years Ended June 30, 2007 and 2006, and Independent Auditor’s Report, September 14, 2007, p. 9.
There are times that organizations have large potential liabilities, called contingent liabilities, that are not shown on the balance sheet. For example, the organization might expect to have a large payment as a result of a lawsuit, but the exact amount cannot be determined. Rather than show an approximate amount, the balance sheet would have a reference to the notes. The note would indicate the nature of the liability. The contingencies note of the Make-A-Wish Foundation is shown in Box 14-11.
BOX 14-11 Contingencies
From time to time, the national organization and the chapters are involved in litigation and claims arising in the normal course of operations. In the opinion of management based on consultation with legal counsel, losses, if any, from these matters are covered by insurance or are immaterial; therefore, no provision has been made in the accompanying combined financial statements for losses, if any, which might result from the ultimate outcome of these matters.
Source: Make-A-Wish Foundation of America. 2006 Annual Report. March 5, 2007, p. 33.
NOTE G: COMMITMENTS
Although Meals does not own any buildings, it does lease space for its soup kitchens and management offices. Meals has several noncancellable lease agreements that terminate December 31, 2016. Minimum rentals under these leases are as follows:
Year Ending December 31:
2013
$20,000
2014
21,000
2015
22,000
2016
23,000
Total
$86,000
If Meals owned its own buildings and had borrowed money on a mortgage to finance the buildings, the mortgage would show as a liability on its balance sheet. If it signs a five-year lease on a building, that lease will not show on the balance sheet as a liability. However, the organization is still required to make payments, the same as if it had a mortgage. This note discloses that important commitment to make payments in future years. This information would be quite important to someone contemplating making a loan to Meals and wondering what other payments it is committed to making. Box 14-12 provides the commitments note from the Prevent Blindness America annual financial report.
Note that although some leases meet rules that result in treating them as liabilities that show on the balance sheet, many do not.