Know The Warning Signs In Your NPO’s Financial Position

Audits are often viewed as an annual chore completed so that your nonprofit organization can continue to solicit contributions, receive grants, or retain debt financing.

However, reviewing your annual audit report is an essential part of governance. Executives and those charged with governance must understand the contents of the report to perform crucial operational and oversight roles. Audit reports provide a wealth of information about the organization’s financial condition but might be difficult to understand if you have a limited accounting or finance background.

There are many components, including the contents of a nonprofit audit report, identifying potential financial warning signs, and providing tips for reviewing financial results using ratio analysis.

Types of NPO Audits

There are different audit requirements for nonprofits depending on the types of funding. All audits of nonprofits will include a financial audit performed in accordance with generally accepted auditing standards (GAAS), which are issued by the Auditing Standards Board and the Association of Independent Certified Public Accountants. GAAS provides the standards auditors must comply with while conducting audit and reporting results. The focus of the financial audit is whether the financial statements and disclosures follow generally accepted accounting principles (GAAP).

Many nonprofits are also subject to audits performed in accordance with generally accepted government auditing standards (GAGAS) when required by law, regulation, contract, agreement, or policy. Organizations that expend $750,000 or more of federal awards, either received directly from the federal government or passed through state/local governments or other nonprofit entities, require an audit in accordance with Subpart F of the OMB Uniform Guidance (2 CFR 200), in addition to being subject to GAAS and GAGAS, often times referred to as a single audit.

Uniform Guidance audits have additional compliance and reporting components. Knowing the type of audit that your organization is subject to is the first step to understanding the audit report.

Audit Opinions

The audit report begins with the Independent Auditor’s Report, which is the auditor’s opinion on the financial statements and disclosures. The audit opinion may be unmodified, modified, adverse, or a disclaimer of opinion.

An unmodified opinion is a “clean opinion” stating the auditor has obtained reasonable assurance the financial statements are presented fairly, in all material respects, in accordance with GAAP. If the auditor notes material departures from GAAP that have not been corrected, or if there was the inability for the auditor to obtain sufficient appropriate audit evidence (a scope limitation), a modified opinion is issued.

The auditor will issue an adverse opinion if the issue causing the material departure from GAAP is determined to be pervasive. And if the scope limitation is determined to be pervasive, a disclaimer of opinion is reported.

If your audit report contains a modified, adverse, or disclaimer of opinion, the matter should be discussed with your auditor to determine if it can be resolved or mitigated, and corrective action taken if possible.

The auditor will report additional opinions required by GAGAS and Uniform Guidance if your organization is subject to these requirements. These opinions are either included in the financial audit report or issued in a separate report.

GAGAS requires the auditor to report on internal controls over financial reporting and on compliance with laws, regulations, contracts, and grant agreements and other matters. The GAGAS report could disclose significant deficiencies and material weaknesses in internal control over financial reporting and reportable instances of noncompliance or other matters, such as fraud or abuse, if they are identified during the audit of the financial statements.

Single audits require an opinion on compliance for the major programs and internal controls over compliance. Information about any significant deficiencies, material weaknesses, noncompliance, or other matters identified by the auditor are included as audit findings in the schedule of findings and questioned costs for audits conducted in accordance with GAGAS and Uniform Guidance. If your audit report includes findings, the causes need to be understood and action should be taken to resolve the issue.

The following are descriptions of each of the basic financial statements and common footnote disclosures.

Statement of Financial Position

The statement of financial position presents the assets, liabilities, and net assets of the organization. A classified statement of financial position segregates current and non-current assets and liabilities. An organization might be required to a present a classified statement if it has debt covenants relating to current ratios or working capital levels or may choose to present in this manner in order to provide useful information about liquidity.

Current assets include any asset that can be reasonably expected to be sold, consumed, or exhausted through normal operations within one year. Current liabilities include obligations that, by their terms, are due on demand or will be due on demand within one year.

Common assets of nonprofits include cash and cash equivalents, grants receivable, accounts receivable, investments, endowment funds, split-interest agreements, promises to give, inventory, collections, and property and equipment. The statement of financial position provides information about the liquidity of the assets and restrictions on the use of certain assets.

Cash, investments, or other assets that have donor-imposed restrictions limiting their use to long-term purposes, are presented separately from cash or investments that are available for current use. Examples of such limitations are investments to be held into perpetuity (endowments) or cash that is restricted for the purchase of property and equipment.

Common liabilities of nonprofits include accounts payable, accrued payroll liabilities, refundable advances, grants payable, and debt. It is important for those charged with governance to understand the nature of the organization’s liabilities and when debt payments are due. Debt payments due within one year of the end of the fiscal year are disclosed as a current liability on the statement of financial position if a classified statement is presented and principal payments due in each of the next five years are disclosed in the notes to the financial statements.

Information about the timing of debt payments is especially important when a note or mortgage payable includes a balloon payment at the end of term. Information presented in the audit report about the nature and timing of the organization’s debt should guide executives and the governing board when determining if utilizing assets on hand to pay off debt is the best use of its assets or if refinancing would be more prudent.

The net assets of a nonprofit represent the excess or deficiency of assets over liabilities and are presented in two classes according to the existence or absence of donor-imposed restrictions. Net assets with donor restrictions are subject to donor or grantor-imposed restrictions. Net assets to be held into perpetuity in an endowment are presented separately from net assets with donor restrictions that are to be spent for a particular purpose or in a specific period of time, either on the statement of financial position or in the footnotes.

Net assets without donor restrictions are not subject to donor or grantor-imposed restrictions. An organization may have board-designated net assets subject to limits that are self-imposed by the organization’s governing board, often earmarked for a specific purpose, project, or the purchase or construction of property and equipment.

The governing board may create a board-designated endowment fund by voluntarily designating a portion of net assets without donor restrictions to function as an endowment. Board-designated net assets are presented as net assets without donor restrictions since the governing board is able to reverse its self-imposed limitations.

Warning signs related to the statement of financial position:

  • Current liabilities equal or exceed current assets;
  • Excessive amount of debt compared to total assets; and,
  • Net assets are in a deficit position (excess of liabilities over assets); and, 4. Large receivable balances that have increased year over year (potentially not collecting on receivables).

Statement of Activities

The statement of activities provides information about the changes in an organization’s net assets and includes revenues, expenses, gains, losses, and reclassifications of net assets.

Revenue is the income generated from providing services, producing goods, or from other activities related to organization’s operations. Expenses are the cash outflows, utilization of assets, or liabilities incurred from providing services, producing goods, or other activities related to organization’s operations.

Gains and losses are increases or decreases in net assets resulting from transactions outside of normal operations, such as realized and unrealized gains or losses on investments or the gain or loss on disposal of property and equipment. Reclassifications of net assets are simultaneous increases to net assets without donor restrictions and decreases to net assets with donor restrictions, typically as a result of a donor restriction being satisfied.

Revenue, gains, and losses are generally reported as increases or decreases in net assets without donor restrictions unless a donor or grantor has placed restrictions on the use of contributed cash or other assets. While donor-restricted donations are generally reported as contribution revenue that increase net assets with donor restrictions, these contributions may be reported as a contribution without donor restriction if the time or purpose restrictions are met in the same reporting period and the policy is followed consistently and disclosed. Gains recognized on investments that are restricted by explicit donor stipulations (such as endowments) are generally reported as increases in net assets with donor restrictions.

Organizations commonly present their expenses on the statement of activities according to the expense’s functional classification, which is the purpose for which the expenses were incurred and include program services and supporting activities. More detailed information about the composition of the organization’s expenses is presented elsewhere in the audit report.

Warning signs related to the statement of activities:

  • Sustained pattern of annual decreases in net assets; and,
  • Significant and unbudgeted fluctuations in revenues or expenses, especially decreases in revenue or increases in expenses.

Statement of Functional Expenses

Nonprofits are required to present an analysis of expenses by their functional and natural expense classifications in one location in the report. This information may be presented on the statement of functional expenses or in a footnote disclosure.

The detailed presentation is designed to provide the reader an understanding of the expenses incurred in carrying out the programs and other activities of the organization. The natural expense classifications are the benefits received from incurring those expenses, such as salaries and fringe, supplies, professional services, and depreciation. The functional expense classifications are the purposes for which the expense was incurred, such as major classes of program activities and supporting services.

Program services expenses are the direct and indirect costs related to operating the organization’s programs. Supporting services expenses are the costs incurred for activities not directly related to the programs that further its mission. Supporting services are typically categorized as management and general, fundraising, or membership development.

Warning signs related to the statement of functional expenses:

  • High percentage of total expenses included in supporting services when compared to organizations of similar size and mission. Keep in mind that research shows that investment in effective supporting services is critical to the success of nonprofit organizations, but organizations should strive to be as efficient as possible.
  • Unbudgeted large fluctuations in expenses (either natural or functional expenses), especially increases.

Statement of Cash Flows

The statement of cash flows details the changes in an organization’s cash during the year, according to principal sources and uses. The cash inflows and outflows are categorized as operating, investing, and financing activities. Non-cash transactions that affect the financial position of the organization are also disclosed.

Cash flows from operations are the result of providing services, producing goods, or other activities related to the organization’s general operations. Examples of cash flows from investing activities include the purchases of and sales proceeds from investments, acquisition or disposal of property and equipment, and amounts loaned and collected from loans receivable. Examples of cash flows from financing activities include proceeds from incurring debt, repayments of debt, and the receipt of contributions that are restricted by the donor to be used for long-term purposes, such as for endowments.

Non-cash investing, financing, and other activities are disclosed, including non-cash contributions or incurring debt to purchase property and equipment. In addition, interest and unrelated business income or excise taxes paid during the year are disclosed in a supplemental schedule of other cash activity.

Warning signs related to the statement of cash flows:

  • Sustained negative cash flows from operations;
  • Persistent decreases in total cash;
  • Financing activities such as borrowing funds that the organization may have difficulty paying back; and,
  • Significant amounts of interest paid.

Notes to the Financial Statements

The notes to the financial statements present information required by GAAP that are not otherwise presented in the financial statements. The notes contain information about the organization’s accounting policies, details about certain amounts reported on the financial statements, and other information about the financial condition of the organization.

The following are noteworthy financial statement disclosures common for nonprofit organizations:

  • Accounting Policies: Significant accounting policies implemented by the organization are required to be disclosed in the audit report.
  • Liquidity and Availability: This disclosure is required for all nonprofit organizations. It provides quantitative and qualitative information about the financial assets available within one year to meet the general expenditure needs of the organization.

When analyzing this footnote, it is important to understand the organization’s operations and business model because it may not be experiencing financial difficulty even if a relatively small amount of financial assets available for general expenditure is disclosed.

For example, nonprofits routinely make use of assets received with donor restrictions in ongoing programmatic and operational activities for which the restrictions relate, and these assets are excluded from the calculation of available financial assets.

In addition, anticipated contributions to be received the following year are only included in available financial assets if an unconditional promise to give was received by the end of the year. Conditional contributions or grant awards for which the condition had not been met as of the end of the year are also excluded.

This disclosure should be reviewed along with the organization’s current liquidity management policies and practices.

Organizations are encouraged to have cash flow projections or similar information available to provide relevant qualitative information for the amount reported in this footnote. This footnote should be reviewed and opportunities to include more qualitative information or context should be discussed with your auditor.

  • Endowments: Disclosures related to donor-restricted or board-designated endowment funds, including information about the net asset classifications and components of the changes in endowment funds during the year. It also provides information about the organization’s spending and investment policies and any underwater endowments (when the fair value of the endowment is less than original gift or amount required to be maintained).
  • Net Assets with Donor Restrictions: Provides detailed information about the nature of the donor restrictions and anticipated timing of the releases from restrictions.
  • Contingent liabilities: Defined as expenses that may be incurred depending on the outcome of an uncertain future event, such as lawsuits, pending investigations, or when your organization guarantees another organization’s debt obligations. Depending on the circumstances, these liabilities may or may not be recorded as a liability in the financial statements. Those charged with governance should understand the status and magnitude of contingent liabilities and the impact possible outcomes may have on the organization’s financial condition.
  • Commitments: Defined as contractual obligations for future goods or services that had not been received as of the end of the year. A construction contract commitment is a common example. Commitments also include long-term leases with required payments for several years, and the lease terms and future payments are typically disclosed in its own footnote. Significant commitments are important to review because of the effect they may have on future cash flows, financial position and changes in net assets.
  • Revenue Concentrations: Significant concentrations of a small number of grantors or contributors are disclosed. These should be reviewed for the potential impact on the organization’s operations if a significant grantor or contributor is lost in the near term.
  • Related-party Transactions: The nature of significant related-party relationships and material transactions with related entities are disclosed. This should be reviewed by those charged with governance to make sure these were previously disclosed to the governing body and potential conflicts of interest are handled appropriately.

Supplementary Schedules

Audit reports of nonprofit organizations often include supplementary information in addition to the basic financial statements. This information is not required for a fair presentation in accordance with GAAP, but an organization may elect to include additional information, or it may be required by grantors.

If consolidated financial statements are issued, management may elect to provide supplemental financial information for each consolidated entity and intercompany eliminations by including supplemental consolidating schedules. Supplemental information may include detailed reporting of a specific grant’s expenditures if required by the funder and the Uniform Guidance requires a schedule of expenditures of federal awards that details the federal awards expended, categorized by federal program.

Other Audit Output

In addition to the audit report, the auditor will issue a required communications letter to the governing body. Information in this letter includes details about changes in accounting policies, sensitive estimates and disclosures affecting the financial statements, misstatements determined to be immaterial and not corrected by management, material audit adjusting journal entries, any difficulties or disagreements with management, and other items of interest.

The auditor may issue a management letter that is combined with the required communications letter or presented separately. If the audit was not subject to GAGAS or Uniform Guidance, significant deficiencies and material weaknesses in internal controls over financial reporting are communicated to the governing body in the management letter. As previously stated, these matters are communicated as findings in the audit report if the audit was subject to GAGAS or Uniform Guidance.

Plans to correct deficiencies should be determined and implemented by management with oversight from the governing body. The auditor may also communicate other matters in the management letter such as suggestions for improving internal controls or operating efficiency.

Interpreting Financial Results Using Ratio Analysis

A useful way to interpret your financial statements is to utilize financial ratio analysis. This is a tool that can be used to assess your organization’s financial condition in a quantitative way and gain insight into your organization’s financial stability and efficiency.

You should select ratios to analyze based on your operations, sources of revenue, and mission. You should also implement trend analysis measuring a consistent set of financial ratios across time so that you can analyze financial improvements or alarming trends.

Comparing your ratios to benchmarks adopted based on financial information of organizations of similar size and mission is also recommended. The federal Internal Revenue Service (IRS) Form 990 is a publicly available document and may be used as a resource to review financial information about peer organizations and develop benchmarks.

Stability ratios measure the availability of financial resources to support the mission of the organization, and efficiency ratios measure the effectiveness of using these resources to support the organization’s mission. 

Working with Your Auditor

Your auditor should have sufficient experience working with organizations in the nonprofit industry and performing GAGAS or single audits, if applicable. The auditor should understand the intricacies of nonprofit accounting and reporting requirements and be able to consult with management and the governing body on industry trends, the impact of future accounting changes, and how the current economic or regulatory environment is impacting organizations like yours.

A best practice is to have your auditor present audit results to the governance committee charged with overseeing the audit and/or the full governing body. You are encouraged to review the audit report prior to the presentation and ask clarifying questions if you need to in order to understand the results of the audit and take full advantage of the benefits of receiving an annual audit. NPT

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Michael Webber, CPA, is an auditor in Wipfli LLP’s nonprofit and government practice. His email is mwebber@wipfli.com