This past Thursday, June 14th, I had the privilege to co-organize (along with The EHL Consulting Group) a seminar for Israeli nonprofits entitled, “Adjusting to the New Normal: Putting Transparency into Practice.”
Even better, I had the opportunity to present on the topic, “Successfully Transmitting Financial Transparency.” As always, I enjoy speaking as it provides me with an opportunity to research today’s hottest topics affecting the nonprofit sector. Last week’s occasion to demystify the buzz words “Financial Transparency” was no exception. (You can see a list of all the great content here.)
In practical terms, Financial Transparency is an organization’s ability to demonstrate from a monetary perspective (1) WHAT the charity is doing and (2) WHY the charity is doing it. Moreover, the ability to clearly answer the above two questions is extremely relevant in today’s environment of increased competition and the need for organizations to differentiate themselves.
But somehow, the train has derailed.
- Today’s Transparency “norm” is for organizations to post some/all of its Financial Reports on its website and for Government-required reports to be available on third party websites.
- However, in the search for openness, we the supporters and professionals in the nonprofit sector have resigned ourselves to settling for “less.”
- In our pursuit for clarity and fairness, we have allowed ourselves to be bombarded by official financial reports – reports that Boards rarely understand, let alone donors.
- And ironically, these relentlessly scanned financial documents that are populating charity and watchdog sites promote openness but fail to advance comprehension.
We need a new tool to equip the masses with Financial Transparency.
THE THREE “MUST-HAVE” REPORTS
Leaving aside the necessary filing required by the IRS or other relevant tax authorities, there are generally three types of Financial Reports:
- Annual Budget
- Income Statement
- Balance Statement
The Annual Budget is prepared ahead of time and is, thus, not relevant for our discussion. It tells us what and how the organization will fund its mission in the upcoming year.
The Income Statement provides an income and expense report for the previous year. One of its key functions is to be compared to the Annual Budget.
The Balance Statement provides a financial snapshot of the previous fiscal year and includes three sections that are best summed up as:
- ASSETS – What the organization HAS
What are the assets? Are they liquid? Are there any restrictions?
- LIABILITIES – What the organization OWES
What are the liabilities? When are they due? Long term or short term?
- NET ASSETS – What the organization is WORTH
Are assets greater than liabilities? Are there surpluses? Are there restrictions in its use?
THE CHALLENGE – WATCHING OUT FOR FLAGS
There are two types of flags to watch out for, Yellow Flags, which signal short-term problems, and Red Flags, which signal long-term problems.
The Nonprofit Assistance (NA) Fund believes that most Boards miss the Red Flags because they are not trained to read the relevant data.
The Income Statement can show Yellow Flags. This report is more familiar with people and more easily understood. In essence, it is only a slightly more complex version of the same analysis that a household executes on its own monthly spending. However, because it only contains financial information from the previous year, it is incapable of signalling potentially larger problems that have been brewing over time nor the overall fiscal health of the nonprofit.
The Balance Sheet is where Boards can spot the Red Flags because this report contains both short-term and long-term data. But as the NA Fund points out, the Balance Sheet is harder to understand because it is based on accounting terminology and standards.
I would extrapolate that if it is difficult for a Board to understand Financial Reports, than for the “regular” donor all the more-so.
Thus, the documents that are readily available on websites, do not actually contribute to understanding the financial health of a charity. In essence, today’s Financial Transparency is mostly superficial.
It is therefore crucial for organizations that are looking to promote both internal and external Financial Transparency to provide their stakeholders with NARRATIVE EXPLANATIONS in conjunction with Financial Reports.
Readers need to understand the significance of the two financial reports and not just see the numbers.
When discussing the Income Statement, a narrative will:
- Relate to tracking progress and expense controls
- Alert the stakeholders of big variances
- Analyze deficits
It goes without saying that examining the Income Statement without access to the Annual Budget handicaps the reader, robbing him or her of a crucial point-of-reference.
When discussing the Balance Sheet, a narrative will:
- Demonstrate the “cumulative effect of the financial activity over time” (NA Fund)
- Signal financial health or problems by relating to either
- Cash reserves vs.diminishing cash
- Built-up assets vs. insufficient working capital
- Unrestricted net assets vs. diversion of or too much restricted funds
- Reasonable debt vs. creeping debt
In an age of “Venture Philanthropy” and “Philanthropic Equity,” it is helpful to equate nonprofit and for-profit corporations. Donors, much like their for-profit investor counterparts, require accurate financial data to adequately analyze the merit of financing a project. They need to understand the financial health and stability of the charities they support in order to balance current impact with long-term effectiveness; thereby, simultaneously answering the elephant in the room, “Will the organization I support now still exist in five years?”
Even Annual Reports (not to be confused with the Annual Budget) that are successful in demonstrating impact and mission, generally neglect to address the implications of the relevant Financial Reports — Programmatic Transparency is not Financial Transparency.
While organizations must decide for themselves the material that it appropriate to disseminate, limiting access to this information shouldn’t translate into avoiding the topic altogether. Ignoring the need of stakeholders is a risk nonprofits can ill afford in today’s climate.
Similarly, while a strategy of financial secrecy and mystery might have been sufficient for the external and internal stakeholders of old, this limited transparency will fail to engage, retain, or recruit today’s supporters.
To be continued in my next post: 3 Reasons Why Nonprofits Should Proactively Pursue Financial Transparency
Disclaimer: This blog houses my personal opinions and is for informational purposes only — not advice. As charity laws can be quite complex and ever-changing, please refer all questions to qualified and licensed professionals. Read the full disclaimer.
Photo Credit: “Look at All These Papers!” by Sonrisa Electrica