Non-Profit Governance: A Layperson's Look at Financial Statements
You're a director, sitting at a board meeting of a local nonprofit organization, looking at the financial statements the treasurer has prepared for a board meeting. You never studied accounting, and you have little idea what all these figures mean. How much do you really have to understand? Can't you just rely on the treasurer's explanations?
As a nonprofit board member, you have a legal standard of conduct you must adhere to. That is, you must act in good faith in deciding whether to accept the financial statements, with a reasonable belief that the activities represented in those statements are in the best interest of the organization, and you must make that decision with the care of an ordinarily prudent person. This article only summarizes the law with which you should become familiar in order to meet the legal standard of conduct required of you. By familiarizing yourself with the law and the background and policies of the organization, you will be able to look at the financial statements for signs on whether or not the organization is operating in its best interests.
First and foremost, you must know the organization's mission and how the activities of the organization allow the organization to be tax exempt. An organization can lose its exemption if a substantial part of its activities benefit private interests, and not the public. There are several classes of nonprofit organizations that will receive tax exempt status. Many organizations are 501(c)(3) organizations, which serve the public through educational, scientific, or religious activities or serve some other charitable need in the community. Donors to a 501(c)(3) organization may take a charitable deduction on their income tax. Other nonprofit organizations include business associations, social organizations, or political organizations. You should know the classification of your organization. In order to gain tax exempt status, the organization filed an application with the IRS detailing the activities it was going to conduct, and where its money was coming from and going to. The organization should adhere to those activities in order to preserve its tax exempt status. If your mission is to provide classes to the public on endangered species, and you see a line on the financial statement that money was received from conducting a dance class, you should raise a question and consult with an independent adviser, if necessary, to determine whether the organization is at risk of losing exemption or paying taxes on that income.
Second, if the organization conducts improper transactions with as an "insider", the organization and the insider may be subject to sanctions from the IRS. Nonprofit organizations cannot provide benefits to private persons, they are supposed to benefit the public or a certain sector of the public. For this reason, the IRS regulations require that a nonprofit not conduct business with insiders without taking steps to ensure that the insider does not benefit more than a person outside of the organization. Insiders are directors of the organization, other staff or persons with decision-making authority, and their family members (whether or not they live with the insider). Among other things, a nonprofit must conduct a market study or get different bids before offering a contract to an insider, and pay no more than market rate for that contract. When you are reviewing financial statements, make sure that you check for payments to insiders and know whether the contract was entered into in accordance with the IRS guidelines. If it hasn't been, both the organization and the insider may be subject to penalties from the IRS.
A third thing to look for in financial statements are expenses related to politics-whether it be a campaign contribution or expenses for advocating a certain piece of legislation. Depending on the exempt classification of your nonprofit, only a certain percentage of your income can be spent on such activities. Going over that amount could cause the loss of your nonprofit status.
Finally, you should know the financial policies of the organization. These will include the budget, checks and balances procedures for bill paying and check signing, who is responsible for keeping within budgets or what approval is required for items over budget. You should also know how grant money or other restricted funds are to be spent. That way, you can listen to the person giving the financial report or ask questions, and know if there are warning signs. While you don't need to analyze each and every line item on the financial report, you should be able to look at a certain line and know whether it seems high or low. For example, if the line for payroll tax paid is zero, you should be concerned (a director can be held personally liable for unpaid taxes). If monthly income is less than expenses, you should ask whether the organization is at risk of insolvency. As a board member, it is your duty to ask questions and demand reasonable explanations before giving your approval to financial reports.
The information contained in this article is not intended to be legal advice or to create a contract between the reader and the author. The reader is encouraged to seek appropriate legal counsel and not to rely on the information contained herein.