Financial governance for NFP’s.

Hi, I’m Rob Lockhart from Westpac’s Davidson Institute to talk to you about ‘Financial governance for NFPs’. In Australia, there are over 750,000 incorporated NFP’s and that number rises into the millions when you include all the unincorporated organisations too. These organisations exist for a social purpose.

These purposes are incredibly diverse but have one thing in common. To achieve their purpose, the organisations need money and that money needs to be efficiently managed to ensure the organisation is able to continue to achieve its purpose. The effective management of money by an organisation is known as financial governance.

In this video we’re going to look at: • “Why do we need good financial governance?” and why it’s important to the organisation. • keeping good financial records, and • understanding financial statements so that you and any other stakeholders know what's going on financially.

Let’s start with why it’s important to get the governance right. Let me pose you the question – why did you get involved with your organisation? It’s my experience that people get involved with an organisation because they are passionate about the outcomes that organisation provides to the community.

Organisations operating in the social sector are established with the aim of enhancing life in some way for someone. Whether it is a charitable organisation that provides food and shelter for the homeless, an organisation that provides services in the disability sector, or a sporting club or arts organisation, the aim is to improve the lives of people in our communities.

It therefore stands to reason, that we want to be able to do this efficiently and over a long period of time … that is, we want to be sustainable. Therefore, understanding the regulatory framework that the organisation works within and the financial position of the organisation is critical for anyone involved in decision making in either a board or management capacity.

Financial governance is one of the most important areas of any organisation as without good financial management and reports it is a bit like running your organisation in the dark. Good record keeping helps to build accurate financial reports to manage the organisation and supports auditing to show that the organisation is compliant.

The records that need to be kept, and checks and balances you put in place, will depend on the constitution of the organisation, and it’s legal and financial structure. While being compliant is important I believe good financial management is about achieving the purpose of the organisation.

By providing, accurate, timely and more understandable financial information for the board, managers and staff they will be better able to allocate resources efficiently and be able to identify more quickly when things are going off track in your organisation.

The NFP sector has a number of different government regulators depending on the size of the organisation, the legal structure of the organisation, and in some cases its purpose. Understanding the role each of these regulators plays, and knowing which applies to your organisation is the beginning of financial governance.

A key regulatory body for anything financial of course is the Australian Taxation Office. Even though your organisation may not pay income tax there are other regulations that you’ll need to comply with.

If you’re structured as a company you need to comply with the Australian Securities and Investment Commission, known as ASIC, and if you’re a charity you will need to comply with the Australian Charities and Not-for-profit Commission, known as ACNC, and provide them with financial information each year.

It’s not just about the government departments, it’s also about how your organisation is structured. There are 3 common structures for NFPs in Australia • Un-incorporated Associations • Incorporated Associations and • Companies limited by guarantee.

There are other structures, but these are the main ones and it's important to understand which structure your organisation uses because this will influence which of those regulatory bodies you need to comply with. This could be at a national level like the Australian Tax Office, but also state government departments or a combination of both.

So, which governing body is relevant for your organisation? If you’re an unincorporated association, you should have a constitution which is usually set up when the organisation is established. Your constitution contains all the rules by which the organisation is run and usually has information about the records you need to keep and whether your accounts need to be audited or not.

Incorporated associations typically have a constitution and are usually incorporated/registered in the state where they are based. It’s important to be familiar with the particular state’s legislation and requirements to operate as they will differ slightly from state to state.

Companies limited by guarantee will also typically have a constitution, sometimes known as a memorandum and articles of association, and you will be obliged to comply with ASIC regulations.

Regardless of the organisation structure, you will most likely have dealings with the Australian Tax Office (or the ATO) at some point. Whilst many not for profits don’t have to pay tax you may still be required to interact with the ATO for other reasons.

If you turnover more than $150,000 you need to collect GST on behalf of the government and return it to the tax office. But even if your turnover is less than $150,000 it might be worth registering for GST because you can then claim back the GST you are paying to your suppliers.

If you employ people and pay them you are going to collect tax on behalf of the ATO and make superannuation payments so you will have dealings with the tax office. If your supplier is not registered for GST and doesn’t provide a tax invoice, then you will be required to withhold PAYG tax and submit that to the tax office.

So, unless you’re a very very small organisation you are probably going to deal with the ATO. The ATO requires you to have an ABN or Australian Business Number and you must keep your financial records for 5 years. The records to be kept are your financial statements and any supporting documents.

If you’re an incorporated association you will also need to meet requirements under your relevant state legislation. Each state has different levels of financial records that need to be kept. For example, in NSW and VIC financial records need to be kept, however if the organisation’s turnover is greater than $250,000 or it has assets worth more than $500,000, the records then need to comply with Australian Accounting Standards.

In NSW they will be audited but in VIC this annual audit requirement only comes into play if turnover exceeds $1M. In QLD records are audited when turnover is greater than $20,000 which of course means that the Australian Accounting Standards apply too. Remember though that your constitution might still say the organisation needs to be audited annually.

So, it’s important to understand your structure and the legislation and regulatory bodies you need to deal with to be compliant in operating. But most importantly, from your own perspective, having an understanding of the financial side of the organisation is imperative in maintaining a sustainable organisation that can continue to achieve its purpose in the community.

So that is the regulatory framework and a brief overview of the various bodies that organisations need to comply with and keep financial records for. But exactly what records do you need to keep? Firstly, you need to keep a record of any money the organisation receives. There are lots of ways for an organisation to get income: donations, corporate sponsorships, government grants, selling goods or services, maybe selling tickets to a fundraising event.

For any money received, records should be kept of … Who did you get the money from? How much did you receive? What was the money received for? and When did you receive the money?

These records are generally initiated by the organisation issuing an invoice – for services rendered, sale of an item, memberships etc. Then when the money is received, a receipt may be issued. Invoices and receipts are the basis of the financial records and copies need to be kept to support those records.

When issuing invoices, remember to include your ABN as this makes it a valid tax invoice. If you don’t include your ABN, businesses can withhold 45% of the amount of the invoice which they then pay to the tax office and you would then need to claim it back. It’s much easier for everyone if you include your ABN on your invoices in the first place.

What about the money going out? Organisations also need to keep good records of the money paid out. Again, this includes details of: Who are you paying it to? How much was paid? What the payment was for? and When it was paid.

Sometimes some expenses need more information. For example, when you’re paying staff make sure you record the number of hours worked and rate of pay and other information required for PAYG tax and superannuation. Copies of invoices, receipts, time sheets etc need to be kept to support these records.

But it’s not just money in and out. Sometimes labour will be provided by volunteers, or you may receive donations in kind, that is goods or services instead of cash. For donations in kind, records of the goods or services received or provided should include information like • What was it? • Who provided or received it? • What for? • When? and • How much? Or what’s the value of it? For example, if your organisation is donated a car, how much would you have had to spend if it wasn’t donated?

And how much might you need to spend to replace it in the future?

As for volunteers … How many hours do they work, what do they do for the organisation? A good exercise is to work out if you did have to pay them, how much money would the organisation be spending? This can help if, in time, the volunteers are not available, and the organisation needs to employ someone to do that task/job.

Another set of records is what's called an Asset register – a list of all those things that the organisation owns– things such as cars, chairs, computers, desks, sporting equipment and so on. Some of the details that should be kept include: • What is it? • When was it purchased? Or where did it come from? • Its value • Where it is (for example which office or whose garage), and • When is it likely to need to be replaced?

It’s a good idea to do an audit regularly to check if the assets are all still there and working properly. An asset register helps to plan for future replacement or repairs as the asset wears out over time.

From all of those records … Money in, money out, donations in kind, volunteers, and asset registers … the accountant will prepare the necessary financial statements for taxation purposes, possibly for audit purposes, and for reporting to the board or other stakeholders.

But more importantly, than for regulatory purposes, the financial statements tell the story about the organisation’s financial performance and position. Vital information for those managing the organisation as it indicates whether the organisation is financially sustainable.

The 2 most common and most used financial statements are the balance sheet and income statement (sometimes known as the Profit and Loss statement or P&L). Let’s have a look at each of these statements and the information they provide about an organisation.

Starting with the Balance Sheet. The Balance Sheet tells us about the financial position of the organisation. It records the assets the organisation owns, and the liabilities and equity that were used to pay for those assets. It’s called a balance sheet because the two sides must balance. That is the Assets must equal the Liabilities & Equity.

The balance sheet shows a snapshot of those things at a specific point in time … commonly at the end of the financial year. Let’s delve a little deeper. ‘Assets’ is the accounting term for things that are owned by an individual, a business, or an organisation. In the case of a NFP organisation the purpose of assets is twofold. They are used to deliver the organisation’s service and to provide operational capacity.

The difference here is that an organisation may have an office to operate from with computer and communication equipment that provides the capacity to be operational, however their actual service may be delivered via a vehicle, for example meals on wheels. As well as service delivery, an organisation also wants those assets to be helping generate more income for the organisation so that they can fund more of the service delivery.

In the balance sheet the assets are broken down into 3 categories Current Assets turn into cash within 12 months. Things like cash, stock, debtors Fixed assets are those that last longer than 12 months – things like motor vehicles, computers, desks, chairs and so on. Intangible assets are those things that you can’t touch or feel but which add value to an organisation– things like goodwill, licenses, patents, or intellectual property.

Liabilities and equity are the sources of money to pay for the assets. Equity is the organisations own money, while liabilities are the money owed to other businesses, organisations, or financial institutions. Current liabilities are those that need to be repaid within the next 12 months – things such as creditors, or short terms loans like credit cards or overdrafts.

Long term liabilities are those that will be repaid over a longer term than 12 months – things like equipment finance or building loans. Equity is, as I said, the organisations own money. This may be initial seed capital or an initiating bequest and may be added to annually by any profits or surpluses made by the organisation.

Let’s have a look at an example. We can see here that this particular organisation has a significant amount of cash and some stock as their current assets; some office equipment and vehicles as their fixed assets – all totalling $355,000.

As you can see there is an equal amount of liabilities & equity – which is broken down into current liabilities … being their credit card and creditors, a long-term loan for the car, and their equity. This is the summation of their financial position at this point in time.

Now let’s have a look at the Income statement also known as Profit & Loss or Statement of Financial Performance The income statement collates all the income that the organisation has collected, expenses incurred, and calculates the surplus or deficit over a period of time, commonly a financial year.

It’s useful to further break down the expenses into those incurred through actually providing the service, and those necessary purely to be operational. As an example, let’s say there’s an organisation that provides a helicopter transport service for people needing medical care … the types of expenses that might be incurred to be operational, are things such as the communications system, insurances, & equipment maintenance.

However, the costs incurred in actually transporting a patient might be things such as fuel, pilot’s wages and air traffic control charges.

Our aim, of course, is to use more on service delivery than operations however this is not always the case. And here’s an example of an Income Statement. This organisation received an income of $240,000 over the financial year being a mixture of grant funding and fund-raising. They spent $230,000 on a variety of expenses, leaving a surplus, or profit, of $10,000.

So, the balance sheet tells us about the financial position of an organisation at a specific point in time, and the income statement tells us about the financial performance over a specified period of time – useful information in both cases.

But it’s when we look at the two statements together, not in isolation, that we get a more complete picture of the financial operations of the organisation. The financial operating cycle describes at a high level how money flows through an organisation. Let’s see how it works.

When the organisation was originally established, a pool of money would have been made available in one form or another which is the original Equity of the organisation. If this wasn't enough to get started, the organisation may have had to obtain some stock on credit or borrow from a financial institution. This borrowed money is known as Liabilities.

Then with our money (the Equity) and the others money (the Liabilities), the organisation uses this money to purchase the assets they need to operate. This may be assets like stock, vehicles, equipment and so on. These assets are then used to provide the organisation’s services and generate more income/revenue. As soon as the organisation starts operating, it will incur expenses such as rent, wages, electricity etc. which will be paid out of the income.

At the end of the period if this process has been managed well the organisation will have a surplus … or money left over. This surplus is retained in the organisation as equity and used in two ways … 1. Reinvested in assets: such as saved as cash, purchase more stock or another piece of equipment, or 2. Used to reduce debt.

The key to long term sustainability is to keep this cycle turning over smoothly and efficiently. We want to efficiently be using assets/resources in providing our service and generating more income for ourselves. We want to efficiently be managing our expenses to provide as much of our service as we can with the money available.

Then efficiently be using any surplus to reinvest in the organisation to either reduce the risk and costs by reducing debt, or to increase our outputs or grow the organisation by reinvesting in assets.

This model also demonstrates the relationship between the financial statements. “Asset = Liabilities + Equity” is the Balance Sheet. “Income – Expenses = Surplus/deficit” is our income statement. And what we can clearly see now is that there is an integral relationship between the two. And to have a complete picture of the organisation’s financial position it’s important to be able to read and understand both.

Before we move on from this model, I just want to make one final point. The model shows that any surpluses are reinvested in the organisation and used it 2 ways. What if the organisation makes a deficit instead of a surplus? … this would indicate that the organisation would either need to borrow more (often not an option) or reduce assets.

A reduction in assets often means a reduction in the organisation’s ability/capacity to be able to deliver on its purpose in the community. Not a position any organisation wants to be in. So, even though organisations may be known as not-for-profit, for long-term sustainability it’s important to operate in surplus.

I did say the key to long term sustainability is to keep this cycle turning over smoothly and efficiently. But how do we measure that efficiency? We use financial ratios. The ratios simply compare one number with another which tells us something about the organisation. As I mentioned earlier a useful ratio to look at is what percentage of expenses is spent on operations and what is spent on service delivery?

It’s also useful to look at how the surplus is being used to either reduce liabilities and reduce the risk to the organisation, or in reinvesting in assets to grow the organisation and increase the social impact.

So, in this video we have looked at the regulatory framework for NFP’s and why it’s important to keep good financial records. We looked at the types of records that need to be kept, then at the financial statements that are collated from these records and what information we can glean from them. It’s vitally important that an organisation’s financial governance be effectively managed for the organisation to continue to be able to provide its service to the community.

Thank you for watching our video on Financial governance for NFPs. We trust you found this information useful and relevant and I encourage you to check out the other financial education resources on the Davidson Institute website to help build your financial confidence. Bye for now.