Five Questions to Ask About The Financial Reports
Your most important responsibility as a board member is to make sure the organisation is financially viable and that it can pay its debts as and when they fall due (i.e. not insolvent).
Unfortunately, for non-financial people – who likely make up the majority of board positions – when they receive the financial reports, a feeling of overwhelm kicks in [yeah, I’ve been there!].
Accounting methods can be funny things. Profit is not the same as cash in the bank. Current and non-current liabilities and assets can be confusing due to the underlying assumptions used to prepare them. And to make things even more confusing, the rules around accounting and reporting methods are often changing.
Nonetheless, there are some questions to keep in the back of your mind to ask yourself each time you receive the financial statements prior to the board meeting (you are getting them, aren’t you?!). Here are my top five:
1. Is the business solvent?
Can the business pay its debts as and when they fall due? If you are a director of an organisation in Australia that trades whilst insolvent (i.e. that can’t pay its debts as and when they fall due) you could face civil penalties, compensation proceedings and criminal charges (read more about these here). This rule applies to all directors – volunteer or paid.
A couple of quick things to look at on the financial reports:
• Spending more than you make (i.e. your expenses are greater than your revenue). This can only be sustained for so long before radical decisions need to be made.
• The assets and liabilities of the organisation – found on the balance sheet. Make sure the current assets exceed the current liabilities. Keep an eye on non-current liabilities and know when they will become due and the likelihood of being able to pay the debt at that time.
• Equity – if it’s going down, this could indicate a solvency concern because the business may be drawing on reserves to continue operating.
2. What basis of accounting was used to prepare the reports?
Cash Accounting and Accrual Accounting are the two accounting methods used by organisations. The method applied to the finances and financial statements will change your interpretation of the information contained in the financial reports, so it’s important to understand the basis of accounting used.
To know which method is used, ask the Chair or CEO (or equivalent persons). This simple guide from business.gov.au explains these two methods.
A word on the financial statements you should be receiving.
In the usual pack of information you receive before every board meeting, you should receive the following financial statements/reports:
· Profit and Loss Statement. Sometimes known as Income Statement, P&L, Revenue Statement, Statement of Financial Performance, or Earnings Statement. This report shows the income (sales), expenses and net profit (note: this is not the same as cash in the bank) for the reporting period.
· Balance Sheet. Also known as Statement of Financial Position. This report shows the assets, liabilities and equity of an organisation at a particular point in time.
· Cash Flow Forecast. This document shows the changes in cash levels during the reporting period and cash flow estimates into the future (usually on a 12 months rolling basis). Cash is king.
3. What does each line item mean?
Each organisation has its own ‘chart of accounts’. Basically a list of the various “buckets” that it allocates each expenditure to (for example, ‘Telephone Bills’ could be allocated to the ‘Office Expenses’ account; and ‘Rent’ could be allocated to the ‘Occupancy Costs’ account).
As you will begin to see, each organisation has its own chart of accounts, and vocabulary and acronyms. Ask for a guide or glossary to these terms so that you can quickly come up to speed with and understand the information you are given.
4. Are there any warning signs?
These can come from many places in the financial reports. A few things I like to keep my eye on are:
• Large variances in actuals to budgets – particularly year-to-date actuals and year-to-date budgets. This could come down to “timing errors” – a phrase that I have come to loathe – or it could indicate cost blow-outs and income deficits. Find out the reason for the variance ASAP. A good process to implement is to have the finance officer / bookkeeper / treasurer to prepare notes to the financial statements that addresses variances beyond x% of budget (e.g. 10% or 20% over or under budget).
• Anything I don’t understand. After time you will begin to understand the relationship between the numbers and the business operations. So some of the ‘weirdness’ in the financial reports can easily be explained and aren’t an issue. Until you get familiar with these nuances – and always forever more – if there is something that does not make sense to you in the financial statements question it! Make sure you get the assurance you’re seeking from someone credible who knows the answer to your question.
• Annual Leave (AL) and Long Service Leave (LSL) Provisions. A large amount of AL accuring can signal that staff are not taking their allocated annual leave – this is a significant workplace health and safety concern in addition to a cash obligation. Ditto for large amounts of LSL. When a staff member decides to take their LSL the business will be required to pay it. This will likely come from cash or cash reserves. Depending on the size of the LSL and the organisation, it could bring with it significant cash flow and solvency challenges. Keep an eye on it and have adequate policies and processes to manage it within reasonable parameters.
• Statutory obligations not being paid. Tax and superannuation are the obvious ones for most businesses. Be very worried if it appears that these are not being paid. Ask for verifying documentation if you are in any doubt.
5. Are we – as a whole – taking responsibility for the financial reports?
Frequently within smaller organisations there is a treasurer. This person usually has the task of preparing the regular financial reports and providing commentary on the financial position of the organisation. Usually – but not always – they have the appropriate qualification for this job. Often times, along with this situation, the other board members rely solely on the treasurer or accountant to know if the organisation is in an OK financial position (i.e. solvent).
Unfortunately it doesn’t work that way in reality. The financial health of the organisation is up to ALL of the directors to understand and agree upon. “Trust but verify” should be the approach that you take. Your position and personal assets are at risk if it all goes pear-shaped. Taking the time to review the financial statements is time well invested.
Don’t be intimidated by the financial reports that you receive as a board member. Invest in learning via courses and other methods. Make some time to sit down with the person who prepares the reports and ask them to go through each report and explain how it is prepared, what the figures mean, and how each report relates to the others. Good luck!