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Beyond the Checkbook: A Financial Management Guide for Leaders of Small Youth-Serving Organizations January 2009 The Finance Project; 1401 New York Avenue, NW, Suite 800; Washington, DC 20005 (202) 587-1000, fax (202) 628-1293, www.financeproject.org Beyond the Checkbook: A Financial Management Guide for Leaders of Small Youth-Serving Organizations Robert E. LaVallee Kate Sandel January 2009 Beyond the Checkbook: A Financial Management Guide for Leaders of Small Youth-Serving Organizations Foreword ................................................. 4 Chapter 1. Thinking About Nonprofits 1.1 How Nonprofits Differ from For-Profits . . . . . . . . . . . . . . . . . . . . . . 6 1.2 Advantages of a Nonprofit Corporation . . . . . . . . . . . . . . . . . . . . . 7 1.3 Disadvantages of a Nonprofit Corporation . . . . . . . . . . . . . . . . . . 9 1.4 Pros and Cons of Forming an Independent Nonprofit . . . . . . . . . 10 Chapter 2. Starting a Nonprofit 2.1 Steps to Form a Nonprofit Corporation. . . . . . . . . . . . . . . . . . . . 12 2.2 Ways to Develop a Board of Directors. . . . . . . . . . . . . . . . . . . . . 14 Chapter 3. Building a Financial Management System 3.1 Elements of Financial Management Systems. . . . . . . . . . . . . . . . 17 3.2 Role of a Financial Manager. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 3.3 Goals of Financial Management Systems. . . . . . . . . . . . . . . . . . 20 3.4 Seven Signs of Financial Health. . . . . . . . . . . . . . . . . . . . . . . . . . 22 Chapter 4. Structuring the Accounting System 4.1 Financial Accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 4.2 Chart of Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 4.3 Financial Accounting Methods. . . . . . . . . . . . . . . . . . . . . . . . . . . 27 4.4 Accounting Software. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Chapter 5. Creating and Using Budgets 5.1 Budget Uses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 5.2 Types of Budgets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 5.3 The Budget Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 5.4 Operating Budgets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 5.5 Types of Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 5.6 How to Project Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 5.7 Types of Expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 5.8 How to Estimate Expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 5.9 Comparison of Projected Revenue and Estimated Expenses. . . . 43 5.10 A Shift from Project Budgets to an Organization Budget. . . . . . 44 5.11 Results-Based Budgeting.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 5.12 Preparing and Presenting the Budget. . . . . . . . . . . . . . . . . . . . . 45 5.13 Reflections on Budgeting Practices. . . . . . . . . . . . . . . . . . . . . . 48 Chapter 6. Applying Financial Management Controls 6.1 The Importance of Internal Financial Management Controls. . . . . 53 6.2 A Complete System of Internal Financial Management Controls. 55 6.3 Receipts Procedures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 6.4 Disbursements Procedures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 6.5 Petty Cash Procedures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 6.6 Payroll Procedures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 6.7 Investment Policies and Procedures. . . . . . . . . . . . . . . . . . . . . . 65 6.8 Reflection on Controls. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 Chapter 7. Allocating Overhead 7.1 Overhead Defined. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 7.2 Reasons to Allocate Overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . 74 7.3 Methods to Allocate Overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . 75 7.4 Ways to Calculate Overhead Rates. . . . . . . . . . . . . . . . . . . . . . . 79 Chapter 8. Creating and Using Financial Reports 8.1 Thinking About Financial Reports.. . . . . . . . . . . . . . . . . . . . . . . . 81 8.2 Using Financial Reports. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 8.3 Identifying Reporting Needs. . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 8.4 Monitoring Performance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 8.5 Interpreting Financial Statements. . . . . . . . . . . . . . . . . . . . . . . . . 87 Chapter 9. Conducting an Audit 9.1 Audits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 9.2 Purposes of an Audit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 9.3 Working With an Auditor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 9.4 Alternative Audits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Chapter 10. Complying with Sarbanes-Oxley and the Revised IRS Form 990 10.1 The Revised IRS Form 990. . . . . . . . . . . . . . . . . . . . . . . . . . . 100 10.2 Preparing the Revised Form 990. . . . . . . . . . . . . . . . . . . . . . . 100 10.3 The Sarbanes-Oxley Act. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Chapter 11. Sharing a Few Final Reminders. . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 4 Beyond the Checkbook Foreword If you are reading this foreword, you may be one of the dedicated and entrepreneurial individuals who, during the past several decades and with the support of public funding and private investments, have helped create many new programs aimed at improving outcomes for youth. If you are a part of one of these newly formed organizations—or organizations that have expanded their missions and services—then you know the serious challenges to your organization’s survival. • Your organization must find effective and efficient ways to operate. • Your organization faces intense competition from the scores of existing youth develop- ment programs nationwide in the struggle to secure funding. • Funding for youth programs tends to be fragmented and often short term, as does funding for most human services programs. Solid financial systems are needed to meet these challenges. While starting or expanding a youth-serving program, it’s common to focus exclusively on defining the mission and building the program. Yet this focus can come at the expense of creating the internal systems that Solid financial systems are needed to keep your initiatives running. Enthusiasm and com- meet these challenges. mitment are essential elements, but you can work more effectively if you take the time to establish policies and processes that will keep your organization’s financial house in order. Youth Programs Defined Throughout this guide, the term “youth programs” is used to describe a wide range of services and activities for youth. Youth programs include prevention, intervention, and developmental programs across multiple disciplines, including academics, workforce preparation, health and well-being, leadership and civic engagement. These programs are provided by large and small and public and private organizations in diverse settings such as schools, workplaces, and community centers. Youth program activities include counseling, mentoring, career exploration, summer employment, dropout prevention, financial literacy, academic assistance, and sports and recreation. Foreword About This Guide This financial management guide is for leaders of small youth-serving organizations. (By small, we mean organizations or programs with budgets of less than $2 million.) We understand that managers of youth-serving organizations often come to their positions with keen insights into providing effective programs for youth but less experience in handling the finances of an organization. Our hope is that this guide will help executive directors, directors of finance and administration, and program managers bridge that gap and understand the dynamic between the operations and the finances of their organization. The guide aims to help leaders of small youth-serving organizations develop the tools and knowledge they need to create and use sound financial management practices. It identifies key components of financial management systems, discusses important considerations and trade-offs that organizations make in designing systems, and provides additional resources for those seeking to pursue specific strategies. The guide also contains checklists, examples, and templates to help clarify key ideas. Financial management systems can be complicated and every organization is unique. Not every situation that a small youth-serving organization might face will be addressed in this guide. For more information, use the resources listed at the end of each chapter or contact a finance professional. Cheryl D. Hayes President and Chief Executive Officer 5 6 Chapter 1 1.1 How Nonprofits Differ from For-Profits 1.2 Advantages of a Nonprofit Corporation 1.3 Disadvantages of a Nonprofit Corporation 1.4 Pros and Cons of Forming an Independent Nonprofit Thinking About Nonprofits Many programs that serve youth begin as special projects or initiatives housed in existing organizations. Successful projects or initiatives sometimes become their own independent organizations, usually nonprofit corporations. This chapter explains the advantages and disadvantages of forming an independent nonprofit and introduces the basic legal requirements to maintain nonprofit status. (Most of the organizations serving youth that decide to incorporate also decide to act as nonprofit entities, so this guide focuses on nonprofit financial management. However, many of the chapters are relevant regardless of tax status.) 1.1 How Nonprofits Differ from For-Profits For-profit and nonprofit organizations vary in several ways. Most importantly, their main objectives are different: for-profits are in business to make money, while nonprofits are in business to advance a specific mission. Following is a summary of the most significant differences between the two types of entities. y• For-Profits Nonprofits y Are owned by individuals or y Have no owner and are account- stockholders and are accountable to them. y Are typically driven by profit and return on investment. y Are subject to income, property, sales, and use taxes. y Have customers. able to the board of directors and funders. y Are driven by mission. y Are tax-exempt, except for income from business unrelated to their mission. y Have clients and other stakeholders. 1: Thinking About Nonprofits 1.2 Advantages of a Nonprofit Corporation Nonprofit status offers certain advantages over for-profit status. These include exemptions from many federal and state taxes, eligibility for additional funding, a separate legal life, flexibility in organizational structure, and lower postage rates. Tax-exempt status. Most nonprofits qualify for federal tax exemption; few, if any, assets and income sources will be taxed. Federal tax exemption requires an application to the Internal Revenue Service (IRS). Moreover, the federal tax exemption usually qualifies the organization for exemption from state and local taxation; the organization will likely need to complete a separate application process through the state. Tax-exempt status does not necessarily mean the organization will not owe any taxes. Some sources of income unrelated to the mission of the organization, known as unrelated business income (e.g., rental property and advertising income), are subject to taxation. Eligibility for public and private funding. Nonprofits are eligible to apply for and accept various public and private funding, some of which may not be available to for-profit organizations. Nonprofits can also solicit gifts, bequests, and donations from the public that are tax deductible for the donors (i.e., contributors may deduct these gifts from their income taxes). The tax impacts vary; restrictions exist on the deductibility of some donations and every individual has different tax circumstances. Separate legal life. A nonprofit is its own legal entity. Although an individual or a group must create a nonprofit organization, the organization exists separately from the people who form it. Nonprofits can conduct business, borrow money, enter into contracts, own property, and sue and be sued. Nonprofit organizations exist until they are dissolved, despite employees coming and going. They also have limited liability. This means the organization is liable for its debts and for court judgments against it, but the founders and directors are rarely personally responsible for the debts. TIPS Fiscal Sponsor: Insurance for the Director, Officers, and Other Board Members Is a Good Idea A fiscal sponsor (or fiscal agent) is a registered non-profit that receivesdirector’s and allocates funds Secure and offi cer’son behalf another organization. (D & O)ofliability insurance, even Throughnonprofi a fiscaltsponsor, though foundersan and organization that is notliability tax-exempt directors have limited from can apply and receive debts and for lawsuits. If you funding are a designated ts. stays director andfor annon-profi officer who informed and takes an active role For more information fiscal in understanding youron organization agents, http://foundationcenand its fivisit nancial position, you fulfill ter.org/getstarted/faqs/html/fi scal your fiduciary duty. By doing this, _agent.html you reduce your liability. Regardless, in the event of extraordinary circumstances D & O liability insurance protects the director, officers, and other board members from most exposure to civil actions against them. Be sure to shop around for the best policy. 7 8 Beyond the Checkbook DEFINITIONS Not all non-profits are alike The Internal Revenue Service has different rules for different kinds of nonprofits. Most youth-serving organizations are considered charitable organizations and have 501(c)3 status, but there are other categories of nonprofits: Flexible organizational structure. Nonprofit organizations have a defined operating structure and procedures, including bylaws and a board of directors. Incorporation places the purpose and structure of an organization above personal interests and differences of opinions among and between directors and founders. Operating as a nonprofit also affords discretion in defining the fiscal year and exemption from certain federal labor rules. • Customization in defining the fiscal year. Nonprofits are not required to match their financial recordkeeping with the calendar year. They can y churches and religious organizations; elect any 12-month period as a fiscal year. This enables you to set the y political organizations; fiscal year in terms of funding or program cycles in a way that makes the y private foundations; and most sense for your organization and its programs. For example, if your y other nonprofits (for example, certain pension and life insurance companies). programs operate on an academic schedule, you may want to set or change the beginning of your fiscal year to September 1. • Exemption from federal labor rules. In some states, nonprofits are exempt from federal labor rules tied to the National Labor Relations Act. In these cases, your organization is not subject to requirements for collective bargaining on wages and benefits, nor is it obligated to allow unionization in the workplace. Lower postage rates. Most nonprofits can use the U.S. Postal Service at substantially reduced rates after receiving a special permit.