FINANCIAL REPORTING

The Balance Sheet – Part 1 – Assets and Liabilities

In previous articles we looked at the many ways that income statement reports answer the question “how are we doing?” and monitor our success in managing revenues and expenses.

The balance sheet tells us what we own and what we owe to others, and it provides a big picture view of our overall financial health. It presents our financial position on a specific date, usually the last day of the month, quarter, or year. Unlike revenues and expenses on the income statement, balances on the balance sheet carry over from one year to the next. For example, the cash balance on 12/31/x1 is the cash balance on 1/1/x2, whereas the revenues and expenses are zero on 1/1/x2.

The balance sheet should be included in the monthly financial statement package. Many smaller nonprofits don’t prepare a balance sheet throughout the year; in some cases just a summary of the cash account balances as a note to the income statement is sufficient. But if your organization has receivables, loans, or other reportable balances, you can be pretty sure that the financially savvy members of your board want to see a balance sheet even if they shy away from asking for it.

When board members look at the balance sheet, they want to know:

  • Do we have the resources to pay our bills?
  • Do we have too much debt?
  • Have we built up equity (unencumbered assets) over the years?

The balance sheet is comprised of three sections:

  • Assets
  • Liabilities
  • Net Assets (also called fund balance, net worth, or equity)

We’ll look at assets and liabilities now and net assets in Part 2.

Assets

  • Cash: for example, donations, fundraising, grant awards, and fees received as a result of the organization’s activities.
  • Receivables: cash that has been promised or earned, but not yet received.
  • Investments: cash that has been invested because it is not needed for everyday operations.
  • Property and equipment (or “fixed assets”) net of depreciation: the value of tangible items and software after depreciation (called “book value”) with an original cost above a specified threshold and a useful life of more than one year.

Liabilities

  • Accounts payable: amounts owed to vendors.
  • Payroll and fringe benefit accruals: amounts owed relating to salaries/wages that have been earned but not yet paid. These include wages, payroll taxes, and retirement plan matching funds.
  • Outstanding principal on loans: Only loan principal owed is shown on the balance sheet; as payments are made, interest expense is recorded on the income statement.
  • Deferred revenue: cash that has been received but not yet recorded as revenue.

WORKING CAPITAL

To make sense of the balance sheet, experienced readers of financial statements look at “working capital” and the “working capital ratio.” Working capital is the arithmetic difference between current assets and current liabilities, and the working capital ratio is current assets divided by current liabilities. These are measures of “liquidity.” The reader needs to see that the resources are there to pay the bills on time. A cash balance of $500,000 looks great, but if the organization currently owes $750,000 to its vendors and employees, then it may be in trouble. A balance of $750,000 on a twenty-year mortgage is a different story.

To assess liquidity, a balance sheet’s assets and liabilities are “classified” as either current or long-term. Current means that the asset or liability will be received or paid no later than one year from the balance sheet date; long-term means longer than one year.

Receivables can be current or long-term. When we invoice a customer we expect to be paid within thirty days or so; that is current. But a donor might make a pledge to give $1,000 per year for five years. Year one is current and years two through five are long-term. Amounts that we owe our vendors are usually current. Accrued payroll and pension match are current, as is the amount of loan principal that is due in the next year. For a newly obtained twenty-year mortgage, the first year’s amount owed is current and years two through twenty are long-term. The next year, year two is current and years three through twenty are long-term.

Throughout our discussions of financial statements we have followed the progress of our fictional organization: Farm Haven Animal Refuge (FH). We looked at its activities in 20×1 through the lenses of their income statement, budget-to-actual reports, and year-end forecast. Now we will look at its balance sheet as of 12/31/x2. You will see that many of the items on the balance sheet shown here follow the dictates of Generally Accepted Accounting Principles (GAAP) concerning grants and contributions. The terms “barrier,” “conditional grant,” and “with donor restrictions,” are explained in the articles on revenue recognition.

Here is what FH was up to in 20×2:

  • FH successfully applied to the ABC Foundation for a five-year grant for a total of $100,000 ($20,000 per year) for the operating expenses of the animal care program. The award letter was received on March 31, 20×2. No barriers were identified in the contract, so the grant is unconditional. Following GAAP, the entire $100,000 was recognized as revenue. $20,000 was treated as unrestricted revenue because the cash was received and used to reimburse approved expenditures during 20×2. The remaining $80,000 was recorded as a donor-restricted receivable ($20,000 current and $60,000 long-term.)
  • A $30,000 grant to replace a specific diagnostic machine was awarded, along with a check for the entire amount, on December 1. This is a conditional grant; the barrier is acquisition of the equipment. FH was not able to buy the machine by December 31, so it recorded deferred revenue rather than revenue, and a three-month certificate of deposit (CD) was purchased with the cash. The net effect on the balance sheet is a $30,000 asset (the CD) and a $30,000 liability (deferred revenue).
  • Throughout the year FH promptly invoiced its funders for amounts due, ending the year with receivables of $35,000, most due in thirty days.
  • A five-year loan of $50,000 was taken out in January of 20×2 and $10,000 of principal was repaid during the year.
  • Additional equipment for the infirmary was purchased for $50,000 on February 28, 20×2 with the loan proceeds. Ten months of depreciation was recorded.
  • Donations totaling $20,000 were received in December in response to a special appeal.
  • FH reported net income of $85,000:
    • $5,000 from operations was reported “without donor restrictions” in net assets.
    • The ABC Foundation restricted grant revenue of $80,000 was reported and designated “with donor restrictions” in net assets.

Example 6 is a classified balance sheet with each item presented in order of its liquidity. In Part 2 we will see the same information with donor restricted amounts presented in a separate column.

The balance sheet is governed by the accounting equation: TOTAL ASSETS = TOTAL LIABILITIES + TOTAL NET ASSETS. The financial types on your board will always do a quick check to be sure that it is in balance. We will talk more about the accounting equation when we look at net assets in Part 2.

Let’s take a closer look at FH’s balance sheet, beginning with its most liquid assets.

Current assets (one year or less)

  • Cash $65,000: Cash is first because it is the most liquid. The balance corresponds to the balance in FH’s bank account on 12/31/x2.
  • Short-term investments $30,000: The CD purchased with the equipment grant proceeds is considered a “cash equivalent” and is therefore listed after cash.
  • Accounts receivable $35,000: The balance reflects all unpaid invoices as of 12/31/x2.
  • ABC Foundation grant receivable $20,000: This represents year two of the ABC Foundation grant receivable. The cash will be collected throughout 20×3 as the expenses are incurred.

Long-term assets (more than one year)

  • ABC Foundation grant receivable $60,000: This amount will be collected in years 20×4 through 20×6.
  • Property and equipment net of depreciation $230,000: This balance represents the combined current “book value” of all property and equipment that has been purchased throughout FH’s history, including the book value of $45,840 for the infirmary equipment purchased on 2/28/x2.

GAAP demands that nonprofits report their fixed assets on the balance sheet at the purchase price less accumulated depreciation. Each year depreciation expense is reported on the income statement, and the asset value on the balance sheet is reduced by the same amount until the asset is fully depreciated. The book value of the infirmary equipment asset at 12/31/x2 is calculated as follows:

  • Purchase price: $50,000
  • Estimated useful life: 10 years
  • Annual depreciation using the “straight-line” method: $5,000 ($416 monthly)
  • Prorated depreciation over 10 months in the year of purchase: $4,160
  • Book value at 12/31/20×2: $45,840.

Smaller nonprofits may report their depreciation only at the end of the year so that assets and income will be properly reflected on the GAAP auditors’ financial statements.

Current liabilities (due within one year)

  • Accounts payable $22,500: This represents invoices recorded but not paid as of 12/31/20×2.
  • Accrued payroll $10,000 and accrued 401k expense of $1,500: These reflect amounts due to employees in connection with hours that have already been worked.
  • The loan payable of $10,000: The amount due over the next twelve months.
  • Deferred revenues equipment grant $30,000: The $30,000 advance on the diagnostic machine grant is shown as deferred revenue.

Why is deferred revenue a liability? Answer: In accordance with the rules for conditional grants, FH is obligated to either spend the money on the specified equipment or return it to the funder. It has not yet earned the revenue. When the equipment is purchased, revenue will be recorded and the deferred revenue balance will go to zero.

Long-term liabilities (due in more than one year)

Loan payable long-term portion $30,000: The equipment loan was taken out in January of 20×2 and $10,000 of principal was repaid in the same year. $10,000 will be paid in 20×3 and is therefore recorded as a current liability. The remaining $30,000 will be paid in years 20×4, 20×5, and 20×6.

You can see in this example that FH’s working capital is $76,000: total current assets minus total current liabilities. Its working capital ratio is 2.03: total current assets divided by total current liabilities. FH should be happy with this ratio. Assuming that the receivables will be collected on time, FH has the resources to cover twice the amount of its near-term liabilities.

Taking the 30,000-foot view, what are the ingredients of FH’s healthy working capital?

  • The cash balance of $65,000 reflects an influx of donations in December.
  • FH has diligently invoiced its funders for amounts due, resulting in healthy cash and receivable balances.
  • FH’s five-year grant application was successful, and in compliance with GAAP. The 20×3 portion of the unconditional grant funding was recorded as a current receivable.
  • FH has very little debt. The current portion of the loan—$10,000— is low enough to have a minimal effect on working capital.

If FH had been less diligent in raising money, invoicing customers, and applying for grants, the balance sheet might show a current ratio closer to one. In this case FH would be struggling to pay bills on time. It might have to borrow to make payroll, assuming that a bank will extend credit to them. Short-term borrowing comes with interest expense which can further impair the organization’s financial health. If the working capital ratio was one, the CFO would be spending a lot of time reviewing cash forecasts, managing the timing of paying bills, and anticipating when withdrawals on the line of credit would be needed.

TO CONCLUDE

The balance sheet contains vital information about an organization’s success in managing its finances. Banks, board members, and funders look to the balance sheet to determine among other things how the organization manages its cash, receivables, and payables, and if it is overloaded with debt or other liabilities. The board needs to see the balance sheet along with the income statement to get the complete picture.

We have concentrated here on two of the three sections of the balance sheet. We will examine net assets in Part 2.