The Basic Financial Statements

Financial Statements: the "Financial Story"

Read this chapter, which guides you through financial statements. You will be able to identify the basic financial statements: balance sheet, income statement, and cash flow statements. You will also be able to recognize key elements in every financial statement and understand what information each statement is designed to convey about an organization.

Financial statements help managers answer a variety of questions:

What and how much does the organization own? What and how much does it owe? Does this organization have enough financial resources to cover its obligations as they come due?
What are the major sources of revenue for this organization? What are its spending priorities? Do the organization's sources of revenue and spending priorities reflect the organization's core mission?
How much of this organization's spending does it control? How much of its spending is directed by outside stakeholders like donors, clients, residents, or investors?
How much, if any, does this organization report in "reserves" or its "rainy day fund"? Given its operations, what would be the optimal level of reserves?

In November 2013, the Contra Costa County (California) Board of Supervisors voted to end nearly $2 million in contracts with the non-profit Mental Health Consumer Concerns (MHCC). The reason: MHCC's savings account had grown too large.

Since the late 1970s, MHCC has offered patient rights advocacy, life skills coaching, anger management classes, and several other mental health-related services to the Bay Area's poorest residents. Much of its work was funded through contracts with local governments.

In 2007, its Board of Trustees began to divert 10-15 percent of all money received on every government contract to a reserve account (or rainy-day fund). MHCC's management concluded this policy was necessary after several governments were consistently late on their payments. MHCC's plan was designed to guarantee that the organization would not be exposed to unpredictable cash inflows. The board and management considered this a prudent use of public dollars and a necessary step to protect the organization's financial future. From 2007 through 2011, nearly $400,000 flowed into the new rainy-day fund.

Contra Costa County disagreed. They interpreted the contracts as reimbursements only for actual service delivery expenses. They also pointed out that those contracts prohibited carrying over funds from year to year. A reserve fund containing County funds was, therefore, a violation of those contracts. MHCC pointed out that they disclosed the reserve fund strategy in their annual financial reports. The reserve allowed them to deliver services uninterrupted, even during the worst moments of the Great Recession. Contra Costa County Supervisor Karen Mitchoff responded that MHCC's financial statements were not the appropriate channel to communicate such a contentious policy choice. She added, "I am not sympathetic to the establishment of the reserve, and the non-profit board knows they had a fiduciary responsibility to be on top of this."

The contracts were canceled, and MHCC dissolved in early 2011.

This episode illustrates two of the key takeaways from this chapter. First, an organization's financial statements are a vital communication tool. They tell us about its mission, priorities, and service delivery strategy. In this case, MHCC decided to deliver less service in the near term in exchange for the ability to deliver more consistent and predictable services in the future. That choice is reflected in MHCC's financial statements (e.g., assets exceed liabilities, and unrestricted net assets were a significant proportion of net assets).

MHCC disclosed the rainy-day fund policy in the notes to its financial statements. Second, and more importantly, financial statements are only useful if the audience knows how to read them. In this case, Contra Costa County failed to understand how the rainy-day fund policy was communicated in the financial statements and how it affected MHCC's finances and its ability to accomplish its mission.

Without the ability or desire to interpret the financial statements, the County considered MHCC's actions a breach of contract. Whether a rainy-day fund is a direct service expense is an important policy question. So is the question of whether and how a government should use financial statements to oversee its non-profit contractors. But to engage these and many other questions, one must first understand how a public organization's financial statements tell its "financial story."

Source: Sharon Kioko and Justin Marlowe, https://uw.pressbooks.pub/financialstrategy/chapter/accounting-and-financial-reporting/
This work is licensed under a Creative Commons Attribution 4.0 License.