The Basic Financial Statements

The Statement of Activities, the non-profit's income statement, is designed to tell us if an organization's programs and services cover its costs. In other words, is this organization profitable?

Every income statement will begin with a summary of revenues and a report of expenses, either by program or line time. In GAAP, revenue is what the organization earns for delivering services or selling goods. Expenses are the cost of doing business. Whenever possible, think of expenses in terms of the revenues they help to generate. For non-profit organizations, this relationship is sometimes clear and sometimes not. For example, imagine that a non-profit conservation organization operates guided backpacking trips. Participants pay a small fee to participate in those trips. To run those trips, the organization will incur expenses like wages paid to the trip guides, supplies, costs related to state permits, and so forth. These are expenses incurred while producing backpacking tour revenue. Here, the relationship between revenues and expenses is clear.

This same organization might sell coffee mugs, water bottles, and other merchandise and then use those revenues to support its conservation mission. The expenses to produce those mugs are known as the cost of goods sold. Here again, the revenue-expense relationship is clear. When that link is clear, we can determine if a program/service/product is profitable. That is, does the revenue it generates exceed the expenses it uses up?

In for-profit organizations, profitability and accountability are virtually synonymous. But for public organizations, profitability has little to do with accountability. For instance, our conservation non-profit might accept donations from individuals in support of its conservation work. Which expenses were necessary to "produce" those revenues? The development director's salary? The administrator's travel expenses to visit a key donor? The expenses from a recent marketing campaign? Here, the revenue-expense link is less clear. Same for in-kind contributions (i.e., donated goods and services) the organization receives in support of its mission. This link is even murkier for governments, where taxpayers pay income, property, and sales taxes. Those taxes have no direct link to the expenses the government incurs to deliver police, fire, parks, public health, and other services.

To put this in the language of accounting, public organizations have a mix of exchange-like activities, such as backpacking trips and coffee mugs, and non-exchange-like activities, like conservation programs and public safety functions that are just as, if not more, central to their mission as their exchange-like activities. That is why profitability is one of the many criteria we need to apply when thinking about a public organization's finances.

That said, the main point of emphasis on the income statement is the relationship between revenues and expenses. As mentioned, net assets are a good indication of that relationship. If revenues increase faster than expenses, then net assets increase. If expenses increased faster than revenues, net assets would decrease. The income statement can help illuminate several follow-up questions to understand an organization's revenues-expenses relationship in some detail:

1. How much did net assets increase since last year? How much of that increase was in net assets without donor restrictions? How much was in net assets with donor restrictions? Growth in net assets without donor restrictions indicates that the organization's core programs and services are profitable. An increase in net assets with donor restrictions can mean many other things. It could mean the non-profit received additional donations that had a time or purpose restriction. The non-profit would need to meet those restrictions over multiple years. It could also mean the non-profit's endowment reported a positive return. That return may be reinvested in the endowment or diverted to cover core operational expenses.
   
   
2. What portion of revenue is from earned income versus contributed income? Earned revenue, or revenue generated when the organization sells goods or services, is attractive because managers have direct control of expenses needed to generate that income. Contributions are less predictable and less directly manageable but do not have an immediate offsetting expense – except for fundraising and development costs. That said, the disconnect between donor and beneficiary provides the non-profit with the ability to manage expenses given changes in contributions.
   
   
3. What percentage of earned revenue is from the organization's core programs and services? What proportion is from other activities and other lines of business (sometimes known as unrelated business income)? It is common for non-core programs and services to subsidize core programs and services, but is that the right policy for this organization to pursue? Non-profits that generate unrelated business income must pay UBIT – unrelated business income tax on profits earned from activities not substantially related to the charitable organization.
   
   
4. To what extent does this organization rely on in-kind contributions? Investment income? In-kind contributions will vary by type of organization. Food banks are more likely to report in-kind contributions as a major source of revenue. Treehouse received an in-kind donation of an interest in their building. Professionals in legal, marketing, and accounting service industries frequently provide local non-profits with services for free or at steep discounts. These are reported as in-kind donations.

How much the non-profit reports as investment income largely depends on the size of the investment portfolio. Foundations, for example, will report investment income as the single largest source of revenue. In contrast, for most non-profits, investment income makes up a smaller portion of overall revenues. Still, it often allows the organization to report a surplus at the end of the fiscal year.

To illustrate, let us examine Treehouse's Statement of Activities for the year ending June 30, 2022. The income statement reports revenues by source and by restriction and expenses by function (program, management, or fundraising). While Treehouse does not report expenses for each program, a detailed list of expenses can be found in the Statement of Functional Expenses.

For FY 2022, Treehouse reported $23.4 million in revenues. Of that, $10.04 million was from contributions and grants, $0.7 million was from in-kind contributions, and $12.7 million from contract revenue. Most of Treehouse's income is not subject to donor restrictions (i.e., without donor restrictions). Investment income, classified as non-operating revenues, is reported separately from operating revenues (i.e., grants, contributions, and contract revenue). Investment income would be classified as operating revenue in instances where the non-profit has invested a substantial proportion of its resources to generate income to support core programs or cover overhead costs. That is not the case for Treehouse.

Net assets released from restrictions represent a reclassification of net assets. That reclassification will appear as a reduction in net assets "with donor restrictions" and a corresponding increase in net assets "without donor restrictions." In doing so, the non-profit is reporting it has satisfied the intent of the donation or grant received in the current or prior period. Remember, restrictions only apply to revenues; they do not apply to expenses, hence the need to release assets from restrictions.

In the expense part of the Statement, we see that expenses for program services were $19.6 million – approximately 83 percent of total expenses. Treehouse reports non-operating income separately from operating income, which indicates that income generated from investments and other sources was not derived from core activities. Not surprisingly, Treehouse reported investment losses at the end of FY 2022 ($1.4 million). It also reported the in-kind donation of an interest in the building ($7.1 million) as a non-operating activity. In doing so, the organization conveys to stakeholders that it does not view this donation or related activities as part of its core operations.

Change in net assets is a focal point when reviewing the Statement of Activities. In FY 2022, Treehouse reported a positive change in net assets of $5.6 million. Much of this can be attributed to the in-kind donation of interest in a building ($7.1 million). Adjusting for the gift, Treehouse reported a deficit at the end of FY 2022. However, that deficit was primarily driven by investment losses – not the nonprofit's core operations. Judging an organization's performance using data from a single year is often difficult. Five years of data could provide a more compelling narrative of the organization's financial position and operating results.