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Understanding Financial Reports - Part Two

Balance sheet report with calculator

Last month, our Understanding Financial Reports series looked at the context of financial governance. This time, we want to give you a bit of accounting context and also to further set the scene with a reminder that financial reports are not just a task for your accountant, they are a source of information that supports your decision making.

Do we invest in that program? Are our unit costs right? Can we afford an additional person to help meet demand? Financials are not the only information source, of course – you should also consider, as appropriate for the particular situation, client or member feedback, KPI measures, engagement or utilisation rates, or whatever is meaningful to your organisation.

In the same way that you use your car dashboard when driving or the weather forecast when planning your weekend, financial reports provide data to inform your decisions.

The words

Accounting 101

Accounting is laden with jargon and acronyms, as are many specialist areas, and we want to explain some of the terms and concepts to help you get comfortable with your financial reports.

In our experience of delivering our Understanding Financial Reports training, we find that people assume they don’t understand finance because they don’t understand the jargon – but as soon as we explain what the terms mean, people are able to make the connection between organisational finance and their own personal or household finances and feel much more confident approaching the financial reports.

The Chart of Accounts is the list of accounts – numbers and names. These are essentially the ‘filing labels’ for your accounting records. There should be not too many, not too few accounts – too many will give you tediously long reports with relatively low values in each and will be very difficult to budget with any accuracy (resulting in lots of low-value variances), while too few will leave you wondering what exactly is bundled into each account.

Italian Renaissance mathematician Luca Pacioli depicted in the old Italian 500 lira coin

There are five categories of accounts – only five, wherever you are in the world, and since the time of the Merchants of Venice – Assets, Liabilities, Equity, Income and Expenses.

The first three categories of accounts – Assets, Liabilities, Equity – appear on the Balance Sheet.

  • Assets are things that you own – tangible or intangible – including cash in the bank, equipment, real property, intellectual property and debtors/accounts receivable.
  • Liabilities are things that you owe to a third party, and include items such as a credit card balance, grants in advance, employee leave entitlements and creditors/accounts payable.
  • Equity is the difference between assets and liabilities, and represents the net assets of the organisation. In NFPs it is often called Accumulated Reserves or Members’ Equity.

The remaining two – Income and Expenses – appear on the Profit & Loss or Income & Expenditure report.

  • Income, also known as revenue, is the money that comes into the organisation – from sales, grants, fundraising, investments, etc.
  • Expenses, or expenditure, is the money that goes out – salaries, client expenses, program costs, rent, utilities, etc.
Woman in in glasses sitting inside and working with laptop

Cost centres are departments or streams within a business with discrete activities and expenses (and maybe income also). Cost centres (called Tracking Categories in Xero, Jobs in MYOB) allow you to track the activities of a department, program, event etc and to understand the costs associated with the activity. When there is matching income, a cost centre report shows whether the program expenditure is within the funding envelope.

Over the years, we’ve met many organisations that try to achieve that program level of detail by replicating accounts rather than using cost centres. For example, they have a separate grant income account for each funding stream, a separate salaries account for each program, or a separate printing account for each department. This approach makes for a very long chart of accounts and very long reports.

It also makes it very difficult to split out the information that has been captured for each activity – while the data is there, it isn’t easy to see how the particular program or activity has performed. Much better to record each transaction against the relevant income/expense account and appropriate cost centre, allowing you to ‘slice and dice’ your financial information in more meaningful ways.

Spreadsheet document opened in laptop

Cash and accrual accounting are two methods of accounting. Cash accounting records transactions when money is received to or paid from the bank. Accrual accounting records transactions at the time the commitment is made. Both are valid methods of accounting but accrual accounting does provide a more full and accurate view of the organisation’s financial performance and position in that it captures obligations – made by you and to you – before they have hit the bank, thereby giving you a better view overall and better ability to make decisions.

Let’s take grant income as an example, often paid quarterly in advance. Under cash accounting, if you receive a quarterly grant instalment in January you would record the whole amount as income in January, and nothing in February and March.

Under accrual accounting, you would record only one-third as income in January, allocate the remainder to a liability account and later transfer from liability to income in February and March (we’ll explore this more when we look at the Balance Sheet in a future instalment).

Accrual accounting takes a little more effort, a few more transactions and a bit more expertise to record correctly, but it does provide a better allocation of income and expenses to the correct period as well as a clearer view of financial performance and position.

The ACNC requires medium and large charities to report to them on an accruals basis, so that applies to all charities with annual turnover greater than $250,000. The ATO has a higher threshold for GST reporting – businesses up to $10 million turnover can choose cash or accrual, and endorsed charities can choose either method, irrespective of turnover. Over the $10 million threshold, accrual accounting is required for GST reporting (note that you could still produce your internal financial reports on a cash basis if you wish).

Next in our series...

We hope this helps to explain some of the accounting terms that you might come across in your review of your organisation’s financial reports. Tune in next time to explore the Profit & Loss statement with us.

Accounting For Good offers our Understanding Financial Reports training as custom training, delivered in the comfort of your boardroom or ours. Contact our team of friendly professionals to find out how we can help you or find out more about not for profit accounting.

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