New AICD Resource: Financial Fundamentals for Not-for-Profit Directors

Australia’s not-for-profit (NFP) sector, with more than 600,000 organsiations, employs over a million people and services millions more, many of whom are disadvantaged. Recent royal commissions mean governance is in the spotlight and that community expectations are higher for NFP and other leaders. In this edited extract from Financial Fundamentals for Not-for-Profit Directors author S. Dianne Azoor Hughes, an independent consultant in governance, risk and audit, shows why her book, which includes questions for those reviewing financial statements, is a timely resource for NFP directors to develop their financial literacy.

Financial governance includes the response to reporting obligations, both internal and external, and the consideration of critical financial issues and risks that are implicit in those processes. For NFP directors and boards, ensuring that “good decisions are made by the right person” includes identifying the expertise and capabilities required to carry out different financial roles within the NFP. Depending on its complexity, the financial skills and expertise needed by the NFP board and senior managers may range from basic bookkeeping to an in-depth knowledge of technical accounting requirements.

Financial governance includes oversight of: The employment of appropriately skilled persons; consultation with external professionals as needed; selection of external advisers with appropriate expertise and experience; and the continuing professional education of financial staff employed by the company.

Financial governance practices will be significantly more extensive in large NFPs with more diverse activities and/or complex transactions.

Reporting

Most NFPs have both internal and external reporting obligations. All NFPs need internal reporting to monitor performance and to ensure that the NFP can pay its debts when they fall due. External reporting obligations vary with the size and nature of the company and its sources of finance.

Many NFPs will have obligations under their relevant reporting legislation to present and approve annual financial statements that are prepared in accordance with Australian Accounting Standards to present a ‘true and fair’ view of the company.

NFPs may be required to lodge their financial reports with the appropriate regulator such as Australian Securities and Investments Commission (ASIC), the ACNC, consumer affairs or the Australian Taxation Office (ATO). NFPs may be obliged to make their financial statements available to the public if they are held on public database such as the ASIC or ACNC databases, or they may choose to make them available to the public by presenting them on their website for funders and donors to access.

NFP directors need to ensure they are aware of the extent of their regulatory responsibilities, together with the need to present information for funding applications, funding acquittals and in response to their members’ and/or supporters’ requests for information. NFPs may also have reporting obligations to the ATO and other government agencies.

Solvency

NFP directors have a responsibility to ensure the NFP is solvent and therefore able to pay its debts as and when they fall due. This means that NFP directors must be able to determine if there are reasonable grounds to believe the NFP can pay its debts. Insolvency is defined as the inability of the NFP to pay all of its debts as and when they become due and payable. There are significant penalties in the Act for directors of for-profit companies that trade while insolvent. For NFP directors, there may also be penalties under the relevant legislation if due care and diligence is not exercised in carrying out their duties.

Financial literacy

Financial literacy encompasses a combination of skills, background and experience. For NFP directors, financial literacy is largely about the ability to: 1. acquit formal legal and statutory obligations as they relate to financial matters, such as signing off on the annual financial reports; 2. monitor financial results to assess solvency and going concern; 3. balance risk mitigation (financial and otherwise) with the ability to drive their NFP’s financial performance by understanding the ‘story’ told by its financial reports; and 4. know when financial experts are required to assist with the above points.

While these are the four pillars of financial literacy, other factors may shade the depth of financial skills and knowledge needed, such as their NFP’s operational model; operational plans and strategy; stage of growth; financial health; risk profile; skills mix around the boardroom table; and fit with the economy.

‘Financial literacy’ describes a basic understanding of the meaning attributed to the financial information of the NFP. The expected level of financial literacy of NFP directors is generally much higher than the level of financial literacy expected in the general population. An NFP board will comprise directors with various skills relevant to the NFP’s purpose and activities. In addition, each NFP director should have an appropriate level of financial literacy, and the NFP board should have at least one NFP director, or an adviser, who is a financial expert. A financial expert can identify and action the most appropriate accounting treatment in a given set of circumstances. A financial reporting expert can choose and apply the correct accounting framework. Accounting frameworks explain when, why, what and how transactions should be described in accounting terms in a financial report. Several different accounting frameworks exist and the applicable accounting framework will not be the same in all circumstances.

However, the financially literate NFP director is not expected to have an in-depth knowledge of different accounting frameworks or the ability to action the required accounting treatment. Instead, a financially literate NFP director should be satisfied that the accounting framework required in the circumstances has been applied. He or she should also be able to understand when financial expertise is needed and why a particular course of action has been followed.

Financial reporting is a language used to explain business activities in financial terms. NFP directors should have an in-depth understanding of the NFP’s activities and must have confidence ‘the story’ portrayed in financial terms in the NFP’s financial statements is consistent with their understanding. The ability to read and understand this ‘story’ is at the heart of an NFP director’s financial literacy.

Summary

NFPs vary in their purpose, legal structure and size. Their reporting obligations are set out in the legislation under which they are established, and their resources and social impact may be closely correlated with support from their stakeholder. NFP directors have a duty of care, similar to the duty of care expected from for-profit directors, to ensure they have a level of financial literacy commensurate with the size and nature of the NFP’s activities. These obligations are set out in legislation and illustrated by numerous examples in recent case law.

Financial literacy is needed to implement financial governance practices that are appropriate for the business model in place. NFP directors need to be concerned with monitoring their NFP’s performance to demonstrate they have reasonable grounds to believe their NFP can pay its debts when they fall due. NFP performance is explained in both internal and external financial reports.