What financial statements can never tell a director

What financial statements can never tell a director was published in the November 11, 2005 edition of Columbus Business First.

Repeated crises and scandals in the public and private sectors continue to place heavy focus on the adequacy of financial statements and the effectiveness of auditors in identifying problems. 

While good should certainly come from this focus, the public discussion is raising false expectations that more auditors and better audited financial statements will make boards effective and avoid disasters.  

These expectations cannot be met for a simple reason:  Financial statements are based on generally accepted accounting principles, which represent a complex and sophisticated system for estimating the financial condition of an organization. An informed board of directors needs far more than complex estimates of condition. It needs reports that tell it in straightforward terms about future risks and timely execution of priorities. 

Aside from outright fraud, I believe most organizational failures have at least one of the following causes:

• Inadequate focus on priorities.
• Poor execution.
• Failure to pay critical bills on time.
• Unanticipated cash shortages. 

There are straightforward ways to stay on top of these issues, but financial statements will not easily yield that information.  The typical financial report a board receives consists of the three financial statements required under GAAP – a balance sheet, an income statement and a cash reconciliation. These tables are not designed to address these four major causes of failure.

Ringing the alarm

Daily management is often a series of interruptions and back-to-back meetings. The press of immediate demands can easily sidetrack management from higher-level strategic issues and from the long-term priorities needed to achieve that strategy. The board, by its more periodic and strategic attention to the organization, can in many circumstances be better equipped to maintain focus on strategy and priorities than the operationally focused staff. Financial statements have limited value on this front. 

Every project has its ups and downs. Slippage in key programs can be subtle but ultimately disastrous when it harms constituents, misleads donors, violates grant requirements or erodes goodwill. Especially in small companies and most nonprofits, slippage occurs because the staff is overcommitted and spread across too many tasks. 

A board needs a process to ring alarms when slips start to accumulate so the board can authorize changes in priorities, resources or commitments in a way that helps the staff to keep the highest priorities on track. Unless slips create significant changes in revenue or expenses, financial statements will not be a reliable ringer of alarm bells. 

Juggling which bills to pay and when to pay them is the name of the game for many finance officers. Putting off paying some bills in order to pay the most vocal vendors can be disastrous when the unpaid bills are to the insurance company, retirement plan or IRS.

Having some bills hang over from the previous month is routine, and financial statements report this well. Unfortunately, financial statements don’t generally distinguish between a bill that is unpaid for two weeks versus one that is unpaid for two months, nor does the typical financial statement tell you if the unpaid bill is to the IRS, the power company or just the local office supply store. 

The tripwire of crisis is running out of cash. Every month you need to know the amount of cash that will be readily available for the next few months and what future events could potentially compromise your solvency if they didn’t occur as planned. The snapshot nature and accrual focus of financial statements aren’t well suited to answering these forward-looking questions. 

What to ask for

To be on top of these critical issues, the well-informed board will ask for these four reports:

• The knowledge that your CEO’s focus is on the highest priorities should come from a monthly narrative report on the CEO’s activities.
• The knowledge that the top priority projects are on track can also come from a monthly narrative report that describes recent progress on those projects and is accompanied by a brief table showing year-to-date revenue from and expenses for each project compared with what the project had planned.
• The knowledge about the organization’s unpaid bills can come partially from an accrual statement, but the board should also receive a monthly table listing all major unpaid bills and highlighting any bills unpaid for over 45 days and to whom they are due. 
• The knowledge of your cash situation can come partially from the cash financial statement, but the board should also receive a cash projection for the next three or four months with a commentary on any major sales, grants, gifts, or payments that are expected in those months. The best way to be on top of this issue is to prepare your budget on a cash basis and report monthly revenue and expenses to the board on a cash basis.  

An effective board receives all the information it needs in a form that is easiest for all its members to use and understand. The four reports are more useful to the board and easier to understand than conventional financial statements.

A board will not be remiss if it leaves the complexity of accrual financial statements to the staff and, if the board is large enough, to the finance and audit committees. 

Allen J. Proctor was chief financial officer of Harvard University and is the author of “Linking Mission to Money, Finance for Nonprofit Board Members.” Reach him at  www.proctorconsulting.org

Copyright 2005. Reprinted with permission, Business First of Columbus Inc.