This article is abridged from Understanding Financial Statements: A Strategic Guide for Independent College & University Boards, by John H. McCarthy and Robert M. Turner with Sandra L. Johnson, Editor. Copyright 1997 Association of Governing Boards of Universities and Colleges, One Dupont Circle, Suite 400, Washington, DC 20036. Reprinted with permission.
To order this or other AGB publications, call the AGB Publications Department at 800/356-6317 or contact the association’s web site at www.agb.org. The cost of Understanding Financial Statements is $39.95 plus $3.00 shipping.
As colleges and universities grew over the last few decades, their finances became increasingly complex. In 1996 the Financial Accounting Standards Board, the accounting and standard-setting body for corporations and nonprofit organizations, including educational institutions, instituted new financial reporting requirements to make financial statements easier to read and use to assess the effectiveness of a school’s use of its resources.
The financial statement of activities presents aggregated information about the revenues, expenses, and other sources of a school’s funds. The basic requirements for a statement are:
- that it report the total amount of the changes in each of the net asset groups (unrestricted, temporarily restricted, and permanently restricted);
- that it show the amount of the total changes in all net assets for the period;
- that it show all expenses as if expended from unrestricted net assets. To the extent that temporarily restricted net assets are available to meet current expenses, they must be shown as having been “released” from restrictions and reclassified into unrestricted resources.
The FASB did not prescribe a single format for the statement of activities; many have been used. However, the new statement of activities is easier to understand than its predecessor, which reported financial information by funds.
Under Statement of Financial Accounting Standards No. 117, a “measure of operations” is permitted in the statement of activities. Most schools manage their financial affairs by establishing operating budgets and measuring their operating performance against that budget. For that reason, many present a measure of operations that is linked directly or indirectly to the budget.
Overall, the statement of activities captures information about the operating activity of a school, its investment management results, and its fund-raising activities. Therefore, the four major areas most schools will want to measure in their statement of activities are overall results, operating results, investment performance, and fund-raising results.
The sample statement of activities for the hypothetical SanJo University on the opposite page is for a school with a budget larger than that of most theological schools, but it gives the basics for analysis. It contains four vertical columns for fiscal year 1996: unrestricted, temporarily restricted, permanently restricted, the 1996 total, and the 1995 total for comparison. Horizontal columns have three major sections in bold face: operating revenues, operating expenses, and nonoperating activities. Subdivisions of these categories are indented beneath each major heading, and are not in bold face. At the bottom, three categories appear: “net increase in net assets”; “net assets at beginning of year”; and “net assets at end of year.”
Questions To Ask
The fundamental question the statement of activities answers is: How well did the institution use its resources to provide services to its constituents? Board members and administrators evaluating the answer to this broad question may find the following eight specific questions helpful.
1. Overall, how did the school perform financially for the year?
Indicators: An increase in net assets as a percentage of the beginning balance of net assets; increase in unrestricted net assets as a percentage of the beginning balance of unrestricted net assets; increase in temporarily restricted net assets as a percentage of the beginning balance of temporarily restricted net assets; increase in permanently restricted net assets as a percentage of the beginning balance of permanently restricted net assets.
The net increase in net assets should be increasing at a rate exceeding inflation and, one hopes, at a much quicker pace. It is important to focus on both the unrestricted and permanently restricted net assets: both should increase at a rate exceeding inflation.
How did SanJo University perform financially in fiscal 1996? The university’s net increase in net assets for the year was $23,850, or 7.5 percent of the total net assets of $317,562 at the beginning of the year. In addition, each of the three net asset groups—unrestricted, temporarily restricted, and permanently restricted—showed growth. In all cases, the level of growth exceeded that of inflation, which was roughly 3 percent. These increases in net assets for SanJo University in fiscal 1996 enhance its financial strength.
2. Is the school living within its means?
Indicator: An increase or decrease in net assets from operating activities.
A net increase from operating activiites indicates the school’s operating revenues exceeded its expenses and that generally it is living within its means. If a school is not living within its means, it must find a way to meet the deficit in the short term and create a surplus in future years.
Now that schools have adopted the financial-reporting models required by FASB, more are likely to budget in a manner consistent with their external financial reports.
SanJo’s operating revenue in fiscal 1996 exceeded its operating expenses, so the university appears to be living within its means. SanJo also can channel a portion of its surplus for the year into quasi-endowment funds or the physical plant, both of which would enhance the university’s long-term financial position.
3. How reliant is the school on each of its operating revenue sources?
Indicator: Each operating revenue source as a percent of total operating revenues.
The broader the school’s revenue streams, the less affected it is by fluctuations in any one source of revenue. Further, each revenue source has a different life cycle. The mix of short- and long-term revenue sources and the volatility of each can be important when considering new long-term commitments.
How reliant is SanJo University on each of its operating revenue sources? Fifty-six percent of its revenue comes from tuition and fees. This indicates that SanJo depends heavily on such revenue, although not to the extent of some private institutions. The university will need to monitor this dependence and consider taking corrective steps if it becomes more dependent on tuition.
4. Do operating expenses by cost category reflect school priorities?
Indicator: The percentage of the total that each operating expense represents tells whether the school’s spending patterns reflect its mission.
Instructional expenses should be as high as possible in relation to total expenses. Schools may also want to assess instructional expenses per full-time-equivalent student. Schools are paying close attention to support expenses (security, legal costs, development), trying to maintain or improve service but at a lower cost.
Other key questions: Are revenues increasing at a faster rate than expenses? Are expenses increasing in line with inflation or more rapidly?
Do SanJo University’s operating expenses reflect its priorities? At 41 percent, the highest proportion of the university’s expenses are being incurred for instruction and research. This suggests that the university focuses its activities on teaching and research. At 16 percent, the second highest proportion of the university’s expenses are being incurred for institutional support (which includes certain administrative functions). SanJo may want to assess more carefully—and possibly reduce—its spending on institutional support.
5. How dependent was the school on investment or endowment income and annual giving to meet its operating needs?
Indicator: Private gifts and grants as well as investment income as a percentage of total operating revenues.
Most schools rely on external financial support. It is important to understand the extent of this reliance and whether the resources are dependable. Private giving and investment (endowment) income also increase a school’s operating flexibility, enabling it to leverage other current revenue sources, especially tuition. Many schools are becoming increasingly dependent on this revenue stream.
How dependent is SanJo University on the return on its endowment investments and annual giving to meet its operating needs? Approximately 12 percent of the university’s total unrestricted operating revenues comes from private giving and investment income. A closer look at SanJo’s statement of activities indicates that private giving has increased but investment income has declined. Clearly SanJo University depends greatly on these other sources to meet operating expenses, and without them it would have incurred a substantial deficit.
6. Do the auxiliary enterprises of the school support their own costs?
Most colleges and universities provide auxiliary services such as bookstores and food services. These need to be priced and operated so they are not a financial drain. It is important to understand the operating results from auxiliary enterprises and the manner in which they are determined. In the past, not all schools allocated fully to these enterprises the costs associated with operating them (for example, depreciation). Many schools are choosing to contract out rather than self-manage certain areas of their operations that are unrelated to the school’s mission.
Are SanJo University’s auxiliary enterprises supporting their own costs? In fiscal 1996, SanJo produced an auxiliary surplus that enabled it to augment certain programs in service to its overall mission. We do not know, however, whether SanJo fully allocates the actual costs associated with operating its auxiliary services to the reported item.
7. How well did the school manage its investments?
Indicator: Interest income and dividends plus net realized and unrealized gains less related management and custodial expenses as a percent of average market value.
Investment income reflects the size of a school’s portfolio as well as earnings on its investments. An imbalance among the rates of investment income, spending, and reinvestment can result in an erosion of the future purchasing power of the school’s portfolio. (Growth must be greater than inflation and use.) Board members need to look at total return on investment, including interest income and dividends as well as net realized and unrealized gains. A board may also adopt a spending policy that permits the use of the yield (dividends and interest) as well as a prudent portion of the portfolio gains.
How well did SanJo University manage its investments in 1996? Some of the requisite information to answer this question is included in three lines: under operating revenues, “long-term investment income,” “investment gains used for operations”; under nonoperating activities, “investment gains reinvested.” The sum of these lines ($24,898) is divided by the average market value of SanJo’s investments in the accompanying investment notes (see Figure 2 at end of this article), and indicate an average market value of $244,948 for investments. Thus the total return on investments is 10.1 percent.
8. How well did the school manage its fund-raising?
The level of giving may not be readily apparent. Unconditional pledges are recorded as contributions when the donor makes the commitment and are reflected in the financial statements at the present value of the amount the school expects to receive. As a result, the amounts reflected in the statement of activities as “gifts” or “contributions” generally will not be the amount of cash the school actually receives from donors during the period.
On the other hand, the statement of activities measures contributions on the accrual basis, which should help readers assess the school’s overall fund-raising activities for the year.
The practices of many development offices differ from the standards the FASB established for recognition of a contribution. Thus the data the development office reports usually will differ from that reported in the financial statements. Conditional gifts or bequests are not recognized for accounting purposes until they become unconditional gifts.
It is important to understand why giving fluctuates from year to year. Charitable giving decreases a school’s reliance on other revenue resources and its need for external financing for capital projects. Charitable giving may be subject to volatility when tax regulations are revised or in times of financial uncertainty or recession. A school may want to compare its charitable-giving trends to those of peer schools. Rating agencies often consider the percentage of alumni (and sometimes the average gift) who give to their alma mater as an indicator of satisfaction.
Another important indicator is a summary of annual and capital campaign activity by source—information not available from the financial statements.
How well did SanJo University manage its fund-raising activities in fiscal 1996? The data is found under operating revenues in the line “private gifts and grants” and under nonoperating activities, in “capital gifts”; the total for 1996 is $13,543; the total for 1995 is $14,158. Fund-raising costs are disclosed in the footnote to the financial statements entitled “contributions” (see Figure 3 at end of this article). The figures in this category increased by $177, making the total fund-raising costs as percent of gifts recorded 20 percent for 1996 and 18 percent for 1995. The university will need to gather information and summarize for board members about the level of its alumni, corporate, and foundation giving for fiscal 1996.
Boards should keep in mind that the major objective of financial reports is to provide information for decision-making in support of the school’s mission. They should help boards address key issues, answer salient questions, and help them develop creative approaches to the challenges their schools face.
To view Figures 1-3, click here.
In addition to AGB publications (see above), The Non-Profit Resource Center web site (John Farino, Certified Public Accountant), http://www.1800net.com/nprc/ offers information on accounting standards and government regulations for nonprofits.