How Board Members Can Learn to Spot Red Flags

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Red Flag

This post is reprinted from NAF’s blog, Balancing the Mission Checkbook.

Here we go again. A few weeks ago, Nonprofit Quarterly reported about the fallout from reports by FEGS Health & Human Services in New York of an unexpected $19.4 million loss: changes in the executive office and cuts to programs and budgets. Like many others in the sector, one of my first reactions was to ask, “Where was the board?”

This question comes up all too often: People’s Health Clinics in Baltimore closed in June 2014 with almost $500,000 owed to the IRS for payroll taxes, a cancelled federal grant, unpaid rent and other bills. Locally, we’ve been following the troubles at Community Action of Minneapolis and St. Paul-based education services provider TIES’ critical audit report and financial challenges. Did the boards of these organizations miss the red flags like diminishing cash, ballooning debts, and recurring deficits? In each of these news stories there is documentation, audit reports, and other evidence of problems. If we can read about the information now, why didn’t the members of the board see the problems and address the problems?

Maybe the boards did miss the red flags. We have the gift of hindsight. At the time, however, the signs may have been obscured for a variety of reasons. One is the role of governance vs. management. In the news article above, the chair of the TIES board’s executive committee said, “Directors were not aware of the problems that the audit revealed because they aren’t involved in day-to-day operations.” That is absolutely true, and one of the quandaries of board members as fiduciaries. After all, how would a board member know that a report was filed correctly, or if a contract payment was adequate? Most board “best practices” warn about micromanaging. Boards rely on the executive and staff to manage the organization and to be forthcoming and transparent with information, including information about problems.

Another factor is the complexity of nonprofit business models. FEGS Health & Human Services is a multi-service agency with a $250 million budget and multiple nonprofit and for-profit subsidiaries. This is a big, complicated business entity with equally complex financial reports. While most nonprofits are much smaller, many nonprofits operate a variety of programs with different types of revenue, cost structure, cash flow, and capital. Business models are complex. If I’m a board member, which of the financial reports do I need to study and scrutinize? This is a serious challenge for all board members, especially those who don’t feel confident in their finance knowledge and skills.

What can board members do? Learn how to ask good questions.

One advantage that board members have is time and a broad scope. Serving on a nonprofit board is a cumulative activity carried out over a three to ten year period. Auditors, funders, and watchdogs generally have a sort of tunnel vision—information is reviewed for a short time period, a single program, or for a limited aspect of the organization. Board members review financial reports, program results, and strategic goals many times and have the opportunity to continually gain more knowledge and understanding. They learn about what’s important or typical or unusual. All of the problems reported in these stories built up over time.

Rather than expecting board members to instantly recognize a problem in the making, let’s encourage boards to learn to ask the questions that will lead them there. One month with a deficit isn’t a red flag. But questions must be asked when a board sees financial reports with unfavorable variances and deficits at meeting after meeting. The same goes for other financial indicators such as cash flow dips or bumps up in liabilities. I know board members who are concerned about asking a “dumb question.” My advice to them is, OK, don’t ask it the first time the question comes up. But, please, ask it by the third time you have the same question.

Practice asking questions like these:

  • “Can you help me understand what this means?”
  • “Is this is a trend or pattern that we should talk about?”
  • “Is this unexpected?”

You can be certain that you aren’t the only member of the board who wants to know the answer. Board members have the advantage of time and cumulative understanding. Take advantage of that, and ask some questions.

Related posts

This post is essentially the next chapter to two earlier posts. In “Why board members miss the red flags,” I suggested that one problem is how board members use financial statements. In that post, I proposed that boards pay too much attention to income statements and budgets—short-term information—and not enough attention to the long-term perspective of balance sheets. Yellow flags are on the income statement. Red flags are on the balance sheet.

In the follow up post, “Why board members miss the red flags, part 2,” I acknowledged the times when boards of nonprofits with critical financial problems looked the other way. There’s usually a combination of embarrassment and fear of tarnished reputations and reluctance to take on the huge task of dealing with the problems. While some individual members may raise the right questions, collectively the board skirts the problems and fails to act. If you are a member of the board of a nonprofit with red flags flying, it may be up to you to grab the reins until attention is paid. It’s not fun, but nothing less will do.

Kate Barr is executive director of the Nonprofit Assistance Fund.

  • Ron Wormser

    There are two basic options for increasing financial literacy of nonprofit boards: educate members or have board members with requisite financial acumen.

    The latter is more easily attained and the more effective use of all board members’ time. Given the need for a broad range of expertise on most boards, better to build a team with diverse expertise, a collection of specialists rather than jacks of all trades.

    A complementary tool is to make effective use of independent auditors by tasking them, during their periodic audits, to look for areas of financial vulnerability. It may cost a bit more, but is cheaper than trying to address long-festering weaknesses.

  • Kate Barr

    Good points, Ron. I have found that even board members with prior financial expertise still need to learn about nonprofit finance and to gain better understanding of the particular business dynamics and financial results of the organization. That’s why I made the point in this piece that board members should take advantage of cumulative understanding and get better and better at recognizing both success and problems – and to ask questions! I also believe strongly that all board members need to be invited in tot eh inner sanctum of finance and dispel the myth that they can’t understand the financials.

  • colleenL

    Thank you for writing this important piece. I have begun using these types of examples in a class I teach to those entering the Development field. We need to understand the financials, and ask the hard questions that potential donors may ask as well.

  • Ron Wormser

    Kate, I couldn’t agree more with you about the imperative for even the financially literate to learn how nonprofit finances differ from those in the private sector. (As an aside, the trend to making nonprofit financial reporting more similar to for-profit report has not, in my view,helped but hindered both awareness and understanding of our sector’s distinguishing characteristics.)

    On the other hand, while I understand and appreciate the theory of all trustees becoming minimally conversant with nonprofit finances and associated reports, despite years of effort, I’ve not seen that Nirvana attained. What I have seen too much of are the very real risks of a little bit of presumed knowledge being manifested, almost always causing more problems than not. Good idea? Yes. Achieveable? Doubtful.

    One final observation: too many nonprofits use financial reports that are designed for accounting purposes for reports to managment and the board. If you wanted to know what was going on in a checical laboratory, receiving reams of formulas would be more confusinig than illuminating. Using accouting data to inform nonaccountants about what’s going on with a nonprofit’s finances is similar.

    Presenting financial information in lay terms, in how management and trustees think about what’s going on at the organization offers a greater potential for the information to be understood and increases the opportunity for decision-makers to make more informed decisions.

  • Keenan Wellar

    Having a requirement that board members have “requisite financial acumen” as Ron suggests is highly problematic because it assumes those same people have the skills they need for governance – strategic and generative abilities that relate to the mission and the change the organization wants to create in the world. They may also be strong other other fiduciary responsibilities – perhaps they love updating bylaws or policies and are very skilled in those tasks.

    A non-profit agency can have a perfect balance sheet and be otherwise a complete disaster. In fact, interpreting financial documents without the requisite understanding of what the organization is trying to achieve and the environmental contexts of those pursuits is probably a much more common board deficit than “lack of financial people.”

    Where there are concerns, more frequent engagement of an independent auditor is certainly an option, but the auditor can report on financial health, but not on organizational health – that’s what non-profit governance is all about, and the financial picture is only one part of that.

    Fiduciary concerns often dominate strategic and generative efforts on boards to the detriment of organizational outcomes, but even then, boards that think they are strong on their fiduciary efforts often forgot that fiduciary responsibilities are not solely limited to bank balance.

  • Kate Barr

    Thanks for your comment, and a hearty “Hear! Hear!” to your observation about financial report format and content. Information created for accounting and compliance with accounting rules is not what boards need to understand and evaluate the financial condition of the organization. Good information takes time to plan and create!

  • Kate Barr

    Keenan:

    Your good points reinforce the reality that in all cases, there is no one question, one answer, or one factor that determines organizational health or success. Thanks for the comment.

  • Keenan Wellar

    Thanks Kate! I recently attended a service club meeting where members discussed a certain charity and other than a vague reference to their tagline, their encouragement to donate to that charity was founded mainly in “their low overhead costs.” And people actually got excited and clapped.

    This made me ever so sad. As it happens, I know the field where this group operates, and a lot of the work they do and the way they do it is arguably delivering very poor outcomes – but with low overhead.

    I’m afraid it’s not an uncommon trend to evaluate charities as though they are making widgets and their efficiency and outcomes can be judged in that light.

  • Gary Altheim

    Here is another Board of directors that has allowed willful blindness for nearly 2 decades. https://www.change.org/p/give-the-fort-washington-armory-back-to-the-community. How do you get Armory Foundation Board members to take responsibility when community board members, city, state and public officials are also turning a blind eye. Willful Blindness is severer and contagious and..

  • Warren Hawk

    I sat on a board for a short time, one year. During that time there was a continuous line item that was labeled miscellaneous in our budget reports, but there was no break down of expenditures. I continually questioned that but was never given a detailed analysis of what it was used for or why we needed it. I later discovered a company credit card was a part of that expenditure and use. At times the Director of the organization mistakenly used the company credit card for personal expenses at different times but was given time to reimburse that account.
    I resigned from that board as I felt there was no honesty or trust in the board member’s judgment.