Targeting Reserves Bulls Eye versus Shot in the Dark

Presented by: Susan E. Colladay, CPA, Partner Charles F. Tate, Managing Partner

Tuesday, July 17, 2012

How Much Should We Have in Reserves?

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Agenda

What are Reserves Enterprise Risk Management Identify Events - Risks and Opportunities Event Quantification and Assessment Targeting Reserves Take Away Points Additional Resources
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What and Why

What are reserves? Why are reserves important? How does your organization define reserves?

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Illustration of Current Liquid Reserves

Total Budgeted Expense Total Net Assets Fixed Assets Expendable Fund Balance Ratio of Expendable Fund Balance to Total Expenses

$ 16,397,494 28,512,121 (135,482) $ 28,376,639 173%

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What are Reserves?

Reserves = Expendable, Liquid Net Assets
Net Assets (Assets - Liabilities)

Unrestricted

Temporarily Restricted

Permanently Restricted

Reserves

Not Available (fixed assets)

Program Restricted

Time Restricted

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ERM Expands on Internal Control Adding Three Components to Risk Assessment

Control Environment ERM Objective Setting Control Activities

ERM Event Identification

Monitoring

ERM Risk Response

Information & Communication

Risk Assessment
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Enterprise Risk Management (ERM)

Developing a reserves target is similar to ERM.

ERM is a process, effected by an entitys board of directors, management, and other personnel, applied in strategy setting across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, in order to provide reasonable assurance regarding the achievement of entity objectives.

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ERM - A Top Down Approach From Strategy to Reserves

Strategic Plan

What are the mission critical initiatives?

Operational Plan

How do we get there?

Financial Plan

How much will it cost?

Reserve Policy

How will the financial plan impact reserves? What is the time horizon and risk tolerance?

Investment Policy

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Identify Events Sample Risks

Economic
Capital availability Credit default Concentration Liquidity Financial markets Unemployment Competition Mergers and acquisitions

Natural Environment
Emissions and waste Energy Natural disaster Sustainable development

Political
Governmental changes Legislation Public policy Regulation

Social
Demographics Consumer behavior Corporate citizenship Privacy Terrorism

Technology
Interruptions Electronic commerce External data Emerging technology

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Identify Events Sample Opportunities

New Programs
New programs in strategic plan Research and development costs Advertising and public relations Related overhead

Use of Facilities
Excess capacity Ideal location Database and systems Acquisition advantage

Personnel
Technically skilled Well trained Highly motivated Strong management team

Unique Aspects
Products or services Reliability or reputation Innovation Expertise in service delivery Customer service Financial stability Member or donor loyalty Fair pricing

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Summary of Quantified Risks

PRESENT VALUE OF OCCURRENCE RISK IDENTIFIED
(Rounded)
$(974,000) (1,912,000) (137,000) (300,000) (146,000) (4,267,000) (4,329,000) (327,000) (2,366,000) (428,000) (315,000) (54,000) (4,654,000) (296,000) (1,012,000) (210,000) (94,000) $(21,821,000)

1. Revenue Volatility 2. Investment Portfolio Volatility 3. States change Licensing Requirements 4. Licensing Changes to a Uniform process 5. Licensing Volumes and Revenues 6. Legislation 7. Legislation 8. One-Stop Shopping 9. Merger of sponsors/industry partners 10. IT Reengineering - general 11. Software upgrade product delivery 12. States Perform Their Own Processing 13. Administrative Fee 14. States Use Other Vendors 15. Competitor Expansion 16. Litigation 17. Massive Disaster
TOTAL ESTIMATED REQUIRED RESERVE
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Identify Events Determine Risk Response

Avoidance Disposing of a program Deciding not to engage in new initiatives/activities Sharing Buy insurance Joint venture/outsource Hedging risks

Risk Response Reduction Diversifying/rebalance Limits/processes

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Acceptance Self insure Accept risk that conforms to risk tolerance

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Identify Events Mapping Risks

ERM Risk Appetite Matrix (Exhibit 3.5 from COSOs ERM Guidance)

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Quantify Events - Risks Assessment

High

$$ $$$$

Amount of reserves will depend on events identified in the SWOT analysis. Events may be interdependent not isolated.

$$

Low

High

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Identify Events - Risks and Opportunities

Unique analysis for each organization

1. 2.

Identify every potential event, no matter how small Narrow the list down to significant events and use broad event categories Determine risk response (avoid, reduce, share, accept) Assess event likelihood / magnitude map the event in the ERM Risk Appetite Matrix Include board of directors, management, and others in event identification and risk assessment to gain consensus

3. 4.

5.

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Risk Quantification Worksheet Summary

Present Value of Occurrence (Rounded) /1 . $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $

No. Risk 1 2 3 4 5 6 7 8 9 Revenue Volatility Investment Portfolio Volatility States change Licensing Requirements Uniform Licensing process Licensing Volumes and Revenues Legislation Legislation One-Stop Shopping Merger of sponsors/industry partners

Exhibit Reference EXHIBIT 8 EXHIBIT 3 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6 EXHIBIT 6

2008 $

2009 471,710 (893,000) (44,500) (350,000) (8,750) (48,750) (167,000) $

2010

2011

2012

2017 (102,750) (200,000) (4,125,000) (4,185,000) (2,187,500) (43,750) (4,500,000) (243,750) (833,000) -

(974,000) $ 1,604,886 (1,912,000) (137,000) (300,000) (146,000) (4,267,000) (4,329,000) (327,000) (2,366,000) (428,000) (315,000) (54,000) (4,654,000) (296,000) (1,012,000) (210,000) (94,000) (21,821,000) $ (1,049,000) 555,886

(678,515) $ (1,447,095) $ (1,594,279) $ (151,000) (20,550) (44,500) (825,000) (837,000) (200,000) (350,000) (375,000) (8,750) (900,000) (48,750) (167,000) (250,000) (111,600) (20,550) (200,000) (44,500) (825,000) (837,000) (200,000) (350,000) (540,000) (8,750) (900,000) (48,750) (167,000) (61,650) (40,000) (44,500) (825,000) (837,000) (350,000) (8,750) (900,000) (48,750) (167,000) -

10 IT Reengineering - general 11 Software upgrade product delivery 12 States Perform Their Own Processing 13 Administrative Fee 14 States Use Other Vendors 15 Competitor Expansion 16 Litigation 17 Massive Disaster Total Estimated Liquid Reserves Needed (Rounded)
/1. Discounted at the 6.00% rate.

$ (1,040,290) $ (4,967,665) $ (5,588,645) $ (4,876,929) $ (16,420,750)

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Targeting Reserves (cont.)

How much is too much?

IRS has not successfully challenged accumulation of reserves in exempt organizations Amount will depend on each entitys Event Identification and Risk Appetite Document Target Reserve Ratio in a written Reserves Policy

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Characteristics of Comparable Organizations

Summary of Liquid Reserves (Exhibit 4)

(Source: 86 Organizations From Tate & Tryon Database)

Budget Net (millions) Assets

Average Median 25th Percentile 75th Percentile High

% of Budget 73% 62% 34% 99% 248%

Net Fixed Assets $3 $2 $1 $4 $23

Reserve $16 $13 $6 $22 $55

% of Budget 61% 48% 26% 84% 232%

$27 $25 $21 $31 $49

$20 $17 $8 $24 $65

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Liquid Reserves of Comparable Organizations A Refined Benchmark

Summary of Liquid Reserves (Exhibit 5)

20 Organizations with Non-Dues Revenue exceeding 90% (Source: Tate & Tryon Database)

Budget
Average Median 25th Percentile 75th Percentile High

Net Assets $20 $17 $11 $23 $61

% of Budget 83% 69% 42% 106% 237%

Net Fixed Assets Reserve $3 $2 $1 $5 $9 $17 $15 $9 $16 $54

% of Budget 70% 49% 32% 84% 210%

$25 $22 $20 $29 $44

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Conclusion

1.

The actual liquid reserve of 173% is at the high end for most organizations of similar size. The calculated reserve of 133% may be viewed as a minimum reserve based on the identified risks. National Association is unique because? We are not aware of any situation where the IRS successfully challenged the reserve of a section 501(c)(6).

2.

3. 4.

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Quantification and Assessment Same

Concept with Different Approach
Example reserves analysis for a 501(c)(3) credit to Operating Reserve Policy Toolkit for Nonprofit Organizations by NORI.
Major natural or manmade disaster Additional reserves needed 585,000 Economic recession (5% GDP decline) 0 Major capital expense Start a new program Funder 3 months late (earned income=$0) 0

90,000

Likelihood of occurring in next 3 years Impact on earned income (12 month period) Impact on donations Impact on investments Impact on demand for your goods and services Short-term impact on cash flow and costs Projected earned income Projected charitable donations & grants Projected investment and other income Projected revenue Projected expenses Net (loss) income if event occurs

50% -25% -15% -10% 50% 0% 300,000 425,000 90,000 815,000 1,500,000 (685,000)

30% -5% -10% -20% -10% 0% 380,000 450,000 80,000 910,000 900,000 10,000

10% 0% 0% 0% 0% 5% 400,000 500,000 100,000 1,000,000 1,050,000 (50,000)

10% 15% 0% 0% 20% 5% 460,000 500,000 100,000 1,060,000 1,250,000 (190,000)

50% 0% 0% 0% 0% 10% 400,000 500,000 100,000 1,000,000 1,100,000 (100,000)

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Take Away Points

Benchmarking is a starting point - not one size fits all Use ERM to develop a Target Reserve Identify Events Quantify and Assess Events Gain Consensus and Board agreement Develop Target Reserve Ratio Accumulating reserves is allowed Implement a Written Reserve Policy
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Questions or Comments?
Susan E. Colladay, CPA Partner, Audit and Assurance Services Direct: 202-419-5112 E-mail: scolladay@tatetryon.com

Charles F. Tate, CPA Managing Partner Direct: 202-419-5101 E-mail: ctate@tatetryon.com

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Additional Resources

Operating Reserves NonprofitAccountingBasics.org Website sponsored by Greater Washington Society of CPAs Educational Foundation Maintaining Nonprofit Operating Reserves A whitepaper by The Nonprofit Operating Reserves Initiative (NORI) Operating Reserve Policy Toolkit for Nonprofit Organizations An outcome of the whitepaper by The Nonprofit Operating Reserves Initiative (NORI) The Chronicle of Philanthropy series: Against the Grain (blog) by Rick Moyers, Vice President, Eugene & Agnes E. Meyer Foundation

Four Things Boards Should Understand About Operating Reserves, April 26, 2011

What Operating Reserves Are and Why They Matter, April 29, 2011 How Nonprofits Build Operating Reserves, May 3, 2011 Theres No Penalty for Having Reserves, May 6, 2011

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Speaker Biography
Susan E. Colladay, CPA, is a partner within the Firm's Audit and Assurance Services practice. In this capacity, she provides audit and consulting services to a wide variety of nonprofit organizations and their related employee benefit plans. Susan graduated cum laude from Hood College with a Bachelor of Arts degree in mathematics and a minor in physics. After graduation, Susan worked for more than 4 years in the accounting department of American Society of Travel Agents (ASTA), a multi-entity trade association. While working for ASTA, Susan graduated with a Bachelor of Science degree in accounting from University of Maryland. Susan joined Tate & Tryon in 1997 and has significant expertise with a multitude of financial issues confronted by her nonprofit clients. Susan has made numerous presentations to audit committees and boards of directors. Ms. Colladay has also lead in-house continuing professional education for Tate & Tryon employees. Susan has written several articles, most recently for the Tate & Tryon newsletter on topics such as Enterprise Risk Management and Red Flags Rules.

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Speaker Biography
Charles F. Tate, CPA, is the Managing Partner of Tate & Tryon and has over 35 years of experience working with nonprofit organizations. Prior to forming the Firm, he worked in the Washington, DC office of Ernst & Young, LLP where he began working with nonprofit organizations. Mr. Tate works directly with the management and boards of hundreds of organizations in helping them assess and improve key aspects of the organizations financial governance, strategy, and operations, such as: Establishing critical links among the key elements of the strategic, operational, financial, reserve, and investment plans; Development of guidelines for financial oversight by top management and the board of directors based on best practices Establishing and benchmarking key performance indicators Enhancing internal control design and structure using the COSO framework

He is a regular presenter to the Greater Washington Society of CPAs and the American Society of Association Executives (ASAE) on these and other related topics on emerging financial practices and financial governance.
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