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

Targeting Reserves Bull’s Eye versus Shot in the Dark

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

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Total Budgeted Expense 16,397,494$

Total Net Assets 28,512,121

Fixed Assets (135,482)

Expendable Fund Balance 28,376,639$

Ratio of Expendable Fund Balance to Total Expenses 173%

What are Reserves?

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Net Assets (Assets - Liabilities)

Unrestricted

Reserves Not Available (fixed assets)

Temporarily Restricted

Program Restricted

Time Restricted

Permanently Restricted

Reserves = Expendable, Liquid Net Assets

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ERM Expands on Internal Control Adding Three Components to Risk Assessment

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Control Environment

Control Activities

Monitoring

Information & Communication

Risk Assessment

ERM Objective Setting

ERM Event Identification

ERM Risk Response

Enterprise Risk Management (ERM)

Developing a reserves target is similar to ERM. ERM is a process, effected by an entity’s 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

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• What are the mission critical initiatives? Strategic Plan

• How do we get there? Operational Plan

• How much will it cost? Financial Plan

• How will the financial plan impact reserves?

Reserve Policy

• What is the time horizon and risk tolerance? Investment Policy

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Identify Events – Sample Risks

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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

Identify Events – Sample Opportunities

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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

Summary of Quantified Risks

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RISK IDENTIFIED

PRESENT VALUE OF

OCCURRENCE (Rounded)

1. Revenue Volatility $(974,000) 2. Investment Portfolio Volatility (1,912,000) 3. States change Licensing Requirements (137,000) 4. Licensing Changes to a Uniform process (300,000) 5. Licensing Volumes and Revenues (146,000) 6. Legislation (4,267,000) 7. Legislation (4,329,000) 8. One-Stop Shopping (327,000) 9. Merger of sponsors/industry partners (2,366,000) 10. IT Reengineering - general (428,000) 11. Software upgrade – product delivery (315,000) 12. States Perform Their Own Processing (54,000) 13. Administrative Fee (4,654,000) 14. States Use Other Vendors (296,000) 15. Competitor Expansion (1,012,000) 16. Litigation (210,000) 17. Massive Disaster (94,000)

TOTAL ESTIMATED REQUIRED RESERVE $(21,821,000)

Identify Events – Determine Risk Response

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Avoidance •Disposing of a program •Deciding not to engage in

new initiatives/activities

Sharing •Buy insurance •Joint venture/outsource •Hedging risks

Reduction •Diversifying/rebalance •Limits/processes

Acceptance •Self insure •Accept risk that conforms

to risk tolerance

Risk Response

Identify Events – Mapping Risks

ERM Risk Appetite Matrix (Exhibit 3.5 from COSO’s ERM Guidance)

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Quantify Events - Risks Assessment

Amount of reserves will depend on events identified in the SWOT analysis.

Events may be interdependent – not isolated.

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$ $$

$$ $$$$

Low

High

High

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Identify Events - Risks and Opportunities

Unique analysis for each organization

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1. Identify every potential event, no matter how small 2. Narrow the list down to significant events and use broad

event categories 3. Determine risk response (avoid, reduce, share, accept) 4. Assess event likelihood / magnitude – map the event in

the ERM Risk Appetite Matrix 5. Include board of directors, management, and others in

event identification and risk assessment to gain consensus

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Risk Quantification Worksheet Summary

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No. Risk 2008 2009 2010 2011 2012 20171 Revenue Volatility EXHIBIT 8 (974,000)$ 1,604,886$ 471,710$ (678,515)$ (1,447,095)$ (1,594,279)$ -$

2 Investment Portfolio Volatility EXHIBIT 3 (1,912,000)$ (1,049,000) (893,000) (151,000) - - -

3 States change Licensing Requirements EXHIBIT 6 (137,000)$ - - (20,550) (20,550) (61,650) (102,750)

4 Uniform Licensing process EXHIBIT 6 (300,000)$ - - - (200,000) (40,000) (200,000)

5 Licensing Volumes and Revenues EXHIBIT 6 (146,000)$ - (44,500) (44,500) (44,500) (44,500) -

6 Legislation EXHIBIT 6 (4,267,000)$ - - (825,000) (825,000) (825,000) (4,125,000)

7 Legislation EXHIBIT 6 (4,329,000)$ - - (837,000) (837,000) (837,000) (4,185,000)

8 One-Stop Shopping EXHIBIT 6 (327,000)$ - - (200,000) (200,000) - -

9 Merger of sponsors/industry partners EXHIBIT 6 (2,366,000)$ - (350,000) (350,000) (350,000) (350,000) (2,187,500)

10 IT Reengineering - general EXHIBIT 6 (428,000)$ - - - (540,000) - -

11 Software upgrade – product delivery EXHIBIT 6 (315,000)$ - - (375,000) - - -

12 States Perform Their Own Processing EXHIBIT 6 (54,000)$ - (8,750) (8,750) (8,750) (8,750) (43,750)

13 Administrative Fee EXHIBIT 6 (4,654,000)$ - - (900,000) (900,000) (900,000) (4,500,000)

14 States Use Other Vendors EXHIBIT 6 (296,000)$ - (48,750) (48,750) (48,750) (48,750) (243,750)

15 Competitor Expansion EXHIBIT 6 (1,012,000)$ - (167,000) (167,000) (167,000) (167,000) (833,000)

16 Litigation EXHIBIT 6 (210,000)$ - - (250,000) - - -

17 Massive Disaster EXHIBIT 6 (94,000)$ - - (111,600) - - -

Total Estimated Liquid Reserves Needed (Rounded) (21,821,000)$ 555,886$ (1,040,290)$ (4,967,665)$ (5,588,645)$ (4,876,929)$ (16,420,750)$

/1. Discounted at the 6.00% rate.

Exhibit Reference

Present Value of Occurrence

(Rounded) /1 .

Targeting Reserves (cont.)

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How much is too much?

IRS has not successfully challenged accumulation of reserves in exempt organizations

Amount will depend on each entity’s Event Identification and Risk Appetite

Document Target Reserve Ratio in a written Reserves Policy

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Characteristics of Comparable Organizations

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Summary of Liquid Reserves (Exhibit 4) (Source: 86 Organizations From Tate & Tryon Database)

Budget (millions)

Net Assets

% of Budget

Net Fixed

Assets Reserve % of

Budget Average $27 $20 73% $3 $16 61% Median $25 $17 62% $2 $13 48% 25th Percentile $21 $8 34% $1 $6 26% 75th Percentile $31 $24 99% $4 $22 84% High $49 $65 248% $23 $55 232%

Liquid Reserves of Comparable Organizations – A Refined Benchmark

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Summary of Liquid Reserves (Exhibit 5) 20 Organizations with Non-Dues Revenue exceeding 90%

(Source: Tate & Tryon Database)

Budget Net

Assets % of

Budget

Net Fixed

Assets Reserve % of

Budget Average $25 $20 83% $3 $17 70% Median $22 $17 69% $2 $15 49% 25th Percentile $20 $11 42% $1 $9 32% 75th Percentile $29 $23 106% $5 $16 84% High $44 $61 237% $9 $54 210%

Conclusion

1. The actual liquid reserve of 173% is at the high end for most organizations of similar size.

2. The calculated reserve of 133% may be viewed as a minimum reserve based on the identified risks.

3. National Association is unique because?

4. We are not aware of any situation where the IRS successfully challenged the reserve of a section 501(c)(6).

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Quantification and Assessment – Same Concept with Different Approach

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Major natural or manmade disaster

Economic recession (5% GDP decline)

Major capital

expense

Start a new program

Funder 3 months late

(earned income=$0)

Additional reserves needed 585,000 0 0 90,000 0

Likelihood of occurring in next 3 years 50% 30% 10% 10% 50%

Impact on earned income (12 month period) -25% -5% 0% 15% 0%

Impact on donations -15% -10% 0% 0% 0%

Impact on investments -10% -20% 0% 0% 0%

Impact on demand for your goods and services 50% -10% 0% 20% 0%

Short-term impact on cash flow and costs 0% 0% 5% 5% 10%

Projected earned income 300,000 380,000 400,000 460,000 400,000

Projected charitable donations & grants 425,000 450,000 500,000 500,000 500,000

Projected investment and other income 90,000 80,000 100,000 100,000 100,000

Projected revenue 815,000 910,000 1,000,000 1,060,000 1,000,000

Projected expenses 1,500,000 900,000 1,050,000 1,250,000 1,100,000

Net (loss) income if event occurs (685,000) 10,000 (50,000) (190,000) (100,000)

Example reserves analysis for a 501(c)(3) credit to Operating Reserve Policy Toolkit for Nonprofit Organizations by NORI.

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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?

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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 There’s No Penalty for Having Reserves, May 6, 2011

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Speaker Biography

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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

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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 organization’s 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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