Finance for Club Boards

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2 Copyright 2013 ClubsNSW The workbook materials are copyright, and copyright is vested in ClubsNSW. Except as permitted by the Copyright Act 1968, no part of it may in any form or by any electronic, mechanical, photocopying, recording, or any other means be reproduced, stored in a retrieval system or be broadcast or transmitted without the prior permission of the publisher, ClubsNSW. Every effort has been made to trace copyright material. Should any infringement have occurred accidentally the authors and ClubsNSW tender their apologies. FFGB Finance for Club Boards Workbook VI Disclaimer This workbook is only intended as a preliminary guide for boards and managers of clubs. It does not replace legal advice or accountant s advice and it is not intended that clubs should rely on information in the guide in lieu of taking such advice. Clubs should take professional advice where appropriate. This information has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. Any information about a third party's products or services is provided for convenience only. Use of the workbook by workshop participants is permitted. No other use, citation or publication (in whole or part) is permitted without the prior written consent of ClubsNSW. Without limiting those general words, clubs must only use the workbook for their own internal purposes. Copies of the workbook are not to be used by, or provided to, anyone else. Author Debbie Organ: Learning and Development Executive, ClubsNSW Example Club Limited Accounts: C. Roan (KPMG) ClubsNSW Contact Details For more information on the content covered in this workbook, ClubsNSW member clubs can contact the ClubsNSW Member Enquiries Centre: Phone: Fax: (02) enquiries@clubsnsw.com.au Web: 2 P a g e

3 CONTENTS INTRODUCTION... 7 ASSESSMENT AND ACCREDITATION... 9 CERTIFICATE IV IN GOVERNANCE... 9 GLOSSARY OF FINANCIAL TERMS UNIT 1: OPERATING IN THE NOT FOR PROFIT SECTOR NSW CLUBS IN THE NOT FOR PROFIT SECTOR TYPES OF CLUBS INCLUDE: WHAT DOES NOT FOR PROFIT MEAN? TYPES OF ORGANISATION PROFIT MAKING ENTITIES NOT FOR PROFIT ENTITIES WHAT DOES INCORPORATION MEAN? COMPANY LIMITED BY GUARANTEE CO-OPERATIVES CLUB CONSTITUTION UNIT 2: UNDERSTANDING FINANCIAL CONCEPTS AND REPORTS SETTING THE SCENE FOR GOOD FINANCIAL REPORTING IMPORTANCE OF FINANCIAL REPORTS STATUTORY FINANCIAL REPORTS ANNUAL FINANCIAL REPORTS ANNUAL REPORTING QUARTERLY REPORTING ANNUAL FINANCIAL STATEMENTS KEY COMPONENTS OF THE ANNUAL REPORT BALANCE SHEET (ALSO KNOWN AS THE STATEMENT OF FINANCIAL POSITION) ELEMENTS OF BALANCE SHEET CATEGORIES OF ASSETS AND LIABILITIES CATEGORIES OF ASSETS CURRENT ASSETS NON-CURRENT ASSETS REVIEW ACTIVITY CATEGORIES OF LIABILITIES CURRENT LIABILITIES NON-CURRENT LIABILITIES MEMBERS EQUITY CLUB SOLVENCY AND LIQUIDITY SHORT TERM SOLVENCY INDICATORS P a g e

4 LIQUIDITY RATIOS REVIEW ACTIVITY 2: BALANCE SHEET LONG TERM SOLVENCY RATIOS UNDERSTANDING YOUR DEBT TO ASSETS REVIEW ACTIVITY 3: BALANCE SHEET LIMITATIONS OF A BALANCE SHEET UNDERSTANDING THE STATEMENT OF COMPREHENSIVE INCOME TOTAL REVENUE GROSS PROFIT OPERATING EXPENSES EARNINGS BEFORE INTEREST, TAX, DEPRECIATION AND AMORTISATION (EBITDA) EBITDA AS A PERCENTAGE OF REVENUE DEPRECIATION AND AMORTISATION EARNINGS BEFORE INTEREST AND TAX (EBIT) FINANCE COSTS/INCOME INTEREST COVERAGE RATIO EARNINGS BEFORE TAX IMPAIRMENT LOSSES OF LAND AND BUILDINGS INCOME TAX EXPENSE COMPREHENSIVE INCOME FOR THE YEAR REVIEW ACTIVITY 4: STATEMENT OF COMPREHENSIVE INCOME REVIEW ACTIVITY 5: LOOKING AT YOUR CLUB S INCOME STATEMENTS UNDERSTANDING THE STATEMENT OF CASH FLOW STATEMENT OF CASH FLOWS CATEGORIES OF CASH FLOWS REVIEW ACTIVITY 6: YOUR CLUB S STATEMENT OF CASH FLOWS UNDERSTANDING THE NOTES TO THE FINANCIAL STATEMENT UNDERSTANDING THE AUDITORS REPORT WHO CAN ACT AS THE CLUB S AUDITOR? TYPES OF AUDIT REPORTS YOUR BANKERS REQUIREMENTS THE EXPECTATION GAP INDEPENDENCE OF THE AUDITOR IS CRITICAL TO THE CLUB APPOINTMENT OF CLUB AUDITORS APPOINTMENT OF A NEW AUDITOR DIRECTORS REPORT DIRECTORS DECLARATION UNDERSTANDING MANAGEMENT ACCOUNTS REVIEW ACTIVITY 7: MANAGEMENT ACCOUNTS UNIT 3: MONITOR FINANCIAL PERFORMANCE BOARD P a g e

5 THE FINANCIAL ROLES AND RESPONSIBILITIES OF A BOARD CEO MANAGEMENT TEAM STAFF FINANCIAL PERFORMANCE MANAGEMENT RECORD KEEPING FOR IMPROVED FINANCIAL INFORMATION PREPARATION OF FINANCIAL INFORMATION FINANCIAL CONTROLS BUDGETING AND FORECASTING BUDGETS WHAT ARE THE ADVANTAGES OF PREPARING A BUDGET? TYPES OF BUDGETS THE BUDGET PERIOD A COMBINED APPROACH? REVIEW ACTIVITY 8: YOUR CLUB S APPROACH TO BUDGETING FACTORS TO CONSIDER KEY PERFORMANCE INDICATORS BENCHMARKING UNIT 4: MANAGING BUSINESS CHANGES CHANGE MANAGEMENT REVIEW ACTIVITY 9: ANALYSING EXTERNAL CHANGES COMMON TYPES OF CHANGES MADE BY CLUBS: REVIEW ACTIVITY 10: BUSINESS CHANGE UNIT 5: EXTERNAL FINANCING EXTERNAL FINANCING DEBT FINANCING UNDERSTANDING YOUR FINANCING COMMERCIAL LENDING DOCUMENTATION TYPES OF DOCUMENTS APPLYING FOR GRANTS P a g e

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7 Introduction 7 P a g e

8 INTRODUCTION Welcome to the ClubsNSW Finance for Club Boards course. Boards of Directors have a significant influence on the management and financial performance of registered clubs. As part of this course you will be asked to refer to the documents and websites listed below. ClubsNSW Club Industry Guide: Governance and Compliance Club Code of Practice Best Practice Guidelines (contained in the Club Code of Practice) Registered Clubs Act 1976 and Registered Clubs Regulation 1996 Corporations Act 2001 (Commonwealth) Associations Incorporation Act 1984 and Associations Incorporation Regulation 1999 The Office of Liquor Gaming and Racing (forms and fact sheets) This course addresses five key areas of finance on club boards: Operating in the not for profit sector Understanding financial concepts and reports Monitoring Financial performance Managing business changes, External Financing options 8 P a g e

9 Assessment and Accreditation Completing the assessments for the Finance for Club Boards course means that you are able to achieve 1 unit of competency in BSB Certificate IV Governance BSBGOV403A Analyse financial reports and budgets. Completing the assessments for the Finance for Club Boards course means that you are able to achieve the following nationally recognised units of competency: AQTF code BSBGOV403A BSB40907 Certificate IV in Governance Analyse financial reports and budgets Assessment questions are clearly marked. There are multiple choice questions at the end of each unit to check your progress that must be completed online. It is important to understand that completing the multiple choice questions only is not sufficient to have an effect on your understanding of financial concepts. You must also complete the practical exercises provided. It is important to note that accreditation is optional. The fee for accreditation is not included in the course fee. Please note that ClubsNSW is not involved in the marking of assessments. It is marked by an external registered training organisation. The award which your unit will go towards is the Certificate IV of Governance. This is a nationally recognised certificate. Certificate IV in Governance ATQF Code CORE BSBGOV401A BSBGOV402A BSBGOV403A ELECTIVES BSBATSIM507A BSBMKG401A BSBMGT405A BSBRSK401A BSBPMG408A BSBREL401A BSBDIV301A BSB Certificate IV in Governance Implement board member procedures Working within an organisational structure Analyse financial reports and budgets Establish and maintain a strategic planning cycle Profile the market Provide personal leadership Identify Risk and Apply Risk Management Processes Apply Contract and Procurement Processes Establish Networks Work Effectively with Diversity 9 P a g e

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11 Glossary of Financial Terms 11 P a g e

12 GLOSSARY OF FINANCIAL TERMS There is wealth of jargon and terminology associated with financial management. It is helpful for you to understand these terms when reading financial statements. Accruals Accrual accounting Accounting entry Accounts payable Accounts receivables Amortisation ASIC Asset Balance Sheet Also called accrued expenses. This item is usually included in creditor s payables and is typically estimated for expenses incurred by the Balance Sheet date but not yet invoiced by suppliers. E.g. Electricity used between the date covered by the last invoice and the Balance Sheet date, or interest on borrowings not paid by the Balance Sheet date. Recognising income and expenses when they occur rather than when income is received or expenses paid. The basic recording of business transactions as debits and credits. The amount the Club owes to vendors or suppliers for the purchase of goods or services that are supplied on credit. Generally these liabilities are non interest bearing (although interest or fees may apply where the invoice is not paid by the due date). Amounts that are owed to the club, also known as debtors. It is the amount owed to the club for from sales of goods and services which are yet to be paid (e.g. a function at a club) for which the customer is yet to pay. Customers are not normally charged interest unless there is a fee for late payment. The process by which the value of an intangible asset is gradually reduced (based on its expected life). It is the allocation of the cost of an intangible asset over its expected useful life to the club. Australian Securities and Investment Commission. Anything having a commercial value that is owned by the club. Also known as a statement of financial position shows all the clubs assets, liabilities and accumulated members funds at a specific point in time. 12 P a g e

13 Bank overdraft Break even Budget Capital expenditure Cash accounting Cash Flow ClubsNSW Cost of goods sold A form of short term finance. Usually provided by a Bank, the Club is authorised to overdraw its account up to an agreed set limit. Costs include set up fees and interest. An overdraft has no fixed term and is repayable on demand by the Bank. For this reason an overdraft should only be used for come and go purposes. The annual sales volume or sales revenue at which total margin equals total annual fixed expenses, that is the exact sales amount at which the club covers its fixed expenses and makes a nil profit ( and avoids a loss). Break even is a useful point of reference in analysing profit performance and the effects of making sales in excess of break even. A financial plan the club, typically done once a year. Funds used by the club to acquire or upgrade physical assets such as property, buildings or equipment. This type of outlay is made by clubs to maintain or increase the scope of their operations. These expenditures can include everything from repairing a roof to building extensions to buying new gaming machines. Accounting for income and expenses as they are received or paid. The flow of cash into and out of the club. The Registered Clubs Association of NSW. The direct costs attributable to the production of the goods sold by the club. This amount includes the cost of the materials used in creating the goods along with the direct labor costs used to produce the good. It excludes indirect expenses such electricity, office costs etc. COGS appears on the income statement and can be deducted from revenue to calculate a clubs gross margin. Also referred to as cost of sales. Constitution Creditors A constitution is a basic set of rules for the daily running of the club. It details for the club s members and others the name, objects, methods of management and other conditions under which the club operates, and generally the reasons for its existence. Any company or person that the club owes money to (creditor balance). 13 P a g e

14 Current Debtors Deferred tax Depreciation EBIT EBITDA EBITDARD Employee Benefits Equity Expenses Refers to the time period of less than 12 months which assists in allocation of assets and liabilities. Any company or person who owes money to the club (debtor balance). The postponement of tax payable to a future period. The write-off of a portion of a fixed assets value in a financial period based on its estimated useful life. Each year of an assets life is charged with part of its total cost as the asset gradually wears out and loses its economic value to the club. Most commonly an accelerated or straight line method of depreciation is used. An accelerated method allocates more of the cost to the early years than the later years. The straight line method allocates an equal amount to every year of the assets expected useful life. Earnings before interest and income tax. Earnings before interest, income tax, depreciation and amortisation. Earnings before interest, income tax, depreciation, amortisation, rent and donations. This represents money owed to employees in the form of wages, bonuses, annual leave, sick leave and long service leave entitlements which are expected to be paid. Also known as Members Equity is the accumulated funds from the operation of the Club. It is the difference between assets and liabilities. Money spent or cost incurred in the clubs efforts to generate revenue, representing the cost of doing business. Expenses may be in the form of actual cash payments (such as wages and salaries), a computed expired portion (depreciation) of an asset, or an amount taken out of earnings (such as bad debts). Expenses are summarised and charged in the income statement as deductions from the income before assessing income tax. 14 P a g e

15 Factoring Financial ratio Financial year Forecasting GST Impairment Income Tax Expense Incorporation Inventory Intangibles A form of short term finance. Finance is secured against the debtors of the club and finance is usually provided by a finance company specialising in factoring. The club is effectively selling its debtor book (at a discount) and receives money in advance. The finance company then collects the payments from the debtors. The method by which an organisation can measure the financial health and compare their organisational operations to those of similar organisations in the same industry. Accounting period that can start on any day of a calendar year and has twelve consecutive months (52 consecutive weeks) at the end of which account books are closed, profit or loss is computed, and financial reports are prepared. It may or may not match a calendar year, but is often the financial year being 30 June. The process of predicting the future financial performance of an organisation. Goods and Services Tax. When the carrying values of an asset is higher than its recoverable amount, the asset must be written down to its recoverable amount. It is the reduction in the value of an asset because the asset no longer generates the benefits expected earlier, as determined by the club through periodic assessments. This could happen because of changes in market value of the asset, business environment, government regulations, changes in technology etc. The total amount the club paid in company income taxes. Means the Club becomes a legal entity in its own right, separate from the individual members. The raw materials, work-in-progress goods and completely finished goods that are considered to be the portion of a business s assets that are ready or will be ready for sale. Inventory represents one of the most important assets that most businesses possess, because the turnover of inventory represents one of the primary sources of revenue generation. Assets that don t have a physical form, e.g. patents, gaming machine entitlements. 15 P a g e

16 IPART Leases (Financial) Liability Loans Independent Pricing and Regulatory Tribunal. Leases are for a fixed period of time and the costs are in the form of interest charges. Security is the equipment being financed. A finance lease is where the underlying substance of the transaction is a financing arrangement. An operating lease is where the underlying substance of the transaction is a rental agreement. The amount the club owes to external stakeholders. Generally provided for a fixed purpose and repayable in a fixed period of time. They have set repayment dates, and costs include interest and set up fees. May be secured secured by club assets. Management Accounts Management accounts are any financial report that a club prepares in order to help make management decisions. As these accounts are prepared for internal use only, the structure and content can be tailored to suit the club, and therefore their content varies greatly from club to club. Mark-up Mutuality principle Non-Current Not for profit Overheads The percentage by which the sales price exceeds the cost. An entity s income consists only of monies derived from external sources. Accordingly, subscriptions and contributions from members for particular services provided by a club or association are generally excluded from the assessable income of that club or association. Refers to the time period of greater than 12 months which assists in allocation of assets and liabilities. Profits are not distributed to the individual members of the organisation while either the organisation is in operation or when it ends, rather any profits must be used to further the organisation. It is reinvested back into the organisation to continue to pay and provide for its activities and services. Costs not directly associated with the products or services sold by the organisation. 16 P a g e

17 Prepayments Profit (surplus) Purchase order Revenue Retained earnings Short Term Finance Statement of Cash Flow Statement of Comprehensive Income Statutory Financial Reports Stock Are payments made in advance for goods and/or services. For example, prepaying for stock which will be delivered in the future, or services such as general insurance paid for in advance in the period in which they will be used (i.e. they will be used in the year after the balance sheet date). Revenue minus expenses. A commercial document issued by a buyer to a seller, indicating the type, quantities and agreed prices for products or services the seller will provide to the buyer. The income the club earns from its activities, including grants, donations, fundraising and any trading income. Profits that have remained in the organisation. Finance for a period of less than one year. It should only be used to finance short-term capital requirements, such as working capital requirements. One of the three primary financial statements prepared by the club which summarises its cash inflows and outflows during a period according to a threefold classification being: Cashflow from operating activities, investing activities and financing activities. The primary purpose of the income statement (also more commonly referred to as a profit and loss statement) is to report the clubs earnings, over a specific period of time (usually one year) to its members. The income statement sets out the clubs income and expenses incurred, as well as its profit or loss for the period. The profit or loss figure is calculated by offsetting income against expenses for the period. Required by and prepared in accordance with Federal or State legislation. As their content is prescribed by law, their structure tends to be similar from club to club, being the clubs annual and quarterly reports. Goods that the club purchases to sell. 17 P a g e

18 Trade credit Working capital A form of short-term finance provided to a business by its suppliers. It has few costs in terms of interest, and security is not required. Clubs should however, be mindful that discounts (for the goods) may be forgone if the club does not pay within a set time frame. The excess of current assets over current liabilities. 18 P a g e

19 Unit 1: Operating in the Not For Profit Sector 19 P a g e

20 OPERATING IN THE NOT FOR PROFIT SECTOR In this section, we outline the distinction of organisations in Australia that classify as profit making entities and those that are not for profit entities. Learning Outcomes: Understand types of clubs which compromise the 1500 venues across the state of NSW. Understand the difference between an organisation that is classified as a profit making entity and one which is not for profit. Understand the definition of incorporation and why it is important. 20 P a g e

21 NSW Clubs in the Not For Profit Sector The NSW Registered Club industry comprises almost 1500 individual venues spread across every region of the state with total membership of approximately 5.7 million. Clubs are independently managed which leads to high levels of diversity within the sector. Whilst clubs share a common non-profit, members based model and operate under the same regulatory regime, they are highly varied in their purpose. Types of Clubs include: Bowling clubs (approximately 471 venues) Sporting and recreation clubs (approximately 265 venues) Returned services clubs (approximately 231 venues) League and football clubs (approximately 76 venues) 16 These clubs are also diverse in their size. The largest clubs can have more than 100,000 members and generate annual revenues in excess of $60 million per annum. These clubs provide a diverse range of products and services to their membership and local communities ranging from traditional hospitality and gaming to aged care, child care, swim centre s and gymnasiums. Large clubs are also increasingly being involved in other commercial activities such as property investment and development, retail leasing and hotel accommodation. At the other end of the spectrum there are several small clubs that generate revenue of less than $20,000 and operate to provide facilities such as bowling green s or golf courses for their small membership base. 21 P a g e

22 What Does Not For Profit Mean? Clubs form an essential part of the social fabric of Australian life. As not for profit organisations, clubs have utilised their revenue to build sporting and community infrastructure, support charities and provide a comfortable and affordable place to meet, eat, drink and enjoy entertainment. Clubs today also provide facilities such as aged accommodation, child minding and other in-house sporting facilities such as swimming centre s and gyms. But do you understand what is meant by not for profit? Types of Organisation Organisations in Australia can be classified as either: Profit-making entities, or Not for profit entities. Profit Making Entities Common types of profit-making entities structures are: Sole Proprietorship: (commonly known as sole trader business) is fairly simple to establish and allows for control of a business by an individual, E.g. Trades people such as plumbers, bricklayers, etc, often operate as sole traders. Partnerships: is where 2 or more individuals form a partnership to conduct business with a view to profit. Common partnerships include doctors, accountants and lawyers. Companies: are the most common structure used in business as a separate legal entity from its owners, who are referred to as shareholders. In these for profit organisations, the aim of the business is to make a profit, and those profits can be distributed to the organizations owners, or to individual members or shareholders. In these organisations, people who are involved in the organisation are entitled to receive a personal benefit from the profits. This benefit can come from direct payments, dividends or money when they sell their shares. 22 P a g e

23 Not For Profit Entities So, is a not-for-profit (NFP) organisation one that makes no profit? The answer is The term is actually a little misleading. Whether your organisation is a not for profit organisation is determined by what your organisation does with that profit, not by whether your organisation makes a profit. Hence a better term would be, not for private gain as opposed to not for profit. In an NFP organisation, the profits are not distributed to the individual members of the organisation while the organisation is in operation or when it ends. Rather, any profit made by the organisation must be used to further the purpose of the organisation, which is reinvested back into the organisation to continue to pay and provide for its activities and services. The distinction between for profit and not for profit is clearly an important one. Given that NFP organisations have not been established by people to make a personal profit, but rather the resources of the organisation will be put back into helping the community, NFP organisations often receive favorable treatment in relation to tax, legal structures, fundraising, etc., and in terms of funding options such as government grants. Since 1969 all registered clubs have been required to be incorporated. Initially clubs could be incorporated under the Company legislation of the day or under the Cooperatives Act. However, the Registered Clubs Act now provides that all clubs must be incorporated only under the Corporations Act What does incorporation mean? Incorporation of a club means that it becomes a legal entity in its own right, separate from the individual members. Put another way, the club is considered at law to have a distinct identity that continues regardless of changes to the membership. 23 P a g e

24 Why incorporate? The major features of becoming incorporated are: the club acquires the powers of a body corporate with perpetual succession and a common seal; the club may enter into contracts and acquire, hold and dispose of property; the club can apply for government grants; Members or officers of the club are generally not liable to contribute towards the payment of debts or liabilities of the club; The club may sue or be sued; If members or office bearers of the club incurred liabilities or obligations on behalf of the club prior to incorporation, those liabilities and obligations can be exercised against the incorporated entity; and The name of the club concludes with the word Incorporated or the abbreviation Inc. as part of its name; There are three different and distinct organisational models within the non-profit sector in Australia and they can be legally structured as: A company limited by shares (under the Commonwealth Corporations Law) Limited by guarantee A cooperative (under the relevant state or territory s Cooperatives Act) An association (under the relevant states or territory s Association Incorporation Act), more suitable to small community based groups with limited resources. In the NSW club industry, most clubs are companies limited by guarantee, however, there are approximately 100 clubs which are cooperatives. As noted above, all new clubs are now required to be incorporated under the Corporations Act, which means they must be companies limited by guarantee. Company Limited by Guarantee Limited by guarantee means the liability of the club s members is limited to the amount the members undertake to contribute in the event the club is wound up. This is typically a nominal amount and is prescribed in the club s constitution. As noted above, the registration of the club creates a legal entity separate from its members. And the club can hold property and can sue or be sued. Clubs are registered under the Corporations Act 2001 (Corporations Act), which is Commonwealth legislation administered by the Australian Securities and Investment Commission (ASIC). 24 P a g e

25 The Club s registration is recognised Australia wide. At the very least the Club must: Have at least three directors and one secretary Have at least one member Have a registered office address and principal place of business located in Australia Have its registered office open and accessible to the public Be internally managed by a constitution or replaceable rules Maintain a register of its members Keep a record of all directors and members; meeting minutes and resolutions Appoint a registered company auditor within one month of its registration Keep proper financial records Prepare, have audited and lodge financial statements and reports after the end of every financial year Send to its members a copy of its financial statements and reports, unless the member has a standing arrangement with the company not to receive them Hold an annual general meeting once every calendar year within five months after the end of its financial year Lodge notices whenever changes to its officeholders, office addresses, constitution and its name occur within specified timeframes as determined by the Corporations Act It is important to note that as a public company limited by guarantee and registered under the Corporation Act, directors generally have the same legal duties, responsibilities and liabilities as directors of commercial entities that are public companies registered under the Act. 25 P a g e

26 Co-operatives Co-operatives are a form of mutual organisation which has existed in Australia since the mid 19th century. The nature and function of co-operatives in Australia vary widely and can be set up as a profit making organisation or as a not for profit organisation. A not for profit co-operative is known as a non-trading co-operative. While a nontrading co-operative can conduct commercial activities, it is prohibited under law to distribute surplus funds to members from profits or winding up. An incorporated non-trading co-operative has mostly the same features of a company limited by guarantee. It is a legal person that is separate from the persons who are its members. It has the power to hold property, enter into contracts, and sue and be sued in its Club name. Like other incorporated bodies, a co-operative is responsible for its debts, not the members who own the co-operative. The co-operative is governed by the Co-operatives Act in each individual state, however, the Co-operatives Act makes reference to or adopts or repeats many relevant provisions of the Corporations Act. Club Constitution Every club has a constitution which sets out its objectives and rules. clubs that were incorporated before the Co-operatives Act came into effect may still have a memorandum and articles of association. Co-operatives are required to have a constitution which is referred to as rules of the cooperative. Since the Corporations Act came into effect the term constitution has been applied to the document which sets out the objects and rules of clubs and covers the memorandum and articles of association. Given the laws relating to clubs change from time to time, the Board needs to review their constitutions from time to time to ensure they are up to date. (In changing the same, given they are technical documents, it is recommended you seek legal advice before making changes to the clubs constitution). 26 P a g e

27 Unit 2: Understanding Financial Concepts and Reports 27 P a g e

28 UNDERSTANDING FINANCIAL CONCEPTS AND REPORTS In this section we will outline the key financial reports that should be prepared by registered clubs. We will provide a summary of the purpose of each type of report and an overview of the key issues and items to watch for when reviewing such reports. We will also look at some of the key financial concepts that should be understood by directors in order to properly administer their duties. Learning outcomes: Understand the difference between statutory reports and management accounts Be able to list the different types of statutory financial reports that are required to be prepared by registered clubs Understand the major components of a statutory financial report prepared in accordance with the Corporations Act 2001 Understand the purpose of the three principal statements generally included in a statutory financial report and be able to identify issues 28 P a g e

29 Setting the Scene for Good Financial Reporting For directors and management, understanding your club s financial position is critical to the success of the club, and therefore, the ability of the club to continually provide services to its members. Good financial management starts with precise record keeping and good information systems. As a director, are you comfortable that your club is keeping accurate records or has the required information systems? Knowing what financial statements or reports need to be produced and how to read these reports is critical to your clubs continued financial success. Importance of Financial Reports One of the principal roles of directors is to monitor the financial aspects of their clubs on behalf of members. This role requires directors to regularly review financial reports prepared by management and to seek explanations on key issues or risks that come to their attention. In addition, directors of registered clubs must ensure that financial information is regularly provided to members for their review. This includes the preparation and distribution of an audited annual financial report and the provision of quarterly information to members. It is therefore critical that directors understand the different types of financial reports, the key things to look for in each and some of the terms that are relevant when reviewing financial information. Types of Financial Reports Broadly, there are two major categories of financial reports: Statutory Financial Reports, and Management accounts. 29 P a g e

30 Statutory Financial Reports These are required by and prepared in accordance with Federal or State legislation. As their content is prescribed by law, their structure tends to be fairly similar from club to club. The main form of statutory financial report is the annual financial report that is provided to the club s members. Management Accounts These are prepared by clubs in order to assess their financial performance or position and to assist management and directors to make informed decisions about their club operations. As these reports are for internal use, the structure and content of management accounts varies significantly from club to club. There are a number of major differences, advantages and disadvantages, between statutory reports and management accounts. These differences are compared in the following table. 30 P a g e

31 Comparison Statutory reports Management accounts Purpose For members and Regulators For board and management Content Frequency Timeliness Dictated by the relevant legislation Format largely standard Includes annual financial report and quarterly report Once per year for Annual Report (Corporations Act 2001) Quarterly report (Registered Clubs Regulation 1996) Annual Report to ASIC within four months of financial year-end Quarterly report within 48 hours of the statements being adopted by the board. Flexible Dependent on the needs of the users As often as required Generally prepared on a monthly basis and provided in advance of board meetings As soon as possible for effective decision making Advantages Disadvantages Information can usually be found easily Prepared in accordance with Australian Accounting Standards enabling comparisons to be drawn between other businesses and clubs. Can provide information on financial performance of competitors given that they are publicly available Often lengthy and can be difficult to understand Publicly available, enabling access by competitors Required to be audited, therefore can be costly Lack of detail, including detailed trading reports for each business unit or club location Structure and content tailored. Access can be restricted, mitigating confidentiality considerations. Often automatically generated by internal accounting software. Quick to prepare and provide timely and relevant information Unless properly tailored, can often be lengthy, complicated and provide too much detail. This can interfere with the objectives of the report. Not audited or required to be prepared with in accordance with the Australian Accounting Standards, therefore potentially reducing the accuracy of the reports. 31 P a g e

32 Statutory Financial Reports Statutory financial reports are any financial report that a club is required by law to prepare. As noted previously, the structure, content and timing of such reports is governed by legislation. Clubs are liable for fines and penalties, if such reports are not prepared in accordance with statutory requirements. There are two main types of statutory financial reports that are prepared by registered clubs in NSW: Quarterly financial reports, and Annual financial reports. Annual Financial Reports As outlined in the Corporations Act the following are the club obligations in relation to Annual and Quarterly reporting: Clubs can no longer distribute concise financial reports. Members must make a standing election whether to receive a copy of the financial report. They can elect not to receive a copy. Those members who chose to receive a copy then elect whether they receive a hard copy or an electronic copy of the full financial report. Annual Reporting Once members have elected their mode of delivery, the full Annual Financial Report must be provided to members the earliest of 21 days before the next Annual General Meeting (AGM) or 4 months after the clubs end of financial year date (sent by or post as requested). What must be sent? Directors Report Financial Report Auditors Report Notice of Annual General Meeting Full Financial Report (no concise report) There is no longer a need to display reports on the clubs website, but you can continue to do so, (you might like to check your club s constitution) 32 P a g e

33 Quarterly Reporting The club is required to prepare Quarterly Financial Reports, and a copy must be provided to those members who request a copy, (either by mail or post). A sign must be displayed at the club and on the clubs website noting the Quarterly Accounts are available. Quarterly financial statements are required to be prepared in accordance with Regulation 47H of the Registered Clubs Regulation P a g e

34 Annual Financial Statements The Components of the Annual Financial Report The key components that are required in the annual financial report include the following: 1. Balance Sheet (also known on statement of financial position). The balance sheet should also be generated on a monthly basis to allow directors and management to review and analyse 2. Statement of Comprehensive Income (or better known as the Profit and Loss Statement) 3. Statement of Cash flows 4. Notes to the financial statements 5. Independent auditor s report and lead auditor s independence declaration 6. Directors report 7. Directors declaration Understanding all components of the annual financial statement is critical. These financial statements provide information on how the club is operating financially and why. Once this is understood, the information can be analysed to show the clubs areas of strengths and weaknesses for a given period. 34 P a g e

35 UNDERSTANDING THE BALANCE SHEET (Statement of Financial Position) In this section, we explore the different components of the Balance Sheet. Learning outcomes: Explain the meaning and purpose of the Balance Sheet Understand what is an asset on a Balance Sheet Explain the distinction between current assets and non-current assets Understand the different types of current and non-current assets Understand what a liability is on a balance sheet Explain the distinction between current and non-current liabilities Understand the different types of current and non-current liabilities Understand the importance of debt on the Balance Sheet and being fully informed regarding the debts maturity profile Understand the meaning of members equity Explain and apply the Balance Sheet equation Understand the definition of solvency Identify and apply various ratios that can be used to assess short term solvency Identify and apply Balance Sheet ratios that can be used to assess long term solvency Identify limitations of the Balance Sheet 35 P a g e

36 Key Components of the Annual Report 1. Balance Sheet (Also known as the Statement of Financial Position) Let s assume you are applying for a loan to put a swimming pool in your backyard. You go to the Bank asking to borrow the money, and the Bank asks for a list of your assets and liabilities. You pull out a piece of paper and write down everything you own of value (your house, money in savings account, car, furniture, etc.). Then at the bottom of the page you write down all of your debt (your mortgage, car payments, credit cards, etc.). You subtract all your debts from the value of all your assets, and you come up with your net worth. Congratulations, you just created a Balance Sheet! The Balance Sheet, also known as the Statement of Financial Position, provides a snapshot of a club s financial position as at a particular point in time. It lists, in detail, the various assets owned by the club, what the club owes to third parties, and the net value of the club (members equity) 36 P a g e

37 Elements of Balance Sheet The three elements of the balance sheet are: Assets: are items of value owned by the club. The asset must have some future economic benefit to the club and it must be possible and reliable to measure the cost or value of such benefit. E.g. Cash, property, accounts receivable, equipment, furniture. Liabilities: are amounts owed by the club to external parties and include funds available to support the clubs operations by way of loans, for example, trade creditors, loans from banks, income tax payable. Equity: also known as member equity, is the accumulated funds from the operations of the club. It is the difference between assets and liabilities. Similar to our swimming pool finance example, the assets of the club minus the liabilities of the club equal the net worth of the club. 37 P a g e

38 The following is an example of what a typical Club Balance Sheet looks like. In the example for Example Club above, assets of $59.971m have been funded through liabilities of $5.415m and accumulated funds of $54.555m. 38 P a g e

39 Assets = Liabilities + Accumulated Funds $59,971,125 $5,415,962 $54,555,163 The balance sheet equation can also be illustrated as - : Assets - Liabilities = Accumulated Funds (Equity) $59,971,125 $5,415,962 $54,555,163 Value of Assets of Club Less Amount Owed To External Parties = Net Worth of the Club Categories of Assets and Liabilities The Balance Sheet, although representing one point in time, does tell a story and Directors should look at the categories of assets and liabilities of the club. Clearly comparing the Balance Sheet at the same time in a previous period will also provide an invaluable source of information as to the financial health of the club. Whilst Directors are not expected to be qualified accountants, the case involving Centro Properties does highlight the obligation of Directors to understand the basic accounting concepts and be confident they understand the financial position of their Club. (see Attached article written by Debbie Organ discussing the Centro Properties Case) Before you can analyse a balance sheet, you have to understand how it is set up. Categories of Assets For accounting purposes, assets are normally separated (as far as possible) into subcategories. The reasoning behind this being that the accounting statements should provide information that is useful in making economic decisions. These decisions can be made more precisely, if some indication is given regarding the nature of the assets of the entity. 39 P a g e

40 The Categories used in Australia are: Current Assets, and Non-Current Assets (sometimes referred to as long term assets or fixed assets). Current Assets Whilst there are a number of ways current assets can be defined in accounting terms, the most applicable for the hospitality industry is: a current asset means an asset that is held primarily for trading purposes or for the short term and is expected to be realized within 12 months of the reporting date. As these assets are easily turned into cash, which is why they are sometimes referred to as liquid assets.' Examples of the Current Assets include: Cash: clubs cash holding will mostly be cash in the Bank, but a portion may also include petty cash or cash waiting to be banked in a safe Accounts Receivable: amounts owing to club by third parties, usually being customers who owe money for sale of goods or services to them (e.g. a function at a club) for which they are yet to pay Inventories: usually stock which the club has purchased for sale which remains unsold Prepayments: are payments made in advance for goods and or services. For example, prepaying for stock which will be delivered in the future, or services such as general insurance paid for in advance in the period in which they will be used (that is, they will be used with in the year after the balance sheet date). 40 P a g e

41 Non-Current Assets Most texts refer to non-current assets as fixed assets. Non-Current Assets generally include those assets which were acquired with the intention of retaining them for the purposes of generating income over a number of years. The term non-current asset is now applicable in Australia. (A non-current asset defined in accounting terms as all assets that are not current assets: AASB 101). Examples of Non-Current Assets include: Land and buildings: usually the land and buildings which house the club premises Plant and equipment: the infrastructure the club owns enables it to produce its goods and services including gaming machines, kitchen equipment, computer equipment etc. Investments: can be savings for a rainy day such as investments in shares, investment properties, or long term interest bearing securities. Intangibles: intangibles are non-physical assets that the club has bought (or valued) that hold value to the club and help it generate income (E.g. patents, brand and trades names etc.). The most common intangible in clubs is poker machine entitlements. These entitlements can be bought and sold, although the market price for these depends on demand at the time and regulatory restrictions for sale of the same. (Value of these should therefore be conservative as an inflated value can provide inflated security to directors/members) In the case of Example Club Limited, you will see the club has Intangible Assets of $678,946. Looking at note 14 to the accounts shows that this consists of 464 poker machine entitlements. 41 P a g e

42 Review Activity 1 Before you progress: Explain in your own words the difference between current and non-current assets and why is it important to classify into sub groups? What current and non-current assets are in your clubs Balance Sheet? Categories of Liabilities As is the case with assets, liabilities are classified into two classes: Current Liabilities, and Non-Current Liabilities Current Liabilities The definition of current liabilities is similar to that of current assets and can be defined in a number of ways in accounting terms, the most applicable for the hospitality industry is: A current liability is a liability that is due to be settled within 12 months of the Balance Sheet date. 42 P a g e

43 Examples of current liabilities include: Bank Overdraft: An overdraft occurs when money is withdrawn from the clubs bank account and the available balance falls below zero. In this situation, the account is said to be overdrawn. If the club has a prior agreement with the Bank for an overdraft limit, then the club can withdraw funds, up to that limit, without being in default of the banking arrangements. Interest (usually higher than normal loan interest rates) is applied to the debit balance on a daily basis. Many clubs have overdraft limits established on their accounts to allow for short term working capital needs, for example, where substantial tax payments are due. The advantage of an overdraft facility is that it is fairly easy to establish an overdraft limit, it is flexible and interest is only paid on amounts borrowed. The disadvantages of an overdraft however, is it cannot (and should not) be used for large borrowings or long term needs, as interest on overdrafts are higher than traditional loans, and Banks can change limits at any time or ask for money to be repaid immediately without notice. Irrespective of how other loans are negotiated or reviewed, an overdraft by definition is repayable on demand, for example, if your Bank suddenly becomes nervous about your club or the industry generally, they can demand payment of the full overdraft amount immediately. This has repercussions for the club, if you cannot repay, as you are immediately in default, which causes a cross default on all other banking facilities. Therefore, such a facility should be used with caution. Trades and Other Payables: Amounts due to regular trade suppliers for goods and services received by the Balance Sheet date but not yet paid. Loans and Borrowings: Amounts borrowed from third parties to help finance the Club. They may also be referred to as interest bearing liabilities and loans. E.g. bank loans, or other bonds and debentures. These loans are due and expected to be paid within 12 months of the Balance Sheet date. They should also include the current portion of any long term debt due, that is the same amount you have to pay during the next year as part of, say a 10 year loan. Employee Benefits: This represents money owed to employees in the form of wages, bonuses, annual leave, sick leave, superannuation and long service leave entitlements which are expected to be paid or fall due within 12 months of the balance date. Provisions: Are estimates for transactions and events occurring by the Balance Sheet date, but not yet paid, and expected to be realized within the next 12 months. Sometimes it can be difficult to estimate and it is not known exactly when it will be paid. 43 P a g e

44 Examples of provisions expected to be settled within one year include provisions for tax payments, provision for link jackpots and member s bonus point s obligations, provisions for restructuring costs etc. Accruals: Also called accrued expenses, this item is usually included in payables creditors payable and is typically estimated for expenses incurred by the Balance Sheet date but not yet invoiced by Suppliers. E.g. Electricity used between the date covered by the last invoice and the Balance Sheet date, or interest due on borrowings not paid by the Balance Sheet date. Other Current Liabilities: Perhaps the most common other current liability you could see on a Club Balance Sheet is Membership fees paid in advance (refer to Example Club Limited). Membership subscriptions represent annual membership fees paid by the Clubs members. The Club should recognise membership subscriptions pro-rata over the term of the membership and any unearned (unused) portion is included as current liabilities. Non-Current Liabilities A non-current liability is defined in accounting terms as: A liability which is not a current liability. These liabilities represent money the Club owes one year or more into the future. Examples of non-current liabilities include: Loans and Other Borrowings May also be referred to as bank debt. This represents money the Club has borrowed that does not need to be paid back for several years (by definition greater than one year). IMPORTANT NOTE When an item has been classified as a non-current liability and becomes due for settlement within 12 months, it should be reclassified as a current liability. (See article written by Debbie Organ, Learning and Development Executive, ClubsNSW. Attached at the end of this section). This is important information for clubs. The reclassification of the item may reveal the club has liquidity and solvency problems if the club does not have the capacity to meet the repayment. For example, the club has a 10 year bank loan that was settled nine years ago. The club may have a good relationship with its Bank and expect that the Bank will merely renew the loan, and therefore it may continue to classify the loan as a non-current liability. 44 P a g e

45 As noted in the article, this was the issue which Centro Properties directors faced, and the directors signed accounts which did not correctly classify substantial debt (over $2 billion) as current debt. Accounting standards require that such a loan must be classified as a current liability. Unless firm arrangements in writing have been completed (approved by the Bank and documents executed) for the loan to be extended beyond 12 months, that is, before the end of the accounting period. It is important for the club s management and directors to be fully informed of the amount of the clubs debt, the interest payable and the maturity structure of the debt (timing of clubs obligations) so that they can properly assess the entities capacity to continue as a going concern. Employee Benefits: This represents money owed to employees in the form of wages, bonuses, annual leave, sick leave, superannuation and long service leave entitlements which are expected to be paid in the future but not within the next 12 months. Other Liabilities: You may find your club has an entry called other liabilities. This is a catch-all category where the Club can consolidate their miscellaneous debt. You would normally find an explanation (in the notes to the accounts) of what makes up these liabilities. Often they consist of provisions, deferred tax liability, accrued expenses, etc. Generally, you should take the time to look at the various other liabilities the club has. Most will be self-explanatory and as a general rule, if classified as other liabilities are not considered as important as the individual liabilities discussed above. Members Equity Member equity is the net worth of the club. It represents the net worth of the club after all creditors and debts have been paid. In the case of clubs, members equity is the accumulated profits (or losses) the club has generated. Looking at the members funds for Example Club Limited, member s equity declined from $54,555,163 in This represents the $850,854 loss the Club recorded in 2011 as shown in the clubs income statement. 45 P a g e

46 Well Done! You now understand what the Club Balance Sheet is and what the categories within the balance represents. 46 P a g e

47 SO WHAT CAN THE BALANCE SHEET TELL YOU? Club Solvency and Liquidity The Directors of the club, in issuing the Annual Report must confirm that to the best of their knowledge the club can meet its obligations when due, therefore the club is solvent. WHAT ARE INDICATIONS OF INSOLVENCY (unable to meet obligations as they fall due?) In a 2003 decision the Courts referred to a check list of indicators of insolvency including: Continuing losses Liquidity Ratio less than 1 Overdue taxes Poor relationship with Bank including inability to borrow No access to alternative finance Suppliers going on COD basis Dishonoring cheques and issuing post dated cheques Inability to produce timely accounts Special arrangements with selected creditors and financiers Solicitors, Letters, Judgments, etc. There would be a few cases where all of these indications are present just as there would be cases of insolvency where none or few were present. Sometimes insolvency can be indicated (if not proved) by looking at the Balance Sheet. 47 P a g e

48 The Club directors and management should endeavor to answer such questions as: Does the club have enough cash to repay its debts tomorrow? Does the club have enough cash to repay its debts if due in six months? Will the club have enough cash to repay the loan if it is due in five years? In examining these questions, we need to: Examine working capital and ratios to assist with short term decisions Examine ratios concerning the long term decision Short Term Solvency Indicators Working Capital Working Capital arguably reveals more about the financial position of any business than almost any other calculation. It tells you what would be left if the club raised all of its short term assets and used them to pay off all of the clubs short term liabilities. The more working capital the club has, the less financial strain on the club. Working Capital is the easiest of all balance sheet calculations. It is represented by the current assets of the club minus its current liabilities. WORKING CAPITAL = CURRENT ASSETS CURRENT LIABILITIES One of the main advantages of looking at the working capital position is being able to foresee any financial difficulties that may arise. Even a club with millions of dollars in fixed assets will quickly find itself in trouble if it cannot pay its monthly bills. A club that fails to properly plan for its working capital requirements is likely to experience difficulties (financial pressure on clubs increased borrowings and late payment to creditors). Liquidity Ratios Further looking into the clubs working capital, Liquidity Ratio s test whether the club will be able to pay its debts as and when they fall due, this is, Is the club solvent? CURRENT RATIO = CURRENT ASSETS CURRENT LIABILITIES 48 P a g e

49 An acceptable current ratio varies by industry; suggest an acceptable minimum ratio of 2:0 is the general norm (that is, current assets twice the value of current liabilities.) Generally speaking, the more liquid the current assets, the smaller the current ratio can be without concern, however, there should be a reasonable buffer of current assets over current liabilities as an indication of the club to pay its debts as when they fall due. As the current ratio approaches 1 (one) or below (which means the club has a negative working capital), the clubs liquidity should be reviewed. Clubs that have ratios around or below 1 should be those that have inventories that can be immediately converted to cash. If this is not the case, and the current ratio is low, this is a cause for concern and the Clubs liquidity should be reviewed and monitored. Review Activity 2: Balance Sheet Review the Balance Sheet for Example Club Limited and calculate the club s working capital. What can be ascertained about this clubs working capital position? Calculate the current ratio for Example Club Limited and comment on the result. When looking at your clubs current ratio, interpretation (as with all other ratios) only makes sense when compared to the industry norm. This, however, is also not as straightforward as it sounds, as industry norms will vary based on the size and overall financial strength of each club. Also, any industry norm (for even like size clubs) will be the average, rather than the best, and so care has to be exercised. The club should also compare the ratio to trends in previous years. A trend showing a declining ratio would be cause for concern. 49 P a g e

50 ACID TEST (or quick ratio) = CURRENT ASSETS INVENTORY CURRENT LIABILITES If the club has concerns regarding its current ratio trends, the club may wish to use a more sensitive measure. This ratio, known as the Acid test of quick ratio, simply excludes the inventory from the current assets and compares the remaining current assets with the current liabilities. The reasoning behind the exclusion of inventory is that it will take time to turn into cash. It first has to be sold and then, where applicable, the debtors have to pay before the club can use the cash to pay creditors. Long Term Solvency Ratios To consider long term solvency, we look for ratio s that assist in answering the last of the 3 (three) questions posed: Will the club have enough cash to repay a loan if it is due in five years? Therefore, will the club survive and remain a growing concern. Looking at our balance sheet, financial risk is the amount of Debt Finance compared to equity (member s funds). GEARING RATIO = TOTAL DEBT MEMBERS FUNDS The debt to equity ratio measures how much money the club should safely be able to borrow over long periods of time. It does this by comparing the clubs total debt (including short term and long term debt) and dividing it by member s equity. The result you get after dividing debt by equity is the percentage of the club that is indebted or leveraged. The acceptable debt to equity ratio will depend on economic factors, industry specific conditions and general feeling towards credit, however, as a general rule, debt to equity ratio s over 45% - 50% should be looked at more closely, compared to like clubs, and compared to the gearing of the club in previous years. 50 P a g e

51 According to a Club index for the Hunter and Central Coast region, gearing ratios for are: INDUSTRY AVERAGE INDSTRY AVERAGE 10/11 9/10 GEARING: (source: the Hunter and Central Coast, Club Index, Forsythes accountants) As an industry, consider why gearing levels might have increased in ? The reason is club borrowing increased considerably during this time. This followed a significant investment in capital improvements by clubs in the periods following the introduction of outdoor smoking bans. Since this time, capital investment in the industry has generally declined allowing clubs to reduce their overall gearing. Of course with consumer confidence currently low, poor consumer spending could be an issue, reducing revenue at a time when clubs are carrying higher debt levels. Monitoring of the clubs liquidity position would therefore be a priority. A club with debt to equity ratios above 50% (especially increased up on the previous year) together with a low working capital, and poor current and quick ratios, is a sign of serious financial weakness. Understanding Your Debt to Assets This ratio measures the percentage of a business's assets that are financed with debt, and can be calculated using the following formula: Debt to Assets = Total Liabilities Total Assets This measures the percentage of assets being financed by liabilities. For example, if the club had $10 million of debt on its balance sheet and $15 million of assets, then clubs debt ratio is: Debt Ratio = $10,000,000 $15,000,000 = 0.67: 1 or 67% 51 P a g e

52 This means that for every dollar of the clubs assets, the clubs has $0.67 of debt. A ratio above 1.0 indicates that the club has more debt than assets. The debt ratio also quantifies how leveraged a Club is. When the debt ratio is high, the Club has a lot of debt relative to its assets. It is thus carrying a bigger burden in the sense that debt repayments take a significant amount of the club's cash flows, and a hiccup in financial performance, or a rise in interest rates, could result in default. When the debt ratio is low, debt repayments payments don't command such a large portion of the company's cash flows, and the company is not as sensitive to changes in business or interest rates from this perspective. However, a low debt ratio may also indicate that the club has an opportunity to use leverage as a means of responsibly growing the business that it is not taking advantage of. Congratulations, you now have the tools necessary to read and understand a balance sheet! Review Activity 3: Balance Sheet Review the Balance Sheet for Example Club Limited and calculate: a) The club s gearing ratio b) The club s debt to asset ratio What do the results show about the long-term solvency of Example Club Limited? 52 P a g e

53 Limitations of a Balance Sheet Whilst now you should have the tools to read and understand a Balance Sheet, you must also understand its limitations. The fact that a balance sheet represents the position of the club at one point in time is a limitation, because it is relevant only at that point in time. At any other time, a new balance has to be prepared. For a balance sheet to be useful it should be up to date as its utility diminishes as time passes. For the balance sheet to provide a relevant measure of the assets and liabilities of the club the value assigned to those assets and liabilities should also be as recent as possible. The way in which assets can be valued varies, and in some cases is more subjective than others. The right value to choose depends on the purpose for which the balance sheet is to be used. For example, if we want to know how much each item costs, then the historic cost would be appropriate. If, on the other hand, we wanted to know how much each item could be sold for, then the fair value or net realisable value would be appropriate. If we wanted to know how much the club as a whole was worth, it is likely that neither of these would be appropriate. Partly because of the difficulties involved in choosing an appropriate valuation method, and partly because of convention, accountants have traditionally used the historic cost as the basis of the valuation of assets in the balance sheet. Clearly, in certain cases this has led to assets being stated at a figure which bears little, if any, relation to their current value. AASB 116 Property, plant and Equipment allows clubs to measure assets on either the cost basis or the fair value basis. If the club chooses fair value, then any changes in the fair value are reported as an asset revaluation reserve. This forms part of the equity on the balance sheet and should not be materially different to its fair value at that point in time. To gain a clear understanding, for example, of the clubs land and buildings a market valuation should be undertaken. Whilst there are no requirements in law, we would suggest an updated market valuation would be appropriate, say every three years, as required with any known substantial changes to market conditions. Of course independent registered valuers should be used to undertake any valuation. In any industry, there has been issues relating to the ways in which a business is perceived and the ways in which management and boards wish the business to be perceived. Some management perceives that bankers are interested in the amount of assets available as security for a loan. There is therefore a temptation to try and enhance the value of assets, in some cases revaluing land and building, before applying for a loan. 53 P a g e

54 Similarly in difficult trading conditions assets have been revalued (or in reverse known asset declines have not been acknowledged) in order to bolster the image of the club and to promote the impression of a sound assets base. Valuing land and buildings prior to approaching a bank for a loan will mostly be expensive and counterproductive. If banks are taking real property as security for a club debt, they will require their own valuation. Whilst the cost of the valuation will be for the club, the bank will instruct valuers. Generally, the value for lending purposes will be less than the current market value. The bank will also only accept valuations from registered valuers on the Bank s panel of accepted valuers. The value of assets should be conservative and realistic. Land and buildings should possibly be revalued every three years. In Australia there are penalties for directors who attempt to inflate assets or decrease liabilities. Allied to the problem of fluctuations in the prices of specific assets is the fact that the unit of measurement, the dollar (or other unit of currency), does not itself represent a constant value over time. You cannot buy as many goods with a dollar today as you could 10 years ago. Once again, this limits the usefulness of the information contained in the balance sheet. The balance sheet is therefore a highly valuable tool, but has its limitations. The balance sheet is just one key in reviewing the financial position of the club. It provides you with certain information but not the entire picture. What is also important is how much cash the club can generate, to service its members in the future. The balance sheet must be looked at in conjunction with the income statement and cash flow statements, and other factors, before you can make an informed decision. 54 P a g e

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59 2. Understanding the Statement of Comprehensive Income In this section we look at the Statement of Comprehensive Income, commonly known as the profit and loss statement. Learning Outcomes: Understand what the statement of comprehensive income is Understand that the statement of comprehensive income measures performance over a period of time, unlike the Balance sheet which is at a point in time Understand where the clubs earns its revenue Typical expenses and criteria of club expenses Understand the tangible and intangible expenses What special tax concessions apply to the club industry Statement of Comprehensive Income (Profit and Loss Statement) The primary purpose of the Statement of Comprehensive Income (also more commonly referred to as a profit and loss statement) is to report the clubs earnings, over a specific period of time (usually one year) to its members. The income statement sets out the clubs income and expenses incurred, as well as its profit or loss for the period. The profit or loss figure is calculated by offsetting income against expenses for the period. Income statements are generally compared the prior year s balance, and are reset to zero at the start of each period. This provides directors and management with important insights into the clubs current revenue, how effectively the club is controlling expenses, the finance income and expenses of the club, and of course whether the club is producing a profit or loss. The purpose of the income statement is to measure the profit or loss for the period. It does this by summarising the income for the period, and subtracting the expenses from the income to arrive at a profit or loss. This could be depicted as: Profit = Income Expenses The best way to learn to read an income statement is to look at an example line by line. The heading of the income statement identifies the club, in this case, Example Club Limited, the name of the financial statement, Statement of Comprehensive Income, and the time period summarized by the statement, in this case for the year ended 30 June The following statement shows an Income Statement for Example Club Limited. 59 P a g e

60 Example Club Limited Statement of Comprehensive Income For the year ended 30 June 2011 Note Revenue 4 42,361,456 38,384,485 Other Income 5 225,000 Total Revenue 42,586,456 38,384,485 Cost of Goods Sold 2,629,442 2,893,156 Gross Profit 39,957,014 35,491,329 Expenses Personnel Expenses 6 (10,044,728) (9,790,101) Advertising and Promotions (1,916,723) (1,861,335) Cleaning (958,533) (718,137) Consulting and Professional Fees (156,671) (98,105) Donations (658,326) (515,478) Net Gain/(loss) on disposal of property, plant and 3,867 (238,218) equipment Entertainment Expenses (271,435) (225,580) Repairs and Maintenance (3,087,039) (3,571,446) Property Expenses (658,326) (515,478) Bowling (851,767) (792,462) Poker Machine Compliance Costs (9,426,430) (7,908,078) Security Expenses (676,994) (733,235) Other Expenses (1,361,272) (1,253,586) Earnings before Interest, Tax Depreciation and 9,892,639 7,270,090 Amortisation (EBITDA) Less Depreciation & Amortisation 3,967,431 3,118,416 Earnings Before Interest and Tax (and before 5,925,208 4,151,674 impairment losses of land and buildings and net finance costs) Impairment Losses of Land and Building (6,714,709) Results from Operating Activities (789,501) 4,151,674 Interest Income 80,211 51,015 Interest Costs (141,564) (485,865) Net Finance Costs 7 (61,353) (434,850) Earnings Before Tax (850,854) 3,716,824 Income Tax Expense Total (Loss)/profit for the year (850,854) 3,716, P a g e

61 Total Revenue The first line of an income statement is an entry called total revenue. This figure is the amount of money the club brought in during the period covered by the income statement. The revenue of any club may consist of-: Revenue from the sale of goods such as: Bar sales Restaurant sales Coffee shop sales Function sales Gift shop sales Revenue from services such as: Poker machine revenue Keno and TAB commissions Raffles Income Show Receipts Membership subscriptions Other income: In addition to sales revenue from sales of goods and services, a club may have income from other sources, for example it may have earnings from rental properties or other investments. In this case income goes on a separate line and is not included in the sale revenue. Cost of goods sold/cost of sales expense: Cost of goods is the expense the club incurred in order to manufacture, create or sell a product. It includes the purchase price of the raw material as well as the expense of turning into a product. The cost of goods sold expense is the cost of products sold to the customer, the associated sales revenue of which is recorded on the sales revenue line. The idea is to match up the sales revenue of goods sold with the cost of products sold to customers, and show the gross margin, which is the profit before all general expenses are deducted. Given many clubs sell more services than products, these clubs disclose a cost of sales expense, that is analogous to the cost of sales reported by more product base clubs, in which case the gross margin line is still reported. The cost of goods sold calculation is most valuable when it is broken down by categories, ie. coffee shop, restaurant, functions, liquor sales. This is a controllable expense and high cost of goods sold percentages suggest inefficiencies such as waste or spoilage, theft or errors in sales or pricing policies. 61 P a g e

62 Gross Profit As noted above, the gross profit is the total revenue subtracted by the cost of generating that revenue. In other words, gross profit is sales minus cost of goods sold or cost of sales. It tells you how much money a club would have made if it didn t pay any other expenses such as salary, income taxes, office supplies, electricity, water, rent, etc. Gross profit = Revenue - Cost of Sales Gross Profit Margin Although we are only a few lines into the income statement, we can already calculate our first financial ratio. The gross profit margin is a measurement of a clubs efficiency in producing its goods. The gross profit margin shows the percentage of revenue / sales left after subtracting the cost of goods sold. A club that boasts a higher gross profit margin than its competitors and industry is more efficient. A low or declining gross margin can be an indicator of inappropriate pricing policies, high cost of supply agreements or abnormal wastage. Gross profit margin = Gross Profit Total Revenue Operating Expenses The operating expenses of the club are generally lumped together, and include a broad range of general and administrative expenses. These are the costs of operating the club and include costs such as Labor costs ( wages, holiday pay, long service, superannuation) Insurance premiums Travel and entertainment expenses Cleaning Advertising Accounting and consulting fees Telephone and internet charges Legal costs Property maintenance costs Office expenses and stationary etc 62 P a g e

63 General Rule of Thumb: If an expense is not directly related to producing or manufacturing a good or service, it goes under the operating expense section of the income statement. In general, you want the management of the club to be efficient, in that they strive to keep operating costs as low as possible, without damaging the service or product offering of the club, and therefore the underlying business. Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) The profitability of club is generally gauged by examining a clubs Earnings before interest, taxes, depreciation and amortisation. EBITDA = Revenue Expenses (excluding interest, tax, depreciation and amortisation) EBITDA provides an indication of the financial performance of the club, being the cash generated by clubs before payments of financing costs or capital expenditure. EBITDA can be used to analyse and compare profitability within the club industry because it allows comparison of similar clubs, before taking into consideration individual clubs finance or capital expenditure requirements. This measure is also of interest to club financiers (or prospective financiers) and creditors as it is essentially the income that the club has free for interest payments. (As noted in later units, clubs will frequently find minimum EBITDA measurements as part of their Bank security covenants). Remember: the limitation of relying on EBITDA A club is generally considered viable if it can generate sufficient funds from its operating activities to enable it to cover the costs of providing services to its membership and community. EBITDA is an indicator of the club s financial performance. However, the club must also be able to meet its financial obligations and have the capacity to reinvest in facilities in order to remain relevant and competitive. The reality is, clubs do have to pay interest, taxes and reinvest in depreciation and amortisation, so you cannot treat these expenses like they don t exist Lesson: EBITDA is a measure for examining the club s performance and does allow comparison with other clubs, however, should not be relied upon in isolation. 63 P a g e

64 EBITDA as a Percentage of Revenue In its, 2008 report into the financial viability of the club industry, IPART nominated EBITDA as a percentage of revenue as the best measure of a clubs profitability. EBITDA % = Earnings before Interest, Tax, Depreciation and Amortisation Total Revenue Guide: >25% club flourishing 15-25% club solid financial position 10-15% stable 5-10% financial distress <5% serious financial distress Results from the IPART report, based on gaming revenue, were as follows: <$1 million 59% Financial distress $5-$10 million 27% Financial distress >$10 million 14% Financial distress There appears to be a marked correlation between the overall level of financial liability of clubs and their size. As clubs increase in size, the proportion of clubs in financial or serious financial distress reduces. Depreciation and Amortisation There is often some confusion over what depreciation or amortisation is. Basically, because few assets last forever, one of the main principles of accrual accounting requires that the value of an asset be decreased, in proportional amounts, over the expected useful life of the asset. It is recording the loss in value of the asset. Depreciation refers to recording the loss in value of a tangible asset cost over the assets life. For example, the clubs mini-bus can be used for a number of years before it becomes run down and no longer drives or operates efficiently. The cost of the mini bus is therefore spread out over its life, with a portion of the cost being expensed each year. Amortisation, on the other hand, refers to spreading the cost of an intangible asset over its useful life. For Example, patents, copyright, goodwill or gaming licenses. 64 P a g e

65 Earnings Before Interest and Tax (EBIT) Earnings, before interest and tax, is a measure of the club s ability to produce income on its operations in a given year. It is calculated as the club s revenue less its operating expenses (including the non cash expense of depreciation and amortisation) but before subtracting any tax liability or interest due on the debt of the club. EBIT = Revenue Operating expense before interest and tax It is important to note that EBIT does not account for one-off or otherwise unusual revenues and expenses, only recurring ones. It is also known as operating profit. Finance Costs/Income Finance Income Clubs sometimes keep their cash in income bearing accounts, short term deposit accounts or in fixed term deposit accounts and the like. The cash placed in these accounts earns the Club interest, which is recorded on the Income Statement as interest income or finance income. Interest income will obviously fluctuate each year based on the amount of cash held by the Club, type of account it is held in and interest rates, as set by the Bank. Finance Expense Clubs often borrow money from Banks and other financial institutions for many purposes, such as building, extensions, purchase equipment or inventory, or to fund day to day operations. For example, the Club borrows $5 million to buy a building to house the Clubs gym. The building is an asset on the Clubs balance sheet, and the associated debt is recorded as a long term liability. The interest the Club pays to the bank, on the other hand, is an expense for which the Club receives no asset. As a result, interest expense must be accounted for on the income statement. Some income statements report interest income and interest expense separately, while others report interest expense as net. Net refers to the fact that management has simply subtracted interest income from interest expense to come up with a net figure. 65 P a g e

66 For example, looking at the Income Statement of Example Club Limited, the club recorded: Interest Income $80,211 Interest Expense ($141,584) Which could have been recorded as net interest expense ($61,373). The amount of interest the Club pays in relation to its revenue and earnings is of significant importance!! 66 P a g e

67 Interest Coverage Ratio Interest coverage is a very important ratio which should be well known to the management and Board of a club. The ratio is used to determine how easily the club can pay interest on its outstanding debt. The interest coverage ratio is calculated by dividing the clubs earnings before interest and tax (EBIT) for any given period by the clubs interest expense in the same period. Interest Coverage Ratio = EBIT Interest Expense The lower the ratio, the more the club is burdened by its exposure to debt. When clubs interest coverage is less than , its ability to meet its ongoing interest expense is questionable. An interest coverage ratio of below 1 indicates that the club is not generating sufficient revenue to satisfy its interest expense. The club would need to urgently address this issue. Frequently a club will have a minimum interest coverage ratio as part of its Banks lending covenants. NOTE: EBIT does have its shortcomings. If the club does need to pay any tax, it would be misleading to rely on this ratio. A conservative club would take the clubs earnings before interest and after tax and divide it by interest expense to provide a more accurate measure of financial safety. 67 P a g e

68 Earnings Before Tax After deducting interest payments, you are left with the Clubs profit before it pays any appropriate tax. Impairment Losses of Land and Buildings Impairment of assets is the diminishing in quality, strength, amount or value of an asset. The term long term assets, as we have discussed previously, refers to assets such as the clubs land and buildings, machinery and equipment. These assets may be susceptible to an impairment (decline of their value), which can be caused by various factors, such as a: Decline in market value. Change in way the asset is used or physical change in the asset. Adverse changes in legal factors or business climate. Accumulated costs in excess of amounts originally expected to construct or acquire an asset. Technological innovations making the asset obsolete. Impairment losses (sometimes called extraordinary items ) are deducted from the clubs net profit before tax in the profit and loss account. In the profit and loss statement, for Example Club Limited, if you refer to the notes to the accounts, specifically note 12: Property, Plant and Equipment, which notes: Valuation of freehold land and buildings The latest independent valuation of the club s freehold land and buildings, carried out on 12 May 2011 and 28 June 2011 by ABC Assets Management, on the basis of an open market value for existing use, resulted in a valuation of land and buildings of $37,500,000. As a result of the independent valuation undertaken, the club has recognised an impairment loss on freehold land and buildings held at 100 Smith Street, Clubstown NSW 2000, amounting to $6,714,709. As with many general accepted accounting principles, the exact definition of impairment is often in the eye of the beholder. Also, determining fair value has always been problematic, with different professionals and valuers providing different valuations based on which measure of value should be used. 68 P a g e

69 Options include: Current cost (replacements costs) Current market value (selling price) Net realisable value (selling price minus disposal costs) The sum of the future net cash flows from the income generating unit Such valuations can be expensive for the club. There is little detailed guidance in accounting for asset impairments, when to recognise impairments, how they should be measured or how they should be disclosed. The definition, of impairment, therefore, can be a matter of individual judgment, so please seek the advice of your club s accountant. Clearly however, management and clubs relying on inflated long term asset values is not in the best interest of the club and provides a false sense of security. Good Governance The clubs accounts should be a reflection of the current finance health of the club. Management and board should review asset values to ensure they are not overinflated. Involve accountants and industry experts in your evaluation, if you are unsure. 69 P a g e

70 Income Tax Expense The income tax expense is the total amount the club paid in company income taxes. The majority of registered clubs in NSW are incorporated under the Corporations Act and are treated as companies for income tax purposes. As a result, in 2011 the majority of taxable income of clubs was taxed at the prevailing company tax rate of 30%. In 2011, Clubs in NSW paid approximately $18.9 million in income tax. Note that clubs are subject to a number of concessions and exemptions which serve to reduce the taxable income of clubs. The two main forms of these explanations are as follows: 1. Sporting Club Exemption Under the Income Tax Assessment Act, registered clubs which are established for the purpose of encouraging sport are exempt from income tax. Figure A summarises the proportion of clubs for which this exception applies: Figure A: Taxable status 2. Principle of Mutuality Registered clubs are non-profit companies that operate under a principle known as the principle of mutuality. The principle of mutuality provides that where a number of persons contribute to a common fund created and controlled by them for a common purpose, any surplus income arising from the use of that fund for the common purpose is not income. The principle of mutuality does not extend to include income that is derived from sources outside that group 70 P a g e

71 The principle of mutuality will apply where the Club has the following general attributes: The rules of the Club prohibit any distribution of surplus funds to the members, Upon dissolution of the Club, the rules of the Club provide that surplus funds must be donated to another Club with similar interests and activities The operations of the Club fall within the ambit of State/Federal laws governing Clubs, and The Club is a member of a recognised Club Association. The result is that for taxation purposes the income derived and the expenditure incurred by a club will fall within one of three categories; wholly exempt, wholly assessable or deductible, or partly assessable or deductible. Revenue/Expenditure wholly exempt Receipts from and/or payments on behalf of the members (E.g. Subscriptions, cost of membership badges). Revenue/Expenditure wholly assessable/deductible Income and/or expenditure from sources outside the club or its member s (E.g. interest on investments, rent from commercial premises etc). Revenue/Expenditure partly assessable/deductible Revenue and/or expenditure derived from the general trading activities of the club which cannot be identified as either member or non-member (E.g. poker machine, bar and catering trading). These exemptions help to reduce the Club s overall tax rate to generally less than the 30% norm. Comprehensive Income for the Year The comprehensive income for the year is net profit before tax minus income tax expenses. Since this forms the bottom line of the income statement, it is frequently referred to the Club s bottom line. Well Done! You now understand what the Club s Statement of Comprehensive Income is and what the lines of the statement represent!! 71 P a g e

72 Review Activity 4: Statement of Comprehensive Income 1. Review the Statement of Comprehensive Income for Example Club Limited. List any comments or observations regarding this statement? 2. Review the Statement of Comprehensive Income for Example Club Limited for 2011 and a) Calculate the club s gross margin. b) Calculate the club s EBITDA as a percentage of revenue. c) Calculate the club s interest coverage ratio. 72 P a g e

73 Review Activity 5: Looking at your club s income statements Open up your club s previous annual financial report and turn to the income statement. 1. What transactions are included within each balance? 2. Identify for movements in the key categories of income or expenses compared with the previous year? 3. What was your club s profit last year? How does this compare with the previous year? Identify the reasons for any change in profitability? 4. The corporate tax rate is currently 30%. Is your club s income tax expense for the year 30% of its profit before tax? Identify are the reasons for the difference? 73 P a g e

74 3. Understanding the Statement of Cash Flow In this section, we explore the different components of the statements of cash flows. Learning Outcomes: Explain the purpose of the statement of cash flows Understand the difference between accrual accounting and cash accounting Understand what is meant by the concept of cash flow of operating; investing and financing decisions Identify cash flows from operating activities and explain the difference between operating cash flow and profit Identify cash flow from investing decisions Identify cash flow from financing decisions Statement of Cash Flows The Statement of Cash Flows is the third main statement included in the club s annual report. In addition to the balance sheet and statement of comprehensive income, reporting entities are required to prepare a statement of cash flows in accordance with Australian Accounting Standard AASBI07. The purpose of the statement of cash flows is to provide information about the cash receipts and cash payments for the club during its accounting period. It is cash and not profits that the club must use to pay its bills. It is possible for a profitable club to have insufficient cash to meet its debts and therefore be insolvent. The cash flow statement shows how much cash comes in and goes out of the club over the period. At first glance, that sounds a lot like the income statement in that it records financial performance over a specified period, however, there is A SUBSTANTIAL difference between the two what distinguishes the two is that the income statement is based on accrual accounting. 74 P a g e

75 What is the difference between accrual and cash based accounting? Before any business starts recording business transactions, you must decide whether to use cash or accrual accounting. The crucial difference between the two accounting processes is how you record your cash transactions. Accrual accounting requires the club to record revenues and expenses when the transaction occurs. With accrual accounting, you record all transactions in the books when they occur, even if no cash changes hands. For example, if the club has provided a function for 500 people and invoiced the organiser, you record the income immediately and enter the account as an Account Receivable until you receive payment. If you buy a large supply of wine for the restaurant, and wine has been delivered, you enter the wine as inventory and enter the invoice into the accounts payable, until you pay the invoice. Almost all large organisations use accrual accounting. Recording transactions based on occurrence means that each accounting period accurately reflects business for each accounting period. However, because the club records revenue when the transaction occurs and not when you collect the cash, your income statement can look good even if you don t have cash in the bank. Similarly, (as we have noted when we reviewed the Statement of Comprehensive Income) the income statement can also include non-cash revenues or expenses, which has no bearing on cash flow. In the statement of Comprehensive Income for Example Club Limited, we noted a comprehensive loss for the year of $850,854. However, just because an income statement shows a profit (or in this case a loss over the period), that does not mean cash on the balance sheet will increase (or decrease in the case of a loss) by the same amount. Therefore, because it shows how much actual cash the club has generated, the Statement of Cash Flow is critical to ensuring the club has enough cash on hand to continue operating. Therefore, understanding the cash flow statement is critical! What does a Cash Flow show? Having established the need for a statement of cash flow, we need to look at what the statement shows. 75 P a g e

76 The cash flow statement provides a useful means of assessing the short-term viability of a club, including whether the club can: Generate positive cash flows in the future; Pay its debts as they fall due; Continue to provide services to members; and Obtain external finance where necessary. A cash flow statement is divided into three parts: Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities Cash Flows CASH INFLOWS = INCREASES IN CASH BEING MONEY COMING INTO THE CLUB CASH OUTFLOWS = DECREASES IN CASH BEING MONEY GOING OUT OF THE CLUB NET CASH FLOW = NET EFFECT OF CASH INFLOWS AND CASH OUTFLOWS Categories of Cash Flows Statements of cash flows must classify cash flows into three categories: Operating activities Cash flows from operating activities include any flows that relate to the provision of goods and services by the club to members and guests. Examples Investing activities Examples Receipts from customers Payments to suppliers Payments to employees Cash flows from investing activities include any flows that relate to the acquisition or disposal of non-current assets including property, plant and equipment, and investments. Payments relating to the construction of new facilities of a club Proceeds from the disposal of gaming machine entitlements, or plant and equipment Payments for the purchase of investment shares Financing activities Examples Cash flows from financing activities include any flows that relate to changing the size and or composition of the club s borrowings. Cash proceeds raised from additional borrowings Cash payments relating to the repayment of borrowings or interest on borrowings 76 P a g e

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78 Review Activity 6: Your club s statement of cash flows Open up the previous annual financial report for your club, turn to the statement of cash flows and consider the following questions. 1. How much cash has your club generated from its operating activities? What do you think this means for the financial viability of your club? 2. What are the main cash flows that the club has generated from its investing activities? How has the club financed its investments? 3. Has your club borrowed additional money or repaid any borrowings during the year? 4. How has the cash balance at the end of the year changed from the previous year? Statement of cash flows for Example Club Limited Based on the statement of cash flows, how do you thing the club is performing financially? 78 P a g e

79 4. Understanding the Notes to the Financial Statement The purpose of including notes in the financial statements is to provide adequate disclosure of important facts (including accounting policies used) about the club that would not be obvious simply by reviewing the financial statements. Learning Outcomes: To understand the purpose of the notes to the accounts Understand what information will be found in the notes Understand how the information relates back to the main financial statements 79 P a g e

80 Understanding the Notes to the Financial Statement The notes to the accounts provide additional information that relate to the balance sheet, income statement and cash flow. You would have noticed in our statements for Example Club Limited, to the side of some entries was the notation of a number which correlates back to the same number in the notes. For Example; in the Sheet of Example Club Limited, next to the entry inventories there is a reference to Note 10. Note 10 in the notes then provides further information that these inventories were held as stock on hand at the bar and stock on hand for catering. On the statement of Comprehensive Income, next to the Revenue you will see note 4. Note 4 in the notes then provides substantial detail on how the Total Revenue of the Club was derived from the following activities: Sale of goods Commissions Poker Machine Revenue Accommodation Revenue Membership Subscriptions Investment Property Rentals Other Revenue The notes to the accounts are therefore vital to any financial analysis of the club because they include all the detailed information not found in the statements Looking at the financial statements without also reviewing the notes, would be like only reading the table of contents of a novel. You don t get the full story until you read the novel and the same is true for the notes that accompany financial statements. 80 P a g e

81 Attached are the notes to the Accounts for Example Club Limited You will note that the information in these notes includes items such as: Notes which clarify individual statement lines (as noted above). For example if the club lists a loss on a fixed asset impairment line in their income statement, the notes would corroborate the reason for the impairment, by describing how the asset was impaired. Notes are used to disclose significant accounting policies, any change in accounting policies, including information of asset valuation methods. Comments relating to any contingent liabilities and their potential impact on the club. Information about off balance sheet financing, such as operating leases. Comments about any significant changes to the club s operations. Information regarding the valuation of land and buildings. Information regarding what the club defines as core and noncore property (as required by the Registered Clubs Act). Detailed information regarding the clubs property, plants and equipment including value, disposals and acquisition and depreciation. Information regarding loans, borrowings and value and the assets securing the same. Information regarding members funds and the number of members as at balance date. Discussion regarding risk management of the club. Details of any upcoming commitments of the club. Details of any material events subsequent to the balance date. You can see that such information is vital to understanding the financial position of the club. 81 P a g e

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98 5. Understanding the Auditor s Report and the Lead Auditor s Independence Declaration In this section we will look at the auditor s report Learning Outcomes: Understand the role of the auditor Understand that the directors are responsible for preparing the accounts of the club, not the auditor Understand what is meant by the expectation gap and why it holds critical importance for directors Why independence is so important with auditors Understanding what the audit report is saying Understanding the clubs roles and responsibilities for appointing or changing auditors 98 P a g e

99 Independent auditors report As most registered clubs are public companies, an independent auditor must audit their annual financial reports The audit report must state whether, in the auditors opinion, the financial report is prepared in accordance with the requirements of the Corporations Act 2001, including: Giving a true and fair view of the club s financial performance during the year and its position at the end of the year; and Complying with Australian Accounting Standards and other Requirements External auditors and the members and user of the club s financial reports wish to be assured that the clubs accounts represent a true and fair assessment of the club s financial position. The independent person who audits the club s financial reports is the auditor. They are seen as an independent external observer, who is called upon to express an opinion that the reports provide a true and fair representation of the club s financial status. However, we must stress, it s the Directors of the club, not the auditor, who are responsible for the preparation and the presentation of the club s annual accounts to members. It is the Directors that must provide and sign the declaration as to the true and fair representation of the accounts. The purpose of an external auditor is to add credibility to the reports presented by the directors and independently review to ensure all reports are presented in accordance with accounting standards. Most clubs will have an internal auditor, treasurer or finance manager who is responsible for monitoring the processes used by the club. An efficient internal audit function reviews policies, procedures and processes and ensures they are working as they should be, making recommendations and aiding changes. The added benefit of this function is that, if conducted properly, will improve policies, procedures and processes of the club which in turn may reduce the time taken and cost of an external audit. 99 P a g e

100 The Corporations Act requires that every registered club must have an auditor. Audited reports are comfort to members and external parties (such as banks) that the clubs accounts can be relied upon. Again, please note that the auditor does not prepare the financial reports, which remains the responsibility of the directors. The auditor s role is to: Review the accounting systems Check the accuracy of certain transactions (particularly those larger transactions) State that the accounts have been prepared in accordance with the Corporations Act and applicable accounting standards and that they provide a true and fair view During the audit, the auditor collects evidence to obtain reasonable assurance that the amounts and disclosures in the financial statements are free of material misstatement. However, the characteristics of evaluating evidence on a text basis, the fact that accounting estimates are inherently imprecise, and the difficulties associated with detecting misstatements hidden by collusion and careful forgery, prevent the auditor from finding every error or irregularity that may affect a user s decision The auditor also evaluates whether audit evidence raises doubt about the ability of the client to continue as a going concern in the foreseeable future. However, readers should recognise that future business performance is often uncertain, and an auditor cannot guarantee business success Through the audit process, the auditor adds credibility to management s financial statements, which allows members. Investors, bankers and other creditors to use them with greater confidence The auditor expresses his assurance on the financial statements in an auditor s report. The report, which contains standard words and phrases that have a specific meaning, conveys the auditor s opinion related to whether the financial statements fairly present the entity s financial position and results of operations. If the auditor has reservations about amounts or disclosures in the statements, he modifies the report to describe the reservations The auditor s report and management s financial statements are only useful to those who make the effort to understand them 100 P a g e

101 Who can act as the club s auditor? A person who is appointed as a club auditor is required, under the Corporations Act, to meet certain requirements. Briefly, the auditor must: Have the appropriate tertiary qualifications and have completed a prescribed course in auditing or have other qualifications or experience that ASIC considers equivalent to both requirements; and Meet one of the following practical experience requirements -Satisfy all the components of an ASIC approved competency standard; or -Have the level of practical experience that is prescribed in the Corporations Regulations or experience that ASIC considers equivalent; and -Satisfy ASIC that they are capable of performing the duties of an auditor and are otherwise a fit and proper person to be registered as an auditor. The auditor is required to form an opinion on the general-purpose financial reports of a club, to determine whether proper records have been kept, and to report to members. The auditor must also inform ASIC of any suspected wrongdoing by management or any non-compliance with applicable accounting standards The auditor can be removed only by special notice, given at the annual general meeting, and the ASIC must be informed. ASIC has the power to stop an auditor from resigning or being removed from the office Besides the statutory requirements noted above, the auditor is bound by professional obligations, which cover: Independence, integrity, confidentiality and ethical considerations Conformity with accounting and auditing standards, auditing guidelines and statements of auditing practice. 101 P a g e

102 The Auditors Report : EXAMPLE CLUB LIMITED: A.B.N Independent Audit report to the members of EXAMPLE CLUB LIMITED. Report on the Financial Report We have audited the accompanying financial report, being a special purpose financial report of Example Club Limited, which comprises the statement of financial position as at 30 June 2011, the statement of comprehensive income, statement of changes in equity and statement of cash flows for the year then ended, notes comprising a summary of significant accounting policies and other explanatory information, and the director s declaration. Directors Responsibility for the Financial Report The directors of the company are responsible for the preparation of the financial report and have determined that the basis of preparation described in Note 1 to the financial report is appropriate to meet the requirements of the Corporations Act 2001 and is appropriate to meet the needs of the members. The directors responsibility also includes such internal control as the directors determine is necessary to enable the preparation of a financial report that is free from material misstatement, whether due to fraud or error. Auditors Responsibility Our responsibility is to express an opinion on the financial report based on our audit. We have conducted our audit in accordance with Australian Auditing Standards. Those standards require that we comply with relevant ethical requirements relating to audit engagements and plan and perform the audit to obtain reasonable assurance whether the financial report is free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial report. The procedures selected depend on the auditor s judgement, including the assessment of the risks of material misstatement of the financial report, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity s preparation of the financial report that gives a true and fair view in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by the directors, as well as evaluating the overall presentation of the financial report. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. In conducting our audit, we have complied with the independence requirements of the Corporations Act 2001, which has been given to the directors of Example Club Limited, would be in the same terms if given to the directors as at the time of the auditor s report. Opinion In our opinion the financial report of Example Club Limited is in accordance with the Corporations Act 2001, including: Giving a true and fair view of the company s financial position as at 30 June 2011 and of its performance for the year ended on that date; and Complying with Australian Accounting Standards to the extent described in Note 1, and the Corporations Regulations Basis of Accounting Without modifying our opinion, we draw attention to Note 1 to the financial report, which describes the basis of accounting. The financial report has been prepared for the purpose of fulfilling the directors financial reporting responsibilities under the Corporations Act As a result, the financial report may not be suitable for another purpose. ABC Auditors John Smith 20 September P a g e

103 Lead Auditor s Independence Declaration under Section 307C of the Corporations Act To: the directors of Example Club Limited I declare that, to the best of my knowledge and belief, in relation to the audit for the financial year ended 30 June 2012, there have been: i) No contraventions of the auditor independence requirements as set out in the Corporations Act 2001 in relation to the audit; and ii) No contraventions of any applicable code of professional conduct in relation to the audit. KPMG (Audit Partner Name) Partner (Place of signing) (Date of signing) 103 P a g e

104 Types of Audit Reports There are effectively five different audit opinions as expressed below. 1. Unmodified or Unqualified Opinion Under an unmodified opinion, the auditor agrees that the financial statements are true and fair and prepared in accordance with Australian Accounting Standards. Example: In the case of Example Club Limited, the financial statements of the entity are prepared in accordance with Australian Accounting Standards and we believe the audit evidence we have obtained is appropriate to provide a basis for our audit position. 2. Emphasis of Matter In an emphasis of matter of opinion, the auditor modifies the report to highlight a matter impacting the club which is discussed in further detail in the financial report. The Opinion remains unqualified. Example: Cash flow forecasts show that the Hassett Club needs the continuing financial support of its members in order to pay its debts as they fall due. 3. Qualified A qualified opinion will be issued where the auditor disagrees with one or more item within the financial statements. Example: In its annual financial report, Club Lindwall recognises its gaming machine revenues inclusive of GST, which is not in accordance with Australian Accounting Standards. The treatment means that the club s revenues are materially misstated and the director s refuse to make an adjustment. The club s auditors qualify their opinion reporting that the financial report is prepared in accordance with Australian Accounting Standards except for revenues which are overstated. This is commonly referred to as an except for opinion (i.e. The auditor states that the financial report is true and fair, except for ). This reliance has been disclosed in the notes to the financial statements and is highlighted by the club s auditors within the auditors report. 4. Adverse An Adverse opinion is expressed where the disagreement is so fundamental that a simple qualification is insufficient. Example: The Directors of the Miller Club refuse to include an income statement in the annual financial report. The club s auditor expresses an adverse opinion because of the fundamental nature of the omission. 5. Disclaimer If the auditor cannot issue any opinion on the financial statements because he/she was unable to gather a sufficient amount of competent evidence, you issue a Disclaimer Report. The auditor shall disclaim an opinion where the auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion, and the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive. 104 P a g e

105 Your Bankers Requirements Please note that a requirement of your banking facilities may be that the club provides the Bank, annually, with a copy of your fully audited financial statements. The Bank will often have written into their terms and conditions a Material Change Clause, which means that the Bank reserves the right to immediately review (or in some cases, via event of default clauses, seek immediate repayment of) all debt if the financial statements suggest an adverse change in the clubs financial position or if for any reason the club s auditor provides a qualified, adverse or disclaimer report in respect to the club s financial statements. The Expectation Gap As discussed above, the directors of the club are responsible for preparing the accounts, and the auditors are responsible for seeing that those accounts have been prepared according to statutory and financial requirements. So, are auditors are responsible for detecting fraud or illegal acts? Are auditors responsible for errors in the financial accounts? For example, if current debt has been recorded as long term debt? The Answer is NO! There is no question that in the past years, the auditing profession has been criticised for not fulfilling what many people thought was its role, Such criticism has gained momentum due to the onset of the Global Financial Crisis (GFC). 105 P a g e

106 The criticism has arisen, at least in part, because numerous organisations have failed after being given an unqualified opinion by their auditors most notably Enron, HIH and OneTel. It is this difference between what an auditor is required to do and what is expected by management and directors, that is, known as the expectation gap. The Case of the Centro Properties Group This case is a perfect example of the Expectation Gap. In this case, the Board of Directors as well as two executives were found to have failed to satisfy their financial reporting obligations, along with more general duties as directors, when it was discovered that the 2007 annual report failed to disclose US 2 billion of short term (current) liabilities (classifying them as long term or non-current), while guarantees for short term liabilities of approximately US 1.7 billion had been granted after the balance date of 30 June The defense of the Centro Board of Directors was that they placed reliance on the competence of their management team, audit committee and auditors (none of which detected an error in the accounts), hence, in their view, they had not breached any duties as directors. Fundamentally, the court rejected such a defense, stating the Board of Directors knew or ought to have known there was significant short term debt, irrespective of the fact their auditors did not detect the error either. It was ultimately the responsibility of the directors! Many clubs and other organisations have pointed the finger at auditors after fraud or illegal activities of staff comes to light. It is important for clubs to be aware that reporting of fraud and illegal acts, whether actual or suspect, is a requirement of the Corporations Act, and again, many see this as the role of the auditor. The issue for the Club however, is that the auditor does not check every transaction in the club, but rather selects a sample of transactions to review. Whilst these sampling methods are based on statistical methodologies, the reality is not every transaction is tested. Audit costs can be substantial. For an auditor to review every transaction that goes through the club, realistically the cost of such an exercise would be unreasonable in terms of cost and time. Therefore, the auditor uses a sampling method to test certain transactions so that he or she can be reasonably assured that the financial statements provide a true and fair view of the Club. Clubs need to be reminded that this is not a guarantee that every error in the financial statements of the Club has been detected. This in part explains the Expectation Gap. 106 P a g e

107 Auditors face similar challenges when it comes to detecting fraud in an audit. It must be realised that they are not detectives, and in some cases, they miss the red flags for fraud. In other instances, they do not always take the appropriate steps to uncover fraud once a red flag surfaces during an audit. Other reasons an auditor may fail to identify the warning signs of fraud are: Over reliance on club s representations Lack of awareness or recognition of an observable condition indicating fraud Lack of experience Personal relationships with clients that cloud their judgment Failure to identify possible fraud schemes (while auditors are not fraud specialists, they can become more proficient in fraud detection skills with appropriate training) A desire not to know A lack of independence such that auditors do not want to rock the boat, which might affect other work or income Independence of the Auditor is Critical to the Club There have been numerous changes to the Corporations Act which has resulted from concerns about the lack of audit independence in high profile cases such as Enron, HIH and OneTel. Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 20,000 staff and was one of the world's major electricity, natural gas, communications, and pulp and paper companies, with claimed revenues of nearly $101 billion during Fortune named Enron "America's Most Innovative Company" for six consecutive years. At the end of 2001, it was revealed that its reported financial condition was sustained substantially by an institutionalized, systematic, and creatively planned accounting fraud, known since as the Enron scandal. Enron has since become a well-known example of wilful corporate fraud and corruption. The scandal also brought into question the accounting practices and activities of many corporations in the United States and worldwide. The scandal also affected the greater business world by causing the dissolution of the Arthur Andersen accounting company. HIH Insurance was Australia's second largest insurance company. It was placed into provisional liquidation on 15 March The demise of HIH is considered to be the largest corporate collapse in Australia's history, with liquidators estimating that HIH's 107 P a g e

108 losses totaled up to $5.3 billion. Investigations into the cause of the collapse have led to conviction and imprisonment of a handful of members of HIH management on various charges relating to fraud. One.Tel was a group of Australian based telecommunications companies, including principally the publicly listed One.Tel Limited established in 1995 soon after deregulation of the Australian telecommunications industry, most of which are currently under external administration by court appointed liquidators. The company was established by Jodee Rich and Brad Keeling and had high-profile backers such as the Murdoch and Packer families. James Packer and Lachlan Murdoch sat on the board of the company. One.Tel attempted to create a youth-oriented image to sell their mobile phones and One.Net internet services. It became Australia's fourth largest telecommunications company before collapsing in Rich and Keeling continued to receive $7m in payments shortly before the company entered administration So what role did the auditors have in these high profile failures? In the case of OneTel, it was alleged the accounting practices were questionable allowing a $7 million loss to be reported as a $25 million profit in 1999, and reportedly concealing $173 million in expenses in Their auditors, however, who were earning substantial fees from OneTel, gave the company a clean bill of health in an unqualified audit report. It was concluded that the auditor failed to observe a proper standard of professional care, skill or competence in the course of carrying out their duties. The independence of Arthur Anderson was also questioned in the HIH collapse. Arthur Anderson had three former Anderson partners on the HIH board and one Anderson partner was the Chairman of the HIH Board. There was a clear conflict of interest. Arthur Anderson was also earning considerable income from consulting fees from HIH, and it was concluded that they did not perform the audit in the best interests of stakeholders, but rather just to please the management of HIH. Similarly, the auditor for Enron was not just providing audit services to the client but was also providing other services such as tax services, consultancy work, accounting, IT and internal audit work. Again, like the case of OneTel and HIH, the fees received for the non-audit services far exceeded the audit fee. 108 P a g e

109 The obvious concern therefore, was that the auditor will be reluctant to be critical of a company in an audit, when they rely on that same company for substantial work and hence income. As a result of the above cases, organisations in Australia are now required to disclose the fee s that they pay to auditors for all the services carried out in addition to the audit and provide a statement as to why any additional fees have not impaired the independence of the audit report. As can be seen in our Example Club Audit report, auditors must also make a declaration about their independence. One of the other issues in the Enron case, as in the HIH case, was ex-partners of the auditors serving on the Enron and HIH board. It was felt such persons could not be truly independent if they were in fact working on or receiving income from the audit. In Australia, there is now a two year ban on former audit partners taking up positions on the boards of former clients. There is also a requirement for an automatic rotation of an audit partner after five years to assist with this issue of independence. Clubs need to ensure that external auditors maintain independence from the club so that they can properly fulfill their duties and give an unbiased opinion about the clubs financial statements. This unbiased opinion is in turn protecting the blub directors who sign off on the club s financial accounts. The club establishing an Audit Committee can further protect the club. Appointment of Club Auditors Every registered club must have an auditor. When a club is first incorporated, the auditor is appointed by the directors and remains in office until the first annual general meeting when the members appoint an auditor. Once appointed, that auditor continues in office until death, resignation or removal from office. It is therefore not necessary to appoint an auditor at each annual general meeting unless there is a vacancy in the office of auditor. If a vacancy in the office of auditor occurs other than by removal from office by the members in general meeting, the directors can appoint an auditor to fill the position but that auditor holds office only until the next annual general meeting of the club, when once again it is for the members to appoint an auditor. The relevant procedures for the removal of an auditor are set out in Section 329 of the Corporations Act. If the club is a co-operative, Section 329 of the Corporations Act should be read in conjunction with the amendments contained in the Co-operatives Regulation. 109 P a g e

110 Notice of intention to move a resolution to remove an auditor must be given to the club at least two months before the meeting at which the resolution is to be considered is held. Notice of the meeting and proposed resolution to remove the auditor must be given to all members at least 21 days prior to the meeting. Immediately after the club receives notice of a resolution to remove the auditor it must send a copy of the notice to the auditor. If the club is a corporation, it must also lodge a copy of the notice with the Australian Securities and Investments Commission (ASIC). If the club is a co-operative, it must lodge a copy of the notice with the Director General of the Department of Fair Trading. After receiving the copy of the notice, the auditor may make representations in writing to the club dealing with the resolution for removal. The auditor may also request that a copy of the representations be sent at the club s expense to every voting member of the club before the meeting at which the resolution to remove the auditor from office is to be considered. The auditor is also entitled to require that those representations be read out at the meeting, without any prejudice to his or her right to be heard at that meeting. The resolution to remove the auditor is an ordinary resolution and therefore requires votes in its favour from not less than a simple majority of those members, who being eligible to do so, vote in person at the meeting Appointment of a New Auditor If an auditor is removed from office at a general meeting, the club may immediately appoint a new auditor by a resolution passed by a majority of not less than three quarters of the members, who being entitled to do so, vote in person at that meeting. If such a resolution is not passed the meeting may be adjourned to a date being not earlier than 20 days and not later than 30 days after the date of the general meeting. At the adjourned meeting, the members may appoint an auditor by an ordinary resolution, that is, by a simple majority. A club must not appoint any person or firm as auditor of the club unless that person or firm has, before the appointment, consented by notice in writing to the club or to the directors to act as auditor, and that person or firm has not withdrawn that consent. Where notice of nomination of a person or firm for appointment as auditor is received by the club, it shall, not less than seven days before the meeting or at the time notice of the meeting is given, send a copy of the notice of nomination to: Each person or firm nominated; Each auditor of the club; and Each person entitled to receive notices of general meetings of the club. That is, all voting members. 110 P a g e

111 These may appear to be intricate procedures; nonetheless, they must be strictly followed. Failure to do so could involve the club and any officer of the club in a breach of the Corporations Act. It is recommended that legal advice be obtained before any steps are taken to remove an auditor or appoint another auditor. 111 P a g e

112 6. Directors Report In June 2010, the Government introduced the Corporate Reporting Reform act which aims to improve Australia s reporting framework. Incorporated into this Act was a requirement for a new streamlined Directors Report. This is a requirement of those clubs limited by guarantee and hence subject to the Corporations Act. The aim is to make this report more meaningful for members. The Directors report for the club must now have the following information included: The clubs short and long term objectives. The clubs strategy for achieving those objectives. The clubs principal activities during the year, stating how those activities assisted in achieving the clubs objectives. How the club measures it performance including any key performance indicators used by the club. The report must also include: The name of each person who has been director of the club at any time during or since the end of the year and the period for which the person was a director. Each director s qualifications, experience and special responsibilities. The number of meetings of the board of directors held during the year and each director s attendance at those meetings. For each class of membership in the club the amount which a member of that class is liable to contribute if the club is wound up. The total amount that members of the club are liable to contribute if the club is wound up. The Directors Report for Example Club Limited is attached for your information. 112 P a g e

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116 7. Directors Declaration In addition to the Directors Report, the annual financial report must include a declaration by the Directors. The directors are required to declare that in their opinion: The financial statements and notes of club comply with accounting statements. The financial statements and notes thereto give a true and fair view of the financial position and performance of the club. The financial statements and notes thereto are in accordance with the Corporations Act 2001 and the Corporations Regulations There are reasonable grounds to believe the club will be able to pay its debts as and when they become due and payable. The Directors Declaration for Example Club Limited is attached for your information. 116 P a g e

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118 Understanding Management Accounts Management accounts are any financial report that a club prepares in order to help make management decisions. As these accounts are prepared for internal use only, the structure and content can be tailored to suit the club and, therefore, their format varies greatly from club to club. Management accounts can be lengthy or brief, depending on the type of club and management decision being undertaken. We again reiterate that the Board is legally responsible for the financial viability of the club; therefore the basis upon which the Board s makes financial decisions and judgments needs to be as reliable and complete as possible. The availability of accurate, up to date, readily understandable management accounts is therefore an essential business tool for clubs. The monthly reports represent a snapshot and convey the current state of financial health and activity of the club. What are the typical components of monthly management accounts that Boards need to consider each month? As noted, whilst the structure and format of management accounts will vary from Club to Club, typical components of management accounts will include: Income Statement (Profit and loss statement) This statement should be presented on a monthly income and expenses basis showing a comparison of: Actual (what actually took place) Budget (what the Club had anticipated) Comparison to last year result Both actual and budget should be shown as monthly result and year to date result. This provides a monthly measuring stick, with a comparison of actual to budget, as well as a comparison to the same time in the previous period, all indicating the ongoing financial performance of the club. How are expenses or income comparing to the previous month, previous time last year, or comparing to budget? Whilst budgets will be discussed in the subsequent unit, compare the result to what was anticipated in the budget. If substantially below budget why? If substantially ahead of budget- why? Is the budget still accurate given changes to operating environment? If substantially ahead/below previous month or similar period last year, why? 118 P a g e

119 Balance Sheet Statement Again showing a comparison of actual and budget figures as well as year to date and monthly comparisons and asking same questions above. Statement of Cash Flow Showing actual cash receipts and cash payments compared to budget and previous period and asking the same questions above. Included should also be a report on the club s debt profile and ability to repay given cash flow results. Trading Statements (also known as Segment or Departmental reporting) Trading statements allow for more thorough and valuable review and analysis of the various segments of the club. Segment reporting is where distinguishable operating activities are reported separately in the income and expenditure statement. For example bar, restaurants, coffee shop, gaming, are all reported separately. Trading statements assist in: Identifying underperforming or loss making areas of the club. Identifying performance issues relating to department managers or other staff Allowing the establishment of specific and measurable goals. Identifying any unusual trends, large transactions or anything unusual within individual departments (which can also be an indicator for fraud issues). Can be split into function, outlets, by location or any combination of the above. Key performance indicators and benchmarking for the club as a whole and/or on a departmental basis Management Report Management discussion should include analysis of overall club performance; actual versus budget and other comparisons, any known industry or environmental factors which the Board needs to be aware. Interpretation and commentary should enable the Board to examine and discuss those items, in particular, where actual figures show deterioration/negative trends. The Board firstly needs to ensure: They are receiving monthly reports from the CEO in a timely manner, including adequate time to review prior to next Board meeting. That each Board member understands the language, form and content of the monthly reports. 119 P a g e

120 That if a Board member does not understand anything presented that they know what questions to ask of management. That each Board member is comparing both monthly and year to date financials. At the monthly meeting the Board should consider each statement separately, and: COMPARE and examine the actual and budget figures ASSESS the differences The sort of questions the Board needs to ask where the actual figures on these three statements are below budget, include: Why any actual figures are not as good as the monthly or year to date budget figures? Whether such deterioration (ie income less than budget or payments more than budget) only applies to the monthly figure or does it also apply to the year to date figure? Whether such deterioration has appeared in previous months figures. Is there a particular activity (segment) causing concern and why? CORRECT the position. What action needs to be taken to correct the position? It may be that hard or critical decisions need to be made to stop the deterioration or at least monitor unsatisfactory results in coming months, but also there may be a reasonable explanation why this is a temporary position (for example, reduction in income due to unexpected closure of coffee shop due to flooding, in which case club should review budgets). By following such a procedure, on a monthly basis, the Board will ensure they have a full understanding of the financial position of the club. If a Board does not compare, assess and correct on a monthly basis, they risk the ongoing financial stability of the club, as areas needing attention are overlooked. 120 P a g e

121 Review Activity 7: Management accounts Consider the management accounts currently prepared by your club. Are they easy to read and understand? Do they provide you with the information you require Are they too detailed? Not detailed enough? Are they available to you, within a reasonable time to review prior to the Board meeting? What time do you consider reasonable? How long after period end are they provided? Do they include all the information recommended above? 121 P a g e

122 Does the CEO provide sound and adequate commentary, focusing on any areas of concern? Does the chair provide advice or guidance to directors who do not understand the accounting? Summary By now you should: Understand the different between statutory reports and management accounts. Be able to list the different types of statutory financial statements required to be prepared by registered Clubs Understand the major components of the statutory financial report prepared in accordance with the Corporations Act. Understand the three basic principal statements included in the statutory financial report and understand what they can tell you: Balance sheet Statement of Comprehensive Income Statement of Cash flows Understand the purpose of management reporting and the typical reports provided to Directors. 122 P a g e

123 Unit 3: Monitor Financial Performance 123 P a g e

124 MONITORING FINANCIAL PERFORMANCE In Unit 3, we will provide an overview of how directors of registered clubs monitor the financial performance and viability of their club. We will look at different types of budgets prepared by clubs and their roles and the importance in monitoring financial performance. We'll also look at the different ways that budgets can be compiled by clubs. Following the recommendations of IPART, we'll also look at performance management and how clubs can use ratios to better understand and report on their financial performance and viability. Finally, we will consider the importance of benchmarking to clubs and how comparable measures can act as a powerful tool for directors to monitor the profitability and efficiency of their clubs. Learning Outcomes: Understand the role of budgets in a financial reporting framework Understand the budgeting process and the various methodologies commonly used by registered clubs in determining budgets Be able to list, calculate and interpret the common financial performance ratios used by registered clubs Understand the value and importance of benchmarking to assess the profitability and efficiency of registered clubs 124 P a g e

125 The total procedure for financial management and monitoring is a team effort with the CEO and staff, finance committee and the Board all working together. As stated previously however, it is the Board who is accountable and has ultimate responsibility to ensure the club has sufficient funds always available to meet the financial commitments of the club as and when they fall due, that is, to ensure the club is solvent at all times. The Board s governance role and function is to: Endorse the strategic and policy framework for the club Ensure financial stability and solvency, and Ensure compliance with all legislative, statutory and contractual duties, obligations and requirements. Board The term Board is used here to encompass the governing structures of the club. By Board we mean the governing body of the club. One of the main responsibilities of the Board is to oversee the financial control and accountability of the club and to ensure that this money is used appropriately to benefit the members. The Board exists to represent the members and to be accountable to those people or agencies that provide the money to make this possible. In some clubs, the Board delegates some of its functions to a Finance Committee. However, all members of the Board still remain responsible, and accountable for, the finances of the club. Proposals put forward by the Finance Committee must be approved by the full Board. The Financial Roles and Responsibilities of a Board The Board is responsible for ensuring the club has adequate resources to carry out its functions: This may not mean actually raising or managing the money, but it does mean monitoring the finances carefully. Ensuring that the organisation uses its time and money well: The Board must see to it that money is not wasted or used to benefit staff members instead of achieving the organisation s objectives. Overseeing the acquisition and management of resources: The Board has to make informed decisions about how the money of the club is spent. This is particularly so when the club wants to buy resources that are costly. It is also the 125 P a g e

126 responsibility of the Board to see that such resources are well looked after. They are part of the assets of the club. Board members have something which is called the Duty of Care. This means that each Board member is expected to be attentive to the affairs of the club, and to behave in the way a reasonable and careful person would behave. The Board can delegate some of its areas of work to experts (e.g. an auditor) but it still has a duty to understand the finances of the organisation and to raise concerns about them. The Duty of Care requires the Board to read and understand the financial statements, and to keep track of the organisation s financial situation. While the board is responsible for financial reporting, they are also responsible for the control of finances by setting up financial policies, to create internal controls and monitoring of those internal controls. Arranging an internal audit process is also beneficial. Board members must attend Board meetings, read all documentation given to them, review available information, and monitor any special areas that have been assigned to them. Board members may need training to help them fulfill their Duty of Care. Board members must: Approve the budget, after due consideration Approve a budget policy that sets discretionary levels (grants of authority) advising the Chief Executive Officer how much he/she can spend without Board approval) Approve all financial policies and other policies that affect the finances of the organisation Review monthly and annual financial reports, looking specifically at variances, balance sheets, and cash flow statements Monitor progress in generating funds Review the audited statements Review the bank balance periodically and make decisions about longer term investments Check that the assets, as listed in the assets register, are actually there and are being appropriately maintained. CEO The Chief Executive Officer (CEO) of an organisation. This is the person who has day-to-day responsibility for: Budgeting Income generation Expenditure Limited rights to make decisions about large expenditures (the Board decides on the limits) Ensuring that financial records are kept Ensuring that books are kept accurately 126 P a g e

127 Ensuring that financial reports are produced on time and distributed to the right people Monitoring that activities are in line with expenditure Checking financial reports and drawing the attention of staff and Board to any problems Introducing lower level policies to deal with problems e.g. policies about telephone usage usage (these are usually approved by the Board or Finance Committee) Appointing financial staff (although, at senior levels, this should be done together with an appropriate Board member). While the CEO may delegate some of the activities, the responsibility is still his/hers. Management Team The management team of the club is usually made up of the senior staff members of the club (often department managers), those that have senior management positions. In a smaller organisation it may be made up of the CEO and middle managers. The most senior financial person on the staff usually sits on the Management Team, unless the organisation uses a financial service organisation and only employs relatively junior financial staff. Everyone on the management team should understand financial reports. These reports should be discussed once a month at the regular management team meetings. Members of the management team should: Budget for their departments or projects. Monitor their budgets against expenditure. Manage their budgets within the limits set. Explain the monthly financial reports for their departments or projects to their management team. Apply their minds to the overall organisational financial reports and give input to the CEO on them. Assist the CEO with income generation, with specific reference to their projects or departments. It may be necessary to provide some training to enable people to meet these expectations. 127 P a g e

128 Staff Different members of staff are usually responsible for different parts of the day-to-day financial control in a club. This is in line with dividing control of power over the money. Many of the tasks are, however, carried out by the bookkeeper. The tasks of the bookkeeper include: Issuing receipts for funds received Depositing money into relevant accounts Preparing cheque requisitions for payment Ensuring accounts are paid on time Ensuring the cash book, or computer spreadsheet, is completed within an agreed time-frame at the end of each month Ensuring control and recording of assets, sundry items and stationery Ensuring all financial documents are available for the auditors. The sorts of tasks to separate (give to different people) for better financial control are the receipting and depositing of cash, and the preparation and approval of cheques. All members of staff involved in the finances must understand the importance of what they are doing and of doing it accurately and on time. It often helps to build this kind of responsibility if staff are also taken through the monthly statements. In this way, they will understand them and see the contribution their work makes. Financial Performance Management Financial management and monitoring is an encompassing term for the activities undertaken and procedures followed by the Board and CEO in the planning, coordinating and control of the finances of the club. This will ensure the best possible business practices and best possible services for its members. The Board should endorse, document and resource appropriate policies and procedures for an effective and efficient financial management and monitoring system. Monitoring of the Clubs financial performance is then a matter of the Board s ensuring that their endorsed policies and procedures are followed explicitly. If there is any deviation from existing procedures, it s ultimately the Board s responsibility to find out the reason for this and correct it. Directors are responsible for ensuring that the club s management team is acting in a responsible and prudent manner, in the best interests of the club. 128 P a g e

129 There are a number of tools available to directors to assist them to properly fulfill this critical role. These include: Budgets: Comparisons of actual and budget performance Financial ratios: Helping to explain the club s financial performance and financial viability Benchmarking: Comparing the club s financial performance against other clubs Record Keeping for Improved Financial Information ONLY ACCURATE DATA THAT IS RECORDED IN A SYSTEMATIC WAY WILL PROVIDE THE NECESSARY FINANCIAL INFORMATION THAT CAN LEAD TO IMPROVED FINANCIAL PERFORMANCE. As discussed previously, the decision made by management and the Board will be based on a review of the financial position of the club. This is achieved by reviewing the statutory and management accounts. The management and Board therefore needs to assure themselves that the financial information is accurate and will be presented in a format that will assist in making the right decisions. In our discussion of the three main financial statements, it is apparent that there are many categories to consider when recording the financial information associated with any transaction. Most clubs would have invested in an appropriate financial recording system. It is valuable exercises to have the club s accountant review your systems from time to time. It is also prudent that the Board review annually how information is being reported and used to ensure it continues to meet the clubs requirements. Preparation of Financial Information To ensure the financial information used by the club is meaningful and will assist in making informed decisions, it is important that the club have policies and procedures in place to support accurate and up to date information. All financial transactions should be recorded regularly, for large clubs daily. Most clubs will use a financial management software system. You should seek advice from the clubs accountant on the appropriate system for your club. 129 P a g e

130 Once you have chosen an appropriate software system, next step is to ensure transactions are entered regularly and accurately. It is also critical to ensure you have in place a suitable backup system, to guard against data loss in the event of hardware or software crash. Ensure that you can restore data from your backup. Financial Controls Financial Management not only is the understanding of financial information of the club, it is also ensuring that the right policies and procedures are in place to ensure that the financial information being used is accurate. Good financial controls are therefore required for complete financial management. A financial control is a procedure that is implemented to: Prevent and detect errors Theft or fraud Policy non compliance Financial control procedures can be implemented by an individual, a team or committee, or as part of an automated process within the financial system. If the financial information being used is not accurate, then this will lead to the wrong decisions being made. Financial control procedures should meet at least the following criteria: Completeness: all records and transactions must be included in club reports Accuracy: correct amounts recorded Authorisation: ensure the correct authorisations and authorities are in place for purchase approvals, payments, data entry and computer access. Policies should be in place to cover these. Validity: checking that the invoice is for a product or services received and approved by the club. Has all work been completed satisfactorily? Existence: this is like an audit procedure. Have purchases or in fact payables, been recorded for goods and services not received? Do all the assets on the clubs balance sheet actually exist? Are you still being invoiced for debts which should have been repaid or contacts that have actually expired? You also need an asset register giving a detailed description of each asset (e.g. gaming machines, photo copiers, furniture etc.) Handling Errors: ensure procedures are in place to ensure that errors in the system are identified and corrected. This will help to identify fraud or errors. Identification of clear segregation of duties: ensures certain functions are separated e.g. person counting cash receipts should not also be doing banking. Clear policies should be in place about which staff member has what responsibilities, and goes hand in hand with authorisations, that is, who has the authority to approve payments, purchase assets and write cheques. 130 P a g e

131 Budgeting and Forecasting Budgets and forecasts are the future financial plans of the club. They are where the strategic plans are translated into financial numbers to ensure that the strategic plans are financially viable. Budgeting and forecasting are essential elements of financial management. They are the tools that develop your club s strategic plan in to a financial statement, which in turn enables the Board and management to monitor the plan. Therefore budgeting and forecasting provides the financial information to enable management to determine if the strategic plan is achievable. Budgeting also allows the club to plan a year or more in advance in an effort to identify possible changes in the club s operating environment, particularly changes that could have negative effects on the clubs success. Forecasting is projecting actual outcomes to budgeted activities, and understanding why the differences might occur and identifying changes in anticipated events. It provides the financial information which shows if the clubs strategic or other plans need to be amended. Good budgeting and forecasting of the clubs operations requires: Preparation in light of the club s strategic plan and goals Budgeted timelines aligned to the preparation of monthly quarterly and annual financial statements Regular comparison of budget results to actual results Scope for amending activities and strategic plans where actual results and identified changes in the operating environment indicate that budgeted outcomes are not achievable, and understanding the consequences of this. Therefore, budgets and forecasts provide the club with information on the future of the club. If planned and well managed, they are central in determining the financial impact of the clubs strategic plan. Budgets What is a budget? It is a business plan expressed in financial terms: a financial estimate of activities planned to take place over a future period of time. The purpose of budgets are: Encouraging planning: The introduction of budgets by the club forces management to look ahead and set short-term targets. By looking to the future, management can anticipate 131 P a g e

132 potential problems. For example, the identification of shortages of cash at particular times in the budget period gives management the opportunity to make provisions to supplement this shortage; for example, by negotiating an overdraft facility with the bank. Coordinate functions within the club: The Preparation of budget tends to increase the coordination between departments within the club, because it requires that the individual plans of managers are integrated. The managers are obliged to consider the relationship between various departments. A form of communication: A budget is often a useful means by which senior management can formally communicate objectives and strategies for the forthcoming period. This function is reinforced periodically through a control mechanism which reviews actual performance against the budget, during the budget period. The extent to which lower level managers are involved in establishing a budget communicates important information about the philosophy of the Board and CEO. Provide a basis for responsibility accounting: Individual managers are identified with their budget centres and are made responsible for achieving the budgeted targets. These targets, in terms of income, expenditure and output, are considered to be within the manager s control. Provide a basis for a control mechanism: The budget provides a basis for comparing actual performance with the plan and identifying any variance from that plan. The identification of these deviations gives management the opportunity to take corrective action so that such deviations do not persist in the future. When budgets are used as a control mechanism, it is described as budget control. Authorise expenditure: The budget can act as a formal authorisation of future expenditure from senior management to the individuals who are responsible for the expenditure. If an item of expenditure is contained in the budget that has been approved by the top management of the organisation, it implies that the item has been approved, and generally no further authorisation is required. The annual and monthly budgets are prepared following discussion on the financial implications of activity at governance, management and operational levels of the club. When discussions have been completed, the budgetary process includes assessment by the CEO, senior staff and Finance committee with recommendations being presented to the Board for consideration and eventual endorsement. 132 P a g e

133 What are the advantages of preparing a budget? The financial position of the club will determine whether the objectives of the business plan, to provide agreed benefits for members or service users, can be achieved. Budgets are a team effort of CEO, senior staff, all subcommittees and the Board. They constitute a critical piece of communication between their key stakeholders. The Board should not accept a budget until satisfied that it meets the requirements and obligations of the club. Should monthly financial reports to the Board show any unsatisfactory trends or results, i.e. too many expenses or not enough income, budgets are immediately reviewed in detail, and changes made to plan a financial result that is satisfactory and acceptable. Budgets provide guidance they can be changed through the year but in doing so the Board will fully understand the effect of such changes. Without a budget this would be very difficult. Types of Budgets A club can prepare numerous budgets for the club as a whole or for a specific project such as a motel, gym facility or extensions to the club. Every club will be different, based on size, location and individual management. Many clubs have a master budget for the club as a whole and then, subsequent, specific dept budgets are prepared. Typical budgets may include the following: 133 P a g e

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135 The Budget Period When preparing all financial statements, a basic decision is required as to which period the statements are being prepared for. This is particularly relevant for budgeted financial statements which can range from short term daily cash flow budgets to long term five year plans. Normally budgets are prepared for a twelve month period but a variety of alternative are possible. Some alternatives that clubs might adopt include: A yearly budget broken down into twelve monthly budgets A yearly budget broken down into four quarterly budgets A yearly budget with the first quarter being broken into months with the remaining portion of the budget in three quarterly increments. This approach would normally be associated with a process which allows a budget revision and the preparation of new monthly budgets for succeeding quarters Continuous budgets, where companies are always budgeting for a number of periods ahead, for example, clubs might be continuously budgeting for the months in the current quarter and perhaps two quarters ahead an agreed yearly budget with indicative budgets for the following year. 135 P a g e

136 The choice by a club will depend on factors such as the size of the business, the nature of the competitive and technological climate in which the club is operating at any given time. Budgeting Approaches There are a number of approaches which can be used by a club in developing budgets. Some approaches include: Approach Description Advantages Top Down Under a top down approach, the senior management team or Directors sets the overall financial goals for the club as a whole (i.e. Total income, profits, capital expenditure etc.) Ease and speed of preparation Gives more control over the budget setting process to the senior management team or Directors Once the overall numbers have been determined, they are then allocated to individual line managers. Allows senior management or Directors to determine the overall targets for the club Incremental Budgeting Under this approach, the actual results in the prior period are adjusted for an arbitrary incremental amount based on anticipated increases in trading or spending. The rate of increment is commonly based on an inflation factor. Disadvantages Low level of accuracy Limited ability to take into account the specific circumstances that face each department within the club Can demotivate staff, due their perceived limited control over or input into the budgeting process Advantages Ease of preparation Same approach can be used across the club s departments Coordination of assumptions (eg. Growth rates) between budgets is easy to achieve Disadvantages Assumes activities and methods will continue in the same way No incentive to significantly improve on budget; will result in a tougher target next year Encourages spending up to budget so that forecast spending can be maintained 136 P a g e

137 Bottom Up Zero Based Under a bottom up budgeting approach, each department or line manager is asked to determine their budget for the forthcoming year This is based on the individual facts or circumstances relating to the department The overall club budget is then determined by adding together the departmental budgets Under this approach, prior period actual results are ignored and the budgeting process starts at a zero-base Accordingly, every line of income and expenses is considered individually and a budgeted amount reached separately to overall growth rates next year Advantages High level of accuracy Ability to take into account the specific circumstances of each department Increase staff motivation by encouraging greater initiative and responsibly in decision making,. Encourages line managers to own their budgets Disadvantages Complex and time consuming Reduced efficiencies innovation, as line managers seek to set achievable targets Inconsistencies in the preparation of departmental budgets Lack of control by senior management means that they are unable to set stretch targets for departments Advantages Drives managers to find effective ways of improving operations Increase staff motivation by encouraging greater initiative and responsibility in decision making Improves efficiency by identifying obsolete or inefficient practices Forces manager to think in detail about income and expenses Disadvantages Forces managers to think in detail about income and expenses Preparation can be time consuming and exhaustive Reliant on highly trained and competent staff There is no right or wrong answers as to which is best, it will be an individual club decision. 137 P a g e

138 A Combined Approach? Many think a combination of the above approaches is appropriate. For example: Combination top-down and bottom-up approach Individual departments prepare their own budgets and provide them to the senior management team for review Senior management then assess the departmental budgets and make changes in light of club-wide targets and identified efficiencies Combined incremental and zero-based approach Budget is determined on a traditional incremental basis, with specific departments or costs selected for a zero-based review Rolling forecast might be a better way to go? If we accept that traditional budgeting approaches have their limitations, such as lack of timely insight or disruptive to business, rolling forecasts can be seen as a more effective way of managing the business. It s about having a base budget but constantly (monthly, quarterly or biannually) adjusting forecasts where do we want to be, given what we know now and given the current environment or changes. Advantages of rolling forecasts: More timely reporting Less disruptive to business (i.e. business as usual) Anticipate changes More strategically focused. Assumptions Irrespective of what budgeting approach is used by your Club, it is imperative that you also document any assumptions made in the process. The Board should understand what key assumptions are used. Clearly if the assumptions prove to be incorrect, then the budget needs to be modified accordingly. 138 P a g e

139 Review Activity 8: Your club s approach to budgeting Think about the approach to budgeting used by your club and consider the following questions. 1. What approach to budgeting is used by your club? 2. Do you think this is the most appropriate approach? Why? 3. Do you think your club would benefit from a new approach to budgeting? 4. Do you use Rolling Forecasts? If yes, what length of time is usually used for the rolling forecast. 139 P a g e

140 Factors to Consider There are a number of factors which should be considered by directors when reviewing or approving budgets. Read through this list and consider how many factors your board takes into consideration. These include: Historical financial performance New services and product offerings Organisational structure / change Industry developments and changes (e.g. regulatory changes) Economic trends Other environmental factors Historical Financial Performance While different budgeting approaches may place a different level of reliance on historical financial performance, prior period results should always be considered in determining whether budgets are relevant and achievable. New services and product offerings The introduction of new services or products by a club is also likely to have an impact on a club s budgeted financial performance. For example the construction of a new bowling alley may have the following effects: Increased trading income (however, will it affect trading during construction?) New costs including wages, repairs and maintenance, power Increased interest expense if the facility was financed with Bank debt. Organisational structure / change Where possible, the structure of budget should align with the club s internal reporting or organisational structure. This will assist both in the assignment of responsibility for part of the budget to designated individuals, and the monitoring of actual performance. For example: Trading areas/locations. Industry developments and changes (e.g. regulatory changes) Changes in the registered club industry can have the potential to impact future financial performance. When setting and reviewing budgets it is important to be mindful of industry developments and consider the impact changes may have on the club s future results. For Example, the introduction of new gaming tax rate could-: Reduce profitability Reduce capital expenditure (if the Club sees fit to reduce gaming installation) Economic Trends Overall economic factors can also have a significant impact on a club s profitability. It is important that clubs consider the impact of changing economic conditions on performance when setting and reviewing budgets. For example, Rising interest rates will increase interest payable by a club on its loans and may affect revenue, with changes impacting on the level of spending by consumers 140 P a g e

141 Other environmental factors Other changes in a club s business environment may impact its future financial performance. These include: Competitive pressures as a result of the entry or exit of competitors, or improvements in the service offerings by other venues; Changes in demographic conditions of the surrounding population; Changes in social trends, such as fashions or tastes. 141 P a g e

142 Key Performance Indicators Key performance indicators (KPIs) are important tools used by clubs to define and monitor their progress against their overall goals. When incorporated into management reports, KPIs allow directors to efficiently assess and monitor the financial performance of their clubs. They can also provide an indication of the club s longer term financial viability. In the club industry, a club is generally considered viable if it can generate sufficient funds from its operating activities to enable it to cover the costs of providing services to its membership and community. The club must also be able to meet its financial obligations and have the capacity to reinvest in facilities in order to remain relevant and competitive. In their 2008 report, the Independent Pricing and Regulatory Tribunal (IPART) performed a detailed examination of the financial viability of the industry by looking at the clubs earnings and expenditures. It also considered the indicators of an individual club s viability and signs of financial distress, and examined how clubs viability varied by size. In addition it considered the reasons why some clubs were prospering while others were declining. IPART s key findings in respect of financial viability include: Most clubs are heavily dependent on gaming machine revenue Individual clubs were prospering or declining for a variety of reasons, including; -Access to volunteer labour, -The skills and effectiveness of its Board and management teams; -Competition within the local community both from other clubs and alternate forms of entertainment; and -Demographic and social changes within their local communities. IPART, in their recommendations, recommended that clubs use the following KPI s in their internal management reports as a guide to monitoring their financial viability and efficiency. 142 P a g e

143 Common KPIs used by clubs Business efficiency Financial Viability Earnings before interest, tax, depreciating, rent and donations as a percentage of total club revenue (EBITARD %) Department revenue as a percentage of total club revenue (Department reliance) Department gross profit as a percentage of department revenue (gross margin %) Department wages as a percentage of revenue (department wages %) Department net contribution as a percentage of department revenue (department net contribution %) Gaming revenue per gaming machine EBITARD % Capital expenditure as a percentage of operating cash flows Operating cash flows / borrowings Operating cash flows as a percentage of working capital deficiency (if relevant) Non-financial Measures No. of restaurant covers Foot traffic Average spend per head Tiered loyalty Employee turnover Occupancy rates 143 P a g e

144 IPART RECOMMENDATIONS The following are the series of measures recommended to the industry by IPART. The Tribunal nominated EBITDA % as the best measure of a Clubs profitability 144 P a g e

145 As shown above, there appears to be a marked correlation between the overall levels of financial viability of clubs and their size (as reflected by their levels of EGM revenues). As clubs increase in size, the proportion of clubs in either financial distress or serious financial distress reduces. As an example, based on the results of Club Census 2011, 59% of clubs with EGM revenues of less than $1 million appear to be in some form of financial distress. This compares with 14% of clubs in the largest EGM revenue category. 145 P a g e

146 Identifying clubs at risk of financial distress IPART S SECOND PROFITABILITY MEASURE In addition to this EBITDA % determination of financial viability, IPART also proposed EBITDARD % as an effective means of identifying clubs that may be at risk of becoming financially distressed. EBITARD is a common efficiency and financial viability measure used in the club industry It aims to provide a comparable measure of profitability, viability and efficiency between Clubs of different sizes. Similar to the EBITDA measure discussed previously, EBITDA aims to provide a simplified indication of the operating cash flow of the club. EBITDARD % introduces two additional items into the EBITDA % above rent expense and donations expense are removed to normalise differences arising from the ownership status of the club s facilities and the contribution to charitable causes. The calculation is as follows: IPART estimated that the average EBITDARD % for the NSW registered clubs industry was approximately 14%. On this basis it considered that clubs which generated an EBITDARD % below 15% should be considered at risk of being in financial distress. In recommending this threshold, the Tribunal noted that the 15% threshold is likely to capture clubs that are not necessarily in financial distress, but may be under performing. 146 P a g e

147 As shown in the previous graphic, 64% of the industry generated an EBITDARD % of below 15% and therefore could be considered at risk of financial distress. This represents a significant risk to the ongoing operation and sustainability of the registered clubs industry in NSW. Keep in mind, however again this is only one indication. An EBITARD % can have its limitations. For example, a club with a high reliance on gaming is probably going to have a higher EBITARD, than a club that has reduced its reliance on gaming. This does not mean that the club with the higher reliance on gaming revenue is the best business model! Industry averages suggest a club that has revenue from their own catering will have a lower return on catering from say, a club who is receiving rent (and has little to no expenses) from a caterer running their own operation contract. EBITARD is a guide but you will also need to understand all components of the business. Keep in mind KPI s tells you nothing on their own. It s the analysis that s the power. 147 P a g e

148 Working capital deficiencies occur where a business current liabilities exceeds its current assets. Working capital deficiencies can indicate problems with a business ability to pay its liabilities as and when they fall due and continue as a going concern. The nature of registered clubs operations means that clubs generally have low levels of current assets relative to other businesses. As a result, many clubs record deficiencies in working capital. On their own, these deficiencies do not raise concerns with financial viability as long as the club has the ability to fund the deficiency by the way of surplus operating cash flows or access to finance (new or existing). This measure aims to provide an indication of a club s ability to fund a working capital deficiency by way of operating cash flows. If the ratio is less than 1, it indicates that operating cash flow is not sufficient to meet the deficiency, and other sources of cash (such as asset sales or additional debt) may be required in order for the club to meet its short-term financial obligations. If the ratio is greater than 3, it indicates that the club should comfortably fund any working capital deficiency by way of operating cash flow surpluses. 148 P a g e

149 When examining the results for this analysis, clubs have been classified as follows: For the largest clubs generating greater than $10 EGM, 31% are prima facie at risk given their operating cash flows achieved are insufficient to fund their working capital deficiency. Whilst a number of clubs in this range undoubtedly face viability issues, it is not unusual for large clubs who actively undertake large capital expenditure programs to be carrying external debt that may require renegotiation in the next 12 months. 149 P a g e

150 As a result the working capital deficiency can be inflated by this fact which, to the extent this current debt is renegotiated, would no longer represent an at risk position. The Centro case, however, shows this is not always the case. On the other hand, whilst 21% of the smallest clubs generating less than $1 million in EGM revenue displayed an at risk factor, it is anticipated a larger proportion of these clubs could face financial viability issues given exposure to increasing fixed costs, a lack of economies of scale and an inability to attract long term debt needed if cash operating cashflows are under pressure. This is further supported by 59% of clubs generating less than $1 million appearing to be in some level of financial distress based on an EBITDA percentage of less than 10%. Borrowings / operating cash flows Borrowings divided by operating cash flows can be used to show the number of years of operating cash flows that the club would be required to generate in order to repay its borrowings. That is, how many years of debt does your Club have? A high or rising ratio is a potential indicator of declining financial viability 150 P a g e

151 Capital expenditure / operating flows Capital expenditure / operating cash flows show the proportion of a club s free cash flows that it is investing in improvements to its facilities. A low or declining level of capital expenditure may result in declining standards of services provided to members. It can also act as an early warning indicator of declining long-term financial viability. 151 P a g e

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154 Benchmarking Benchmarking is the process of comparing a KPI produced for a specific club with another measure regarded as best practice or industry standard. Benchmarking provides a snapshot of the performance of a club and helps managers and directors understand how their club compares with the industry at large. The result is that weaknesses and limitations can be identified and focused on by clubs. IPART Recommendations In its June 2008 report, IPART noted the following in relation to benchmarking: While some clubs (particularly the larger clubs) already use benchmarking, IPART considers all clubs should be encouraged to monitor their performance on a range of measures, and compare their performance to industry benchmarks. IPART considers that monitoring these measures will assist clubs to assess the efficiency and profitability of their operating departments and business as a whole, and identity if their financial viability is declining. Advantages of Benchmarking Identifies performance gaps within their clubs operations Highlights strengths and weaknesses within their operations Assists in developing business improvement strategies Provides a platform for decision making and performance management Encourages best practice Sources of Benchmarking Data Analysis of publicly available information, for example: Annual reports Club websites Purchasing subscriptions to various benchmarking services, for example: Club Data Online Note this service is good but keep in mind it is not whole of industry. Perhaps clubs but not all. 154 P a g e

155 Unit 4: Managing Business Changes 155 P a g e

156 MANAGING BUSINESS CHANGES In this unit, we ll consider the financial impact of common changes implemented by clubs. We will examine the role of directors in determining their club s response to these changes including the identification of a need for change, evaluation of competing options, deciding on a response and monitoring implementations. Learning outcomes: Understand the major business changes encountered by clubs Examine the financial impact of several major types of changes on clubs Understand the role of directors in managing the club s response to changes Be able to list and explain the various activities undertaken by clubs in seeking to manage changes 156 P a g e

157 Change Management Nothing is permanent, except for change. Heraclitus, 5BC. The business world experiences constant change in the internal and external environment and this includes clubs no matter where they are located. Factors such as changing economic conditions, new competition, laws and regulations, evolving consumer tastes and new technologies have had significant impact on clubs and have required them to adapt. Club boards and management must consistently monitor developments, and assess any resulting opportunities or threats to their operations. It is therefore critical that directors of clubs are equipped with some of the skills required to manage changes faced by their clubs and to monitor the responses to those changes. Sources and Responses to Change Sources can be internal or external, and changes need to be made accordingly. INTERNAL SOURCE OF CHANGE Examples: New management team Changing financial performance Declining cash reserves Change in Club membership Change in Board membership EXTERNAL SOURCE OF CHANGE Examples: Changing economic conditions Changing demographics Changing laws and regulations Changing tastes of customers Community attitude to Clubs BUSINESS CHANGES/RESPONSE TO CHANGE Examples: Invest in improved facilities Diversification Disposal of assets Operational change Amalgamation closure 157 P a g e

158 Review Activity 9: Analysing external changes Think about some of the external changes faced by your club in recent years (eg. Changing economic conditions, smoking restrictions, amendments to gaming machine tax rates etc.) 1. List 2 changes affecting your club. Did your club anticipate the change and plan its response. 2. What was your Clubs response to these changes? Common types of changes made by clubs: Capital investment Diversification Sale of assets Amalgamation Rationalisation Closure Briefly, the changes can be described as follows: Capital investment Capital investment programs are amongst the most common responses by clubs to changes. Aimed at: Improving existing services Adding new services Examples: Refurbished of the club s facilities, investment in additional catering services or the acquisition of new gaming machine licenses 158 P a g e

159 Diversification Diversification into new areas of business is another common response to changes There is plethora of options available to clubs. Examples: Function facilities, accommodation, franchising arrangements, bowling alleys gymnasium and property development Sale of assets Sale of assets is another potential response to changes. Can be used to generate additional cash in order to: Reduce debt; or Invest in improves core facilities It is important that the club consider the legislative restrictions on the sale of assets under the Registered Clubs Act Clubs should also consider the impact that the disposal may have on the long-term operations of the business. Example: Sale of land used for parking Amalgamation The choice as to whether to amalgamate is one of the most significant that a club will face. It is therefore crucial that both parent and child clubs properly assess and understand the implications of the change on their respective financial positions as well as on their service offerings to members. The significant complexity and risk surrounding amalgamations means that club should seek expert and independent advice when considering amalgamating. Rationalisation/closure/deamalgamation Rationalization or closure of the club s facilities can be a difficult decision and should be considered carefully prior to approval by the Board of Directors. It is important that the club consider the legislative restrictions/requirements under the Registered Clubs Act P a g e

160 Evaluation and approval process Introduction Sources of and responses to change Common changes made by clubs Evaluation and approval process Investment evaluation process and tools ClubsNSW Best Practice Guidelines Business changes should be properly researched and analysed in respect of market feasibility and the long term strategic position of the club. Business change should be properly defined, documented, cost planned and approved. Business changes should be implemented with the appropriate contracts with the chosen suppliers or other partners. Clubs should seek professional advice in relation to major business changes. Club members should be provided with information and given opportunities to comment at regular intervals during planning and execution or major business changes. Directors should act diligently and in the interest of members in approving and overseeing major business changes. Directors should avoid conflicts of interest in relation to business changes. Proper processes should be used to appoint third parties. Where non-price criteria are used to select these third parties, the criteria should be documented. Legal requirements should be adhered to in all circumstances. 160 P a g e

161 Evaluation and approval process Identification of need for business change Step 1: Preliminary appraisal of options Determine whether to proceed Step 2: Detailed appraisal of preferred option (or short list) Approval / rejection of business change Step 3: Implementation of business change Step 1: Preliminary appraisal High level analysis of the various options available to the club in making the change. May involve: Brainstorming sessions Engagement of consultants Consultation with members Aims to: Understand the high-level costs and benefits of all options Determine whether the business change appears feasible Appraisal should develop either a recommendation or short list of preferred options for more detailed evaluation or appraisal. 161 P a g e

162 Change committees Often a change project will benefit from the establishment of a change committee at the inception of the project. The committee will generally be charged with the responsibility for managing the dayto-day activity of the project and comprise representatives of management and the Board. Step 2: Detailed appraisal At this stage the club should seek to answer the following questions: What is the justification for the change? Has the change been sufficiently defined? Does the club have the necessary resources to implement the change? Has the club addressed the key financial issues relating to the business change? Justification for the change? Prior to proceeding with a business change, clubs should consider the following: Affordability Benefits of the change to members or to the community Forecast increase in patronage/membership Necessity and drivers of the change Conformity with the club s medium to long-term business plans and strategic goals Defining the change? Clubs must properly scope and define exactly what will be required. This is in order to accurately determine the financial impact that the project will have on the club. Example: Catering expansion Assessment should extend to: Cost of the development Impact on capacity Determination of staffing requirements and costs The expected gross margin on sales Expected increase in management and administrative costs Projected benefit to the Club financial and operational Necessary resources? Many significant business changes often require a high degree of expertise to properly design, document and implement the change. 162 P a g e

163 Clubs should perform a skills gap analysis to determine what additional resources will be required. Example: Refurbishment Club may need to hire a project manager to oversee the design, documentation and construction phases of the project Addressed financial issues? A thorough financial analysis needs to be prepared at this stage quantifying the financial benefits and costs of the change both in the short-term and during its long-term operation. We will consider the issues in greater detail shortly. Investment evaluation process and tools Introduction Sources of and response to change Common changes made by clubs Evaluation and approval process Investment evaluation process and tools Assess the final impact of a business change Investment evaluation Market analysis Cash flow forecast Sensitivity analysis Investment ana Market analysis Market analysis should be prepared where clubs are seeking to enter a new business or construct a new facility. It seeks to profile the new market and its desirability. Factors that should be considered as part of a market analysis include: Demographics Competition Forecast growth in industry/market Other environmental factors that impact market (i.e. regulation, consumer tastes, technology, natural environment etc.) 163 P a g e

164 Cash flow forecast The club should prepare a monthly cash flow forecast showing: Expected cash inflows Expected cash outflows The club should have a good understanding of the likely costs associated with implementing the change and the expected timing of cash payments before preparing the forecast. The club should also consider the longer-term impacts on the club s cash flows from additional sales and expenses generated by the business change. Forecasts will be based on certain assumptions which are uncertain and may not eventuate. Sensitivity analysis Sensitivity analysis is effectively a number of what if scenarios which shows the impact that a change in the assumptions will have on the club s cash flow forecast. Example: Club shutdown What would the impact be on a club s cash flow forecast if a planned three month shutdown for a redevelopment actually took 12 months? Could the club still meet its obligations to creditors? What would happen if the assumed increase in revenues didn t arise? Sensitivity analysis seeks to consider these risks. Investment analysis There are numerous investment tools available to assist clubs complete an investment evaluation. Each club will have different criteria in evaluation the business change and accordingly there is no right or wrong approach to use. Three common tools include: Return on investment Payback period Net present value 164 P a g e

165 Return on investment Return on investment (ROI) is a tool used to assess the expected yield that a club will derive from a business change. The higher the ROI, the more appealing the investment. It can be used to evaluate whether a business change is worthwhile. A simple ROI works well as a guide when both the gains and costs of an investment are easily known, and where they can be identified as clearly resulting from the action. However, in a complex business, it is not always easy to match specific returns (such as increased profits) with the specific costs that are associated with them (such as the costs of a marketing program) therefore, ROI is not always trustworthy. It should be used as a guide only. Payback period Payback period is simply the period of time that it will take for the investment to pay for itself. The shorter the payback period, the more appealing the investment. Value of initial investment Annual net contribution from operation Net present value Net present value (NPV) shows the present value of a stream of future net cash flows. The future net cash flows are discounted back to present values by a rate that reflects the expected rate of return. In the club industry, this is often calculated as the after tax long-term rate of borrowing. NVP is expressed in dollar terms and effectively represents the value of an investment. 165 P a g e

166 Step 3: Implementation of business change Once the business change has been sufficiently defined and approved, implementation can commence. It is important that the Directors and/or the Change Committee continue to monitor the business change to ensure that it is implemented appropriately and that any issues that arise are appropriately dealt with. The directors should seek additional management reports in order to complete this evaluation process and consider the following steps as part of this process: Have there been any changes to the approved plans during implementation? Are there any changes in the expected costs associated with the business change? Should these be discussed and approved by the Board? Have there been any changes to the expected completion of the change? How will this impact on the cash flow forecasts? Do we need further information to assess this impact (i.e. sensitivity analysis)? Review Activity 10: Business change 1. Think of a recent business change that has been implemented by your club. Consider the following questions: a) Did you perform a preliminary analysis of all the viable options that were available to your club in applying the change? b) Are you confident that you considered all available options when evaluating the change? c) Do you think your club would have benefited from the establishment of a change committee to manage the process? If so, would you have been a member of the committee? 166 P a g e

167 2. The cost of constructing a new bowling alley at a club will be 25% higher than the original budget included in the cash flow forecast. The total cost of the construction is being funded by an interest only bank loan. What do you think the likely impact of the following sensitivities would be? 3. What is the payback period for the following investment? The Club is considering acquiring 10 additional gaming machine entitlements. The cost is expected to be $30,000 each, where each additional entitlement is expected to generate additional net contribution of $10,000 per year, after all expenses are taken into account. 4. What is the club s ROI for the following project? The club plans on entering into a new marketing program which is expected to cost $500,000 over the next five years. Conservatively, the club expects this program to generate a net gain to the club, over the same period, of $700,000. Summary By know you should: Understand the major business changes encountered by clubs Examine the financial impact of several major types of changes on clubs Understand the role of directors in managing the club s response to changes Be able to list and explain the various activities undertaken by clubs in managing changes. 167 P a g e

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169 Unit 5: External Financing 169 P a g e

170 EXTERNAL FINANCING Options available to Clubs Learning Outcomes: Understanding your debt financing requirements Understanding the types of short term and long term finance products available to the club Understanding the most common Commercial lending documents Learn to identify the main sections of a Bank s Facility Agreement, and gain a basic understanding of critical terms Understanding the clubs external funding options Understand what various government entities offer grants that clubs may access Tips to apply for government grants. 170 P a g e

171 External Financing The Directors and CEO should ensure that all types of financing available are fully understood and matched to the clubs needs resulting in good financial management. Almost all clubs will require financing at some time to support the operational activities and capital expenditure to improve services to their members. Financing for clubs will generally come from retained profits, grants, membership subscriptions, grants and external debt financing. Grants and external debt finance are subject to terms and conditions. It is critical that the club be fully aware and fully understands the consequences of these terms and conditions before the club accepts any method of finance. Debt Financing Debt financing will be provided to the club from an external source, being a supplier, Bank, credit union or other financier. Before discussing the different types of financing, it is critical to appreciate that the choice of appropriate finance (and its associated terms and conditions) can be vital to the long term success of the club. The type of finance should match the purpose for which it is used. For example, using short term finance for the purchase of an investment property will create short term problems for the club when the finance needs to be repaid. The club expects to own the property for a long term, and so to repay the short term loan, refinance will be needed unless the club has substantial cash reserves available. Similarly, taking out a 10 year loan to buy gaming machines which have an expected life of three to five years, for example, would leave the club in the position of paying interest on money it no longer needs. Whilst these are extreme examples, but they serve to illustrate the point that finance must be matched with the purpose for which it is to be used. Type of Finance The finance used, and the period of that finance, should be matched to the period for which it is required and the purpose for which it is to be used. Understanding Your Financing To select the right funding product for your Club, you should: Understand the various products in the market their nature and features, costs and fees, and tax implications Match the product to your Club s specific requirements and circumstances 171 P a g e

172 Whilst not always clear cut, we tend to generally look at the broad categories of finance as being: Short Term Medium - Long Term Finance Some of the more common facilities are discussed, however, hybrid facilities are ever evolving. See also attached finance facilities table. Short Term Finance Short Term Finance is defined as finance that will be repaid within one year. As discussed when we reviewed the Balance Sheet, the clubs working capital is defined as the club s current assets minus its current liabilities, and it is imperative that any club plan the funding of required working capital. The club will hold, as current assets, a certain level of inventories and trade and other debtors. So how will the club finance such assets? Trade Credit Suppliers generally allow the club a period of time, after goods have been delivered, before requiring payment. The period of time and limit of credit available from different suppliers will depend on a number of factors, including: The generally regarded normal terms of trade of that industry The strength of the club financially The club s importance to its supplier Known as trade credit this is a source of finance widely used by most organisations, including the club industry. Effective management of the club requires a balance to be struck between taking advantage of trade credit and not being perceived as a slow payer in case the supplier imposes less favourable terms. Also, be mindful of not relying too heavily on trade credit, which can leave the club vulnerable to a supplier taking action to recover its monies owed. Also, trade credit is often thought of as being cost-free credit, which is actually not always the case, as many suppliers (gaming machine manufactures in particular) allow a small discount for early payment. Therefore, if the club uses the full period offered to pay their invoice, the opportunity cost is the discount forgone. This cost can be significant. For Example: Let s assume a gaming machine manufacturer offers terms of 2/10 NET 30. This means that a 2% discount is given if the payment is received within 10 days of receipt of the invoice, otherwise the full net amount of the invoice is payable in 30 days. To forgo the discount means a cost of 2% is paid for a further 20 days. This equates to a cost of approximately 36% per annum, which is expensive! 172 P a g e

173 Clearly this opportunity cost has to be weighed against the availability of funds in the club and the cost of raising additional funds. Unlike other forms of short term finance, there are generally no requirements for security, except for the goods supplied. (In the example above, if the club did not pay the gaming manufacturers invoice, it is feasible the supplier could repossess the machines). Factoring If a club makes sales on credit it will have to collect payment from its debtors at some stage. Until this money has been collected, the club will have to finance those debtors either through trade credit, an overdraft or its own cash reserves. Whilst clubs have not traditionally carried substantial debts receivable, some clubs, particularly smaller clubs, have struggled to finance their debts. A strategy used by some clubs to reduce the money tied up in debtors is to approach a factoring company, who specialise in the collection of payments from debtors. Briefly, the factoring company would assess the club s debtors in terms of risk and collectability, and then agrees to collect on behalf of the club. Once agreed, the factoring company pays the club immediately for its debtor s receivable. It is then the factoring company s responsibility to collect the debts. The cost to the club is usually a flat fee plus an interest rate (the book value of the debtors less a discount). This form of finance is more expensive than trade credit, but allows the club to improve its cash flow in a relative quick time frame and with no additional security. The only security provided by the club is the debtors themselves. Bank Overdraft Banks and other financial institutions frequently provide short term finance in the form of an overdraft. An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. In this situation the account is said to be over drawn. If there is a prior arrangement with the Banks for an overdraft, the amount is overdrawn within a pre-agreed overdraft limit. Interest is then charged daily on the balance outstanding. The facility can be used when and as required and interest charged only when it is used. 173 P a g e

174 In terms of interest, the rate charged is related to the perceived financial risk of the club, the industry generally, and market conditions for interest rather at the time. Interest rates tend to be high for such facilities. Also fees and ongoing management fees apply. Overdrafts can be unsecured, secured by a floating change over the club or secured by first class land and buildings. IMPORTANT Clubs must be aware that overdrafts are repayable on demand. Whilst a letter of offer by the bank may note the club s overdraft facilities limit is subject to annual review, the bank has the ability to demand repayment of this debt, immediately, at their discretion. Also it is imperative that the club stays within their agreed overdraft limit. Exceeding an overdraft limit, even for only one day without written approval by the bank, can trigger an event of default which entitles the bank to seek repayment of all debts. Bank Overdraft Over drafting an account up to an agreed, pre-determined overdraft limit to meet short term cash flow needs can require security in most cases. Insurance Premium Funding Clubs should be aware that insurance premium finding is readily available. It is short term finance that allows you to pay insurance premiums and associated charges by a monthly direct debit over an agreed term of between 6-12 months. Usually no security is required. The facility is cost effective, and smoothes the clubs cash flows by paying for your insurance premiums in installments. Fast simple application process. Medium to Long Term Finance TERM LOANS OR LINES OF CREDIT TERM LOANS Loans usually for a fixed purpose, fixed term and set repayment dates. Costs include application fee, interest and ongoing fees. Normally secured over fixed assets. Term loans should only be used by the club when finance is required for a known period of time that relates to the life of the asset or the purpose for which the finance is to be used. 174 P a g e

175 A loan facility is structured and arranged in advance. Term loans can be arranged for short, medium or long terms. Repayment of the loan is negotiated at the time, and is generally at fixed intervals. Loans can be repayable by interest only installments over the term (the balance will be repayable at the end of the term) or principal and interest repayments over the term. The interest payable is also based on predetermined parameters agreed in advance. Interest can be fixed for the term, variable during the term and subject to market movements, or a combination for both fixed and variable. It is imperative that the club fully understand the benefits and pitfalls of fixed and variable interest rates before executing the bank s documentation. Also imperative is understanding how fee s and margin for risk are calculated and applied to the facility ( see subsequent discussion titled Commercial Documentation). As with all other sources of finance, the availability of the source of finance, the interest and fees applicable, security required, terms and conditions will also depend on the lenders assessment of the club, the industry as a whole the economy generally, and the bank s lending policies. Asset Finance Instead of purchasing equipment and paying the capital cost in a lump sum, many clubs use commercial leasing to smooth out the club s cash flow and pay for the equipment, usually over a term of 2-5 years. There are however, various forms of finance and it is critical that the club understands the products available in advance. All have different tax consequences which should be referred to your accountant. Products include: Commercial Hire Purchase (CHP) This is an agreement between the club and the financier. The financier owns the equipment, however, you gain equity in the equipment as you make payments. At the end of term and on all payments being made, title in the equipment automatically transfers to the club. A CHP can be arranged with or without a final balloon payment at the end of the term, depending on your budgetary requirements. The repayments are calculated over the term of the CHP, and an upfront trade in or deposit is optional and will reduce you payments. This is usually medium term finance, traditionally being from 1-5 year. 175 P a g e

176 Payments are based on the asset cost including GST. GST is not payable on the monthly repayments. During the term of the loan, the club may be able to claim depreciation of the purchase price of the equipment plus interest charges as a tax deductable expense, together with ongoing expenses to maintain the equipment. The asset needs to be shown on the balance sheet as both an asset and a liability. Finance Lease Finance is a lease agreement whereby the finance company purchases the goods for you and then leases it back you for an agreed monthly repayment. Whilst the finance company retains title in the equipment, at the end of the term you can offer to purchase the equipment for the residual value. If you do not pay the residual, the financer will sell the equipment and the club must pay the short fall between proceeds and the residual. The term of the finance agreement can be 1-5 years in line with the Australian Tax Office Guidelines. Deposits are not required for a finance Lease. The full purchase price must be financed. The monthly payments are then deducible. The amount of financial in exclusive of GST, however, monthly payments are subject to GST. The asset needs to be shown on the balance sheet as both an assets and a liability. Operating Lease In the case of an operating lease (more commonly referred to as a rental agreement), the finance company purchases the equipment and rents it to you for an agreed payment schedule (usually monthly or quarterly repayments) over a fixed term. With an operating lease, however, at the end of the term you do not own the equipment. At the end of the Rental Period, the club can either: Return the goods to the finance company Return the goods to the finance company and enter into another agreement for new equipment Purchase the equipment at a fair market value (as determined at their discretion at the time) Re-rent the goods at a lower rate for a further term. The club must remember you have use of the equipment but you never own it. Rental payments are tax deductable because they are considered an operating expense. The rented equipment you do not own, hence, it will not appear on the balance sheet (it is considered an off balance sheet form of financing). 176 P a g e

177 You should proceed with caution before executing any operating lease (rental agreement). Operating Lease finance can be very expensive and the documentation often includes highly detrimental clauses which can result in excessive costs to the club. Chattel Mortgage A Chattel Mortgage is simply a business loan agreement to borrow funds to purchase equipment such as a new motor vehicle, gaming machines, commercial kitchen equipment etc. Security for the loan is a mortgage over the equipment financed. Under a Chattel Mortgage a finance company lends money to the club to purchase a car or other equipment (the "chattel"), and the club makes regular repayments, usually over a term of 2-5 years. The Club takes ownership of the equipment at the time of purchase, but the finance company also takes out a "mortgage" over the equipment by way of an ASIC-registered Fixed and Floating Charge to provide security for the loan. Once the term of the loan is completed and any residual (balloon) value is paid, the finance company removes the Charge, giving the club clear title to the equipment. Both the asset and the liability are recorded on balance sheet. The asset is depreciated over its life and the interest component is a deductible expense. GST on the full purchase price is claimed by the club upfront. There is no GST on payments. Novated Lease A novated Lease is an agreement between the club, the employee of the club and the financier, where the obligation to meet the repayments under the finance leases is with the employer.it is used for the finance of cars. A novated lease is a three way agreement ( novation agreement ) between the club, employee and lease provider. The club leases a vehicle from the lease company, and employer agrees to take on the employee s obligations under the lease. The employer then makes the lease payments on behalf of the employee, and deducts them out of the employee s pre-tax income (known as salary packaging a vehicle). If the employee ceases to be employed by the club, or the lease agreement ends, the employee retains the vehicle but all obligations assumed by the employer under the novation agreement revert back to the employee. Under a novated lease agreement, the employee has the right to take the motor vehicle with them should they change jobs and, structured correctly, there may be tax advantages with an employee s remuneration package. As with other leasing structures, repayments with a novated lease are flexible and amounts depend on the term, interest rate, amount borrowed and the residual payment. 177 P a g e

178 Commercial Lending Documentation We noted earlier that any external finance should be matched to the period of which it is required and the purpose for which it is to be used. It is then critical that the management and Board of the club ensure that the financing agreed is exactly as reflected in the Bank s (or other financial institution s) lending documents (For simplicity, we will herein refer to the lender as the Bank ). Those documents are prepared by the bank, for the bank, and naturally favour the bank. They aim to protect the bank in all situations they might encounter. When reading the documents, know that the bank is entitled to strictly enforce the documents according to their terms and is not required to take a commercial approach in exercising its rights. Understanding what the documentation is and what the documents mean is critical for any club. Types of Documents Each bank or financial institution will have its own set of standard documents, however, the following are the most common documents clubs will encounter: Indicative Letter of Offer During discussion with the Bank, frequently the club will be provided with an Indicative Letter of Offer, for the Boards consideration. Indicative Letters of Offer are frequently provided to clubs following detailed discussions where the club have made their finance requirements known, or in cases where the club has tendered for its banking needs. An Indicative Letter of Offer is issued on the basis that it is not a commitment to lend, but rather represents an indication only of the terms and conditions that the Bank is prepared to consider. The letter will set out all the basic details of the debt proposal including: Total amount of finance required by the club Indicative interest rate plus margin for risk and any other line administration fee s Term of the facility Repayment terms Security required Establishment fee and all other fees. The letter should also outline the non-refundable fee due if the club accepts the indicative offer and it is either not be approved by the Bank; or approved and then not accepted by the club Expected covenants and other major terms and conditions that would be applicable to the facility. Please note that you must compare these to 178 P a g e

179 any final letter of offer as often additional covenants are added as a condition of approval The letter will note that nothing contained in the letter shall be deemed a commitment by the Bank but represents an indication only. It will also note that the interest rates and margins quoted are indicative only, subject to change. The letter should then go on to outline the information the Bank requires of the club to progress the application to formal approval stage. Under no circumstances should the club rely on any information in this letter until, they have a full written, fully approved offer from the Bank. We have seen instances where clubs did not understand the letter they received was indicative only and they have written to their existing Banker advising all facilities would be repaid, only to have the new facility declined! Letter of Offer This is an offer of finance that you may accept, to form a contract between you and the bank. Of course there is no obligation to accept the offer. It is a binding document (once accepted), but the format is less intimidating to some clubs than a full Loan Agreement. Depending on the nature and amount of the approved facilities, the form of the Letter of Offer will vary. Short form Letters of Offer will be used when a Facility Agreement is also to be prepared. The Short Letter of Offer details the important aspects of the facility. The full legal terms of the facilities will be contained in a separate Facility Agreement and in the mortgage or security documents. Longer form Letters of Offer will be used where the letter of offer itself is to be the Facility Agreement. That is, this will be the document evidencing the terms and conditions of the loan. Of course, mortgage/security documents will be prepared separately for execution, registration etc, (security documentation is prepared after acceptance of the Letter of Offer and payment by the club of the application fee. 179 P a g e