After nearly 20 years of living with the current not-for-profit reporting model, users of financial statements of nonprofit organizations in many cases still do not have a true understanding of an organization’s financial position and performance, and the achievement of its mission. The FASB reacted to these concerns by undertaking a project that reimagines the design of the financial statements and related disclosures.
In April 2015, the FASB issued an exposure draft of an Accounting Standards Update (Standard) that would change the presentation of financial statements for not-for-profit entities, including health care entities. The FASB has referred to its contemplated design as a refresh, but the exposure draft includes some fairly significant proposed changes to the design of not-for-profit financial statements and two changes in recognition standards, the first pertaining to the placed-in-service option for expirations of donor-imposed capital restrictions and the second relating to the net asset classification of losses associated with underwater endowments.
That said, it is important to emphasize that the proposed reporting model, apart from what was discussed in the preceding paragraph, does not change the current manner in which nonprofits recognize revenues or expenses. The proposed Standard is principally focused on how the activities of all nonprofit organizations are presented for a reporting period. The reporting model will be applicable for all types of nonprofits (e.g., museums/cultural institutions, higher education, social services, foundations, associations, and religious organizations).
The Standard largely contains an array of more prescriptive approaches to sequencing and positioning/classifying a nonprofit’s activities for a reporting period. While the intention is to achieve more symmetry in reporting across the industry sectors, the proposed design still allows for a fair amount of flexibility and autonomy in how nonprofits report their activities.
Effective date and transition are yet to be determined.
The FASB did not propose an effective date. Instead, one will be determined after considering constituents’ comments. Retrospective application of the proposed changes will be required upon adoption. In the initial year of application, the annual financial statements will disclose the nature of any reclassifications or retrospective adjustments and their effects on the change in the net asset classes for each year or period presented. Interim financial statements will not need to reflect the Standard’s application in the initial year of application.
FASB has split the project into two tracks.
The FASB’s comment period for this exposure draft ended on August 20, 2015, and the FASB has subsequently decided to divide its redeliberations of the proposed Standard into two workstreams. The first workstream would reconsider issues that are not dependent on other FASB projects, currently in process or contemplated, and are improvements the FASB might finalize in the near-term. The second workstream would involve reconsideration of other proposed changes that are likely to require more time to resolve and consider the effort required to implement.
The first workstream includes the following areas of focus:
1) Net asset classification scheme, including:
- Reducing the number of net asset classes presented by eliminating the distinction between temporarily restricted and permanently restricted net assets
- Requiring presentation of the statements of financial position and activities based on net assets with donor-imposed restrictions and net assets without donor-imposed restrictions
- Disclosure of board-designated funds
- Underwater endowments
- Placed-in-service option for expirations of donor-imposed capital restrictions
2) Expenses, including:
- Expenses by nature and an analysis of expenses by function and nature
- Netting of identifiable external and direct internal investment expenses against investment return
- Disclosure of netted investment expenses
- Enhanced disclosures about cost allocation methodologies
3) Operating measures: improving disclosures by those not-for-profit entities that choose to present such a measure
4) Improved disclosures of information useful in assessing liquidity
5) Statement of cash flows: Whether to require the direct method of presenting operating cash flowsLonger-term workstream
The FASB’s second workstream will involve reconsideration of other elements of the proposal, including the following:
1) Operating measures: all other elements of the proposal, including:
- Whether to require intermediate measure(s)
- Whether and how to define such measure(s) and what items should or should not be included in the measure(s)
2) Statement of cash flows:
- Whether to re-categorize certain items previously reported as part of operating cash flows to align with the proposed definition of operations in the statement of activities
The FASB’s first workstream considerations may create significant near-term impacts
1. Eliminate the distinction between donor-imposed temporary restrictions and permanent restrictions in the financial statements
The most fundamental proposed modification would be the change to the current net asset reporting scheme. Specifically, the concept of permanently restricted, temporarily restricted and unrestricted net assets would be revised. The current three classes of net assets would be replaced by similar requirements for two classes of net assets, specifically: (1) net assets with donor-imposed restrictions and (2) net assets without donor-imposed restrictions. The current requirement to provide information about the nature and amounts of different types of donor-imposed restrictions included in net assets is modified to (a) deemphasize the hard-line distinction between temporary restrictions and permanent restrictions on the face of the financial statements, and (b) focus instead on describing differences in the nature of the restrictions with an emphasis on both how and when the resources (net assets) could be used.
A nonprofit’s net asset reporting has always been an enigma to users of business-oriented financial statements, and the changes contemplated in the proposed Standard with respect to net asset reporting should remove some of the confusion. Simplifying the presentation of restricted net assets will likely reduce reporting complexity on the face of the statements of financial position and activities and enhance the understandability of a nonprofit’s net asset position. Additionally, the revised naming scheme clarifies that restrictions are those imposed by donors, rather than other non-donor imposed types of restrictions, such as bond sinking funds, quasi-endowments, other trusteed and contractual restricted funds, and the plant fund.
Although the labels “temporarily restricted” and “permanently restricted” are eliminated and replaced with the simpler “net assets with donor restrictions”, nonprofits would still be required to disclose information about the nature and amounts of donor-imposed restrictions pertaining to their net assets and the actions required by the organization to satisfy such restrictions.
Nonprofits would also be required to disclose information about the amounts and purpose(s) of board-designated net assets without donor restrictions. Currently, there are no required disclosures about these funds, except as they pertain to endowment funds. The proposed Standard requires disclosures for all board-designated funds, including those earmarked for specific future programmatic expenditures, such as for the acquisition or construction of a building.
2. Define underwater endowment accounts as a reduction of net assets with donor restrictions
Currently, when the fair value of an individual donor-restricted endowment fund is less than the original gift amount required to be maintained by the donor or by law, the resultant deficit is reported as part of the unrestricted net asset class. The proposed Standard allows this loss to be charged to net assets with donor restrictions, rather than burdening unrestricted net assets.
The proposed Standard requires nonprofits to disclose the governing board’s policy on spending from underwater endowment funds which will lead to an enhanced understanding of endowment management. The proposed Standard also requires nonprofits to disclose the original gift amount — or level required by donor stipulations or by law to be maintained — of underwater endowment funds in the aggregate, as well as their fair value in the aggregate.
3. Revise presentation of investment return and expenses
Nonprofits would be required to report a net presentation of investment expenses against investment return on the face of the statement of activities. Identifiable external and direct internal investment expenses would be required to be netted against investment return. Nonprofits would no longer be required to disclose the components of investment return (loss) and the amount of investment expenses for the reporting period; they would no longer have the option to report investment expenses within total expenses. The netted investment expenses would be limited to known external and direct internal investment expenses incurred during a reporting period. The total amount of internal salaries and benefits (and related direct costs) netted against investment return would be disclosed.
4. Disclosures are required for expense allocations
Many categories of expenses are attributable to more than one program or supporting service expense category, and have traditionally been allocated accordingly. The proposed Standard requires qualitative disclosure of the methods used to allocate costs among the various functional expense categories. Management and general activities are defined in the proposed Standard as supporting activities that are not identifiable with one or more program, fundraising, or membership-development activity. Therefore, such expenses would require allocation on a reasonable and systematic basis that is consistently and rationally applied.
5. Require the reporting of expenses by functional category in a separate statement, schedule or note, or on the face of the statement of activities
All nonprofits, not just social services providers, as is currently the case, would be required to report all expenses in one location with operating expenses allocated by function and natural classification. No specific format is prescribed in the proposed Standard. A nonprofit would have a choice in presentation style — on the face of the statement of activities, in a schedule in the notes, or in a separate financial statement using a reporting format commonly known as a statement of functional expenses. Financing and investing expenses, along with other nonoperating expenses and losses, would be reported by natural expense category on the face of the financial statement and in any separate statement or schedule of functional expenses; however, reporting by function would be optional for nonoperating expenses and losses. Additional expense reporting by function and natural expense category is helpful in enhancing the understandability of a nonprofit’s operations and overall financial performance in terms of achievement of its mission.
6. Require disclosure about liquidity
Better understanding liquidity is another principal focus of the proposed Standard, in that infusing a nonprofit’s financial statement disclosures with more information would allow a user to make more informed judgments about overall liquidity. The prescriptive addition of fairly robust disclosures would compel an organization to share more information about how liquidity — both quantitative, such as the horizon (e.g., 30, 60, 90 days or longer) over which it manages and assesses liquidity, and qualitative.
Nonprofits would be required to disclose the following quantitative and qualitative information with respect to liquidity.
- Total amount of financial assets
- Amounts that, due to external or internal limitations, are not available to meet cash flow needs within the defined time horizon
- Total amount of financial liabilities due within the defined time horizon
- How liquidity is managed (e.g., a strategy for addressing entity-wide risks that may affect liquidity, a policy for establishing liquidity reserves or a basis for determining the time horizon used to manage liquidity)
- How investment asset allocation strategies are used to provide operating cash flows, as well as long-term investment growth
7. Require the statement of cash flows (operating activities) to be presented using the direct method
The proposed Standard requires the direct method of reporting cash flows provided (used) by operating activities. It removes the requirement to reconcile the change in net assets to net cash flows from operating activities (presently required by the indirect method). This approach would detail more specifically the sources and uses of cash for the period in the operating section of the statement. The direct method may enhance the understandability and usefulness of a nonprofit’s cash flows for each reporting period, however, it is acknowledged that the indirect method likewise provides meaningful benefits to the users of the statement as well.
The FASB’s longer-term considerations may include the following
1. Define operating activities based on the mission of the organization and the availability of the funds
In organizing financial performance into operating and nonoperating categories, the proposed Standard introduces two overarching principles — a mission dimension and an availability dimension.
Resources that are from, or directed at, carrying out a nonprofit’s purpose for its existence
Resources that are available for current period activities, considering both external and internal limitations
Under the proposed Standard, the statement of activities would be separated between operating and all other activities on the basis of two dimensions, as defined above and further described below. Since the definition of operations is principles-based, significant judgment would be required in applying the mission and availability dimensions to a nonprofit’s activities.
The proposed Standard would require all nonprofits to present in their statement of activities two measures associated with the change in their net assets without donor restrictions:
1. Operating excess (deficit) before transfers
2. Operating excess (deficit) after transfers
Nonprofits would be required to present on their statement of activities (1) all transfers in a discrete section; and (2) a subtotal of operating revenues and expenses before such transfers (intermediate measure), which is in addition to presenting an intermediate measure of operating surplus (deficit) after such transfers. At a minimum, nonprofits would have to present the aggregate of transfers out of operating activities separate from the aggregate of transfers into operating activities. They would also have to provide details for aggregated transfers in a note describing the purpose, amounts and types of transfers — for example, those transfers occurring due to standing board policies, as one-time decisions or for other reasons. The nonprofit could choose to display all transfers as separate line items on the face of the statement of activities and provide qualitative information in a note.
The proposed Standard addresses whether a number of specific activities would be considered operating or nonoperating, including:
- Financing activities, including interest expense and debt issuance costs are not considered operating expenses.
- Capital transactions and events are considered operating activities.
- Gifts of long-lived assets without donor-imposed restrictions would be reported initially as part of operating revenues. Currently, these are most typically reported as part of nonoperating revenues. If the gifted long-lived asset is not monetized or is placed into service, nonprofits would report the entire amount of the asset as a transfer out of operations in the transfer section. The long-term nature of the gifted asset would make it not fully available for current operations. When the asset is placed into service, operating expenses would include the applicable annual depreciation expense.
- Purpose-restricted gifts of long-lived assets and gifts of cash restricted for acquisition or construction of long-lived assets would be reported initially as revenues that increase net assets with donor restrictions. Revenues with donor-imposed restrictions would not be considered in the operating measure; all revenues with donor-imposed purpose restrictions would be recognized outside of operations until released from restriction in satisfaction of relevant donor/time stipulations. When the asset is placed into service — unless there were further donor restrictions — nonprofits would report the release from donor restriction as an increase in net assets without donor restrictions within operating activities and a decrease in net assets with donor restrictions. Consistent with the treatment of gifts of long-lived assets without donor restrictions, nonprofits would then report a transfer out of operations for the entire amount of the gifted asset. Operating expenses would also include the applicable annual depreciation expense.
- The option to release the donor’s restriction over an asset’s estimated useful life would be eliminated. Nonprofits currently following this approach would be required to immediately release any restricted net assets related to assets previously placed in service.
- Write-off of goodwill upon the acquisition of an entity (required of nonprofits predominantly supported by contributions and investment income) would be reported on a separate expense line in operations and could not be combined with other expense and loss items. If the acquired entity was for a purpose not directed at carrying out the purpose of the acquirer’s existence, then it would be a nonoperating expense.
- Accessions of noncapitalized collection items acquired with resources that were without donor restrictions would be reported as a separate expense line in operations, and deaccessions of noncapitalized collection items would be reported as a revenue in the operating section on a separate line.
- Equity transfers (i.e., between a parent and a subsidiary or entities under common control) would be reported within operating activities unless they were not for the current period’s use in carrying out the reporting entity’s mission. These transfers would be reported separately from revenues, expenses, and gains and losses, but included in the operating excess (deficit) before transfers.
- Other nonoperating revenues and expenses will continue to be reported in a manner consistent with current practice. Valuation gains and losses associated with long-term assets and liabilities would continue to be reflected as nonoperating activities. Other items, such as the change in fair value of interest-rate swap agreements, adjustments to conditional asset retirement obligations, post-retirement benefit expense (other than net periodic benefit cost), change in value of split-interest agreements and loss on disposal of capital assets would continue to be presented outside of the operating measure.
- Broadly speaking, investment return is generally regarded as an activity that provides support for propelling a nonprofit’s mission forward. However, the FASB does not view the earnings from an investment portfolio as operating revenue generated from carrying out the nonprofit’s mission. Gifts invested in the portfolio would be reflected as operating revenue when received, absent explicit donor restrictions, and the choice between investing and spending those gifts is a board action. Earnings generated from that board action would be outside of the mission of the nonprofit. The earnings of the endowment portfolio and other short-term interest earnings would be reported in a section after the “Operating excess after transfers” line. This section could be titled “Investing and financing activities” or “Nonoperating activities,” or it could simply list the revenue and expense line items without titling the section. Related investment expenses would be netted against investment earnings. Investment expense would include direct internal salaries (and related costs) associated with managing the portfolio and identifiable external expenses.
2. Redefining cash flow line items
The proposed Standard provides new definitions for operating, financing and investing cash flows. Also included are several other substantive changes to the positioning of activities among the categories, specifically the classification of interest and dividends, and the purchase and sale of property. The repositioning of these items is intended to better align the activities of the statement of cash flows with the changes in the reporting format of the statement of activities. The proposed recategorizations include:
To operating cash flows
- Cash payments to acquire and cash proceeds from the sale of long-lived assets (currently investing)
- Cash gifts restricted for acquisition of long-lived assets (currently financing)
From operating cash flows
- Cash receipts of interest and dividends (to investing)
- Cash payments of interest on debt (to financing)
The proposed changes present only a part of your story.
On the whole, the proposed Standard may help nonprofits better communicate their financial story, but it is a story of revenue inputs and cost outputs; and not of performance outcomes. Since the proposed Standard stops short of requiring management’s discussion and analysis of operations, it is not a reporting model for programmatic outcomes and progress in reaching financial and mission objectives. Information about programmatic outcomes and the relationship of those outcomes to cost outputs is valuable to users of financial statements. As nonprofits begin to think about implementing the Standard, within the context of their own organization, consideration should be given as to how to better communicate outcomes and related information to the users of the financial statements.
Tom Brean is the partner-in-charge of Grant Thornton’s Audit Services for audits and consulting for a wide variety of not-for-profit groups. He works with large national and international charitable organizations, professional and trade associations, social service, schools, arts and religious organizations, and community development organizations. Brean is currently the lead partner working with the YMCA of the USA, United Way of Metropolitan Chicago, Salvation Army Central Territory, Lions Clubs International, The Commercial Club of Chicago, the Museum of Science and Industry, the Alzheimer’s Association and the Chicago History Museum. He is also a frequent speaker on not-for-profit topics. – See more at: http://www.grantthornton.com/people/bios/b/brean-thomas.aspx#sthash.e5eR6tW0.dpuf
Dennis Morrone is the partner-in-charge of Grant Thornton’s National Not-for-Profit and Higher Education Audit Services practices. Prior to joining Grant Thornton, Morrone was part of Arthur Andersen’s Metro New York not-for-profit practice. Morrone has represented Grant Thornton on the AICPA’s Center for Government Audit Quality. He is a member of Grant Thornton’s national not-for-profit leadership team and part of Grant Thornton’s professional excellence and technical committees. He has taught numerous courses on not-for-profit topics and has also written several articles for Grant Thornton’s not-for-profit industry letters as well as for the Not-for-Profit Times. Morrone has also recently been appointed to the AICPA Not-for-Profit Industry Conference Planning Committee.