The Financial Accounting Standards Board is getting ready to unveil a set of proposals that could have a major impact on the way nonprofit organizations present their financial statements.
The board voted earlier this month to issue a proposed accounting standards update that would include improvements to the current net asset classification scheme and the required information about an organization’s liquidity, financial performance and cash flows (see FASB Proposes Accounting Standards Change for Nonprofits). FASB plans to issue the proposals in mid-April and ask for public comments.
FASB’s announcement provided few details and instead directed interested parties to the project page on the FASB Web site. Lee Klumpp, National Assurance Technical Director in BDO’s Nonprofit & Education practice, has been closely involved with the project as both a FASB fellow and at BDO, and he filled in Accounting Today on what to expect. He was the project manager for the first year and a half of the project at FASB.
The project dates back to 2009, he noted, when FASB formed a Nonprofit Advisory Committee, which meets twice a year at FASB’s headquarters in Norwalk, Conn. The NAC includes representatives from various types of not-for-profit organizations, including charities, arts organizations, foundations, health care organizations, religious institutions, watchdog groups, and colleges and universities. They were asked to address the big issues that nonprofits are facing.
“If you went out and polled users of nonprofit financial statements, what they really want to know, based on our research, is to understand how nonprofits use their resources and what resources they have available to them,” said Klumpp.
Two of the main issues, as far as FASB is concerned, are FAS 116 and 117, the two financial accounting standards that changed the scope of financial reporting for nonprofits back in 1993. But more than two decades have gone by with little change to either standard. Only one change was made to the presentation standard to address the Uniform Prudent Management of Institutional Funds Act, also known as UPMIFA, to deal with issues surrounding the solvency of some endowments, mainly at colleges and universities, in the wake of the recession. Changes in the fair value of the investments put some of those endowments effectively “underwater.” UPMIFA has been enacted by 49 states, the District of Columbia and the U.S. Virgin Islands, but not by Pennsylvania or Puerto Rico.
The Nonprofit Advisory Committee recommended in 2011 to FASB that it was time to re-evaluate the nonprofit standards, and in 2012 the board added two projects to the agenda. One was a standard-setting project to deal with financial statement presentation and the other was a research project to deal with how nonprofits report financial results to stakeholders. FASB later decided to drop the research project from its agenda because it was uncertain whether it was within its purview to require a management discussion and analysis from nonprofits when an MD&A is not required of private companies.
However, the financial statement presentation project lived on and has now come to fruition, Klumpp noted. It deals with six areas: net asset classes, financial performance, reporting of expenses, the cash flow statement, liquidity, and notes to the financial statements.
NAC started by looking at what other groups in the U.S. and abroad had been doing to improve reporting by nonprofit organizations. One of those was an ongoing FASB project called the Financial Disclosure Framework Project, which is examining what disclosures are important and how a preparer, such as a nonprofit’s CFO, should address them.
NAC also looked at research from the National Association of College and University Board Officers for NACUBO’s “Blank Slate Project,” which reimagines new ways to do financial reporting for colleges and universities. NAC also examined the Governmental Accounting Standards Board’s Business Type Activity model, and an overhaul by the American Institute of CPAs of the AICPA’s Audit and Accounting Guides for not-for-profit and health care entities.
“We even looked at what other countries were doing,” said Klumpp. “We looked at the U.K., Australia, New Zealand and Canada and talked to others about what they were doing. There was a lot of research that went into this project. We even went back to a project that was part of a convergence project with the IASB that dealt with how business entities report financial performance and what were the concepts in that. That project eventually got put on the shelf. It’s now been brought back and is being re-evaluated only at the FASB level. It’s not a joint project anymore, but we looked at that information. I can tell you that during my time there doing research, we looked at several hundred financial statements of nonprofit organizations to understand what people were doing. There’s a lot of flexibility for nonprofits currently in GAAP as to how they report and tell their story around their financial performance. So we looked at that information and tried to understand what people were doing and what were some of the best practices that were out there, and do those best practices make sense to be applicable to everybody.”
Financial Performance Measures
They also began trying to define a financial performance measure of some sort. “A lot of the watchdog groups use ratios in order to find whether or not a nonprofit is efficient and effective, but one ratio in one given year doesn’t tell that story,” said Klumpp.
He noted that charity watchdog groups oftentimes use metrics related to fundraising or how the organizations are spending their resources to achieve their mission in an effort to hold nonprofits accountable. Groups such as Charity Navigator typically rely on information gleaned from the Form 990 that is filed with the Internal Revenue Service. But financial reporting differs a great deal from tax reporting.
“The idea was, could we come up with another metric that might be helpful,” said Klumpp. “There are already metrics that aren’t used. Nobody ever bothers to look at the cash flow metrics.”
He noted that there is no requirement in the U.S. for statutory financial statement filings by nonprofits, as there are for publicly traded companies. However, charities are required in many states to report their charitable registration with the state’s attorney general or whichever state office is responsible for charitable solicitation. Thus, organizations over a certain threshold, such as $200,000 or $1 million, frequently need to provide audited financial statements, which are usually reported on a GAAP basis.
Many states now make those financial statements available on their Web sites. The financial statements of nonprofits that issue municipal tax-exempt bonds are available on the Web site of the Municipal Securities Rulemaking Board via the MSRB’s EMMA database.
Many nonprofits also provide their audited financial statements on their Web sites for interested donors.
“I think more and more organizations have their financial statements available to the public, whether the organization wants to or not,” said Klumpp. “And if you receive federal funds and have any type of federal funds under the Single Audit Act, the financial statements are available under the Freedom of Information Act.”
Cost of Implementation
He noted that there seems to be more of an inclination by federal officials to make information about the finances of various nonprofits available to the public, perhaps through the Federal Audit Clearinghouse site.
Even small nonprofits will be expected to comply with the new accounting rules once FASB issues them, but Klumpp does not believe they will present a major challenge or that FASB will need to make a distinction between the requirements for small and large organizations.
“These rules are only for financial statement presentation,” he said. “For the most part, it’s probably easier for the smaller organization, and the cost of implementing this project should be fairly small. It’s only presentation, so nobody is going to have to change their general ledger or go buy an accounting system. It’s on the face of the financial statements.”
Klumpp pointed out that the operating measure will simply be a line item on the statement of activities.
“The defining of the intermediate operating measure is about mission and availability,” he said. “When you take that piece of information, that’s pretty easy for a nonprofit to be able to address, because in order for it to be available to be in the operating measure, it’s got to be available in the current period and reflect the limits imposed by the donor and by internal actions of the nonprofit governing board.”
Donor Restrictions on Assets
Other changes are underway with the operating measure. “It used to be that a nonprofit, if they had an intermediate operating measure, had to have that intermediate operating measure in the reconciliation of unrestricted net assets. That’s no longer required,” said Klumpp. “Previously a nonprofit couldn’t issue a statement of operations. They had to issue a statement of changes in unrestricted net assets, or a statement of operations and changes in unrestricted net assets. Now they can issue a statement of operations, which looks very similar to an income statement of a private company. If they do that now, they still have to issue a statement of changes in net assets because you still have to reconcile the net assets, but the reality of it is that there’s more flexibility for not-for-profits in using some of these requests.”
FASB’s proposed changes will make it easier for nonprofit board members to understand an organization’s unrestricted net assets.
“One of the things that’s going to happen is they’re changing the names on the net asset classes, so you’re going to have with donor restrictions’ and without donor restrictions,’” Klumpp explained. “So unrestricted net assets’ will become without donor restrictions’ and then all the donor-restricted net assets will be combined.”
Temporarily restricted net assets and permanently restricted net assets will be combined into a classification known as “with donor restrictions.”
“We did a lot of research to understand what were the important classifications and the important pieces of information for stakeholders in nonprofit financial statements,” said Klumpp. “We need to know what’s restricted and what’s not. What can we use now and what has actually been earmarked for other specific projects or at some point in time to be used?”
He noted that UPMIFA has blurred some of the lines between temporarily and permanently restricted net assets. “We’re going to two classes of net assets, but they’re going to take the disclosure requirements around net assets and make them more robust so that they can turn around and present to the reader information about the timing, purpose and use of those funds,” said Klumpp.
He pointed out that many funds are typically named after someone who bequeathed money to a nonprofit to be used for specific causes. “If you look at some of the small nonprofits, they’ll have names like the George Washington Fund,” said Klumpp. “It’s always people who are no longer alive. Somebody gave them money and now they’re memorialized in their financial statements. Wouldn’t it be better to know what’s available for continuing operations, what’s available for scholarships, what’s available for the operating reserve? What can be used currently and what can be used in the future? What’s restricted by the donor and what’s designated by the board? Those are the more important pieces of information.”
He pointed out that the difference between a board and a donor is that a board designates, while a donor restricts.
“What a board designates, a board can undo, but if you look at unrestricted net assets and it’s $100 million, you can’t tell how much of that money has been earmarked for something else,” said Klumpp. “Why is this nonprofit so rich? Well, maybe they’re not so rich because $85 million of it is tied up in property, plant and equipment.”
The other $15 million might enable the organization to operate for another year and provide needed services, even if one of its main sources of funding falls through.
“Their $15 million may be tied up in an operating reserve,” said Klumpp. “But it’s important to the reader [of financial statements] to know that, that there is an operating policy as far as reserves and how that works. More robust disclosures around net assets related to the nature and timing and use of the funds would help the reader to better understand how the organization is going to use their resources.”
Klumpp anticipates that there will be some questions about the exposure draft once FASB issues it. BDO has already been involved in reviewing an early version of it.
“There are a couple of areas that are going to create some questions,” he said. “One is in the operating measure. There is now something called transfers. You have a board that has set aside money as a quasi-endowment. Say you’ve got $25 million sitting over in a quasi-endowment. The earnings on that quasi-endowment help to fund programmatic activities. When those earnings come in, a lot of organizations just show all those earnings as interest and dividends. But it’s really not interest and dividends because it’s investment, and it’s reinvested, so the financial statements are a little misleading.”
Some organizations will show in their non-operating activity the interest and dividends net of the appropriation for operating activity, he noted. “Let’s say there’s $100,000 of interest dividends and unrealized gains and losses, and the board has a policy that 10 percent of that is used in current operations,” Klumpp explained. “Then what you’ll see is $90,000 reported in the non-operating section and $10,000 reported in the operating section. Well, the thing is it’s all part of changes in net assets. It doesn’t misreport anything, but what you don’t understand is that I’ve got this piece in non-operating. I’ve transferred it up, and it’s sitting in my total revenue and support. Well, it’s really not part of the funds that were made available in the period by the donors, and resources became available in that period. It’s resources that were made available. So now you’re going to have revenue and support, which is all funds received by the organization in the current period that were not restricted by a donor, but also funds that were made available because restrictions have been met.”
In addition to funds in which the restrictions have been met, exchange transaction revenue, similar to fee-for-service revenue, will come into total revenue. “Then you’re going to have total expenses, and then you’re going to have this transfer,” said Klumpp. “And the transfers are basically funds that have been made available by the action of the board.”
Areas of Controversy
Another area where questions may arise is the cash flow statement. “They’re going to require the direct method of cash flow for all nonprofits,” said Klumpp. “Currently, if you look at the cash flow, it’s the indirect method, the cash provided by or used in operations. If you look at that section of the cash flow statement, it looks like an accountant’s reconciliation. As a matter of fact, that’s what it is. If you were to go out and look at a nonprofit’s financial statements, it talks about the change in pledged receivables, the change in accounts receivable, or change in AP and most readers who are not accountants don’t understand that. The direct method of cash flow will be much easier for board members and others who are stakeholders to understand, because it’s going to say the cash that flowed in and the cash that flowed out. They’re no longer going to require the indirect method, and that was part of the problem. Previously if you did the direct method, you had to do the indirect method anyway, so people just did the indirect method.”
Klumpp predicts this change may create a little controversy, but that won’t be the only controversial matter. “The bigger controversy is they’re going to re-characterize certain items on the cash flow statement,” he added. “Cash from interest and dividends has always been an operating cash flow. It now will turn around and be an investing activity. Cash paid for long-term debt has always been an operating activity, and they’re suggesting that it be actually financing activity. Those are major changes in how people think about operating versus financing investing. The other piece of it is cash gifts and purchases of property, plant and equipment will be considered an operating activity in the statement of cash flows. Currently those are investing activities, and if it’s from a donor, it’s financing. Those are big issues for nonprofits, bigger for some particular industries within a sector than others.”
Timing for Implementation
The exposure draft is due to be issued in April and the comment period is likely to go for four months, until July 31. Klumpp estimates the standard may be finalized by the end of the year or the beginning of next year.
“Then the big question is how long do they give the nonprofits for implementation?” he said. “They’ve discussed it in their meetings. I don’t believe they’ve come to a final determination on that. There are things to consider. How much of a period do you need? Do you need a year, two years or three years? When FAS 116 and 117 came out, they actually did a staggered implementation where the larger organizations implemented it first and the smaller organizations implemented it a year later. Whether they will do that again, I don’t know. I’m not privy to those conversations any longer. But I know that they’re thinking about it. The staff may present that, but it will be up to the board to decide.”
Impact on Different Organizations
A wide variety of nonprofits are likely to be affected by the changes, according to Klumpp. For example, organizations with many buildings, such as large hospitals, colleges and universities will probably see a greater impact from the property, plant and equipment rules than others. Any nonprofits with large endowments, such as private foundations, religious organizations, colleges and universities, may be more affected by the interest and dividend rules. In addition, any organization that has financed a large portion of its activities, such as the purchase of buildings, will have to watch out for changes in the financing piece of the standards update.
“That could be just about anybody, so the effect is all over the place,” said Klumpp.
Natural and Functional Expenses
The AICPA, as part of its recommendation, had suggested the statement of functional expenses be required for more organizations besides voluntary health and welfare organizations, but FASB ultimately decided to require natural expenses and functional expenses for all nonprofits.
“They are no longer requiring the statement of functional expenses for voluntary health and welfare organizations, or for any organization,” said Klumpp. “But what they’re saying is you can have the flexibility to report on the face of the statements either your expenses by function or by natural expense, whichever makes more sense for your organization to tell the story about how you use resources, and what those resources are. But what they do want is that in the statements there will be both the reporting of natural and functional. What they’re thinking is that there will probably be in the notes to the financial statements some kind of table-type format which will show function and natural at a very high level.”
Many nonprofit stakeholders want to be able to understand how an organization is reporting its use of funds by function and programmatic activity versus supporting services. But they also want to know details such as how much of that is payroll, how much is occupancy, how much of it is maintenance, and how much is being paid to consultants.
“That’s a big issue,” said Klumpp. “The other issue is liquidity. Keep in mind the thinking around this project started in 2009, and it was actually put on the agenda in 2012. We were in the middle of a recession. A lot of nonprofits were having liquidity problems. If you think about liquidity, liquidity is really what assets do I have that I can turn around and make readily useful to meet my debt and current obligations? Then the other piece of it is, what do I have sitting on the side that may have restrictions or internal limits that I can make available?”
FASB’s Nonprofit Advisory Committee examined these issues, and Klumpp proposed a classified balance sheet and a separate presentation of assets for limited use.
“The board thought those might be helpful, but they didn’t think that would tell the whole story,” he said. “What they ended up with was just requiring a liquidity footnote. What they said was different organizations have different time horizons on liquidity.”
For example, the time horizon for a college or university might be a semester. For a trade association that charges yearly dues, it might be 12 months. For a summer camp, it might be the three months of the year that it operates.
“You come up with a time horizon and then you say, OK, what are my total financial assets, and then if I back out those assets that are not available to meet my cash needs based on my time horizon, such as having internal limitations, or they have been set aside by the board and designated for a purpose, that tells me what I have available as liquid assets.’ They’re going to have a liquidity measure and then they’re going to be required to disclose how does the entity turn around and manage this risk related to liquidity, including things like using lines of credit or having guarantees by related organizations, etc. Then they’re going to be required to disclose information about their policies around liquidity reserves and whether they have established a reserve or not, as well as what the basis was for that time horizon.”
Organizations will effectively need to show if they have enough liquid assets to meet their operational needs based on their time horizon.
“Now you’re going to have organizations talking about, Do I have the funds? I may look rich on the balance sheet, but do I have the funds available to meet my obligations?’” said Klumpp. “I know organizations that look like they’re rich if you look at the balance sheet because it’s a huge number in total assets. They’re property and equipment rich, but they don’t have enough money to make payroll. Or they have a lot of money sitting in donor-restricted net assets, but they can’t use that for payroll because they haven’t met the requirements put on them by the donor.”
Even organizations that appear to be “filthy rich” because they have millions of dollars set aside may have to make some decisions about redirecting some of those funds to meet their operating needs. “If I don’t have an operating reserve, but I’ve got all kinds of moneys that have been set aside and board designated and if I back those numbers out, it doesn’t mean that what the board has set aside it can’t un-set aside,” Klumpp pointed out. “Now the board can turn around and say, We have set aside $5 million for future expansion of our programmatic activities. Those funds could be used at any point should we have an operating liquidity issue.’ That could be disclosed.”
Many organizations may be surprised by what they find when they apply the proposed standard. “The funny piece of this is, a lot of organizations big and small may end up with a not so pleasant liquidity number when they first do this,” said Klumpp.
He cited research from the Nonprofit Operating Reserve Initiative’s NORI Project, which studied Form 990 information from not-for-profit organizations around the District of Columbia.
“One of my colleagues worked on that committee and it basically determined, of the 50 nonprofits they looked at in the Washington, D.C., area, less than 10 percent had operating reserves,” said Klumpp. “A lot of them didn’t have money put away for a rainy day, and the problem with that is nonprofits have a lot of rainy days.”
If a recession or economic downturn occurs, nonprofits can see their funding plummet. “When there are recessionary issues or economic issues, that’s when the nonprofit can least afford to have a liquidity problem because the people that they serve in a lot of cases are more needy during that period than at any other period, and that was a big issue during the recession,” said Klumpp. “The liquidity reserve, I believe, will get more people talking about a nonprofit’s liquidity, and whether or not it’s healthy, related to a liquidity measure.”
Klumpp sees a wide-ranging impact from the upcoming accounting standards update. “What you’ve got coming out of this project is some enhancements to financial statement presentation, but you’ve also got some things that are allowing nonprofits to look at other measures,” he said. “You’ve got an operating measure now that will be required for all nonprofits. You’ve got a liquidity disclosure that will help people understand the health of the organization. You now have a more clearly defined operating measure in the statement of cash flows. These are just additional tools to help understand how healthy a not-for-profit is. In and of itself, one year doesn’t make a nonprofit healthy or unhealthy. You have to look at this information comparatively or maybe even over a multiple number of years, three to five years, because there are cycles to certain not-for-profits and to our economy.”
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