The Financial Accounting Standards Board is expected to release a long-awaited accounting standards update this month to clarify a key issue in the nonprofit world, standardizing how grants are classified, as either an exchange transaction or a contribution.
The guidance is likely to provide real-life examples of when a nonprofit organization would classify a grant as an exchange as opposed to a contribution. It will also provide more clarity on how FASB’s new revenue recognition standard can be applied by nonprofits.
FASB issued an exposure draft of the upcoming guidance last year (see Nonprofits need to get ready for revenue recognition standard). There will be a few changes from the exposure draft in the final standard, according to Lee Klumpp, a partner in BDO USA’s Nonprofit & Education practice, a former FASB fellow, and author of a book on the recent changes to nonprofit financial reporting, “How to Read Nonprofit Financial Statements: A Practical Guide, 3rd Edition.”
“There are a couple of changes around that particular exposure draft,” he told Accounting Today. “Originally, one of the indicators of a determinative barrier that they were going to use would be an additional action indicator. If it required any additional action, that would be a barrier that might make the contribution conditional. The board decided to remove that particular requirement.”
Instead the indicator that the contribution is conditional would be a measurable performance-related barrier, such as a milestone, or a stipulation that limits the discretion of the grant recipient. “You’ve got to meet that milestone,” Klumpp explained. “A milestone usually has some kind of measurement or performance level. We’re starting to see some more of those in state and local government contracts, and also in some of the fed contracts. And also the extent to which a stipulation limits the discretion of the recipient on the conduct of the activity, if the grantee or the government specifically says, ‘Here’s how you do this. You have to follow steps A through C, and there’s no discretion at all. You have to do it exactly this way.’ Basically if they’re drawing specifications around how the contract is going to be carried out, that would create a barrier. The stipulation is then related to the purpose of the agreement.”
Another important component of the new standard involves a right of return of transferred assets or a right of release of the promisor’s obligation.
“Let’s say the foundation gives them $5 million upfront, and any funds not expended for the purpose of the contract have to be returned, or if the contract is not carried out in accordance with the various barriers, you have to return the funds,” said Klumpp. “A lot of times, contracts are on a cost reimbursement basis, but if the grantee doesn’t carry out the contract to the letter of the law, the grantor could turn around and say, ‘You haven’t done this the way we agreed to in the contract. Therefore we’re going to exercise our release for providing assets to pay for these costs. You haven’t done it the way you were supposed do it.’ Those are considered conditions that you would have to do, and then you would look at the various indicators that might create those conditions. Then if you meet both of those criteria, and they really don’t exist, then you get to move on. If you don’t have either one of those types of barriers, or some kind of indicator that would restrain you, then you actually get to recognize the contribution at that point.”
FASB wanted to improve the existing guidance, which dates back over 20 years, in light of the new revenue recognition standard, which takes effect next year for most nonprofits.
“Organizations are trying to figure out what they really have,” Klumpp explained. “If I have these contracts and grant agreements, is it really a contract with a customer or is it really something else? A lot of not-for-profits don’t perceive these rights and contracts as being reciprocal, like from a customer. They see them as supporting their mission and activities. The FASB has gone on to say that this accounting guidance clarifying conditional contributions doesn’t necessarily change what you call something on the face of the statement. It’s giving guidance or accounting for certain types of transactions that fall within this parameter and then if it doesn’t fall within this parameter, what other parameters does it fall into? Is it a contract with a customer under rev rec, Topic 606, or is it under the ASU that’s to be issued, or is it more of a contribution or is it even something else? It’s trying to give us a set of tools in the nonprofit industry in which to figure out what best depicts the pattern of recognition for revenue.”
There are some important differences in the upcoming standard from the existing guidance on exchange and non-exchange transactions.
“I think the really big thing they walked away from here is that if you look at the current guidance that’s out there on how to do it in practice, if the general public is a beneficiary, then it’s considered an exchange transaction,” said Klumpp. “Under the new guidance, if the general public is the beneficiary of the contract or the agreement, then it’s a non-exchange and thereby a contribution. There is a gray area between exchange and non-exchange that’s not really been addressed, and that’s where you have some specified third party. The FASB and some others are looking at trying to understand better what that might be. If you have a government resource provider and they’re a third-party payor on behalf of an identified customer, for instance. Let’s say you have a local government that says, ‘OK, I want these individuals.’ They’re either specifically named, or individuals that meet a specific requirement that they determine to be delivering certain services. That might actually fall into an exchange. But if I’ve got a program to run an after-school daycare program for high-risk individuals to get them on grade level for reading, the only requirement is that they have to be high risk and they have to be below grade level on reading based on the statement I just made. But I can go throughout the community and identify those individuals and pick out who they are. That would probably be non-exchange and the general public. But if the school system identifies them and sends them to me, and I have to carry that out specifically to their requirements, then I’m probably an exchange.”
The details in the agreements will help determine the appropriate treatment under the upcoming guidance and how it fits in with the revenue recognition standard.
“You have to read the agreements to figure it out,” said Klumpp. “The more specific the contract is, the more it might fall under exchange and thereby Topic 606. This standard is probably going to be very meaningful for nonprofits in trying to determine how much they have to do related to the implementation of Topic 606. Becoming familiar with this and Topic 606 is going to be very important for not-for-profit organizations in the next couple of years.”
The revenue recognition standard can be complex to implement, even though it’s built around a five-step process. “It seems pretty easy when you look at Topic 606 because it’s a principle, with five steps, but in each of those steps, there are five or six more steps that you have to really consider,” said Klumpp. “It’s not going to be easy for people.”
He believes many nonprofits will nevertheless benefit from the improved clarity. “I think it’s going to help a lot of nonprofits move some of their grants and agreements into contribution accounting,” said Klumpp. “We’re still calling them grants and contracts on the face of the statement, but using contribution accounting to address how to recognize the revenue related to these agreements.”
The effective date, based on a recent FASB board meeting, could be starting soon for some nonprofits if they can be classified as a conduit debt obligor, for example, a hospital that asks the city where it’s based to issue bonds to finance an expansion project for its facilities.
“The effective date is for annual periods beginning after June 15, 2018, including interim periods, for public business entities, or for not-for-profits that have issued, as a conduit debt obligor,” said Klumpp. “If you’re not in those categories, for all other entities, it’s for periods beginning after Dec. 15, 2018. The reason for that disparity is we’ve got nonprofit organizations out there that have bonds on which they are conduit debt obligors, and they may have issued interim financial statements on a quarterly basis. This way, using this new effective date concept of after June 15, 2018, they won’t have to go back and restate those interim statements they issued previously. That’s for recipients. Resource providers have a little bit different date, because this actually addresses resource providers as well as recipients of grants and contracts. For them it’s for annual periods beginning after Dec. 15, 2018 for those that are considered public business entities or nonprofits with conduit debt. For all others, it’s for periods beginning after Dec. 15, 2019.”
Many smaller nonprofits may have trouble making the transition by those dates, just as many companies have had difficulty implementing the new revenue recognition standard in time.
A recent survey of nonprofits by BDO found that many of them lack adequate financial resources. Even though expanding programs is on the two-year horizon for nearly 50 percent of the nonprofits surveyed, many organizations lack the financial strength for sustainable growth. Approximately one out of five nonprofits could be at risk of falling into the starvation cycle of underfunding critical infrastructure and technology in favor of high program-related spending. More than 50 percent of nonprofits lack adequate operating reserves, falling short of the recommended six-month level. Many organizations still have unrealistic standards for nonprofit spending, with 58 percent of nonprofits saying rising overhead costs are a challenge.
“I think it’s going to require them to allocate specific resources to implementation,” said Klumpp. “The timing of this possibly could have been better from an implementation perspective. However, I think that coming out right now is important because the nonprofits that are working on their 2019 budgets, those that have 12/31 year ends, for that they’re going to need to allocate some resources. Whether that’s reallocating internal resources or going out and hiring some new resources to help them, but I think the discussion around revenue for all not-for-profits is going to be on the top of the list for the next year or so.”
Certain types of nonprofits are more likely to feel the impact of the new grant standard than others.
“I think college and universities and research institutions will be highly impacted by this, and organizations that have a lot of federal financial assistance to help support carrying out their programs,” said Klumpp. “This is more of an issue for federal, state and local grants and contracts than grants and contracts from individuals and corporations. Private foundations and funding organizations are going to have some impact from this. They’re going to have to re-evaluate how they write their grants and contracts. If they’re a funder or a receiver, they’re going to have to think about the language that they use for contracts when they enter into them. This is going to be an educational process for a lot of not-for-profits.”
Many charities won’t need to worry about it much, though. “The true charities that receive straight contributions, like the March of Dimes or the American Cancer Society, this probably is not going to change very much how they recognize revenue or the issues,” said Klumpp. “It’s when they start entering into contracts and agreements that cover a period of time, that are more specific than just making a donation to a charity in carrying out their good works. I think all nonprofits are going to have an effect one way or another, but the more you’re involved in grants and contracts that specifically give direction to carry out the activities of your organization or activities that are according to the grantor, I think that’s going to be a little bit harder for organizations to get their arms around.”
Some nonprofit clients can have dozens of contracts with different funding sources all over the world, and they will also need to deal with the revenue recognition standard for revenue from contracts. “Not every nonprofit is going to have that,” said Klumpp. “Some may only have four or five, and it may be it will take a little bit of time. There’s going to have be a commitment of resources by every nonprofit to some degree — some a lot smaller than others — but some degree to address these two new standards.”
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