Changes are on the way for how not-for-profit organizations classify net assets and report their statement of activities, cash flows and liquidity. The updates come as part of the Financial Accounting Standards Board (FASB)’s exposure draft of the proposed accounting standards update, Presentation of Financial Statements of Not-for-Profit Entities. Provisions outlined in the update reflect recommendations from the FASB’s Not-for-Profit Advisory Committee (NAC) as well as feedback from stakeholders. Stakeholders identified the following areas for change because of either diversity of practice under current U.S. generally accepted accounting principles (GAAP) or because of the complexity involved in the current reporting requirements.
Net Asset Classification
Not-for-profit organizations currently classify their net assets into three categories: unrestricted, temporarily restricted and permanently restricted. Current classifications of net assets are based on the absences or presence of donor-imposed restrictions. Stakeholders raised concerns about the usefulness of three net asset classes. Over the years, state regulatory changes to endowments, specifically the adoption of Uniform Prudent Management of Institutional Funds Act (UPMIFA), have blurred the distinction between temporarily restricted and permanently restricted assets. Additionally, financial statement users have struggled with understanding the definition of unrestricted net assets and any Board designations of unrestricted net assets.
The exposure draft recommends reducing net asset classes to two categories: net assets with donor restrictions and net assets without donor restrictions. Further information about the nature of the donor restrictions and any Board designations would be reported as an enhanced disclosure.
Proposed updates also make changes to reporting “underwater” endowments with value that has fallen below the original gift plus any additions as defined by donor or by law. In most states, not-for-profits can spend underwater funds with certain limitations. Current U.S. GAAP requires endowment funds that are underwater to be separated from the permanently restricted net assets and classified as a component of unrestricted net assets. Stakeholders told the FASB this practice created confusion among financial statement users.
The exposure draft recommends underwater endowment funds be classified under assets with donor restrictions. Enhanced disclosures would include information about the amount by which the fund is underwater. Additionally, the not-for-profit would disclose any policies related to the use of underwater funds.
Statement of Activities
Modifications made to the number of net asset classes would also affect statement of activities reporting. Not-for-profits currently classify changes in net assets by net asset type and in the aggregate. This requirement would not change under the new rules. Not-for-profits will report changes in net assets with donor restrictions, net assets without donor restrictions and total net assets on the statement of activities.
Other statement of activities updates include:
Intermediate Operating Measures: Reporting an intermediate measure of operations varies in current practice because not-for-profits are not required to report one under current U.S. GAAP. Entities that choose to report an intermediate operating measure of performance often use definitions of operations that differ from those used in the presentation of cash flows. The proposed update would require not-for-profits to present two intermediate operating measures (subtotals) for changes in net assets without donor restrictions. The first operating measure would report the change in net assets without restrictions before consideration of any internal transfers. The first subtotal would include operating revenues, support, expenses, gains and losses of the entity. The second subtotal would include the effects of any internal transfers such as Board designations, appropriations and similar transfers.
Placed In-Service Approach: Donor-restricted funds used to purchase long-lived assets create another trouble spot in not-for-profit reporting. Entities in current practice have the option to release the donor restriction over the useful life of long-lived asset or to report the release of restriction once the asset is placed in service. The proposed update eliminates the first option and requires the entity to use the placed-in-service approach for reporting expirations of donor restrictions on funds or other gifts used to purchase long-lived assets. This change in current U.S. GAAP is likely to be considered the most controversial change since those not-for-profits that are capital intensive and receive funding for these capital expenditures will report significant operating losses in years following the initial acquisition of the capital asset.
Presentation of Expenses: Current practice creates diversity in reporting expenses. Some entities choose to disclose information about the function and nature of their operating expenses, and others do not. In the proposed accounting standards update, not-for-profits would be required to include information about the nature and function of their operating expenses in one of three ways: within the statement of activities, as part of a separate statement or in the notes to the financial statements. They would also be required to include enhanced disclosures about the method the entity used to allocate its costs.
Diversity in practice also exists with reporting investment return net of investment expenses. Some entities elect to report investment expenses as a component of operating expenses on their statement of activities, but this is not universal. The FASB is proposing that all not-for-profits present investment return net of related external and internal expenses within their statement of activities.
The FASB reasons that the proposed changes to statement of activities reporting should create greater comparability in communicating the financial performance of not-for-profits enabling users such as governing boards and managers to benchmark their performance to peers within their industry.
Presentation of Cash Flows
Cash flow presentation in current U.S. GAAP permits the use of the indirect method of reporting cash flows from operating activities. Entities can also use the direct method of accounting to provide additional information about their cash flows. The FASB heard from stakeholders that the indirect method of reporting made financial statements more difficult to understand. The proposed update would essentially flip the current practice, so that not-for-profits would be required to use the direct method of reporting their operating cash flows and allowed to use the indirect method of reporting to show additional information.
Classification of certain cash flows would also be aligned with the updates to the statement of activities:
Cash Flows Involving Long-Lived Assets: Long-lived asset purchases, assets limited to the purchase of long-lived assets and proceeds from the sales of long-lived assets would be classified as operating cash flows. Current practice labels them as investing cash flows.
Payments of Interests on Borrowing: Entities would classify payments of interest on cash management activities and other borrowings as financing cash flows. These payments are currently classified as operating cash flows.
Receipts of Interest Excluding Program Investments: Cash flows from loans and investments that the entity does not use for its tax-exempt programs would be considered investing cash flows. In current practice, receipts of interest and dividends are classified as operating cash flows.
The proposed update also includes new disclosure requirements about a not-for-profit’s liquidity position. The FASB recognized the need to improve a user’s ability to assess a not-for-profit’s liquidity position and how the not-for-profit manages its liquidity. Under the proposed guidance, the not-for-profit would disclose specific quantitative information such as the amount of financial assets at the end of the reporting period. They might also disclose the amount of financial assets not available to meet current cash needs in the near term due to restrictions or limitations on their use from either external donors or internal Board designations as well as the amount of financial liabilities that require cash in the near term.
Required qualitative disclosures would also enhance a user’s understanding of the not-for-profit’s strategy for addressing entity-wide risks that may affect its liquidity, including its access to lines of credit, its policy for establishing liquidity reserves and its basis for determining the time horizon used for managing its liquidity.
Adopting the Changes
The effective date of these proposed changes will likely be determined by the nature and number of comments received by the FASB (the comment period ends on August 20, 2015). We encourage preparers and users of not-for-profit financial statements to submit their comments on the proposed changes given the likelihood that your organization’s financial statements will be significantly affected by some of the changes in the proposed update.
Not-for-profits operate in a very competitive environment and should consider preparing pro forma financial statements using the guidance in the exposure draft to fully understand the impact on their financial statements. Will grantor agencies understand the changes made under the proposed update and the likely need to modify the financial scorecard used to evaluate grant applicants? Or will not-for-profits who are otherwise worthy of the grant based on their success at achieving program outcomes miss out on funding opportunities solely as a result of the changes in their reported measure of operating performance? Conversely, you may find that other changes to the not-for-profit financial reporting model facilitate a user’s understanding of your organization, its access to liquidity and other financial measures.
All comments are welcome by the members of the FASB and are important in the final consideration of any needed changes to the final accounting standards update.
Whenever the changes go into effect, entities would adopt them on a retrospective basis. Financial statements for interim periods would need to be restated if they appear with the entity’s financial statement in the year of adoption.
For More Information
We will keep you up-to-date on the modified requirements. If you have any specific questions, comments or concerns, please contact us.
Tracey McDonald is a Managing Director at CBIZ MHM in the Tampa Bay office. She can be reached at 813.594.1400 or Tracey.McDonald@cbiz.com.