After a recent meeting, the Financial Accounting Standards Board (FASB) voted to draft the final accounting standard related to the first part of its not-for-profit financial statement presentation project. Among the changes are provisions that will make a not-for-profit’s liquidity more transparent.
The first part of the accounting standard is expected to be released in the third quarter of 2016. Phase two is expected to be completed after the completion of phase one. To prepare for the new reporting requirements, not-for-profits should begin examining their approach to liquidity, as the standard will require not-for-profits to be more explicit about how their organization manages its resources to meet its cash needs. Now is the time, before the standard takes effect, for not-for-profits to evaluate their liquid assets and ensure that their approach and financial statements adequately address their risks and budgetary needs.
What is Liquidity?
Assets are considered liquid when an entity can quickly convert them to cash. Both the for-profit and the not-for-profit sectors are encouraged to have liquid resources (reserves) to handle emergencies or other unplanned events that arise that may require cash on hand.
Not-for-profits must be mindful of their level of liquidity because their financial and spending decisions tend to draw scrutiny. An organization with too much, or too little, in reserves may raise questions with the board of directors or other users of their financial statements.
When determining what is appropriate to have in reserves, not-for-profits should consider their needs and risks. Organizations that rely heavily on contributions may need to have more in reserves than organizations that rely on program revenues, as contributions may be more vulnerable to external market conditions and variability in timing. As a general rule, not-for-profits should aim for liquid resources that could cover at least three months of annual expenses. Other benchmarking tools can help determine what needs to be in reserves. Reviewing benchmarking tools periodically is a good practice to ensure that your organization is financially healthy and equipped for its operating environment.
Presentation of Assets and Net Assets
Accounting changes under the first part of the not-for-profit financial statement presentation project are designed to make it easier for users of financial statements to understand how a not-for-profit manages its assets. Part of this entails clear reporting around the type of assets a not-for-profit holds.
Entities generally account for assets and liabilities by type or by groups with similar characteristics. Some elect to classify assets by how easily they can be converted into cash, or in the case of liabilities, by the maturity date of the liability. Assets can also be grouped by nature of the asset, such as marketable securities, cash or other types of investments.
Classifying assets in the traditional statement of financial position, however, does not always reflect their restrictions on use, which have a bearing on the assets’ liquidity. A not-for-profit could have a large reserve of assets, but if a donor earmarks or restricts them for a particular purpose, the assets cannot be used to address budgetary shortfalls or other cash needs that may arise.
Currently, U.S. generally accepted accounting principles (GAAP) for not-for-profits segregates net assets into three asset types: unrestricted, temporarily restricted and permanently restricted. During the process of setting the new guidelines, stakeholders have shared with the FASB that the category of temporarily restricted assets was not clear and that the current categories did not clearly reflect the assets a not-for-profit’s board designates for a particular use.
In the coming changes, the three net asset classes will be narrowed to two: those with restrictions and those without. Net assets with donor restrictions or board designations will require disclosures in the statement of financial position or in the notes to the financial statements, and such disclosures will further articulate the restrictions. The changes are designed to make it easier for users of financial statements to understand how assets can be used by the organization.
Enhanced Disclosure of Liquidity Will Be Required
The upcoming accounting standard will also require not-for-profits to provide additional information about their liquidity in their financial statement footnotes. Not-for-profits should be prepared to communicate their process for managing their assets to meet cash needs that arise within a year of the balance sheet date. They should also prepare to communicate in their notes or on the statement of financial position the availability of their assets to meet their cash needs. This also presents the opportunity for organizations to articulate how they run the organization, manage risks and plan for the future.
Presentation of Cost Allocation Disclosures
Not only will the assets themselves be more transparent in the new guidelines, but the expenses the assets help cover will also be made more transparent. The FASB recently voted to include guidance in the final accounting standard that would require not-for-profits to classify their expenses by both function and nature. This may make it easier for users of financial statements to understand how a not-for-profit spends its resources. The changes, for example, could make it easier for financial statement users to identify the largest program expenditures as well as whether the function of those expenditures is contributing directly to the not-for-profit’s mission. The enhanced disclosures related to how a not-for-profit allocates its costs to various programs may also bring more transparency to how not-for-profits manage their costs and operations.
Changes Require Planning
Increased transparency around how you manage your expenses and reserves may require some changes to your accounting processes, internal systems or other decision-making. For assistance in preparing for the changes, please contact us here.
David Brown, Jr. is a Director at CBIZ and a member of the Not-for-Profit & Education Practice. He is based in the Minneapolis, MN office and can be reached at 612.376.1205 or firstname.lastname@example.org.