Tax-exempt organizations are working through the biggest change to not-for-profit financial reporting in 25 years. FASB Accounting Standard Update (ASU) No. 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities, brings significant changes for all not-for-profit organizations, and implementation may require a significant investment of time and effort.
While this can be particularly challenging for smaller organizations with limited staff, the following considerations and best practices can help ease implementation for these organizations and the CPAs working with them.
A LOOK AT THE CHANGES
ASU 2016-14 is an enhancement, not an overhaul, of existing guidance. The goal is to reduce some of the complexities of not-for-profit reporting while making it easier for financial statement users to understand an organization's financial position and related activities.
The changes are designed to improve the presentation of information communicated in not-for-profit financial statements, in particular net assets, liquidity, financial performance, and cash flows. ASU 2016-14 emphasizes liquidity and statement of financial position improvements.
ASU 2016-14 is effective for organizations with calendar-year 2018 and fiscal-year 2019 year ends. The impact on smaller organizations depends on the complexity and nature of their financial statements. Several aspects of the update affect nearly every organization, including net asset classifications, liquidity and availability of resources, and the functional allocation of expenses. The remaining changes, such as endowments, board-designated net assets, and statement of cash flows, affect a smaller number of organizations.
This article highlights six of ASU 2016-14's main provisions.
NET ASSET CLASSIFICATIONS
What to know: Previously, not-for-profit organizations had three distinct net asset classifications: unrestricted, temporarily restricted, and permanently restricted. ASU 2016-14 combines temporarily restricted and permanently restricted net assets into "net assets with donor restrictions" and renames unrestricted net assets as "net assets without donor restrictions" (see the chart, "Net Asset Presentation: Then and Now"). This reflects the fact that permanently restricted net assets can be spent as long as the organization acts prudently.
Absent specific donor stipulations, ASU 2016-14 requires the use of the placed-in-service approach for reporting expiration of restrictions in gifts of cash or other assets to be used to acquire or construct long-lived assets, thereby removing the option to release the donor-imposed restriction over the estimated useful life of the asset acquired.
Net asset presentation: Then and now
Implementation considerations and best practices: Organizations should continue to internally track the corpus of endowments, unappropriated earnings, and underwater amounts on a unitized basis (for each separate endowment) due to legal reasons and the fact that the nature of net asset restrictions was not removed from ASU 2016-14. If the organization maintains a single endowment pool for multiple endowments, it would be prudent to separate the accounting for each. The assets can still be invested as a pool.
Organizations should consider reformatting their internal financial statements to comply with the two net asset classifications, which is not a significant change. However, these two net asset classes are required at a minimum; further disaggregation of net assets can be disclosed in the footnotes. Net assets with time or purpose restrictions could be segregated from those held in perpetuity (such as an endowment) if this is beneficial to the users of the financial statements.
LIQUIDITY AND AVAILABILITY OF RESOURCES
What to know: Not-for-profit organizations are now required to disclose qualitative information about how they manage liquid resources available to meet cash needs for general expenditures within one year of the date of the statement of financial position. Quantitative information is required to disclose the availability of the not-for-profit's financial assets to meet cash needs for general expenditures within one year of the date of the statement of financial position, either on the face of the statement of financial position or in the notes.
Implementation considerations and best practices: Availability of resources is affected by several factors, such as the nature of the resource, limits imposed by donors and other parties, and internal limits set by the board. Common restrictions on the liquidity and availability of resources are endowments and capital campaigns. Depending on how the not-for-profit structures its disclosures, these long-term restricted resources would be deducted or excluded from the resources available to meet cash needs for general expenditures within one year of the date of the statement of financial position.
Smaller organizations should analyze their current cash position and develop a cash management strategy to assess where cash balances, including reserves, should be on at least a quarterly basis. For certain not-for-profits like churches and schools, cash balances are often much lower in the summer than in December and January, and cash needs should be considered.
The use of liquidity ratios such as days of unrestricted cash available can be an important tool in monitoring cash reserves. Management should have a realistic forecast of revenues, expenses, and capital expenditures. If a negative result is anticipated, management should implement actions such as capital campaigns, key donor requests, or expense by department analysis to reduce costs. Areas that aren't strategic to the entity's mission can be analyzed to determine if they are an effective use of the organization's resources. In addition, the organization should monitor a cash flow forecast regularly with the help of all supervisors. Organizations should also consider whether alternate sources of funds could be obtained through a fundraising campaign or a line of credit to improve liquidity.
What to know: Not-for-profit organizations are now required to provide an analysis of expenses by their natural classification (such as salaries, rent, and depreciation) as well as their functional classification (program, management and general, and fundraising) in one location. This can be on the face of the statement of activities, in a separate statement, or in the notes to the financial statements. Previously, only voluntary health and welfare organizations were required to include the statement of functional expenses as part of a complete set of basic financial statements.
The analysis of expenses by nature and function should show, by their natural classification, expenses that are reported by other than their natural classification, such as salaries included in cost of goods sold or facility rental costs of special events, and reported as direct benefits to donors. Items excluded from the presentation include investment expenses netted against investment returns, gains and losses, and certain other items such as foreign currency translation and pension and post-retirement prior service costs.
ASU 2016-14 includes clarifying guidance on the definition of management and general activities to assist in better depicting costs that can (or cannot) be allocated among program or support functions. Supporting activities are clarified to mean those "that are not directly identifiable with one or more program, fundraising, or membership development activities." The update does not change the definition of program expense or supporting service. In addition, it requires a disclosure on how expenses are allocated (allocation methodology used).
See the chart "Sample Statement of Functional Expenses" for an example of this reporting.
Sample statement of functional expenses
Implementation considerations and best practices: Financial statement users will have more visibility into program costs, and donors can more easily see where their dollars are going. While a separate statement of functional expenses isn't required, it may be the most effective presentation option for smaller organizations with more than one program. The amount of time needed to implement this element depends on whether the organization files Form 990, Return of Organization Exempt From Income Tax. If it does, it's a best practice to align the financial statement presentation with the Form 990 documents.
The complexity of this implementation will be driven by the number of departments and employees. Activities in each department that represent direct conduct or direct supervision of program or other supporting activities will require allocation from management and administrative activities. Tracking and proper coding of expenses by department throughout the year is critical.
Organizations should take the opportunity to revisit their existing functional allocation methodologies and substantiate assumptions used. Research time may be needed to properly allocate items such as employee time between program and supporting activities. Inconsistencies in allocation methods should be identified, and a line-by-line analysis of accounts may be needed. Certain areas such as information technology should be analyzed for direct supervision or direct conduct of program activities.
Organizations should also consider revising their chart of accounts to easily identify natural expenses. Consider whether accounts with programmatic descriptions, such as "Local and Global Outreach," "Missionary Support," "Easter Services," or "Adult and Youth Programs," should be eliminated and replaced with accounts that have natural expense descriptions for the related costs.
What to know: Within the bounds of prudence under various states' versions of the Uniform Prudent Management of Institutional Funds Act (UPMIFA), not-for-profit organizations are able to spend from endowment funds even if the funds are below the original gift or historical amount. ASU 2016-14 no longer requires that the underwater amount be disaggregated within the overall endowment fund amount and separately classified as net assets without donor restrictions. The update instead requires classifying the full amount of donor-restricted endowment funds, including underwater endowments, within net assets with donor restrictions. Enhanced disclosures on underwater endowment funds are now required, including the fair value of underwater endowments, their original gift amount (or required level by law), and the aggregate of the amount of underwater deficiencies.
Implementation considerations and best practices: Under the new standards, visibility into the original gift amount (or the amount by which the donor or law requires it to be maintained) and deficiencies in liquidity will be more transparent to users. Policies that a not-for-profit may have in place to reduce or eliminate spending from endowment funds to retain original gift levels will also be more transparent. Users will be more aware of the relative degree to which endowments are underwater, potential actions that governing boards might take in response, and how such actions can affect liquidity.
Organizations should have an investment policy that clearly complies with UPMIFA and addresses how management, within prudence, interprets spending funds from endowments. Organizations should take advantage of the opportunity to communicate their stories and decision-making processes in this area of the disclosures.
BOARD-DESIGNATED NET ASSETS
What to know: Not-for-profit organizations are required to disclose board-designated net assets either on the face of the financial statements or in the notes to the financial statements. Board-designated net assets are net assets without donor restrictions that are subject to self-imposed limits by action of the governing board. They may be earmarked for a specific purpose, for example, and they can be undesignated at the board's discretion.
Implementation considerations and best practices: Smaller organizations may need to adopt new policies and practices for tracking board-designated net assets. They should identify all board-designated net assets and understand the purpose of such funds for disclosure purposes. Funds unnecessarily designated may need to be undesignated.
STATEMENT OF CASH FLOWS
What to know: ASU 2016-14 eliminates the requirement to provide a reconciliation from the direct method to the indirect method when presenting the statement of cash flows using the direct method. The indirect method works well for less complex organizations because the approach is to begin with the total change in net assets and then generally adjust for noncash transactions and changes to operating statement of financial position accounts, such as accounts receivable and accounts payable. In contrast, the direct method lists cash received from customers and donors, cash paid to vendors and employees, and other receipts and payments. This is often easier for an average reader to understand if the organization is more complex, with a large noncash and non-operating statement of financial position accounts.
Implementation considerations and best practices: The statement of cash flows update does not change the underlying transactions in the statement. In deciding whether to switch from the indirect to the direct method, organizations should consider the needs of their financial statement users. The direct method of presenting the statement of cash flows is more intuitive and generally more understandable, as it provides more visibility into the sources and uses of the organization's funds. In ASU 2016-14, FASB noted that many organizations that implemented the direct method found that it was not that difficult or costly, particularly after the first year. If an organization switches to the direct method, in the year of adoption it should build a good template for use in future years.
Organizations should consider the following in their preparation and adoption of ASU 2016-14:
- Understand the main elements of the update and communicate with key users as necessary.
- Create and document an implementation plan and use a checklist (with timelines) and an accounting system that complies with not-for-profit accounting.
- Consider recasting prior-year financial information under the current-year standards to identify missing or potentially problematic areas.
- Consult with the organization's auditors to determine their expectations.
Finally, remember that these changes are designed to help not-for-profits improve their financial reporting. Although implementing ASU 2016-14 requires time and work, it allows organizations to better tell their financial stories.
About the authors
Christopher M. Gordon, CPA, is a partner in Orange County, Calif., and Ruth Granlund, CPA, is a senior manager in Los Angeles at CapinCrouse LLP.
To comment on this article or to suggest an idea for another article, contact Ken Tysiac, the JofA's editorial director, at Kenneth.Tysiac@aicpa-cima.com or 919-402-2112.
- "Checklist: Tips for NFP Internal Reports," Nov. 2018
- "Avoid These Common Not-for-Profit Financial Statement Mistakes," July 10, 2018
- "Tips From a Not-for-Profit Standard Early Adopter," July 28, 2017
- "Tips for Implementing FASB's Not-for-Profit Standard," Aug. 23, 2016
- "FASB Modifies Not-for-Profit Accounting Rules," Aug. 18, 2016
- Not-for-Profit Industry Conference, June 10—12, Washington (#NOT17)
For more information or to register, visit aicpastore.com or call the Institute at 888-777-7077.
- AICPA Not-for-Profit Section
- ASU 2016-14 Toolkit
- "FASB's New Standard Aims to Improve Not-for-Profit Financial Reporting"
- "4 Tips for Your New Nonprofit Liquidity Disclosure"
- "4 Steps to Improve Nonprofit Functional Expense Reporting"
- "Rethink Your Not-for-Profit's Chart of Accounts (Part I)"
- "Rethink Your Nonprofit's Chart of Accounts, Part II"
- "Financial Statement Changes: 5 Steps for Nonprofit Boards"