FASB’s new revenue recognition standard will become effective for most not-for-profit (NFP) entities in 2019. Although this date may seem distant, the new standard will require a considerable transition effort in advance. The author focuses on the key accounting and auditing concerns that NFPs must address under the new standard, including a hypothetical example that illustrates some of the unique complexities the standard presents for the NFP environment and a discussion of significant challenges the new requirements are likely to pose for NFP auditors.
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Financial reporting for not-for-profit (NFP) entities is about to experience a sea change under three new accounting standards. Issued by FASB after more than a decade of deliberation, two will be effective for most NFPs in 2019—Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606), and ASU 2016-02 Leases (Topic 842). The third, ASU 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities, is effective for 2018. While each will dramatically alter NFP financial statements and demand considerable transition effort, the new revenue recognition standard is probably the most radical. The new revenue recognition standard creates a completely new accounting model for the core activity of every organization: the generation of the resources needed to carry out its mission.
This article focuses on the key considerations for NFPs under the new revenue recognition standard and the critical implications for their CPAs. While its title may suggest otherwise, NFPs are not excluded from the standard’s scope. Moreover, although it is sometimes assumed that NFPs are supported primarily through charitable giving, the reality is quite different. The largest category of financial support for many NFPs is revenue generated through fees for goods and services from private sources. For example, in a 2015 analysis of the nonprofit sector, the Urban Institute reported that these fees accounted for nearly half of all the revenues of public charities (Brice S. McKeever, The Nonprofit Sector in Brief 2015: Public Charities, Giving, and Volunteering, October 2015, http://urbn.is/2mfvTag).
Highlights of the New Standard
The new revenue recognition framework supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific guidance throughout the Accounting Standards Codification (ASC). For NFPs, this industry guidance is currently found in subtopic 958-605, Not-for-Profit Entities—Revenue Recognition. As explained below, some of this guidance will remain in force, mainly the portions relevant to contributions; however, with certain limited exceptions, all revenue generated through exchange transactions (“contracts with customers”) will be subject to the standard. In the NFP environment, this revenue commonly comes from such sources as membership fees, sales of products and services, naming rights, sponsorships, and special events. These transactions, however, often include a contribution element that complicates implementation of the new standard. Therefore, NFPs will have to separate the exchange component, a task that will require considerable judgment.
The core principle of the new standard is that revenue recognition should “depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services” (ASC 606-10-05-3). To accomplish this objective, reporting entities are to apply a five-step approach:
- Identify the contract with the customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
Like their commercial counterparts, NFPs will find many of these steps somewhat difficult, particularly allocation of the transaction price. Fees in the form of membership dues, for example, may obligate the NFP to provide numerous types of benefits at various points in time, and revenue recognition is likely to be highly sensitive to the judgments and estimates needed to make these determinations. Fortunately, certain aspects of current GAAP’s existing NFP guidance applicable to these types of fees will remain, and it should prove to be even more useful under the new model. In particular, FASB notes that NFPs often refer to their donors as “members” (ASC 958-605-55-9). In some cases, the amounts that these individuals or entities pay as dues are nonreciprocal transfers, the key characteristic of a contribution. But in many instances, dues entitle the member to certain benefits, so the payment or a portion thereof represents an exchange transaction that will be subject to the new standard. FASB has previously identified indicators to help differentiate contributions from exchange transactions generally (ASC 958-605-55-8), as well as similar guidance specifically applicable to membership dues (ASC 958-605-55-12). These provisions will continue in a renamed ASC subtopic after the new revenue recognition requirements become effective.
Illustration: Museum Revenues
The example below illustrates some of the more significant potential reporting differences under the new standard. It assumes a museum with members who each pay $60 in annual dues, in exchange for such benefits as designated museum parking, a monthly newsletter, and access to the museum’s archives. The museum has determined that the fair value of these benefits is $60. Therefore, consistent with current GAAP (ASC 958-605-25-1), the museum has been reporting the entire $60 as dues revenue over the one-year membership period, based on the conclusion that the receipt includes no contribution component and instead represents a reciprocal transfer.
Under the new standard, the benefits specified in the membership agreement embody goods and services that the museum has promised to transfer to members. These promises are termed “performance obligations,” and the $60 transaction price must be allocated to each, a task that may prove challenging for many NFPs. For the sake of simplicity, this example assumes that the museum decides to view the member benefits as a bundle of goods and services, and regard them as a single performance obligation. In reality, many of these benefits would likely be considered individually distinct under the standard because they are not interdependent and each can be used on its own or remain unused at the member’s discretion (ASC 606-10-25-19). In order to illustrate the challenges of allocating transaction prices, other performance obligations are introduced into the example, as further described below.
Allocation of the transaction price to performance obligations.
In an effort to increase its support base, the museum launches a fall membership drive with two new promotional benefits to be included in the $60 dues: 1) a single free admission to the museum, the usual entrance fee being $15, and 2) a $25 discount on any purchase of $100 or more in the museum gift shop. Under the new standard, the membership contract will now include two additional performance obligations, and these will require allocation of the $60 transaction price.
To illustrate the major financial statement effects when contracts overlap two fiscal periods, the example assumes that in response to the fall drive, a member pays the museum $60 in October 2021 and uses the free admission in January 2022. It further assumes that during the January visit to the museum, the member makes a $100 purchase in the gift shop and receives the $25 discount. In applying current GAAP, the museum concludes that any revenue associated with these promotional benefits is not earned unless the member uses them, so no revenue is recognized until January. Application of the new revenue standard’s final step—recognizing revenue as performance obligations are satisfied—also results in January recognition. The steps under the new model leading up to this result, however, produce different financial statement effects.
Having previously identified three performance obligations, the museum must allocate the $60 contract price to each on what the new standard terms a relative “stand-alone selling price” basis (ASC 606-10-05-4d). This value is defined as “the price at which an entity would sell a promised good or service separately to a customer” and must be based on observable evidence (ASC 606-10-32-32). When a directly observable price does not exist, this price must be estimated using a method that maximizes the use of observable inputs (ASC 606-10-32-33).
Development of stand-alone selling prices for two of the three performance obligations—member services and museum admission—is relatively straightforward. With respect to the former, the museum has previously determined that the member services included in the basic dues have a $60 fair value, and it uses this amount as their estimated stand-alone selling price. With respect to the latter, directly observable evidence is available for the museum admission’s stand-alone selling price, specifically, the normal $15 entrance fee.
Estimating a stand-alone selling price for the third performance obligation, the gift shop discount, is somewhat more involved. Under the logic of the new standard, it represents an option to purchase goods at a price lower than that normally charged and thus provides the member with a material right (ASC 606-10-55-42). In many instances, estimation of the stand-alone selling price of such an option will prove challenging. At a minimum, it requires assessment of the likelihood that the option will be exercised (ASC 606-10-55-44b). If the museum believes it reasonably certain that the member will make a purchase of at least $100, the discount’s estimated stand-alone selling price is $25, calculated as the $25 discount multiplied by a 100% probability that it will be used. If the museum believes the likelihood of a member making such a purchase is less than certain, the discount’s estimated stand-alone selling price would accordingly be lower. Additionally, a discount expressed as a percentage rather than a fixed amount could add complexity to the estimation.
Of course, the one-time free museum admission could be viewed in the same way, that is, as an option to buy additional goods and services at a price lower than normally charged. As indicated above, however, this right has a directly observable stand-alone selling price ($15). Nevertheless, uncertainty about whether it will be exercised could lead to a modification of this amount.
With these three prices now determined, the museum follows the new standard’s requirement to allocate the $60 transaction price to each performance obligation on a relative stand-alone selling price basis. In effect, this process assigns a discount to each obligation whenever the sum of the stand-alone selling prices of the goods and services promised exceeds the consideration received. An important feature of the new standard is that, in the absence of observable evidence that the implied discount applies only to certain performance obligations in the contract (as determined using the standard’s criteria), it must be proportionately allocated to all of them (ASC 606-10-32-36). In this example, the museum lacks such evidence, having never before offered the two promotional benefits. In fact, it has evidence to the contrary, given that members now receive these new benefits in addition to those already provided in the annual dues and the basic benefits have a previously determined value equal to the full amount of the transaction price ($60).
The allocation process assigns proportional values to the three performance obligations using percentages of 60%, 15%, and 25%, and a separate “contract liability” is created for each. The new standard defines this term to mean “an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration” (ASC 606-10-45-2). It permits the use of alternative descriptions in the statement of financial position, and a reporting entity might choose to continue labeling these amounts as “deferred revenue,” as commonly seen in many NFP financial statements. Nevertheless, the new term is used throughout this example for emphasis.
Financial statement effects and alternative interpretations.
Exhibits 1 and 2 display sample journal entries that the museum might record under both current GAAP and the new standard and summarize the key respective effects on its statements of activities, respectively. Revenue is recognized under the new standard as performance obligations are satisfied, specifically as goods and services are transferred to the member. For dues revenue, this transfer occurs evenly throughout the one-year membership period. For the revenue attributable to the free museum admission and gift shop discount, transfer occurs at the point in time when the member is granted entrance and makes a purchase. Other highlights include the following:
- The contract liability that arises for each of the performance obligations in the membership agreement means that the museum reports comparatively higher total liabilities in its statement of financial position at the 2021 year-end. This result could impact loan covenants or other agreements tied to the museum’s financial statements.
- Given the absence of explicitly applicable recognition requirements under current GAAP, the museum might choose to make no entry for the free January admission and instead disclose this decision as an accounting policy. Under the new standard, however, the admission is a measurable performance obligation for which allocated consideration has been received, and it must be reported as a contract liability that cannot be derecognized until transfer of the promised service occurs in January.
- Although the total revenue reported over the two fiscal periods is the same, the timing of its recognition differs under current and new GAAP, as does its composition. The new standard results in a presentation that reports the museum’s transfer of goods and services at amounts reflecting the consideration it was entitled to receive in exchange, thus achieving the standard’s core objective.
Statements of Activities
It is important to emphasize that the example is meant to illustrate possible reporting approaches. Even under current GAAP, but especially under the new standard, financial statement effects are highly sensitive to judgments and estimates, and other interpretations could lead to different results.
The performance obligation pertaining to the free admission, for example, might have been identified not as the admission itself, but as the promise to permit entrance to the museum. If so, a portion of the $9 in admissions revenue would be shifted into 2021 because, from this perspective, the museum would consider its performance obligation as one satisfied over time simply by being open on a regular basis. This view reflects the standard’s position that performance obligations can take the form of standing ready to provide a good or service by making it available for use whenever the customer decides (ASC 606-10-25-18e). Thus, a customer’s advance payment for the right to receive a good or service in the future creates a contract liability representing the obligation to stand ready to transfer the good or service (ASC 606-10-55-46).
Yet another possible interpretation could be made using the standard’s emphasis on customer control. Specifically, revenue is to be recognized when a performance obligation is satisfied through the transfer of a promised good or service, and such transfer is deemed to have occurred when the customer obtains control of same (ASC 606-10-25-23). In the example here, at the point of payment the member receives the right of admission and controls the determination of when to exercise it. Thus, the museum might conclude that immediate recognition of the $9 in admissions revenue is appropriate.
Although previously referenced guidance elsewhere in the standard supports the approach illustrated in the Exhibits, these alternative views do serve to emphasize the extent to which NFPs will need to exercise reasoned, thoughtful judgment in applying the new requirements. NFP auditors will thus need to be equally cautious when evaluating these judgments.
Auditors of NFP entities will likewise find that the new revenue standard poses significant challenges. The NFP environment is characterized by many unique risks that in turn create financial statement risks, and these will increase. At a minimum, the auditor’s risk assessment will need to incorporate considerable new scrutiny of the NFP’s resource streams and the processes it maintains for capturing, analyzing, and recording revenues.
Understanding the NFP entity.
As a potential starting point, auditors will want to take a fresh look at how and where NFPs obtain their resources. Facing the financial pressure of a changing and often turbulent economy, NFPs continue to seek new sources of funding and alternative forms of revenue as a way to supplement the support they receive from donors. Therefore, GAAS’s requirement to understand the entity’s industry and its operating environment will take on much greater importance.
Auditors will need to obtain a thorough understanding of how an NFP identifies contracts and the performance obligations they create, and this knowledge must include several key considerations. For example, a revenue arrangement need not be written to be within the scope of the new standard. Contracts may be oral or implied, and an auditor must determine who within an NFP is empowered to obligate it. This power may be particularly audit-relevant in NFPs that have less structured fund-raising efforts or a “hands-on” governing board. Likewise, a significant focus of the new standard is accounting for contract modifications. Therefore, it is important to learn the identities of those individuals who can alter contracts and to understand the processes that exist for analyzing and recording the effects of these changes.
Considering internal controls.
More broadly, an auditor’s understanding of the NFP’s business processes should encompass all controls relevant to risks of material misstatement, and the challenges of implementing the new standard will likely increase those risks. The breadth of the standard’s changes will require an intense audit focus on the adequacy of existing revenue-related controls and the potential need for new ones. Of crucial importance are the controls that management maintains for differentiating contributions from exchange transactions and identifying which of the latter represent principal–agent arrangements.
The standard itself provides a blueprint for establishing or strengthening internal controls, given that misstatement can occur at every point along its five-step path to revenue recognition. To the extent that controls are inadequate in their capacity to address these misstatements, auditors may conclude that significant deficiencies and material weaknesses now exist and must be communicated. They will want to discuss this concern with their NFP clients well in advance of the standard’s implementation, especially those NFPs subject to regulatory and compliance audit requirements where the consequences of such communications can be particularly severe.
Focusing on key assertions.
An auditor’s understanding of revenue-related controls must extend to the potential for material misstatement at the assertion level, and certain assertions are critical under the new standard. Chief among them are the following:
- Rights and obligations. The standard’s definition of a contract incorporates this assertion: an agreement between two or more parties that creates enforceable rights and obligations (ASC 606-10-05-4). As previously indicated, an NFP’s control structure should include controls designed to identify contracts and the performance obligations they contain, as well as any agreements that create contract liabilities (or contract assets) at the reporting period’s end.
- Occurrence. The new five-step model ties revenue recognition to the satisfaction of performance obligations and the transfer of goods and services. Although conceptually similar to current GAAP’s “earned” criterion, the new standard establishes specific and extensive requirements for determining when transfer occurs, and thus when revenue should be recognized. Auditors should make certain that NFPs apply these requirements carefully rather than rely on current assumptions about when revenue is earned.
- Completeness. The standard increases the possibility that revenue may be understated through misapplication of its new and unfamiliar requirements. Auditors should look beyond revenue, however, because the new standard affects the completeness of other financial statement elements as well, particularly assets and liabilities in the statement of financial position. For example, certain contract costs expensed under current GAAP will be capitalized. In addition, to the extent that it affects the timing of unrelated business income recognition, the new standard could create the need to record deferred income taxes.
- Cutoff. In implementing the new standard, an NFP may find that it recognizes revenue at a different point in time or that its allocation of revenue between two periods differs from current GAAP. Member dues that include a nonrefundable upfront fee, for example, may be subject to a new pattern of recognition. Auditors should pay close attention to any revenue arrangements spanning two or more fiscal periods or involving performance obligations fulfilled over time, such as the provision of member benefits.
- Accuracy. The potential for misstating revenue amounts is greatly increased under the new standard. Numerous judgments and estimates must be made throughout the five-step model, including many not required under current GAAP. For example, if made under a right of return, the gift shop sales in the illustration would require a determination of the transaction price that reflects estimated returns. The consideration in such sales is considered “variable” and must be estimated using one of the methods specified in the standard (ASC 606-10-32-8). In this situation, the accounting model gives rise to two estimate-based financial statement elements that may be new to many NFPs, both of which must be reassessed at the end of each reporting period: a liability for expected refunds and an asset representing the right to recover products. Because of these and various other judgments and estimates, auditors must carefully consider the subjectivity and sensitivity of these determinations, especially given that those regarded as significant must be disclosed.
- Presentation and disclosure. The new standard adds requirements affecting the display of revenue in the financial statements and greatly expands both the amounts and types of revenue-related information that they must disclose. Although nonpublic entities are exempt from many of these provisions, NFPs may still find that their accounting information systems require changes in order to capture and develop a number of new disclosures applicable to all entities. A key aspect of the required revenue disclosures is that they are both quantitative and qualitative, and all are intended “to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts” (ASC 606-10-50-1). Auditors should ensure that their NFP clients separately present or disclose revenue from contracts with customers, disaggregated according to its timing and supplemented with descriptions of the economic factors affecting it and the performance obligations giving rise to it.
The standard provides a blueprint for strengthening internal controls.
In preparing these and other new disclosures, NFPs may also want to consider ASU 2016-14. Among its new disclosure requirements is information about the NFP’s liquidity, including a qualitative description of how that liquidity is managed. As mentioned earlier, the new revenue standard will alter not just the statement of activities but also the statement of financial position, and these changes may affect users’ perceptions about the NFP’s liquidity. Given the subjective nature of the new disclosures, auditors should give careful consideration to their clients’ planned comments.
Documenting audit evidence.
The preceding considerations mean that auditors can expect a substantial increase in audit documentation during the transition. The need to prepare much of it should arise as a natural result of existing audit requirements. For example, revenue is ordinarily considered a financial statement element that poses significant risks, including fraud risk. Under GAAS, these characteristics require extensive documentation. Further documentation requirements apply to accounting estimates, and, as previously emphasized, the new standard includes numerous estimates sensitive to their underlying assumptions.
An auditor may conclude that matters such as these need explicit mention in the letter of management representations. Additional modification of the letter may be required for NFP revenues likely to pose challenging measurement issues under the new standard. Revenue derived from corporate sponsorship of special events or from naming rights negotiated with other resource providers, for example, may merit inclusion in the letter, given the potential valuation difficulties that these arrangements can involve. More generally, the considerable number of significant implementation concerns that will arise under the new standard means that, throughout the engagement, auditors will frequently find themselves in dialogue with management and others. Given the GAAS documentation requirements applicable to significant findings and issues, auditors should document these discussions as they occur.
Monitoring client relationships.
The scale of change that the new revenue standard brings will create many opportunities for auditors to offer advice and insight. These opportunities are not without risk, however, because they may put auditors in danger of impairing their independence. Like their small business counterparts, smaller NFPs in particular may have greater need for help in implementing the new standard and so may look to their auditors for assistance. Professional standards permit auditors to advise their attest clients provided they are careful not to assume the role of management. As previously mentioned, discussions with clients about the many aspects of implementation will occur frequently, and auditors will need to avoid making any comments that could cross this line.
This need for a heightened concern for independence is obviously not limited to auditor relationships, as many NFPs engage CPAs for attest services other than auditing, especially for their interim financial statements. The AICPA’s Statements on Standards for Accounting and Review Services (SSARS) include independence requirements for both compilations and reviews, and, though not required, independence is still a concern for CPAs providing the new financial statement preparation service under SSARS 21, Statements on Standards for Accounting and Review Services: Clarification and Recodification. As this standard emphasizes, CPAs performing these engagements should remain alert to circumstances that might impair their independence, particularly if a client may later require attest services for financial statements covering the same period. Therefore, CPAs whose NFP clients engage them to prepare financial statements during the transition period will need to be especially cautious. Implementation assistance that impairs independence would not jeopardize the interim preparation engagement but would preclude the CPA from performing an audit or review for the annual period.
A Complex Transition
FASB believes its revenue standard will significantly enhance the usefulness of financial statements through greater comparability across reporting entities and increased emphasis on meaningful disclosures. Given the unique challenges they face in implementing the new standard, NFPs may be skeptical of this claim. CPAs serving NFP entities should not delay the necessary planning and preparation if they hope to help these organizations traverse this rugged terrain.