In 2016, FASB issued ASU 2016-14, Presentation of Financial Statements of Not-for-Profit Entities, effective for fiscal years beginning after December 15, 2017. The standard is unusual because it substantially reduces the detail required to be reported in not-for-profit financial statements, largely in the areas of display and terminology. Though most not-for-profit organizations should have little difficulty adjusting to the standard, they and the CPAs who advise them should examine the new requirements for both qualitative and quantitative disclosures with respect to liquidity. In some cases, not-for-profit management will need to implement or articulate policies related to liquidity management.
Major Provisions of the New Standard
The financial reporting model for not-for-profit organizations was established in 1993 under SFAS 117, Financial Statements of Not-for-Profit Organizations. The most important consequence of SFAS 117 is that it put all private not-for-profit organizations under a single reporting format, which focused on the overall entity. Universities, museums, and religious organizations had previously reported by fund types, whereas hospitals and trade associations had focused on the consolidated entity. The newly released not-for-profit reporting standard retains the current approach, focusing on the organization as a whole and providing a uniform reporting format across varying industries in the nonprofit sector.
Net asset classes.
Another key aspect of SFAS 117 was that residual equity was displayed within three asset classes: unrestricted, temporarily restricted, and permanently restricted. The statement of activities reported revenues within these three categories, depending upon the existence and nature of donor-imposed restrictions. Yet FASB felt that over time, the distinction between permanent and temporary restrictions had become less useful. Under certain circumstances, laws now permit entities to spend from a permanently restricted endowment, even when the value of the endowment has fallen below its original corpus.
ASU 2016-14 reduces the number of net asset classes from three to two. Amounts currently reported as temporarily or permanently restricted should now be reported in a single class: net assets with donor restrictions. Those amounts currently reported as unrestricted net assets should now be reported as net assets without donor restrictions. In addition to having just two residual equity accounts, only two columns (plus a “total” column) are required in the statement of activities. Because the standard establishes a minimum of two net asset categories, organizations that wish to retain the distinction between temporary and permanent restrictions are permitted to do so.
Reporting of expenses.
Voluntary health and welfare organizations are nonprofits that derive their revenue primarily from contributions by the public for purposes connected to health, welfare, or community services. These include the Salvation Army, Girl Scouts, United Way, and organizations dedicated to social issues like curing or treating disease. (The distinction between a voluntary health and welfare organization and other nonprofits is not always clear.) Such organizations are currently required to present a statement of functional expenses that displays a matrix of expenses by both functional and natural categories. Functional categories include fundraising and management and general, as well as individual programs that the organization has undertaken. In contrast, natural categories include salaries and benefits, supplies, professional fees, depreciation, and interest, among other operating costs and expenses.
FASB believed that detailed information on expenses is important when evaluating nonprofits, regardless of their purpose or means of funding. ASU 2016-14 requires all not-for-profits to provide information on expenses by both functional and natural categories. The detail of expenses may be provided on the face of the statement of activities, in the notes to the financial statements, or through a separate schedule (e.g., the statement of functional expenses). Although expanded expense disclosures represent an additional requirement for some nonprofits, many organizations are currently reporting this information. Tax-exempt entities organized under Internal Revenue Code sections 501(c)(3) and 501(c)(4), for example, are already reporting similar information in section IX of Form 990, “Return of Organization Exempt from Income Tax.”
Statement of cash flows.
Private notfor-profit organizations will continue to have a choice of whether to use the direct or indirect method of reporting cash flows from operations; however, organizations choosing the direct method are no longer required to prepare a reconciliation of changes in net assets and cash flows from operations. This should make that method more appealing because it reduces the complexity in preparing the statement, as well as its overall length.
Recording fixed assets.
Previous FASB standards gave not-for-profits an option when recording resources restricted for the purchase of fixed assets that allowed them to continue to report the fixed assets as temporarily restricted and reclassify amounts to unrestricted only as the asset was depreciated. (In most cases, this option is no longer permitted.) Contributions received for fixed-asset acquisitions will be recorded as net assets with donor restrictions. When these resources are used to acquire fixed assets, the not-for-profit entity must report the resources as having been released from restriction, effectively reclassifying the fixed assets as net assets without donor restriction.
Reporting of investment income.
Previous FASB standards required nonprofits to separately report investment expenses; they can now report investment returns net of investment-related expenses. Organizations that invest through mutual or hedge funds have difficulty determining the amount of expense charged by these external investment managers, especially when the mutual fund year-end differs, or when balances are moved in or out of the fund during the year. This change should make it easier for not-for-profits to report investment activities and provide greater comparability among organizations using internal and external investment managers.
Like most new standards, this update comes with changes to the content of note disclosures, including the following:
- Information useful in assessing liquidity and a description of how the organization manages its liquid assets to meet general expenditures over the next year
- Quantitative measures of the amount of financial resources available to meet the cash needs for general expenditures over the next year and the effect (if any) of limits imposed by grantors, donors, laws, contractual arrangements, or the governing board on the availability of financial resources
- Methods used to allocate costs among program and supporting activities
- Disclosures related to “underwater endowments” (i.e., endowments whose market value has declined below the original value).
The disclosures related to liquidity should particularly assist creditors, donors, and other users in assessing the near-term availability of (and requirements for) cash. Under current practice, resources may appear to be available for short-term cash needs, but in fact are not available to the organization because of donor-imposed limitations on their use. (For example, cash or pledges restricted for capital additions may appear as current financial assets but are in fact not available for other purposes.) In addition, resources invested as quasi-endowments may appear to be unavailable for near-term cash needs but could be liquidated by action of the governing board if cash needs arose. This requirement to disclose the not-for-profit’s liquidity management policy could provide the necessary incentive for some organizations to articulate and adopt such policies. After evaluating their needs, not-for-profit organizations might wish to take other actions, such as negotiating a line of credit as part of this liquidity management policy.
It is helpful to analyze example financial statements applying ASU 2016-14. Note that there is only a single restricted column in the statement of activities (Exhibit 1). All expenses continue to be reported as unrestricted (without donor restrictions), and amounts are reported as net assets released from restriction as donor-imposed restrictions are satisfied. In addition, no distinction is made with respect to the permanence of donor-imposed restrictions in the net assets accounts on the statement of financial position (Exhibit 2).
Sample Statement of Activities
Sample Statement of Financial Position
Also presented are sample note disclosures related to liquidity management and expenses (Exhibit 3). The liquidity management note will be new to most nonprofits and might require governing boards to adopt policies supporting these disclosures. For purposes of illustration, assume that ABC Foundation has $291,800 (discounted to present value) of pledges for capital additions, of which $45,000 is classified as current. The remaining $100,000 of contributions receivable is unrestricted as to purpose but have an implied time restriction because the amounts are not available until received in the following year. Contributions receivable are presented net of estimated uncollectible amounts and discounted to present value, unless expected to be collected within 12 months.
Potential Future Changes
The initial April 2015 exposure draft of ASU 2016-14 also contained other, more controversial proposals dropped from the final standard, including new cash-flow classifications and the reporting of intermediate performance measures. Some comment letters pointed out that FASB has research projects planned for commercial preparers dealing with classification of cash flows and defining operating activities; however, these topics have not yet made it to FASB’s technical agenda for business entities. The not-for-profit exposure draft was therefore ahead of related projects planned for private sector businesses, and FASB decided to give itself more time by dividing its not-for-profit effort into two parts. The new standard addresses matters on which there was greater consensus, while leaving others for future consideration.
Which items from the original exposure draft were left out of ASU 2016-14, potentially to come in the future? The exposure draft called for requiring the direct method of reporting cash flows from operations and eliminating the reconciliation of cash flows from operating activities with the statement of activity. The recently issued standard still permits the indirect method, though it did eliminate the reconciliation when the direct method is used. The proposal would also change the classification of cash flows. Cash received on investments would be displayed among investing activities and cash paid for interest among financing. This would improve comparability with public-sector nonprofits, such as government hospitals and public universities, whose cash flows are similarly classified. A bigger change would be in the reporting of cash flows from the purchase and sale of fixed assets; under the exposure draft, these would be reported as operating, rather than investing, activities.
With respect to reporting the results of operations, the 2015 exposure draft retained an overall performance measure, change in net assets. The proposal, however, included intermediate performance measures: 1) operating excess before transfers and 2) operating excess after transfers. Because these measures are limited to “operating activities,” a new section would be added to the statement to reflect nonoperating revenues (investment income) and expenses (interest).
In deciding what to include in the two intermediate performance measures, FASB identified two components: mission and availability. Mission-related activities include most revenues and expenses, other than investment income and interest expense. Items meeting the mission component are included in calculating the first intermediate performance measure (operating excess before transfers). Adjustments are then made to calculate the second intermediate performance measure (operating excess after transfers). Adjustments are necessary for items meeting one component, but not both.
For example, equipment used in operations meets the definition of mission-related, and donations restricted for the purchase of fixed assets would be included in the first intermediate performance measure (operating excess before transfers); however, because fixed assets are not deemed available to finance current operations, the amount expended for equipment would then be “transferred” out of operating excess after transfers and would appear in yet another section of the statement of activity dedicated to reporting these transferred amounts.
Implementing the Standard
It appears that FASB still has a good deal of work to do to convince its constituents that more detailed statements of activities or new cash flow classifications serve the public interest; for this reason, those portions of the nonprofit reporting project have been deferred until a future time. The changes required in ASU 2016-14, on the other hand, simplify financial statements and improve disclosures, particularly in the area of liquidity management. In implementing the new requirements, not-for-profit management should review expense allocation practices and review or, if necessary, adopt liquidity management policies. Moreover, management should take steps to ensure that the organization’s accounting system is properly designed to identify and track restrictions affecting the availability of resources for near-term cash needs, identify underwater endowments, and track expenses by functional and natural categories. Auditors can help by providing recommendations that will facilitate the implementation process.