How Will the New Guidance for Financial Statements Impact Nonprofits?

Nonprofit Financial Statements After almost four years of research, analysis, and debate, the Financial Accounting Standards Board (FASB) released its highly anticipated update on financial reporting for nonprofits. The update, which was officially released on August 18, 2016, has been designed to “help not-for-profits tell their story through their financial statements.”

The existing guidance has been in effect since 1993, and while it has held up well over that time, “stakeholders expressed concerns about the complexity, insufficient transparency, and limited usefulness of certain aspects of the model,” said FASB Chairman Russell Golden. “The new guidance simplifies and improves the face of the financial statements and enhances the disclosures in the notes,” he added.

Basically, the Accounting Standards Update, designated ASU No. 2016-14, decreases the number of net asset classes from three to two. The new classes will be:

  • Net assets with donor restrictions
  • Net assets without donor restrictions

The update will change the way all not-for-profits (NFPs) classify net assets and prepare their financial statements.

Different Classifications of NFPs

All nonprofits, from the local soup kitchen, to major colleges and universities, have been using the same financial statements for the last 20 years. While good, at the behest of stakeholders, the FASB saw the need to make improvements to the existing model.

The new guidance applies to all NFPs, including: 501c3, 501c4 and 501c6 entities.

  • 501c3 – This is the most common classification of nonprofits. To qualify as a 501c3, an organization must fit into an “exempt” purpose as defined by the IRS. These include charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competitions and preventing cruelty to children or animals.
  • 501c4 – There are only two types of organizations that will qualify as a 501c4 organization: social welfare organizations and local associations of employees. Social welfare organizations can include homeowner associations and volunteer fire companies if they fit the exemptions.
  • 501c6 – The 501c6 designation is for qualifying business leagues, chambers of commerce, real estate boards, boards of trade and any professional football leagues, that are not organized for a profit.

There are actually 29 different types of NFPs identified by the tax codes, but these are the three most common entities. Regardless of the classification, all nonprofits will be required to follow the new financial statement requirements.

The FASB has produced a video, explaining why the standard needed to receive a makeover.

Details of the New Guidance for Nonprofits’ Financial Statements

The update was designed to help not-for-profits provide more relevant information about their resources, and any changes in those resources to donors, grantors, creditors, and other users, in effect to “better tell their stories.”

The FASB believes that the update, not only simplifies and improves communications with stakeholders, it should also reduce certain costs, related to the complexities in preparing their financial statements.

Specifically the new standard:

  • Will allow “underwater endowments,” those that are now worth less than when they were originally gifted, to be classified in net assets with donor restrictions.
  • Continues to allow preparers to choose between the direct method and indirect method for presenting operating cash flows. However, if the direct method is used, it is no longer mandatory to present the indirect method reconciliation.
  • Requires NFPs to be more transparent regarding providing information on how it manages its liquid resources and liquidity risks. A classified statement of financial position may be an effective way for organizations to comply with many of the new disclosure requirements.
  • Requires reporting of expenses by function and nature, as well as an analysis of expenses by both function and nature.
  • Requires that a net presentation of investment expenses against investment return appear on the face of the statement of activities.

When Do the Changes Take Effect?

The changes will take effect for annual financial statements issued for fiscal years beginning after Dec. 15, 2017, and for interim periods within fiscal years beginning after Dec. 15, 2018.

This is just “Phase 1,” of the FASBs project to revamp financial statements for nonprofits. The organization says there will be a “Phase 2.” Phase 2 is slated to address ways to improve operating measures and provide enhanced alignment between the statement of activities and statement of cash flows. The FASB has not indicated any timeframe for the completion of the second phase.

Certainly, these new regulations will have a significant impact on all nonprofit organizations and those stakeholders who rely on their financial statements. While the changes were designed to simplify financial reporting for NFPs – and in the long run, they will – getting used to the new requirements could still be complex. The earlier you begin working with your tax professional, the easier it will be to implement the necessary changes to ensure your financial statements will be in compliance with the new standards when they take effect.

 




Updated Standards for Nonprofit Financial Reporting

Nonprofit Financial Reporting TipsOn August 18, 2016, the Financial Accounting Standards Board (FASB) released Accounting Standards Update (ASU) 2016-14 changing the way nonprofits prepare their financial statements.  FASB’s overall goal in solidifying these changes was to improve financial reporting for nonprofits so that outsiders can more easily understand the organization’s financial position.  FASB accomplished this goal by changing the net asset classifications, enhancing the statement of cash flows, clarifying information regarding liquidity and availability of cash, simplifying the reporting of investments, and adding consistency across organizations on reporting expenses by function and nature.

Net Asset Classifications

Under the new Standards, FASB attempts to ease confusion over the net asset nomenclature by completely changing the names of the three existing net asset classifications.

  • “Unrestricted” net assets will now be termed “Net Assets without Donor Restrictions”.
  • Both “Temporarily Restricted” and “Permanently Restricted” net assets will be renamed “Net Assets with Donor Restrictions”.

Any Board of Director designations, such as funds that are “restricted” by the Board, will need to be fully disclosed – including listing the purpose of the restriction and the amount.  Organizations will also have to disclose the type, purpose, and amounts for all donor restrictions.

Endowments will be included in “Net Assets with Donor Restrictions” and any underwater endowments will need to be disclosed by listing the current fair value of the endowment less the original value of the donation, as well as the organization’s policy regarding appropriating funds from these underwater endowments.

Statement of Cash Flows

Nonprofits will now be able to use either the direct or indirect method of reporting cash flows.  Previously, nonprofits who used the direct method had to provide the indirect method as well; however, under the new Standards, this additional reconciliation will no longer be required.  Thus, FASB is allowing organizations to use the method that is most beneficial to the organization as opposed to mandating one methodology over another.

Liquidity and Availability of Cash

Under the new Standards, FASB is now requiring nonprofits to provide a qualitative description of how the organization manages its resources in order to meet liquidity needs and manage liquidity risk, as well as a quantitative description of the financial assets available for general expenditures within one year of the balance sheet date.  (A financial asset being cash, evidence of ownership interest in an entity, or a contractual agreement with another entity that clearly shows the organization’s intent to receive cash or an exchange of a financial instrument).  Organizations should note that an untapped line of credit does not meet FASB’s definition of a financial asset.

Essentially, FASB wants nonprofits to disclose how much the organization has available at the date of the balance sheet to meet cash needs for one year.  As this change will affect all organizations and will be the most onerous of the changes implemented by ASU 2016-14, FASB is not requiring organizations to provide comparative information in the first year that these Standards are implemented.

Reporting Investment Returns

Under the new guidance, organizations will now have to report net investment returns on the Statement of Activities.  Thus, external costs for investments plus all direct internal costs associated with the strategic and tactical activities involved in generating investment return (such as salaries, benefits, travel costs, and other costs associated with staff who are responsible for the development and execution of the organization’s investment strategy) will be netted against the actual investment income listed on the Statement of Activities.  These expenses will therefore not show up under “expenses” but in “revenues”.

Reporting Expenses by Function and Nature

Lastly, one additional change made by ASU 2016-14 is the requirement that all organizations complete a Statement of Functional Expenses as part of their annual financial statements.  This information can be presented as a standalone Statement, on the face of the Statement of Activities, or in the footnotes.  Due to the change in the reporting of investment returns (described above), investment expenses should not be included in the Statement of Functional Expenses.  In addition, FASB is requesting that organizations disclose how the organization allocates costs among program and support functions.  For example, if rent is allocated to programs based on level of effort, this specific methodology should be disclosed in the footnotes so that readers do not assume these costs appear solely in General and Administrative Costs.  During the first year that these Standards are implemented, FASB is not requiring organizations to provide comparative information on the Statement of Functional Expenses.

Implementation

ASU 2016-14 is effective for fiscal years beginning after December 15, 2017; thus, for most organizations, the financial statements starting in 2018 will need to be prepared using the new Standards.  However, FASB is allowing organizations to adopt the new Standards earlier, and, according to most auditors, early adoption should be exercised specifically by organizations that currently have “underwater” endowments.

FASB is currently considering additional changes to nonprofit financial reporting which are expected to address standard operating measures; however, no timeline has been set by FASB for deliberating these proposed changes.  Given the fact that ASU 2016-14 is FASB’s most comprehensive revision to nonprofit financial reporting since FAS 116 and 117 issued over 20 years ago, nonprofits should expect additional changes to come as FASB attempts to improve overall nonprofit financial reporting.

Fund Accounting for Nonprofits: What Is It and How Does It Work

Fund Accounting for Nonprofits: What Is It and How Does It WorkThe concept of fund accounting is one of the main differences between for-profit and nonprofit accounting. Its name comes from the fact that revenues and expenses are segregated in the accounting system into “funds” for the purpose of tracking each fund separately – primarily for reporting purposes.

As opposed to for-profit organizations which focus on profitability, nonprofits use fund accounting to focus on accountability, and the use of separate “funds” with their own ledger allows nonprofit organizations to more easily assess each fund individually. Depending on the nonprofit, a separate fund is typically established for each of the organization’s various programs as well as its overhead, general administrative, and fundraising activities. To track such revenues and expenses separately, the organization will set-up in the fund accounting system and assign to these transactions a unique fund code. In most cases, the fund code will contain a string of unique identifiers – such as a code for the donor, grant, project, location, and so on. Depending on the organization, this code string may go by different names – a budget code, project code, cost center, or similar. But despite the nomenclature used by the organization, these identifiers essentially serve the same purpose — allowing the accounting staff to easily run queries and generate reports in the accounting system by any value in the code string.

An added benefit of fund accounting is that, by tracking revenues and expenses separately for each fund, organizations can easily see how donors’ funds are being spent. This is essential not only for the purpose of easily developing financial reports for those donors who require them as part of their grant agreement, but also for the purpose of tracking fund restrictions and generating accurate financial statements. For example, if an individual donates money to a nonprofit organization and limits how the organization can use the funds, that money is considered restricted solely for that purpose. When these funds are recorded in the fund accounting system, the accountant must designate whether the donated monies are restricted and assign the monies to a given fund code. As the organization spends the donated monies on the purpose for which they are intended, the revenues associated with these expenses are no longer restricted, and the corresponding revenues are reclassified from the restricted net asset account to the unrestricted net asset account. Thus, at any time, the accounting staff can easily determine, based on the expenses assigned to each fund, how much of a donor’s money is remaining and how much of the organization’s net assets is categorized as restricted versus unrestricted.

Of course, fund accounting does not only benefit the accounting staff, but also program managers who rely on such financial information in order to appropriately monitor their program’s resources.  By segregating revenues and expenses into separate funds, the accounting staff can more easily provide programmatic staff with updated spending information, budget variances, forecasts, burn-rates, and pipelines, as well as monitoring program spending against donor-imposed restrictions (such as restrictions on budget line-item flexibility) – all of which is essential to program managers and to ensure overall programmatic success.

Given the unique role of nonprofits in our society, there is understandably a focus on an organization’s programs and its programmatic outcomes. But there is also a strong need for nonprofits to monitor the availability of funds that are designated for each individual program. Doing so helps the organization see where funds are being spent and where the organization should focus its fundraising activities. It also allows nonprofits to individually assess programs for effectiveness and efficiency.  And the use of fund accounting is essential to nonprofits in achieving these objectives.

 

Understanding Nonprofit Financial Statements

Understanding Nonprofit Financial StatementsWhether you are starting a new job at a nonprofit organization, joining a nonprofit Board of Directors, or looking to donate money to a charity, it’s important to familiarize yourself with the unique way in which nonprofits present their financial statements.  Although most individuals have a general understanding of accounting and the accounting principles, it’s interesting to note that most of what we learn, especially in accounting courses, is generally geared towards for-profit companies, and, as you will see, the way in which nonprofits present their financial statements is a bit unique.

Let’s start with the Statement of Financial Position.  This statement is similar to the for-profit world’s Balance Sheet in that it lists the values of all the assets held by the organization and the values of all the debts owed, but the Statement of Financial Position also reports the organization’s net assets.  Similar to equity, the net assets section denotes the “value” of the nonprofit. This value, however, is further divided on the Statement of Financial Position into restrictions – either temporarily restricted, permanently restricted, and unrestricted net assets.  These classifications are used to segregate funding based on any restriction(s) imposed by each donor as to how the funds can be spent.  For example, if an individual donates money to a nonprofit organization and limits how the organization can use the funds, that money is considered restricted solely for that purpose.  Depending on the nature of the donor-imposed restriction, these funds may be permanently restricted (such as endowments that cannot be spent) or temporarily restricted (such as funds that are to be spent, not held, on a specific project).  On the other hand, if an individual donates money to an organization but never specifies on what or how the organization can use the funds, these funds have no restrictions and are therefore classified as “unrestricted”.  It is interesting to note that occasionally funds are restricted internally (i.e., management or the Board of Directors decides to restrict how some of the unrestricted funds are to be spent).  The funds are still considered unrestricted for reporting purposes but the internal restriction is noted in the Statement or in the accompanying notes (such as in the example below whereby the Board of Directors restricted $1M of the organization’s unrestricted funding for a given purpose).

Understanding Nonprofit Financial Statements

It is important to note when reviewing financial statements that some smaller nonprofit organizations, especially those not using a fund accounting system, may produce financial statements with the term “fund balance” instead of “net assets”.  They may also fail to properly disclose the “fund balance” by restriction; however, this is usually corrected on the audited financial statements prepared by the external auditing firm.

In addition to segregating net assets based on restrictions, the Financial Accounting Standards Board (per Statement of Financial Accounting Standards No. 117) requests organizations to further report — either in the net assets section of the Statement of Financial Position or within the financial statement notes — any assets that are donated to the organization with “stipulations that they be used for a specified purpose, be preserved, and not be sold” (i.e., land or works of art) or assets donated with “stipulations that they be invested to provide a permanent source of income” (i.e., endowments).

The next financial statement that you will see presented after the Statement of Financial Position is the Statement of Activities.  This statement is in lieu of the Income Statement that is used by for-profit companies, and it reports the change in permanently restricted, temporarily restricted, and unrestricted net assets.  As shown below, this is accomplished by listing each net asset fund in a separate column.  Expenses, which are by nature considered “unrestricted” even if they were spent with restricted funds, will appear solely in the unrestricted column, and the revenues tied to those expenses incurred using restricted funds will appear in the line item “net assets released from restrictions”.  Accountants will typically state that those revenues were “released” from their donor-imposed restrictions once the expenses were incurred, thus the Statement of Activities will present a decrease in these restricted funds and an increase in the unrestricted funding for the same amount in the revenue section of the statement (as seen in the example below).

Understanding Nonprofit Financial Statements

As opposed to an Income Statement which shows a profit or loss, the Statement of Activities instead shows a positive or negative change in each net asset fund.  In the example above, you will see that the amount of temporarily restricted revenue collected during the reporting period was less than the expenses incurred using temporarily restricted funding (the sum of the temporarily restricted revenues is less than the amount of temporarily restricted revenue released from restrictions).  Thus, there is a drop in the ending balance of the temporarily restricted net assets.  Individuals used to reading for-profit financial statements typically consider this a “loss”; however, nonprofits are not in the business of making a profit (or a loss), thus this is an incorrect assumption.  Instead, the financial statement is showing that the organization expended some of the net assets that were obtained in a prior financial period(s).  This is not a loss but utilizing funds for their intended purpose (thus meeting the donor-imposed restrictions).  If you are interested in assessing the organization’s financial stability, it is best to analyze the financial statements for the past five or so years to ascertain if the organization has been consistently utilizing its net assets and not replenishing them with additional funding as this could possibly indicate long-term instability.

As noted earlier, net assets denote the value of the organization.  However, since restricted net assets cannot easily be used by the organization (without satisfying the donor-imposed restrictions), it is quite common in the nonprofit world to consider the organization’s unrestricted net assets to be the actual value of the organization.  Thus, if the organization had to close its doors, those unspent funds held that were restricted for use would have to be returned to the donors since the organization did not earn them.

Lastly, to show the correlation between the two financial statements that we covered, you will notice that the ending value of each net asset fund listed on the Statement of Activities matches the same amount listed on the Statement of Financial Position.

Another financial statement produced by nonprofit organizations is the Statement of Cash Flows, which is produced following the same procedures used by for-profit companies.  This statement shows the inflow and outflow of cash within the organization.  As shown in the sample statement below, the cash flow starts with the change in net assets – which equals the amount listed on the Statement of Activities.  The changes in the balance sheet accounts are then added to this amount to derive at the total increase or decrease in cash.  When this total amount is added to the cash balance at the beginning of the reporting period, you will end up with the current cash balance, which will match the amount listed on the Statement of Financial Position.

Understanding Nonprofit Financial Statements

Finally, nonprofits will also produce a Statement of Functional Expenses.  This statement will detail the expenses incurred during the reporting period and allocate it by program services and support services.  Best practice, although not required, is to break-out the program service costs by the organization’s various programs and list the expense categories from highest to lowest.  Program services are considered “direct costs” as they are the mission-related activities performed by the organization, while support services include such costs as fundraising, overhead, management and/or general administration.

Understanding Nonprofit Financial Statements

Again, all of the financial statements are connected.  For the Statement of Functional Expenses (as shown in the example above), the total expenses will equal the same amount reported on the Statement of Activities.

These four statements represent the primarily financial statements that nonprofit organizations prepare; however, some may include additional statements that provide even more insight into the organization’s finances.  Familiarizing oneself with how these financial statements are developed will undoubtedly help users better understand a nonprofit organization’s financial position.  And, from this standpoint, users can more easily begin to interpret the statements through such techniques as common-sizing and performing ratio analyses to get a better understanding of how the organization is performing financially – a key skillset for anyone working or doing business with a nonprofit.

10 Simple Steps to Prepare for the Year-End Audit

10 Simple Steps to Prepare for the Year-End AuditYear-end is a stressful time for nonprofit finance staff. In addition to completing the normal day-to-day tasks, finance staff is also inundated with closing the fiscal year books and preparing for the year-end audit – a process that can take anywhere between one to three months depending on the nonprofit and the timing of the audit. Although the process needn’t be too strenuous if the finance department properly processes monthly closes – whereby all transactions are posted, allocations properly completed, support schedules updated, and accounts thoroughly reviewed – there is inevitably much to do between the final month of the fiscal year and the start of the annual audit.

To help ease this strenuous time, finance staff should keep in mind these ten simple steps that will undoubtedly facilitate the audit process:

  1. Review all lease agreements and leasehold improvements. Make sure all leases are readily available for the auditors, especially any new leases signed during the year. Keep in mind that any tenant improvement allowances provided by the landlord must be recorded in the accounting system and amortized over the life of the lease. Since tenant improvements are typically incentives provided by and paid for by the landlord and result in no cash outlay for the recipient organization, many organizations fail to record these transactions.
  2. Review all contracts, pledges, and grant agreements, and have them scanned and available for the auditors on the first day. The auditors will review these agreements to make sure revenues and expenses were properly recorded and conform to the revenue recognition rules (including donor restrictions).
  3. Set a clear deadline on collecting prior-year expenses from employees, contractors, and vendors, and send multiple reminders as the deadline approaches. Nothing is more frustrating than closing the books for the year only to receive an unexpected prior-year expense report from an employee after the fact. And, after all expenses are posted, make sure you thoroughly review variations between current year and prior year-end totals for each account. Auditors typically ask the finance staff why certain expenses have significantly increased or decreased compared to the prior-year.
  4. Conduct a physical inventory check and update any fixed asset or equipment lists. Make sure all inventory is properly tagged and that any equipment currently carried on the books hasn’t “disappeared” over the course of the year. A good auditor will ask to see your inventory list and then request to see the physical pieces of equipment.
  5. Review accounts payable and accounts receivable aging reports as well as bank reconciliations. Make sure all AP/AR is current (or at least not more than 30 days past due) and confirm that all outstanding checks on your bank reconciliations are also current. Keep your books clean by contacting individuals who have yet to cash your checks, and, if necessary, void old checks and have them reissued if any recipient claims his/her check was lost.
  6. Review all support schedules for completeness and adherence to organizational policies. Although it’s easy to review the schedules to make sure they are balanced and complete, be sure to compare the results to the organization’s policies (i.e., if staff advances must be cleared within 30 days, make sure the staff advance support schedule shows no employee with an outstanding advance that runs counter to that policy).
  7. Gather all Board documents including bylaw changes, resolutions, and minutes, and put together a list of all Board members — being sure to highlight any Board offices held. Auditors inevitably ask for this information. And make sure any outstanding items included in the Board minutes are followed-up on and any bylaw changes or resolutions were fully enacted.
  8. Review all personnel files to make sure they are complete. Be sure the files contain documentation for any salary increases, tax and employment forms (such as I-9s), and updated job descriptions. Make sure there is an updated organizational chart as well and a current list of employees available for the auditors.
  9. 10 Simple Steps to Prepare for the Year-End AuditReview the accounting files to make sure proper support documentation exists and that all calculations are correct. This includes double-checking that documents were processed correctly (in accordance with the organization’s policies) and that proper approvals were obtained. Be sure to also focus on any manual journal entries and any transactions that require management’s estimate – such as an allowance for doubtful accounts and valuing in-kind donations. You will also want to double-check any year-end accrual calculations and payroll reconciliations. And, as a nonprofit organization, keep an eye out for any transaction that runs counter to the organization’s charity mission as it may be subject to unrelated business income tax.
  10. Lastly, review the organization’s internal control structure. Throughout the year, due to staff turnover, it’s possible that the internal control process may have been compromised. Although it’s important to do this regularly, especially after major hiring or downsizing phases, year-end is also an appropriate time to review the overall internal control structure. Most auditors will require organizations to complete risk assessments as part of the audit process – a task that helps the auditor pinpoint areas of weakness in the internal control process.

Given the vital role the finance department plays in nonprofit organizations, it’s important to make sure the department is functioning properly and operating at its best. Preparing for the year-end audit, although a stressful time for most, is actually the perfect opportunity for the department to focus on what it’s doing right and where improvements are needed. With the right planning and a solid year-end check-list focused on reviewing the accounting books, organizational records, financial processes, and control structure, finance departments can be assured a successful annual audit.

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