The Financial Accounting Standards Board (FASB) has issued the first major changes to the accounting standards for not-for-profits’ financial statement presentation in more than two decades. Accounting Standards Update (ASU) No. 2016-14, Not-for Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities, affects just about every not-for-profit, including charities, foundations, private colleges and universities, nongovernmental health care providers, cultural institutions, religious organizations, and trade associations.
The new standard is intended to provide improved net asset classification requirements and information about not-for-profits’ resources (and changes in those resources) to donors, grantors, creditors and other users of not-for-profits’ financial statements. It changes the classification of net assets and the information presented in the financial statements and footnotes about an organization’s liquidity, financial performance and cash flows. As a result, stakeholders should find it easier to understand how not-for-profits manage their funds.
Background on the ASU
Not-for-profits’ financial statements currently are prepared according to guidance published in 1993 as Statement of Financial Accounting Standards No. 117, Financial Statements of Not-for-Profit Organizations (incorporated into Topic 958 in the FASB Accounting Standards Codification). The FASB believes that this reporting model remains sound, but stakeholders have expressed concerns regarding several areas, including:
- The complexity and “understandability” of net asset classification,
- Deficiencies in information about an organization’s liquidity and the availability of its resources,
- The lack of consistency in the type of information provided by different organizations about expenses and investment returns, and
- Misunderstandings about and opportunities to enhance the usefulness of the statement of cash flows.
In response, the FASB issued an Exposure Draft, Presentation of Financial Statements of Not-for-Profit Entities, in April 2015. After receiving an unusual amount of feedback, much of it negative, the FASB decided to split its deliberations into two phases.
The issuance of ASU No. 2016-14 represents the conclusion of Phase 1. Phase 2 will focus on certain issues considered more challenging, such as aligning the presentation of measures of operations between the statements of activities and cash flows, as well as those that might depend on a related FASB project addressing financial performance reporting by for-profit entities. The FASB hasn’t yet announced a timeline for the second phase.
New net asset classifications
One of the more notable changes in the new standard is the replacement of the existing three net asset classes (unrestricted, temporarily restricted and permanently restricted) with two new classes (net assets with donor restrictions and net assets without donor restrictions). The FASB expects this to reduce the complexity of financial reporting for not-for-profits, while increasing the understandability for stakeholders.
The new approach recognizes changes in the law that now allow organizations to spend from a permanently restricted endowment even if its fair value has fallen below the original endowed gift amount. Such “underwater” endowments will now be classified as net assets with donor restrictions, rather than the current presentation as unrestricted net assets. The guidance also requires expanded disclosures regarding underwater endowments.
In addition, the new standard eliminates the current “over-time” method for handling the expiration of restrictions on gifts used to purchase or build long-lived assets such as buildings. Not-for-profits must use the placed-in-service approach (in the absence of explicit donor stipulations to the contrary).
In other words, not-for-profits must reclassify these gifts as net assets without donor restrictions when the asset is placed in service, rather than over the asset’s useful life. As a result, organizations won’t be able to match the depreciation expense with the release of these restricted net assets unless stipulated by the donor.
Information about liquidity and availability of resources
The new standard includes specific requirements to help financial statement users better assess a not-for-profit’s available financial resources. Organizations must provide:
- Qualitative information that indicates how they manage their liquid available resources to meet cash needs for general expenses within one year of the balance sheet date, and
- Quantitative information that indicates the availability of their financial assets at the balance sheet date to meet cash needs for general expenses within one year.
An asset’s availability may be affected by its nature; external limits imposed by donors, grantors, laws and contracts with others; and internal limits imposed by board decisions. Disclosure is also required for board designations or other internal limits on the use of net assets without donor restriction.
Information about expenses
To provide a clearer picture of a not-for-profit’s spending, the new standard requires reporting of expenses by both function (which is already required) and nature in one location. This presentation, showing how the nature of expenses (for example, salaries and wages, employee benefits, supplies, and rent) relates to the functions (program services and supporting activities), can be presented on a separate statement, on the statement of activities or in the footnotes. In addition, the standard calls for enhanced disclosures regarding specific methods used to allocate costs among program and support functions.
This information will help financial statement users assess the degree to which expenses are fixed or discretionary, how the related resources are allocated, and the costs of the services provided.
Information about investment returns
Not-for-profits will now be required to net all external and direct internal investment expenses against the investment return presented on the statement of activities. Financial statement users will be better able to compare investment returns among different not-for-profits, regardless of whether investments are managed externally (for example, by an outside investment manager who charges management fees) or internally (by staff).
The new standard also eliminates the current required disclosure of those netted expenses. This should eliminate the difficulty some not-for-profits had with identifying management fees embedded in investment returns.
Presentation of operating cash flows
One of the more controversial components of the FASB’s Exposure Draft was its requirement that organizations use the “direct method,” not the “indirect method,” to present net cash from operations on the statement of cash flows. The two methods produce the same results, but the direct method provides more understandable information to financial statement users.
The final version of the new standard allows not-for-profits to use either method. But, should an organization opt for the direct method, it will no longer need to include an indirect method reconciliation. The FASB hopes this change, which should reduce the costs of the direct method, will encourage more not-for-profits to use it.
Some not-for-profits will incur additional costs to comply with the new standard, including costs related to gathering incremental data for the new disclosure requirements, making changes to financial reporting processes and controls, and communicating the changes to stakeholders. The FASB predicts, though, that the ongoing compliance costs after implementation will be insignificant.
The new standard takes effect for annual financial statements issued for fiscal years beginning after December 15, 2017, and for interim periods within fiscal years beginning after December 15, 2018. Early application is allowed.
Not-for-profits should resist the temptation to delay preparations even though they may also be dealing with the implementation of the new accounting standards for lease accounting and revenue recognition. If you have questions about how the new standard will affect your not-for-profit, please contact us.