April 6, 2017
MBAF's Robert Dyson, along with colleague Travis Carey provide an in-depth analysis of the update, and how it affects the presentation of non-profit financial statements in the April 2017 edition of the The CPA Journal.
FASB’s Accounting Standards Update (ASU) 2016-14, Presentation of Financial Statements of Not-for-Profit Entities, contains changes in reporting requirements that will significantly affect how nonprofits communicate with stakeholders. The authors walk through how the ASU affects the presentation of an organization’s financial statements, particularly liquidity and the availability of resources, financial performance, and cash flow. An example using a hypothetical nonprofit illustrates the changes to asset classes and the alternatives in the statement of activities.
Changes in The Master Glossary
Board-designated endowment fund: An endowment fund created by an NFP’s governing board by designating a portion of its net assets without donor restrictions to be invested to provide income for a long, but not necessarily specified, period.
Board-designated net assets: Net assets without donor restrictions subject to self-imposed limits by action of the governing board. Board-designated net assets may be earmarked for future programs, investment, contingencies, purchase or construction of fixed assets, or other uses.
Donor-imposed restriction: A donor stipulation that specifies a use for a contributed asset that is more specific than broad limits resulting from the nature of the NFP, the environment in which it operates, or the purposes specified in its articles of incorporation or bylaws.
Donor-restricted endowment fund: An endowment fund created by a donor stipulation requiring investment of the gift in perpetuity or for a specified term.
Donor-restricted support: Donor-restricted revenues or gains from contributions that increase net assets with donor restrictions.
Endowment fund: An established fund of cash, securities, or other assets to provide income for the maintenance of an NFP. The use of the fund’s assets may be with or without donor-imposed restrictions. Endowment funds established by donor-restricted gifts may provide income either in perpetuity (permanent endowment) or for a specified period (term endowment).
Functional expense classification: A method of grouping expenses according to the purpose for which costs are incurred. The primary functional classifications of an NFP are program services and supporting activities.
Natural expense classification: A method of grouping expenses according to the kinds of economic benefits received in incurring those expenses, such as salaries and wages, employee benefits, professional services, supplies, interest expense, rent and utilities, and depreciation.
Net assets with donor restrictions: The portion of net assets subject to donorimposed restrictions.
Net assets without donor restrictions: The portion of net assets not subject to donor-imposed restrictions.
Programmatic investing: The activity of making loans or other investments that are directed at carrying out an NFP’s exempt purpose rather than investing in the general production of income or appreciation of an asset. An example is a loan made to lower-income individuals to promote home ownership.
Underwater endowment fund: A donor-restricted endowment fund for which the fair value of the fund at the reporting date is less than either the original gift amount or the amount required to be maintained by the donor or by law that extends donor restrictions.
In August 2016, FASB issued Accounting Standards Update (ASU) 2016-14, Presentation of Financial Statements of Not-for-Profit Entities, with the stated purpose of improving financial reporting by not-for-profit entities (NFP). Among other provisions, ASU 2016-14 reduces the number of classes of net assets from three to two, requires the presentation of expenses in both natural and functional classifications, and eliminates the requirement to prepare a reconciliation in the statement of cash flows when applying the direct method. It also revises the definitions of certain terms, which are presented in the sidebar, Changes in the Master Glossary. FASB has relegated some of the changes contemplated in the original exposure draft, including intermediate measures of operations, defining such measures, and aligning the operating definitions in the statements of activities and cash flows, to a second phase of the project, to be addressed in the future.
ASU 2016-14 was amended by ASU 2016-18, Restricted Cash, and ASU 2017-02, Clarifying When a Not-for- Profit Entity That Is a General Partner or a Limited Partner Should Consolidate a For-Profit Limited Partnership or Similar Entity. ASU 2016-18 requires that cash restricted by donors and other outsiders be combined with unrestricted cash in the statement of cash flows.
ASU 2016-14 is effective for fiscal years beginning after December 15, 2017, with early application permitted. It should be applied on a retrospective basis; an NFP, however, has the option to omit the analysis of expenses by both “functional” and “natural” classification, as well as certain disclosures about liquidity and availability of resources, for any comparative periods originally presented before the period of adoption.
To date, Form 990 and related state tax forms have not been revised to reflect the ASU. NFPs may wish to defer early adoption of ASU 2016-14 until the forms’ instructions are revised to reflect the update. This article provides an example of implementing ASU 2016-14 that focused on the following concepts:
- Liquidity and availability of resources
- Financial performance
- Cash flow reporting.
Delta Education and Cultural Development Agency (Delta) is an NFP that operates educational and cultural programs. Delta elected to adopt ASU 2016- 14 for its fiscal year ending on June 30, 2018. Exhibits 1 and 2 present the effects of adopting ASU 2016-14 on the statement of financial position and endowment funds, respectively. Exhibits 3 and 4 present the effect of adopting ASU 2016-14 on the statement of activities.
Liquidity and Availability of Resources
NFP resources may be limited due to donor restrictions, contractual obligations, or board designations. Current accounting guidance focuses on the existence or absence of donor-imposed restrictions by presenting an NFP’s net assets and revenue in three classes: permanently restricted (the donor stipulates the amounts that can never be used), temporarily restricted (the donor restriction expires when the stipulated time has elapsed, when the stipulated purpose has been fulfilled, or both), and unrestricted (the amounts can be used for any activity consistent with the NFP’s exempt purpose).
The current guidance also does not identify all amounts that are not available for general operations. Resources limited by grantors, laws, and contracts are not clearly presented, even though they affect an NFP’s liquidity. In addition, the statement of financial position does not reflect laws that permit access to certain amounts of permanently restricted net assets.
Background. As shown in Exhibit 1, Delta’s statement of financial position as of July 1, 2017, presents temporary donor restrictions of $10,050,000 and permanent donor restrictions of $9,000,000, broken down as follows.
In 2004, Delta received a gift restricted to the purchase of land and building. Delta elected to classify the gift as temporarily restricted and recognize the release from restrictions over the building’s useful life, which approximates depreciation. At June 30, 2017, the net carrying value of the facility was $2 million. In addition, the donor specified that Delta use its own funds to maintain a separate bank account with a balance no less than $250,000 until June 30, 2022, to be used solely for major repairs and replacements of that facility. Although the donor did not provide the funds, its requirement to maintain a major repairs and replacements account is a donor-imposed stipulation on the use of resources; accordingly, Delta recorded the $250,000 as temporarily restricted net assets and restricted cash.
Temporarily restricted net assets also include $5 million of other donor-restricted contributions. This amount included $1.5 million, which the board designated as an endowment fund, and a $900,000 gift, which is restricted to the renovation of Delta’s facility (which had not begun as of June 30, 2017) and the purchase of equipment for the educational programs. The amount and use of the board-designated endowment fund is totally at Delta’s discretion.
Permanently restricted net assets include one endowment fund with an original balance of $8 million. It is deemed an “underwater endowment fund” because it incurred net unrealized losses of $500,000, leaving it with a balance of $7.5 million. Applying the current guidance, Delta reflected the $500,000 in unrestricted net assets.
In the year ended June 30, 2016, Delta received a gift of $1 million, which required the establishment of a $3 million matching fund. The gift permits Delta to spend all income generated by the original gift and matching fund, which includes interest and dividends as well as realized and unrealized gains and losses on the underlying investments. In addition, Delta may reduce the matching fund balance by no more than $200,000 per year, either by reflecting unrealized losses on the investments or by expenditures. Delta classified the $1 million gift in permanently restricted net assets. Applying the same policy as discussed above in the major repairs and replacements account, Delta accounted for the $3 million matching fund as restricted cash and in temporarily restricted net assets. At June 30, 2017, the balance was reduced to $2.8 million as a result of a net unrealized loss of $150,000 and the expenditure of $50,000 for operations.
The new guidance. ASU 2016-14 does more than change the categorization of net assets. The objective of ASU 2016-14 is to clearly present an NFP’s liquidity and ability to operate. Unrestricted net assets are now called “net assets without donor restrictions.” Permanently restricted and temporarily restricted net assets are combined into “net assets with donor restrictions.” An NFP may elect to continue to present net assets with perpetual donor restrictions and those expected to be released from restrictions over time or for a particular purpose. Regardless of the detail in the presentation, the NFP must present total net assets with donor restrictions, total net assets without donor restrictions, and total net assets in the statement of financial position.
Other provisions of ASU 2016-14 may affect both the balances of the different classes of net assets and those of endowment funds. For example, contributions restricted to the acquisition of long-lived assets are currently recorded as increases in temporarily restricted net assets; the release from restrictions can either be when the asset is acquired and placed in service or over its useful life. ASU 2016-14 removes that option. Although NFPs are still required to classify contributions restricted to acquire long-lived assets as donor-restricted support, the contributions are released from restrictions and reclassified to net assets without donor restrictions when the asset is acquired and placed into service, unless the donor placed a time restriction on the use of the asset.
As with the current guidance, ASU 2016-14 requires the recognition of net assets released from restrictions in the period the stipulated time has elapsed, when the stipulated purpose has been fulfilled, or both. At that time, the amount is reclassified from net assets with donor restrictions to net assets without donor restrictions.
Changes in the accounting for net assets currently classified as permanently restricted reflect laws permitting appropriation by the NFP. In New York State, the New York Prudent Management of Institutional Funds Act (NYPMIFA) permits the governing board, after considering eight specific factors, to appropriate a “prudent” expenditure of funds from a donor-restricted endowment fund (currently classified as permanently restricted net assets). At that time, the appropriated amount is reclassified from net assets with donor restrictions to net assets without donor restrictions. NYPMIFA is similar to the nationwide model, the Uniform Prudent Management of Institutional Funds Act; a fuller discussion of both is beyond the scope of this article.
Endowment funds are created either by one or more donors or by an NFP’s governing board. Endowment funds created by a donor who stipulates restrictions on the use of the assets to specific activities, to specific future time periods, or in perpetuity are classified in net assets with donor restrictions. Endowment funds created by an NFP’s governing board are generally reported in net assets without donor restrictions, because the governing board can reverse its decision to create the fund. ASU 2016-14 notes, however, that a board-designated endowment fund may include a portion of net assets with donor restrictions. For example, Delta’s decision to designate $1,500,000 of donor-restricted contributions as an endowment fund results in a donor-restricted, board-designated endowment fund.
As seen in Exhibit 1, Notes 3 and 5, a underwater should include the accumulated losses of that fund in net assets with donor restrictions and not in net assets without donor restrictions. The NFP is required to disclose the fair value of the underwater endowment funds, the original gift required to be maintained by donor stipulation, and the amount of deficiencies in the underwater endowment funds.
ASU 2016-14 also enhances disclosures regarding liquidity and how restrictions affect the use of resources. It expands disclosure requirements on the nature and amounts of different types of donor-imposed restrictions as well as the amounts and purposes of board-designated net assets. Furthermore, ASU 2016- 18 requires disclosure of the nature of the restrictions on cash while also combining restricted cash with unrestricted cash on the statement of cash flows.
Other than changes in the net asset section, ASU 2016-14 does not change the format of the statement of financial position. It does, however, change the format of the statement of activities, as discussed below.
ASU 2016-14 aligns current reporting requirements in the statement of activities to the two new classifications of net assets. donor-restricted endowment fund that is The statement of activities reports revenues as “increases in net assets without donor restrictions,” unless the use of the assets received is limited by donor-imposed restrictions. Donor-restricted contributions whose restrictions are met in the same reporting period received may, however, be reported as “unrestricted support in net assets without donor restrictions,” provided that an NFP has a similar policy for reporting investment gains and income, reports consistently from period to period, and discloses its accounting policy. Expenses are reported as decreases in net assets without donor restrictions. ASU 2016-14 presents three alternate formats for the statement of activities:
- Format A presents a single column, which facilitates comparative financial statements
- Format B presents the three columns—without donor restrictions, with donor restrictions, and total
- Format C presents two statements of activities—one showing changes in net assets without donor restrictions, and one showing changes in net assets with donor restrictions.
Formats A and B are illustrated in Exhibits 3 and 4, respectively. All three formats separate program activities from supporting activities.
Program activities consist of services rendered to beneficiaries that fulfill the NFP’s mission. Those services are the major purpose for Delta and relate to both educational and cultural programs. Supporting activities are all of Delta’s activities other than program services. Generally, supporting activities include management and general activities, fundraising activities, and membership development activities.
ASU 2016-14 permits the presentation of intermediate measures of operations. Because “intermediate measures of operations” is defined by the reporting entity, the ASU requires disclosure of the description of the nature of the term “operations” if it is not apparent from the details provided on the face of the financial statements. ASU 2016-14 generally considers revenues as being derived from transactions that are part of the NFP’s central activities, and gains and losses as being derived from incidental and peripheral transactions or from events and circumstances beyond the control of the NFP. Incidental or peripheral activities include sale of property no longer needed and certain investment gains and losses. Investment gains and losses appropriated for operations are reclassified as operating activities; contributions to endowment funds are reclassified to non-operating activities. Delta’s statement of activities showing the intermediate measure of operations is presented in Exhibit 4.
Gains and losses on investments (other than programmatic investing) and other assets (or liabilities) are recognized as increases or decreases in net assets without donor restrictions unless their use is restricted by explicit donor stipulations or by law. In a change required by ASU 2016-14, external and direct internal investment expenses are netted against investment returns and reported in the net asset category in which the net investment return is reported. In addition, these expenses are no longer required to be disclosed.
Direct internal investment expenses involve the direct conduct or direct supervision of the strategic and tactical activities involved in generating an investment return. These include costs associated with the officer and staff responsible for the development and execution of investment strategy, such as salaries, benefits, and travel, as well as other allocable costs associated with internal investment management and supervising, selecting, and monitoring external investment management firms.
A new requirement of ASU 2016-14 is to provide information ordinarily included in a statement of functional expenses for all NFPs. Currently, only voluntary health and welfare organizations are required to provide this information. ASU 2016-14 requires a presentation of the relationship between functional and natural classification for all expenses in an analysis that disaggregates functional expense classifications (such as major classes of program services and supporting activities) by their natural expense classifications. This information should be presented on the face of the statement of activities, as a schedule in the notes to the financial statements, or in a separate financial statement, such as a statement of functional expenses.
Because certain activities benefit more than one function, costs reflecting direct supervision of program or other supporting activities are allocated from management and general to program activities. For example, Delta’s CEO is responsible for oversight of both program and administrative activities. Administrative activities include spending time with current and potential donors during fund-raising and supervising administrative activities. As a result, Delta allocated a portion of the CEO’s compensation and benefits and other expenses to program, fund-raising and management, and general functions based on the time spent on those activities. In addition, information technology directly benefited management and general, fundraising, and program delivery. Accordingly, information technology costs were allocated among those functions.
In contrast, Delta’s human resources department was involved in the benefits administration for all personnel. The human resources department’s related costs were not allocated to any specific program; rather, those costs were charged to management and general expenses because benefits administration is a supporting activity for the entire entity.
Statement of Cash Flows
ASU 2016-14 permits NFPs to present operating cash flows using either the direct method or the indirect method, but no longer requires the reconciliation of the change in net assets to net cash provided by (used in) operating activities if an NFP elects to apply the direct method. FASB concluded that removing the requirement to prepare the reconciliation when the direct method is applied might encourage more NFPs to choose the direct method.
Prepare for Changing Presentation
ASU 2016-14 contains additional changes that affect the presentation of financial statements. Financial statement preparers should review the update to determine its effect on their own particular circumstances and whether they need to expand their current financial statement disclosures.
Travis Carey, CPA, is managing director of Carey LLC, New York, N.Y. Robert A. Dyson, CPA, is the director of quality control at MBAF CPAs LLC, New York, N.Y, as well as a member of The CPA Journal Editorial Board.