By Melisa Galasso, CPA
On April 22, 2015, the U.S. Financial Accounting Standards Board (FASB) issued Proposed Accounting Standards Update (ASU) 2015-230, Not-for-Profit Entities (Topic 958) and Health Care Entities (Topic 954), Presentation of Financial Statements of Not-for-Profit Entities. It proposes some of the largest changes for nonprofit financial statements since Financial Accounting Standards (FAS) 116 and 117 were issued in 1993. While the proposed ASU does not make changes to recognition or measurement, the impact on the presentation and disclosures for nonprofit financial statements is vast. FASB’s Not-for-Profit Advisory Committee was instrumental in requesting that financial statements be updated to help better communicate the financial situation for nonprofit entities, which include private colleges and universities; private hospitals; and religious and charitable organizations, in addition to foundations and trade associations.
FASB has faced many challenges in proposing a standard that would meet the needs of this diverse industry. We’ll break down the proposed changes by financial statement affected.
Statement of financial position
One of the biggest proposed changes for the statement of financial position is the reduction of net asset classes. Currently, nonprofit entities present three classes of net assets: Unrestricted, temporarily restricted and permanently restricted. Each class comes with its own set of issues.
First, the term “unrestricted” is often interpreted to mean that there are no restrictions on spending. However, that is typically not the case. Unrestricted indicates that there are no donor restrictions, but there could be board, legal or contractual restrictions, or the amount may be in assets that are not spendable. Therefore, in the exposure draft, FASB proposed renaming this class “net assets without donor restrictions” to more clearly label the true intention of the classification.
In addition, in the world of the Uniform Prudent Management of Institutional Funds Act, many boards have policies to prudently spend from their permanently restricted net assets. With this ability, there was some discussion over whether something was permanently restricted if an organization was able to spend it. Therefore, FASB proposed to combine the current temporarily and permanently restricted net asset classes and call the new classification “net assets with donor restrictions.”
While this may appear to reduce the information to the user, this change only occurs on the face of the financial statements. In fact, the required disclosures actually increase the information required to be provided to users. Information about the restrictions imposed by donors on the use of contributed assets, including their potential effects on specific assets, and on liabilities or classes of net assets, would be required to be disclosed. Additionally, the proposed ASU would require the disclosure of the composition of net assets with donor restrictions at the end of the period and how the restrictions affect the use of resources.
Currently, some nonprofit entities disclose information about board of directors’ designations. In the proposed ASU, organizations would be required to disclose board designations, appropriations and transfers that impact self-imposed limits on the use of resources. Organizations would be required to disclose the description of the purpose, amounts and types of transfers and qualitative and quantitative information about any period-end balances. These disclosures would include quasi-endowments, liquidity reserves and any other campaigns for which the board restricts the use of funds for a given purpose or time period.
Liquidity is another area affected by the proposed ASU. Many nonprofits were greatly impacted by the recession in the latter part of the 2000s. Many found that while they had endowments or other investment vehicles, the illiquidity of the assets caused serious issues. As a result, the proposed ASU would require both qualitative and quantitative disclosures about the organization’s liquidity. A nonprofit organization would also have to disclose a self-defined time horizon for the consideration of liquidity. It would then need to breakdown its financial assets between those that were available within the self-defined time horizon and those that were not. It would then disclose the amount of financial liabilities due within the same period of time. Qualitatively, the organization would disclose how it determined the time horizon, as well as the organization’s strategy, for addressing entity-wide risks that could affect liquidity and if the entity had a policy for establishing liquidity reserves.
Another proposed change to the statement of financial position includes presenting underwater endowments within the “with donor restrictions” class of net assets.
Statement of activities
The statement of activities has some major proposals to give it a remodel. The first includes adding an intermediate measure of operations for all entities. The exposure draft proposes using two dimensions — availability and mission — to separate the statement of activities into operating and non-operating. Mission would be all items related to the nonprofit’s purpose. In addition, only those items that are considered “available,” meaning there were no donor or board restrictions on use, would be considered operating. The goal is to provide more comparability between nonprofits.
Currently, nonprofits in the health care industry are required to present a performance indicator. The proposal would remove the requirement of a performance indicator and require all nonprofits to present an “intermediate measure of operations.”
The proposal also requires the presentation of transfers on the face of the statement of activities. Transfers out of operations occur when the board (or its authorized designees) takes a portion of net assets, makes them currently unavailable and requires they be used in a future period. On the other hand, a transfer into operations occurs when the board makes net assets available that were previously unavailable — through a spending policy, for example. These transfers would show as line items within a separate section called “transfers” on the face of the financial statement. In addition to showing those transfers, organizations would be required to disclose the purpose, amount and types of transfers in the notes.
Using the concept of transfers and intermediate measure of operations, the proposed statement of operations would have at a minimum five subtotals: change in net assets, change in net assets with donor restrictions, change in net assets without donor restrictions, operating excess (deficit) before transfers and operating excess (deficit) after transfers. While this may seem a little overwhelming, FASB offers flexibility in how to present these required subtotals: a one- or two-statement approach.
Under both approaches, the same net number will be used. In addition, there will always be a total for operating amounts, non-operating amounts and donor-restricted amounts. In a one-statement approach, all the subtotals would appear in one statement. In Table 1, all the items in light green include the intermediate measure of operations. The orange indicates those items that are non-operating because they are either not related to the mission or not available. The items in the dark green would include any donor-restricted amounts.
Table 1. One-Statement Approach to Statement of Activities
As you can see in Table 2, the statement is broken up into two separate statements. The first is the statement of operations, which includes all items in the intermediate measure of operations (all items in light green that are available and mission-oriented). Then in a separate statement, the final value from the statement of operations is carried over and the items that are non-operating (dark green), and donor restricted (orange) are added in a statement called the “Statement of Changes in Net Assets.”
In both examples, all the same items are shown. It would be at the preference of the organization to decide to use either a one-statement or two-statement approach.
Table 2. Two-Statement Approach to Statement of Operations and Statement of Changes in Net Assets
The exposure draft also requires all nonprofits to disclose all operating expenses by both nature and function in one place within the financial statements. FASB says this can occur within the statement of activities, in a separate statement of functional expenses or in the notes to the financial statements. Natural expenses would be typical general ledger classifications (i.e., salaries, rent, utilities etc.). Functional expenses would analyze expenses between the various programs of the entities, with a separate category for supporting activities. Because the supporting activities are mission-driven, they would be considered operating expenses and included in the analysis. Non-operating expenses would only be required to be reported by nature.
In addition, FASB proposes changes to the presentation of investment income. Organizations would report investment returns net of any related external and direct internal investment expenses. Investment return net would then be presented as one line item in the non-operating section of the statement of activities. The draft also proposes disclosing the amount of internal salaries and benefits that have been netted against investment return.
Statement of cash flows
The cash flow statement also has several proposed changes; most notably is the requirement to use the direct method of cash flows for all entities. Currently all entities — public, private and nonprofit alike — have the option to use either the direct or indirect method under FASB. Those entities that follow the U.S. Governmental Accounting Standards Board (GASB), however, are required to use the direct method. Many people believe that the direct method is easier for users to understand and provides clean explanations for how cash was received and spent. Conversely, many preparers feel it is more difficult to prepare. Currently, if an entity prepares the cash flow statement using the direct method, they must also present a reconciliation similar to the indirect method. In the proposal, the FASB eliminates the requirement to also present the reconciliation and would only require the direct method. The reconciliation would be permitted but not required.
The exposure draft proposes a reclassification of certain items within the cash flow statement. The goal would be to more closely align the cash flow statement with the statement of activities and the new concept of “operating.” Some of the proposed reclassifications include presenting purchases of long-lived assets, contributions restricted to acquire long-lived assets and sales of long-lived assets as operating cash flows. Payments for interest on borrowings and cash contributions restricted for long-term (non-programmatic) investing would be treated as financing cash flows. Finally, cash receipts of interest or dividends would be treated as financing cash flows. Cash receipts or payments for interest or dividends that are programmatic in nature because of their mission orientation would continue to be treated as operating.
The big picture
The exposure draft proposes retrospective adoption of all the changes included in the proposal. It did not include an expected effective date, but did include a question for respondents on whether the effective date should be the same for all types of nonprofits. The draft was issued with a 5-2 vote; FASB Chairman Russell G. Golden and Vice President James L. Kroeker both voted against the proposal. In the basis for their dissent, they indicated their support for many of the features, but felt that some areas in the proposal were not unique to nonprofits and should not be included.
FASB received 264 comment letters from academics, accounting firms, preparers, users and other interested individuals. In addition to the comment letters, FASB held 10 workshops to solicit feedback in five cities across the United States. They also held three public roundtables: two in FASB’s hometown of Norwalk, Conn., and one in California.
I had the opportunity to attend the afternoon session in Norwalk as a representative of the North Carolina Association of CPAs (NCACPA). The discussions were lively and attendees passionately discussed the topics. All FASB members were present at the roundtable I attended. In addition, we had users, preparers and auditors in the room. It was a great experience to see due process in action.
At FASB’s Oct. 28, 2015, meeting, they discussed constituents’ feedback. The staff concluded that, overall, constituents support the objectives of the project. Concerns include the diversity of the nonprofit industry and the further divergence from for-profit entity financial statements. Based on the feedback, the staff proposed and FASB agreed to split the exposure draft into two workflows.
Those items that could be completed by June 30, 2016, as enough feedback was provided, will be considered workstream 1. Those items that the staff felt could be deliberated in one day include net asset classes presented as two classes, disclosure of board designated funds, underwater endowment classification, as well as requiring expenses by both nature and function and changes to investment expenses. Items that could be completed by June 30, 2016, and that are included in workstream 1 but would require more than one meeting, include the direct method of cash flows and liquidity disclosures. Items that would be deferred until workstream 1 is complete include the operating measure and the realignment of the statement of cash flows.
The FASB has considerable work ahead of them to get a final ASU issued. I expect additional discussions and outreach for the near future. Nonprofits, users of nonprofit financial statements and auditors of nonprofit statements should continue to monitor the progress.
Melisa Galasso, CPA, is the founder of Galasso Learning Solutions LLC in Charlotte, N.C., where she designs and facilitates courses in advanced technical accounting and auditing topics, including nonprofit and governmental accounting. She is a member of the VSCPA Board of Directors and sits on the Disclosures Editorial Task Force.