On April 22, 2015, the Financial Accounting Standards Board (FASB) issued an exposure draft (ED) of proposed accounting standards updates (ASU’s) that would substantially revise the format and content of the financial statements of not-for-profit organizations. The ED, entitled Presentation of Financial Statements of Not-for-Profit Entities, represents the culmination of a FASB project to reevaluate the current not-for-profit financial reporting model, which was established in 1993 with the issuance of FASB Statement No. 117, Financial Statements of Not-for-Profit Organizations.
In conjunction with its Not-for-Profit Advisory Committee, FASB has been working on the revised financial reporting model for several years, aiming to provide more relevant and understandable information to nonprofit financial statement users. Updating the financial reporting model also reflects changes that have occurred in the not-for-profit industry over the last two decades.
Revisions to the financial reporting model are grouped into four broad categories:
- Net asset classification
- Statement of activities presentation
- Statement of cash flows presentation
- Liquidity information
Net Asset Classification
Under the current financial reporting model, not-for-profit financial statements present net assets in three categories, based on the nature of restrictions on net assets imposed by donors:
- Unrestricted net assets (net assets without donor restrictions)
- Temporarily restricted net assets (net assets with restrictions limiting their use to a specific purpose or a specific time period)
- Permanently restricted net assets (net assets that may never be expended but must be invested permanently as endowment corpus)
However, over the last several years, the line between temporarily and permanently restricted net assets has become blurred as most states have adopted the Uniform Prudent Management of Institutional Funds Act (UPMIFA). UPMIFA permits not-for-profit organizations to spend from the corpus of donor-restricted endowments if they deem it prudent to do so. In response to this development, the ED reduces the net asset categories presented from three to two:
- Net assets with donor restrictions
- Net assets without donor restrictions
The exposure draft continues to require footnote disclosures that elaborate on the nature and amounts of donor-imposed restrictions on net assets. It also requires similar disclosures about designations of net assets by the organization’s governing board, which can also significantly impact operations.
The ED also revises the accounting treatment for underwater endowments (donor-restricted endowments in which the fair value of the assets has fallen below the amount specified by the donor to be permanently retained as endowment corpus). Currently, the amount required to be retained permanently as endowment corpus is presented as permanently restricted net assets, and the shortfall of the fair market value below this amount is presented as a reduction of unrestricted net assets. The ED requires an underwater endowment to be reported entirely as part of net assets with donor restrictions. The aggregate amount of underwater endowments would be disclosed in the footnotes to the financial statements.
Finally, the ED requires the placed-in-service approach to report expired restrictions on gifts of cash and other assets used to acquire or construct a long-lived asset. In other words, once the long-lived asset is in service, the net assets associated with the restricted gifts are released to net assets without donor restrictions. Previously, organizations had the option to release such net assets over the useful life of the acquired asset.
Statement of Activities Presentation
The ED requires that the statement of activities separately present changes in net assets for the two categories of net assets described in the preceding section. This can be accomplished by displaying separate columns for each net asset class. Additionally, for the first time, all nonprofit organizations are required to show a measure of operations on the statement of activities – similar to net income in the for-profit world. Previously, not-for-profit organizations were permitted, but not required, to present a measure of operations.
Specifically, the column for changes in net assets without donor restrictions would present two measures of operations, reflected as subtotals:
- The first subtotal includes operating revenues, support, expenses, and gains and losses without donor restrictions before internal transfers.
- The second subtotal includes the effects of internal transfers resulting from governing board decisions, appropriations, and similar actions that place (or remove) self-imposed limits on the use of resources that make them unavailable (or available) for current period operating activities.
The ED also requires all not-for-profit organizations to present information about their operating expenses both by nature and by function. This may be done on the face of the statement of activities, as a separate statement, or in the notes to the financial statements. This must be supplemented with disclosures about the methods used to allocate costs among functions. Under the current financial reporting model, only voluntary health and welfare organizations are required to present a statement of functional expenses.
Finally, the exposure draft requires all organizations to present investment return net of related external and direct external expenses. Under the current financial reporting model, organizations have had the option to present investment return and related expenses using either a gross or net format.
Statement of Cash Flows Presentation
The ED requires all nonprofits to use the direct method of reporting for the operating section of the statement of cash flows. In other words, instead of reconciling the change in net assets to cash flows from operating activities (i.e., the indirect method), cash flows from operating activities must be presented in various categories of receipts and disbursements. The intent is to make the statement of cash flows more understandable and useful. Organizations are permitted, but not required, to also reconcile the change in net assets to cash flows from operating activities using the indirect method at the bottom of the cash flow statement.
Additionally, the ED changes the cash flow statement classification of certain types of transactions in order to better align with the distinction between operating and nonoperating transactions as presented on the statement of activities. Specifically, the ED makes the following changes to cash flow classification:
- Purchases of long-lived assets, contributions restricted to acquire long-lived assets, and sales of long-lived assets are to be presented as operating activities. Under the current reporting model, these are presented as investing activities.
- Payments of interest on borrowings are to be presented as financing activities. Under the current reporting model, these are presented as operating activities.
- Receipts of interest and dividends on loans and investments other than those made for programmatic purposes are to be presented as investing activities. Under the current reporting model, these are presented as operating activities.
The ED requires various new disclosures so financial statement users can better assess an organization’s liquidity and how liquidity is being managed. Under the current financial reporting model, it is often difficult to evaluate how liquid a not-for-profit organization is. The following quantitative and qualitative disclosures are required by the exposure draft:
- The amount of financial assets at the end of each period
- The amount of financial assets that, because of restrictions or limitations on their use, are not available to meet near-term cash needs
- The amount of financial liabilities that require cash in the near term
- The way an organization manages liquidity, including the time horizon being used
Effective Date & Implementation
The exposure draft does not establish an effective date for the proposed ASU’s. Instead, FASB will determine the effective date, and whether early adoption will be permitted, once the responses to the ED are evaluated. However, the ED does indicate that retrospective application of the provisions of the ASU’s will be required, meaning that prior periods presented in comparative financial statements must be recast to comply with the new financial reporting model.
FASB is accepting comments in response to the exposure draft from nonprofit organizations, not-for-profit financial statements users, and other interested parties. We encourage you to review the exposure draft and submit a comment letter to FASB so your concerns, whether favorable or not, can be considered during the finalization of the standard. The comment deadline is August 20, 2015.
The full exposure draft can be read here.
Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.
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