For the first time in more than two decades, the Financial Accounting Standards Board (FASB) has issued major changes to the accounting standards for not-for-profit organizations’ financial statement presentation. 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 organization, including charities, foundations, private colleges and universities, nongovernmental healthcare 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). 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 (such as donors, grantors, creditors and other users of not-for-profits’ financial statements) should find it easier to understand how not-for-profit organizations manage their funds.
Background on the ASU
Not-for-profit organizations’ financial statements currently are prepared according to guidance published in 1993. 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 significant feedback, much of which was 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. These issues include the presentation of an operating measure designed to enhance comparability from one organization to the next. The statement of cash flows may include significant revisions as well in an attempt to align more closely with an entity’s operations. 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 change to reduce the complexity of financial reporting for not-for-profits, while increasing the understandability for stakeholders. Under current standards, many donor-restricted gifts have elements that may be broken into both permanently and temporarily restricted components (for example, a permanently restricted gift where the income is used for a specified purpose). Organizations will now be able to tell the story on donor restricted gifts in a more concise fashion.
Organizations with endowment funds that are “underwater” will now be allowed to show their deficit in the fund to be presented in the donor restricted category. Currently, these deficits are presented as a reduction in unrestricted net assets. The guidance requires expanded disclosures regarding these underwater endowments.
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
The nature of an asset may affect its availability. For example, external limits imposed by donors, grantors, laws and contracts with others and internal limits imposed by board decisions can all affect an asset’s availability.
Board designations or other internal limits on the use of net assets without donor restriction will now require disclosure. Organizations and their boards or finance committees may need to consider adopting guidelines or policies (if they are not in place already) to address these disclosure requirements.
Information about expenses
To provide a clear 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, management and general, and fundraising), can be presented in one of three ways:
- on a separate statement
- on the statement of activities
- or in the footnotes
Most commonly, this information is included in a separate statement of functional expenses.
In addition, the standard calls for enhanced disclosures regarding specific methods used to allocate costs among program and support functions. These methods may include time spent, square footage or other allocation measures.
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 able to compare investment returns among different not-for-profits more easily, 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 change 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 will encourage more not-for-profits to use the direct method of reporting operating cash flows.
The new standard takes 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. 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 organization, please contact us.