Current financial reporting standards for not-for-profit organizations have been in place for nearly 25 years. The Financial Accounting Standards Board (FASB), the board responsible for setting the standards for not-for-profit organizations, recognized that while existing guidance held up well, some improvements were necessary. The updated standard reflects the desire for not-for-profit organizations to be able to tell their unique story while simultaneously improving relevance, transparency, and comparability for the ease of the intended users. It’s no surprise that over time the needs of intended users of financial statements have changed, thus changing the way information needs to be presented.
Key Changes Included in the Standard’s Updates
The updates are being executed in two phases. Phase I was issued in August 2016 and is effective for periods beginning on or after December 15, 2017. Key Phase I changes impact the following:
- Net asset classification
- Expenses/investment return
- Operating measures
- Liquidity/availability of resources
- Statement of cash flows
The most significant change in net asset classification eliminates the concept of temporarily versus permanently restricted net assets. Instead, the categories presented will be “without donor restriction” (otherwise known as unrestricted) and “with donor restriction.” Organizations can choose to disaggregate net assets with donor restriction further, but they are no longer required to. In addition, there are expanded disclosure requirements related to limitations on resources (whether self-imposed or donor restricted). Underwater endowments have additional disclosure requirements, including the aggregate gift amount and governing board policy/actions regarding appropriation and that the underwater balance is required to be reported as “with donor restriction” versus being reported as unrestricted in the old rules. Finally, the FASB now requires the “placed in service” methodology for reporting expirations of capital restrictions versus over time as the asset is depreciated or “used.” Ultimately, these changes are meant to simplify and improve the information related to limitations on resources.
In relation to expenses, an analysis of expenses by function and nature is now required for all not-for-profit entities. Previously, this type of analysis was necessary only for voluntary health and welfare organizations. Practitioners interpret the standard to mean that the FASB is requiring this as part of the basic financial statements, whether in the front schedules or in the footnotes. In addition, the standard’s update requires the netting of direct internal and external investment expenses with investment return, versus having an option to net or report as expense in the past, and eliminates the requirement to disclose investment expenses. Finally, the update requires expanded disclosures related to the allocation methods used in preparing the statement of functional expenses. These changes should lead to better and more consistent information about expenses and the allocation of shared costs.
Aligning with the simplification of net asset classification, the enhanced disclosures surrounding operating measures and liquidity/availability are meant to provide a person reading the statements a simplified, more relevant picture of the organization, especially board appropriations, designations, or similar transfers. In essence, the organization should be able to communicate two key pieces of information:
- How does the not-for-profit manage its liquid available resources and its liquidity risk?
- How are the not-for-profit’s assets available at the financial statement date to meet cash needs for general expenditures within one year?
This enhancement recognizes that the availability of resources can be impacted by many factors, including the nature of the asset, limits imposed internally (by boards of directors) or externally (by donors, grantors, law, or contracts), and that it is essential that a reader understand any limitations.
Currently, either the direct or indirect method of cash flow reconciliation is allowed; however, the direct method requires an additional reconciliation of the change in net assets to net cash provided by operating activities. The standard’s update continues to allow for a choice in methodology but has eliminated the requirement for an additional reconciliation if the direct method is chosen.
What the Standard’s Updates Mean for Your Organization
It’s unlikely that the standard’s updates will impact any internal financial accounting processes. Instead, this is an external financial reporting update that will change your audit report. The updates will largely require you to gather information in order to present the required piece of information outlined above. If you prepare your organization’s draft audit report, it will be very important to understand the key changes to avoid missing required disclosures or schedules.
If your audit firm prepares your draft audit report, it will be imperative that you gather and provide the necessary information for disclosure and presentation. Your report is yours for a reason; you take responsibility for the information presented. Your auditors should not and cannot realistically gather all the information necessary to comply with the standard’s updates. Many audit firms have developed a tool kit for implementation. If you have not heard from your audit firm, reach out and ask whether a tool like this is available to you.
How to Tackle Implementation
Start early. This communication is a concise, high-level summary of the standard’s updates, but it is a good start. Start talking with your auditors now about what the standard’s updates will mean for your financial report. It will be critical to understand them so your organization can gather the information, draft the disclosure updates, and prepare any new schedules that are necessary.
Be diligent. Ask your auditors whether they have a tool kit that can be a starting point in guiding you through the data collection process. Perhaps your auditors have examples of disclosures or schedules that you can use. The more you do to prepare—and the earlier you do it—the lower the likelihood that your auditor will bill you extra for implementation time. Discuss early implementation if that’s something your organization is interested in.
Look for efficiencies. Your financial accounting software may already be capable of generating a report that will meet the analysis of expenses by function and natural classification, or other information that will be helpful in accomplishing the disclosure objectives.
Engage your board. Compile the additional disclosures and schedules ahead of time and present them to your audit/finance committee for review and approval ahead of time. Not only does this encourage engagement and oversight, but it contributes to the system of internal control over financial reporting, a key area that your auditors review each year.
Understand your options. You can adopt earlier than the required implementation date (December 31, 2018, basically), but there are some key points to understand. If you choose to adopt early, you must adopt all the provisions. If your financial report is comparative, you must apply all provisions to both years presented, but you can choose not to present the analysis of expenses by nature and function and the enhanced disclosures surrounding liquidity and availability of resources. One thing you may notice as you learn more about Phase I is that a lot of the updates are already-existing options in accounting principles generally accepted in the United States (GAAP). For example, presenting investment expenses netted with investment return is currently an acceptable presentation. In addition, some organizations already choose to present an analysis of expenses by function and natural classification. These examples are areas where you can “implement early” without formally choosing to implement the entire standard early. The only changes that cannot be implemented without formal adoption include:
- Changing the net asset classification.
- Changing the classification of underwater endowment net assets.
- Eliminating the disclosure of investment expenses netted with investment return.
- Eliminating the requirement to present the indirect reconciliation if the direct method of cash flow reporting is used.
Be aware of Phase II. This phase will deal with more controversial—or complex—topics, those which required more discussion and deliberation by the FASB. Some of the proposed topics in Phase II include whether to require an operating measure for not-for-profits (and how to define, if so), whether a not-for-profit should present segment information instead of expenses by nature and function, and additional cash flow clarification.