Implementation Considerations Under FASB ASU 2016-14, Presentation of Financial Statements of Not-for-Profit Entities
In an effort to improve information presented in a not-for-profit entity’s financial statements regarding liquidity, financial performance and cash flows, and to provide more useful information to users of not-for-profit financial statements, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-14, Presentation of Financial Statements of Not-for-Profit Entities, on August 18, 2016. With the intention of updating, not overhauling, the current not-for-profit financial statement model, the new standard includes qualitative and quantitative requirements in the following areas: (1) net asset classes; (2) investment return; (3) expenses; (4) liquidity and availability of resources; and (5) presentation of operating cash flows. ASU 2016-14 will be effective for fiscal years beginning after December 15, 2017, with early adoption permitted. Accordingly, ASU 2016-14 is effective in 2018 for not-for-profits with December 31 year-ends and in 2019 for not-for-profits with all other year-ends.
ASU 2016-14 is the first significant update to the not-for-profit financial statement reporting model in more than 20 years. Therefore, it will require a change in mindset as preparers of not-for-profit financial statements begin to implement this standard. Below are some practical considerations for implementation.
Net Asset Classes
Changes required by ASU 2016-14 in this area impact net asset classifications, board-designated net assets and underwater endowments.
Under accounting principles generally accepted in the United States of America (U.S. GAAP), not-for-profits currently classify their net assets into three categories: unrestricted, temporarily restricted and permanently restricted. Under ASU 2016-14, unrestricted net assets are renamed “net assets without donor restriction,” while temporarily restricted and permanently restricted net assets are combined to become “net assets with donor restriction.” When an organization adopts the new standard it should consider changing the descriptions in its general ledger to conform to this new terminology.
While information regarding board-designated net assets previously only had to be included in the endowment note disclosure, under ASU 2016-14 not-for-profits are required to enhance disclosures to include the nature and amounts of board-designated net assets. This period prior to adoption would be a good time for the entity to review the existing board-designated funds and evaluate their purpose based on the current environment of the entity, as well as whether they are still consistent with the not-for-profit’s mission. Reallocation or designation can be done prior to the standard taking effect. As a measure of good governance, entities should develop policies and procedures relating to the management of the board designated funds (e.g., their creation, future funding, disbursement and dissolution).
ASU 2016-14 provides a much-needed formal definition of “underwater endowment funds” as “a donor restricted endowment fund for which the fair value of the fund at the reporting date is less than either the original gift or the amount required to be maintained by the donor or by law that extends donor restrictions.” In addition to disclosing the total amount of underwater funds required by the current standard, the new standard requires an entity to disclose the total amount of the original gifts, the fair value and its policy concerning appropriation from underwater endowment funds. While all not-for-profits with endowments should already have an endowment investment and management policy, not all not-for-profits with endowments currently have an underwater endowment appropriation policy. Therefore, entities with endowments should consider developing such a policy, if one does not exist, prior to the implementation of ASU 2016-14.
Under current U.S. GAAP, there is diversity in practice regarding the presentation of investment expenses within the financial statements. ASU 2016-14 formalizes the presentation of investment expenses by requiring investment return to be presented net of investment expenses. In addition to external investment-related expenses, direct internal investment-related expenses should also be netted against investment return. Direct internal investment expenses represent the direct conduct or direct supervision of the strategic and tactical activities involved in generating investment return. These include expenses, such as compensation, of officers and staff responsible for the development and execution of investment strategy and allocable costs associated with internal investment management, such as supervising, selecting and monitoring external investment management firms. This does not include the salaries of personnel responsible for the bookkeeping of investment activity. While the change in net assets would not be affected by the new standard, total revenues and total expenses could both be potentially less, since direct internal investment expenses are netted against investment return and not recorded as expenses. Additionally, the FASB has indicated that expenses netted directly against investment return do not need to be included in the statement of functional expenses.
Not-for-profits should develop formal policies and procedures that specify which expenses are considered direct internal investment expenses and how these expenses will be tracked and allocated. A not-for-profit may need to consider allocating a portion of executive decision makers’ expenses (such as chief executive officer and/or chief financial officer related expenses) if they are involved in the activities noted above.
ASU 2016-14 requires all not-for-profits to provide both a quantitative and qualitative description of their functional expenses, (which is not required under current U.S. GAAP other than for voluntary health and welfare entities). The quantitative disclosure will show expenses by the most material natural expense categories (e.g., salaries, professional fees, grant expenses) and allocate these categories across the functional categories, which include program and supporting categories (e.g., management and administrative), fundraising and membership services). There is flexibility with respect to where this quantitative disclosure will appear: It can be shown with the Statement of Activities, the not-for-profit could choose to include a full Statement of Functional Expenses (which many do already), or it can be included as a note disclosure. Additionally, all not-for-profits will need to disclose a description of the methodology used to perform the allocations. The FASB continues to provide for flexibility in the methodology employed in allocating expenses, such as using salary hours or square footage to allocate costs including overhead or depreciation. If a not-for-profit’s allocation policies are informal or absent, or possibly controversial, the not-for-profit should start developing and formalizing allocation methods and policies or revising its current policies, before they have to be disclosed to users of their financial statements.
Presentation of Operating Cash Flows
Under both current U.S. GAAP and the new standard, an entity can choose to present its cash flows from operations using either the direct or indirect method. Currently, an entity that chooses to use the direct method of presenting operating cash flows must also include an indirect method reconciliation, something that many view as redundant. Because current U.S. GAAP requires the inclusion of an indirect method presentation under both methods, and because the indirect method of presenting operating cash flows is generally easier to prepare, the indirect method is the most prevalent method currently utilized within the sector. Should an organization choose to switch to the direct method once ASU 2016-14 becomes effective, it would involve the identification of the specific sources and uses of cash within operations and, accordingly, we recommend that clients consider restructuring the chart of accounts to help make such information more easily identifiable.
Liquidity and Availability of Resources
ASU 2016-14 adds a new requirement to show a not-for-profit’s liquidity both quantitatively and qualitatively. This is accomplished quantitatively by disclosing, either on the statement of financial position or in the footnotes, a not-for-profit’s financial assets that are available for general expenditure within one year of the year-end date of the financial statements. The new standard also requires a not-for-profit to disclose qualitative information on how the not-for-profit manages its liquid available resources and its liquidity risks.
After identifying the liquid assets, the not-for-profit then drills down on donor restrictions, covenants, and so forth to arrive at the balance that is available to be spent on general operations within 12 months from the year-end date. We recommend that this analysis happen earlier than adoption so that an organization can familiarize itself with the process and understand the impact of factors, such as a board-designated endowment, that may have on this disclosure.
The guidance suggests that to satisfy the qualitative disclosure, a not-for-profit can describe its policy to reinvest a portion of its annual investment return or describe a cash reserve that was put in place by the board. Those are just two possible disclosures that would satisfy this requirement. In preparing for this new disclosure, we recommend that a not-for-profit consider establishing a formal policy to manage its liquidity, sometimes known as a cash management policy. If the not-for-profit has such a policy, it should consider reviewing and revising it to ensure that the policy disclosed in the notes to the financial statements – and viewed by users of the financial statements – is in line with the its mission.
Implementation of ASU 2016-14 will require additional efforts on the part of management and the not-for-profit’s board to prepare for and comply with the standard. At a minimum, it will require not-for-profits to possibly revise or develop certain policies and procedures. However, once implemented, FASB’s goal is that each not-for-profit’s financial statements will paint a more transparent picture of the organization to its financial statement users. We look forward to partnering with our clients as they prepare for adoption and offer ourselves as a resource for questions and guidance.