As mentioned in our series intro, in 2011 the FASB began a project to improve Not-for-Profits’ (NFPs’) financial reporting. The FASB concluded that the existing standards are sound but that it was time to determine improvements that could be made. Indeed the current not-for-profit financial reporting has held up since 1993, well over 20 years, but stakeholders expressed concern over the complexity, insufficient transparency, and limited use of certain aspects of the model. In 2015, the FASB presented its findings/improvements to the public and received significant and mixed feedback. As a result the FASB decided to divide the project into two phases – phase 2 will roll out in the future and includes items that are more controversial or tied to other FASB initiatives. This article will only cover the major Phase 1 changes at a high level: (1) net asset classification changes, (2) expense changes, (3) availability and liquidity and (4) cash flow changes.
Changes in net asset classifications
The new standard will replace the three existing categories (unrestricted, temporarily restricted and permanently restricted) with two net asset categories – net assets without donor restrictions and net assets with donor restrictions. Essentially the FASB is trying to reduce the complexity that is involved in deciphering the proper classifications under the three existing categories. Net assets without donor restrictions is replacing unrestricted net assets and net assets with donor restrictions is replacing temporarily and permanently restricted net assets.
More specific terminology
In the past, users of financial statements sometimes misinterpreted unrestricted net assets to mean that there were no contractual or legal obligations over these types of net assets, when really the meaning was that they were unrestricted in terms of donor restrictions. This misinterpretation led to incorrect conclusions over the financial statements. The terminology in the new categories is more specific and clearly states ‘donor’ within the categories.
Aligns with UPMIFA
The distinction between net assets with temporary and permanent differences became blurred when the model Uniform Prudent Management of Institutional Funds Act (UPMIFA) was approved in 2006 and subsequently adopted by most states. UPMIFA provides governance over endowment funds for NFPs. It changed the approach of how it governs endowment funds by de-emphasizing the concept of historical dollar value (original gift). By doing this, UPMIFA changed its focus from the prudent spending of the appreciated funds to the prudent spending of the entire fund (including the original gift amount). An NFP is now permitted to spend, within bounds of prudence, from an endowment fund that may have fallen below the original gift amount – referred to as an underwater fund. Thus the FASB’s decision to now combine the two restricted net asset classes into one net asset class is more in line with the changes in law resulting from UPMIFA.
Currently, when an endowment is ‘underwater’, meaning its fair value is less than the original gift amount, the losses are shown in unrestricted net assets. Under the new standard, NFPs will report the accumulated deficiency in net assets with donor restrictions. Said another way, if an NFP has an original gift of $110,000 that decreases in value to $100,000, the old standard would show $110,000 in permanently restricted net assets and ($10,000) in unrestricted net assets. Under the new standard, NFPs will just show $100,000 in net assets with donor restrictions.
- Donor-imposed restrictions are still required to be disclosed under the new standards. The disclosures will now focus on both how and when, if ever, the net assets can be used.
- Board designations of net assets without donor restrictions are required to be disclosed under the new standards. Prior to the new standard, US GAAP included specific disclosure requirements related to board-designated endowment funds. Now, the disclosures are required for all board-designated net assets.
- Underwater endowment disclosures are expanding under the new standard. Historically only the amount by which the endowment was underwater needed to be disclosed. Under the new standard the following must be disclosed: (1) amounts by which endowment funds are underwater, (2) original gift amount of the endowment funds, (3) fair value of underwater endowment funds and (4) NFPs interpretation of its ability to spend and its policy, and actions it took during the period, concerning appropriation from underwater endowment funds.
NFPs need to consider the impact that this new accounting guidance has on current loan and bond covenants and will need to proactively consult with its CPAs, bankers and bond counsel to avoid violations to existing agreements due to these changes.
The IRS Form 990 will need to incorporate FASB’s changes within its form, but this may take some time. The IRS will most likely provide instructions to tell NFPs how they can continue to use the current form to report net asset information after implementation of the standard.
Look for topic 2 in our series: Functional expense changes and cash flow statement changes!