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OVERVIEW OF NOT-FOR-PROFIT ORGANIZATIONS

PERSPECTIVE AND ISSUES

Not-for-profit organizations represent a significant portion of the economy of the United States. Over one million of these organizations provide almost every conceivable type of service from education to politics, from social services to country clubs, and from religious to research organizations. The number and importance of these organizations to the overall US economy continues to grow. The Financial Accounting Standards Board (FASB) defines not-for-profit organizations by distinguishing them from profit organizations. It defines not-for-profit organizations as entities that possess the following characteristics not usually found in other organizations:

  1. They receive contributions from significant resource providers who do not expect a commensurate or proportionate monetary return.
  2. They operate for purposes other than to make a profit.
  3. There is an absence of ownership interests like those of business enterprises.

While not-for-profit organizations share many of the same accounting principles as commercial enterprises, their accounting and financial reporting are quite unique because the focus of financial reporting for not-for-profit organizations is not on the measurement of net income. Reflecting this, and other differences, the FASB has issued some pronouncements specifically affecting the accounting and financial reporting of not-for-profits. In addition, the application of the FASB's other accounting standards to not-for-profit organizations typically requires some modification for applying those standards to not-for-profit organizations because the primary focus of financial reporting for not-for-profit organizations is not on the measurement of net income or comprehensive income.

Typically, not-for-profit organizations are controlled by boards of directors composed of individuals who generally volunteer their time. The size of not-for-profit organizations varies greatly. A small not-for-profit organization may have no paid staff; all functions may be performed by a governing board and volunteers. On the other hand, some not-for-profit organizations are quite large with hundreds or even thousands of employees, such as a university, a health-related research association, or a large cultural organization such as a museum. When a small, newly formed organization becomes large enough or complex enough in operation to require it, the board may delegate either limited or broad operating responsibility to a part-time or full-time paid executive. This executive may be given any one of many alternative titles—president, executive director, administrator, manager, etc. Regardless of the size of the not-for-profit organization, the board will usually appoint one of its own part-time volunteer members as treasurer. In most cases, the treasurer is second in importance only to the chairperson of the board because the ability of the organization to carry out its programs is based on strong oversight and administration of its finances.

Every board member has a fiduciary responsibility for all of the affairs of the organization, including finances. While the treasurer may be charged with paying special attention to this area, this does not excuse any board member from exercising diligent oversight in the finance, as well as all other areas of operation. The governing board's involvement with setting appropriate levels of executive compensation is an area that has come under closer public and regulatory scrutiny in recent years, and is an important area for consideration in fulfilling these fiduciary responsibilities.

The treasurer has significant responsibilities, including the following:

  1. Keeping financial records;
  2. Preparing accurate and meaningful financial statements;
  3. Budgeting and anticipating financial problems;
  4. Safeguarding and managing the organization's financial assets;
  5. Complying with federal and state reporting requirements.

While this list certainly is not all-inclusive, most of the financial problems the treasurer will face are associated with these five major areas.

In the public company commercial accounting environment, the role of the board of directors (including board members who are part of an organization's audit committee) has been under close scrutiny. This scrutiny has a number of different causes, but certainly the inappropriate (or perceived inappropriate) application of accounting principles by a number of these public companies can be described as one of the more important factors leading to this scrutiny.

While the circumstances receiving public attention relate primarily to public companies, not-for-profit organizations are not immune to the misapplication of accounting principles. Boards of directors, management, and independent auditors of not-for-profit organizations must be vigilant to ensure that accounting principles used are appropriate and are appropriately applied. In addition to meeting the “letter of the law” as found in various accounting standards, not-for-profit organizations must ensure that the application of generally accepted accounting principles to their financial statements results in statements that truly do present fairly the activities and financial position of the organization. Further, some states have enacted legislation that defines certain responsibilities for boards of directors, including audit committees, covering areas such as the relationship with independent auditors, conflicts of interest policies, and other governance matters.

Not-for-profit organizations that are large enough to be required by the laws and regulations of the state in which they are located to have their financial statements audited each year (or in some cases compiled or reviewed) are increasingly establishing audit committees to oversee this obligation. Generally the audit committee members represent a subgroup of the members of the board of directors, although sometimes nonboard members are invited to join audit committees. States are becoming increasingly active in requiring not-for-profit organizations to comply with prescribed governance requirements. These requirements can impact board and audit committee functions and composition. Some states have established specific requirements for establishing audit committees, including specific requirements on their membership and duties.

Audit committees generally concern themselves with ensuring the integrity of the financial reporting process of the not-for-profit organization by understanding and overseeing the organization's internal control, internal audit function (if any), financial reporting process, engaging the independent certified public accountant that will audit the financial statements, as well as reviewing the annual Form 990 filed with the Internal Revenue Service. Audit committees should have a direct relationship with the independent certified public accountant in terms of planning the audit, reviewing the results of the audit, and addressing how the not-for-profit organization responds to any recommendations that the independent auditor makes as a by product of the audit.

Key Differences between Not-for-Profit and Profit Organizations

One of the principal differences between not-for-profit and profit organizations is that they have different reasons for their existence. In oversimplified terms, it might be said that the ultimate objective of a commercial organization is to realize net profits for its owners through the provision of some product or performance of some service wanted by other people, whereas the ultimate objective of a not-for-profit organization is to meet some socially desirable need of the community or its members.

Like any organization, a not-for-profit organization should have sufficient resources to carry out its objectives. However, there is no real need or justification for “making a profit” (having an excess of revenue over expenses for a year) or having an excess of assets over liabilities at the end of a year beyond that which is needed to provide a reasonable cushion or reserve against a rainy day or to be able to take advantage of an unexpected opportunity. While a prudent board of a not-for-profit organization should plan to provide for the future, the principal objective of the board is to ensure fulfillment of the programmatic functions for which the organization was founded. A surplus or profit, per se, is only incidental. That said, larger not-for-profit organizations sometimes borrow funds, and often the lender imposes certain financial criteria as a condition for the loan (usually called debt covenants), which can make attention to reported results important.

Instead of profit, many not-for-profit organizations are concerned with the size of their cash and investment balances. They can continue to exist only so long as they have sufficient cash resources to provide for their programs. Thus the financial statements of not-for-profit organizations often emphasize the liquid financial resources of the organization. Commercial organizations are also very much concerned with cash, but if they are profitable they will probably be able to finance their cash needs through loans or from investors. Their principal concern is profitability and this means that commercial accounting emphasizes the matching of revenues and costs.

The nature of most not-for-profit organizations’ operations is that they receive most of their revenues from contributions (rather than receiving fees for services). This means of receiving revenues gives a not-for-profit organization an important fiduciary responsibility for the funds that it receives. This responsibility is why donors to a not-for-profit organization are significant users of the financial statements of not-for-profit organizations.

Somewhat conceptually in between a simple donation and selling a can of paint in the above example, are fee-for-service activities that not-for-profit organizations sometimes perform for governmental entities, often in the social services area. These services may include providing care for the developmentally disabled, educational services, or perhaps temporary housing. While the not-for-profit organization may be receiving a payment based on the number of clients served (a fee-for-service activity), it is almost always the case that the governmental grant or contract provider will have specific requirements that must be adhered to with respect to the use of funds, how those funds are “earned,” and to the potential disallowances of costs upon audit by the government grantor or contractor.

Not-for-profit organizations also usually have a responsibility to account for specific funds that they have received. This responsibility includes accounting for certain specific funds that have been given for use in a particular project, for a particular constituency, or for a specified period of time. In some cases, donors provide not-for-profit organizations with resources in the form of an endowment, in which the not-for-profit organization must maintain the principal or corpus of the gift in perpetuity and only use the investment earnings in support of its programs. Emphasis must also be placed on accountability and stewardship of these specific types of resources in addition to the general fiduciary aspects discussed above.

In commercial or business enterprises, there is no such thing as a “pledge” or a contribution for something other than obtaining an ownership interest. If the business is legally owed money, that amount is recorded as an account receivable. A pledge to a not-for-profit organization may or may not be legally enforceable, or even if technically enforceable, the organization may (for public relations reasons) have a policy of not taking legal action to attempt to enforce unpaid pledges because they know from experience that they will not collect them. This represents another accounting and financial reporting challenge for not-for-profit organizations.

Resource Use Consideration

The fundamental purposes for the existence of not-for-profit organizations have a significant impact on how these organizations use their available resources and compete for new resources in the marketplace. Not-for-profit organizations often struggle to find resources to support their administrative functions because there is always a preference to spend their resources on program activities. For example, in a competitive labor market, not-for-profit organizations may find it difficult to allocate resources to attract and retain the necessary talent needed to effectively manage their operations. There are no stock option plans or performance share programs that are available to commercial enterprises to compensate a not-for-profit organization's staff. In addition, application of new technology is costly to implement and yet, in many cases, essential for existence. These factors may create a resource gap between not-for-profit organizations and commercial enterprises, particularly with smaller not-for-profit organizations.

Generally Accepted Accounting Principles

The purpose of this book is to provide the reader with information about how generally accepted accounting principles apply to not-for-profit organizations. In addition, other information related to financial activities of not-for-profit organizations is included for the reader's use, including discussions of budgeting, fund accounting, and federal tax compliance.

The FASB Accounting Standards Codification (the Codification) is the source of authoritative United States generally accepted accounting principles recognized by the FASB to be applied to nongovernmental entities, including not-for-profit organizations. All previously existing accounting and financial reporting standards (other than those promulgated by the United States Securities and Exchange Commission for public entities) were superseded. Any nongrandfathered (discussed below) non-SEC accounting literature not included in the FASB ASC is not considered authoritative. The Codification does contain in its SEC Sections authoritative content of the SEC related to the basic financial statements. Note that the issuance of the Codification did not change any of the requirements of previously existing GAAP. It does rearrange and organize the standards to make them more available and to give the indicated standards the same level of authority in the GAAP hierarchy. Since its issuance, the Codification has been updated by Accounting Standards Updates (ASUs), which are issued periodically each year.

The Codification provides that if the guidance for a transaction or event is not specified within a source of authoritative GAAP for an entity, that entity should first consider accounting principles for similar transactions or events within a source of authoritative GAAP for that entity and then consider nonauthoritative guidance from other sources. Examples of the sources of nonauthoritative accounting guidance are provided as follows:

  • Practices that are widely recognized and prevalent either generally or in the industry;
  • FASB Concepts Statements;
  • AICPA Issues Papers;
  • International Financial Reporting Standards of the International Accounting Standards Board;
  • Pronouncements of professional associations or regulatory agencies;
  • Technical Information Service Inquiries and Replies included in AICPA Technical Practice Aids;
  • Accounting textbooks, handbooks, and articles.

Of course, the appropriateness of the other sources of accounting guidance depends on its relevance to particular circumstances, the specificity of the guidance, the general recognition of the issuer or author as an authority, and the extent of its use in practice.

The FASB issued ASU 2013-12, Definition of a Public Business Entity — an Addition to the Master Glossary. The FASB's primary purpose in issuing ASU 2013-12 was to specify which entities would be within the scope of its Private Company Decision-Making Framework: A Guide for Evaluating Financial Accounting and Reporting for Private Companies (the Guide). The Guide provides a context in which the FASB began issuing certain ASUs in 2014 meant to simplify certain accounting and financial reporting requirements for private companies. In addition, the FASB has increasingly been distinguishing between public and nonpublic entities when establishing accounting and financial reporting standards, as well as when those standards become effective. However, no single definition of a public business entity was contained in the Codification's Master Glossary.

ASU 2013-12 d specifies that:

  1. An entity that is required by the SEC to file or furnish financial statements with the SEC, or does file or furnish financial statements with the SEC, is considered a public business entity.
  2. A consolidated subsidiary of a public company is not considered a public business entity for purposes of its standalone financial statements other than those included in an SEC filing by its parent or by other registrants or those that are issuers and are required to file or furnish financial statements with the SEC.
  3. A business entity that has securities that are not subject to contractual restrictions on transfer and that is by law, contract, or regulation required to prepare US GAAP financial statements (including footnotes) and make them publicly available on a periodic basis is considered a public business entity.

ASU 2013-12 notes that generally, most not-for-profit organizations have received the same financial accounting and reporting alternatives within US GAAP that have been available to nonpublic business entities. Distinctions about which not-for-profit organizations would receive financial accounting and reporting alternatives within US GAAP typically have been made on the basis of whether the not-for-profit organization has public debt securities, including conduit debt.

ASU 2013-12 specifically excludes all not-for-profit organizations from the definition of public business entity so that a public versus nonpublic distinction will no longer be made between not-for-profit organizations in future standard setting. Instead, the FASB will consider factors such as user needs and not-for-profit organizations, resources, on a standard-by-standard basis, when determining whether all, none, or only some not-for-profit organizations will be eligible to apply financial accounting and reporting alternatives within GAAP for private companies. All employee benefit plans are also excluded from the definition of public business entity in a manner similar to not-for-profit organizations as described above.

This can be summarized as follows: Not-for-profit organizations are not included in the new definition of public business entities; however, they cannot use the private company framework accounting standards unless the FASB specifically says they can in each ASU that is issued.

Also of note is that prior definitions of public entities in existing standards are still applicable to those standards. Hence, not-for-profit organizations previously subject to a requirement because they were considered public entities (usually because they were conduit debt obligors) are still subject to those requirements. The new definition is not retroactive.

The main provisions of ASU 2016-14 are as follows:

  1. The statement of financial position would report amounts for two classes of net assets at the end of the period—net assets with donor restrictions and net assets without donor restrictions, rather than for the currently required three classes. The statement of activities would report the amount of the change in each of the two classes of net assets rather than that of the currently required three classes.
  2. The statement of cash flows would continue to be permitted to be prepared on either the direct or indirect methods. To encourage use of the direct method, the reconciliation of the indirect method would no longer be required when the direct method is used.
  3. Provide enhanced disclosures about the following:
    1. Governing board designations, appropriations, and similar transfers that result in the addition or removal of self-imposed limits on the use of resources without donor-imposed restrictions.
    2. Composition of net assets with donor restrictions at the end of the period and how the restrictions affect the use of resources.
    3. Qualitative information about how the organization manages its liquidity. In addition, quantitative information about financial assets available to meet cash needs for general expenditures within one year of the balance sheet date. ASU 2016-14 notes that the availability of a financial asset may be affected by (1) its nature; (2) external limits imposed by donors, grantors, laws, and contracts with others; and (3) internal limits imposed by governing board decisions.
    4. Expenses, including amounts for operating expenses by both their nature and function. That information could be provided on the face of the statement of activities, as a separate statement, or in notes to financial statements.
    5. Method(s) used to allocate costs among program and support functions.
    6. Underwater endowment funds, which are donor-restricted endowment funds for which the fair value of the fund is less than either the original gift amount or the amount required to be maintained by the donor or law. In addition to disclosing the currently required aggregate amount by which funds are underwater, a not-for-profit organization would be required to disclose the aggregate of the original gift amounts (or level required by donor or law) for such funds and any governing board policies or decisions to spend or not spend from such funds. In addition, a not-for-profit organization would classify the amount by which the endowment is underwater in net assets with donor restrictions rather than in the current unrestricted net asset category.
  4. In the absence of explicit donor stipulations, use the placed-in-service approach for reporting expirations of restrictions on gifts of cash or other assets to be used to acquire or construct a long-lived asset, thus eliminating the option to release the donor-imposed restriction over the estimated useful life of the acquired asset.
  5. Report investment income net of external and direct internal investment expenses, and no longer require disclosure of those netted expenses.

ASU 2016-14 is effective for annual financial statements issued for fiscal years beginning after December 15, 2017, with early application permitted.

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