A Complicated Set of Class Financial Statements

There are two principal financial statements that most readers want to see. Most important is a statement of functional expenses, which provides information on expenses in their functional and natural classifications and, of lesser importance, the statement of financial position. If all transactions have been skillfully summarized on these two statements, it is then possible to provide a third schedule that shows the appropriate detail of the information on the two primary statements. The key to successful presentation in this third schedule is showing totals that tie back into the statement of functional expenses.

The J. W. M. Diabetes Research Institute financial statements are a good example of how substantial detail can be provided on “name” funds without detracting from the reader's overall understanding of the results of operations. While these statements relate to a medical service and research institute, the form would essentially be the same for almost any type of organization. Exhibits 1, 2, and 3 show these statements.

Revenue and Expense Recognition

GAAP provides guidelines for recognizing revenues and expenses during interim periods.

1. Revenue should be recognized during interim periods on the same basis as followed for the full year. A contribution should be recognized in the interim period in which it is received, even if it funds activities in subsequent interim periods of the year.
2. Adjustments should not be made to annualize seasonal revenue.
3. Expenses directly associated with revenue, such as material costs, wages and salaries, and fringe benefits, should be reported in the same period that the related revenue is recognized. Not-for-profit organizations often have contracts that provide for reimbursement of costs. Such contracts would fall into this category.
4. Costs and expenses (except any product costs that would be treated as inventory) should be charged in the interim period in which they are incurred or be allocated among interim periods based on the best estimate of the costs applicable to the interim period. Procedures adopted for assigning specific cost and expense items to an interim period should be consistent with the basis used to report the annual change in net assets.
5. Gains and losses should be recognized in the interim period in which they arise and not be deferred to later interim periods within the same fiscal year.
6. Costs and expenses incurred in an interim period that cannot be readily identified with the activities or benefits of other interim periods should be charged to the interim period in which they are incurred. However, such costs should not be arbitrarily assigned to an interim period.
7. The precise amounts of certain costs and expenses, such as depreciation, employee benefit plan contributions, and year-end bonuses, may not be known until the end of the year. Usually, however, these costs can be reasonably estimated during interim periods. Such adjustments should be estimated and the estimated costs and expenses assigned to interim periods so that the interim periods bear a reasonable portion of the anticipated annual amount.
8. Material unusual or infrequently occurring items and gains and losses on disposal of a segment of a business should be recognized in the interim period in which they occur and not prorated over the full fiscal year. Materiality consolidation should be based on the full fiscal year.
9. Changes in accounting estimates should be accounted for in (1) the period of change if the change affects that period only or (2) the period of change and future periods if the change affects both, as provided in FASB ASC 250-1. A change in accounting estimate should not be accounted for by restating or retrospectively adjusting amounts reported in financial statements of prior periods or by reporting pro forma amounts for prior periods.
10. Changes in accounting principles made in an interim period should be reported by retrospective application as provided in FASB ASC 250-1. However, the impracticability exception may not be applied to prechange interim periods of the fiscal year in which the change is made. When retroactive application to prechange interim periods is impractical, the desired change may only be made as of the beginning of a subsequent fiscal year. Additional descriptive information about these requirements is provided in Chapter 27.

Inventories

While most not-for-profit organizations do not have significant manufacturing or retailing operations that result in complex inventory accounting issues, for those organizations that do, the guidance of FASB ASC 270 is provided below. The principles used to determine ending inventory and cost of goods sold in annual reports are used in interim reports, although GAAP provides that the following modifications to inventory accounting principles may be appropriate in interim periods:

1. The gross profit method may be used to estimate cost of goods sold and ending inventory. Because physical inventories usually are not taken at interim dates, many organizations use the gross profit method to estimate inventory and cost of goods sold or other expense in interim periods. Not-for-profit organizations that use the gross profit method during interim periods when this method differs from the method used in a prior interim period or at year-end must provide the necessary adjustments to reconcile with the annual physical inventory.
2. When LIFO layers are liquidated during the interim period but are expected to be replaced by year-end, organizations should not include the effect of such temporary liquidations in their interim period financial statements. Instead, cost of sales or other expense should reflect the expected cost of replacing the liquidated LIFO layer and should reflect an invasion of a LIFO layer. However, not-for-profit organizations would rarely be users of the LIFO method of inventory accounting.
3. Temporary market declines in inventory prices do not need to be recognized if substantial evidence exists that market prices will recover before year-end. Thus, if LCM losses recorded in one interim period are recovered by year-end, the cost of goods sold should simply reflect current costs.
4. Where a standard cost system is used, planned standard cost variances expected to be offset by year-end should not be recognized during interim periods, but should be deferred until year-end. However, unanticipated purchase price or volume variances from standards should be reported in interim financial statements. Again, not-for-profit organizations rarely are heavy users of standard cost systems.

Other Costs and Expenses

Most other costs and expenses are recognized in interim periods as incurred. However, an expenditure that clearly benefits more than one interim period (e.g., annual repairs or property taxes) may be allocated among the periods benefited. The allocation is to be based on estimates of time expired, benefit received, or activity related to the periods. Such allocation procedures should be consistent with those used by the firm at year-end reporting dates. However, if cost or expense cannot be readily associated with other interim periods, such costs should not be arbitrarily assigned to those periods. Application of these interim reporting expense principles is illustrated in the examples below.

1. Costs expensed at year-end dates that benefit two or more interim periods (e.g., annual major repairs) should be assigned to interim periods through use of deferrals or accruals.
2. Quantity discounts given to customers based on annual sales volume should be apportioned to interim periods on the basis of sales to customers during the interim period relative to estimated annual sales.
3. Property taxes (and like costs) may be deferred or accrued at a year-end date to reflect a full year's charge to operations. Charges to interim periods should follow similar procedures.
4. Advertising costs may be deferred to subsequent interim periods within the same fiscal year if such costs clearly benefit the later interim periods. Advertising costs may be accrued and charged to interim periods preceding the time the service is received if there is an advertising program clearly implicit in the sales arrangement.
5. For cost-reimbursable contracts, appropriate matching of revenues and costs should be made for interim periods.

Costs and expenses subject to year-end adjustment, such as uncollectible pledges receivable, should be estimated and assigned to interim periods in a reasonable manner.

Unrelated Business Income Taxes

At each interim date, the organization should make its best estimate of the effective tax rate expected for the full fiscal year that relates to any unrelated business income that it earns during the year. This estimate should reflect expected federal and state tax rates, tax credits, and other tax-planning techniques. However, changes in tax legislation are reflected only in interim periods after the effective date of the legislation.

The tax effect of losses in early quarters of the year should be recognized only when such losses can be carried back, or when the realization of the carryforward is reasonably assured. In the absence of contrary evidence, an established seasonal pattern of early-year losses offset by income later in the year constitutes reasonable assurance.

Discontinued Operations

The effects of disposal of a segment should be reported separately in the interim period in which they occur. The same treatment is given to other unusual or infrequently occurring events. No attempt should be made to allocate such items over the entire fiscal year. Materiality is determined by relating the item to the annual results of operations.

Accounting Changes

Retroactive changes in accounting principle are handled on the same basis as in annual reports. Previously issued interim financial statements are retroactively restated.

Contingent Items

In general, contingencies at an interim date should be accrued or disclosed in the same manner required for annual reports. The materiality of the contingency should be evaluated in relation to the expected annual results.

Certain items that are adjustments related to prior interim periods, such as a settlement of litigation, are accorded special treatment in interim reports. If such items are material, directly related to prior interim periods of the current fiscal year, and become reasonably estimable in the current interim period, they should be reported as follows:

1. The portion directly related to the current interim period is included in that period's income.
2. Prior interim periods are restated to reflect the portions directly related to those periods.
3. The portion directly related to prior years is recognized in the restated first-quarter income of the current year.

Seasonality

The operations of many not-for-profit organizations are subject to significant seasonal variations. Such organizations should disclose the seasonality of their activities to avoid the possibility of misleading interim reports. GAAP also suggests that such organizations supplement their disclosures with information for twelve-month periods ending at the interim date of the current and preceding year. Many not-for-profit organizations receive significant amounts of contributions in December of each calendar year. This seasonal variance may be an appropriate disclosure in the interim financial reports that include this month.

Fourth-Quarter Adjustments

When the fourth-quarter results are not separately reported, material year-end adjustments as well as disposals of segments, extraordinary items, and unusual or infrequently occurring items for the quarter should be disclosed in a footnote to the annual report.

Definition

The ASC Master Glossary defines subsequent events as:

Events or transactions that occur after the balance sheet date but before financial statements are issued or are available to be issued. There are two types of subsequent events:

1. The first type consists of events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements (that is, recognized subsequent events).
2. The second type consists of events that provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date (that is, nonrecognized subsequent events).

There are two often-used examples (modified for the not-for-profit environment) that demonstrate these concepts.

• Recognized subsequent event—A not-for-profit organization has a past-due pledge receivable from a donor outstanding at its year-end, June 30. While the donor has been known to be having financial difficulties, the not-for-profit organization has believed that there was a good chance the donor would overcome the financial difficulties in the future and pay the pledge receivable, hence no allowance for uncollectibility was set up for this receivable. On July 15 (after year-end, but before the financial statements are issued, or available to be issued) the donor declares bankruptcy, meaning that this pledge will never be paid. In this case, an event has occurred after year-end that has provided evidence about conditions that existed at the date of the statement of financial position. Accordingly, this subsequent event would be recognized (i.e., the pledge receivable would be written off).
• Nonrecognized subsequent event—Continuing the same fact pattern above, the same not-for-profit organization has one of the buildings that it owns destroyed by a fire that occurred on July 14. On June 30, the date of the statement of financial position, the building was perfectly fine, although as of July 14, it is now destroyed. This subsequent event would not be recorded because the condition of the building (and therefore its carrying amount) was not impacted at June 30. This subsequent event (assuming material to the financial statements) would be disclosed in the notes to the financial statements, with no adjustment made to the carrying amount of the building.

For nonrecognized subsequent events, GAAP (ASC 855-10-50-2) provides that some such subsequent events may be of such a nature that they must be disclosed to keep the financial statements from being misleading. For such events, the not-for-profit organization shall disclose the following:

1. The nature of the event.
2. An estimate of its financial effect, or a statement that such an estimate cannot be made.

This basic concept has existed in financial reporting for a long period of time, although its requirements were moved fairly recently from the auditing literature to an FASB Statement, which is now included in the ASC. As part of including these requirements in the accounting literature (FASB ASC 855), two additional requirements were included:

• The concept of whether the evaluation of subsequent events is performed through the date that financial statements are issued or available to be issued.
• Financial statements must disclose the date through which management evaluated subsequent events, and whether that date is the date the financial statements are issued or available to be issued.

The ASC Master Glossary defines issued and available to be issued as follows:

Issued—Financial statements are considered issued when they are widely distributed to shareholders and other financial statement users for general use and reliance in a form and format that complies with GAAP.

Available to be issued—Financial statements are considered available to be issued when they are complete in a form and format that complies with GAAP and all approvals necessary for issuance have been obtained, for example, from management, the board of directors, and/or significant shareholders. The process involved in creating and distributing the financial statements will vary depending on an entity's management and corporate governance structure as well as statutory and regulatory requirements.

The FASB issued ASU 2010-9, Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements, which provides that an entity that is either:

1. An SEC filer or
2. A conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets)

is required to evaluate subsequent events through the date that the financial statements are issued.

If an entity meets neither of these two criteria, then it should evaluate subsequent events through the date the financial statements are available to be issued.

As a result of ASU 2010-9, most not-for-profit organizations will be required to use the date that the financial statements are available to be issued as the date through which management discloses it has evaluated subsequent events. However, not-for-profit organizations, particularly larger organizations, are often conduit debt obligors, and as described below, would be considered public entities and be required to use the issued date for evaluating subsequent events.

Public Entities

Certain FASB pronouncements have specific requirements or implementation deadlines that apply specifically to “public entities.” Some not-for-profit organizations may fail to realize that this term, as defined by the FASB, is not synonymous with publicly traded SEC reporting entities. In fact, more than a few not-for-profit organizations are considered public entities under the FASB definition because they are obligated for “conduit debt,” which is discussed next.

The FASB definition of a “public entity” is contained in the ASC Master Glossary and is defined as an entity that meets any of the following conditions:

1. Its debt or equity securities trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally.
2. It is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).
3. It files with a regulatory agency in preparation for the sale of any class of debt or equity securities in a public market.
4. It is required to file or furnish financial statements with the SEC.
5. It is controlled by an entity covered by criteria a through d.

Not-for-profit organizations are sometimes “conduit debt obligors” as discussed below, which would mean that they would meet the definition of public entity as to the application of FASB standards. Also be aware that an entity that is controlled by a not-for-profit organization that is a public entity would also be considered a public entity under item e above.

Conduit Debt Obligors

Many not-for-profit organizations (particularly colleges and universities) frequently avail themselves of financing through conduit debt securities. As explained in the ASC Master Glossary, conduit debt securities refer to certain limited-obligation revenue bonds, certificates of participation, or similar debt instruments issued by a state or local governmental entity for the express purpose of providing financing for a specific third party (the conduit bond obligor) that is not a part of the state or local government's financial reporting entity. Although conduit debt securities bear the name of the governmental entity that issues them, the governmental entity often has no obligation for such debt beyond the resources provided by a lease or loan agreement with the third party on whose behalf the securities are issued. Further, the conduit bond obligor is responsible for any future financial reporting requirements. Additional discussion of conduit debt is provided in Chapter 10 of the AICPA not-for-profit audit and accounting guide.

For not-for-profit organizations that are conduit debt obligors and use the date through which financial statements are issued to evaluate subsequent events, the definition of when financial statements are considered issued is important. Unlike an SEC filer where the issuance/filing date is clear, not-for-profit organizations typically don't have a specific requirement to distribute their financial statements on the date that they are issued. Accordingly, these not-for-profit organizations should take steps to ensure that there is at least some distribution of the financial statements (e.g., posting on a website) on the issuance date to effectively “stop the clock” on the time period for which they are responsible for evaluating subsequent events.

The FASB issued ASU 2013-12, Definition of a Public Business Entity—an Addition to the Master Glossary to, among other things, establish a single definition of “public business entity” to use within GAAP. Not-for-profit organizations are not considered by ASU 2013-12 to be public business entities. However, requirements for public entities, such as those discussed above, that existed prior to ASU 2013-12 will continue to be required for entities, including not-for-profit organizations, that met previous definitions. Accordingly, the requirements above regarding not-for-profit organizations that are conduit debt obligors regarding evaluation of subsequent events to the date of the financial statements remain in effect.