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Corey Kennedy |
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September 2008 Four Key Concepts in Not-for-Profit Accounting If NPO managers and directors understand four important concepts, they will be much better positioned to benefit from and comply with the required accounting standards Some of the most complex accounting rules apply to not-for-profit organizations (NPOs). Unfortunately, complying with those rules generally requires internal expertise that few NPOs can afford. If NPO managers and directors understand four important concepts, they will be much better positioned to benefit from and comply with the required accounting standards. The four concepts are:
Revenues: Contributions vs. Exchange Transactions This principle is the foundation of many of the NPO accounting requirements. NPOs generally receive revenues from a variety of sources. Those revenues are broadly classified into two basic categories: contributions and exchange transactions. These two types of revenues are fundamentally different, as are the accounting requirements for each.
Because there is no “earning process” associated with contributions, they should be recognized as revenue when they are received. This includes unconditional promises to give, where a donor promises a specific contribution in the future. As such, the concept of deferred (or unearned) revenue does not pertain to contributions. Accounting standards call for contributions to be measured at fair value, which is easy for a cash donation, but gets a little more involved when the contribution is a 1976 Camaro. Exchange transactions should be recorded as revenue when they are earned. In the above example of purchasing a putter, the earnings process was complete when I took possession of the putter, and XYZ Foundation could recognize the revenue at that point. However, if I paid for the putter but it was not delivered to me for a month, XYZ Foundation must wait until delivery to recognize revenue, resulting in a deferred revenue liability. In the examples above the distinction between contribution and exchange transaction was clear. However, in many cases the distinction is less clear and judgment is required. Complicating the matter further is that some words are used imprecisely, potentially leading to confusion. One example of this is the word “grant.” To some, a grant always means a contribution. To others, a grant is by definition an exchange transaction. In distinguishing between contributions and exchange transactions, names are less important than the substance of the transaction. The facts and circumstances of each situation must be considered. Finally, a transaction can have elements of both a contribution and an exchange transaction. In these cases, the transaction is split into two pieces and accounted for according to the substance of each piece. For example, if I paid $200 for the $50 putter, then the NPO has received $50 as an exchange transaction and $150 as a contribution. In-Kind Contributions One often overlooked type of contribution is an in-kind contribution. Common examples of in-kind contributions include donated rent, utilities, materials, and services such as advertising. Donated assets such as cars or equipment are also considered gifts in-kind. In some situations, NPOs are granted a discount for the purchase of certain items. The excess of the fair value over the amount paid is also considered a contribution. As with any contribution, these transactions should be recorded at fair value, requiring an estimate in many cases. The fair value of the contributions should be recorded as revenue with an equal amount of expense, resulting in no impact on the bottom line. However, for donated assets, the offset to revenue would be an asset rather than an expense. Recognizing in-kind contributions paints a more complete picture of the activities of the NPO and the resources used to accomplish its mission. Donor Restrictions and Restricted Net Assets The NPO accounting concept donor restrictions has given rise to some confusion. Under the GAAP definition of “restricted,” only contributions can be restricted (thus, revenue from exchange transactions can never be restricted). As an example, my $50 check to purchase the putter in the example above would not be considered restricted because it was not a contribution. Only donors can restrict the use of their contribution. The board of directors of an NPO may choose to designate some of an NPO’s net assets for certain purposes, but that is not a restriction. A contribution is considered to be restricted if the donor stipulates that the contribution be used for a purpose that is more specific than the NPO’s overall mission. For example, a museum donor who requests that her contribution be used to support the purchase of a specific exhibit has placed a temporary restriction on the contribution. When the specific exhibit is purchased, the restriction is fulfilled. Donors can also place permanent time restrictions on contributions. Contributions receivable are generally considered to have an implied time restriction since the money cannot be used until it is given to the NPO. In understanding donor restrictions, it is also important to recognize the distinction between assets and net assets.
Examples of assets include cash, receivables, and
property and equipment. “Net assets” is the NPO equivalent of equity – it is the
result of deducting liabilities from assets. Donor-restricted contributions
always result in an addition to either temporarily or permanently restricted net
assets, but they may or may not result in restricted assets. When restrictions
are fulfilled, the restricted amount is reclassified from restricted net assets
into unrestricted net assets. Functional Classification of Expenses NPOs are required to show their expenses according to functional categories, either on the face of the financial statements or in the notes. Functional categories such as program services, management and general, fundraising, and membership development show why the money was spent. Natural categories such as salaries, rent, or utilities show what the money was spent for, but give no indication of the purpose for which it was spent. Some expenses clearly pertain to only one functional category. For example, the cost of printing a fundraising brochure is clearly a fundraising cost. However, many expenses benefit more than one function. In these cases, the expense is allocated to the various functions. The executive director’s salary is a good example; the NPO would need to estimate the amount of time spent by the executive director on various functions. The challenge with reporting expenses according to functional categories is that many NPOs – especially smaller ones – track expenses in their accounting software only according to natural categories. In these cases, allocating the expenses according to functional categories may become a time-consuming manual process. Incorporating information about both natural and functional categories in the chart of accounts can save time in preparing year-end GAAP financial statements and will provide management with better information throughout the year. NPOs that derive their revenue primarily from voluntary contributions from the general public (which excludes governmental entities) are required to present a statement of functional expenses as one of the basic financial statements. This statement is in a matrix format that typically shows functional categories across the top as columns and natural categories down the side as rows. Conclusion. In addition to the concepts discussed here, there are many other accounting issues that are unique to NPOs. However, understanding these four principles will go a long way toward taking the mystery out of GAAP financial statements. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |