Article by Thomas J. Sneeringer, McGladrey LLP
More rigid reporting requirements and more transparent disclosure requirements: In a nutshell, that summarizes how the FASB’s proposed changes to not-for-profit financial reporting will likely play out for nonprofit independent schools. The details are nuanced, of course, so here is our analysis of what NBOA members should expect from the final changes, which would replace guidance issued in the mid-1990s. Collectively, they may represent the most significant nonprofit accounting changes in a generation.
Background and Overview
In April, FASB (the Financial Accounting Standards Board, the governing board of financial accounting and reporting practices) proposed significant changes to how not-for-profit organizations, including nonprofit independent schools, report their financial results under generally accepted accounting principles. FASB issued the “proposed accounting standards update” (Proposed ASU) to Accounting Standards Codification (ASC) Topic 958 in April, and the comment period closed on August 20. The final ASU is expected to be released in 2016, and industry insiders believe the earliest it would take effect is the fiscal year beginning December 15, 2017, or fiscal year 2019 for most independent schools.
We recommend that independent schools monitor the process closely, as the resulting rules may require them to develop new systems for capturing and presenting financial results. Schools are also advised to educate users of their financial statement, especially lenders, on the meaning of the conveyed information, and to renegotiate or clarify debt covenants.
Net Asset Classifications: from Three Categories to Two
SFAS 117 (the original guidance issued 20 years ago) requires organizations to report net assets on the actual financial statement (not in the notes) in three categories: unrestricted, temporarily restricted and permanently restricted. The Proposed ASU would merge the two restricted categories to one, labeled “net assets with donor-imposed restrictions.” The unrestricted category, in turn, would be relabeled “net assets without donor-imposed restrictions.” FASB believes the hard-line distinction of the restricted category has been blurred with the enactment in most states of UPMIFA (Uniform Prudent Management of Institutional Funds Act), and that the notes are a better medium to distinguish donor-imposed endowment funds from time- and purposes-restricted gifts.
Also under the Proposed ASU, not-for-profit organizations would no longer need to separate the components of donor-imposed endowment funds under various classes of net assets. However, they would need to provide additional disclosures for endowment funds whose current value is below the original gift amount (i.e. “under-water”).
Operating Measures: Tighter Definitions
Under the current SFAS 117, not-for-profit organizations are not required to distinguish results of activities between operating (above the line) and non-operating (below the line) items. By the same token, they are not precluded from developing their own definitions of what they viewed as operating or non-operating. The Proposed ASU would limit this flexibility by a significant degree.
Under the proposed changes, “operating” items would be:
- revenues that are mission-related, including non-restricted contributions and released restrictions in the current period
- expenses used to meet the organization’s exempt purpose, including significant one-time expenditures
“Non-operating” revenues and expenses would be those related to investing and financing activities, including investment income and interest expense.
However, the Proposed ASU recognizes that many organizations use board designations to make available resources in a current period, or to defer resources to future periods. In such cases, financial statements would require a second sub-total of net asset change. Activity designated for the current period would appear before non-operating items and offsets. For example, if a school received a large bequest without donor restrictions in a particular year, the bequest would be considered operating income and part of the first sub-total (operating excess, before transfers). If the school’s board decided to add the bequest to the quasi endowment, it could then be shown as a reduction before arriving at the next sub-total (operating excess, after transfers).
Many schools define operating and non-operating items to align with debt covenants as negotiated with the bond authority and/or financial institutions. With the new definitions constraining their ability to customize the statement of activities, schools would have to work with their lenders to make sure covenants would either be interpreted the same or change as needed. These discussions should take place well before implementation so that school leaders are on the same page as lender(s) and can manage and track results as the year progresses—and avoid surprises after the year ends.
Operating Expense Reporting: by Nature as well as Function
Independent schools generally are not required to report expenses by natural classification (e.g. salaries, benefits, supplies, etc.), and instead often report by functional category (e.g. instruction, auxiliary, management, development, etc.). The Proposed ASU would require organizations to report expenses by both function and nature.
Independent schools generally are not required to report expenses by natural classification (e.g. salaries, benefits, supplies, etc.), and instead often report by functional category (e.g. instruction, auxiliary, management, development, etc.). The Proposed ASU would require organizations to report expenses by both function and nature, using a grid presentation either on the face of the financial statements or in the notes. FASB believes that most users of financial statements would benefit from this information and better determine how resources are allocated between fixed and variable components.
In addition, both interest and investment expenses would be excluded from operating expenses and considered non-operating. In the case of investment expenses, they should be netted with investment income, which is only optional under the current standards.
Statement of Cash Flows: Direct Method, and Several Reclassifications
The Proposed ASU would have a dramatic impact on the statement of cash flows. Instead of the indirect method favored by most schools, it would require the direct method (gross cash inflows and outflows from operations). In addition, it would reclassify several components from the operating section to the investing and financing sections, while moving other items from investing and financing to the operating section. For instance, acquisitions of property and equipment used in operations would be viewed as operating outflows, not investing outflows. Interest and dividend income would move to investing, and interest expense would move to financing.
Another change: During periods of construction activity, cash flows from operations may be negative (often viewed as a “flag” under current rules). Schools are advised to educate lenders and other users of their financial statements on these changes. They should also know that a negative cash flow from operations may not necessarily be an issue if it is caused by a planned plant expansion.
Liquidity Measures: Enhanced Disclosures
The liquidity crisis of the past decade has shown flaws in the current not-for-profit financial reporting model. Schools may report a large unrestricted net asset balance at the end of the fiscal year, but this may be due to non-liquid assets such as net property and equipment, or financial resources restricted to collateral. Under the Proposed ASU, schools would not need to do anything differently with regard to how they manage liquid assets. However, they would need to enhance disclosures around liquidity and how they manage it, giving users a more accurate picture of available resources.
Other Considerations
As long as minimum requirements are met, FASB would allow organizations flexibility on their financial statements, as well as in notes, in order to better explain their financial position, results and cash flows. For example, they could split the statement of activities into two financial statements (statement of operations and statement of changes in other net assets). Similarly, they would be able to separate net assets without donor-imposed restrictions by undesignated and designated components, or net assets with donor-imposed restrictions by endowment and non-endowment. Also, they would still be able to present cash flows using the indirect method so long as they also use the mandated direct method.
While these proposed changes are a few years away from taking effect, independent schools should become familiar with them now and craft a plan of transition that includes communications with all users of their financial statements, internal and external alike.
