Financial statements of nonprofits display net assets (equity) in three classes: unrestricted, temporarily restricted and permanently restricted. These categories are based on the existence or absence of donor-imposed restrictions and are defined in the accounting standards under FASB ASC 958-210-20.
Readers rely on these classifications to determine what assets have external purpose or time restrictions or, in other words, what assets are spoken for and what assets are available for use. While this net asset reporting model has been around for quite some time, challenging classification issues and reporting pitfalls still exist.
The determination of whether a grant should be treated as a contribution or as an exchange transaction continues to present a challenging issue affecting the classification and reporting of net assets. The distinction is not always clear, often requires judgment and significantly affects the financial statements. FASB ASC 958-605-55 includes a table with indicators that are helpful in determining whether a grant or asset transfer is a contribution, exchange transaction or a combination of both.
Misclassifying contributions as exchange transactions, or exchange transactions as contributions, can result in improper revenue recognition, as well as improper reporting of the resulting net assets as unrestricted or temporarily restricted.
Grants treated as contributions should be recognized upon receipt or notification. Depending on the nature or absence of any donor restrictions, any unspent funds will drop to the bottom line as income and increase unrestricted or temporarily restricted net assets.
In contrast, grants treated as exchange transactions look and feel more like reciprocal contracts and are classified and recognized as unrestricted revenue subject to the earning process, meaning revenue is recognized when the obligation to the resource provider is fulfilled. Often this means revenue is recognized only to the extent the allowable expenditures are incurred (i.e., a net zero income result). Any expenditures over and above the funds received, or any funds received over and above expenditures incurred, flow through the statement of financial position as a receivable or deferred revenue/refundable advance, respectively.
The proper reporting of revenue from gifts of long-lived assets (e.g., property, buildings, equipment) is also often overlooked, leading to misclassifications. The revenue from these gifts-in-kind is still being incorrectly reported by many nonprofits as unrestricted, without regard to donor intent or alternative accounting rules. If a donor places a time or purpose restriction on the donated long-lived asset, the revenue should be temporarily restricted.
Absent a donor stipulation, the nonprofit can choose to adopt a policy to imply a time restriction, in which case it would also treat the gift as temporarily restricted. At that point a calculated amount, based on the estimated useful life of the asset, is released from temporarily restricted net assets each year.
The determination of the amount to report as permanently restricted net assets, with regard to endowment fund reporting, presents yet another challenge. Historic dollar value of the original gift corpus has been a typical measure used to determine the minimum amount of an endowment fund to report as permanently restricted.
Since state law typically allowed for the net appreciation of the endowment’s investments to be spent (in the absence of any permanent or temporary restriction to the contrary by the donor), the historic dollar value amount gave present and future governing bodies the flexibility to spend those appreciated investment funds.
Interest, dividends and gains on the permanently restricted endowment funds were then classified as temporarily restricted net assets until they were appropriated by the organization for expenditure.
The adoption by many states of the Uniform Prudent Management of Institutional Funds Act (UPMIFA) made the determination of the amount to report as permanently restricted net assets a bit more difficult. It required organizations to interpret the law as requiring that they determine how they would “act to preserve ‘principal’ (i.e., to maintain the purchasing power of the amounts contributed to the fund) while spending the ‘income’ (i.e., making a distribution each year that represents a reasonable spending rate, given investment performance and general economic conditions).” This means an organization needs to monitor principal in relation to inflation or deflation and determine the adjustment to value needed to maintain the purchasing power of the fund and, correspondingly, the amount to report as permanently restricted net assets. This involves judgment and complicated calculations using various economic indexes. The impact of this interpretation can present undesirable consequences, as illustrated by the following simplified example.
Suppose the original gift to an endowment fund was $500,000, and this is the same amount the governing body determines is the amount they need to preserve permanently. Let’s assume the endowment fund is “underwater” and the value of the investments are now only worth $400,000. Accounting standards require this $100,000 loss to be displayed in the unrestricted net asset class, after first reducing temporarily restricted net assets for any donor-imposed temporary restrictions on the net appreciation of the endowment fund.
Suppose, however, that the governing body had determined that the law required them to preserve the purchasing power of the endowment fund. If the original value of the gift had been adjusted for appreciation and inflation to $750,000 to retain the purchasing power of the gift, and the investments are now only worth $400,000 as in the above example, the deficit that would flow through the unrestricted net asset class could be as high as $350,000, after first reducing temporarily restricted net assets for any donor-imposed temporary restrictions on the net appreciation of the endowment fund.
The aforementioned issues are just some of the more troublesome ones to consider. Reporting net assets in the appropriate classification is not always an easy determination. It requires judgment, an understanding of legal and accounting standards, and the ability to look ahead to the consequences and implications of these classifications.
Audrey J. Sherrick, CPA, is a partner, Friedman LLP. She is a member of the New Jersey Society of Certified Public Accountants. Her email is [email protected]