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Are you ready for significant changes to the financial statements of not-for-profit organizations?

On August 18, 2016, the FASB issued Accounting Standards Update (ASU) No. 2016-14 Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities.  ASU 2016-14 requires a number of changes to the financial statements of not-for-profit organizations (NFPs).  This article provides an overview of those key changes.

Why Make Changes?

ASU 2016-14 is the result of a multi-year FASB project conducted to review the current financial reporting model for NFPs that has been in place for approximately 20 years.  As a result of the review, the FASB identified several areas of the financial reporting model that needed improvements or updates to provide better information to those who rely on the financial statements issued by NFPs.

The FASB has indicated that it does not intend ASU 2016-14 to be a complete overhaul of the current financial reporting model for NFPs contained in generally accepted accounting principles (GAAP).  The current financial reporting model in GAAP is fundamentally sound, so the goal of ASU 2016-14 is to improve how NFPs communicate their financial performance and condition, while also reducing certain costs and complexities in preparing financial statements.

More specifically, the FASB noted it heard concerns about the following areas that need improvement:

  • Complexities around the three required classes of net assets.
  • Difficulties in understanding some NFPs’ liquidity.
  • Inconsistencies in the information NFPs provide about expenses and investment returns, and
  • Limited usefulness of the statement of cash flows, particularly regarding the reporting of operating cash flows.

What Specifically is Changing?

ASU 2016-14 requires eight key changes to financial reporting for NFPs:

1. Net assets will now be reported in two classes (net assets with donor restrictions and net assets without donor restrictions).

2. NFPs will be required to disclose board-designations on net assets.

3. Additional disclosures will be required for “underwater” endowment funds.

4. NFPs will no longer be allowed imply a time restriction on donations of, or contributions restricted for the purchase of, property and equipment.

5. All NFPs must present a statement of functional expense or include a similar matrix-type disclosure in the footnotes and also disclose the methods used to allocate costs to the different functional categories.

6. Investment expenses will be required to be presented net with investment return in the statement of activities and NFPs will no longer be required to disclose the amount of investment expenses.

7. NFPs that elect to use the direct method of presenting operating cash flows are no longer required to present the indirect reconciliation.

8. New required qualitative disclosures regarding how a NFP manages its liquidity and required quantitative disclosures that communicate the available financial assets to meet cash needs for general expenditures within one year of the balance sheet date.

When Are These Changes Effective?

ASU 2016-14is effective for fiscal years ending in or after December 2018.  Early implementation is allowed.

Want to Learn More?

This article highlights the key changes required by ASU 2016-14.  In future articles we will discuss each of the key changes in more detail along with practical guidance on implementation issues.  In the meantime, please contact your Clark Nuber service team or Andrew Prather if you would like to discuss how these changes will impact your NFP’s financial statements.

© Clark Nuber PS and Developing News, 2016. Unauthorized use and/or duplication of this material without express and written permission from this blog’s author and/or owner is strictly prohibited. Excerpts and links may be used, provided that full and clear credit is given to Clark Nuber PS and Developing News with appropriate and specific direction to the original content.

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Lease Accounting Changes – Light at the End of the Tunnel?

Many companies worldwide will soon take a different view of their balance sheets. Entities that pay to lease real estate, airplanes, office equipment, fleet vehicles and other items will be required to recognize significant debt-like obligations and add billions onto their balance sheets. After more than a decade of drafts, surveys and redrafts of the Lease Accounting Standards, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have finally set effective dates for leaseholders to adopt the respective Lease Accounting Changes. FASB issued Accounting Standards Update (ASU) 2016-02 earlier this year. The new guidelines are outlined in the Accounting Standards Codification (ASC) Topic 842 and take effect December 2018. IASB’s changes, outlined in IFRS 16, take effect January 2019. What Does the Change Mean? Simply stated, the new standards require lessees to convert their operating leases (off-balance sheet) to capital leases (on-balance sheet), which reflects the lease’s liability (rent). Although the standards may seem onerous and complex, the overall goals of the proposed changes are simple - to create more transparency of a company’s assets and liabilities and avoid the accounting scandals that have plagued world economics. Of particular concern was the possibility of abuse of off-balance sheet reporting of liabilities. FASB is trying to create transparency by taking a very common and significant economic and legal liability (the obligation to make lease payments), which is often reported off the balance sheet (particularly with office leases), and create consistency by making everyone report it on the balance sheet. Variables - Altered Capital and Disclosures? The addition of lease liabilities to the balance sheet is expected to have a significant impact on financial ratios relied upon by the users of a company’s financial statements (i.e., investors, lenders, etc.). So, will these new rules create consistency for all? Not necessarily. Although all companies will play by the same rules, not all companies’ financial ratios will be affected in the same manner. Industries with modest leasing needs will appear to be performing better than those with higher leasing needs (such as retail, manufacturing, aerospace and healthcare). However, this doesn’t mean that companies with heavy leasing needs will suddenly become a poor investment choice. It is important to understand that investors, lenders and analysts will need to re-calibrate their metrics as a result. Financial ratios to pay attention to include:
  • Debt to Equity (D/E) - The debt to equity ratio is used to measure the amount of leverage, or debt, used in the business. This new standard will result in adding assets and liabilities to the balance sheet, with no impact on equity, which will cause a spike to the D/E ratio. With a higher leverage ratio, this is sure to cause discussion between companies and their lenders.
  • Return On Assets – Return on assets is used to measure a company’s return on the investment it makes in its assets. This ratio will take a hit as companies add assets to the balance sheet. Overnight, assets will rise and earnings will stay the same, causing the return as a percentage of those assets to decline.
  • Working Capital – As a measure of a company’s ability to pay its current liabilities with its current assets, the addition of the portion of leases to be paid over the next year to current liabilities will definitely skew the working capital ratio.
Important, but Not Important Companies have generally taken the liberty of burying their lease obligations deep within the Form 10-K footnotes.  Because finance and capital leases are already accounted for, it’s primarily the operating leases that need to be reflected on the balance sheets. This practice shouldn’t have much of an impact on corporate profits, and none of this should come as a surprise to the ratings firms and large institutional investor who typically have the off-balance sheet assets and liabilities already accounted for. It’ll be the small investors who don’t have the resources or experience to scrub through the massive amounts of footnotes who will generally be surprised by the changes. But let’s not let the tail wag the dog. The idea of moving lease assets and liabilities onto the balance sheet just isn’t that important throughout the financial and accounting circles. It’s acknowledged as more of a laborious headache than a safeguard of checks and balances. Take a back seat! What’s important when taking on a leased obligation is that companies negotiate and structure the best deal possible. Why? Because the goal of the new standards is to create transparency – not provide any benefits or leverage to either the lessor or lessee. While the accountants and finance people should work out the details, there needs to be open and frequent conversation between a company’s different groups (accounting, finance, treasury and any other department(s) responsible for the obligations of the lease). This will ensure that all goals and objectives are met. The proposed accounting changes might not change the outcome of the leasing decisions made by a company, but it’s certain to change the process companies undertake to come to consensus on the decisions. The two primary goals companies take into consideration when negotiating a lease are to satisfy operational needs and meet financial objectives.  Two variables govern these goals:
  1. Lease Versus Buy – With the knowledge that the assets will transfer to the balance sheet, companies will need to consider if it’s advantageous to continue leasing or instead purchase the asset. Companies can benefit from tax benefits through depreciation over the asset’s life or factor depreciation over the lease term.
  2. Lease Term – It may be tempting to negotiate a shorter lease term to lessen the impact the lease obligations will have on the balance sheet, but be careful! Short lease terms will generally cause higher rental rates. Concentrate on cash flows and negotiate the lease that will provide the best cash flow result.
Leasing should provide flexibility, so don’t become handcuffed with terms and conditions that don’t consider your company’s best interest.  Negotiate the best deal for your company and let the accounting and finance people work out the details. Next Steps There will be many decisions for companies to make over the next few years to best structure their entities for a smooth transition while continuing to provide shareholder value. With the issuance of the standards this year and (only) 2 ½ years before companies must start reporting under the new guidelines, there are mixed emotions about jumping in knee-deep and engaging new systems, policies and procedures – remember Sarbanes-Oxley? Executives of many companies were uncertain of the magnitude and cost associated with implementing the Sarbanes-Oxley compliance measure. It’s no wonder company leaders aren’t motivated to dive into the new lease accounting standards. Preparation, communication and execution are the fundamentals every company needs to address. Financial executives within companies will need to study the new guidance and assess the impact on their financial statements well ahead of the switch-over date.  Ratios involving cash flows and Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) will be unaffected, but those involving balance sheet accounts will likely be impacted heavily. The time is now to assess if the company has the resources/staffing and financial capacity to handle this task in-house or if the work should be outsourced. It is also time to understand the severity of the impact this will have on balance sheets and to develop a communication strategy with investors and lenders so there are no surprises. Consult your CPA if you have any concerns or questions about the new guidance. The long-anticipated standards for transparency and consistency in lease accounting will be here sooner than you think. © Clark Nuber PS and Adam Milhlstin, 2016.  All Rights Reserved

How Unrestricted Are Your Net Assets?

One typically thinks of net assets in one of three categories: unrestricted, temporarily restricted, or permanently restricted. Organizations with endowments are very familiar with the concept of comparing the organization’s permanently restricted net asset balance to the related investment balance, and determining the amount that those net assets are over or under water. A similar concept exists with unrestricted net assets, which too few non-profits are looking at. Monitoring this equation, however, could prove be one of the best indicators of positive or negative financial trends in your organization. The concept is simple: determine the amount of unrestricted net assets that you could spend on any purpose, whenever you need to spend them. The equation is also simple: Unrestricted, undesignated net assets - Net assets invested in non-liquid assets = Readily Available Net Assets The steps to calculating Readily Available Net Assets are explained in detail, below: Step 1. Calculate unrestricted, undesignated net assets: First, subtract the amount of net assets that have been set aside for another purpose, such as a quasi-endowment or operating reserves, from the total unrestricted net assets. Step 2. Identify net assets invested in non-liquid assets: Begin by subtracting balances from your total assets. First, look at your net assets. If you have any permanently restricted net assets, subtract the corresponding investment balances first. If you have assets that exist due to receipts from temporarily restricted net assets campaigns (ex. money raised for a capital campaign), then subtract those next. You will then begin subtracting more difficult items. Next, subtract fixed assets. These assets are typically unrestricted, but don’t contribute to your Readily Available Net Assets. Receivables come next. If the money for your receivables isn’t going to be used for everyday operating costs, then subtract it from this number. When you think you are done, give your value a reasonableness test - this is the most difficult step in the process. Does it make sense that you have cash, short-term investments, prepaids and some operating receivables left over? If this is indeed what you are left with, you are on the correct track. Step 3. Identify liabilities that exist because of the assets invested in non-liquid assets: It wouldn’t be fair to subtract fixed assets from the equation in step two if you didn’t get to add the related liabilities back in. Identify those liabilities, as you will be able to add them back in step four. Step 4. Complete the equation: Take the value identified in step one, subtract the value identified in step two, and add back the value identified in step 3. You now have calculated your Readily Available Net Assets. Step 5. Monitor the equation: If you only complete this equation one time, you will gain valuable insight. The true value, however, comes from monitoring your equation over time. As your organization grows, notice if the value of your Readily Available Net Assets is growing at a comparable rate. If your Readily Available Net Assets decreases, is there a specific “investment” made by your organization that explains the decrease? I’m often asked if I have benchmarking data for organizations to compare themselves to. This can be helpful for certain organizations, but the organization that it is most important to benchmark against, is your own organization over time. Make sure to compare your company’s key organizational metrics, such as Readily Available Net Assets, before benchmarking against other organizations. If your organization starts to dig itself into a hole wherein its Readily Available Net Assets is negative and continues to grow more negative, there will come a day when your organization’s “powers that be” realize there is a problem. Unfortunately, unless your organization can generate a lot of earned income, or find donors to fund operating deficits, it may already be too late. Situations like this are very difficult to pull out of, but can be prevented by monitoring Readily Available Net Assets along the way. Bryan Dean is a Senior Manager in Clark Nuber’s Not-for-profit auditing practice. He also serves as the chair of the Washington Society of Certified Public Accountants Not- for-Profit committee. © Clark Nuber PS, 2016.  All Rights Reserved

The Possible End to Reporting Donor Contributions

On June 14, the House passed a bill prohibiting the requirement that Section 501(c) organizations must disclose their donors on Schedule B. Under current law, all organizations exempt under §501(c) must provide the IRS with a listing of any donor that gave $5,000 or more during the tax year. Some organizations qualify for the special 2% rule that increases this $5,000 threshold, thus further limiting the donor disclosure. Except in the case of private foundations, Schedule B is not open to public inspection. The new bill, H.R. 5053: Preventing IRS Abuse and Protecting Free Speech Act, would prohibit Treasury from requiring that charities disclose donor information on their annual Form 990 or 990-PF filing. There are two exceptions to the proposed disclosure requirement change:
  1. Donations from any officer, director or person with powers or responsibilities similar to an officer or director must be disclosed; and
  2. Donations from any of the organization’s five highest paid employees for the current tax year must be disclosed.
The IRS commented late last year saying it too was considering dropping the donor listing requirement. At a conference last December, Tamera Ripperda, director of Exempt Organizations at the IRS, indicated the IRS is considering whether they actually need that information for tax law enforcement. The IRS is also running the idea by state regulators, as many have an interest in the donor listing for state compliance purposes. Impact on Public Charities This new bill would largely affect public charities, were it to become law. While many do receive donations from their board members, many large donations also come from unaffiliated individuals. The donor reporting for most of these organizations would be minimal under the proposed bill. Some may no longer have a Schedule B at all. Impact on Private Foundations Under current law, private foundations do not fall within the public disclosure exception for Schedule B. Instead, all donors listed on Schedule B are open for public inspection. This should not be surprising, as in many cases, the private foundation is named after the donor. Under the proposed bill, donations from these individuals would still be disclosed, assuming the founder is an officer or director of the private foundation. However, private foundations that receive donations from outside sources would no longer be required to include those donations on Schedule B. Impact on Non-501(c)(3) Organizations There is speculation that this bill targets non-501(c)(3) exempt organizations. Section 501(c)(4) organizations have received much scrutiny these past few years by the IRS, Congress and the media. Many believe these organizations are conducting political activities and donors are contributing to them to hide their donations (donor listings for political action committees are made public while donations to (c)(4) organizations are subject to the normal public disclosure rules). Many democrats say the bill is a shield for campaign influence by the wealthy. Also, while it is illegal for foreign donors to contribute money in a U.S. election, foreign donors are allowed to contribute money to a 501(c)(4) organization. By eliminating the majority of donor reporting, the IRS would have no way of knowing whether a 501(c)(4) organization that is participating in political activity received any funding from overseas donors. Will It Pass? Whether or not the bill will become law ultimately depends on the President. Many believe the Senate is likely to approve the bill since Republicans currently control the Senate. The biggest hurdle will be getting the President’s signature. The current thought is that President Obama will likely veto the bill. In the meantime, stay tuned. Regardless of this new legislation, the IRS still has the authority to remove the Schedule B requirement on its own. This means that even if this prohibition bill is vetoed, it is entirely possible that the IRS will decide to make this change, regardless. Sarah Huang is a senior manager in Clark Nuber's Tax Services Group. She specializes in serving a variety of clients, including not-for-profit organizations, partnerships, corporations, and high net worth individuals. © Clark Nuber PS, 2016.  All Rights Reserved

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