Nonprofit Accounting and Auditing - · PDF fileMARCH 31 FORUM NONPROFIT ACCOUNTING AND...

MARCH 31 FORUM NONPROFIT ACCOUNTING AND AUDITING

Nonprofit Accounting and Auditing of 74 ECFA FORUMS 2011 www.ECFA.org

Nonprofit Accounting and Auditing

Presenter: Richard F. Larkin, C.P.A.,

Institute for Nonprofit Excellence, BDO USA, LLP, Bethesda, Md. [email protected]; 301-634-4931

Agenda:

• How to Get Ahead in Tough Times • Accountability, Fraud, and Internal Controls • Financial Reporting and Accounting Considerations - Old and New • Income Tax Reporting Matters, Primarily Relating to Contributions Received • Common Financial Statement Mistakes

* * * * * * *

I. How to Get Ahead in Tough Times This part of the outline was first prepared about two years ago; since then things have improved somewhat, but the lessons are still worth looking at. Prepare to see your cash inflows decrease further:

• Many of your individual donors are feeling the pinch - even some wealthy ones (they may have invested with Madoff), so are likely to give less

• Your business donors are feeling the pinch: merging, closing facilities, going out of business, so are likely to give less (including corporate foundations)

• Federated fundraisers (e.g., United Way) are seeing their contributions decrease, so they have less to allocate; at the same time they are getting more requests for funding

• Your foundation donors have seen the value of their portfolios shrink, so they have less to grant

• Your state and local government funders have seen their tax revenues decrease and will be reluctant to increase - or even to continue - funding; (it is too soon to assess effects of federal changes and proposals)

• The value of your own investment portfolio - if you have one - has shrunk (Harvard was down $8 billion - from $37bn.), so you do not have capital gains to use, and your investment income is probably down or, at best, flat; the 'remainder' of remainder trusts is worth less, as is the value of an estate in probate

• Depending on your sources of earned income, it may decrease also (e.g., member dues, conference fees, ticket sales, more students will ask for financial aid, more patients will be unable to pay, etc.)

• Collection of existing pledges and loans receivable will be less certain, and often slower; a pledge of real estate, or denominated in shares of stock, is probably worth less

• Consider what you can do to replace as much of the lost cash flow as possible: additional fundraising, outreach to prospective members, keep current donors and members happy, etc.

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As for cash outflows: • The need for your services may (depending on the nature of your programs) increase,

but • You may have to cut back expenses to match your reduced revenue • Look at expenses - even whole programs - with a sharp pencil; cut frills, be efficient,

defer payment when possible, try to obtain goods and services pro bono, investigate budget variances promptly and thoroughly

• Be prepared for heightened board, funder, and public scrutiny of expenditures which may be perceived as lavish or unnecessary (e.g., numerous recent examples in both the business and nonprofit sectors)

• If you have government grants, you still have to meet all the compliance requirements • If you are a private foundation, you still have to make the 5% payout, even if it means

invading corpus or borrowing • If you are party to split-interest agreements (e.g., gift annuities) with fixed or minimum

payouts, you still have to make those payouts • If you have a defined-benefit pension plan, the plan assets are likely worth less, which

may increase your legal funding requirement Balance sheet issues:

• Re-visit your investment policy (with professional help) to reduce risk of further losses and prepare for a (hoped for) recovery

• Monitor collection of pledges and loans receivable more carefully • If you have assets in other countries, monitor the state of those countries’ economies

(e.g., Iceland, Russia) • Your creditors will be pressing for payment because they are hurting too • Fine tune your cash flow forecast, scrutinize every item, play devil’s advocate; have a

backup plan • Be especially alert for attempts - by insiders (including volunteers) and outsiders - to

alleviate personal financial distress by committing fraud against you (e.g., embezzlement, kickbacks, computer-based fraud, scams, etc.); reassess your internal controls to identify risks and take steps to mitigate them

Relationships with other organizations:

• Monitor the soundness of your bank with deposits over the FDIC coverage, and of your investment custodians and managers (including administrators of pension plans and split-interest agreements)

• Consider dividing your cash among more than one bank (even if FDIC coverage is not an issue, you do not want to lose access to all your cash, even for a short time, in case of a bank failure/takeover followed by a possible delay in reopening)

• If your liquidity depends on a line of credit or other borrowing, make sure it will continue to be available; in any case, have a backup plan for maintaining liquidity

• If you have guaranteed obligations of another entity, monitor the likelihood of being required to perform

• If you are party to derivative contracts, monitor the continuing ability of the counterparties to perform



• Know your legal rights as a lessee under your lease, should the facility you rent be foreclosed upon; monitor your landlord’s financial situation

• Monitor the financial situation of your insurance company(ies) • If your activities are greatly dependent on one source of supplies or equipment, or on

some other vendor, have a backup plan in case that vendor gets in financial trouble; monitor the vendor’s financial situation

Accounting and financial reporting concerns:

• Determination of fair value of assets, especially ‘alternative investments’ and real estate (even if assets held for investment are not reported at fair value in the balance sheet, it is still a required footnote disclosure), including assets held in third-party trusts, pension plans, etc.

• Estimating required reserves for estimated uncollectible pledges and loans • Possible asset impairment, e.g., goodwill, inventory, assets held for sale, real estate • A private foundation with unrealized investment losses will record a deferred tax asset,

but will then have to fully reserve the asset, since its realizability depends on recovery of the securities markets and, thus, is inherently uncertain

• Compliance with financial covenants in debt and grant agreements • If you get into business-type activities to increase income, assess possible uncertain tax

positions • Consider how to clearly explain your reduced financial position to your constituents: your

governing board, your donors and members, others - especially when capital losses in donor restricted funds have been charged to the unrestricted class (as is required in many cases by GAAP)

Auditing concerns:

• Assessment of adequacy of reserves for uncollectibles • Obtaining appropriate independent evidence of valuation of alternative investments • Consideration of post-balance sheet market declines (‘subsequent events’) • Assessment of asset impairment, generally; is it other than temporary? (‘OTTI’) • Appropriateness of accounting judgments - especially related to revenue - where a

different judgment would change the financial statement effect of a transaction, as to timing or method of recording (e.g., is a transaction a contribution or exchange, is a pledge conditional, is a gift restricted, has a restriction or condition been met, do volunteer services meet the criteria for recording?)

• Fairness of expense allocation methods, especially ‘joint costs’ (possible attempt to ‘window-dress’ the financial statements to meet funders’ or public expectations or expense ratio limitations, or to meet budgets set by funders or the governing board)

• Other window-dressing attempts (e.g., improper capitalization; improper revenue recognition; failure to properly record losses - realized and unrealized; improper classification; improper cutoff)

• Contingent liabilities for guarantees, violation of donor restrictions or compliance requirements, etc.

• Has organization been the victim of fraud? (e.g., Madoff; and not just whether the organization invested with Madoff, but whether mutual funds or trusts it owns invested with Madoff)



• Possible going concern questions II. Accountability, Fraud, and Internal Controls 1. AICPA Statement on Auditing Standards (SAS) No. 99: Consideration of Fraud Auditor is required to:

• Specifically assess the risk of material mis-statement of the financial statements due to fraud

• Assess and document internal accounting controls • Consider that assessment in designing audit procedures to be performed • Consider fraud risk factors that relate to both mis-statements arising from: • Fraudulent financial reporting, and • Misappropriation of assets [in each of the categories noted below] • Perform tests and document results; • Consider test results in assessing fairness of financial statements; communicate any

findings to management. Boldface items are recent major changes:

• Formal discussions of fraud risks among engagement personnel during the planning phase (‘brainstorming’);

• Additional inquiries of management - and others outside management and finance; o Are you aware of fraud or the risk of fraud? (After a recent fraud, an uninvolved

employee was asked whether he had been aware of what was going on. He said he had been. “Why didn’t you say something?” “No one ever asked me.”)

• Evaluation of entity’s response to identified fraud risks; • Consideration of linkage between identified fraud risks and audit work; • Specific responses to address risk of management override of controls;

The statement discusses two types of fraud:

• misappropriation of assets; • financial statement mis-statement.

Overall fraud risk factors are:

• incentive/pressure; (almost everyone has this) • opportunity; • attitude/rationalization. (fortunately, few people have this)

The AICPA has also issued a practice aid, Fraud Detection in a GAAS Audit - An Auditor’s Field Guide, to help implement SAS 99; this includes sections for various industries, including nonprofits. See below for particular nonprofit considerations regarding financial statement mis-statement. Note that the audit focus is still on material mis-statement of the financial statements. A normal audit is not designed to, and cannot be relied on to, detect all possible fraud, or to report on the adequacy or effectiveness of internal controls. Such an audit would be cost-



prohibitive. (The ‘Section 404 Report’ required by the Sarbanes-Oxley Act for public companies, covering only the internal control system, has raised audit fees by anywhere from 40 to 100%) Of course the auditor will bring to the attention of the client any actual fraud detected, as well as any recommendations that may be developed for improvements in the internal controls. Keys to minimization of the incidence of fraud:

• Organization culture of ethics and honesty - ‘tone at the top’ • Strong internal controls - act as a deterrent as much as a detective; bank reconciliation

is important • Risk assessment - by management, as well as the auditors • Budgetary analysis

2. Ethics and the Public Perception of Charities While not subject to SEC oversight, nonprofits do have numerous constituencies to which they must routinely answer. These include government regulators - federal, state, and local, private accrediting agencies, their own governing boards, parent organizations, the media, various kinds of funders, members, customers, and employees. (A more complete list of constituents is provided in the sidebar below to help nonprofits consider who likely has an interest in them and their good behavior.) Sarbanes-Oxley and Not-For-Profits Should nonprofits comply with the Sarbanes-Oxley Act?

• Yes, with probable exception of the costly 'Section 404' report on internal controls; • The rest is virtually cost free, and consists of things that organizations should have been

doing anyway: • Audit Committee, including at least one financially knowledgeable member; (some

members could come from outside the Board – chair should be a Board member) • Code of ethics; • Whistleblower policy (this is required by Sarbanes for all organizations); • Public attestation by management (CFO and CEO) as to fairness of financial statements

and soundness of internal controls. Funders, members, media, others will be demanding this. Is there anything about your organization that would be embarrassing to see on the front page of [your local newspaper]? Consider that when someone steals from a nonprofit or wastes its resources, the loss is really ultimately borne by the organization’s clients, who, in many cases, are the needy members of society - the homeless, the hungry, the sick, the depressed, etc. Whatever was stolen or wasted is no longer available to help these people. Further, when considering charitable giving, donors are much more sensitive to the organization’s reputation than are buyers of a company’s products. Business misbehavior has to rise to an exceptionally high level (think Exxon Valdez, apartheid in South Africa) before customers will turn to a competitor solely because they dislike something about the company. But once even a whiff of scandal touches a nonprofit, the sound of checkbooks closing can be heard far and wide. Donors will give elsewhere. One charity saw its annual gifts drop from



$45 million to $18 million following a series of revelations of misbehavior on the part of the organization’s leadership. That is a very expensive lesson in organization governance. I believe that nonprofits should hold themselves to an even higher standard of behavior than businesses need to if they wish to retain the trust of the public, which is vital for them to succeed. And there are a lot of different persons and groups that have an interest in good behavior by nonprofits; see the second sidebar below. Sidebar Five things that nonprofits should at least consider in the era of Sarbanes-Oxley:

• Create an audit committee (if you do not already have one), and ensure it is active and aware. (In a smaller organization, the finance committee can also function as the audit committee.)

• Have your CEO and CFO publicly attest to the accuracy, completeness, and fairness of your financial statements (Form 990, if you use that as a public financial statement), and to the adequacy of your internal accounting controls.

• Publicly disclose that you have adopted, and follow, a code of ethics, including a whistleblower policy, for staff, management, and the governing board. (If you do not have such a code, adopt one at once!)

• Have all non-audit work by your outside auditors approved by your audit committee, and be sure it does not even appear to compromise their independence.

• Consider very carefully all transactions between your organization and any 'insider' - including executive compensation and fringe benefits and perks. (See below for definition of Insider.) Would you be even slightly embarrassed to read, and know that your donors are reading, about details of these transactions in your local newspaper?

'Insiders' (sometimes called Related Parties) include:

• organization officers, directors, trustees, • management in decision-making positions, • major donors, and • members of the immediate families of any of the preceding; • controlled and affiliated organizations and trusts, and • businesses in which any of the preceding are in significant positions of authority (owner

or manager). Second sidebar - Constituents of nonprofits

Who is looking over your shoulder? Overseers and regulators

• The Internal Revenue Service, which monitors compliance with federal tax-exempt status, and comparable state taxing authorities;

• State charities regulators (mostly state attorneys general, but in a few states another department performs this function), which regulate fundraising practices, including those of out-of-state charities, which solicit in the state; (About 42 states have some form of such regulations.)

• Other federal, state, and local governmental bodies that regulate specific types of organizations, such as health departments (hospitals and clinics), education



departments (colleges and universities), labor departments (unions), insurance departments (organizations which issue gift annuities), etc.

• Private 'watchdog' organizations such as the Better Business Bureau Wise Giving Alliance, the Evangelical Council for Financial Accountability, and others, which act on behalf of the public to monitor and evaluate the behavior of charities;

• Private accrediting organizations such as those for colleges, hospitals, and the like; • An organization's own governing board; • A 'parent' organization, if the nonprofit is part of a larger group; • The media, acting on behalf of the general public.

Funders • Federated fundraisers such as United Ways, community arts councils, and the like; • Private and community foundations which make grants to nonprofits; • Other nonprofit organizations; • Corporations and corporate foundations; • Individual donors; • Federal, state, and local government funders; • Taxpayers, who indirectly subsidize many nonprofits, both through the tax-deductibility of

charitable contributions, the non-taxability of most income of nonprofits, and direct government funding of some nonprofits.

Other constituents • Members of an association, club, church/synagogue/mosque/temple, etc.; • Parents and students who pay tuition to a college or school; • Patients, employers, and insurers who pay healthcare fees; • Other purchasers of services from nonprofits; • Insurers which write fidelity bonds, and directors & officers liability insurance on

nonprofits; • Underwriters and buyers of bonds issued by nonprofits, and government regulators of

such bonds; • Employees of nonprofits and their families.

* * * * * * * 3. Fraud Risk Factors for a Nonprofit Organization Fraud risk factors are events or conditions that indicate the presence of:

• incentives or pressures for management, employees, or volunteers to commit fraud,

• opportunities to commit fraud, usually combined with a belief that the fraud will go undetected, and/or

• attitudes/rationalizations on the part of management, employees, or volunteers to justify committing fraud.

Consider whether information about the organization, its personnel, and its operations indicates the presence of one or more fraud risk factors. (If the audit is a Single Audit, consider both the financial statements and the federal award programs.)

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The risk factors presented for consideration are classified into: • factors related to fraudulent financial reporting, and • factors related to misappropriation of assets.

Note that factors related to fraudulent financial reporting, such as management dominance without compensating controls, or ineffective oversight of financial reporting, may also be present when misappropriation occurs. Consider each item; however, the factors listed are only examples and may spark awareness of additional relevant risk factors. Use professional judgment to determine whether a risk factor is present and thus should be considered further. Of course the mere presence of one or more risk factors does not necessarily indicate that fraud is occurring. For further guidance, consult AICPA Statement on Auditing Standards (SAS) No. 99, Consideration of Fraud in a Financial Statement Audit.

A. Fraudulent Financial Reporting Factors which increase the risk of financial statement misstatement due to fraudulent financial reporting: (see also Appendix 1) 1. Incentives/Pressures Consider whether information about the entity, its operations, and its industry indicates the presence of incentives or pressures for management to intentionally misstate the financial statements. Consider risk factors such as:

a. Indications that the financial stability or operating results of the organization may be

threatened by economic, industry, or operating conditions, such as:

(1) The organization is experiencing a high degree of competition or market saturation and declining margins: (a) There is intense competition for a limited pool of resources, such as

contributions and grants, thereby pressuring management to manipulate financial reports to attract those contributions and grants.

(b) There is increasing competition from other nonprofit (or for-profit) organizations

for clients, members, students, patients, or other program participants.

(2) The organization is experiencing high vulnerability to rapid changes such as changes in technology, interest rates, or demand for the organization’s services.

(3) Economic or political events are causing, or may cause, significant decreases in revenue (contributions - including gifts-in-kind, grants, dues, fees, sales, investment return).

(4) Threat of a major source of funding (contributions or dues) being terminated or

significantly reduced.

(5) Difficulty in generating cash flows from activities; pressure to obtain more grants or contributions for programs or to cover expenditures.



(6) Shortfalls in unrestricted revenues that may create incentives to use restricted

amounts to cover.

(7) Significant revenues are based on formulas tied to the organization’s budgeted or actual revenues or expenses that creates incentives to alter financial reports to maximize these revenues.

(8) Claims of unusually rapid growth in contributions or service fees, especially when compared to historical trends or similar nonprofit organizations.

(9) The financial results are significantly better or worse than those of similar organizations, or compared to prior periods or to budgets, for no apparent reason.

(10) Threat of imminent bankruptcy or foreclosure.

(11) The organization is subject to new accounting, statutory, or regulatory requirements that

could impair the organization’s operating results or financial stability.

(12) The organization has been the subject of recent significant adverse publicity.

(13) There is suspicion of asset misappropriation, and management may be trying to cover up the effects.

b. Indications of pressure on management to meet requirements or expectations of third

parties, such as:

(1) Management has committed to significant creditors, major funders, members, or others to achieve unduly aggressive or unrealistic forecasts.

(2) Donors, grantors, other contributors, or lenders have imposed significant restrictions or conditions based on reported financial statement amounts.

(3) High dependence on debt financing, financing agreements have debt covenants that are difficult to meet, or there is a marginal ability to meet debt repayment terms.

(4) Unusual focus by external financial statement users (such as contributors, members, rating agencies, and the media) on reported amounts such as revenue or the change in unrestricted net assets, or on maintaining favorable ratios between program, management and general, and fund-raising expenses.

(5) Perceived or real adverse consequences on a significant pending transaction (such as a pending financing arrangement, large contribution, or grant) if poor financial results are reported.

(6) Pressure to charge unallowable or questionable costs to government or other grants.

(7) Unusual pressures to meet budgetary targets:

(a) To avoid expense budget overruns, or to offset overruns in one budget category or grant against under-expenditures in another category or grant.

(b) To appear to attain budgeted revenue amounts, especially if matching grants are involved.



(8) Pressure to avoid or minimize balances in:

(a) Unrestricted net assets, because of the potential perceived effect of such

balances on fund-raising.

(b) Programs for which surpluses would have to be returned to the funding source.

(9) There is a mix of fixed price, units of service, and cost-reimbursement programs funded by third parties, which could create incentives to shift costs or manipulate accounting transactions.

(10) The organization is involved in certain activities, which if disclosed to the public or to members, may, in the opinion of management, adversely affect contributions or other revenue.

c. Indications that management’s personal financial situation may be threatened by the

organization’s financial performance, such as:

(1) A significant portion of management’s compensation depends on bonuses, or other incentives, which depend on the organization meeting performance goals (for example, fund-raising or membership targets, program accomplishments, budget numbers, financial position, cash flow, or other financial or operating goals).

(2) The organization is experiencing a weak or deteriorating financial condition, and board members or management have loaned money to, or personally guaranteed debts of, the organization.

d. Management exerts pressure on operating personnel to meet or exceed financial targets,

such as targets for fund-raising efforts or individual programs. This may involve practices, such as:

(1) Use of controversial or aggressive accounting policies or reporting methods.

(2) Inappropriate bookkeeping, resulting in a need for the auditors to propose large numbers of adjustments.

(3) Reluctance to record adjustments proposed by the auditors.

(4) ‘Opinion shopping.’

e. Significant interest by management in minimizing taxes (such as unrelated business income or foundation excise taxes) through inappropriate means (including inappropriate allocation of costs between for-profit and tax-exempt subsidiaries or aggressively interpreting the definition of the organization’s exempt purpose to include taxable sales).

f. Significant interest in ‘managing’ reported contribution revenue or unrestricted net assets:

(1) to make the organization look more ‘needy’ to potential contributors (minimize), or

(2) to meet matching requirements of other contributions (maximize).

g. Members of the governing board inappropriately attempt to micro-manage the organization.

h. Other:

2. Opportunities



Consider whether information about the organization, its operations, or its industry indicates opportunities for management to intentionally misstate the financial statements. Consider risk factors such as:

a. The organization:

(1) engages in significant related-party transactions not in the ordinary course of

business (including transactions with related entities that are unaudited or audited by another firm, or with different fiscal years).

(2) has financial statement data based on significant estimates involving unusually subjective judgments or uncertainties that are difficult to corroborate, or that could significantly change in the near term in a manner that may be financially disruptive to the organization.

(3) has significant, unusual, or complex transactions (particularly close to year-end) that are difficult to assess for substance over form (such as grants or split-interest agreements with complex provisions).

(4) has diverse programs with multiple funding sources and complex compliance requirements (such as provisions of donor restrictions, statutes, or grant, trust, or contractual agreements).

(5) (See factor A-1. b. (9) above.)

(6) has operations in foreign jurisdictions with differing accounting principles, business environments, and cultures.

(7) has bank or investment accounts, or subsidiary or branch operations, in tax-haven jurisdictions for which there does not appear to be a clear business justification.

b. There is ineffective monitoring of management as a result of circumstances such as:

(1) Management is dominated by a single individual (such as the board chair, executive

director, development director, a program director, or a large funder or dues-paying member) or a small group, without compensating controls such as effective oversight by the board of directors or an audit committee.

(2) Ineffective board-level oversight over financial reporting and internal control. Financial information provided to the board is delayed, incomplete, of questionable validity, or difficult to understand.

(3) Board members or management with oversight responsibilities lack appropriate background and experience in nonprofit organization management and the organization’s programs, or they appear to lack a commitment to diligently fulfilling their duties.

(4) Members of the governing board or management, their close family members, businesses under their control, or major resource providers (donors or members) have business relationships with the organization without prior knowledge and



approval by the full governing board - not just by a small clique of ‘insider’ board members.

c. Conditions that indicate a complex or unstable organizational structure, such as:

(1) It is difficult to determine whether the organization controls, or is controlled by, a

related party.

(2) An overly complex organizational structure involving unusual legal entities, lines of managerial authority, or contractual arrangements that do not appear to have an organizational purpose.

(3) High turnover in management-level employees, board members, officers, or counsel.

(4) Major subrecipient or subcontract relationships, especially without a clear program or organizational purpose.

(5) Multiple and/or distant locations with inadequate management oversight.

d. There are deficiencies in internal controls due to circumstances such as:

(1) Management fails to implement and adequately monitor internal controls over the financial reporting process.

(2) There have been high turnover rates, and/or management continues to rely on

ineffective accounting or information technology (IT) personnel (employees, contractors, or volunteers).

(3) Management continues to use ineffective, or poorly documented accounting

systems, especially those with significant known deficiencies in internal control.

e. Other:

3. Attitudes/Rationalizations Consider whether information about the entity, its operations, and its industry appears to indicate management attitudes/rationalizations that might justify intentional financial statement misstatement. Consider risk factors such as:

a. Management and the governing board fail to effectively define, communicate, implement, support, and enforce strong positive organizational values or ethics, including strong ‘whistleblower’ policies and procedures, or they communicate inappropriate values or ethics.

b. The organization as a whole or leadership of the organization has a poor reputation in the community.

c. A history of assertions that the organization, management, or board members have committed fraud, or violations of laws and regulations or grant terms, or have engaged in inappropriate or unethical fundraising practices.

d. Nonfinancial management, personnel, or volunteers excessively participate in (or demonstrate an excessive preoccupation with) the determination of significant judgments



and estimates or selection of accounting principles (such as accounting for contributions and other revenue, or allocation of costs).

e Excessive interest by management in manipulating the organization’s trends in contribution revenue, the change in net assets, or expense allocations by using unusually aggressive accounting practices.

f. Management frequently attempts to justify marginal or inappropriate accounting on the basis of materiality.

g. An attitude that it is acceptable to overcharge grants, since ‘funders have lots of money anyway.’

h. (See factor A-1. f. above.)

i. Management fails to promptly correct known reportable conditions in internal control.

j. Management frequently and inappropriately overrides the organization’s control policies and procedures.

k. Management and others display significant disregard for accounting rules and regulatory requirements.

l. Indications of strained relationships between organization leadership and current or predecessor auditors, such as:

(1) Frequent disputes over accounting, auditing, or reporting matters.

(2) Unreasonable demands, such as unreasonable time constraints for completion of the audit.

(3) Restrictions (formal or informal) that inappropriately limit auditor access to people or information, or inappropriately limit communication with the board of directors or audit committee.

(4) Domineering behavior by management or the board of directors, especially involving attempts to influence the scope of the auditor’s work or the selection of persons assigned to the audit team.

(5) Failure by personnel to respond readily to inquiries or to offer information, especially regarding significant or unusual transactions, evasive answers to questions, only providing information reluctantly when pressed.

(6) Disputes over fees for services.

m. Other:

B. Misappropriation of Assets

Factors which increase the risk of financial statement misstatements arising from asset misappro-priation: (The extent to which the auditor considers the various risk factors will be influenced by the degree to which assets susceptible to misappropriation are present. In addition, some of the risk factors related to fraudulent financial reporting may also be relevant here.) 1. Incentives/Pressures

Consider whether information about the entity and its operations appears to indicate the presence of incentives or pressures for management, employees, or volunteers to misappropriate assets. Consider risk factors such as:



a. Personal obligations (such as arising from addictions or abuse related to gambling, alcohol, drugs, or other behavior, or from a family or medical situation) create financial pressure on management, employees, or volunteers.

b. Indications of adverse or strained relationships between the organization and its employees or volunteers with access to assets susceptible to misappropriation, such as: (See also Factor 3. f. below)

(1) Known or anticipated future employee or volunteer layoffs.

(2) Unfavorable recent or anticipated changes in employee compensation or benefits, or volunteer rewards.

c. Other:

2. Opportunities

Consider whether information about the entity, its operations, and its industry indicates opportunities for management, employees, or volunteers to misappropriate assets. Consider risk factors such as:

a. Indications of higher susceptibility of assets to misappropriation (including unauthorized disbursements or unauthorized trading in securities), such as: The organization

(1) maintains or processes large amounts of cash, or assets easily convertible to cash (e.g., bearer bonds, collectibles).

(2) receives numerous small-dollar contributions for which donors receive no or only routine acknowledgment, and/or contributions said to be from ‘anonymous’ donors.

(3) receives cash and other contributed assets in numerous departments (e.g., development, programs, accounting, administration), or in numerous locations, especially locations such as conferences not under strong controls.

(4) uses a complex fee structure, and/or bases fees on ‘ability to pay,’ making it difficult for management to ascertain that proper charges have been made and collected for all services rendered.

(5) has inventory and/or fixed assets easily susceptible to misappropriation (e.g., due to small size, high value, high demand, portability, marketability, lack of ownership identification).

(6) has significant amounts of assets, such as cars, computers, etc. susceptible to personal, nonofficial use.

(7) is susceptible to unauthorized disbursements (such as vendor, payroll, or subrecipient disbursements) being made in material amounts, especially in cash.

(8) engages in an activity, such as unsupervised securities trading, that could cause assets held by custodians to be susceptible to misappropriation through engaging in unauthorized transactions.

b. Indications of possible deficiencies in internal controls over assets susceptible to misappropriation, such as:

(1) Weak segregation of duties, not mitigated by factors such as effective management or board oversight.



(2) Inadequate screening procedures when hiring employees, or recruiting volunteers.

(3) Lack of timely and adequate documentation, recordkeeping, and/or reconciliation procedures over assets susceptible to misappropriation (e.g., cash and noncash contributions, cash collections from pledges).

(4) Ineffective physical safeguards over assets susceptible to misappropriation (e.g., cash donations not secured, inventory or collection items not stored in a secured area, computers not secured, cash or investments kept in unlocked drawers, pre-signed checks available, or unprotected passwords).

(5) Lack of management oversight of assets susceptible to misappropriation (e.g., inadequate supervision of remote locations or failure to develop adequate controls over contributions and grants because scarce resources are assigned to program activities rather than internal control).

(6) Lack of appropriate systems for authorizing and approving transactions (e.g., in purchasing, travel and entertainment, or payroll disbursements), especially involving charges to restricted funds.

(7) Regular budget variance analysis not performed and reviewed on a timely basis.

(8) Board members or management with oversight responsibilities lack necessary background and experience in nonprofit organization management and program activities, or lack commitment to fulfilling their duties.

(9) Significant financial functions performed by volunteers not under strong management oversight and review.

(10) Vacations for personnel in key control functions not mandatory, or those persons’ duties not performed by others while they are absent.

(11) Management has a weak understanding of IT that could enable IT personnel to perpetrate fraud.

(12) Computer security not regularly assessed by a qualified professional.

(13) Inadequate controls over access to electronic records, including controls over and review of computer event logs (e.g., audit trail functionality of accounting software not used or can be bypassed by users).

c. Other:

3. Attitudes/Rationalizations

Consider whether information about the entity, its operations, and its industry indicates attitudes/rationalizations on the part of management, employees, or volunteers to engage in or justify misappropriation of assets. Consider risk factors such as:

a. Inadequate acceptance of the importance of adequately monitoring and safeguarding assets; attitude that ‘the organization has plenty of money’ and ‘this little bit won’t be missed.’

b. Belief that a ‘temporary loan’ which (of course) will be repaid ‘soon’ does not constitute misappropriation of assets.

c. Attitude that internal controls are more of a ‘nuisance’ than a benefit; every dollar spent on ‘overhead’ is a dollar that did not go to help achieve the organization’s goals.



d. Attitude that any action which appears to ‘further the cause’ is acceptable, even when laws, regulations, controls, or organizational policies are thereby violated (e.g., providing benefits to ineligible recipients or for less than standard rates, excess lobbying or political activity, not ‘wasting time’ by keeping required records, etc.).

e. Disregard for internal controls designed to prevent or detect misappropriation, for example, by ignoring or overriding controls or failing to correct known deficiencies in controls.

f. Dissatisfaction with the organization or with other personnel.

g. Indications of strained relationships between the organization and its employees or volunteers, such as:

(1) failure to receive promotions or other expected rewards, or proper recognition for volunteer efforts.

(2) a perception that ‘insiders’ are being unjustly rewarded.

h. The auditor, or other employees or volunteers, have observed unusual changes in behavior or lifestyle that may indicate assets have been misappropriated to support this behavior or lifestyle.

i. Other:

4. Deliberate Misstatements of Nonprofit Financial Statements Unlike the normal tendency in the business world, where, if management is motivated to misstate the financial statements, it is likely to try to make an organization look more financially healthy than it really is (often by overstating sales and earnings), nonprofit organization management is often more likely to try to make the organization look somewhat less financially healthy. This is based on the assumption that donors are more likely to give (members are more willing to pay dues) to an organization that is perceived as needy, rather than to one that is perceived as flush. Of course this would not be taken to an extreme that would make the organization appear to be in serious financial trouble, as that would probably make donors unwilling to give to a ‘sinking ship.’ Also, other factors such as debt covenants or challenge (matching) grants that must be met, might partly counteract this motivation. Another common concern of nonprofit management is to try to make the ratio of program expenses to total expenses as high as possible, to make it appear that the organization is using most of donors' gifts (members' dues) for direct program services rather than for overhead - management and fundraising. (Conversely - to try to make fundraising expenses as a percentage of contributions raised as low as possible.) Following are some of the ways in which management of a nonprofit organization might attempt to make the organization look less well off (to make an organization look better off, simply reverse the items in the list below), and to make the program expense ratio look high:

Goal Methods General 1- Report lower net assets

- especially unrestricted Understate: a) assets, b) revenue, c) unrestricted net assets;

Overstate: d) expenses, e) liabilities



2 - Report higher program expense ratio

Overstate program expenses; Understate management expense and fundraising expense

Specific 1a - Understate assets Do not record unconditional pledges receivable until collected Understate pledges and other receivables by overestimating the uncollectible

amount Use an inappropriately high interest rate to discount long-term pledges

receivable Do not report assets irrevocably held by others for the benefit of the

organization (trusts, endowment funds, etc.) Do not defer expenses that will benefit future periods Do not accrue income receivable (e.g., income on investments) Write off PPE acquired with grant money * Do not record donated PPE Use inappropriately short useful lives to compute PPE depreciation Do not report inventory as an asset (if donated, do not record at all; if

purchased, write off to expense when acquired) Do not mark all appreciated SFAS 124 investments to current market Use inappropriately low fair values under SFAS 157, especially for Level 3

assets Treat payments to other organizations as grants when they are really loans Do not consolidate a controlled affiliate (per SOP 94-3) (especially museums) Do not capitalize collection items, even though the

criteria in SFAS 116 for non-capitalization are not met 1b - Understate revenue also see various items under 1a and 1e Treat contributions (especially pledges) as conditional when they are really

unconditional Improperly cut off transactions at the end of a period 1c - Understate unrestricted

net assets Do not release temporarily restricted net assets that should be released

because the restrictions have been met or have expired Record expendable endowment investment return - especially capital gains -

in the permanently restricted class Report unrestricted gifts as restricted revenue Report exchange transactions with legal limitations on the amount as

restricted revenue Report board-designated net assets as restricted net assets 1d - Overstate total

expenses Improperly write off assets

also see ‘aggressive accrual’ item under 1e below Improperly cut off transactions at the end of a period 1e - Overstate liabilities Defer revenue improperly, especially treat contributions as exchange

transactions Be overly aggressive in accruing liabilities such as employee benefits,

anticipated losses, taxes, grants to others, etc. Use an inappropriately low interest rate to discount long-term liabilities such

as annuity funds, remainder trusts, etc. 2 - Overstate program;

under-state supporting expenses, especially fundraising

Be overly aggressive in applying SOP 98-2: a) by improperly concluding the allocation criteria are met, and/or b) in determining what portion of the joint activity qualifies as program



Mis-characterize supporting activities as programs Be overly aggressive in allocating allocable expenses to the program

category (time sheets, space occupied, telephone usage, etc.) Improperly re-allocate management expense to other categories Do not record non-program volunteers, even though the criteria in SFAS 116

are met; Do record program volunteers, even though the criteria are not met

Do not record in-kind contributions (e.g., free or reduced-cost rent, printing, supplies, etc.) allocable to supporting activities

Bury material fundraising costs in management expense Capitalize prepaid fundraising expenses Record pass-through contribution transactions - as revenue and program

expense - that should not be recorded under SFAS 136 * Some grantors require the recipient to report the full amount expended for PPE as a charge against the grant budget in the period expended. While this may be done in budgets and special reports to funders, it is contrary to GAAP.

5. Other risk factors especially relevant to the not-for-profit sector: When these are present, they may be indicative of higher risk. A. Management/governance characteristics - The executive director (or other person in a position of authority) possesses significant

power and latitude in managing activities, and has the power to override controls [often found]

- A major donor exercises undue influence over the affairs of the entity - A ‘sleepy’ governing board B. Industry conditions - Difficulty in establishing benchmarks for comparison of financial data C. Operating characteristics - Complex, and changing, administrative or programmatic requirements imposed by funders - Inadequate resources devoted to establishment of sound controls (e.g. inadequate pay to

attract top people to management, inadequate checks and balances procedures, inadequate time spent by senior people (paid and volunteer) on controls) Belief often encountered in the not-for-profit sector: "Every dollar spent on 'overhead' is a dollar not going to feed the hungry (or whatever)."

D. Possible misappropriation of assets - Fundraising, in general (due to inherent limitations on ability of management and auditor to

test full inclusion) - Inadequate documentation of pledges, especially conditional pledges not recorded on the

books E. Community Support - Decline in utilization of organization's services by the local community (fewer students,

patients, visitors, members, or other users). - Decline in real dollar support through gifts, bequests, and membership dues. - Decline in hours of time made available by volunteers.



- Increasing incidence of turndown of grant requests. F. Financial Independence - A growing percentage of own-source unrestricted revenues committed to meet matching-

fund requirements or needed to supplement restricted revenues for special projects. - Increasing reliance on very few different sources of support. - Rapid increases in fixed cash costs (salaries and fringes, rent, debt service, others). - Continuing decline or deficit in operating income or unrestricted net assets (fund balance). G. Productivity - Cost per unit of service and/or Number of employees per unit of service rising rapidly. - User fee rates rising rapidly (unless resulting from a deliberate management decision to

reduce the amount by which such fees are subsidized from other revenue sources). H. Deferred Current Costs - Proceeds of long-term debt or sales of long-term investments being used for current

purposes. - Deferring needed maintenance of capital assets. - Low or declining funding of replacement of capital assets near the end of their useful life. - Failure to pay payroll or other taxes when due. I. Management Practices - A pattern of budget cost overruns, either overall or in specific programs/departments. - Earnings on investments declining disproportionately to general trends of investment

yields. - Levels of receivables, inventory, or prepaid expenses increasing faster than related

activity would dictate. - Failure on the part of board members or management to understand and accept the

seriousness of the financial situation.

6. Internal Control - What is internal control? Internal control comprises the plans, procedures, and records by which achievement of an organization's goals is enhanced. • Internal accounting controls (IAC) are the subset of control related to accounting. • But do not overlook other aspects of internal control, for example,

- "Do we have procedures to assure that the heart we are about to transplant into this patient is of the same blood type as the patient's?"

- "Do we have procedures to assure that actions by the organization or its personnel (including volunteers) do not constitute torts, or violations of laws or regulations?" Q.v., The Hydrolevel Case.

- "Do we have procedures to assure that organization personnel who have been credibly accused of improper behavior with children are removed from positions permitting such improper behavior in the future?" [you know of whom I speak]

• Failure to have such procedures in place can prove highly detrimental to an organization's financial health.



A. Why have internal controls? After all, they are not cost-free! • Consider the objectives of a not-for-profit organization:

• Primary: - Provide effective service to its constituency (members) • Supporting: - Attract cash and other resources to cover cost of services - Administer organization efficiently - Promote good community image: attract volunteers; members - Protect sensitive information (personnel, client, member)

B. IAC is mainly concerned with ensuring that financial resources are available.

But, it is also related to community image. Publicity about incidents of waste, abuse, or fraud hurts the organization's image and makes it more difficult to attract future financial resources, volunteers, and members - note recent examples: United Way; NAACP; Nature Conservancy).

Financial resources might be unavailable for several reasons:

a. Ineffective member recruitment or fund-raising efforts b. Theft of cash receipts c. Cash disbursed for improper (illegal, or not in fulfillment of the organization’s

mission) purposes d. Theft of non-cash assets (e.g., inventory, supplies, equipment) e. Cash disbursed in a wasteful manner

These reasons can be categorized into: • Error • Mismanagement • Fraud

C. Although many people associate IAC mainly with prevention of fraud, it is relevant to error and mismanagement, too. IAC will not prevent errors, mismanagement, or fraud, but it will:

• deter some persons from even attempting to commit fraud, • make it more difficult to successfully commit fraud, • reduce the severity of fraud when it does occur,

and help ensure: • prompt detection, • assignment of responsibility, and • correction of those situations.

D. IAC is just as important, if not more so, in nonprofit organizations as in businesses.

• Consider that when someone steals from a nonprofit or wastes its resources, the loss is really ultimately borne by the organization’s members or clients.

• In the case of an association, these are people who are counting on the association to provide them with services they need;

• In the case of charities, these are often the needy members of society - the homeless, the hungry, the sick, the depressed, etc.



• Whatever was stolen or wasted is no longer available to help these people or to serve members.

Further, when considering membership or charitable giving, members and donors are often much more sensitive to the organization’s reputation than are buyers of a company’s products.

• Business misbehavior has to rise to an exceptionally high level (think Exxon Valdez, apartheid in South Africa) before customers will turn to a competitor solely because they have heard something bad about the company’s internal operations.

• But once even a whiff of scandal touches a nonprofit, the sound of checkbooks closing can be heard far and wide. Members will disappear; donors will give elsewhere.

• One charity saw its annual gifts drop from $45 million to $18 million following a series of revelations of misbehavior on the part of the organization’s leadership.

• That was a very expensive lesson in organization governance.

Nonprofits should hold themselves to an even higher standard of behavior than businesses need to if they wish to retain the trust of the public, which is vital for them to succeed. Especially consider that, although the dollar amount involved in a scandal or fraud may be relatively small (e.g., United Way of America - less than $1 million out of $3 billion revenue), the impact on the organization's finances resulting from bad publicity may be far worse (estimated effect on United Way system – many $100s of millions).

E. The principles of IAC are the same as for businesses, as are most of the practices. A

good control system is: • Tailored to the size, structure, and activities of a particular organization • Flexible (includes reasonable exceptions and alternatives) • Cost and time-effective • Inclusive of mechanisms for promptly identifying problems and proposed

approaches for solutions. General Principle of IAC Desirable practice in a

not-for-profit organization - Competent people following clear

procedures, keeping adequate records. - Do pay what it takes to attract good staff.

Take the time to create and implement sound financial procedures.

- Segregation of duties. - Achieve this as much as possible. When

not possible (often the case in very small organizations), set up alternate controls. Be sure that at least the bank reconciliation is performed promptly, by someone with no other accounting functions

- Review/approval of transactions by

knowledgeable persons. - (Same as in a business.)



- Physical control of assets, including access to computer systems.

- (Same as in a business.)

- Balancing and reconciliation procedures - (Same as in a business.) - Top level review of operations and results.

(Often, the most important control, in the absence of other procedures.)

- Sound budgetary process. - Involvement by senior people. - Timely, meaningful financial information

furnished to key people. Particular aspects of IAC in the nonprofit environment:

• Nonprofit organizations are almost exclusively service organizations rather than manufacturers or sellers of goods, i.e., the "product" is intangible, and calls for different types of procedures to insure that all services (for which it is intended to charge) are billed at proper rates.

• Some nonprofit organizations depend heavily on nonreciprocal transactions (gifts,

bequests) for their support. (Many associations have 501(c)(3) affiliates.) Such transactions are especially difficult to control to ensure that all amounts intended for the organization are actually received and deposited.

• Some nonprofit organizations operate under restrictions imposed by donors and grantors

on use of assets, performance of functions, and recordkeeping. Violation of restrictions can attract severe penalties. Particular controls are needed to ensure compliance.

• Persons involved with nonprofit organizations (board, staff) are often more "cause"

oriented than business oriented. IAC may not appear important to these people. The attitude of “trust” is often especially prevalent.

• Some nonprofit organizations operate with few assets and small staffs. Reserves to fall

back on are limited, and desirable segregation of duties is difficult. • For many nonprofits, there may be nothing comparable to "profit" used as a measure of

performance. Goal setting and measurement of the degree of achievement of goals are more difficult.

Consider some not-for-profit problems, and some of the factors that contributed to them:

• PTL: [CEO ran organization as his personal fiefdom] - Management characteristics - Executive with significant power; Lack of board oversight

• Episcopal Church: [embezzlement by CFO] - Management characteristics; Overseers lacked appropriate expertise

- Chronicle of Philanthropy, May 18, 1995: "Very few church officials, [a church consultant] says, have sophisticated enough business skills to really provide the kind of oversight that is required."

- Virginia Episcopalian, Feb./Mar. 1996: "Browning [the CEO – title: Presiding Bishop] said that he has 'faced the difficult fact that this was ultimately my responsibility,'..."

• United Way of America: [CEO lived the high life on organization money] - Management characteristics - Executive with significant power; sleepy board



• American University: ditto

• Washington Teachers’ Union: ditto

• Smithsonian Institution: ditto

• Several universities: [identity theft, by hackers, of personal information from university computer records] – Insufficient security surrounding computer systems, especially sensitive data

• New Era Philanthropy: [Ponzi scheme] - Management characteristics - Executive with significant power; "Anonymous donors"

• Stanford University: [improper expense allocation] - (several factors)

• American Kidney Fund: [off-the-books fundraising fraud by executive director] - "Anonymous donors"

• Numbers of local churches: [misappropriation of assets] - Currency; Trust; Other factors Sidebar – Take back to your CFO and audit committee:

Not-for-Profit Financial "Checkup" (generic document - to be tailored to particular organization)

Should be completed at least annually; more often if concerns arise I. Related parties and other sensitive areas

Do we have a formal conflict of interest policy? ____ Describe (or attach a copy): What transactions have we had with related parties* (other than the executive director's compensation)?

Were they approved by the board - with knowledge of the relationship; without input from the related party? ___

Has the executive director's total compensation been approved by the full board? ____ Who approves board members' and the executive director's travel and entertainment expenses?

II. Internal controls and risks

Is there a healthy attitude about internal controls, originating at the very top of the organization? ____ Do we have adequate written procedures manuals for important financial and operational areas? ____ What procedures do we have in place to assure that:

All cash receipts are recorded and deposited? Especially contributions? Only proper cash disbursements are made? Assets are protected from theft?



Who reconciles our bank statements, and how quickly?

Is this person independent of other cash and bookkeeping functions? ____

Has our auditor made recommendations for improvements in controls? ____ If so, have they been implemented? ____

How soon after the end of an accounting period is a budget-to-actual comparison made and significant variances (or lack thereof, where expected) investigated? ______

Has someone knowledgeable about computers reviewed our computer security? ____

Has someone knowledgeable about nonprofit taxes reviewed our activities for possible exposure? ____ Consider, as relevant: - Private inurement or benefit, especially compensation - Possible unrelated business income - Possible excess lobbying/political activity - Employee vs. independent contractor status - Public disclosure of Form 990 on request

Has a knowledgeable attorney reviewed our activities for possible legal risks? ____ Is there anything about our organization or its operations that we would be embarrassed to have published in the [local newspaper]/discussed on the evening news? ____

III. Financial reporting and audits

Have we received clean (unqualified) reports from our auditor? _____

Are we satisfied that our auditor is independent? ____ How much in non-audit fees have we paid our audit firm? $________

Does our auditor understand that (s)he has unrestricted access to the board/audit committee? ____

Has our auditor received a clean peer review report? ____

Have we filed all required government reports (Form 990, state forms, etc.) on a timely basis? ____

IV. Other

Have we made all payroll tax deposits fully and on a timely basis? ____ (If this is not done, officers and board members can be held personally liable.)

Do we carry adequate property and liability insurance? ____

Has our board adopted a formal policy on desired levels of operating reserves, and are we comfortable that our reserves are adequate? ____ [You probably aren't, but get working on it.]



* - "Related parties" include organization officers, directors, trustees, and management in decision-making positions, major donors, and members of the immediate families of any of the preceding; controlled and affiliated organizations and trusts, and businesses in which any of the preceding are in significant positions of authority (owner or manager). F. Nonprofit Best Financial Practices

Accounting and financial reporting Qualified staff Persons who recruit/hire personnel (including volunteers) understand what knowledge and skills are required in accounting staff for a nonprofit organization

Adequate background/reference checks done of all new hires/recruits Adequate training is available for accounting personnel (in-house or outside) Persons who supervise accounting personnel have adequate knowledge of accounting

to effectively supervise work of accounting staff Including the executive director, who must adequately supervise the CFO/controller Periodic performance evaluation of all staff/volunteers

Adequate non-staff resources are available to provide guidance in challenging situations (could be board treasurer, outside CPA, consultant, others)

Organization offers compensation adequate to attract the caliber of accounting staff required, given the complexity of the organization's needs

Accounting manual Chart of accounts meets information needs

for GAAP and other external financial reporting for needs of internal management and governing board

Updated regularly as needs change Includes record retention policy (consider IRS rules, management needs, legal matters,

etc.) Transaction processing

Approvals (documented): cash disbursements investment transactions write-off of receivables, especially pledges acquisition of fixed assets other major purchases disposal of assets borrowing contracts (leases, construction, services, etc.) travel and entertainment expenses of senior staff and volunteers other non-standard transactions (see also personnel matters, below)

Review of non-standard transactions by appropriately high authority, and written documentation thereof

Control over proper billing of customers when service fee rates vary by circumstances (e.g., ability to pay in a charity clinic)

Sequentially numbered documents used where worthwhile (this will not prevent a determined thief, but it may deter some from trying)

Blank negotiable instruments (blank checks) under adequate physical control List maintained and disseminated of who has review/approval authority/responsibility

Bookkeeping Reconciliations

Promptly done by persons who do not process or approve transactions Reviewed by appropriately high authority



Unusual items promptly investigated and followed up Integration (as much as possible) of various information systems, e.g., general ledger

with (as appropriate): Membership records Patient records Student records Donor records Grantee records Budget system Asset records (property, investments, collections, etc.) Financial reporting systems (including tax and regulatory reporting)

Off-site backup storage of key records (manual and electronic) Management reporting (see below re reporting to governing board)

Adequate and timely Users have ability to understand the information they are given Users regularly solicited to provide input as to what financial information they would like to receive Users understand what are the key performance indicators for the organization Interim information normally available no later than two weeks after end of period; year-end -three weeks (unaudited) (see below re budgeting and variances)

Training for non-accountant managers to understand financial information External financial reporting

CEO/CFO public attestation (Sarbanes-Oxley provision) Adequate consideration of ability of outside financial statement users to understand the

information provided Training available for those who wish to become more proficient Simplified versions of statements available to those who prefer that format If financial information is publicly available on a website, there are adequate controls against hackers tampering with the data. A reporting schedule is maintained to ensure that deadlines are not missed

Auditing Hiring an outside auditor - done by audit committee (see below)

Independent Competent - knowledgeable about nonprofits Consider periodic requests for proposal from other firms

But do not automatically change unless dissatisfied with incumbent Change if dissatisfied with service or fee

Follow up of auditor recommendations re internal controls and procedures Who is responsible, and who monitors?

OMB A-133 audit if required Auditor meets GAO requirements (CPE, peer review, other)

Consideration of desirability of a formal internal audit function If not a formal function, then consider an informal one (volunteers perform limited functions)

Internal accounting controls

Strong control environment set from the top (board and chief executive) Benefits of strong controls clearly communicated to entire organization (including

volunteers) Be prepared to convince skeptics as to the value of controls

If someone were to ask the CEO/board chair what is the risk of fraud in the organization, would he/she be comfortable saying the risk is low? If not, why not?

Do we regularly consider whether there is anything about our organization and its operations that we would be embarrassed to read about - and know that our donors/members are reading about - on the front page of the local newspaper?



Identify risks specific to organization Fraudulent financial reporting

Understand why/how financial information might be mis-stated not to look too rich high ratio of program expenses to total expenses

Theft of assets Adequate internal controls established and enforced

Segregation of duties Where small size limits ability to do this, alternative procedures followed All persons must take vacation regularly, during which time their duties are performed by others

Review and approval of key transactions and reconciliations (see above) Especially over:

(Contributions received - see below) Cash receipts, generally Compliance with donor restrictions

Government grants, especially: time records, procurement procedures, allowable costs, subrecipient monitoring, reporting

Purchasing (competitive bid requirements, conflict of interest consideration, etc.) Related party transactions, generally, including transactions with:

Members of the governing board and its committees Officers Senior management Major donors Close family members of the above Controlled and affiliated organizations and trusts Businesses in which any of the above have an ownership or management interest

Including over functions performed outside the organization's premises, e.g., at service bureaus, banks, caging houses, on-site at conferences, etc.

Procedures to ensure that goods and services are provided only to those who have paid for them, e.g., admission to events (concerts, conferences, meetings, classes, dinners, etc.), sending of member publications, issuance of diplomas and transcripts, treatment in clinics, etc.

Proof of payment required to obtain services, and/or Reconciliation of attendance to cash collected (sold vs. unsold tickets) Reconciliation of number of members to cash collected

Regular review of adequacy, and need (cost/benefit) (See above re follow-up of auditor recommendations) (See below re ethics policies)

Management also gives appropriate consideration to internal controls over activities outside the financial function. Although such weaknesses are not directly related to financial transactions, they can result in severe financial consequences if not addressed (recent examples of failures include control of human organ transplants to ensure proper blood type match, and misbehavior of organization staff/volunteers with respect to children.)

Data processing

System design and implementation Adequate technical expertise readily available at all times Approval of all changes to programs

Restrictions on access (authorized and unauthorized) to equipment, programs, & data Define who is permitted access to what equipment and programs Passwords established and changed regularly Physical access to equipment restricted as much as possible Logs kept of persons accessing equipment/programs

Data control - review of input and output for reasonableness by knowledgeable personnel



Employees, and volunteers, adequately informed about procedures and responsibility to maintain safety of equipment and integrity of data

All personnel formally acknowledge their responsibility in this area Web site design and content reviewed and approved Protection from hackers and viruses (internal and external) (see also above under

external financial reporting) Consider encryption of especially sensitive data Hardware permanently marked with organization identification and physically secured

whenever possible Backup and recovery procedures for hardware, software, and data

Disaster plan Created and regularly reviewed by knowledgeable professionals Approved by top management Backup equipment and communications lines Procedures for restoration of data

Periodic test of procedures

Asset control Investment management

Formal investment policy, approved by board, communicated to all advisors and managers

Choice of managers and advisors Regular monitoring of results Investments kept with reliable custodian or in safe deposit box under dual control

Custodian maintains adequate insurance Cash management

Cash forecast Backup resources available in case of need (line-of-credit, loans, donors, etc.) Each petty cash fund under the control of only one person

Other asset management (also see below re collection of pledges) Inventory under adequate physical and accounting controls Museum collections - special concerns regarding conservation, protection from theft

and damage Adequate processes for determining fair value (SFAS 157) Buildings and equipment (also see above re data processing equipment)

Periodic physical inventory taken Purchasing procedures (also see below re ethics policies) Insurance

Property (including fidelity) Liability (including vehicles, workers' compensation, malpractice, D & O, etc.)

Especially important if any of the following are present: - Activities involving children - Medical care of any sort - Organization makes public statements on controversial issues

Loss of income (business interruption) Employee benefits (health, life, pension, etc.) By outsiders, with organization as a named beneficiary (caterers, contractors,

investment custodians, etc.) Appropriate level of deductibles, to reduce cost Consider self-insurance in appropriate situations, but have an ‘umbrella’ backup Needs and risks regularly reviewed/assessed by an outside professional



Budgeting Adequate strategic planning process

But don't do so much planning that implementation never happens Budget preparation and approval

There are really three budgets: operating, cash, capital Primary responsibility lies with operating management, not the financial personnel

Financial people are not the dictators of organization activities, but should sound the alarm if disturbing trends are noticed

Those who are to be held to achievement of budgetary goals must participate in the process of budget creation/approval

Do not ‘plug’ the budget by assuming that contributions will somehow be available to make up a deficit

All strategic and operational decisions with budget implications should be made and approved before the final draft budget is brought to the full board for approval

Do revise the budget if necessary Variance analysis - timely & thorough

Do not overlook items where there is no variance, if one would be expected (there may be offsetting factors at work)

Watch for motivation by operating people to force actual amounts to match budget Follow-up to deal with problems (or opportunities)

But don't shoot the messenger

Legal and tax Adequate legal/tax advice available and used when called for

Attorney/tax advisor are appropriately knowledgeable about nonprofit legal/tax matters Awareness of nonprofit tax pitfalls

Lobbying limitations Difference between direct and grassroots lobbying, and limitations on each No political contributions by a (c)(3) Private inurement prohibition Especially executive compensation - be prepared to justify Unrelated business income rules

Regularly have a qualified professional review activities for possible UBI implications, and also do this before undertaking any major new activity

Donor tax deduction rules Do not give tax advice to donors (unless professionally qualified to do so), but Do try to keep donors out of tax trouble (know enough to recognize situations where a donor should be obtaining their own professional tax advice) Do not provide valuation information to donors (it their responsibility to obtain this independently)

Employee vs. independent contractor rules Be prepared to justify every independent contractor

Withheld payroll taxes are promptly remitted (there is personal liability for failure to do so) Failure to make required federal and state (and local) filings, including public disclosure

New Form 990 is very different from previous version Much more detail, especially about compensation, governance, related entities, foreign

activities If your Form 990 is on someone else's website (e.g., Guidestar), check that it is complete and

accurate Be sure to remove private donor information (name, address) from copies of Form 990 made

available to the public Be careful about activities not under direct central control (volunteer committees, affiliated

organizations, individual volunteers, etc.) which could cause tax or legal problems



Fundraising Persons involved with fundraising have adequate awareness of legal, accounting, and tax implications Organization has a policy on what types of gifts it will accept, especially regarding:

Property Possible pollution (inside - e.g., asbestos, or underneath) Existing tenants in a rental building [example] Possible difficulty in converting to cash (if that would be desired)

Non-marketable investments, or investments in certain companies Gifts from donors as to with whom there is a question about the organization's willingness to be publicly identified Donor-imposed restrictions on the use or retention of gifts Donor-imposed conditions precedent to receiving a gift Adequate internal reporting of amounts raised and related expenses Policy regarding retention vs. sale of non-cash gifts Appropriate control over contributions received, including

Collection of pledges and write-off of uncollectibles (See above re controls over compliance with donor restrictions, and tax awareness)

Personnel, and similar information

Background checks for new employees and volunteers Clear job descriptions Ethics policies created, communicated, and enforced regarding:

Bribes, kickbacks, other unauthorized payments Conflicts of interest

Identification of potential conflicts as soon as they arise Person with conflict does not participate in approval of transaction Policy applies to all management (including volunteers) and board personnel

Discrimination and harassment Whistleblower procedures and protection in place and enforced All personnel aware of how to report problems

Theft (of tangible assets, information, services, etc.) Libel and slander Policies communicated to all personnel (including volunteers) All personnel (including volunteers) affirmatively acknowledge their responsibility for

appropriate behavior All instances of inappropriate behavior appropriately dealt with

Regular performance evaluation, counseling, and feedback Privacy protection

Personnel/payroll information Other organization information, e.g., as appropriate:

patient/client information (health care or welfare organization) student information (school/college) donor information customer/member credit card information member information (membership organization - club, association, etc.) information about a foundation's grantees proprietary organization operational information

Control over changes to personnel and payroll records Time reporting (especially important if federal funds are involved) Approval of payroll

Approver is knowledgeable enough to notice any irregular items Employee benefits

Regular review of types and levels of benefits by an outside expert Review for compliance with tax rules



Governance Adequate financial expertise on board

If not currently available, nominating committee is making active effort to obtain Active audit committee (2 - 3 meetings per year; more if needed)

At least one financial expert, and a strong chair No compensated personnel (including close family of same, or outside contractors) on committee (but management should attend part of meetings) If finance committee is to also serve as audit committee, be sure they understand that they wear two hats Clear charter, approved by full board and reviewed regularly Process for educating its members about their responsibilities Formal meeting agendas

Meets with outside auditors (and internal, if applicable) without management present Meets with management without auditors present

Regularly reports to full board Understands its responsibility and authority (does not pull punches)

Solely responsible for final decision on hiring outside auditor Assures adequate and prompt follow-up of outside auditor recommendations Regularly reviews quality of financial reports and internal controls Is always alert to any indication of problems Does not allow itself to be intimidated But does not micro-investigate

Adequate training for all board members to understand financial information When hiring a new executive director, financial knowledge and comfort with numbers are among the qualities assessed Board is fully aware of its overall fiduciary responsibility for the financial health of the organization

Board insists on a strong internal control environment Board has a policy on desirable level of operating reserves, and works to achieve that level

Timely and understandable financial information is provided to board Board does not hesitate to insist on obtaining the information it needs, in a format it can understand, on a timely basis

But board does not micro-manage

Disaster Preparedness and Recovery Understand the risks specific to the organization Try to prevent disasters as much as possible

Risk management consultant - see insurance, above Prepare for the ones that cannot be prevented

Insurance - see above Plan how to respond to the ones that happen

Effect on people Effect on operations Effect on facilities and equipment

Especially computers - see above Effect on finances



III. Financial Reporting and Accounting Considerations - Old and New The current status of FASB projects may be reviewed at http://www.fasb.org/project/index.shtml See Appendix A, below, for a cross-reference between the new Accounting Standards

Codification (ASC) and previous nonprofit accounting literature. Materiality, as always, is a consideration in all areas, but since the focus of users’ concerns is different with nonprofits, different measures of materiality may be appropriate.

1. Not-for-Profit GAAP Update A. SFAS 157 (ASC 820) - Fair Value Measurements (2006) - Not-for-Profit Perspective

Nonprofit organizations use fair value accounting when they are:

(1) required by certain accounting standards to use fair value (FV) for certain transactions and balances, and

(2) permitted by certain other accounting standards to use fair value for certain other transactions and balances, as listed in Table 1 below.

Determination of fair value is governed by SFAS No. 157, Fair Value Measurements, and its related FASB staff positions and ASUs, but SFAS 157 itself does not ever require the use of FV.

The overall project objective is to develop a framework for applying the fair value measurement (FVM) objective in GAAP. The framework, which is being developed in phases, initially focused on ‘how’ to measure fair value, not ‘what’ or ‘when’ to measure at fair value. The Board is separately considering what to measure at fair value on a project-by-project basis. Related objectives are to improve the consistency and comparability of the measurements, codify and simplify the guidance that currently exists for developing the measurements, and improve disclosures about the measurements. Paragraph 5 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This is often called the ‘exit’ price – i.e., what you could sell an asset for, or what you would have to pay to settle a liability. The definition emphasizes the exchange price notion contained, either explicitly or implicitly, in the definitions of fair value previously included in other AICPA and FASB definitions of fair value. SFAS 157 also requires the value to be based on the ‘highest and best use’ of the item, regardless of whether that use is the one intended by the organization. Consider, for example, a donated painting that could be sold, but won’t be. The fact that it won’t be is irrelevant; fair value is based on what a ‘market participant’ - that is, a hypothetical buyer of the painting if it were sold - would pay for it. (But see below for discussion of a donor restriction that the specific painting may not ever be sold.) An interesting question has arisen, but not been fully resolved: Should the recorded value of FAS 124 securities include commissions? Clearly the purchase commission will not be recovered on sale (‘exit’), so should not be part of the FV. But should the FV also be net of the inevitable sales commission, which, of course, will also not be collected in cash upon a future sale (‘exit’)? Probably not; that should probably be a cost of the period of sale. The AICPA committee is considering this. (Similar logic would be applied to real estate.)



FAS 157 mentions three valuation techniques (para. 18):

• market for identical or comparable items • future income (discounted) – see also Appendix B to the statement • replacement cost,

(In some cases, two or all three techniques may be used in determining fair value.)

and three levels of a hierarchy of inputs: • Level 1 (para. 24-27) – quoted prices in active markets for identical items • Level 2 (para. 28-29) – observable inputs other than quoted market prices • Level 3 (para. 30) – unobservable inputs.

It also gives an example of its application in a situation where a donor has placed a restriction on an asset that is donated (para. A-30). If the restriction it irrevocably linked to that particular asset, then the asset value should be adjusted to reflect any diminishment of value due to the restriction. However if the restriction is linked only to the related net assets, then the value of the property is probably not affected by the restriction. FASB has subsequently issued a number of amendments and interpretations to 157, including:

- FSP 157-3 - Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active

- FSP FAS 157-4 - Determining Whether a Market Is Not Active and a Transaction Is Not

Distressed - FSP FAS 115-2, FAS 124-2, and EITF 99-20-2 - Recognition and Presentation of Other-

Than-Temporary Impairments. This FSP includes one very controversial provision

• Intent and ability to hold to recovery: The FSP changes the existing requirement that management assert it has both the intent and ability to hold the impaired asset until recovery. The FSP now requires that management assert (a) it does not have the intent to sell the asset, (b) and it is more-likely-than-not it will not have to sell the asset before recovery.

Note the subtle, but important, difference between the two italicized phrases in the two preceding sentences.

- ASU 2009-05 - Measuring Liabilities at Fair Value. (E.D. was Proposed FSP 157-f). - ASU 2009-12 - Investments in Certain Entities That Calculate Net Asset Value per Share

(or its Equivalent). (E.D. was Proposed FSP 157-g) ASC 820-10-35-59: A reporting entity is permitted, as a practical expedient, to estimate the fair value of an investment within the scope of [para. of the ASU discussing when there is not a readily determinable FV] using the net asset value per share (or its equivalent, …) of the investment, if the net asset value per share of the investment is calculated in a manner consistent with … Topic 946 [the investment companies Audit Guide] as of the reporting entity’s measurement date.



SFAS 157 and its various amendments also require extensive disclosures, including new disclosures required by ASU 2010-06. These include:

- A reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers; and

- In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (gross rather than net).

In addition, ASU 2010-06 clarifies the requirements of the following existing disclosures:

- For purposes of reporting fair value measurement for each class of assets and liabilities, a reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities; and

- A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements.

ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. Early application is permitted.

Nonprofits are especially likely to need to apply SFAS 157 in connection with:

• Non-cash contributions received and made, (includes both items which will be capitalized on the balance sheet, and donated services and use of property which flow through the income statement)

• Non-marketable (so-called alternative) investments,

• Acquisition accounting for a combination, and

• Any asset or liability for which the fair value option is elected under SFAS 159.

Balance sheet items for which SFAS 159 is most likely to be elected, and which are likely to require additional effort to determine the fair value, are pledges and loans receivable and payable. For long-term receivables and payables discounted to present value under APB 21, the effect of using fair value is to unfreeze the interest rate used to compute the discount. Under APB 21 the interest rate is set at the inception of the agreement and is not changed over the life of the agreement; under SFAS 157 the interest rate is adjusted each period to a current rate.

Non-cash contributions are required to be valued at fair value by SFAS 116, and, even if alternative investments are not reported at fair value in the balance sheet, SFAS 107 may require disclosure of their fair value in a footnote.



Table 1: Nonprofit Organizations’ Use of Fair Value:

Items for which fair value (FV) accounting is required or permitted at and/or after initial recording

Item Method of valuation Comments ‘Level’

Balance sheet:

Financial assets / liabilities

Cash & equivalents Face value (unless restricted by law, e.g., cash in a foreign country with restrictions on export of currency)

face value is presumed to be fair value

1

Investment securities covered by FAS 124

Quoted market price (excluding purchase commission and fees, and without any blockage discount)

already at fair value, per SFAS 124

normally 1

Non-FAS 124 investments, except affiliates *

Various, see para. 18 of SFAS 157; also adjust for liquidity constraints, if any

permitted alternative, per Appendix A to Chapter 8 of the AICPA Audit Guide

2, or 3, depending on nature

Assets and liabilities of an acquiree under SFAS 164

Fair value - see other items

Investment in affiliates not meeting criteria for consolidation (SOP 94-3)

Various, see para. 18 of SFAS 157; also adjust for liquidity constraints, if any

probably 3

Derivatives Amount required to cancel the contract

already at fair value, per SFAS 133

1 or 2

Beneficial interests in irrevocable trusts held by a third party

Present value of estimated future cash flows, using a current interest rate

interest rate adjusted each period

2 or 3

Earned income receivable (sales, investment income)

Normally, face value discounted if long term probably 2

Contributions (pledges) receivable/payable



2 or 3



Loans receivable Present value of estimated future cash flows, using a current interest rate adjusted to reflect debtor’s risk


2 or 3

Loans payable Present value of estimated future cash flows, using a current interest rate


2 or 3

Deposits held by/for others Normally, face value discounted if long-term 1 or 2

Accounts payable and accrued expenses **

Normally, face value discounted if long term 2 or 3

Obligations under split-interest agreements



2 or 3

Notes and bonds payable Face value, adjusted for debtor’s risk

2 or 3

Statement of Activities:

Contributions of property other than cash and investments:

(All contributions are initially recorded at fair value, per SFAS 116)

(for cash and investments, see above)

- unrestricted

- financial asset (see above for the type of property)

- nonfinancial asset Appraised value Fair value used for initial recording only

- with a donor restriction as to use

same as unrestricted, but see right column

See Para. A-30 of SFAS 157, and above for comment

Forgiveness of debt Carrying value of debt at time of forgiveness (see above)

Donated service of volunteer

What the organization would otherwise have to pay for the service 1

(see below)

Donated use of property What the organization would otherwise have to pay for the use of the property 1

(see below)

* - non-marketable equity securities, property, collectibles, mortgage notes, partnership interests, etc. ** - other than: (1) compensation-related items (see below for list), and (2) most obligations under leases (see below)

1 - Since SFAS 157 only discusses assets and liabilities, it provides no guidance for measuring fair value of these types of transactions, which do not affect the balance sheet. There is an open question as to whether the fair value is:



(1) the amount the owner of the property or the provider of the service normally charges paying customers/clients for similar property or services, or (2) the amount that the recipient organization would otherwise have paid to acquire the use of property or services of equal utility to the organization.

The concept of an ‘exit price’ cannot be applied since there is no market - real or implied - for such items; they are available only to the organization in question. It is also unclear what effect applying the concept of ‘highest and best use’ might have in these contexts. For example, consider:

Services

an experienced neurosurgeon volunteers to provide routine medical care in a charity clinic

the high rate that neurosurgeon normally charges for highly skilled professional services?

the lower rate the charity would otherwise have paid to hire a less experienced (but still well qualified) doctor?

Property

a property owner allows a charity to use very lavish property rent free

the high rent the owner charges for similar property?

the lower amount the charity would have paid to rent property of equal utility to it?

Proposal: All Financial Instruments at Fair Value - In July 2009, the Board agreed to propose a model to improve financial reporting for financial instruments. The Board reached the following decision:

... to propose that all financial instruments will be presented on the balance sheet at fair value with changes in value recognized in net income or other comprehensive income with an optional exception for own debt in certain circumstances, which will be measured at amortized cost. ....

While the main effect of this proposal will be to change SFAS 115, it would also presumably remove the options that nonprofits now have under the audit guide for non-SFAS 124 investments.

In May 2010, FASB issued a proposed ASU that would largely implement this decision. Its proposed effects are:

Effects of Proposed ASU (May 2010) on Nonprofit Organizations' Use of Fair Value (FV) for Financial Instruments

Item Present method of valuation (unless FAS 159 has been adopted for the item)

Effect of this ED

Change?

Cash & equivalents Face value, which is assumed to be FV

no change No

Investment securities covered by FAS 124

Quoted market price (excluding purchase commission and fees)

already at FV, per SFAS 124

No



Non FAS 124 investments that are:

financial instruments, (except investment in affiliates) *

Various, see para. 18 of SFAS 157, and permitted alternatives per Appendix A to Chapter 8 of the AICPA Audit Guide

required to use FV Yes

not financial instruments ** " none; only applies to financial instruments

No

Assets and liabilities of an acquiree under SFAS 164

Fair value - see other items

Investment in affiliates not meeting criteria for consolidation (SOP 94-3):

carried at equity Various, see para. 18 of SFAS 157; also adjust for liquidity constraints, if any

excluded from scope of ED (para. 4e), but see ***

Maybe

not carried at equity " required to use FV Yes

Derivatives Amount required to cancel the contract

no change; already at fair value, per SFAS 133

No

Beneficial interests in 3rd-party irrevocable trusts

Current FV of assets in trust no change No

Earned income receivable (sales, investment income), and accounts payable and accrued expenses ****

(see para. 33)

short-term (<1 year) Normally, face value (amortized cost)

may report at amortized cost

No

other " (discounted) required to use FV Yes

Contributions (pledges) receivable/payable

Present value of estimated future cash flows, using the historical interest rate

excluded from scope of ED by para. 4n

No

Assets and obligations under split-interest agreements


for most, no change; already at FV

Mostly, No



Loans receivable and payable (except mortgages payable - see next item)

Amortized cost, adjusted to reflect debtor’s risk


Mortgages payable Amortized cost may use amortized cost if meet criteria in para. 21 & 28 (related to nonfinancial asset)

Normally, no

Notes and bonds payable Face value, adjusted for debtor’s risk


* - non-marketable equity securities, mortgage notes, partnership interests, etc. ** - property, collectibles, etc. *** - criteria for use of equity method are changed; see para. 130. (Only if there is significant influence &

activities are related) **** - other than: (1) compensation-related items (excluded from ED by para. 4c), and (2) most obligations

under leases (excluded from ED by para. 4i)

Proposal - In June 2010, FASB issued another proposed ASU that would amend FAS 157; it would:

- make terminology and clarifying changes to further converge US and International accounting standards

- clarify that the 'highest and best use' concept would only apply to non-financial assets; - provide guidance on measuring FV of an instrument classified in equity (not normally

applicable to nonprofits); - provide additional flexibility for measuring FV of assets and liabilities managed in a

portfolio on the basis of the entity's net exposure to a particular market risk (interest rate, currency, price) or credit risk of a counterparty;

- expand the prohibition against applying blockage factors at all input levels; and - require additional disclosures, including:

- measurement uncertainty inherent in Level 3 inputs; - if an asset that is valued using a highest and best use basis, but is not actually being

used that way; and - categorization by input level of assets not reported at FV, but whose FVs are disclosed

in notes. AICPA Issues Paper - In January 2010, the AICPA issued a draft issues paper intended to provide additional implementation guidance for applying FAS 157 in three areas:

- Unconditional promises to give cash (pledges); - Beneficial interests in perpetual trusts; - Split-interest agreements.

As of August, it has not yet been issued final.



B. Other GAAP Issues Receivables - ASU 2010-20 Amends ASC Topic 310. Applies to all organizations. This ASU was issued in July 2010, and is effective for nonpublic entities for periods ending on or after December 15, 2011 (essentially calendar 2011 and later); for public entities, certain disclosures are effective one year earlier. It requires additional disclosures about the allowance for credit losses and the credit quality of financing receivables. Many of the requirements do not apply to most trade accounts receivable due within one year, and the statement excludes unconditional promises to give (pledges), as well as debt securities. It includes loans receivable, which is where its main effect on the nonprofit sector is expected to be - particularly loans to students and faculty made by educational institutions, and loans to churches and other religious organizations made by religious denominations and other higher-level religious entities. The purpose of the statement is to enhance disclosures about the nature of credit risk inherent in a portfolio of financing receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and the reasons for those changes in the allowance. The required disclosures are very complex and detailed; organizations with affected receivables need to study the statement carefully to assess its effects on their financial statement footnotes. Loss Contingencies - Exposure draft to amend ASC Topic 450. Will apply to nonprofits.

An exposure draft was issued in July 2010; comments were due in August. FASB first indicated that a final statement was anticipated in the third quarter of that year, with an effective date for nonpublic entities of fiscal years beginning after December 15, 2010 (essentially calendar 2011 and later). As of March 2011, they are still deliberating, and it looks like it may be a while.

It deals only with disclosures (nonpublic entities are permitted to make slightly fewer disclosures). In addition to its obvious applicability to litigation, it will also apply to subjects such as environmental remediation, asset retirement obligations, product warranties, guarantees, and contingencies related to business combinations. It will not apply to uncertain tax positions (already well covered by FIN 48/ASC 740), or employee benefits (covered by various other standards) - except that it will apply to a potential liability that would be incurred upon withdrawal from a multi-employer benefit plan.

The proposal would not eliminate any existing requirements, but it would add new requirements to disclose information about the nature of loss contingencies, their potential magnitude, and the potential timing (if known). Thus it is proving controversial because of the effect it may have on auditors' communications with attorneys, and disclosure of information about litigation that, while it may be publicly available in court records, distribution of which most defendants would probably prefer to keep as limited as possible, such as the contentions of the parties, amounts of claims, and possible insurance recoveries.



Aggregation of information about similar types of contingencies will be permitted. Information about certain potentially severe remote loss contingencies will be required. When assessing materiality, possible insurance recoveries would not be considered. Going Concern and Subsequent Events: These have been the subjects of auditing guidance. However, since they are really more closely related to questions of when, what, and how to make certain accounting entries, FASB decided to issue accounting standards for them. Exposure drafts were issued and one final statement - No. 165, Subsequent Events - is out. FASB now plans to issue a second exposure draft on Going Concern this fall. No significant changes to current practice are anticipated, except that the look-forward period for going concern questions will no longer be an arbitrary one year; rather accountants will consider all conditions of which they are aware. Some terminology will also change. Revenue recognition: The Board is pursuing an approach that focuses on changes in assets and liabilities (consistent with the definition of revenues in Concepts Statement 6). This project will apply to business transactions - and thus to certain activities of many nonprofits, but FASB has specifically noted that nonreciprocal transfers (contributions) received should not be excluded from revenues and should be disclosed as a separate line item in the income statement. The project is focused on complex revenue transactions, which are rarely encountered in the nonprofit sector. A ‘preliminary views’ document was issued in the fourth quarter of 2008; an exposure draft was issued in June 2010 and amended in July; comments are due this fall; a final statement is anticipated in mid-2011. Consolidations: Policy and Procedure: The Board has on its agenda a long-term research project, the objective of which is to develop comprehensive accounting guidance on accounting for affiliations between entities, including reconsideration of ARB No. 51, Consolidated Financial Statements. SOP 94-3 (included in ASC 958-810) could potentially also change. The IASB is also working in this area, and the FASB may decide to follow their lead. Current rule:

- If you control it by majority ownership, consolidate; - If you control it by control of its governing board and have an economic interest,

consolidate; - If you control it through other means (contract, overlapping boards, etc.), and have an

economic interest, consolidation is optional; if not consolidated, make extensive disclosures;

- If you have either control or economic interest but not both, do not consolidate; make related party disclosures.

Reminder - FASB Staff Position 126-1 - Definition of a Public Entity: Conduit Bond Obligors

FASB has issued the above document which affects nonprofits that are obligors on ‘municipal bonds’ issued by a state or local government. It applies when the bonds are publicly traded, but not when they are held privately by one or more institutional investors, so a determination is required as to whether the bonds are publicly traded.



FASB Lease Exposure Draft – August 2010: Effects on Nonprofit Organizations The Financial Accounting Standards Board (in conjunction with the International Accounting Standards Board) has issued its long-awaited exposure draft on accounting for leases. While implementation of the proposed standard will likely not have a major impact on the statement of activity of most lessees, its effects on the balance sheet will often be significant. This proposed standard will apply to all organizations - including nonprofits, and to all leases (with minor exceptions – see below). There is no proposed effective date stated in the draft; that will be determined after the exposure period. Since the exposure period ended December 15, 2010, the effective date is not likely to be earlier than calendar 2012. Current accounting standard: As of early 2011, accounting for leases is the subject of FASB Statement No. 13 and its numerous amendments (codified in Topic 840 of the FASB Accounting Standards Codification). Its requirements are not discussed in detail in this outline, as they are in no way peculiar to not-for-profit organizations, and are discussed elsewhere. Briefly, leases are classified as either 'operating' leases, or 'capital' leases; the criteria for classification being, in essence, whether or not the lease amounts in substance to a purchase of the asset by the lessee. Operating leases are not reported on the lessee's balance sheet, rather each year's rent is reported as an expense of that year, and the future obligation to make rental payments is disclosed in a footnote. Capital leases are reported essentially as purchases by the lessee (similar, but reverse, criteria apply to the financial statements of lessors); the asset is capitalized on the lessee's balance sheet, with a corresponding liability for the future lease payments. The asset is amortized over the lease term, and the liability is reduced by the periodic rental payments. FASB currently is working on a project to revise this standard, and has already decided that after some future date - probably within a couple of years, all leases will be accounted for in essentially the way capital leases are now. For operating leases, this change will normally have little effect on an organization's income statement, since what is now reported as rent expense will henceforth be reported as amortization expense of a similar amount. The principal effect will be to gross up the balance sheet for the asset and liability described above, with little or no effect on net assets. In many cases, this gross-up will not matter to financial statement users, however organizations should consider whether the increase in liabilities will negatively affect any covenants contained in debt and grant agreements to which the organization is subject. For example, if there is a covenant requiring the maintenance of no more than a certain maximum ratio of debt to equity (net assets), the debt amount will be higher, while the equity amount will probably not change, possibly causing the organization to be in violation of the covenant. For example, suppose that under the current accounting rules an organization's balance sheet reports assets of $1 million, liabilities of $600 thousand, and net assets of $400 thousand. Its debt to net assets ratio is 1.5 to 1. Further suppose it is subject to a covenant requiring this ratio to be no greater than 1.8 to 1. Now suppose it has leases now classified as operating leases, which, when their future obligations are calculated under FASB's proposed new rules, will add another $400 thousand of liabilities. Total liabilities will now be $1 million (total assets will now be $1.4 million, so net assets will remain at $400 thousand) and the ratio will be 2.5 to 1 - in violation of the covenant.



Consequences of this violation might - depending on the terms of the debt or grant agreement include:

• acceleration of the debt repayment schedule

• inability to refinance or roll over the debt, or cancellation of a line of credit • increase in the interest rate on the debt • a requirement to post additional collateral • cancellation of future grant payments on current grants

• inability to obtain future grants from that funder Organizations should identify any such covenants to which they are subject, determine whether they are likely to find themselves in violation after the revised accounting standard takes effect, and, if so, discuss the matter with the other party to the covenant (lender or funder) to try to have the covenant modified. Types of Leases At the joint FASB/IASB Board meeting on February 17, 2011, the Boards tentatively concluded that there are two different types of leases, rather than a single type. The change in direction results from outreach activities and comment letter responses to the Boards’ original proposal. Some board members described the first type (“the finance lease”) as a contract in which the lessee essentially purchases the underlying asset by obtaining substantially all of its risks and rewards through the lease. The second type of contract (“the other-than-finance lease”) is intended to create more financial flexibility, to mitigate the risk of ownership (for example, technological obsolescence), and/or to outsource the maintenance of an asset. The current working definitions for each type of lease are:

• Finance lease – The profit or loss of a finance lease has a pattern consistent with the ED, including interest expense/income using the effective interest method, as well as the lessee’s amortization of its right-of-use asset. This profit or loss pattern reflects leases that contain a significant financing element where the right to use the underlying asset is conveyed on an installment basis.

• Other-than-finance lease – A lease transaction in which the financing element is not considered significant. The profit or loss pattern of an other-than-finance lease is characterized by straight-line recognition.

The Boards plan to develop a principle and related indicators to distinguish the two types of leases.

Shortly after the Boards’ joint meeting, there were conflicting reports as to whether both types of leases would be recorded on the balance sheet, or whether only finance leases would create recognized assets and liabilities. We have now confirmed the Boards continue to believe all leases should be recorded 'on balance sheet,' consistent with the May 2010 Exposure Draft (ED).

In a finance lease, a lessee would record a right-of-use asset and corresponding liability. The liability would be amortized using the effective interest method, like a mortgage, and the right to use asset would be amortized, similar to depreciating a fixed asset. This treatment is the same as what the Boards originally proposed in the ED.



In addition, since the Boards have tentatively agreed that the second type of lease contract does not contain a significant financing component, they intend to deliberate alternative attribution and presentation models for the income statement. In other words, the Boards will consider whether “rent expense” should be presented in the income statement, as opposed to the amortization and interest expense which would be presented under a finance lease. The Boards will also further evaluate whether a straight-line pattern of recognition—as tentatively indicated in the working definition—would be more appropriate than the accelerated pattern that results from applying the effective interest method to the lease payment liability.

In short, the Boards believe financial statement users will benefit from different income statement models to differentiate in-substance purchases from other leases. Finance leases will signal that the lessee has purchased substantially all of the risks and rewards of a leased asset by reflecting interest expense for the significant financing component. Conversely, other-than-finance leases will indicate when a lessee hasn’t substantively purchased the asset. But in all cases, a lessee will portray its rights and obligations under the lease by reporting a right-of-use asset and a lease payment liability on its balance sheet.

For contracts that combine service and lease components, the right to receive lease payments and the liability to make lease payments would exclude payments arising from distinct service components.... [deleted words applicable only to IFRS] For leases of 12 months or less, lessees and lessors would be able to apply simplified requirements. The exposure draft also proposes disclosures based on stated objectives, including disclosures about the amounts recognized in the financial statements arising from leases and the amount, timing and uncertainty of cash flows arising from those contracts. One aspect of the proposed accounting that is likely to prove challenging for many nonprofits is the requirement for lessees to use their incremental borrowing rate (or the interest rate implicit in the lease, if determinable by the lessee) to discount the long-term obligation to make lease payments. As is often the case, FASB has written this requirement with for-profits in mind - assuming that all lessees know their borrowing rate, which is likely true for most for-profit entities. However many – especially smaller – nonprofits have never borrowed, and some of these probably are in a financial condition that would make it virtually impossible for them to borrow, so they would not know, and often could not determine this rate. They may also not be able to determine the rate the lessor has used to set the lease payments, or, in some cases, that rate may not be appropriate for the lessee to use. It is hoped that FASB will provide some guidance to help with this problem.

FASB GAAP Codification - The FASB has issued its “Accounting Standards Codification” (ASC), including SFASs and interpretations, EITF consensuses, APB opinions, AICPA SOPs and Audit Guides, etc. Some minor GAAP changes were made. One section (958) covers specific nonprofit matters. See Appendix A below.

AICPA Nonprofit Audit and Accounting Guide - The AICPA Nonprofit Expert Panel continues work on the new edition of the nonprofit audit guide. Completion is planned in a couple of years. Meanwhile, revised versions of the guide, updated only for ‘conforming changes’ (i.e., changes required by other new professional standards or laws) will continue to



be issued each year. The 2010 edition of the guide has been issued; it incorporates references to the ASC. The 2011 edition is expected soon.

The AICPA Audit Risk Alert for Not-for-Profit Organizations is also issued each year. (The 2010 edition is out.)

C. Current Auditing Developments

Reminder: Auditing interpretation - non-marketable investments - The interpretation (AU9328 - 1) regarding tests of fair value of investments held by third parties such as trusts, requires that, when the assets are other than marketable securities (non-marketable securities such as: venture capital funds, hedge funds, restricted securities, limited partnerships, real estate, etc.), additional information may need to be obtained and tested. It has had the expected effect of there being more qualified opinions and disclaimers of opinion for audit scope, since trustees and fund managers are not always willing to cooperate in providing the information needed, or the information may not be auditable. The AICPA has also issued a practice aid, Alternative Investments - Audit Considerations, a Practice Aid for Auditors, as guidance in complying with this interpretation. It can be downloaded from their website at: http://www.aicpa.org/members/div/auditstd/alternative_investments.htm Communication with Those Charged with Governance (SAS 115) SAS 115 (slightly amended by SAS 117) changed the definitions of the various types of deficiencies. Following is part of the new form of auditor's report: "A deficiency in internal control exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent, or detect and correct misstatements on a timely basis. A material weakness is a deficiency, or combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity's financial statements will not be prevented, or detected and corrected on a timely basis. .... “A significant deficiency is a deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness, yet important enough to merit attention by those charged with governance." Related update - The GAO is in the process of revising the Yellow Book.

* * * * * * *

http://www.aicpa.org/members/div/auditstd/alternative_investments.htm



Appendix A: Not-for-Profit Accounting Literature

Cross-references between the ASC and previous guidance ASC - from previous: ASC Subject matter Previous Guidance (primarily)

958- 10 Overall AAG (AICPA audit guide) Ch. 1, Para. 15.04 20 Financially-interrelated entities FAS 136 30 Split-interest agreements AAG Ch. 6, DIG B-35 205 Presentation of financial statements FAS 117, FSP 117-1, FAS 124 210 Balance sheet FAS 117 225 Income statement FAS 117, others 230 Statement of cash flows FAS 117, AAG Ch. 3 310 Receivables FAS 116, AAG Ch. 5 & others 320 Investments - debt and equity securities FAS 124, AAG Ch. 8 325 Investments - other FAS 124, FSP 124-1, AAG Ch. 8 360 Property, plant, and equipment FAS 116, FAS 93, AAG Ch. 7, 9 405 Liabilities AAG Ch. 10, 11, 13, EITF D-089 450 Contingencies FAS 116, AAG Ch. 10, 3 470 Debt AAG Ch. 10 605 Revenue recognition FAS 116, FAS 136, AAG Ch. 5 715 Compensation - retirement benefits FAS 87, 88, 106, 132(R), 158 720 Other expenses FAS 117, SOP 98-2, AAG Ch. 13 805 Combinations FAS 164 810 Consolidation SOP 94-3, FSP 94-3-1, EITF 90-15, 96-21, ARB 51 815 Derivatives and hedging DIG B-35 840 Leases SOP 94-3, EITF 90-15, 96-21, 97-01 Previous - to ASC:

Previous Guidance Subject matter ASC (primarily)

FAS 87, 88, 106, 132(R), 158 Retirement benefits 958-715 FAS 93 Depreciation 958-360 FAS 116 Contributions 958-605 FAS 117 Financial statement presentation 958-205, 210, 225, 230, 720 FSP 117-1 Endowments 958-205 FAS 124 Investments 958-320, 325, 205 FSP 124-1 Investments 958-325 FAS 136 Pass-through gifts 958-605, 20 FAS 157 Fair value 820 FAS 164 Combinations 958-805 FIN 48 Uncertain tax positions 740-10 ASU 2009-06 Application of FIN 48 740-10-15, 50, 55 DIG B-35 Derivative in a split-interest 958-30, 815



SOP 94-3 Consolidation 958-810 FSP 94-3-1 Consolidation 958-810 SOP 98-2 Joint costs 958-720 AAG-NPO, Chapter: 1 Introduction 958-10 2 Auditing (not in ASC) 3 Financial reporting 958-205, 210, 230 4 Cash 958-210 5 Contributions 958-605, 310 6, DIG B-35 Split-interest 958-30, 815 7 Other assets 958-605, 360 8 Investments 958-320, 325 9 Property, plant, and equipment 958-360 10 Liabilities 958-405, 450, 720 11 Net assets 958-225 12 Exchange transactions 958-605, 310 13 Expenses 958-720, 225 14 Auditors’ reports (not in ASC) Para. 15.04 (Exempt status) Tax 958-10-15-6 Rest of Ch. 15 Tax (not in ASC) 16 Fund accounting (not in ASC)

* * * * * D. Other Accounting Matters

• The what, why, and how's of accounting for contributions - SFAS 116 and 136; using

judgment

• What is different about nonprofit financial statement format - SFAS 117

• Accounting for investments and related income, gains, and losses - SFAS 124

• Allocation of joint costs under SOP 98-2

• Mergers - SFAS 164

• Expense reporting

• Taxes - FIN 48

1. The what, why, and how's of accounting for contributions - SFAS 116 and 136; using judgment

- Contributions received (SFAS 116; Audit Guide (AG) Chapter 5) (unique to nonprofits)

(ASC 958-605)

- General rules - Timing of revenue recognition

- Unconditional gift or pledge – when made (communicated to donee) - Conditional gift or pledge – when condition is substantially met



- Valuation – Fair value at date of gift (APB 29/SFAS 157)

- Contribution is never recorded as deferred income, except: - Conditional gift already paid (refundable advance) - Pooled income fund – see split interests, below

- Reported in class according to any donor restrictions

- If temporarily restrictions are met in same period as received, may report as unrestricted

- If this is done, must be consistent for all such contributions and investment income

- The judgments often encountered with contributions: ('accounting continuum' follows)

- Is it a contribution or an exchange? - Is it to or for the benefit of this organization? - Is it a promise or just an intention? - Is it conditional or unconditional?

- Is there an uncertain future event which must occur before gift becomes final?

- How uncertain does it have to be? Judgment (AG par. 5.32-.34) - Is it restricted or unrestricted?

- Only the donor of a gift can place a legally binding restriction - Board designated amounts are not restricted

- Because board can undesignate as it wishes - When has the restriction been met? - Does the volunteer work require specialized skills? - Would the recipient otherwise 'have to' purchase the volunteers’ services?

Note that ‘judgments’ as used here (qualitative) differ from ‘estimates’ (quantitative).

- Pass-through from A to B for the benefit of C (SFAS 136; AG par. 5.04-.21)

- Accounting by A, B, & C - Does A record an asset or expense? - Does B record revenue or a liability? - When does C record revenue?

- Accounting depends on - Exact terms of the transfer from A to B - Degree of discretion available to B - Nature of relationship(s) among A, B, & C

- Sometimes C and A are the same entity

- Variance power for B means it records revenue - Community foundations all have variance power

- If B & C are financially interrelated organizations, they both record increase in net assets

- Noncash gifts

- Recorded at fair value (APB 29/SFAS 157 - see below; AG par. 5.61)



- Pledges - Unconditional promise to give

- Verifiable documentation (AG par. 5.50) - Discount to present value (APB 21; AG par. 5.67)

- Accretion of discount is contribution income, not interest income (SFAS 116 par. 20)

- Interest rate is frozen at inception (APB 21), unless fair value option is elected (SFAS 159)

- Net of allowance for estimated uncollectible amount - Subsequent changes in value of pledge are sometimes recorded (SFAS 157)

- Depends on nature of asset pledged and whether change is up or down (AG par. 5.70-.76)

- Presumed to be temporarily (time) restricted, unless specified otherwise (SFAS 116 par. 15)

- Conditional promises are not recorded; must be disclosed - Notice of mention in a will is normally conditional on the will not being

changed - Interest in a revocable trust - conditional until collected or made irrevocable

(AG par. 6.06) - Certain disclosures are required (AG par. 5.78, 5.81)

- Split-interests (AG Ch. 6) - Essentially these are recorded as pledges, at present value of future cash flows - Lead interests

- Charity’s interest is in current income – record as contribution - Remainder interest is a liability

- Remainder interests - Charity’s interest is in the remainder – contribution - Current income flows through to life tenant - liability - Pooled income fund is special case since there is no current liability until

income is earned - Non-contribution portion is recorded as deferred income

- Perpetual trust is essentially like permanent endowment - Recorded at current fair value of trust – permanently restricted - Periodic income recorded as earned

- In all cases, values are adjusted periodically for changes in: (also consider SFAS 157) - Life expectancy and other actuarial assumptions - Asset value - Accretion of present value discount

and temporarily restricted net assets are reclassified as time restrictions lapse - FASB DIG Issue B35 says a split interest may be a derivative under certain

circumstances

- Supplies, equipment, etc. – usual rules - For valuation, consider quantity and condition of items (AG par. 5.55)

- Estimates may be appropriate (AG par. 7.03) - If items cannot be either used or sold, then do not record



- Museum collections (AG Ch. 7) - Special rules; if 3 criteria are met, may choose not to capitalize (SFAS 116 par. 11)

- Items are held for public exhibition, education, or research, not financial gain - Items are protected, kept unencumbered, cared for, preserved - Subject to organizational policy requiring any sales proceeds be reinvested

in collection - If museum elects not to capitalize

- Make certain disclosures - Donated items are not recorded as either revenue or expense - Purchased items are reported as reductions in net assets

- Volunteer services (A or B) A - 3 criteria, if all are met, recipient must record as revenue and expense

- (assuming value can be determined) 1- Services require specialized skills 2- Volunteer possesses those skills 3- Recipient would otherwise have to purchase the services

- Intent of this is similar to the 'central/peripheral' distinction in SFAC 6 par. 78, 80, 84 - If central, would have to purchase; if peripheral, would not have to

- If any criterion is failed, services may not be recorded; may disclose amount in notes

B - Services involve creating or enhancing a non-financial asset - Record services and capitalize asset

- Certain disclosures required (AG par. 5.79)

- Use of property – revenue and expense as used - For a long-term pledge (e.g., a multi-year lease), follow usual rules for pledges

(AG par. 5.58)

- Valuation question may arise regarding services and use of property (SFAS 157) - If the person/property is intrinsically 'worth' more than organization would

otherwise pay: - Some say the amount recorded should be the amount that would otherwise

have been paid - Others say the fair value of the actual person/property should be used



THE ACCOUNTING CONTINUUM

Contribution Unrestricted Intention to give (or less) Conditional Not a specialized skill Would not have to purchase Does not control [affiliate]

Exchange transaction Restricted (by donor) Promise to give Unconditional Specialized skill Would have to purchase Controls [affiliate]

Very clear

Very clear

Probably Probably Not so clear

Not so clear

Unclear

vs. vs. vs. vs. vs. vs. vs. vs.



2. What is different about nonprofit financial statement format - SFAS 117 - Requirements of SFAS 117 are actually quite limited:

- 3 statements - balance sheet, income statement, cash flows

- Functional expense statement required for charities; optional (encouraged) for others

- Total assets, liabilities, net assets, change in net assets

- Net assets and change in net assets by class (unrestricted, temporarily restricted, permanently restricted)

- There must be some indication of relative liquidity of assets and liabilities

- Revenue and expenses must be reported gross, not net; gains and losses can be netted

- All expenses are unrestricted

- Expenses reported by function: program(s), management, fundraising

- Temporarily restricted net assets released to unrestricted as restrictions expire or are fulfilled

- Investment return classification follows donor instructions or state law - see SFAS 124, below;

- Revenue and expenses may be divided between 'operating' and 'non-operating' but this is not required;

- Statement does not specify sequence of items, or particular terminology.

- Comparative prior period information is encouraged but not required. (This presenter would require.)

- Cash flow statement may use either direct (preferred) or indirect method. (This presenter would require direct.)

(FASB is in the process of changing the two previous items)

* * * * * * * 3. Accounting for investments and related income, gains, and losses - SFAS

124; FSP 117-1 Balance sheet:

- Marketable securities (publicly-traded stocks, all bonds) reported at current market value

- other investments (non-marketable securities, real estate, etc.) reported at value determined under rule in whichever old AICPA audit guide applies - see current audit guide, para. 8.34 A-8, 9, 10

- consider post-balance sheet market declines for possible disclosure

- consider effect of UPMIFA, if applicable, on net asset classification of endowments (board judgment)



- AICPA has issued an auditing interpretation regarding investments held in trust or otherwise by third parties; confirmation with the holder is not sufficient audit evidence regarding the valuation assertion

Statement of Income:

- Current income reported when earned in class appropriate to any donor restrictions on income; default in absence of stipulation is to unrestricted, except that unappropriated income from donor-restricted endowment funds is temporarily restricted until appropriated (FSP 117-1)

- accounting literature is silent, but most accountants believe that, if the donor is silent, or absent contrary donor stipulation, return on temporarily restricted investments is also temporarily restricted

- there is a one-time accounting policy choice to either report restricted return when the restrictions have been met in the period earned as: (1) temporarily restricted and released from restriction, or (2) unrestricted; the same choice must also apply to temporarily restricted contributions

- Change in value (distinguishing between realized and unrealized is permitted but not required) included in change in net assets:

- but components of return may be reported various ways within income statement1

- capital gains are unrestricted unless donor stipulates, or state law requires, otherwise: - if donor has restricted income, gains are presumed restricted absent contrary

donor stipulation;

- losses are unrestricted absent contrary stipulation for gains, except that if gains are temporarily restricted: - then losses are also temporarily restricted up to the extent of any remaining

unreleased gains; excess losses are unrestricted

- gains and losses are permanently restricted only: - if donor so stipulates, or state law requires, or

- if they result from change in value of assets with a donor stipulation that those specified assets must be held in perpetuity (e.g., specific securities, real estate, collectibles, etc.)

Disclosures

- composition of investment return (income, net gains/losses on fair value and on other investments)

- if return is separated into operating/non-operating components, reconciliation of total return to operating portion

- aggregate carrying amounts by major types (equity, government, corporate, mortgage-backed, real estate, etc.)

- basis for valuing non-marketable investments

- methods and assumptions used to estimate fair values of non-financial investments if reported at fair value

- aggregate deficiencies, if any, in donor-restricted endowments



- significant concentrations of market risk, if any

- roll-forward of endowment balances (FSP 117-1)

- descriptions of interpretations of laws, investment policy, spending policy

* * * * *

1 - common methods of reporting investment return include: • All investment return (dividends and interest, and realized and unrealized gains) on one line in

the revenue section of the statement of activity - the amount might be negative if major losses have been sustained (if this is done, a footnote must disclose major components of the amount);

• Investment income and gains on two or more lines in the revenue section - e.g., dividend and interest income, realized gains (losses), unrealized gains (losses);

• Investment income and realized gains (losses) in the revenue section, and unrealized gains (losses) below an “operating” subtotal;

• Investment income only in the revenue section, and all capital gains (losses) below an operating subtotal;

• All investment return down below; • If the organization uses a 'total return' approach to managing its investments, the expendable

return per the client’s formula (e.g., five per cent of asset value) in the revenue section, and the difference between that amount and the actual total return down below - again, this difference may be negative.

4. Allocation of joint costs under SOP 98-2

- All joint costs are fundraising unless three judgmental criteria are met:

- Purpose

- Audience

- Content - including a call to action (other than contributing) that furthers organization's mission.

Planning tip - meet with auditor before activity is undertaken to be sure it will pass the tests, especially the Call to Action.

5. Mergers - SFAS 164 (ASC 958-805) (SFAS 141 does not apply to nonprofits; 142 now applies):

Accounting for combinations of not-for-profit organizations: • SFAS 164 distinguishes between a Merger and an Acquisition • Mergers accounted for on ‘carryover basis’ - similar to pooling accounting under APB 16 • Acquisitions accounted for on ‘acquisition basis’ - similar to SFAS 141(R) • Determining factor of a merger: ceding of control by the governing bodies of two (or

more) organizations to a new organization; the governing board of the new entity must be newly formed, but establishing a new legal entity is not a requirement

• Other factors such as relative size, relative dominance of the process and of the combined entity, and relative financial health, can be considered in judging whether control has been ceded, but are not themselves determinants of a merger vs. an acquisition

• All other combinations are acquisitions



Accounting for a merger: • Add together the historical financial data of the merging entities as of the merger date

(not, as under APB 16, as of the beginning of the fiscal year in which the merger occurs) • Financial statements of the period of the merger include data only since the date of the

merger (except that for a public company (FSP 126-1), pro forma disclosure is required as if the merger had occurred at the beginning of the fiscal year)

• Conform accounting policies, except, because this is not a ‘fresh-start’, a merger is not an event that permits the election of accounting options that are restricted to the entity’s initial acquisition or recognition of an item (or the reversal of a previous election). Thus, for example, one merging entity’s election of the fair value option (SFAS No. 159), for a particular financial asset or liability permits neither the new entity’s election of the fair value option for other financial assets or liabilities nor reversal of a previous election of this option.

• Eliminate effects of any intra-entity transactions • All reclassifications, adjustments, and other changes needed to effect a merger are rolled

into opening balances • Since the successor organization after a merger is a new entity, there is no prior period

statement of activity or cash flows (an ‘opening’ balance sheet may be presented if desired)

Accounting for an acquisition: • Identifiable assets and liabilities (and any noncontrolling interest) of the acquired entity

are brought in at their fair values at date of acquisition • Exceptions specific to nonprofits: Collections are accounted for in accordance with the

policy of the acquirer; conditional pledges are not recorded; no value is attributed to donor relationships

• Exception for leases: Leases are classified (operating vs. capital) according to their terms at lease inception, unless they have been modified

• If the value of the acquired assets exceeds the sum of the acquired liabilities plus any consideration, the difference is recorded as an inherent contribution and reported as a separate credit in the statement of activities

• If the sum of the liabilities plus consideration exceeds the assets, the difference is recorded as goodwill, except:

• if the entity is predominantly supported by contributions and/or investment return, the goodwill is written off immediately as a separate charge in the statement of activities (‘predominantly supported by’ means that contributions and investment return are expected to be significantly more than the total of all other revenues)

• Any noncontrolling interests are accounted for in accordance with SFAS 160 • Acquisition-related costs are period expenses, except for debt issuance costs

SFAS 142 (Goodwill) is made fully effective for not-for-profit entities (goodwill is no longer amortized, rather it is tested for impairment) Various descriptive, quantitative, and qualitative (why the merger/acquisition occurred) disclosures are required. Effective date:



• Combinations occurring in reporting periods beginning on or after 15 December 2009; • Early adoption prohibited

Statement 164 includes many more details than summarized above. The statement should be consulted for guidance. 6. Expense Reporting - various matters (ASC 958-720; AG Ch. 13)

- Fundraising costs must be expensed as incurred, even if they will benefit future periods

- Total fundraising expense is a required disclosure - charities wish they did not have to!

- Solicitation of exchange revenue (e.g., advertising - even of program services) is G & A, not program

- Solicitation of donated services of volunteers - even if they will not meet the criteria for recording - is fundraising

- Interest expense should be allocated if possible; otherwise is G & A

- Payments to affiliates should be allocated if possible; otherwise a separate supporting service

- Expenses of federated fundraisers (United Way) are fundraising, even though that is their program

- Do not overlook a possible need to record deferred income taxes

- Direct donor-benefit costs of special fundraising events may not be netted, but may be reported as a deduction from event revenue (like sales and COGS)

- Depreciation is required (SFAS 93), exception for certain museum collections

Otherwise nonprofits follow GAAP unless exempt (e.g. APB 28, SFAS 115, 128, 131) (AG Chapter 1, Appendices), but note FASB Staff Position 126-1, which treats nonprofits with conduit debt outstanding in the hands of the general public as public entities for purposes of other disclosures – mainly SFAS 132 re employee benefits and 109 re taxes.

* * * * * * * 7. FIN 48 - Accounting for Uncertainty in Income Taxes

Taxes – (Yes!) FASB has issued FIN 48 (ASC 740-10), Uncertain Tax Positions, which requires specific consideration of every tax ‘position’ taken by an organization. Tax positions include consideration of whether or not an item of income is taxable, whether a deduction is allowable, and whether filing a return is required. Uncertain (less than 50% probable of being sustained on audit) positions require disclosure and possibly accrual of a liability. FIN 48 Is not inapplicable to nonprofits. Nonprofits do have tax positions, some of which may be uncertain. For nonprofits there are up to five areas requiring consideration: • Tax-exempt status has not been compromised by too much lobbying, private inurement,

failure to file, etc.



• Unrelated business income: characterization and amount of income, deductible expenses (complex area)

• Excise tax on investment income of private foundations • Taxable subsidiaries • Filing requirements

New IRS Form 990 requires inclusion of the FIN 48 footnote from the financial statements. (“Come audit us!”) This Interpretation is a consideration when there is uncertainty about: • whether a particular type of tax is applicable to an entity at all • in what jurisdictions (Federal, state, local, and foreign) a tax return must be filed and

taxes paid • amount of income potentially subject to tax • amounts of deductible expenses, especially when allocations are involved • amounts of deferred tax assets and liabilities

It is now fully effective for nonprofits.

* * * * * * * I. An overriding tax position for nonprofit organizations is whether they do in fact qualify for

tax-exempt status. If there is uncertainty about this position, then FIN 48 would apply to it. Circumstances that might raise questions about qualification for tax-exempt status include: • Private inurement or benefit (consider especially compensation of highly-paid people,

insider transactions, loans, asset sales and purchases, etc.) • Excessive lobbying or political activity • Failure to meet the ‘organizational’ and ‘operational’ tests (in other words, failure to do

what you told the IRS you would do when you applied for exempt status) • Having so much UBI (as a percentage of total income) that the IRS might assert you are

really a business • Gross violations of other laws and regulations (e.g., repeated failure to file Form 990,

discrimination, etc.)

II. In addition, FIN 48 would apply to uncertain tax positions of nonprofit organizations associated with:

A. Private foundation excise tax on net investment income, under IRC Sec. 4940

[Although this is technically an excise tax, it is covered by FIN 48 because it is calculated based on a type of income. See the definition of ‘income tax’ in the Glossary (Appendix E; para. 289) of SFAS 109, Accounting for Income Taxes.] However, FIN 48 will only infrequently need to be considered, as the applicability and computation of this tax (including deferred amounts) are in most cases not likely to be uncertain. Further, since the tax rate is only 2% (1% in some cases), any uncertain tax amounts are not likely to be material to a foundation’s financial statements.



Two exceptions to the above could be when: • The foundation has sold at a gain investment securities which had been donated to it.

The basis of the securities used to compute the taxable capital gain is their basis in the hands of the original donor (or, if higher, their value on December 31, 1969, if the securities were owned by the foundation on that date); the foundation may not be readily able to accurately determine this amount.

• The status of a 501(c)(3) organization as a private foundation vs. a public charity under IRC Sec. 509(a) is open to question. The organization may thus be uncertain whether it is liable for this tax at all.

B. Tax on unrelated business income (UBI), under IRC Sec. 511

FIN 48 will usually need to be considered in relation to this tax. The first question is whether the organization has over $1000 of net income, as defined in IRC Sec. 512(a), from an unrelated trade or business, as defined in Sec. 513(a). Since there is allowed a specific deduction of that amount, lesser amounts of net income will not result in any tax payable. (There is a $1000 gross income threshold for filing Form 990-T, but if no tax is due, there will be no penalty for failure to file this form.) The following aspects of this tax may give rise to uncertain tax positions:

• Every nonprofit organization (including those not required to file Form 990 such as churches and small organizations) must analyze its sources of gross income and determine which ones might be considered by the IRS to be UBI.

• Aspects of the IRC definition of UBI that are especially subject to judgment, and thus to uncertainty, include whether an activity is:

• 'unrelated' to the organization’s exempt purpose,

• considered a 'trade or business,' and

• 'regularly carried on'. • So-called 'passive income' - return on investments - is, by law (Sec. 512(b)), not

generally subject to the UBI tax. However the rules surrounding some types of this income, such as royalties and certain rental income, are complex. There may be uncertainties as to whether an item qualifies as a royalty, or whether part or all of rental income is taxable because of certain of its attributes. (Such attributes include whether it: is from debt-financed property; is from rental of personal - as opposed to real - property; also includes payment for provision of personal services; is based on a percentage of the net - as opposed to gross - income of the property).

• Income from certain trade shows conducted by 501(c)(3, 4, 5, & 6) organizations may be excluded from taxable income (Sec. 513(d)(3)), but only if certain judgmental criteria are satisfied.

• UBI also does not include income from: activities carried on largely by volunteers, selling of donated merchandise, and activities carried on for the convenience of members, students, patients, etc. (Sec. 513(a)). These definitions are subject to interpretation and may be challenged by the IRS.

• Once a source of UBI has been identified, then there may be uncertainty in computing the amount of gross income from this source. Besides normal matters of accounting judgment:



• Advertising income is taxable, but when the affected publications are furnished to dues paying members of a membership organization, a complex allocation is required to compute the taxable advertising amount and related deductible expenses.

• There is often some judgment involved in determining amounts of expenses that may be deducted in computing taxable net income. This is especially likely to be the case when allocations of expenses are required, as is usual for personnel costs, occupancy, administrative expenses, etc.

• Allocation of occupancy costs is especially subject to IRS challenge if the facility is used for both exempt and non-exempt purposes.

• There are exceptions to most of the rules (and exceptions to the exceptions!). • If an organization operates in multiple taxing jurisdictions, there may be uncertainty over

allocating the taxable income among those jurisdictions. • If timing differences between book and taxable amounts exist, there may be

uncertainties as to the expected timing of the reversal of those differences, and the recoverability of any deferred tax assets.

C. Tax on income of a taxable subsidiary of a nonprofit organization All of the normal uncertainties affecting for-profit organizations apply here; they are discussed in FIN 48 and elsewhere in professional literature. Organizations need to make an inventory of their tax positions and judge which ones might be considered uncertain (less than 50% likely to be sustained on audit).

* * * * * * * IV. Income Tax Reporting Matters, Primarily Relating to Contributions Receivable A. Donor tax matters that the non-specialist needs to know (for the complicated things, see

a specialist) to try to keep donors out of tax trouble (See IRS Publication 526, Charitable Contributions) - Don’t give donors tax advice; know when to urge them to get their own advice. - Deduction (IRC Sec. 170) is the fair value of the property given, with some exceptions

(inventory, art, conservation property, scientific research property); it is the donor's responsibility to prove the value (See IRS Publication 561, Determining the Value of Donated Property)

- Be generally aware of limitations on tax deductibility of gifts as a percentage of donor's income (vary depending on the nature of the donor, nature of the recipient, nature and use and of the gift property - rules are complicated)

- Try to ensure that donor is aware of documentation requirements: - Form 8283 requirement for donor ($500 or more, except cash and publicly traded

securities; aggregate donor's gifts over $1,000 in year); charity will have to sign form to acknowledge receipt of property, but should not provide an appraisal. (Form 8282 requirement for charity, if property is sold within two years (advise donor))

- Over $5,000 - donor may need to obtain written appraisal



- All cash gifts – Written documentation (canceled check, donee receipt, etc.) (new requirement)

- All gifts of $250 or more - Written acknowledgement from recipient (canceled check is not enough) or donor loses deduction:

- Payment was a gift - Amount, or description of property (but not the value of non-cash property) - Whether anything of value was given in exchange

- Special rules for vehicles (autos, boats, planes, etc.) - Rules may be different for appreciated property and partial interests in property, and to

private foundations - Deduction is limited to excess of gift over any quid pro quo received (see below) - Gifts by a U.S. taxpayer intended to be used outside the United States are not deductible

(but can be made deductible if given to a U.S.-based charity which is left discretion as to the exact use of the gift); foreign affiliate of a company can make the gift, but tax deduction rules will be different

- No deduction for value of volunteer services (may usually deduct unreimbursed out-of-pocket expenses, although rules are complicated)

- Special considerations for charity auctions.

Charity responsibilities: - Disclosure to donor of non-deductible portion, if applicable:

- non-(c)(3) organization (some exceptions), - premium (over about $10) involved - gift over $75 (‘Quid pro Quo’ contribution)

- Written receipt to donor for individual gifts of $250 or more (or donor loses deduction) - receipt must: state that the payment is a gift

give the amount (or description of non-cash gift) state whether anything of value was given to donor (even if nothing

was) - State registration and filing requirements - public solicitation in state (some cities) - IRS and state rules regarding annuity gifts

Get IRS Publications 1391 Deductibility of Payments to Charities Conducting Fund-

Raising Events, and 1771 Charitable Contributions-Substantiation and Disclosure Requirements.

B. Form 990 - Sec. 6033 [Electronic filing is being phased in.]

- Filing requirements: normally (3-year average) over $25,000 gross income, except: churches and certain other types of religious organizations, and certain others (private foundations file 990-PF instead) (current consideration of raising limit)

- Small organizations must file an electronic ‘post card’ (Form 990-N) each year. - Smaller orgs. (receipts < $100,000 and assets < $250,000): Form 990-EZ - limits are

changing. - Due 4 ½ months after year end (f.e., May 15); extension available (Form 2758) - 501(c)(3)'s - also Schedule A - Salary, fees information details must be given (990-part V & Sch. A-parts I, II) - Use organization mailing address for all board members (privacy)



- Public disclosure of entire form (including salaries), except donors' names (Schedule B); by written request, or at main office/any branch office with three or more employees, during business hours; also exemption application (1023/4) and attachments. (Consider putting on web site)

- Must furnish copy on request (mail or in person); may charge for copying - Penalty for failure to file form or disclose all required parts - $20/day or more; for 3

years – loss of exemption - The current form (filed starting in 2009) is very different from the previous form.

C. Unrelated Business Income (UBI) - Sec. 511-514

- Unrelated to exempt purpose (Form 1023) - regardless of destination of income - Gross receipts: $1,000 or more - Business, or debt-financed passive income (profit motive) - Regularly carried on - Except: - passive income - dividends, interest, gains, (unless debt-financed)

- royalties (watch the definition of these; IRS frequently challenges)) - rent (pitfall if personal property or personal services are involved) - activity is carried on by volunteers, or selling donated goods - for convenience of students, patients, visitors, etc. - (c)(3)'s only - certain unrequested low-cost ($5, indexed - currently around $10) articles

- Activities to watch: advertising income (complex allocation formula) mailing list sale, rent, trade (certain exceptions) commissions: travel, insurance, credit cards non-member/public services gift shops, bookstores, etc. insurance (can result in loss of exemption) income from partnerships, joint ventures, controlled subs trade shows corporate sponsorship income, under certain conditions

- Estimated tax deposits (Form 990-W - worksheet, deposit forms) - Form 990-T - regular corporate rules, $1,000 specific deduction - No exception for churches, small organizations, state/local government colleges - Consider creating a for-profit subsidiary if UBI is substantial - Get IRS Publication 598 Tax on Unrelated Business Income of Exempt Organizations.

D. Employment-related matters

- Generally same rules as for businesses - 501(c)(3)'s exempt from Federal Unemployment Tax, not from FICA or state

unemployment tax - Know that responsible officials (management, board) can be held personally liable for

unpaid withheld payroll taxes, plus penalties and interest (corporate form or organization bankruptcy are not protection)

- Certain differences related to deferred compensation - Know difference between employee and independent contractor

- IRS presumes everyone is an employee, wants payroll taxes



- Be prepared to justify independent contractor status (IRS Reg. 31.3401(c)-1; 20 factors)

E. Lobbying, political activity

- Know what constitutes lobbying (IRS regulations) - Lobbying limited for (c)(3)'s; prohibited for private foundations, churches - Political activity prohibited for (c)(3)'s, limited for others - must usually establish a

separate political organization (PAC) - ‘Political activity’ related to ballot propositions is lobbying since the public is the

legislature in this case. - 501(h) election for (c)(3)'s: no substantial part test vs. formula (Form 5768) - Excise tax, possible loss of exempt status for excess lobbying - Distinction between grassroots and other lobbying (grassroots is more limited)

* * * * * * *

V. Common Financial Reporting Mistakes - Here is what not to do: Matters of compliance with GAAP *

* - Normal matters of articulation of numbers among and within statements and notes, adequate disclosure (see not-for-profit disclosure guide), mathematical accuracy, format, proper terminology, etc., are not mentioned unless they are frequently noted as a problem.

[GAAP citations below are normally to the highest level (SFASs/APBs/ARBs/AICPA Guides/SOPs) where relevant guidance is found. In many cases there is additional discussion of the subject in lower levels of GAAP, that further explain the guidance in the higher level, such as the AICPA Audit Guide, Not-for-Profit Organizations, explaining guidance in the FASB statements. After the FASB GAAP Codification takes effect, these references will all change.] Balance Sheet/Statement of Financial Position:

- One of the required totals (i.e., assets, liabilities, net assets by class and in total) is omitted. The most commonly omitted total is unrestricted net assets, when that net asset category has been (as permitted) subdivided into two or more components (e.g., net investment in plant, board-designated endowment, operating, etc.) [SFAS 117, par. 10]

- Dues receivable are reported as an asset when in fact a receivable under GAAP does not

exist (e.g., if the organization books the entire next year’s dues as receivable and deferred revenue when the annual invoices are sent to members, or, in the case of organizations with staggered membership years, on the first of the month for all members scheduled to renew that month). This is true even if the organization factors down the amount by an estimated “non-renewal” percentage based on historical renewal rates. Dues receivable should be reported only if there is an obligation on the part of the member to pay for goods or services already received (this circumstance will be rare since most membership organizations will not allow the privileges of membership until dues are paid). [Definition of asset - SFAC 6, par. 26: part (c) of the definition (the “all-events” test) is the part not met here.]



- The initial recognition of unconditional promises to give is reported net of an allowance for estimated uncollectible amounts. Promises to give should be reported at fair value, which is usually the present value of the expected cash flows or, for promises expected to be collected in less than one year, the net realizable value. For example, if a group of donors promise to give $100 in five years, but the organization expects to receive only $70, and the present value of the $70 is $50, the initial receivable, net of discount, and revenue should be reported as $50 ($70 less $20) - not $100 less $30 less $20. An allowance should only be reported if there are subsequent decreases in the expected collectible amount. [Audit Guide, par. 5.64, including Exh. 5.1] Disclosure of the $20 discount should be made in a note - see Example 2 in par. 5.81 (disclosure of the $30 is not required (but is not prohibited).)

- Assets or liabilities are reported at fair value subsequent to initial acquisition, even though

there is no provision in GAAP for reporting that type of item at fair value, and either the organization has not adopted SFAS 159 or SFAS 159 does not apply to that type of item. (Some people are confused by SFAS 157 and think it requires reporting at fair value in cases where fair value is not otherwise permitted.)

- A beneficiary of a trust held by a community foundation reports a receivable as due from the

trust or foundation prior to the foundation formally awarding a grant to the beneficiary. Amounts held by community foundations are subject to the foundation's variance power, and the beneficiary is not assured of getting anything until a specific grant is made. [SFAS 136, par.15, 16, 12]

- Fundraising costs are reported as an asset or otherwise deferred. (This includes items such

as printed materials that would be considered inventoriable if held for sale.) [Audit Guide par. 13.06]

- Unrestricted, but board-designated amounts are reported as restricted. Board designations

do not create restrictions on otherwise unrestricted net assets. Such amounts may be segregated and displayed separately within the unrestricted class (preferably only in the net assets section of the balance sheet), if desired. (Amounts, which are temporarily restricted by a donor, and which are also board designated, are temporarily restricted – instances will be rare - most often seen in universities.) [SFAS 117, par. 13]

- A debit (negative) balance is displayed in either the total or any sub-part (individual fund or

other component disclosed in a note) of the temporarily restricted net asset class. It is not possible to release more restricted amounts than you started with. Any “overspending” of restricted net assets should be charged to the unrestricted class, unless there is an unconditional pledge to cover the deficit, in which case recording the pledge will cause the temporarily restricted class to show at least a break-even balance.

- A balance sheet is presented in which assets are classified (current/long term), but liabilities

are not so classified. [SFAS 117, par. 12b] Statement of Activities:

Revenue:

- Unrestricted - or temporarily restricted - investment return (including gains/losses) from permanent endowments is first reported as a change in permanently restricted net assets and then transferred to another class, or left in the permanently restricted class. All return



should be reported directly in the class stipulated by donor restriction, if any, or law on the income/gains. If income from a fund is restricted, then gains are also restricted (unless the donor has stipulated otherwise). [SFAS 124, par. 8, 9] Losses reduce temporarily restricted net assets to the extent of available gains in that class and then reduce unrestricted net assets (absent donor stipulation otherwise). [SFAS 124, par. 12]

(Other than new contributions, almost nothing can change permanently restricted net assets. The main exceptions are investment return explicitly stipulated by the donor, or required by state law, to be retained permanently, and certain uncommon reclassifications - see below.)

- Revenues from exchange transactions (commonly referred to as earned income) are

reported as increases in restricted net assets. Even earned income with legal restrictions (e.g., college dormitory fees deposited directly in a sinking fund pursuant to a bond indenture; special member assessment by a country club to build a new swimming pool) should be reported as increases in unrestricted net assets; but the required use should be clearly indicated – such as by reporting the item on a separate line in the statement of activities. (Note that these examples are examples of the rare case where individual assets may be legally restricted, rather than the related net assets.) [SFAS 116, par. 3 - 2nd sentence; SFAS 117, par. 20]

To put the above another way, the only types of revenue which should be reported as increases in restricted net assets are contributions with specific donor stipulations as to use (such contributions are sometimes referred to as gifts, grants, allocations, etc.), including amounts restricted by donors under matching provisions of gifts, investment return (interest, dividends, rent, realized and unrealized gains, etc.), including investment return required to be reported as temporarily restricted under FSP 117-1, arising from the investment of restricted contributions, and (while not, strictly speaking, revenue, since it is often displayed within the revenue section) the negative side of the release of temporary restrictions. All earned income (even though there may be legal limitations on its use) and other revenue should be reported as unrestricted. Gains and losses (and prior period adjustments and cumulative effects of accounting changes, if any) may be reported as restricted or unrestricted depending on the specific facts and circumstances. [SFAS 116, par 14; SFAS 124, par. 8,9; Audit Guide, par. 5.31]

- Contribution revenue related to pledges receivable is reported as unrestricted (it should

generally be temporarily restricted because of the implied time restriction, unless (a) the donor has stipulated that when collected the gift is permanently restricted, in which case the revenue is initially recorded directly in that class, or (b) explicit donor stipulations or other circumstances surrounding the receipt of the promise make it clear that the donor's intention is to support activities of the current period.) [SFAS 116, par. 15; Audit Guide, par. 5.49]

- Revenue and related expenses such as from a special fundraising event, gift shop sales,

conferences, etc. are reported as a single net number. The following is permitted as gross reporting:

Gross proceeds of activity (Less expenses of activity)

Net revenue from activity

NPOs have flexibility in terms of where on the statement of activity the above is reported. It may be most meaningful to report it in the revenue section, unless the expenses exceed the revenue, in which case it may be more meaningful to report it in the expense section, with



the expenses first. It is also acceptable to present the revenue and expenses each in its own section. (GAAP requires such amounts to be reported gross, with the exception of investment management expenses, which may be netted against investment income, or if the activity is considered incidental - and thus related inflows and outflows are gains and losses, which may be netted). [SFAS 117, par. 24; Audit Guide par. 13.23-.25]

- Not recognizing contribution revenue for all gifts-in-kind (e.g., free rent; services provided by

another organization; donated supplies). [SFAS 116, par. 5, 9] - Not reporting contributed services of volunteers that meet the SFAS 116 recognition criteria.

There can be only be two reasons for not recognizing contributed services: the services do not meet the recognition criteria in SFAS 116, or there is truly no reasonable way to assign a value to the services - which should be rare. Simply choosing not to report them is unacceptable, as is claiming that no objective value is determinable when a reasonable estimated value could be determined with a reasonable and practical effort and estimation. [SFAS 116, par. 9; APB 29 par. 20, 25 - extrapolated to this item - see SFAC 6, par. 31 and SFAS 116, par. 5]

Expenses/Losses:

- The organization aggregates categories of functional expenses that should be reported separately (every organization must have at least one program, and will have management and general expenses - even if the organization has only one program; many will also have fundraising [and/or membership development] expenses.) Interest and payments to affiliates should be allocated to the appropriate functional categories if possible. [SFAS 117, par. 26; As to interest and payments to affiliates: Audit Guide, par. 13.40 - last sentence, and 13.58, respectively]

- Total fundraising expense is not disclosed. If an organization asserts that it is not necessary

to disclose fundraising expense because the amount is immaterial, auditors should consider the extent of the attention that financial statement users often devote to this item in determining whether the judgment of a reasonable person relying upon the financial statements would have been changed or influenced by the inclusion or correction of the item. If fundraising expenses are not disclosed and contribution revenue is displayed, the authors believe that the auditor should insist that the organization’s accounting policy footnote state that, “immaterial amounts of fundraising expenses are included in [management and general] expense.” [Audit Guide, par. 13.35 - last sentence]

- Depreciation and occupancy (operation and maintenance of plant, or similar captions) are

reported as functional expense categories, rather than being allocated to other functions (program, management, fundraising). If an organization insists on showing such expense categories as separate line items on the face of a functionalized income statement (strongly not recommended), some accountants believe that this deficiency may be remedied by a footnote that discloses their functional allocation. (However, other accountants believe that such footnote disclosure is not sufficient to meet the requirements of SFAS 117.) [Audit Guide, par. 13.40]

- Advertising of the organization’s program services for which fees are charged (e.g., clinic,

concert, museum exhibit) is reported as program expense. Such expense is a management expense. [Audit Guide, par. 13.34 - last sentence]



- Expenses are reported in either of the restricted classes of net assets. (All expenses should be reported as decreases in unrestricted net assets per SFAS 117.) Losses may be reported in any class. [SFAS 117, par.20]

The next three items may be a major concern for some organizations, in the current state of the securities markets as to both values of investment assets and investment returns:

- Failure to report the effect of a decline in the fair value of pension fund assets. [SFAS 87, par. 29-34]

- Failure to disclose circumstances in which the return on investments being used to fund gift annuity payments declines below the required annuity payout rate; any resulting deficiency results in the organization effectively losing money on the annuity since the liability is a general liability of the organization. (No additional liability is needed since the actuarial liability has already been recorded.) [Although this scenario is not discussed as such in Chapter 6 of the Audit Guide, it is implicit in SFAS 5, par. 10.] (This would not be a problem if the organization had locked in long-term fixed-income investments to fund the payments.)

- Failure to disclose circumstances surrounding a decline in investment return of a trust used to pay liabilities under split-interest agreements:

- although it does not result in a direct liability of the trust's charitable beneficiary (remainderman), since the liability is limited to trust assets;

- it may result in the trust's life tenants losing current income, which may adversely affect the charity's ability to raise future contributions (contingency).

- also, the remainderman may need to record a loss resulting from the decline in the estimated actuarial value of its remainder interest. [Audit Guide, par. 6.29]

- Reclassifications/transfers are made:

- out of permanently restricted. - into temporarily or permanently restricted [permitted only for the matching portion of

a restricted challenge (matching) gift/grant - see Audit Guide, par. 5.40].

[Exceptions to the above are: - Any reclassification is permitted as a correction of an error (prior-period adjustment);

these will be rare. - Any reclassification is permitted if a donor of a gift changes the nature of a restriction,

in a year subsequent to initial recording of the gift (the organization may wish to consult an attorney regarding the legality of certain types of reclassification, e.g., the placing of a restriction on a previously unrestricted gift.)]

- Temporarily restricted net assets subject to both a time and purpose restriction are released

when one but not the other is met. The release can occur only after both are met. [SFAS 116, par. 17, f/n 5]

Other:

- Any amount (other than prior-period adjustments [and, of course, beginning and ending net assets]) is reported below the caption, "Change in Net Assets." There may be any number of subtotals above Change in Net Assets, but too many are discouraged in the interest of reader understanding. [SFAS 117, par. 18]

- Change in net assets for each net asset class - applicable to the organization - and in total

are omitted. The author has observed financial statements that received unqualified



opinions when the total change in unrestricted net assets was not presented in cases where that class has been disaggregated into two adjacent columns and a change was presented for each column. The columns were directly adjacent; there were only two. The author believes that presentation does not conflict with (meets the spirit of) GAAP. [SFAS 117, par. 19]

Statement of functional expenses: (if presented, or, even if not presented, since the allocations displayed on this statement are required to generate a proper functional categorization of expenses in the statement of activity, these points apply to all organizations)

- Some expense categories are not allocated to all affected functions, such as fund raising. For example, it is inappropriate to automatically include all occupancy, utilities, depreciation, insurance, etc. in management expenses, or to not allocate a portion of these items to fundraising if, as is usually the case, they have benefited to some extent the fundraising function. [SFAS 117, par. 26]

Also, if salaries have been allocated to a function, then it is improbable that no occupancy expense is allocable to that function (the employees have to sit somewhere.)

Even if the amount properly allocable to a function is small, the allocation should be made to avoid giving the impression to a reader that the organization (or the auditor) does not understand proper allocation procedures.

- The statement of activity presents more than one program (and the statement of functional expenses is a required statement), and the functional expenses are presented in total rather than individually for each program shown on the statement of activity. [SFAS 117, par. 26]

- All management/general expenses are fully re-allocated to other functional categories. (It can be appropriate to do this for purposes of issuing a special report on expenses chargeable to a grant or contract, or for internal management purposes.) It is acceptable to re-allocate a portion of management expense, if indirect function costs are initially accumulated in the management category for bookkeeping purposes.

Statement of Cash Flows:

- Purchases and sales of long-term assets (investments, PPE) are displayed as a net amount in the investing cash flows section. SFAS 95, par. 11 requires such amounts to be reported gross. [also SFAS 117, par. 149]

- Non-cash items (e.g., the amount of gain/loss on investments or other assets; increase in cash surrender value of life insurance; amounts related to the inception of a capital lease) are displayed in the investing or financing sections of the statement. Only any underlying cash transactions may be reported here. [SFAS 95, par. 7] (Most gains/losses are adjustments to the change in net assets to reconcile to operating cash flows; many other unusual items such as assets acquired under a capital lease, are disclosed as non-cash items, but not included in the statement itself.)

- Capital-type contributions (endowment gifts; gifts restricted for acquisition of property) are reported in the operating rather than the financing cash flows section. [SFAS 117, par. 30d]

- Amounts which have been board designated for some purpose are reported as financing flows (such amounts are still unrestricted and must be presented in the operating section when received.)

- Non-cash financing and investing transactions are not disclosed, e.g., receipt of donated fixed assets and donated investment securities, acquisition of fixed assets under a capital



lease, forgiveness of debt. The subsequent sale of donated non-cash investment assets is an investing transaction. [SFAS 95, par. 32, as amended by SFAS 117, par. 30g]

- If the indirect method is used, the required disclosures of interest paid and taxes paid are not made (they have to be shown outside the main part of the statement - can be in a note). [SFAS 95, par. 29 - last sentence]

Footnotes: - The accounting policies footnote [to a set of financial statements on which an auditor

expects to give an unqualified opinion] describes a policy being followed by the organization which is not in conformity with GAAP (e.g. reporting investment income or uncollectible receivables on the cash basis), and the note does not indicate that the departure does not have a material effect on the financial statements (if it did have a material effect, the auditor would have to qualify the report). (Alternatively, if the amount involved is really insignificant, and the policy is not evident from other information presented: do not describe the accounting policy at all.)

- Failure to include all required disclosures about: - unconditional promises to give (pledges) receivable: present value discount, discount

rate used, allowance for uncollectible, maturity by years, information about conditional pledges. [SFAS 116, par. 24-25; APB 21, par. 16; Audit Guide, par. 5.63 and .65]

- fair value of receivables. [SOP 01-6] (But note exceptions to certain disclosures required by SFAS 107, if the criteria in SFAS 126 are met - generally smaller non-public organizations.)

- fair value, generally [SFAS 157] - joint costs of multipurpose activities: types of activities involved, statement that such

costs have been allocated, total amount allocated and the portion allocated to each function [encouraged but not required: amount of joint costs for each kind of joint activity]. [Audit Guide, par. 13.54-.55, and illustrations in Chapter 13 – Appendix D]

- donated services of volunteers: nature and extent of contributed services received, description of the activity(ies) involved, amount recognized [encouraged but not required: fair value of contributed services received but not recognized]. [SFAS 116, par. 10; Audit Guide, par. 5.79, 5.81]

- nature of restrictions on temporarily and permanently restricted net assets. [SFAS 117, par. 14]

- details of investments by major types when mutual funds are held (listing “mutual funds” or naming a mutual fund family is not sufficient). [SFAS 124, par. 15a]

The following group of items is not strictly a matter of GAAP compliance (since GAAP is mostly silent, i.e., does not get into this level of detail). However it is related to the GAAP concept of classes of net assets, and represents the author’s views:

If the balance sheet is disaggregated by class: (This practice is not encouraged by FASB, but it is often seen. FASB’s concern stems from a belief that, in the absence of a specific donor stipulation requiring retention of a particular donated asset (i.e., it can’t be sold or converted into another asset), only net assets are restricted; individual assets generally are not).



- Any items other than the following are displayed in either of the restricted columns: cash, investments, pledges receivable, assets held by others under trust agreements, annuity liabilities, and net assets;

However fixed assets may be displayed:

- in the temporarily restricted column if the organization’s accounting policy is to consider the restriction on donated fixed assets (and fixed assets purchased with gifts restricted for that purpose) to expire ratably over the assets’ useful lives; and

- in the permanently restricted column if it is reasonable for the organization to have such assets, e.g., capitalized museum collection items which cannot be disposed of, undeveloped land held by a conservation organization under a perpetual conservation easement, investment real estate received as a permanent endowment gift, etc.

- Amounts receivable under cost-reimbursement grants are displayed as restricted (since any temporary restrictions originally associated with such amounts have been released by the activity giving rise to the receivable.)

- Pledges receivable are reported in other than the temporarily (usually - because of the implied time restriction) or permanently (if the pledge is stipulated by the donor for permanent endowment) restricted columns. Any significant pledges displayed in the unrestricted column should be explained. [SFAS 116, par. 15]

- If there are long-term pledges receivable displayed, there should be at least that amount of temporarily (normally) and/or permanently restricted net assets.

- Prepaid expenses and accounts payable are displayed in the temporarily restricted column in other than the uncommon circumstance where expenses have been incurred under the terms of a restricted contribution but the restriction itself has not yet been met. (An example is receipt of a gift to commission a new piece of music or artwork; progress payments are made to the composer/artist, but the restriction will not be lifted until the piece is complete and has been delivered to the commissioning organization.)

- Deferred revenue is reported in the temporarily restricted column (except in certain rare circumstances). Since only donations can be reported as restricted, and all donations are revenue when received, normally there can never be temporarily restricted deferred revenue. [Exceptions: refundable advances; pooled income funds – SFAS 116, par. 22 – last sentence, and Audit Guide, Chapter 6, respectively]

- Liabilities related to annuities held in a trust are displayed in other than the temporarily restricted column (unless the proceeds will be permanently restricted upon maturity).

Matters more of style and preference All financial statements:

- “Other” or “Miscellaneous” captions should be avoided as much as possible. If used, the amounts associated with such captions should be small - at least not much larger than any other amount in the same section (e.g., assets, liabilities, revenue, expenses). For example, presenting Prepaid expenses of $6,000 and “Other assets” of $80,000 will give a reader the impression that the organization is trying to hide something it is embarrassed about.

- Try to keep the number of columns to a minimum, in the interest of reader understanding. See SAS 106 regarding financial statements being ‘expressed clearly.’



Balance Sheet:

Net assets:

• If the organization owns significant non-liquid assets (e.g., property), it may be helpful to financial statement users to disaggregate the net assets related to those assets within the unrestricted class, especially if the organization’s liquid assets are insufficient to cover current liabilities. This avoids hiding a working capital problem from the board and management.

• If the unrestricted net assets caption includes a sub-caption for equity in fixed assets, this caption should equal (or at least approximate) the amount of net fixed assets minus related long-term debt.

• Permanently restricted net assets should normally be no larger than investments (including restricted cash and revolving fund loans receivable, if any) plus permanently restricted pledges, (and permanently restricted fixed assets (if there are any – see above).)

• It would be unusual to designate an amount of unrestricted net assets such that the resulting undesignated portion is negative.

Statement of Cash Flows: - A statement prepared using the direct method is generally more likely to be understood by

readers than a statement prepared using the indirect method. (If the direct method is used, it is recommended that the required reconciliation to operating cash flows be presented in a note rather than with the statement.) FASB explicitly recommends – but does not require – the direct method (SFAS 95, par. 27, and SFAS 117, par. 147).

Statement of Functional Expenses Try to keep the number of lines to a minimum, in the interest of reader understanding. For example:

- The total of salaries, wages, payroll taxes, and fringe benefits - rather than showing each line separately – is probably as much information on this subject as most readers need.

- Similarly, total occupancy is likely just as informative as details of rent, maintenance, janitorial, utilities, etc.

- A subtotal before depreciation likely adds nothing to anyone’s understanding, and more likely detracts. (The old voluntary health and welfare audit guide illustrated such a subtotal, but SFAS 117 does not.)

Footnotes: - If an organization’s accounting policy departs from GAAP in a way that is evident from

cursory review of the financial statements (e.g., the balance sheet includes investment assets but there is no investment income receivable presented; a private foundation does not present an amount for federal excise tax expense), but the effect on the financial statements has been judged to be immaterial, the accounting policy footnote should state that fact. This will avoid giving the impression to a reader that the organization – and the auditor – do not know what GAAP are.

- Accounting policy-type notes should not merely state that some type of transaction "... is recorded in accordance with SFAS No. XXX," with no further description of what SFAS XXX says (except possibly its title). While CPAs presumably know such things, the vast majority



of readers of not-for-profits' financial statements do not, and should be more adequately informed.

- For donated services that are not recognized, the reason should be stated (i.e., do not meet criteria in SFAS 116, or no objective value can reasonably be determined - see above.)

Grammar and Usage

Be especially careful in using often-confused words such as: - affect/effect - principal/principle - comprise/compose/consist [of] - its/it’s

Improper usage gives readers a poor impression of both the organization and the auditor.

* * * * * * * Accounting and Auditing Bibliography

FASB - see also the Accounting Standards Codification, especially section 958 (cross-references above)

Statements of Financial Accounting Standards: - 93 (depreciation) - 116 (contributions) - 117 (financial statement format), and FASB Staff Position 117-1 - 124 (investments) - 136 (pass-through transactions) - 164 (combinations - mergers and acquisitions) - exposure draft - consolidation – draft issued 2006; final ? (meanwhile see SOP 94-3)

Concepts Statements: - No. 4 – Objectives of Financial Reporting by Nonbusiness Organizations - No. 6 - Elements of Financial Statements

AICPA:

- Accounting Principles Board Opinion No. 29 – Non-monetary Transactions (see also SFAS 157 - fair value)

- Statements of Position (SOP): (all are included in Audit Guide) - 94-2 (applicability of GAAP to not-for-profits) - 94-3 (consolidation) – to be superseded by FASB - 98-2 (joint costs)

- Audit Guide, Not-for-Profit Organizations – updated annually; overhaul in process – draft in 2011 ?

- Audit Risk Alert, Not-for-Profit Organizations Industry Developments (annual)

- Practice Aid, Accounting Trends & Techniques - Not-for-Profit Organizations

- Audit Committee Toolkit: Not-for-Profit Organizations

Other:

- Financial and Accounting Guide for Not-for-Profit Organizations, 7th ed. – (John Wiley & Sons) & annual supplement

- Not-for-Profit GAAP 2011 – (Wiley)



- Standards of Accounting and Financial Reporting for Voluntary Health and Welfare Organizations, (‘Black Book’) 4th ed. – (National Health Council)

- Accounting and Financial Reporting Guide for Christian Ministries - (Evangelical Joint Accounting Committee)

- Guide to Forming and Running an Effective Audit Committee for a Not-for-Profit Organization - (BDO Seidman, LLP)

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