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Getting the statement of unrestricted activities to tell the "true" story.

Coping with Nonprofit Accounting Rules

By Robert N. Anthony

Many nonprofit organizations and their accountants feel the disclosure requirements of SFAS No. 117, Financial Statements of Not-for-Profit Organizations, may distort the results of their operations. However, the statement provides a great deal of flexibility in presenting results and the author shows how to use this flexibility to tell it as it is.

SFAS Nos. 116 and 117 challenge the accountant to find a sensible way of preparing an operating statement for nonprofit organizations that have contributed endowment, plant, or museum objects. The Statement of Unrestricted Activities illustrated in SFAS No. 117 mixes operating transactions with nonoperating transactions and leads to what many believe to be a useless bottom line. Recognizing this fact, paragraph 23 of SFAS No. 117 permits organizations to develop an operating statement as one section of the Statement of Unrestricted Activities, and it allows complete latitude in the format and content of such a statement, provided only that if the organization's use of the term operations is not apparent, the nature of the reported measure or of the items excluded should be described in a note.

The recent experience of mythical Carmel College suggests techniques that should be helpful in solving this problem and in meeting criticisms that some may have as to these ideas.

In the fall of 1995, Carmel's financial vice president, Charles Anderson, asked Jerry Holden, engagement partner of Carmel's public accounting firm, to recast the 1995 financial statements as a basis for discussion. Working with the Carmel accounting staff, two versions of the Statement of Unrestricted Activities were prepared, as shown here. Exhibit 1 is prepared according to the format and content illustrated in SFAS No. 117. Exhibit 2 reports the same information divided into two sections, one for operating items and the other for nonoperating items.

These exhibits were discussed at a special meeting of the audit committee. After the committee had glanced at them, the chairman, Ann Constable, said, "No way will we accept Exhibit 1. Its bottom line says that Carmel had a surplus of $6 million, compared with a surplus of $200,000 in the operating section of Exhibit 2. Exhibit 2 reports what we know to be our operating results. Exhibit 1 surely will raise questions from parents about tuition, from faculty about salaries, and from contributors about whether Carmel really needs their money."

Mr. Holden asked that judgment be suspended until he had described both exhibits and pointed out problems associated with publishing Exhibit 2.

Preparation of the Operating Statement

Exhibits 1 and 2 are condensed versions of the statements given to the audit committee. They omit details of expenses, and combine items not relevant to the discussion as "other."

Contributions. Mr. Holden pointed out that Contributions on both exhibits consisted of two items. On Exhibit 1, the first item was the $4,406,000 received from the annual alumni fund and from other unrestricted resources during the year. The second item, "Contributions from prior years, $3,247,000," reported similar contributions that had been reported initially in the temporarily restricted class that became unrestricted with the passage of time or in carrying out the restricted purpose. SFAS No. 116 requires this reclassification from the temporarily restricted to the unrestricted class be reported separately (even though some feel this serves no useful purpose).

Of the total amount reported as contributions revenue on Exhibit 2, $871,000 was for plant items placed in service in FY 1995. This is one of the two ways of accounting for contributed plant permitted by SFAS No. 116. This new plant certainly did not provide financial resources to meet operating expenses; on the contrary, the new plant probably added to operating expenses. It was therefore listed in the nonoperating section of the statement.

Of the remainder, $3,804,000 was also not available to finance operating activities in the current year; these contributions were intended for endowment. They were not legal endowment because the donor did not specifically require they be treated as endowment, even though this was the donor's intention. They were classified as board-designated endowment, so as to signal they were not to be used to finance operating activities. About one third of Carmel's endowment consists of board-designated contributions. The $3,804,000 therefore is listed in the nonoperating section of Exhibit 2.

Endowment. Exhibit 1 lists $2,798,000 as "Endowment income" and $4,099,000 as "Net realized and unrealized gains on endowment," a total of $6,897,000. This amount was not relevant in measuring operating revenue. Like most organizations, Carmel arrived at the amount of endowment available for operating purposes by using the spending-rate method. In this method, a specified rate (4.75% for Carmel) was applied to the average market value of the endowment, both legal and board-designated, to arrive at the amount available for spending in the current year. This rate was much lower than the average return expected to be earned on the endowment; by retaining the difference between the spending rate and the actual return in the endowment fund, the principal of the fund increased with inflation and its spending power was maintained. This practice also shields operations from short-term fluctuations in endowment returns. Its use is permitted by regulatory bodies in almost all states.

The spending-rate amount was $4,448,000, and this amount was entered as "Endowment income used for operations" in Exhibit 2; the $2,449,000 not used for operations was listed in the nonoperating section.

This treatment also had the advantage of alleviating another problem. Many people regard the FASB's requirements regarding the treatment of gains and losses on endowment as illogical and impractical. Moving this item to the nonoperating section assures that much less attention will be paid to it than if it were an operating component.

Nonoperating expenses. SFAS No. 117 requires all expenses be listed in the Statement of Unrestricted Activities. Carmel incurred two types of expenses that were not related to operations. They are similar to expenses incurred in a pension program, that are not listed on a business income statement.

One was $697,000 of expenditures incurred for Carmel's capital campaign. These were incremental expenses of staff and other costs above the amount normally incurred for development purposes. They were costs of the campaign and were properly deducted from the gross additions to plant and endowment generated by the campaign to determine the amount of its actual success.

The other was $538,000 of expenditures incurred in managing the investment portfolio. For Carmel, these expenditures included both fees paid to those managers who did not deduct them directly from the return on the funds they managed and expenses associated with certain partnerships in which endowment funds were invested.

If an organization used endowment funds to operate rental property, stores, or other business activities, the expenses associated with these activities would be reported in the Statement of Unrestricted Activities according to the literal reading of SFAS No. 117.

Exhibit 2 lists both types of expenditures in the nonoperating section of the Statement of Unrestricted Activities.

Problems with an Operating Section

Although Mr. Holden agreed that $201,000 was a much more realistic statement of Carmel's operating performance than $6,090,000, he had reservations about the use of Exhibit 2 as one of Carmel's financial statements. His concern was that although all transactions in FY 1995 (and, so far as he could recollect, all prior years) could be unambiguously classified as either operating or nonoperating according to Carmel's understanding of these terms, transactions might occur in future years whose classification was controversial. If the auditors viewed them differently from the way management did, Carmel would either be required to conform to the auditor's understanding of the FASB's requirements or risk a qualified audit opinion.

As an example, he stated that the AICPA was developing an Accounting and Audit Guide for nonprofit organizations, and several industry associations were preparing guides for their industries. These guides might require organizations to report expenses by functions, and the definition of "function" and the rules for allocating common expenses to functions might differ from those used by Carmel. (Carmel's functional classification provided for only minimal allocations; building maintenance and administrative expenses were treated as separate functions.)

He was not opposed to having a statement along the lines of Exhibit 2 in the "Notes" section of the financial statement. With such a note, readers could obtain the same message about the financial results of operating activities as that given in the operating section of Exhibit 2.

Mr. Anderson, the financial vice president, said that although the FASB could prohibit a Statement of Unrestricted Activities along the lines Carmel used in constructing its Exhibit 2, he thought this was highly unlikely. Paragraph 23 of SFAS No. 117 is careful not to specify any rules for the form and content of an operating statement, and this should prevent lesser rules-setting bodies from making such requirements. Paragraphs 26, 58, 59, 60, 62, 64, 67, 68, 74, 75, 80, and 82 of SFAS No. 117 all contain the message of flexibility.

With respect to the requirement for a functional report, paragraph 26 of SFAS No. 117 does require such a report, but the requirement can be satisfied by a note in the financial statements, similar to the Note on Segment Reporting required in business accounting. Paragraph 82 states that the FASB wants industry associations to "encourage" their members to prepare material with useful formats and content in the financial statements or in the notes; this is fundamentally different from "requiring" their members to do so. In any event, no lesser body can require a statement inconsistent with FASB pronouncements. Guides established by industry associations could affect the construction of such a note, but they could not impose additional or inconsistent requirements for the Statement of Unrestricted Activities.

As for having a note along the lines of Exhibit 2, but reporting the Statement of Unrestricted Activities in Exhibit 1, Mr. Anderson thought this would be confusing. Reporting $200,000 of operating surplus in a note, when the Statement of Unrestricted Activities referred only to a $6 million surplus, would lead many readers to conclude the organization was playing games with the numbers. In any event, the most important single piece of information about an organization's overall operating performance should not be relegated to a note. Notes are supposed to amplify numbers described in the statements, not contradict them.

The Decision

Mr. Holden said that, although Mr. Anderson's analysis was persuasive, he was unwilling to commit his firm to giving a clean opinion to Carmel's alternative format without consulting other partners in his firm. He did so, and three weeks later he reported the firm would give a clean opinion to Carmel's alternative. Mr. Anderson thereupon convened a telephone conference call of the audit committee, and the committee voted unanimously to adopt the format in Exhibit 2. *

Robert N. Anthony, DCS, is Ross Graham Walker Professor of Management Control, Emeritus, at Harvard Business School.


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