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The New Not-for-Profit
Audit and Accounting Guide

By D. Edward Martin and Julie L. Floch

In Brief

Comprehensive Guidance

AcSEC has issued a new audit and accounting guide, Not-for-Profit Organizations, that replaces many of the SOPs and guides that represented authoritative literature in this area.

The scope of the new guide is broad, and it incorporates the requirements of recently issued FASB pronouncements that have had a significant impact on accounting for nonprofit organizations.

Most chapters contain an addendum that provides a detailed table of auditing considerations. Guidance is given on documenting the scope of the examination, matters to consider in planning the audit, and reporting issues.

Split-interest agreements, where the contributor divides the benefits among the not-for-profit entity and one or more other parties, receives in-depth coverage in the guide. (An example of a split-interest agreement is a charitable remainder trust.)

Accounting matters covered include investments, contributions, and expense classifications and disclosures. The guide also gives very explicit examples of the treatment of fund-raising expenditures.

In 1978, the American Institute of CPAs' Accounting Standards Executive Committee (AcSEC) issued Statement of Position (SOP) 78-10, Accounting Principles and Reporting Practices for Certain Nonprofit Organizations. This SOP (the guidance from which was later expanded in an AICPA audit and accounting guide for other nonprofit organizations) was intended to provide accounting and reporting help for those many types of entities that--unlike voluntary health and welfare organizations, colleges and universities, and not-for-profit hospitals--did not receive specific direction from a formal AICPA guide. But there was an even larger goal in mind.

For most entities and their auditors, not-for-profit accounting and reporting was at that time a mixed bag of concepts and methods appropriated from the commercial sector, existing AICPA audit and accounting guides and SOPs, and established practices of individual not-for-profit industry sectors. Thus, many saw SOP 78-10 as an opportunity to make not-for-profit accounting and reporting guidelines more consistent from one entity to the next, regardless of their missions. But, more than that, they hoped to use the SOP as a catalyst to bring virtually all of the diverse enterprises beneath the not-for-profit umbrella under the aegis of a single authoritative accounting and auditing document. At long last, nearly two decades later, that ambition has been largely realized.

Most persons with an interest in the independent sector, as it is frequently called, are well acquainted with the Financial Accounting Standards Board's (FASB) activities in this area, beginning most notably in 1980 with Statement of Financial Accounting Concepts No. 4 on "nonbusiness" entities, continuing in 1987 with SFAS No. 93 (requiring capitalization of fixed assets and related depreciation) and culminating in the mid-1990s with SFAS No. 116 (on contributions made or received), SFAS No. 117 (on display of financial statements), and SFAS No. 124 (on accounting for investments at market value). Now, effective for financial statements ending on or after December 31, 1996, AcSEC has set in place the capstone to the changes of the past several years with the issuance of its new audit and accounting guide, simply titled Not-for-Profit Organizations.

Scope of the New Guide

At nearly 200 pages (before appendices), the AICPA's new audit and accounting guide covers a lot of ground. It incorporates the requirements of FASB Statements Nos. 116, 117, and 124, while superseding the audit and accounting guides for colleges and universities, voluntary health and welfare organizations, and other not-for-profit organizations. SOP 78-10 also bites the dust, as do SOP 74-8, Financial Accounting and Reporting by Colleges and Universities (included in the college and university guide); SOP 87-2, Accounting for Joint Costs of Informational Materials and Activities of Not-for-Profit Organizations That Include a Fund-Raising Appeal; and SOP 94-2, The Application of the Requirements of Accounting Research Bulletins, Opinions of the Accounting Principles Board, and Statements and Interpretations of the Financial Accounting Standards Board to Not-for-Profit Organizations. The new guide absorbs the essence of these last two SOPs, while including as appendices SOP 92-9, Audits of Not-for-Profit Organizations Receiving Federal Awards, and SOP 94-3, Reporting of Related Entities by Not-for-Profit Organizations.

The new guide applies to all nongovernment not-for-profit entities except those health-care organizations subject to the AICPA audit and accounting guide for such enterprises, which replaced the previously mentioned guide for hospitals. Government organizations are not affected by the new guide if they follow the AICPA audit guide model as addressed in GASB Statements No. 15 and No. 29. Moreover, the new guide's definition of a not-for-profit entity expands the description included in SFAS No. 116, which excludes those entities that provide lower costs or other economic benefits directly to their owners, members, or participants (e.g., country clubs and trade associations). The AICPA considers all those organizations previously covered by its superseded/absorbed not-for-profit pronouncements to meet the spirit of the FASB definition and are thereby included within its scope.

Significant Auditing

The days of accountants treating not-for-profit audits as "off-season" or "filler" work have passed, and care must be taken to address a variety of auditing issues--those common to all enterprises, as well as those unique to the not-for-profit community. The FASB does not address auditing standards or procedures, so the new audit and accounting guide provides even experienced practitioners with valuable insights and techniques for sharpening the applications of the attest function to the not-for-profit sector. Of particular note is that, as an addendum to most of its chapters, the guide provides a detailed table of auditing considerations, describing the applicable financial-statement assertions, specific audit objectives, and examples of selected controls and auditing procedures.

Scope of the Engagement. As a starting point, the independent accountant and client must establish an understanding--preferably in writing--of the scope of service to be rendered and reports to be issued. Not-for-profit entities frequently have special reporting needs, and the guide reminds auditors to design their engagements in a manner that will satisfy relevant contractual, legal, and regulatory requirements.

For example, entities that receive sufficient levels of Federal funding will have to meet the reporting requirements, with their auditors' assistance, of the United States Office of Management and Budget (OMB) Circular A-133, Audits of Institutions of Higher Education and Other Nonprofit Institutions, while these and other organizations with governmental ties may have to have reports that meet the requirements of Government Auditing Standards (commonly referred to as the "Yellow Book"). Moreover, the auditor may assist in the filing of special reports to state regulators, as well as the more usual reports often prepared for lenders or contributors.

Audit Planning. In recent years the financial press has reported a number of instances in the not-for-profit community of what may best be described as ethical lapses or inappropriate management decisions regarding officer compensation and stewardship of resources--not to mention outright fraud or misappropriation of funds. Accordingly, auditors must take a harder look at their not-for-profit clients when designing their audit approaches.

The new guide provides standard direction for risk and materiality assessments but also discusses unique substantive tests that the auditor may wish to consider. For example, confirmation of contributions or "pledges" receivable need not be performed under the guidelines of Statement of Auditing Standards (SAS) No. 67, The Confirmation Process; nonetheless, the guide acknowledges that confirmation may be used to determine the existence of such assets, their expected remittance dates, any donor-imposed restrictions and conditions, etc., using SAS No. 67 as a guide.

The guide's discussion of internal control considerations is also comprehensive. It expands the guidance of SAS No. 55, Consideration of the Internal Control Structure in a Financial Statement Audit, as amended by SAS No. 78, by providing the following examples of characteristics of a not-for-profit organization's control environment the auditor should consider:

* Role of management and governing board;

* Frequency of governing board meetings;

* Qualifications of management and governing board members;

* Governing board members' involvement in the organization's operations; and

* Organizational structure.

The guide also notes that, for the auditor to obtain sufficient knowledge of the other components of internal control, he or she should understand the ways in which--

* restricted contributions are identified, evaluated, and accepted;

* promises to give are valued and recorded;

* contributed goods, services, utilities, facilities, and the use of long-lived assets are valued and recorded;

* compliance with donor restrictions and board designation is monitored;

* reporting requirements imposed by donors, contractors, and regulators are met;

* conformity with accounting presentation and disclosure principles, including those related to functional and natural expense reporting and allocation of joint costs, is achieved; and

* new programs are identified and accounted for.

Reporting Issues. One of the most notable changes in the guide is the revision of the language to the standard auditor's report as it relates to not-for-profit organizations. As set forth in SAS No. 58, Reports on Audited Financial Statements, as amended, the standard report's reference to "results of operations" (i.e., net income for the year and other changes in net worth) is intended for commercial enterprises and not for not-for-profit activities. Accordingly, the opinion paragraph of the auditor's report will now read as follows:

"In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the McAlman Society for the Encouragement of the Arts as of December 31, 1996, and the changes in its net assets and its cash flows for the year then ended in conformity with generally accepted accounting principles."

In the years prior to SFAS Nos. 116 and 117, it was not unusual to see not-for-profit financial statements composed of a number of columns, reported on a "by-fund" basis, often on foldout pages that would accumulate their breadth of information. A recurring reporting issue was whether to treat the prior years' data on the same page or on an adjacent page, with the same amount of detail, or summarized as a single total. The problem for the auditor was whether a prior year's single total column (omitting the supporting columns actually included in the prior year)--when compared to the current year's multicolumn approach--was sufficient to be reported upon using the criteria of SAS No. 58. The usual answer arrived at was that all the prior year columns were necessary for meaningful comparison, and the auditor did not report on the "summarized information" of the prior year.

While it does not mandate the use of fund accounting, SFAS No. 117 does require that certain basic information (e.g., net assets and changes in net assets by net-asset class) be included in the financial statements. The guide reiterates that, number od columns aside, if the prior year's financial statements present such basic information, they are not to be considered as summarized information and should be reported on by the auditor. If the prior year's data is insufficient for a report, that fact should be appropriately highlighted in the financial statements. If the financial statements do not do this adequately, the auditor should add an explanatory paragraph to his or her report.

Significant Accounting Matters

The new guide incorporates the accounting and reporting provisions included in SFAS Nos. 116, 117, and 124, so users will not find conflicting guidance when referring to the two sets of authoritative literature. However, the guide expands upon or interprets many of the accounting and reporting principles the FASB has established, sometimes in ways that not-for-profit entities and their auditors would not have anticipated. Some organizations might think certain of their current practices are unaddressed or remain unchanged, only to find the guide examines those practices with more specificity.

The comprehensive population of not-for-profit concepts, practices, and procedures now embodied in the FASB's pronouncements and in the new guide poses issues for understanding and implementation too numerous to be adequately addressed in this small amount of space. Not-for-profit organizations and their accountants have a lot of reading in store for them! Nonetheless, the following comments provide some measure of the broad extent of additional direction the guide contains.

Investments. The treatment of investments as an asset and as the essential element of endowment is a key area of focus for many not-for-profit entities and their auditors. SFAS No. 124 addresses not-for-profit investments in detail, and the new guide devotes a chapter to summarizing significant auditing, accounting, and reporting considerations for investments.

The handling of net appreciation of endowment in the financial statements depends on legal determinations, and the guide directs auditors to obtain "representations from management about any interpretations made by the organization's governing board concerning whether laws limit the amount of . . . endowment funds that may be spent." Where there are questions about the appropriateness of spending policies, auditors should request the organization to obtain a clarifying opinion from legal counsel.

Contributions. Outside of concerns about accounting for the conditions and/or restrictions a donor may place on a gift (and the guide requires disclosure of material noncompliance with restrictions), perhaps the most important aspect of contributions is distinguishing between true contributions and exchange transactions (in which the recipient not-for-profit organization provide goods or services directly to the resource-provider or its designees). The new guide provides a lengthy table of indicators valuable in differentiating between the two, as well as a useful illustration of how some contributions-in-kind received for fund-raising purposes (e.g., tickets, works of art, and merchandise) may result in transactions that are part contribution and part exchange transaction. Agency transactions are also mentioned in the guide, and, shortly after the guide's issuance, the FASB released Interpretation No. 42, Accounting for Transfers of Assets in Which a Not-for-Profit Organization Is Granted Variance Power, which provides instruction for those transactions in which a not-for-profit organization acts as an agent, trustee, or intermediary.

The guide devotes significant space to split-interest agreements, which are arrangements in which the contributor divides the benefits of a contribution among the not-for-profit recipient and one or more other parties. (A charitable remainder trust is a prime example.) Among the key points addressed in the guide are that--

* a not-for-profit beneficiary should record the economic impact of the arrangement once it becomes aware of it (even if a third party holds the assets--unless that third party has substantial discretion over the distribution of benefits, in which case the arrangement may be a conditional contribution to the not-for-profit entity, and thus not recordable until the condition is met);

* irrevocable arrangements should be accounted for as part-gift, part-exchange transactions, with assets received accounted for at fair value and a liability recorded relating to the agreement's exchange portion (e.g., an annuity to a life tenant);

* revocable arrangements should be accounted for as conditional, with those assets received in advance correspondingly offset with a liability for the obligation to refund.

Also of particular value in the guide's coverage of split-interest agreements is an appendix of journal entries that illustrate the flows of resources in these often complicated transactions.

It goes without saying that a not-for-profit organization's failure to comply with the restrictions a donor may place on its contribution poses a significant problem, for both the entity and its auditor, even if the noncompliance is temporary (such as when required minimum asset levels cannot be maintained throughout a reporting period). If there is a reasonable possibility that (I) a material contingent liability has been incurred or (II) failing to follow the contributor's dictates could lead to a material loss of revenue or even to a question about its ability to continue as a going concern, the guide requires that such noncompliance be disclosed.

Expense Classifications and Disclosures. The new guide deals with some major areas of expense recognition that have been particularly troublesome for not-for-profit organizations. In the area of fund-raising, for example, the guide is very clear:

"Fund-raising costs, including the cost of special fund-raising events, are incurred to persuade potential donors to make contributions . . . and should be expensed as incurred. Fund-raising costs incurred in one period, such as those made to obtain bequests, compile a mailing list . . ., or solicit contributions in a direct response activity, may result in contributions that will be received in future periods. These costs also should be expensed as incurred."

Moreover, total fund-raising expenses must be disclosed in the financial statements, either in the statement of activities or supporting notes.

Reporting the cost of special fund-raising events, such as dinners, concerts, and theater parties, has often been troublesome to organizations and their auditors. The guide provides helpful illustrations of ways in which the results of a special event can be displayed in the statement of activities.

Although most of its comments on expenses are expansions of or elaborations on the concepts and practices already promulgated by the FASB, the guide stresses the importance of providing readers with the total of program expenses. Total program expenses must be disclosed in the financial statements--in the supporting notes, if not on the face of the statement of activities itself--and there must also be an explanation of any discrepancies in amounts between the statement of activities and notes.

What Happens Next?

Of course, the refurbishing process for not-for-profit accounting, auditing, and reporting is still underway, as there will always be additional issues to be addressed and approaches to be refined. For example, auditors need to stay on top of the changes in store for fund-raising cost allocation. The AICPA's September 1993 exposure draft of a proposed SOP, Accounting for Costs of Materials and Activities of Not-for-Profit Organizations and State and Local Governmental Entities that Include a Fund-Raising Appeal (which would revise existing SOP 87-2), is expected finally to be released this year. On the regulatory side, tax authorities continue to look with a jaundiced eye at lobbying and advocacy activities by not-for-profit entities, as well as at innovative funding techniques, and the auditor must "look beyond" the financial-statement numbers to be certain an enterprise is in compliance with the basis for its tax exemption. And, just as SOP 78-10 provided examples of financial-statement disclosure for a variety of entities, there is a need for developing illustrative, sector-specific financial statements that will highlight both the similarities and differences between organizations, in accordance with the requirements of SFAS No. 117.

Indeed, the absence of such helpful, by-type-of-organization examples of financial statements seems to be the only substantive disappointment in the audit and accounting guide voiced thus far by practitioners. There is a limit to what can be accomplished in such a major undertaking, however, and the AICPA deserves high marks for its accomplishment. In fact, its not-for-profit committee has already formed a subcommittee to address the wide range of reporting considerations inherent to sector-specific financial statements, and it has this and a variety of other accounting and auditing issues on its agenda. Although the new guide provides practitioners--and the organizations they serve--with a valuable new weapon for addressing the accounting and reporting challenges that face the not-for-profit community, there are more dragons yet to slay. *

D. Edward Martin, CPA, is a partner with Richard A. Eisner & Company, LLP and a former member of the Auditing Standards Board. Julie L. Floch, CPA, is the director of not-for-profit services at Richard A. Eisner.

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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