Cash Flow Classification of Restricted Funds

By Wayne Alderman and Jennifer M. Mueller

Not-for-profit organizations often have investments in equity securities that are subject to restrictions, which vary and can be permanent or temporary. The nature of restrictions creates a unique reporting circumstance for not-for-profit entities. The potential for misclassification of not-for-profit investments, especially on the statement of cash flows, is significant.

While applicable to not-for-profit entities, the predominant guidance on reporting the nature of cash flows, SFAS 95, Statement of Cash Flows, was originally written for business enterprises. As a result, SFAS 117, Financial Statements of Not for Profit Organizations, provides little guidance on reporting cash flows beyond that offered in SFAS 95. The language of investment securities for business enterprises and not-for-profit entities is diverse, at least for reporting purposes. Business enterprises must determine whether securities are “trading” or “available for sale” as defined by SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, in order to classify cash flows related to the securities. Not-for-profit entities, however, do not use the trading/available-for-sale nomenclature but rather classify cash flows related to securities based on the type of restrictions over the securities, a concept foreign to business enterprises.

The General Rule

Investments in equity securities with no donor restrictions set the general rule for reporting cash flows. Expenditures for buying and proceeds from selling the securities are reported as investing activities. Dividends received are classified as operating activities.

Before SFAS 102, Statement of Cash Flows—Exemption of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale, this is how business enterprises also dealt with cash flows related to equity investments. Now, however, sales and purchases of businesses’ trading securities are reported as operating cash flows, because they are bought specifically for resale to gain on short-term price increases. One caution for not-for-profit entities is that certain unrestricted securities may resemble trading securities. However, just as not-for-profit organizations do not use the trading and available-for-sale nomenclature, cash flows from buying and selling such securities should never be reported as operating activities.

Exceptions to the Rule

Securities that have donor-imposed restrictions create some exceptions to the general rule. (Securities with board-imposed restrictions are considered unrestricted and follow the general rule.) Most restricted assets are tied to an endowment fund (in which the principal amount is inviolable). Permanently restricted assets are most often related to a permanent endowment which requires that the original investment be maintained to provide a permanent source of income to the entity. Temporarily restricted assets are also often tied to an endowment. The restrictions may exist for a specific period or until a certain event occurs or action is taken by the entity. Although most securities held as restricted assets are related to an endowment fund, securities that are not part of an endowment may also have donor-specified restrictions. The nature of the restrictions, rather than whether the restricted assets are part of an endowment, is what determines the classification of cash flows.

Sales proceeds and expenditures to acquire securities held as restricted assets often follow the general rule and are reported as investing activities. An exception is if the proceeds are restricted for acquiring, constructing, or improving long-term assets. In this case, the proceeds are considered financing activities, regardless of whether permanently or temporarily restricted.

Classification of the dividends from restricted investments depends upon whether the restriction extends to the receipt of dividends. If the use of the dividends is unrestricted by the donor, then dividends received are classified according to the general rule as operating activities. However, if use of the dividends is restricted to increasing an endowment, they are classified as financing activities.

Unique Circumstances

The goal of SFAS 117 was to prompt not-for-profit organizations to produce financial statements that would be comparable to those of business enterprises. The statement of cash flows is intended to enhance financial statement users’ understanding of how the entity obtains and spends cash. Although the form of the statement is the same, the content is derived quite differently for businesses and not-for-profit entities. The classification of not-for-profit entities’ securities held as restricted assets is one such important difference.

The difficulty of applying SFAS 95 to not-for-profit entities is mentioned in the fine print of SFAS 117. It is noted that “transactions involving … permanently restricted and temporarily restricted assets [investment securities] … may not fit easily into the categories prescribed in FASB Statement No. 95.” Indeed, during the conception of SFAS 117, the restricted cash flows had no home among the three statement of cash flows categories—operating, investing, financing—and were potentially going to be placed in a fourth category. Although at times the classification into one of these three categories may seem unnatural, proper classification is required for the statement of cash flows to be in accordance with GAAP.

Wayne Alderman, PhD, CPA, is the Torch Mark Professor of Accounting, and Jennifer M. Mueller, PhD, is an assistant professor, both at the school of accountancy at Auburn University, Auburn, Ala.