Get ready, here they come: as the effective date for FASB Statements nos. 116 and 117 approaches, not-for-profit organizations must prepare for significant financial reporting changes.

As the effective date for FASB Statements nos. 116 and 117 approaches, not-for-profit organizations must prepare for significant financial reporting changes.

Not-for-profit organizations (NPOs) face implementing new accounting standards that will require major changes in financial reporting. Financial Accounting Standards Board Statement no. 117, Financial Statements of Not-for-Profit Organizations, addresses financial reporting by all NPOs. A companion statement, Statement no. 116, Accounting for Contributions Received and Contributions Made, includes accounting and reporting requirements of donor-imposed time and purpose restrictions. These statements are part of an ongoing FASB project addressing inconsistency in financial reporting among NPOs.

Accounting standards evolved to meet NPOs' external and internal needs, resulting in different accounting and reporting practices for the various not-for-profit industry groups. Comparability of statements among NPOs from different industry groups is therefore difficult at best, requiring external financial statement users to learn different accounting conventions.

Because of these varying accounting practices, the new FASB standards will not have the same effect on all NPOs. Colleges and universities likely will feel the largest impact, followed by voluntary health and welfare organizations. Hospitals and health care service providers will have the fewest changes to deal with.

The effective date for the new accounting guidelines is years beginning after December 31, 1994 (December 15, 1995, for NPOs with less than $5 million in total assets and less than $1 million in annual expenses). Although early implementation is encouraged, most organizations are taking a "wait and see" attitude. Statement no. 117 establishes certain minimum requirements for financial statements but allow considerable flexibility and encourage experimentation. In the first quarter of 1995 the American Institute of CPAs accounting standards executive committee expects to issue an exposure draft of the audit and accounting guide Audits of Not-for-Profit Organizations. The guide will address Statements nos. 116 and 117 and provide additional guidance.

In the meantime, there are several steps CPAs can take to help clients prepare for the changes required by the two standards. The purpose of this article is to describe ways auditors can help not-for-profit clients prepare for the significant changes that lie ahead.

THE NEW REQUIREMENTS

Statement no. 117, which is directed at reporting aggregate financial information for an entire entity, requires three basic financial statements:

* A statement of financial position.

* A statement of activities.

* A statement of cash flows.

A statement of cash flows is new for many organizations and the other two statements will be significantly different from the ones used currently. Traditional reporting by fund groups in the financial statements is replaced by three classes of net assets: permanently restricted, temporarily restricted and unrestricted. The first two classifications are based on the existence of certain donor-imposed contribution restrictions.

The standard requires that entities report total assets, total liabilities and total net assets (both in total and by the three classes of net assets) in the statement of financial position. Changes in net assets (again in total and by the three classes) also must be reported in the statement of activities. Currently, most organizations report totals only by fund. The statement of cash flows will be similar to one currently required by FASB Statement no. 95, Statement of Cash Flows, but the classifications of cash flows are expanded to reflect certain long-term donor-restricted activity.

The standard allows considerable flexibility in formatting financial statements; the FASB encourages organizations to experiment with financial statement formats. Clients will want to consider carefully which format best meets their needs in reporting the financial operations of their own organizations.

The three classes of net assets reflect more than just an aggregation of the current fund balances. In many cases the timing and classification of certain transactions will be altered. For example, Statement no. 116 requires that a donor's unconditional promise to give over a number of years (a pledge) be reported as revenue in temporarily restricted net assets (time restriction) even if the pledge is unrestricted in purpose. Externally restricted resources that do not represent contributions will be reported as either unrestricted or agency transactions based on the true nature of the restriction. Thus, existing funds may be split between different net asset classes.

The financial statements' focus will be on the entity as a whole and will reflect only donor-imposed restrictions on net assets. Management's internal designation of funds will have no effect on the three net asset classes. For some NPOs, this is a significant departure in reporting financial resources.

IS FUND ACCOUNTING STILL NEEDED?

Most NPOs use fund accounting to record and report financial activity. The new standards do not address fund accounting directly but, instead, call for a different level of aggregation in the financial statements. Institutions won't need to abandon their current accounting systems but, with some additional work, should be able to add the current funds together to produce financial statements in the new format. The current fund structure may become less useful over time, but no immediate action is needed.

In preparation for implementing the statements, clients need to investigate the origins of certain fund balances. In some cases, internally designated unrestricted and other externally restricted resources have been combined with donor-restricted resources in certain funds; for example, the loan funds used by colleges and universities. It will require a detailed analysis to determine the true character of these funds based on any donor-imposed restrictions and to categorize future fund additions or deductions properly. Because this analysis may be time-consuming, CPAs and their clients should begin reviewing the composition of all funds as soon as possible.

PLEDGES

Not all NPOs record unconditional promises to give (pledges) in the financial statements and Statement no. 116 requires these amounts to be recorded at the present value of estimated future cash flows. The standard also provides new guidance on reporting contributed services and works of art, historical treasures and other additions to an institution's collection. Clients need to review their current systems to determine if they can provide the information the standard requires.

RECOGNITION OF RESTRICTIONS BEING MET

NPOs use several different methods to account for the inflow of restricted resources as well as for their recognition as revenue. Statement no. 116 will significantly alter current accounting for such resources. It requires that resources with either donor-imposed time or purpose restrictions be recognized as revenue when received, which increases either temporarily restricted or permanently restricted net assets. (A provision allows organizations to elect to recognize as unrestricted revenue donor-restricted resources received and spent in the same year.

For example, if a hospital receives a gift that is restricted by the donor for art supplies in the pediatrics ward, the hospital will record it as revenue, increasing temporarily restricted net assets. When art supplies are purchased, the hospital will report a reclassification of resources from temporarily restricted to unrestricted. The expense will be reported on the financial statements as a decrease in unrestricted net assets. The standard calls for reclassification of restricted net assets to unrestricted net assets whenever the institution fulfills the gift's restriction.

If expenses are incurred for the restricted purpose, the donor-imposed restriction is considered satisfied for financial reporting purposes whether unrestricted or restricted resources are used. In many organizations, management decides which resources-restricted or unrestricted-are used to pay expenses. The standard will alter how many institutions report restricted resources in the financial statements and may significantly change how some institutions manage these resources. At a minimum, clients will need to develop an internal structure to monitor fulfilling donor-imposed restrictions for financial reporting purposes.

PLANT ASSETS AND DEPRECIATION

If an organization receives a donation of a fixed asset with a stipulation that it be retained for a certain period, the asset should be reported as part of temporarily restricted net assets. Depletion of this asset (depreciation) will be recorded annually as an expense of unrestricted net assets. A reclassification for this amount also will be reported between temporarily restricted and unrestricted net assets. Many organizations do not separate fixed assets based on time restrictions, and clients should review their records for such prior donations.

Donations of fixed assets without stipulations on how long they must be retained, or fixed assets purchased with money restricted by the donor for that purpose, may present a special recordkeeping problem. Should they be reported as temporarily restricted or unrestricted net assets? Statement no. 116 allows institutions to choose one of two accounting methods.

The first method classifies them as unrestricted net assets; the second follows the accounting treatment described earlier for donation of fixed assets with time-use stipulations. If the latter is chosen, substantial time may be needed to determine the, origin of all such fixed assets. An NPO must follow only one of the two methods for fixed assets either donated or acquired with cash from donations restricted for their acquisition. Auditors should explain this option to clients and explore the need for adopting new recordkeeping requirements.

ENDOWMENT GAINS AND LOSSES

In most states, trust laws allow institutions to use an endowment fund's net appreciation. Traditionally, gains and losses from endowment fund investments have been accounted for as part of that fund group. When a governing board authorizes spending these funds, a transfer is recorded in the endowment fund. Unless either the donor or the law requires net appreciation be added to principal, Statement no. 117 requires that net appreciation from the endowment fund be reported as either unrestricted or temporarily restricted net assets (based on the existence of donor-imposed restrictions on spending endowment income).

Clients will need to review their practices of accounting for gains and losses. Many institutions accumulate all gains and losses in a separate account in the endowment fund, and additional efforts will be required to determine proper classification of the net appreciation between unrestricted and temporarily restricted net assets. Furthermore, if institutions have allocated gains and losses to individual funds, net accumulated appreciation will first have to be reconstructed.

BUDGETS AND RESULTS OF OPERATIONS

The two standards will significantly alter the presentation of financial statement information. In many cases, NPOs' operating budgets closely resemble their financial statements' operating fund, but the new statement of activities for unrestricted net assets may no longer reflect the operating budget. For example, colleges typically include fixed-asset purchases in the operating budget and exclude depreciation expense. The statement of activities will do just the opposite--depreciation expense will be reported and fixed-asset purchases will be excluded. Fixed-asset purchases will affect only balance sheet accounts. Clients should consider relating the budget process to the information reported in the statement of activities.

As stated earlier, Statement no. 117 allows flexibility in developing the new financial reports. One option organizations have is to develop some type of result of operations measure in the statement of activities. If organizations wish to inform statement readers about operating and nonoperating activity in the financial statements, the standard requires that they also report changes in unrestricted net assets and describe this measure in the notes.

The change in unrestricted net assets reported in the statement of activities may differ significantly from the change in operating funds currently reported. Because of the way that fixed assets, restricted resources and endowment gain and losses are reported under the two standards, some NPOs will report significant increases annually in unrestricted net assets. Management's past practices in allocating resources may be questioned by some new statement users. For example, employees may question the level of salary increases if an organization reports a large increase in unrestricted net assets from endowment gains. Auditors need to work with clients to reeducate financial statement users; clients also may need to review their approach to resource allocations.

PREPARING FOR THE NEW MODEL

NPOs have less than a year to prepare for major financial reporting changes required by the two FASB statements. Although additional guidance is forthcoming from both the AICPA and the FASB, auditors need to discuss immediately with clients the information requirements of the new standards and, where necessary, help them prepare for the new reporting model. Clients may need help reviewing and analyzing financial records and making certain reporting method decisions. Once the mechanical problems have been addressed, clients and auditors will need to devote considerable thought to explaining the changes to financial statement users.

RELATED ARTICLE: EXECUTIVE SUMMARY

[] FASB STATEMENT NO. 116, Accounting for Contributions Received and Contributions Made, and Statement no. 117, Financial Statements of Not-for-Profit Organizations, will require dramatic changes in the financial statements of most not-for-profit organizations.

[] ALTHOUGH THE REQUIRED implementation date for some organizations is years beginning after December 31, 1994, there are several steps an auditor can take now to assist clients in preparing for the new reporting standards:

-- Determine the true character of certain fund balances based on the existence of externally imposed contribution restrictions.

-- Review gift accounting systems to ensure they provide adequate pledge information.

-- Review management's practice of accounting for fulfilling donor-imposed restrictions and determine if additional recordkeeping is required.

-- Assist them in selecting an accounting treatment for restricted fixed assets and determine any recordkeeping requirements.

-- Review the accounting treatment of investment gains and losses on endowment funds and determine if additional analysis and recordkeeping are required.

[] REEDUCATING FINANCIAL statement users will be and important step in implementing Statements nos. 116 and 117. Because of the new reporting requirements, different information will be reported and the presentation of existing information will be revised.

BRUCE W. CHASE, CPA, PhD, is assistant professor of accounting, Radford University, Radford, Virginia. He is a member of the American Institute of CPAs, the governmental accounting and auditing committee of the Virginia Society of CPAs and the American Accounting Association.