Which GAAP should NPOs apply?

CPAs who work for or with not-for-profit organizations (NPOs) must address a serious question: Is the organization using the appropriate subset of generally accepted accounting principles? Some NPOs are under Financial Accounting Standards Board jurisdiction; others follow the Governmental Accounting Standards Board. Determining whether an NPO is subject to the government or the nongovernment GAAP hierarchy is the first and most important step in preparing or auditing its financial statements.

Misclassified NPOs will issue financial statements that do not comply with GAAP. Auditors who fail to recognize that an NPO applied the wrong GAAP hierarchy might improperly render an unqualified opinion on its financial statements, violating numerous auditing and professional ethics standards and possibly subjecting the auditor to professional or legal sanctions and financial liability.

NPOs and their auditors must ask if the entity should implement FASB Statement no. 116, Accounting for Contributions Received and Contributions Made, and Statement no. 117, Financial Statements of Not-for-Profit Organizations. The answer to this question also dictates whether the NPO should implement American Institute of CPAs NPO guidance, such as Statement of Position 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.

If the entity is a government NPO, it is prohibited by GASB Statement no. 29, The Use of Not-for-Profit Accounting and Financial Reporting Principles by Governmental Entities (effective for periods beginning after December 15, 1994), from following this guidance. Statement no. 29 requires government NPOs to use one of two reporting models, discussed below. This interim guidance was issued to keep government NPOs from applying Statement nos. 116 and 117. Other GASB projects are likely to require them to change to a different model in the near future.

TWO DISTINCT SETS OF GAAP

The issue of which GAAP applies to entities such as health care organizations, museums, not-for-profit housing services, foundations and not-for-profit radio and television stations results from the provisions of Rule 203 of the AICPA Code of Professional Conduct and Statement on Auditing Standards no. 69, The Meaning of "Present Fairly in Conformity with Generally Accepted Accounting Principles" in the Independent Auditor's Report. These standards recognize the GASB as the primary standards setting body to establish GAAP for state and local governments. Likewise, the FASB is designated as the primary authority for all nongovernment entities.

Each body's standards has the lowest level of authority in determining GAAP for entities under the other's jurisdiction (except for specific standards recognized by the other body). Thus, GASB pronouncements are considered "other accounting literature" in the nongovernment GAAP hierarchy and FASB pronouncements are ranked similarly in the government GAAP hierarchy.

Determining which NPOs are Government NPOs is critical. The only available

professional guidance is a GASB staff paper, Applicability of GASB

Standards.

NPO GAAP BEFORE SAS 69

Before SAS no. 69 was issued, neither the FASB nor the GASB had issued comprehensive guidance on accounting and reporting for NPOs. The pertinent AICPA industry audit guide, Audits of Voluntary Health and Welfare Organizations, and SOP 78-10, Accounting Principles and Reporting Practices for Certain Nonprofit Organizations, (which together are the basis of the government NPO model) were the primary sources of comprehensive guidance for NPOs - government or nongovernment.

Under the government GAAP hierarchy, the above guidance had to be modified for government NPOs to conform to specific GASB standards, such as Statement no. 16, Accounting for Compensated Absences, and Statement no. 3, Deposits with Financial Institutions, Investments (Including Repurchase Agreements), and Reverse Repurchase Agreements. While application of specific GASB standards to government NPOs resulted in some differences in government and nongovernment NPO financial statements, both categories of organizations were at least reporting under the same basic models. The reporting differences were no more pronounced than those of a government electric utility and a for-profit utility.

Because GASB Statement no. 29 prohibits government NPOs from applying Statement nos. 116 and 117 and SOP 94-2, implementation (during 1995 to 1997) by nongovernment NPOs of Statement nos. 116 and 117 will cause more dramatic reporting differences in the future. These differences emphasize the need for NPOs to ensure they are following the appropriate standard-setting body's guidance. Therefore, accountants and auditors must clearly understand which entities are deemed "governmental" for purposes of determining whether GASB or FASB standards apply and what accounting and financial reporting guidance government NPOs must apply.

WHICH NPOs ARE GOVERNMENT ENTITIES?

The first issue - determining which NPOs are government NPOs - is critical. The only professional guidance available is a GASB staff paper, Applicability of GASB Standards. Described as advisory, the paper is significant even though such documents generally have a low level of authority. No other guidance exists and the chairpersons of the FASB and the GASB jointly transmitted the paper to the trustees of the Financial Accounting Foundation, who determine the jurisdictions of the two bodies. In November 1993, FAF trustees authorized distribution of the paper to help resolve questions about which hierarchy a particular entity should follow.

The staff paper said an NPO is a government if it meets either of two criteria:

1. It is identified in a statute as a "public corporation" or a "body corporate and politic."

2. It is created by one or more states or territories, the District of Columbia, municipal corporations or organizations identified as public corporations or bodies corporate and politic and one or more of the following is true:

* Government officials (possibly from various governments) appoint or approve the appointment of a controlling majority of its officers.

* Its officers are popularly elected.

* The organization has taxing power.

* The organization can directly issue federal-tax-exempt debt.

* The creating government(s) can unilaterally dissolve the organization and assume its net assets without compensation.

The paper further asserted that some NPOs not created by governments may still be governments for purposes of determining whether to apply government GAAP. This determination requires professional judgment based on factors such as legal decisions, U.S. Bureau of the Census classification and the basis for an organization's federal income tax exemption.

One example of an NPO that is tax exempt under Internal Revenue Code section 501(c)3 but that would be classified as a government under this guidance is a public television station established by a state university as a legally separate, not-for-profit corporation. The station's employees are on the university payroll and all major operating decisions are approved by the university governing board. Other examples include public school foundations, emergency medical services organizations, medical clinics and entertainment (festival) corporations established by cities as 501(c)3 corporations and whose governing boards are appointed by the cities that created them.

WHAT GUIDANCE SHOULD GOVERNMENT NPOs APPLY?

To avoid misapplying GAAP, government NPOs must understand what guidance applies to them. Statement no. 29 specifically addresses this issue. The flowchart below highlights the key factors in the decision. Nongovernment NPOs of all types must always apply both Statement no. 116 and no. 117 and all other pertinent FASB and AICPA guidance. On the other hand, government NPOs are prohibited from applying these standards. In addition to prohibiting application of Statement nos. 116 and 117, the fundamental purpose of Statement no. 29 was to specify the guidance government NPOs should apply.

As discussed above, before SAS no. 69 and Statement nos. 116 and 117, accounting and financial reporting for all NPOs was similar. Indeed, the 1986 AICPA industry audit guide, Audits of State and Local Governmental Units, directed government voluntary health and welfare organizations and certain other NPOs to the same sources of reporting guidance nongovernment entities followed. SOP 78-10 and Audits of Voluntary Health and Welfare Organizations had to be modified, of course, to conform to any conflicting GASB or predecessor body pronouncements. Thus, when Statement nos. 116 and 117 were issued, many wondered if the same approach would apply and government NPOs should (or could) apply them.

The possible application of these standards seemed even more reasonable because of the provisions of GASB Statement no. 20, Accounting and Financial Reporting for Proprietary Funds and Other Governmental Entities That Use Proprietary Fund Accounting, which required governments to report their proprietary activities in accordance with all FASB (and predecessor body) guidance issued on or before November 30, 1989, that does not conflict with GASB guidance applicable to proprietary fund accounting and reporting. Statement no. 20 also gave governments the option of reporting these activities in accordance with all subsequent FASB pronouncements that do not conflict with GASB pronouncements.

Since most government NPOs used a proprietary-type accounting model (revenue and expense based), many presumed the Statement no. 20 reporting option was available to government NPOs. Had this interpretation been accepted, government NPOs choosing this option would have been able to apply Statement nos. 116 and 117 and SOP 94-2.

Statement no. 29 has eliminated this option. A key provision says that when a government opts for its proprietary activities to follow all FASB standards that do not conflict with GASB guidance (under paragraph 7 of Statement no. 20), only those FASB statements and interpretations issued after November 30, 1989, and developed for businesses should be applied. Governments cannot apply FASB statements and interpretations whose provisions are limited to NPOs - such as Statement no. 1 17-or that address issues primarily of concern to such organizations - such as Statement no. 116.

Statement no. 29 further makes it clear that no government entity may apply Statement nos. 11 6 and 117. The basis for conclusions to the standard points out that GASB Statement no. 15, Governmental College and University Accounting and Financial Reporting Models, permitted government colleges and universities to use one of only two financial reporting approaches - the model in AICPA industry audit guide Audits of Colleges and Universities or the state and local government reporting model as it applies to all other government entities (referred to as the government model). Consequently, government colleges and universities may not apply those FASB statements.

Statement no. 29 explicitly addresses accounting and reporting for government NPOs other than colleges and universities. Government health care entities are reported as proprietary activities and may not apply Statement nos. 116 and 117 because of the "apply only business guidance" modification of Statement no. 20. Statement no. 29's basis for conclusions says such entities should apply the AICPA industry audit guide Audits of Providers of Health Care Services, which is being revised. The revised guide is expected to allow government hospitals and other health care providers to continue reporting in accordance with the currently effective guide with respect to contributions and financial statement display.

Proper reporting under Statement no. 29 for other types of government NPOs depends on their past reporting practices. Government NPOs that previously applied the AICPA not-for-profit model - either SOP 78-10 or the voluntary health and welfare organizations audit guide - have the option of applying that model (the government NPO model) or the government model in the future. Statement no. 29 defines the government NPO model as the accounting and financial reporting principles in SOP 78-10 or the voluntary health and welfare organizations audit guide, as modified by FASB pronouncements issued through November 30, 1989, and by most applicable GASB pronouncements. One exception: The provisions relating to the joint costs of information materials and activities that include a fundraising appeal need not be applied. This exception avoids elevating the authoritative status of this guidance above that of a forthcoming AICPA document revising it. (See box at right.)

Government NPOs that had not previously applied the NPO model are not permitted to do so in the future. Instead they must apply the government model - the guidance applicable to all other government entities. This group includes, among others, NPOs established after the effective date of Statement no. 29 and those that did not issue GAAP basis financial statements before that time.

Government NPOs that have applied Statement nos. 116 and 117 must change their accounting and reporting to conform to Statement no. 29. If comparative statements are presented, the prior-year financial statements must be restated. Government NPOs that had previously applied the NPO model without making the modifications needed to conform to GASB standards must implement those conforming changes within one year of implementing Statement no. 29. Entities that have not been accounting for pensions in accordance with GASB guidance do not have to modify their pension accounting until the effective date of GASB Statement no. 27, Accounting for Pensions by State and Local Governmental Employers (periods beginning after June 15, 1997).

To achieve conforming changes, numerous areas may be affected. GASB reporting guidance differs from that in SOP 78-10 and the voluntary health and welfare organizations audit guide in reporting cash flows, pension accounting, accounting for restricted grants and certain deferred compensation plans and debt refundings.

IMPLICATIONS FOR PRACTITIONERS

The issues outlined here have several significant implications for accountants and auditors of NPOs:

* CPAs working for or with NPOs must understand the criteria used to classify organizations as government or nongovernment.

* NPOs must be classified appropriately to determine the applicable GAAP hierarchy. A crucial first step is to acquire a copy of the GASB staff paper.

* CPAs dealing with government NPOs must have or develop appropriate knowledge of government GAAP.

Finally - and of great importance - there may be significant implications for NPOs that receive sufficient federal financial assistance to require a single audit under the Single Audit Act of 1984. If the entity is a government NPO, it may be required to meet Office of Management and Budget Circular A-128 requirements instead of Circular A-133. (The wisest approach is to seek the agreement of the cognizant or oversight agency on which circular to apply - particularly since the agency may or may not accept the GASB staff paper guidance for purposes of the single audit classification. The continuing proffessional education topics an credits that qualify under government auditing standards also may be affected.

NEED FOR ACTION

Determining the GAAP applicable to a specific NPO is not always simple or clear cut. Indeed, the current situation is highly complex and undesirable in many ways. Little has been done to alert practitioners to the need to first determine whether an NPO is a government. The AICPA can play a vital role in informing professionals of this key issue by addressing it in all of its NPO-related continuing education, audit guides and SOPs.

A second problem is fundamental. Authoritative guidance is needed to determine which entities are governments. Since organizations cannot identify which GAAP hierarchy to apply until they make this determination, the AICPA, the standard-setting bodies or the FAF should provide definitive guidance on determining whether an NPO comes under GASB or FASB jurisdiction.

One State's Misclassified NPOs
Special-purpose            Percentage using
government                 the wrong GAAP
Public libraries                 70%
Mental health centers            67%
Planning districts               71%
Hospitals                        79%
Drainage districts               86%
Total                            74%
Source: Mississippi State Auditor's Office

Ordering Information

GASB Statement no. 29, The Use of Not-for-Profit Accounting Reporting Principles by Governmental Entities, can be obtained by contacting the GASB Order Department, Governmental Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk, CT 06856-5116 or by calling [phone], extension 10. The cost is $9.50 and the order number is GS29.

The GASB staff paper Applicability of GASB Standards is available only by requesting a copy in writing from Mary Milligan at the GASB (address above); be sure to include your address. There is no charge for this staff paper.

EXECUTIVE SUMMARY

* Not-for-profit organizations must make certain they apply the correct generally accepted accounting principles. Misclassified NPOs will issue financial statements that do not follow the correct GAAP hierarchy. An auditor who fails to recognize this could improperly render an unqualified opinion on the statements, violating numerous auditing and professional ethics standards and possibly resulting in professional or legal sanctions and financial liability.

* Some NPOs are considered governments and are subject to Governmental Accounting Standards Board jurisdiction. GASB Statement no. 29 requires government NPOs to apply either the government reporting model or the government NPO model. It also prohibits them from applying FASB Statement nos. 116 and 117 and AICPA SOP 94-2.

* A GASB staff paper, Applicability of GASB Standards, is the only guidance available to help determine which NPOs might be governments. The paper listed criteria CPAs can use to decide if an entity should apply government GAAP.

* Government NPOs that have already applied FASB Statement nos. 116 and 117 must change their accounting and reporting to conform to GASB Statement no. 29. If comparative statements are presented, prior-year financial statements must be restated.

CRAIG D. SHOULDERS, CPA, PhD, is associate professor of Accounting, Virginia Polytechnic Institute and State University, Blacksburg. ROBERT J. FREEMAN, CPA, PhD, is Distinguished Professor of Accounting at Texas University, Lubbock, and a member of the Governmental Accounting Standards Board.

Professor Freeman is a member of the Governmental Accounting standards Board. His views, as expressed in this article, are his own. Official GASB positions are determined only after extensive due process and deliberation.

CASE STUDY

How One State Auditor Required Special-Purpose

Government Entities to Follow GASB Standards

The concern about governments applying the right standards, addressed in GASB Statement no. 29, is not new. In May of 1994, the Mississippi State Auditor's Office tested the application of GASB Statement no. 14, 7he Financial Reporting Entity, by surveying the financial statements of several types of special-purpose government entities-public libraries, water and planning districts and mental health centers.

Of the 94 entities Mississippi surveyed, 70 improperly used nongovernment generally accepted accounting principles, primarily not-for-profit GAAP under SOP 78-10. "We concluded these entities were governments," said Devon Townsend, manager of special projects in the State Auditor's Office in Jackson, Mississippi, "and we wanted them to use government accounting standards."

Townsend said so many misclassified special-purpose entities created a considerable obstacle in conforming with Statement no. 14, because all of their financial statements would have to be adjusted to be included in each county's financial statements. Townsend estimated it would take approximately 8,000 hours for his audit staff to convert the financial statements to government GAAP in Mississippi's 82 counties. "I decided the best way to get the job done was to have the governments and their CPA firms do it," said Townsend. In the fall of 1994, under the authority of the Mississippi State Auditor's Office, Townsend drafted a guide requiring all special-purpose entities to follow GASB accounting and reporting standards in external financial reports filed with the state beginning in 1995.

What is a Government?

"Many of the entities required to use GASB standards under our new guidance had never before identified themselves as government entities," said Townsend. "Either the entity did not understand it was one or the auditor failed to realize it." Townsend said Statement no. 29 allows entities such as county libraries, which perhaps never knew they were governments, to use the government model or to continue using the NPO model. If this choice had not been available, some entities would not be following the appropriate GAAP and their CPAs would be in violation of ethics rules requiring use of the correct standards.

To ensure Mississippi's guidance included a clear definition of "government entity," Townsend based it on information in the 1993 GASB staff paper, Applicability of GASB Standards. "The definition of government entity in the GASB staff paper is magnificent," said Townsend. "It would be beneficial to the profession if the GASB could elevate this paper to standard level."

Townsend said that although his state's conversion process was in its early stages, many of the special-purpose governments that once had filed their financial statements using not-for-profit GAAP were now using GASB standards. "This conversion will enable our county governments to issue GAAP financial statements for the reporting entity much more efficiently than before we issued our requirements," said Townsend.

Update

At a meeting in September, the American Institute of CPAs agreed that Audits of Voluntary Health and Welfare Organiztions, SOP 78-10 and Audits of Colleges And Universities all would remain in effect. The AICPA also indicated its intention to fully conform this literature to government standard; conforming changes are expected to be made as of May 1, 1996.