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Why not-for-profits should report their commitments: current GAAP financial reports provide little understanding of future obligations.


Current GAAP financial reports provide little understanding of future obligations.

Accountants cannot apply commercial concepts to noncommercial activities without great risk of misleading themselves. The differences between the two kinds of enterprises have serious implications for financial reporting.

Some common threads run through all accounting and relate to all entities for which financial reporting is needed. At the same time, some organizations are different from those for which generally accepted accounting principles were developed. Not-for-profit organizations fall into this category. In sincere attempts to apply present GAAP to these entities, some well-intentioned people have produced financial statements that boggle the mind and turn readers away uninformed.

An earlier article (JofA, Aug.89, page 60) notes the GAAP concepts of assets and liabilities do not provide for adequate reporting of some of the valuable properties owned and used by not-for-profit organizations. This article discusses why adequate financial reporting for not-for-profit organizations requires that "commitments" receive much more attention than is now provided in GAAP.(*)


A commercial enterprise is started by investors who provide funds in exchange for an equity interest in the enterprise. The investors expect the entity to be operated for their financial benefit and to provide them with withdrawable or otherwise realizable gains. To do so, the enterprise attempts to create and sell a product or service at a price exceeding all costs of production and sale. If operations are successful and a profit results, that profit accrues to the equity holders. By recovering its costs through the sale of its product or service, the enterprise also maintains its capital and continues its operations.

A not-for-profit organization is begun by people "investing" funds in exchange for no equity interest. These "investors" know the organization won't be operated in their financial interest. Once established, the not-for-profit organization obtains and distributes products or services in accord with its stated purposes--but at no cost to those who receive the products or services. The organization thus depletes its resources and must seek additional contributions to continue its operations. Remember the not-for-profit organization has no equity interests and no profits. Moreover, distributing the product or service does not replenish the organization's capital to permit continuing operations.

From an accounting point of view, these are monumental differences. Much of present accounting theory, for example, is concerned with issues of income measurement, capital maintenance and distinctions between liabilities and equity.


Now consider the possible sources and uses of cash for these two types of enterprises. For-profit companies depend on investments and revenues from sales for an inflow of cash; not-for-profits depend on contributions. For-profit companies expend cash to produce or purchase products for sale and to distribute to equity interests. Not-for-profits spend cash to produce or purchase products for free distribution and never make payments to equity interests. Of course, both for-profits and not-for-profits may obtain cash by borrowing and may use cash to repay debts.

What's the impact of these differences? A commercial company strives to transfer funds from its customers in to its equity holders; a not-for-profit transfers resources from its contributors out to its "clients."


The conventional CPA responds: "I know all this. Can't I just assume contributions-in are the equivalent of sales and contributions-out are the equivalent of cost of goods sold so I can prepare an operating statement and a balance sheet in compliance with sound business principles?" That's what CPAs have done for years. And in doing it, they have produced financial reports that provide little understanding of a not-for-profit's activities.


Most financial statement readers are interested in the answers to two questions:

1. How successful is the reporting entity in attaining its purposes currently?

2. How likely is it to continue successfully meeting its purposes into the future?

To answer for a commercial company, accountants emphasize the interrelationship of costs and revenues, of profit and investment, of resources and obligations and of equity and liabilities.

How can CPAs answer for a not-for-profit organization? A conventional statement of income does not serve well. An excess of donations over expenditures, rather than being an indication of success, may mean the entity has failed in its true purpose. Here's what most readers want to know about current not-for-profit activities:

* Has the entity really spent the resources received?

* Has it spent them as it promised?

* How much does it have left for next year?

A simple summary of expenditures by category, receipts by source and a list of expendable assets left over should answer these questions.

This may tell how the not-for-profit entity met its purposes during the current period but it tells very little about its ability to continue to meet those purposes. Consider the future of a not-for-profit. It must keep donations-in and donations-out in reasonable balance. The major questions are: How has it committed itself to future activities and what is the probability it can meet those commitments?

A new program or the construction of a new facility constitutes a commitment, which results in the expenditure of funds. Good management of a not-for-profit consists of making the right commitments and in keeping commitments and contributions in reasonable balance.

So if accountants can accurately report its commitments--that is, its plans and obligations to provide product and services to clients--and compare these with its proven ability to obtain contributions, they will have provided readers with information bearing directly on the entity's ability to continue into the future.


There are some real difficulties in emphasizing commitments: Obligations that result from some commitments are overlooked. For example, when a wealthy alumnus presents his university with a fine new research laboratory or other facility, he also presents it with an obligation to staff, maintain and perhaps replace that facility sometime in the future.

Conventional GAAP accounting does not require that such obligations be recognized as liabilities in a balance sheet. Yet unless the university can meet such obligations, probably indefinitely, a healthy future is far from assured. Once faculty members and students become accustomed to the services provided by a new laboratory, closing it down or failing to replace it become difficult options.


For most elected officials, the current budget is a matter of great sensitivity. Holding current expenditures to politically acceptable tax increases is essential. Consider the mayor who settles an embarrassing strike by garbage haulers, not with a raise in pay but with increased retirement benefits. Without any additional cost in his current budget, he has solved his problem and left a bigger one for a successor who must someday pay for the increased retirement benefits. Failure to include the obligation to pay those benefits leaves the city's financial statement readers with an inadequate basis for anticipating what the city's future will be.

Consider also the governor who has made an agreement with all the state's grade school children: "If you will forgo drugs and alcohol until you enter college, you will receive tuition-free education in any state college or university." Again, the governor has done a great thing in the drug war at no cost in his current budget, but pity the future governor who inherits those deferred payments. They're obligations that must be met some day--obligations that should be included in any serious consideration and presentation of the state's true financial condition.

Deliberate understatement of commitments in a not-for-profit entity's financial statements is analogous to intentionally overstating income for a commercial enterprise. These actions contribute to an appearance of success not justified by the facts in the case.


Another problem in accurately reporting the commitments of a not-for-profit organization is that service facilities wear out and must be replaced. During any period of growth, especially one requiring unusual numbers of additional facilities, the organization becomes subject to a snowball effect on its commitments. This has major implications for cash expenditures at recurring intervals into the future.

For example, assume a state plans well and budgets carefully. Each year it builds 10 miles of new highway. The rate of use of these highways is such that a major reconstruction of each 10-mile section is required every 10 years. Thus, for the first 10 years of the highway construction program, the state must budget sufficient funds to build 10 miles of highway each year. In the second 10 years of the program, the state must provide sufficient funds each year to build 10 new miles and also to reconstruct 10 miles built 10 years earlier and now in need of reconstruction. In the third 10-year period, it will need funds to build 10 new miles and to reconstruct 20 miles.

As commitments, service facilities represent obligations that will recur on a remodel/replace cycle. The organization has committed itself to continue providing the service. To do so, it must take care not only of current needs for new construction and for staffing and maintaining existing facilities but also for remodeling or reconstructing older facilities on a recurring basis.

One can argue that, for the most part, remodeling and rebuilding are sufficiently distant to be ignored. Yet, if there was a significant expansion any time in the past, the need for significant remodeling or rebuilding can come as a very unpleasant surprise if no one has been tracking the life cycles of the facilities in question for budgeting and cash flow purposes.

Remember the recurring need to renew facilities does not result in a liability. The commitment the organization has made leads to an obligation but not one that meets the Financial Accounting Standards Board's technical definition of a liability. Thus, balance sheet presentation in accordance with GAAP is inadequate to provide the information necessary to inform financial statement readers of a not-for-profit entity's prospects for the future.


If CPAs are to provide information that will help those readers, they need to stress the obligations arising from the entity's commitments rather than assets or liabilities found in a conventional balance sheet. To do this well, they must present the not-for-profit's obligations for more than a single year. For the state with the highway program, adequate disclosure would cover no less than a 10-year period with footnotes explaining the long-term aspects of its recurring obligations.

Perhaps the disclosure need not cover every year. A summary showing the next five years and then a column for each of the eleventh and twenty-first following years could provide enough information. What's important is that the extent of the commitments already made and the recurring obligations they will cause in the future be made abundantly clear.

As suggested above, service facilities aren't the only commitments a not-for-profit entity makes that lead to obligations. Any program that will require funds for some period into the future constitutes a commitment. Of course, some programs may be discontinued; some facilities may be abandoned and not replaced. These then no longer represent commitments. But for any continuing program, for any facility in continuing use, the implications of recurring obligations should be disclosed in a statement of future obligations. (See exhibit 1 at left.)


Any statement of future obligations contains elements of forecasting but, except for the influence of inflation, such forecasts should not be unduly difficult to make. The justification for them, if any is needed, lies in their importance. Without some reasonably accurate measure of a not-for-profit's commitments and obligations, one has little basis for judging future success. The usefulness of past activities as a basis for anticipating the future of a not-for-profit entity can be destroyed by the introduction of new commitments.

Accountants are hesitant to include forecasts in financial statements because they fear unsuccessful investors may seize on them as a basis for litigation that alleges the financial statements were misleading. This is unlikely in not-for-profit organizations in which there's no investor interest.

The emphasis in this article is on financial reporting, not accounting. Accounting is best restricted to completed transactions and their equivalents. Financial reporting can include any verifiable disclosure helpful to a reader's understanding of past accomplishments and future probabilities. Omission of clear and complete information about commitments would appear to be a failure of not-for-profit disclosure.


Better not-for-profit reporting: statement of future obligations

To judge a not-for-profit's ability to continue serving its constituency, financial statement users need an accurate disclosure of anticipated costs to compare with the entity's track record for fund raising. This might be presented in a statement of future obligations with columns for a number of future years adapted to the nature of the entity and the understanding of financial statement users. The annual obligations for each of the following types of commitments might be included:


Debt commitments

Required debt payments in appropriate detail.

Total debt commitments. Program commitments

Present programs.

Anticipated new programs.

Total program commitments. Facilities commitments

Staffing and maintaining present facilities.

Construction of committed new facilities.

Staffing and maintaining committed new facilities.

Remodeling and replacing existing facilities.

Total facilities commitments. Investment commitments

Planned build-up of investment assets in appropriate


Total investment commitments.

Total commitments.


Anticipated contributions, fees, etc.:

Average annual contributions last __ years:

Not all commitments have equal status. Some are tentative, the first to go if contributions fall below expectations. Others, such as debts, may be legally enforceable. Significant differences should be clearly disclosed in any statement of commitments or future obligations.

Finally, a summary of the not-for-profit's anticipated contributions for the same years should be presented along with its recent history of actual contributions. Any other information relevant to obligations and contributions also should be presented.

(*)For purposes of this article, all not-for-profit organizations are considered to make no charge for products or services supplied to clients. Of course, some do make a charge, but as long as the charge is intentionally less than cost, the essential principle is the same. This discussion also recognizes no distinction between government and other not-for-profit entities. The difference between donations and tax payments certainly is important to taxpayers but should have little influence on general purpose financial reporting.

R. K. MAUTZ, CPA, PhD, is vice-chairman of the Public Oversight Board, which oversees the activities of the SEC practice section of the American Institute of CPAs division for CPA firms. A retired partner of Ernst & Ernst, he is professor emeritus of the University of Illinois, Champaign-Urbana, and the University of Michigan, Ann Arbor, and a past president of the American Accounting Association.
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Author:Mautz, R.K.
Publication:Journal of Accountancy
Date:Jun 1, 1990
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