These categories are based on the existence or absence of donor-imposed restrictions and are defined in the accounting standards under Financial Accounting Standards Board (“FASB”) ASC 958-210-20. Readers of financial statements rely on these classifications to determine what net assets have external restrictions, which could be purpose or time restricted. Although these classifications may appear simple, there are several issues and reporting pitfalls that exist.
One of these pitfalls is the determination of whether a grant should be treated as a contribution or as an exchange transaction. The distinction is not always clear, typically requiring the use of an individual’s judgment. If a contribution is mistakenly classified as an exchange transaction, or vice versa, the result could be improper revenue recognition and reporting of the resulting net assets as unrestricted or temporarily restricted.
Contributions and grants received from individuals, corporations, and foundations should be recognized as revenue upon receipt or notification. A determination needs to be made immediately regarding whether the donor has imposed any restrictions, thereby requiring the not-for-profit organization to classify the contribution or grant as a temporarily or permanently restricted contribution or grant income. Temporarily restricted contributions or grants will be reclassified to unrestricted net assets upon either the passage of time or satisfaction of a purpose restriction. Permanently restricted contributions are maintained in perpetuity, thereby not allowing for the principal corpus to be utilized. Grants awarded by federal, state, or city government agencies are treated as exchange transactions similar to contracts, meaning a service is provided in exchange for the funds granted and are classified and recognized as unrestricted revenue when the obligation is fulfilled or service is provided.
There are typically three types of grants or contracts:
- Expense reimbursement grants whereby revenue is recognized only to the extent the allowable expenditures are incurred.
- Fee-for-service contracts which are recognized upon the completion of the service.
- Performance-based contracts which are a results-oriented contracting method that focuses on the outputs, quality, or outcomes that may tie at least a portion of a funding to the achievement of specific, measurable performance standards and requirements, often referred to as milestones.
The proper reporting of revenue from gifts of long-lived assets (e.g., property, buildings, equipment, etc.) is also often overlooked, leading to misclassifications. A common misclassification is reporting revenue from gifts-in-kind as unrestricted, without regard to donor intent or alternative accounting rules. If a donor places a time or purpose restriction on the donated long-lived asset, the revenue should be classified as temporarily restricted. The gifts would remain in temporarily restricted net assets until the purpose or time restriction is met.
Endowment funds which are an established fund of cash, securities, or other assets restricted by the donor with the stipulation that they be invested in perpetuity to provide income to maintain the organization’s activities should be classified as permanently restricted net assets. Determination and related reporting of the amount to classify as permanently restricted net assets is typically measured by the historic dollar value of the original gift. The historic dollar value (“HDV”) is used as the minimum amount of an endowment fund to report as permanently restricted. Additionally, interest, dividends, and gains on the permanently restricted endowment funds tend to be classified as temporarily restricted net assets until they are appropriated for by the not-for-profit organization’s governing board for expenditure.
Endowment funds are governed by the Uniform Prudent Management of Institutional Funds Act (“UPMIFA”) which became effective in July 2006. Some highlights of this legislation include:
- Abolishing the HDV limitation on expenditure. This limitation was replaced by a provision that allows the organization’s governing board to appropriate for expenditures of the endowment fund that it deems prudent, and the actions must be in “good faith,” or the same care that an ordinarily prudent person in a like situation would exercise under similar circumstances.
- Investment managers having more flexibility in the types of assets that can be maintained in a portfolio compared with the requirements under the Uniform Management of Institutional Funds Act (“UMIFA”).
- Investment management fees must be managed prudently in relationship to the assets being invested in for the endowment, the purposes of the organization, and the skills available to the charitable organization.
- Total return expenditure of investment returns is expressly authorized under the prudent standards relating to the charitable organization’s economic situation.
The aforementioned issues are just some of the more troublesome ones to consider. Reporting net assets in the appropriate classification is not always an easy determination. It requires judgment, an understanding of state laws, regulations, and accounting standards, and the ability to look ahead to the consequences and implications of these classifications.
For more information on the pitfalls of reporting on net assets, please contact Not-For-Profit Practice Leader Adam Reiss.