More on Nonprofit Financial Statements

1. More on Nonprofit Financial Statements Webinar 2

2. Today’s Session Topics • Cash and accrual basis of accounting • Fiduciary and financial reporting requirements for restricted resources • Review of Pilgrim Services Society financial statements

3. Cash vs. Accrual Accounting • Cash basis recognizes: • Revenues when cash received • Expenses when cash is paid • Used by individuals, some small businesses and nonprofits • Benefits • Easy to implement • Easy for a third party to verify • Costs • Can misrepresent the financial condition, activities and cash flows of an organization • Cash basis of accounting is not permitted under GAAP.

4. What’s Wrong with the Cash Basis – An Example • The Situation: Ann has a new job with a salary of $50K: she bought a new car for $20K with an auto loan: and used her new credit cards to cover all her expenses ($25K) except her rent ($20K) which she paid for the year.

5. Revenue Recognition – Accrual Basis • Under accrual accounting, revenue is recognized when two key criteria are met: • Revenue is EARNED • The critical event in process of earning revenue has taken place – a service is performed, goods are provided, ownership is transferred, etc. • Revenue is MEASURABLE • Amount to be collected is reasonably assured and can be measured with a fair degree of reliability • “Net realizable value”

6. Expense Recognition – Accrual Accounting • Under the accrual basis • Recognize expenses when “incurred” and “measurable” when benefit has been received or liability incurred • Work has been performed by employees • Food has been ordered and received for cafeteria • Matching principle applies – expenses are recognized when related revenue is recognized

7. Accrual Basis of Accounting • Required under GAAP • Cash can be received before or after revenue and expense is recorded • Benefits • Reflects ultimate financial performance and position irrespective of cash payments or receipts • Cons • More difficult and costly to maintain • Relies heavily on estimations and judgments • Modified Accrual basis is a compromise for small, international or developing NGOs

8. Practical Compromise • Size or development stage of nonprofits may limit ability to fully implement accrual accounting – particularly international NGOs • Cash basis of accounting is used by some NGOs in developing countries • Modified accrual basis of accounting is a reasonable compromise: • Cash basis of accounting used for monthly or internal reporting • Conversion to accrual basis done for audit, or for monthly/quarterly/annual financials • External accountant used for accrual adjustments • Restricted funds must be separately accounted for in all cases.

9. Asset in Accrual Accounting • Accounts Receivable - revenue recognized in advance of cash being received • Prepaid Expenses - advance payments • Inventory - supplies acquired before use • Fixed assets - purchase that will benefit multiple future periods for buildings, equipment • Depreciation expense – annual “use” of fixed assets

10. Liabilities in Accrual Accounting • Accounts payable to reflect expenses not yet paid for • Deferred revenue to reflect revenue received but not yet earned • Notes payable - borrowings that must be repaid • Long term obligations - pension

11. Revenues, Expenses, Assets or Liabilities???? • Purchase of supplies to be used in next year • Payment of salaries for current month • Receipt of subscriptions for a magazine for 3 years • Receipt of unrestricted gift

12. Valuation Concepts – Assets and Liabilities • Assets are generally recorded at the lower of cost or market value – or net realizable values • Investments are recorded at market value • Fixed assets are recorded at cost less depreciation • Accounts receivable (and pledges) are recorded at net realizable value (net of allowance for uncollectible accounts) • Liabilities are recorded at amounts expected to be paid • Assets and liabilities are periodically adjusted to reflect changes in values due to: • New circumstances (market values, sales) • Use in the operations (fixed assets, deferred revenue)

13. Capitalization vs. Expense A Cost can be expensed immediately or deemed an asset. If an asset, it is stored on the balance sheet until it is expensed or used up. To recognize/capitalize an asset, it must meet two criteria: 1. Rights Acquired Rights to future benefits have been acquired in a transaction 2. Measurable Benefits are in the future and can be estimated with reasonable certainty

14. Purchasing a Computer A computer is purchased for $10K today that will be used for 5 years • Right Now • Fixed Asset is recorded– this resource will benefit the future (Asset increase) • Cash is reduced (Asset decreased) • As asset is used over time • Expense is recognized for $2K in each year of use (Expense Increased) • The value of the fixed asset is “depreciated” (Asset decreased) • Fixed assets show net undepreciated or remaining value • Generally • Costs to maintain an asset’s benefits are expensed • Costs to increase an asset’s benefits are capitalized

15. Fixed Asset Accounting

16. Accounting for Debt • Debt includes two components: • Principal = amount borrowed less payments to date • Interest = annual expense to reflect cost of borrowing at stated rate applied to principal balance • Accounting for Payments: • Principal payments reduce liability • Interest payments increase expense (cost of borrowing)

17. Accounting for Debt

18. Importance of Estimates • Assets and liabilities recorded at expected ultimate realizable value • Major areas of estimation in nonprofit organizations: • Accounts receivable • Pledges receivable • Investments (next class) • Judgments are required to reflect appropriate values in financial statements

19. A Telemarketing Campaign • As a result of a telemarketing campaign, 1,000 people promise to contribute $50 each to an NFP in February. Historically 4% of donors fail to pay. • NFP records revenue now for: • $50K as a receivable (asset and revenue increase) • Less uncollectible bad debt of $2K (reduction of asset and an increase to expense)

20. Patient Accounts Receivable • Services to patients total $100K which have not yet been collected • Assessment of age and payment source shows 25% uncollectible experience • Receivable and revenue recorded for $100K • Allowance for uncollectibles of $25K is recorded to reduce receivable to net collectible amount with bad debt expense of $25K

21. Importance of Footnotes • Notes to Financial Statements add critical data and insight: • Details accounting policies and practices – “GAAP summary” • Detail on financial statement components – investments, fixed assets, debt • Highlight financial matters not included in the numbers – uncertainties, contingencies, estimates • Audited financial statements are required to contain such disclosures

22. New Resource – Khan Academy • You Tube Educational Videos – Thousands of Topics • Try these (listed under “Finance” category: • Cash Accounting • Accrual Accounting • Comparing Cash and Accrual Accounting • Balance Sheet and Income Statement Relationship • Basic Cash Flow Statement

23. Accounting for Restricted Resources • Gifts or resources are provided which contain restrictions as to use • NFPs have a fiduciary responsibility to record and account for these resources through “fund accounting” – identifying revenues, expenses, and net assets separately in the accounting records • Financial statements must disclose nature and activity of net asset categories (“funds”) • Three types of funds (net assets): • Unrestricted net assets • Temporarily restricted net assets • Permanently restricted net asssets

24. Unrestricted Net Assets • Unrestricted net assets are the resources available for use in accordance with the general purposes of the NFP • Also called: • Operating funds • General fund • Board designated funds are unrestricted funds which have been designated by the board for a specific purpose • Whatever a board designates, it can undesignate

25. Temporarily Restricted Funds • Temporarily restricted funds are resources given to the NFP which contain either time or use restrictions • Temporarily restricted funds include: • Restricted grants and contracts • Funds for specific purposes • Pledges receivable which are due in more than one year – an implicit time restriction • When restrictions are met, amounts are released through a transfer to unrestricted funds

26. Permanently Restricted Funds • Permanently restricted funds are resources given to a NFP which require that the principal (corpus) be invested in perpetuity with the income used for restricted or unrestricted purposes • Permanently restricted funds • Are also called Endowment Funds • Realized and unrealized gains are usually classified as temporarily restricted funds or unrestricted funds – depending upon state legislation

28. Pilgrim Services Society “Road Map” • Gain further understanding of financial statement information • Realize importance of “Notes to Financial Statements” • Begin analysis of financial information

32. Other Questions? • Growing vibrant organization? • Dependence or risk on certain revenues? • Overall capital structure? • Other risks? • What else would you want to look at before you gave PSS a grant or a loan?