In January 1992, The Canadian Institute of Chartered Accountants (CICA) issued an Exposure Draft entitled “Non-Profit Organizations” which makes a number of proposals related to some significant and controversial issues. If adopted, it would require many organizations to make substantial changes in their accounting and/or financial-statement presentations.
The CICA Handbook (CICA, “Financial Statement Concepts”, CICA Handbook, Section 1000 (Toronto: CICA)) states that the objective of general-purpose financial-statement reporting is to “communicate information that is useful to investors, members, contributors, creditors and other users (“users”) in making their resource allocation decisions and/or assessing management stewardship … ” The purpose of the Exposure Draft is to improve general-purpose financial reporting by nonprofit organizations by having them provide a more complete and understandable basis of accountability to users of the financial statements.
This article will review the key issues and recommendations in the Exposure Draft.
Background to the Exposure Draft
Nonprofit organizations became subject to generally accepted accounting principles (GAAP) and CICA Handbook recommendations effective for fiscal years beginning on or after January 1, 1989; however, the CICA Hand book and GAAP have been developed with profit-oriented enterprises in mind. While the recommendations provide some guidance on certain matters specific to nonprofit organizations, some very significant issues are not addressed.
In October 1989, the CICA established the Task Force on Non-Profit Organizations to address some of the unresolved issues-accounting for capital assets, how the reporting entity should be defined, fund accounting, revenue and capital recognition, and what may comprise appropriate financial statements. This Task Force includes representatives from major types of nonprofit organizations (including a large charitable organization, a university, a hospital, and a religious organization), as well as two practising public accountants. The Task Force developed the January 1992 Exposure Draft which was approved for public comment by the CICA Accounting Standards Board.
Review of the Exposure Draft
Accounting for capital assets
Accounting for capital assets by nonprofit organizations is one of the most contentious issues in the Exposure Draft. Strong but opposing views exist on whether capital assets should be recorded on the balance sheet and, if so, whether they should be amortized to expense over their estimated useful lives. [See Comment beginning p. 40.]
The Exposure Draft proposes that a capital asset be recorded on the balance sheet at cost and that amortization be recognized in a rational and systematic manner appropriate to the nature of the capital asset. This proposal would apply to purchased and constructed capital assets. Donated capital assets would also be recorded on the balance sheet at fair value at the date of donation and amortized on the same basis as above. Given the wide range of accounting for capital assets currently permitted under GAAP (capitalize and depreciate, capitalize but do not depreciate, and expense immediately), the recommendations on capital assets will probably affect many nonprofit organizations.
The CICA concluded that the achievement of the fullest measure of accountability depends upon the fullest possible reporting of assets and liabilities within the practical constraints of measurability, and this translated into the recommendation to show capital assets on the balance sheet. They did recognize that there may be circumstances where the fair value of the capital asset cannot be determined in which case the asset would be recorded at a nominal value supported by a narrative description of the type of asset and its expected useful life.
The requirement to capitalize and depreciate capital assets may be troublesome to some organizations. For example, works of art and museum collections would have to be capitalized and depreciated. This requirement gives rise to two basic issues: Is it practical or useful to capitalize and depreciate art and museum collections? If so, can reasonable amortization periods be established? (The Exposure Draft proposes a maximum of 40 years, unless a longer useful life can be estimated and clearly demonstrated.)
Some organizations may have difficulty determining what should be capitalized. For example, a museum may receive contributions of objects (e.g., fossils) which may have educational value or historical significance but no easily established market value. How would a fair value be determined? If fair value cannot be reasonably determined, and the fossils are recorded at a nominal value, is it practical to think that an estimate of their useful lives can be made to meet the disclosure requirements?
Nonprofit organizations receive contributions in many forms: contributions may have externally imposed restrictions which may be temporary or permanent (e.g., endowments), and they may be in the form of pledges, materials or services, or cash. Accounting for contributions is an issue because different reporting methods are chosen by nonprofit organizations for similar types of contributions. Accounting standards should result in similar transactions and circumstances being treated alike.
The proposed general recommendation in the Exposure Draft is that contributions (whether they be government grants, private donations, capital, or restricted donations) would normally be taken into revenue when received or receivable. This proposed accounting would represent a significant departure from procedures followed by many nonprofit organizations.
Under existing GAAP, a restricted donation (a donation that is designated by the donor to be used in respect of a particular activity) is frequently accounted for as a deferred revenue liability until the donation is used for its specified purpose. It is a common view that the restriction imposed by the donor and the requirement of the nonprofit organization to provide the necessary services or goods to meet the terms of the restriction would create a liability until such time as performance to earn the revenue has taken place. This practice would no longer be acceptable as such donations would have to be treated as revenue when they were received or receivable. Restricted donations would be presented separately in the statement of revenues and expenses from donations without external restrictions through either the use of fund accounting or disclosures. The challenge facing nonprofit organizations will be to provide adequate descriptions and disclosures of restricted amounts in the financial statements in order to communicate that these amounts are not available for use at the organization’s discretion. The proposals may lead more organizations to use fund accounting which separates restricted amounts into separate funds.
Capital grants and capital donations received to finance the purchase or construction of a capital asset are generally accounted for in a manner similar to the capital asset to which they relate. For example, if the policy of an organization is immediately to expense the cost of the capital assets, one would have expected the applicable capital grant or donation to be recognized as revenue in the same period. Alternatively, if the organization capitalized and depreciated capital assets generally, the grant or donation would be deferred and amortized to income over the related expense. The proposed accounting would require capital grants and capital donations to be recorded as revenue in the period received while requiring, in subsequent accounting periods, that the expense show the amortization of the gross asset cost. There would be no recognition of the relationship between the capital contributions and the expense.
One of the objectives of financial statements is to provide information about the reporting organization’s total economic resources. The issues addressed in the Exposure Draft are: What resources and activities should be included in the reporting entity and what circumstances would require a nonprofit organization to combine the financial statements of another nonprofit organization with its financial statements?
The CICA proposes a concept of control under which the financial statements of a nonprofit organization would include all assets, liabilities, revenues and expenditures-its own and all entities that it controls. The Exposure Draft defines control as “the continuing power to determine an entity’s strategic operating, investing and financing policies without the co-operation of others”. It suggests that one organization should normally be presumed to control another organization when it has the right to appoint the majority of the members of the controlled organization’s board of directors. In addition it states, “In determining whether control exists, it may be helpful to assess the extent to which the reporting organization and the controlled organization have common or similar overall objectives and work together to achieve those objectives”.
The question of whether to include the financial statements of an affiliated organizations or how the “control” concept may apply will be difficult given the limited guidance above. On a practical level, consider how one would apply the proposed concept of control to the following situations:
Foundations that are separate from, but in some sense affiliated with, a nonprofit organization (such as a hospital or university). In many cases, the foundation may have a separate board of directors; however, the foundation and the organization may have similar names, the funds held by the foundation may be used almost exclusively for the benefit of the organization, and the overall objectives may be the same; or
Nonprofit organizations that have national, provincial and local chapters or agencies. In certain cases, the local chapter may have the right to appoint the majority of its own board of directors; however, both the provincial and national chapters may be represented on the board. A funding formula may be in place whereby the local chapter contributes to the provincial chapter which in turn contributes to the national chapter. The objectives of the chapters may be the same-it’s just how the objectives are achieved that differs (i.e., the local chapter may deal directly with the contributor or member and the national chapter may provide the educational resources to do so).
The Exposure Draft would also require disclosure of the names of related entities and the nature of the relationship when the nonprofit organization is related to entities other than those combined in the organization’s financial statements. Organizations are considered to be related when one organization has the ability to exercise, directly or indirectly, control or significant influence over the operating and financial decisions of the other.
Nonprofit organizations frequently receive contributions which can be used only for specific purposes. In order to ensure the observance of limitations and restrictions placed on the use of these resources, many nonprofit organizations classify these resources into separate funds according to the specific purpose. This self-balancing set of accounts within financial statements is referred to as “fund accounting”. Existing GAAP are silent on fund accounting and there is considerable diversity in practice in the financial statements currently presented.
Although the Exposure Draft would not require fund accounting, it does define it, provides various alternatives, and sets out some requirements if fund accounting is used. For example, organizations who use fund accounting would be required to show totals for the organization as a whole for each financial statement item and interfund transfers could not be included in the statement of revenues or expenses. These would represent significant changes in the way many organizations prepare their financial statements.
The CICA suggests that understanding the financial statements and the nature of the reporting entity as a whole is facilitated by presenting organization-wide totals so users can compare entities in total, irrespective of the groupings of restricted resources.
This article has provided only a summary of the significant issues and recommendations in the Exposure Draft. Given the extensive nature and implications of the proposals, it is important for nonprofit organizations to study the Exposure Draft and fully understand the effects it will have on them. Nonprofit organizations should be identifying any conceptual difficulties, practical implementation problems, lack of clarity or inconsistencies that they may see in the CICA proposals and providing comments and submissions to the CICA as soon as possible. Reporting problems with the standards once they are approved and set out in the CICA Handbook is seldom productive because they cannot easily be changed. In recognition of the significance of its proposals, CICA set the deadline for comment at July 31, 1992 but it is widely believed that this will be somewhat extended.
Ernst & Young, Chartered Accountants, Toronto