Not-for-Profit Accounting & Auditing Update

The last few weeks have seen an extraordinary flurry of activity in accounting and auditing standards. Discussed below are the main items of interest to nonprofit organizations.

(Italicized sections of this material are of particular significance to nonprofits and/or their auditors.)

The current status of FASB projects may be reviewed at http://www.fasb.org/project/index.shtml

Accounting
The FASB has recently issued two exposure drafts focused on not-for-profit entities - mergers of not-for-profit entities and goodwill and other intangible assets.

• Pooling-of -interests accounting will be forbidden; purchase accounting will be required for all acquisitions. Purchase accounting requires revaluation of assets and liabilities of the acquired entity to fair value at date of merger.
• Practical problem is how to identify the acquirer when the merger is really a merger of equals.
• Comment period ends January 29th, 2007. Probable issuance - mid-2007; effective 6 months later.

On October 9, FASB issued its long-awaited exposure drafts of statements on accounting for mergers of not-for-profit organizations, and accounting for goodwill and other intangible assets - companion statements to SFAS 141 and 142. When issued, the mergers statement will be a separate statement; the goodwill statement will be an amendment to SFAS 142. Copies of each proposal may be downloaded from the FASB's website at www.fasb.org.
    The effective date for the two statements is stated to be, "prospectively in [the] fiscal year that begins approximately six months after the issuance of a final Statement. For example, if a final Statement is issued on June 30, 2007, its application would be required in fiscal years beginning after December 15, 2007. Earlier application would be encouraged for organizations with annual periods that begin on or after the date a final Statement is issued." The two statements must be adopted at the same time.

A brief summary, prepared by FASB, is quoted here.

Not-for-Profit Organizations: Mergers and Acquisitions, would eliminate the use of the pooling-of-interests method of accounting by not-for-profit organizations, in which assets acquired and liabilities assumed are recorded at "carryover" amounts recorded on the books of acquired organizations. This proposal would instead require the application of the acquisition method to all mergers and acquisitions by a not-for-profit organization. In applying that method, the proposal generally would require that not-for-profit organizations:

1. Recognize the identifiable assets acquired and liabilities assumed that compose the business or nonprofit activity acquired in a merger or acquisition;
2. Measure those assets and liabilities at their fair values as of the acquisition date;
3. Recognize either goodwill of the acquired business or nonprofit activity or the contribution inherent in the merger or acquisition as a residual based on the value of the identifiable assets acquired, liabilities assumed, and the consideration transferred (if any); and
4. Disclose information to enable users of the financial statements to evaluate the nature and financial effects of the merger or acquisition.

Not-for-Profit Organizations: Goodwill and Other Intangible Assets Acquired in a Merger or Acquisition proposes accounting guidance for those intangible assets after a merger or acquisition. The proposed guidance is consistent with the accounting for all other acquired intangible assets - whether purchased or donated, or whether acquired individually or as part of a group.
    Under this proposal, not-for-profit organizations would be required to provide consistent and comparable information about identifiable intangible assets acquired by not-for-profit organizations in a merger or acquisition; and more faithfully representative and relevant information about events resulting in impairments of goodwill that a not-for-profit organization has acquired. Goodwill will not be amortized.

More details are included in Appendix A below.

Revenue recognition (exposure draft expected in 2007):
The planned comprehensive revenue recognition Statement will (a) eliminate the inconsistencies in the existing authoritative literature and accepted practices, (b) fill the voids that have emerged in revenue recognition guidance in recent years, and (c) provide a conceptual basis for addressing issues that arise in the future. The Board is pursuing an approach that focuses on changes in assets and liabilities (consistent with the definition of revenues in Concepts Statement 6). This project will apply to business transactions - and thus to many nonprofits, but FASB has specifically noted that nonreciprocal transfers (contributions) received should not be excluded from revenues and should be disclosed as a separate line item in the income statement.

SFAS 157, Fair Value Measurements (issued September 2006):
The overall project objective is to develop a Statement that will establish a framework for applying the fair value measurement (FVM) objective in GAAP. The Statement focuses on "how" to measure fair value, not "what" or "when" to measure at fair value. The Board plans to separately consider what to measure at fair value on a project-by-project basis. Related objectives are to improve the consistency and comparability of the measurements, codify and simplify the guidance that currently exists for developing the measurements, and improve disclosures about the measurements.
    Paragraph 5 defines fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." The definition emphasizes the exchange price notion contained, either explicitly or implicitly, in the definitions of fair value previously included in other FASB definitions of fair value.
    FAS 157 is effective for years ending after November 15, 2007.

The "Fair Value Option" for Financial Assets and Financial Liabilities
Proposed statement of financial accounting standards. Final statement planned for December 2006. (This is Phase 1 of the project; Phase 2 will extend to non-financial assets and liabilities.)
Summary of proposed provisions:

What it does

• Offers an alternative measurement treatment for recognized financial assets and financial liabilities, except as indicated in paragraph 4. It does not apply to nonfinancial assets and nonfinancial liabilities.
• Permits fair value to be used for both initial and subsequent measurement, with changes in fair value recognized in earnings [change in net assets] as those changes occur, based on a contract-by-contract election. The availability of that election is referred to as the fair value option.

Scope

• Applies to all entities [including nonprofits]
• Paragraph 4: The Statement excludes the following; the fair value option may not be elected for any of them:
• An investment (principally an investment in a subsidiary) that would otherwise be consolidated.
• Employers' and plans' financial obligations for pension benefits, other postretirement benefits (including health care and life insurance benefits), postemployment benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements (SFAS 35, 87, 106, 112, 123R, 43, and 146, and APBO 12).
• Financial liabilities recognized under lease contracts as defined in SFAS 13. (This exclusion does not include a contingent obligation arising out of a cancelled lease or a guarantee of a third-party lease obligation.)
• Written loan commitments that are not accounted for as derivative instruments under SFAS 133.
• Financial liabilities for demand deposit accounts.
• Current and deferred income tax assets and liabilities.

Definitions

1. Financial asset - Cash, evidence of an ownership interest in an entity, or a contract that conveys to a second entity a contractual right (a) to receive cash or another financial instrument from a first entity or (b) to exchange other financial instruments on potentially favorable terms with the first entity.
2. Financial liability - A contract that imposes on one entity a contractual obligation (a) to deliver cash or another financial instrument to a second entity or (b) to exchange other financial instruments on potentially unfavorable terms with the second entity.

Effective date:

• Effective concurrently with SFAS 157 as of the beginning of the first fiscal year beginning after December 15, 2006. Retrospective application of the Statement to fiscal years preceding the effective date is not permitted.

The main effect if adopted would be on receivables (including pledges) and payables.

Applicability of fair value option to balance sheet items commonly found in nonprofits:

Item	Applicability
Cash and cash equivalents	None. Already in the form of cash.
Investment securities covered by SFAS 124	None. Already valued at market under FAS 124.
Non-FAS 124 investments, except affiliates (non-marketable equity securities, property, collectibles, mortgage notes, partnership interests, etc.)	Applicable, but fair (market) value is already an option for these assets under Audit Guide Chapter 8, Appendix A, Para. A.8, 9, & 10.
Derivatives	None. Already valued at market under SFAS 133.
Investment in affiliates that: Meet criteria for consolidation (SOP 94-3) Do not meet criteria for consolidation	Excluded from applicability by this Statement Applicable
Beneficial interests in trusts	Applicable
Earned income receivable (sales, investment income)	Applicable
Contributions (pledges) receivable/payable	Applicable
Loans receivable/payable	Applicable
Deposits held by/for others	Applicable
Inventory for sale or use	Not applicable. Not a financial asset
Property, plant & equipment	Not applicable. Not a financial asset
Collection items, if capitalized	Not applicable. Not a financial asset
Prepaid expenses	Not applicable. Not a financial asset
Intangibles (copyrights, patents, etc.)	Not applicable. Not a financial asset
Goodwill	Not applicable. Not a financial asset
Accounts payable and accrued expenses: Under SFAS 35, 87, 106, 112, 123R, 43, 146, APBO 12 (compensation-related items) Others, except under leases	Excluded from applicability by this Statement Applicable
Lease obligations (SFAS 13)	Excluded from applicability by this Statement
Deferred revenue	Not applicable. Not a financial liability
Income tax assets/liabilities (current/deferred)	Not applicable. Not financial assets/liabilities

SFAS 158 - Pensions and postretirement benefits (issued September 2006):
FASB has begun to revisit the subject of accounting for and reporting post-retirement benefits. This is the first phase of the project; the most significant part is in boldface below.

• Improve the reporting of employers' obligations for pensions and other postretirement benefits by recognizing the overfunded or underfunded status of defined benefit postretirement plans as an asset or a liability in the statement of financial position. This means that a sponsoring entity will recognize all previously unrecognized items (such as unrecognized actuarial gains and losses) even when the plan is fully funded.
• Retain the present method for reporting how plan assets and benefit obligations are measured under FASB Statements No. 87, Employers' Account­ing for Pensions, and No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions.
• Retain the basic approach for measuring the amount of annual net benefit cost reported in earnings.
• SFAS 158 is effective for years ending after December 15, 2006. [but after 15 June 2007 for nonprofits]
• Eliminate the provisions in State­ments 87 and 106 that permit plan assets and obligations to be measured as of a date not more than three months prior to the balance sheet (i.e., to require entities to report the overfunded or underfunded status measured as of the date of the financial statements). (but this is effective in 2008)
• Require recognition of an asset for overfunded plans and a separate liability for underfunded plans.

FASB Staff Position No. 126-1 - Def­i­ni­tion of a Public Entity: Conduit Bond Obligors: FASB has just issued this document which will affect many nonprofit organizations that are obligors on "municipal bonds" issued by a state or local government. However it applies only when the bonds are publicly traded. If the bonds are held privately by one or more institutional investors, the FSP does not apply. Thus it will be necessary in all cases where an organization has such bonds outstanding to determine whether they are publicly traded.

The key parts of the FSP that might affect nonprofit organizations follow:

FASB Staff Position

5. An entity that is an obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets) meets the definition of a public entity or enterprise. ...This FSP amends only the accounting literature in the appendix to this FSP to include conduit bond obligors in the definition of a public entity or enterprise.

6. The guidance in this FSP shall be applied prospectively in fiscal periods beginning after December 15, 2006." (i.e., a 2007 calendar year, or a fiscal year ending June 30th 2008)

The Appendix to FSP 126-1 discusses amendments to the following literature. Notes related to the impact on not-for-profit entities are also included:

APB Opinion No. 28, Interim Financial Reporting

• This statement will now apply to nonprofit organizations that are conduit debt obligors. It does not require the issuance of interim financial statements, but it prescribes certain requirements when an organization chooses to issue such statements.

• This statement will now apply to nonprofits that are conduit debt obligors, but there are likely not many nonprofits around with such activities.

FASB Statement No. 109, Accounting for Income Taxes

• Nonprofits that are conduit debt obligors will now be required to make the full tax-effect disclosures required by the second paragraph of Paragraph 43, and by Paragraph 47.

• Nonprofits that are conduit debt obligors will no longer be permitted to omit the disclosures about fair values of financial instruments required by SFAS 107.

• This statement has been amended, but it still does not apply to nonprofit organizations, regardless of whether they are conduit debt obligors.

• Nonprofits that are conduit debt obligors will now be required to make the full disclosures required by Paragraphs 5 and 9, rather than the reduced disclosures permitted by Paragraphs 8 and 10.

• This statement has been amended, but Paragraph 12, which exempts nonprofit organizations has not been amended, so SFAS 141 still will not apply to nonprofits until the pending exposure draft on this subject is issued final.

AICPA Accounting and Auditing Guide, Health Care Organizations

• Paragraph 1.24 in the nonprofit guide (1.55 in the health care guide) has been amended to note that APB 28 (see above) will now apply to nonprofits that are conduit debt obligors. (end of discussion of FSP 126-1)

Credit Losses Related to Loans - The AICPA is preparing a Statement of Position, Disclosures Concerning Credit Losses Related to Loans, on this subject, which will require much more extensive disclosures about loans, related allowances for uncollectible amounts, and the methods and assumptions used to estimate the allowance. This document will apply to pledges receivable by a nonprofit organization. An exposure draft was expected in the 2nd Quarter of 2006, but has not yet been issued as of mid-November.

Auditing
Audit Documentation - The AICPA issued Statement on Auditing Standards No. 103, Audit Documentation, in December 2005. Among other things, the SAS:

• States that oral explanations on their own do not represent sufficient support for the work the auditor performed or conclusions the auditor reached, but may be used by the auditor to clarify or explain information contained in the audit documentation.
• Requires the auditor to document audit evidence that is identified as being contradictory or inconsistent with the final conclusions, and how the auditor addressed the contradiction or inconsistency.
• Requires that the auditor assemble the audit documentation to form the final audit engagement file within 60 days following the report release date. After this date, the SAS requires the auditor not to delete or discard existing audit documentation, and to appropriately document any subsequent additions.

This SAS also amends AICPA, Professional Standards regarding Dating of the Independent Auditor's Report. The amendment requires that the auditor's report not be dated earlier than the date on which the auditor has obtained sufficient appropriate audit evidence to support the opinion on the financial statements, rather than simply the date of the end of fieldwork. Thus most reports will be dated later than in the past.

Risk Assessment - The AICPA's Auditing Standards Board has issued eight Statements (Nos. 104-111) on Auditing Standards relating to the assessment of risk in an audit of financial statements. These Statements establish standards and provide guidance concerning the auditor's assessment of the risks of material misstatement (whether caused by error or fraud) in a financial statement audit, and the design and performance of audit procedures whose nature, timing, and extent are responsive to the assessed risks. Additionally, the State­ments establish standards and provide guidance on planning and supervision, the nature of audit evidence, and evaluating whether the audit evidence obtained affords a reasonable basis for an opinion regarding the financial statements under audit.
    The primary objective of these Statements is to enhance auditors' application of the audit risk model in practice by specifying, among other things:

• More in-depth understanding of the entity and its environment, including its internal control, to identify the risks of material misstatement in the financial statements and what the entity is doing to mitigate them.
• More rigorous assessment of the risks of material misstatement of the financial statements based on that understanding.
• Improved linkage between the assessed risks and the nature, timing, and extent of audit procedures performed in response to those risks.

Auditor Communication with Those Charged with Governance - The Audit­ing Standards Board has issued Statement on Auditing Standards (SAS) No. 112, Communicating Internal Control Related Matters Identified in an Audit, which replaces SAS No. 60, Communication of Internal Control Related Matters Noted in an Audit.
    It is applicable whenever an auditor expresses an opinion on financial statements (including a disclaimer of opinion).

Among other things, the SAS:

• Requires the auditor to communicate control deficiencies that are significant deficiencies or material weaknesses in internal control.
• A significant deficiency is a control, or combination of control deficiencies, that adversely affects the entity's ability to initiate, authorize, record, process, or report financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the entity's financial statements that is more than inconsequential will not be prevented or detected.
• A material weakness is a significant deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected.

The SAS also effectively makes mandatory the, now optional (except if there is an audit committee), communication of the matters in SAS 61.

Other matters - UMIFA: The National Conference of Commissioners on Uniform State Laws has prepared a revised version of the Uniform Management of Institutional Funds Act for consideration by the states. It does not make major changes in UMIFA, but would give nonprofit governing boards somewhat more flexibility in making expenditure decisions. Effects on accounting and financial reporting may not be significant in most states, unless a state makes significant changes in its law beyond the uniform act, although there is ongoing discussion as to its impact, especially on the reporting of permanently restricted net assets.
    The revised act will require adoption by each state, so it may be some time before this takes effect. It will likely be called the Uniform Prudent Management of Institutional Funds Act and is already known by that acronym, UPMIFA.

Appendix A:

Main proposals included in the mergers of not-for-profit entities and goodwill and other intangible assets drafts are:
Mergers of Not-for-profit Entities:

• Examples of a merger or acquisition include (Mergers, par. 5):
• An organization legally merges with one or more not-for-profit organizations into a single, surviving organization.
• An organization receives by contribution a group of assets (or a group of assets and liabilities) that constitutes a business or nonprofit activity.
• An organization purchases the assets and assumes the liabilities that constitute a business or nonprofit activity in exchange for cash or other assets.
• An organization obtains control of and initially recognizes a subsidiary (a business entity or a nonprofit organization) in its financial statements under SOP 94-3 or the health care Guide by obtaining a right to:
• Appoint or designate all or a majority of the acquiree's governing board either through an acquisition of a majority of shares or through other means.
• Exercise decision-making powers of control over the acquiree through the terms of a contractual agreement.
• Be named the sole member of a not-for-profit membership corporation.

• Participation in the formation of a joint venture under joint control is not a merger or acquisition. (par. 6b)
• Acquisition of a group of assets and liabilities that does not constitute a business or nonprofit activity is not a merger or acquisition. (par. 6c)
• The Board believes that virtually all mergers or acquisitions are, in substance, the acquisition of net assets; (par. B-25ff.) [Some believe this is controversial.]
• Mergers are not poolings of interests. (par. B-34ff.)
• The "fresh start" method (revalue both organizations' balance sheets) is also rejected. (par. B-38ff.)
• The acquirer is the organization that obtains control of the acquiree and recognizes the acquiree in its financial statements. (par. 4b)
• Control is "the direct or indirect ability to determine the direction of management and policies through ownership, contract, or otherwise" (paragraph 20 of AICPA Statement of Position (SOP) 94-3). (par. 4i)
• The Statement does not apply to mergers or acquisitions between entities under common control. (par. 3)
• Recognize the identifiable assets acquired and liabilities assumed that compose the business or nonprofit activity acquired in a merger or acquisition, with certain exceptions. (par. 1a)
• Measure those assets and liabilities at their fair values as of the acquisition date, (certain exceptions). (par. 1b)
• Fair value is "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date" (paragraph 5 of FASB Statement No. 157, Fair Value Measurements). (par. 4k)
• Recognize either goodwill of the acquired business or nonprofit activity or the contribution inherent in the merger or acquisition as a residual value as follows (par. 1c):
• Measure goodwill as the amount by which the value of the consideration transferred (if any) exceeds the net of the amounts assigned to identifiable assets acquired and liabilities assumed.
• Measure the contribution inherent in the transaction as the amount by which the values assigned to the identifiable assets acquired exceeds the consideration transferred (if any) and the liabilities assumed.
• The acquirer would not be required to measure the fair value of the acquiree as a whole.
• Any event that requires a not-for-profit organization to consolidate a previously unconsolidated entity is a merger or acquisition and would be accounted for in accordance with the guidance in this proposed Statement. (par. 2)
• This proposed Statement would retain the existing guidance used by a not-for-profit organization in determining whether another entity should be consolidated. That guidance, which includes AICPA Statement of Position (SOP) 94-3, Reporting of Related Entities by Not-for-Profit Organizations, and AICPA Audit and Accounting Guide, Health Care Organizations, describes circumstances in which consolidation is not required or is prohibited. This proposed Statement would not change that existing guidance. (question 1)
• Requires the identification of an acquirer in all mergers or acquisitions. (par. 9)
• Determining whether an organization obtains control of an acquiree would be based on existing guidance, including SOP 94-3 and the health care Guide. (par. 10)
• If an acquirer cannot be determined based solely on that guidance, this proposed Statement would require that the factors provided in paragraph 11 be considered. [see below]
• Certain identifiable assets acquired and liabilities assumed would continue to be recognized and measured in accordance with other GAAP, including:
• Certain intangible assets (par. 17)
• Assets and liabilities arising from acquired leases (par. 22)
• Assumed liabilities for costs associated with restructuring or exit activities (par. 24)
• Certain inexhaustible collection items (par. 25)
• Conditional promises to give (par. 27)
• Operating leases (par. 28)
• Assets held for sale (par. 34)
• Deferred taxes (par. 35)
• Pension and other postemployment benefits. (par. 36)
• Provides a period after the acquisition date during which the acquirer may adjust provisional amounts recognized at the acquisition date. That measurement period would end when the acquirer receives the necessary information about facts and circumstances that existed at the acquisition date, when the acquirer learns the information is unobtainable, or within one year from the acquisition date, whichever occurs first. (par 52-57)
• Facts and circumstances to be used in identifying the acquirer (paragraph 11): mostly they deal with the selection of the governing board of the merged organization; other factors include relative size, name, selection of management, and whether any consideration was exchanged (the latter is rare in nonprofits).
• If a new not-for-profit organization is formed to effect a merger or acquisition by a not-for-profit organization, one of the entities that existed before the merger or acquisition shall be identified as the acquirer based on available evidence. (par. 12)

• Applies SFAS 142 to not-for-profit organizations, as follows:

• For intangible assets other than goodwill - follow normal rules of 142: (Goodwill, par. 5)
• If useful life is finite, amortize over that useful life
• If useful life is not finite, do not amortize
• Test annually for impairment of indefinite lived intangible assets under SFAS 144, and record a loss if necessary
• For goodwill acquired in a merger or acquisition: (par. 6)
• Assumed to have indefinite life; hence, do not amortize
• But test for impairment annually or more frequently as required, and record a loss if necessary
• Impairment test differs from that in 142 for "reporting units," which are primarily supported by contributions and returns on investments: (par. 7)
• A reporting unit is the level of reporting at which goodwill is evaluated for impairment. A reporting unit is an operating segment (as described in paragraphs 10-14) or one level below an operating segment. (par 4h)
• An organization shall consider all relevant qualitative and quantitative factors in determining the nature of a reporting unit's primary support. For example, qualitative and quantitative information about all forms of contributed support, including contributions that are precluded from being recognized or are not required to be recognized in the financial statements (such as certain contributed services and collection items, and conditional promises to give), would be considered in the determination (par. 22)
• Use the qualitative evaluation described in paragraphs 33-36 of the Statement. In that evaluation, goodwill attributable to a specific acquisition is deemed to be impaired when an event (an "impairment event") occurs that provides evidence of impairment.
• A not-for-profit organization that assigns goodwill to a reporting unit that is primarily supported by contributions and returns on investments shall, as of the acquisition date, identify the reasons why goodwill arose in the acquisition. (par. 33)
• A not-for-profit organization that assigns goodwill to a reporting unit that is primarily supported by resources other than contributions and returns on investments shall apply the fair-value-based evaluation (par. 37)