More on Nonprofit Financial Statements

Webinar 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.

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.CASH BASIS ACCRUAL BASIS

BALANCE SHEET BALANCE SHEET

Cash $30k Cash $30k

Car $20k

Total Assets $30K Total Assets $50K

Credit Card Debt $25K

Car Loan $20K

Total Liabilities $45K

Net Worth $30K Net Worth $ 5K

INCOME STATEMENT INCOME STATEMENT

Salary $50K Salary $50K

Rent 20K Rent 20K

Other Expenses 25K

Net Income $30K Net Income $ 5K

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

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

7

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

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

11

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)

12

13

Capitalization vs. ExpenseA 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 AcquiredRights to future benefits have been acquired in a transaction

2. MeasurableBenefits 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

Fixed Asset AccountingYear Fixed Asset

(original cost)Accumulated Depreciation

(annual accumulation)

Net Fixed Asset(Balance Sheet)

Depreciation Expense (Activity

Statement

1 10000 2000 8000 2000

2 10000 4000 6000 2000

3 10000 6000 4000 2000

4 10000 8000 2000 2000

5 10000 10000 0 2000

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)

Accounting for DebtYear Cash Activity

Balance SheetDebt Activity

Balance SheetDebt BalanceBalance Sheet

Interest ExpenseActivity

Statement

1 45000 50000 50000 5000

2 (14000) (10000) 40000 4000

3 (13000) (10000) 30000 3000

4 (12000) (10000) 20000 2000

5 (11000) (10000) 10000 1000

6 (10000) (10000) - -

Net Impact $15k less cash net 50k Borrowed $50k Repaid $15k cost of

borrowing

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)

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

20

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

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

22

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

23

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

24

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

25

Permanently Restricted Funds

26

• 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

27

Pilgrim Services Society “Road Map”

• Gain further understanding of financial statement information

• Realize importance of “Notes to Financial Statements”

• Begin analysis of financial information

The Pilgrim Service SocietyBalance Sheet

As of June 30, 2005

UnrestrictedTemporarily Restricted

Permanently Restricted Total

ASSETS:Cash $63,022 $120,971 $183,993Short-term investments 770,000 770,000Accounts receivable 19,584 19,584Grants and pledges receivable 115,961 115,961Interest receivable 12,253 12,253Prepaid expenses and other assets 29,365 29,365Total current assets 1,010,185 120,971 0 1,131,155Investments 44,407 474,007 660,000 1,178,414Pledges receivable 1,550,684 1,550,684

Property and equipment, net of accumulated depreciation 1,104,934 1,104,934

Total assets 2,159,526 2,145,662 660,000 4,965,187

LIABILITIES: Accounts payable 866,952 866,952 Deferred revenue 483,469 483,469 Current portion of long-term debt 50,000 50,000 Total current liabilities 1,400,421 0 0 1,400,421

Long term debt 798,409 798,409 Total liabilities 2,198,830 0 0 2,198,830

NET ASSETS: Accumulated operating deficits (547,393) (547,393) Property and equipment 256,525 256,525 Board designated 251,563 251,563 Restricted for program activities 2,060,130 2,060,130 Endowment appreciation 85,532 85,532 Restricted endowment 660,000 660,000 Total net assets (39,305) 2,145,662 660,000 2,766,357

Total liabilities and net assets $2,159,525 $2,145,662 $660,000 $4,965,187

2005

30

The Pilgrim Service SocietyStatement of Activities

for trhe years ending June 30, 2005

UnrestrictedTemporarily Restricted

Permanently Restricted Total

OPERATING SUPPORT & REVENUEOperating support: Contributions $2,174,893 $956,019 $3,130,912 Grants 313,290 537,465 850,755 In-kind contributions 47,839 47,839 Special events 493,234 493,234 Net assets released from restrictions 1,070,048 (1,070,048) 0 Total operating support 4,099,304 423,436 4,522,740

Program service fees & other income: Individuals 1,795,000 1,795,000 Commercial insurance fees 751,295 751,295 Contract revenue 5,323,805 5,323,805 Investment income used for operations 50,000 50,000 Other income 150,428 150,428 Total program service fees & other income 8,070,528 8,070,528 Total operating support & revenue 12,169,832 423,436 0 12,593,268

EXPENSESProgram services: Community social services 4,729,253 4,729,253 Daycare services 2,789,241 2,789,241 Behavioral health & addiction services 2,763,117 2,763,117 Total program services 10,281,611 0 0 10,281,611

Support services: Management & general 1,673,750 1,673,750 Fundraising 678,411 678,411 Total support services 2,352,161 2,352,161

Total expenses 12,633,772 12,633,772 Changes in net assets from operations (463,940) 423,436 (40,504)

OTHER CHANGES IN NET ASSETS Return on investments 41,600 76,935 118,535 Income used for operations (17,327) (32,673) (50,000) Net assets released for non-operating purposes 100,472 (100,472)

124,745 (56,210) 68,535

Change in net assets (339,195) 367,226 0 28,031

NET ASSETS, beginning of year 299,890 1,778,436 660,000 2,738,326

NET ASSETS, end of year ($39,305) $2,145,662 $660,000 $2,766,357

2005

31

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?

32