How Proposed Accounting Rules Would Affect Nonprofits and Donors

After years of deliberation, the Financial Accounting Standards Board last week released a draft of proposed changes to accounting rules for nonprofits. Many of the changes will be useful to donors and others who want to better evaluate a nonprofit’s financial health. And for the most part, the new changes will be easy for organizations to adopt, with a few exceptions.

Here are some of the key ideas:

Charities will disclose more details about how they split costs in calculating program vs. “overhead” expenses. In what could ultimately become the biggest change of the rules, nonprofits would be able to show readers of financial statements how spending among program, fundraising, and administrative categories was classified. For example, a nonprofit might have decided to split the cost of rent between programs and administrative overhead, based on how much office space is used for each kind of activity. If so, the organization would now be expected to explain that rationale as part of its financial reporting.

Many outsiders seeking information to evaluate nonprofits see the program vs. overhead distinction as a key measure, but what they often don’t realize is how flexible the reporting can be. Nonprofits have so much discretion in allocating costs that the financial reporting ends up being far more art than science. Being upfront in explaining how decisions were made should add some rationality and nuance to the conversation.

Nonprofits will need to show details of where their cash comes from and where it goes.

Today, many nonprofits take the easiest approach to showing their cash flow by using the so-called indirect method, which amounts to a mechanical reconciliation of the statement of financial position rather than the more complex “direct” approach of tracking and presenting details on the sources and uses of their cash.

Though this approach increases record-keeping requirements for charities, it can be a big help for people trying to assess a nonprofit’s financial health.

At a time when many donors, regulators, and others are concerned about liquidity and whether nonprofits have the wherewithal to generate cash flows to meet short-term needs, the new approach should provide much-needed information about a nonprofit’s cash trends and risks.

Restrictions on assets will be easier for nonprofits to report. Under the new approach, nonprofits will simply list whether donors have placed restrictions on their assets or not.

This will be easier for nonprofits than current rules, which require organizations to separate gifts with restrictions into two categories, depending on whether donors made a short-term request or a permanent demand, such as placing money in an endowment.

This seemingly minor change will benefit donors and others who review financial statements. In the past, some people got confused by the classifications, not realizing that assets that aren’t restricted by donors still face other requirements, such as fulfilling a board’s request to invest in growth. By no longer labeling such assets as “unrestricted,” but instead as “without donor restrictions,” this distinction should become clearer.

Expenses must be classified in ways that show both the specific type and their general purpose. Nonprofits will be expected to label expenses such as rent, salaries, and legal fees clearly and also classify each type of spending among program, fundraising, and administrative categories. This approach mirrors what voluntary health and welfare organizations have long been required to provide in a statement of functional expenses and others must do on their informational tax returns, or 990s. As a result, the change is unlikely to be difficult for nonprofits to put in place.

By uniformly requiring disclosure of expense details, both by type and purpose, this approach should reinforce the idea that donors need to look at the details of where money goes, rather than just focusing on simple measures like the share of spending that goes into programs.

Statements will now show more clearly what actions affected a nonprofit’s financial performance. Many nonprofits misunderstood what the accounting board announced when it unveiled the changes last week, thinking that introducing additional performance measures meant a new approach that embraced arguments by those seeking alternatives to classifying costs as program vs. overhead.

Instead, what this change represents is an attempt to provide details not about whether spending choices were wise but whether spending and revenues represent operating activities in the current period or those not related to the current year.

Say, for example, an organization has an investment fund (quasi-endowment) that each year provides 5 percent of its balance to fund operations. That fund might have recorded a 15-percent return in a given year, creating the impression in the financials that it could have (or even should have) spent all those gains right away. Under the new system, increases in the value of the fund beyond the 5 percent will be classified separately, reflecting that they were not available for current spending.

Information like this will help readers better understand what changes in assets are related to typical day-to-day operations and which relate to investments, long-term planning, or unusual changes.

And it will make it clearer that it’s not always wise or possible to spend earnings right away; there are good reasons to hold back.

Nonprofits and others can provide their feedback online to the accounting board through August 20. After that, the board will mull the comments and shape a final version.