Nonprofits: Are you ready for the new contribution guidance?

When the Financial Accounting Standards Board (FASB) updated its rules for recognizing revenue from contracts in 2014, it only added to the confusion that nonprofits already had about accounting for grants and similar contracts.

Fortunately, last year, the FASB provided some much-needed clarification with Accounting Standards Update (ASU) No. 2018-08, Not-for-Profit Entities (Topic 958): Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made. Calendar-year nonprofits must follow this guidance when preparing their 2019 year-end financial statements.

Complicated rules

Nonprofits traditionally have taken varying approaches when they:

  • Characterize grants and similar contracts as exchange transactions (also known as reciprocal transactions) or contributions (nonreciprocal transactions), and
  • Distinguish between conditional and unconditional contributions.

The FASB’s updated revenue recognition guidance — ASU 2014-09, Revenue from Contracts with Customers — eliminated some of the previous guidance for nonprofits and imposed extensive disclosure requirements that didn’t seem relevant to contributions. ASU 2018-08 clarifies matters by laying out rules that will help nonprofits determine whether a grant or similar contract is indeed a contribution — and, if so, when they should recognize the revenue associated with it.

Exchange vs. contribution

To determine how to treat a grant or similar contract, you must assess whether the “provider” receives commensurate value for the assets it’s transferring. If it does, you should treat the grant or contract as an exchange transaction. ASU 2018-08 stresses that the provider (the grantor or other party) in a transaction isn’t synonymous with the general public. So, indirect benefit to the public doesn’t represent commensurate value received. Execution of the provider’s mission or positive sentiment received from donating also doesn’t constitute commensurate value received.

What if the provider doesn’t receive commensurate value? You then must determine if the asset transfer is a payment from a third-party payer for an existing transaction between you and an identified customer (for example, payments made under Medicare or a Pell Grant). If it is such a payment, the transaction won’t be considered a contribution under the ASU, and other accounting guidance would apply. If it isn’t such a payment, the transaction is accounted for as a contribution.

Conditional terms

According to ASU 2018-08, a conditional contribution includes:

  • A barrier the nonprofit must overcome to receive the contribution, and
  • Either a right of return of assets transferred or a right of release of the promisor’s obligation to transfer assets.

Unconditional contributions are recognized when received. However, conditional contributions aren’t recognized until you overcome the barriers to entitlement.

Is there a barrier to overcome before your organization can receive a contribution? Consider the inclusion of a measurable performance-related barrier, limits on your nonprofit’s discretion over how to conduct an activity or a stipulation that relates to the purpose of the agreement (not including administrative tasks and trivial stipulations such as production of an annual report). Some indicators might prove more important than others, depending on circumstances. And no single indicator is determinative.

Net effect

As a result of the updated guidance, nonprofits will likely account for more grants and similar contracts as contributions than they did under the previous rules. Check with your CPA to determine what that means for your financial statements, loan covenants and other matters.

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FAQs about prepaid expenses

The concept of “matching” is one of the basic principles of accrual-basis accounting. It requires companies to match expenses (efforts) with revenues (accomplishments) whenever it’s reasonable or practical to do so. This concept applies when companies make advance payments for expenses that will benefit more than one accounting period. Here are some questions small business owners and managers frequently ask about prepaying expenses.

When do prepaid expenses hit the income statement?

It’s common for companies to prepay such expenses as legal fees, advertising costs, insurance premiums, office supplies and rent. Rather than immediately report the full amount of an advance payment as an expense on the income statement, companies that use accrual-basis accounting methods must recognize a prepaid asset on the balance sheet.

A prepaid expense is a current asset that represents an expense the company won’t have to fund in the future. The remaining balance is gradually written off with the passage of time or as it’s consumed. The company then recognizes the reduction as an expense on the income statement.

Why can’t prepaid expenses be deducted immediately?

Immediate expensing of an item that has long-term benefits violates the matching principle under U.S. Generally Accepted Accounting Principles (GAAP).

Deducting prepaid assets in the period they’re paid makes your company look less profitable to lenders and investors, because you’re expensing the costs related to generating revenues that haven’t been earned yet. Immediate expensing of prepaid expenses also causes profits to fluctuate from period to period, making benchmarking performance over time or against competitors nearly impossible.

Does prepaying an expense make sense?

Some service providers — like your insurance carrier or an attorney in a major lawsuit — might require you to pay in advance. However, in many circumstances, prepaying expenses is optional.

There are pros and cons to prepaying. A major downside is that it takes cash away from other potential uses. Put another way, it gives vendors or suppliers interest-free use of your business’s funds. Plus, there’s a risk that the party you prepay won’t deliver what you’ve paid for.

For example, a landlord might terminate a lease — or they might file for bankruptcy, which could require a lengthy process to get your prepayment refunded, and you might not get a refund at all. Banks also might not count prepaids when computing working capital ratios. And since reporting prepaid expenses under GAAP differs slightly from reporting them for federal tax purposes, excessive prepaid activity may create complex differences to reconcile.

With that said, your company might receive a discount for prepaying. And companies without an established credit history, that have poor credit or that contract services with foreign providers, may need to prepay expenses to get favorable terms with their supply chain partners.

For more information

Start-ups and small businesses that are accustomed to using cash-basis accounting may not understand the requirement to capitalize business expenses on the balance sheet. But matching revenues and expenses is a critical part of accrual-basis accounting. Contact us with any questions you may have about reporting and managing prepaid assets.

© 2019

Risk Assessment: A Critical Part of the Audit Process

Audit season is right around the corner for calendar-year entities. Here’s what your auditor is doing behind the scenes to prepare — and how you can help facilitate the audit planning process.

The big picture

Every audit starts with assessing “audit risk.” This refers to the likelihood that the auditor will issue an adverse opinion when the financial statements are actually in accordance with U.S. Generally Accepted Accounting Principles or (more likely) an unqualified opinion when the opinion should be either modified or adverse.

Auditors can’t test every single transaction, recalculate every estimate or examine every external document. Instead, they tailor their audit procedures and assign audit personnel to keep audit risk as low as possible.

Inherent risk vs. control risk

Auditors evaluate two types of risk:

1. Inherent risk. This is the risk that material departures could occur in the financial statements. Examples of inherent-risk factors include complexity, volume of transactions, competence of the accounting personnel, company size and use of estimates.

2. Control risk. This is the risk that the entity’s internal controls won’t prevent or correct material misstatements in the financial statements.

Separate risk assessments are done at the financial statement level and then for each major account — such as cash, receivables, inventory, fixed assets, other assets, payables, accrued expenses, long-term debt, equity, and revenue and expenses. A high-risk account (say, inventory) might warrant more extensive audit procedures and be assigned to more experienced audit team members than one with lower risk (say, equity).

How auditors assess risk

New risk assessments must be done each year, even if the company has had the same auditor for many years. That’s because internal and external factors may change over time. For example, new government or accounting regulations may be implemented, and company personnel or accounting software may change, causing the company’s risk assessment to change. As a result, audit procedures may vary from year to year or from one audit firm to the next.

The risk assessment process starts with an auditing checklist and, for existing audit clients, last year’s workpapers. But auditors must dig deeper to determine current risk levels. In addition to researching public sources of information, including your company’s website, your auditor may call you with a list of open-ended questions (inquiries) and request a walk-through to evaluate whether your internal controls are operating as designed. Timely responses can help auditors plan their procedures to minimize audit risk.

Your role

Audit fieldwork is only as effective as the risk assessment. Evidence obtained from further audit procedures may be ineffective if it’s not properly linked to the assessed risks. So, it’s important for you to help the audit team understand the risks your business is currently facing and the challenges you’ve experienced reporting financial performance, especially as companies implement updated accounting rules in the coming years.

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The Art and Science of Goodwill Impairment Testing

Goodwill shows up on a company’s balance sheet when the company has been acquired in a business combination. It represents what’s left over after the purchase price in a merger or acquisition is allocated to the company’s tangible assets, identifiable intangible assets and liabilities. Periodically, companies must test goodwill for “impairment” — that is, whether the carrying value on the balance sheet has fallen below its fair value. This assessment can be complicated.

Reporting recap

Under current U.S. Generally Accepted Accounting Principles (GAAP), public companies that report goodwill on their balance sheet must test goodwill at least annually for impairment. In lieu of annual impairment testing, private companies may elect to amortize acquired goodwill over a useful life of up to 10 years.

All companies — regardless of whether they’re publicly traded or privately held — must test goodwill for impairment when a triggering event happens. Examples of triggering events that could lower the fair value of goodwill include:

  • The loss of a key customer or key person,
  • Adverse regulatory actions,
  • Unanticipated competition, and
  • Negative cash flows from operations.

Impairment may also occur if, after an acquisition has been completed, there’s an economic downturn that causes the parent company or the acquired business to lose value. Impairment write-downs reduce the carrying value of goodwill on the balance sheet. They also lower profits reported on the income statement, which may raise a red flag to lenders and investors.

Quantifying impairment

Calculating goodwill impairment was originally a two-step process: First, businesses must figure out whether an impairment exists, and then they must put a dollar figure on it. The second step includes determining the implied fair value of goodwill and comparing it with the carrying amount of goodwill on the balance sheet.

The rules for testing goodwill impairment were simplified in Accounting Standards Update (ASU) No. 2017-04, Intangibles — Goodwill and Other, Simplifying the Test for Goodwill Impairment. The changes go live for fiscal periods starting after:

  • December 15, 2019, for public companies that file with the Securities and Exchange Commission,
  • December 15, 2020, for other public companies,
  • December 15, 2021, for privately held businesses.

Early adoption is permitted for testing dates after January 1, 2017. The updated guidance nixes the second step of the impairment test. Instead, a business will perform the impairment test by comparing the fair value of a reporting unit that includes goodwill with its carrying amount.

Who can help?

Few companies employ internal accounting staff with the requisite training and time to handle impairment testing. And most auditors won’t perform valuation services for their audit clients for fear of violating their independence standards. Instead, valuation specialists are often called in to handle these complex assignments. Contact us for more information.

© 2019

Manage Your Working Capital More Efficiently

Working capital is the difference between a company’s current assets and current liabilities. For a business to thrive, its working capital must be greater than zero. A positive balance enables the company to meet its short-term cash flow needs and grow.

But too much working capital can be a sign of inefficient management. In general, you want to generate as much income as possible from the money that’s tied up in receivables, inventory, payables and other working capital accounts. Here’s how to find the sweet spot between too little and too much working capital.

Benchmarking performance

Current assets are those that can be easily converted into cash within a 12-month period. Conversely, current liabilities include any obligations due within 12 months, including accounts payable, accrued expenses and notes payable.

In addition to calculating the difference between these two amounts, management may calculate the current ratio (current assets ÷ current liabilities) and the acid-test ratio (cash, receivables and investments ÷ current liabilities). A company’s working capital ratios can be compared over time or against competitors to help gauge performance.

You can also compute turnover ratios for receivables, inventory and payables. For example, the days-in-receivables ratio equals the average accounts receivable balance divided by annual sales times 365 days. This tells you, on average, how long it takes the company to collect customer invoices.

Staying positive

There are three main goals of working capital management:

  1. To ensure the company has enough cash to cover expenses and debt,
  2. To minimize the cost of money spent on funding working capital, and
  3. To maximize investors’ returns on assets and investments.

Maintaining a positive working capital balance requires identifying patterns of activity related to line items within the current asset and liability sections.

Digging deeper

Suppose your company’s current ratio has fallen from 1.5 to 1.2. Is this good or bad? That depends on your circumstances. You’ll need to identify the reasons it’s fallen to determine whether the decline is a sign of an impending cash flow shortage. Often the answer lies in three working capital accounts: 1) accounts receivable, 2) inventory, and 3) accounts payable.

For example, when it comes to collecting from customers, how much time elapses between the recognition of an accounts receivable and its collection? Are certain customers habitually slower to pay than others?

Inventory has significant carrying costs, including storage, insurance, interest, pilferage, and the potential for damage and obsolescence. Has your company established target inventory levels? If so, who within the organization monitors compliance? To avoid running out of materials, companies often hold too much inventory. And it’s often financed through trade debt, which can prove costly over the long term.

With respect to the payment of accounts payable, does your company pay according to the credit terms offered by the vendor? Are there penalties for paying past those terms? It might be time for your company to renegotiate its payment terms.

We can help

Working capital management is as much art as it is science. Contact us to help determine the optimal level of working capital based on the nature of your business. We can help you brainstorm ways to fortify your financial position and operate more efficiently.

© 2019 

Close-Up on Pushdown Accounting for M&As

Change-in-control events — like merger and acquisition (M&A) transactions — don’t happen every day. If you’re currently in the market to merge with or buy a business, you might not be aware of updated financial reporting guidance that took effect in November 2014. The changes provide greater flexibility to post-M&A accounting.

Pushdown accounting is optional

Accounting Standards Update (ASU) No. 2014-17, Business Combinations (Topic 805): Pushdown Accounting (a consensus of the FASB Emerging Issues Task Force), made pushdown accounting optional when there’s a change-in-control event. The update applies to all companies, both public and private.

Pushdown accounting refers to the practice of adjusting an acquired company’s standalone financial statements to reflect the acquirer’s accounting basis rather than the target’s historical costs. Typically, this means stepping up the target’s net assets to fair value and, to the extent the purchase price exceeds fair value, recognizing the excess as goodwill. Previously, U.S. Generally Accepted Accounting Principles (GAAP) provided little guidance on when pushdown accounting might be appropriate.

For public companies, Securities and Exchange Commission (SEC) guidance generally prohibited pushdown accounting unless the acquirer obtained at least an 80% interest in the target and required it when the acquirer’s interest reached 95%. The SEC has rescinded portions of its pushdown accounting guidance, bringing it in line with the FASB’s updated standard.

To push down or not?

Under the updated guidance, all acquired companies may decide if they should apply pushdown accounting. Whether it’s appropriate depends on a company’s circumstances. For some companies, there may be advantages to reporting assets and liabilities at fair value and adopting consistent accounting policies for both parent and subsidiary. Other companies may prefer not to apply pushdown accounting to avoid the negative impact on earnings, often associated with a step-up to fair value.

After pushdown accounting is applied to a change-in-control event, the election is irrevocable. Acquired companies that apply pushdown accounting in their standalone financial statements should include disclosures in the current reporting period to help users evaluate its effects.

We can help

If you’re contemplating an M&A deal, we can help you decide whether pushdown accounting is a smart choice for reporting your transaction. Whichever option you choose, our accounting pros also can help you comply with financial reporting requirements under GAAP.

© 2019

GAAP vs. tax-basis: Which is right for your business?

Young woman comparing two things.

Most businesses report financial performance using U.S. Generally Accepted Accounting Principles (GAAP). But the income-tax-basis format can save time and money for some private companies. Here’s information to help you choose the financial reporting framework that will work for your situation.

The basics

GAAP is the most common financial reporting standard in the United States. The Securities and Exchange Commission (SEC) requires public companies to follow it — they don’t have a choice. Many lenders expect large private borrowers to follow suit, because GAAP is familiar and consistent.

However, compliance with GAAP can be time-consuming and costly, depending on the level of assurance provided in the financial statements. So, some private companies opt to report financial statements using an “other comprehensive basis of accounting” (OCBOA) method. The most common OCBOA method is the tax-basis format.

Key differences

Departing from GAAP can result in significant differences in financial results. Why? GAAP is based on the principle of conservatism, which prevents companies from overstating profits and asset values. This runs contrary to what the IRS expects from for-profit businesses. Tax laws generally tend to favor accelerated gross income recognition and won’t allow taxpayers to deduct expenses until the amounts are known and other deductibility requirements have been met. So, reported profits tend to be higher under tax-basis methods than under GAAP.

There are also differences in terminology. Under GAAP, companies report revenues, expenses and net income. Conversely, tax-basis entities report gross income, deductions and taxable income. Their nontaxable items typically appear as separate line items or are disclosed in a footnote.

Capitalization and depreciation of fixed assets is another noteworthy difference. Under GAAP, the cost of a fixed asset (less its salvage value) is capitalized and systematically depreciated over its useful life. For tax purposes, fixed assets are depreciated under the Modified Accelerated Cost Recovery System (MACRS), which generally results in shorter lives than under GAAP. Salvage value isn’t subtracted for tax purposes, but Section 179 and bonus depreciation are subtracted before computing MACRS deductions.

Other reporting differences exist for inventory, pensions, leases, start-up costs and accounting for changes and errors. In addition, companies record allowances for bad debts, sales returns, inventory obsolescence and asset impairment under GAAP. But these allowances generally aren’t permitted under tax law.

Departing from GAAP

GAAP has become increasingly complex in recent years. So some companies would prefer tax-basis reporting, if it’s appropriate for financial statement users.

For example, tax-basis financials might work for a business that’s owned, operated and financed by individuals closely involved in day-to-day operations who understand its financial position. But GAAP statements typically work better if the company has unsecured debt or numerous shareholders who own minority interests. Likewise, prospective buyers may prefer to perform due diligence on GAAP financial statements — or they may be public companies that are required to follow GAAP.

Contact us

Tax-basis reporting makes sense for certain types of businesses. But for other businesses, tax-basis financial statements may result in missing or even misleading information. We can help you evaluate the pros and cons and choose the appropriate reporting framework for your situation.

© 2019

Valuing Profits Interests in LLCs

Handsome african american businessman got a gold award in the online contest from monitor. Modern male character. Flat vector.

The use of so-called “profits interest” awards as a tool to attract and retain skilled workers has increased, as more companies are being structured as limited liability companies (LLCs), rather than as corporations. But accounting complexity has caused some private companies to shy away from these arrangements. Fortunately, relief from the Financial Accounting Standards Board (FASB) may be coming soon.

New twist on equity compensation

Corporations tend to award traditional stock options. But profits interests are used exclusively by LLCs. As the name suggests, these arrangements provide recipients with a share of the company’s future profits. Under existing U.S. Generally Accepted Accounting Principles (GAAP), these transactions may be classified as:

  • Share-based payments,
  • Profit-sharing,
  • Bonus arrangements, or
  • Deferred compensation.

The classification is determined by the specific terms and features of the profits interest. In most cases, the fair value of the award must be recorded as an income statement expense. Profits interest can also result in the recognition of a liability on the balance sheet and require footnote disclosures.

Need for simplification

Profits interest arrangements can accomplish a variety of business objectives. Though they’re most often awarded to employees, profits interests can also be given to investors, third-party service providers and other individuals.

These awards are usually issued in exchange for future services, without direct payment or financial investment. Various terms and features can be incorporated into a profits interest. For example, these awards often have contingency features, such as vesting requirements, participation thresholds, the occurrence of certain events, limited time periods, expiration dates and forfeiture provisions. In turn, this variability can cause additional complexity compared to other forms of equity compensation and require special valuation techniques.

“Profits interest continues to come up as an area private companies are struggling with,” said Candace Wright, Chair of the Private Company Council (PCC) during a meeting with the FASB earlier this year. Private companies have been clamoring for practical expedients and additional guidance from the FASB on such issues as acceptable valuation methods, audit techniques and disclosure requirements.

Work in progress

Simplification of the financial reporting guidance would be welcome news for employers, employees and other stakeholders. Contact us for help reporting these transactions under existing U.S. GAAP or for an update on the latest developments from the FASB.

© 2019

Reasons Why Cash is King

Dollar Pipeline – lots of 20 Dollar Bills building a tube.

In financial reporting, investors and business owners tend to focus on four key metrics: 1) revenue, 2) net income, 3) total assets and 4) net worth. But, when it comes to gauging short-term financial performance and creditworthiness, the trump card is cash flow.

If a business doesn’t have enough cash on hand to pay payroll, rent and other bills, it can spell disaster — no matter how profitable the company is or how fast it’s growing. That’s why you can’t afford to cast aside the statement of cash flows and the important insight it can provide.

Monitoring cash

The statement of cash flows reveals clues about a company’s ability to manage cash. It shows changes in balance sheet items from one accounting period to the next. Special attention should be given to significant balance changes.

For example, if accounts receivable were $1 million in 2018 and $2 million in 2019, the change would be reported as a cash outflow of $1 million. That’s because more money was tied up in receivables in 2019 than in 2018. An increase in receivables is common for growing businesses, because receivables generally grow in proportion to revenue. But a mounting receivables balance also might signal cash management inefficiencies. Additional financial information — such as an aging schedule — might reveal significant write-offs.

Continually reporting negative cash flows from operations can also signal danger. There’s a limit to how much money a company can get from selling off its assets, issuing new stock or taking on more debt. A red flag should go up when operating cash outflows consistently outpace operating inflows. It can signal weaknesses, such as out-of-control growth, poor inventory management, mounting costs and weak customer demand.

Categorizing cash flows

The statement of cash flows typically consists of three sections:

1. Cash flows from operations. This section converts accrual net income to cash provided or used by operations. All income-related items flow through this part of the cash flow statement, such as net income; gains (or losses) on asset sales; depreciation and amortization; and net changes in accounts receivable, inventory, prepaid assets, accrued expenses and payables.

2. Cash flows from investing activities. If a company buys or sells property, equipment or marketable securities, the transaction shows up here. This section could reveal whether a company is divesting assets for emergency funds or whether it’s reinvesting in future operations.

3. Cash flows from financing activities. This shows transactions with investors and lenders. Examples include Treasury stock purchases, additional capital contributions, debt issuances and payoffs, and dividend payments.

Below these three categories is the schedule of noncash investing and financing transactions. This portion of the cash flow statement summarizes significant transactions in which cash did not directly change hands: for example, like-kind exchanges or assets purchased directly with loan proceeds.

Keep a watchful eye

Effective cash management can be the difference between staying afloat and filing for bankruptcy — especially in an unpredictable economy. Contact us to help identify potential problems and find solutions to shore up inefficiencies and shortfalls.

© 2019

Nonprofits: New Alternatives for Reporting Goodwill and Other Intangibles

nonprofit banner – word abstract in vintage letterpress printing blocks stained by color inks

Did you know that the Financial Accounting Standards Board (FASB) recently extended the simplified private-company accounting alternatives to not-for-profit organizations? Many merging nonprofits, including educational institutions and hospitals, welcome these practical expedients. Here are the details.

Alternative for goodwill

The first alternative accounting method allows for the amortization of goodwill on a straight-line basis over 10 years (or less if a shorter useful life is more appropriate). It applies only to:

  • Goodwill recognized in a business combination after initial recognition and measurement,
  • Amounts recognized as goodwill in applying the equity method of accounting, and
  • The excess reorganization value recognized by entities that adopt fresh-start reporting under U.S. Generally Accepted Accounting Principles (GAAP) for reorganizations.

Once an alternative has been elected, the organization must apply all the alternative’s subsequent measurement, derecognition, presentation and disclosure requirements to existing goodwill and all future additions to goodwill that fall within the scope of the accounting alternative.

Upon adoption of the accounting alternative, the organization must decide whether to test goodwill at either the entity level or the reporting unit level. However, annual impairment testing isn’t required under the alternative. Rather, testing for impairment is required only if a triggering event occurs that indicates that the fair value of the nonprofit entity (or the reporting unit) may be below its carrying amount.

Alternative for identifiable intangible assets

The second accounting alternative allows a nonprofit organization to bypass the separate recognition of noncompete agreements and customer-related intangible assets unless they can be sold or licensed independently from other assets of a business. In other words, such items would be considered part of goodwill. Nonprofits that elect this alternative would recognize fewer intangible assets in a business combination.

It applies to nonprofit organizations that are required to recognize or consider fair value of intangible assets when:

  • Applying the acquisition method for a business combination,
  • Evaluating the nature of a difference between an investment’s carrying amount and the underlying equity in the net asset of an investee when applying the equity method of accounting, or
  • Adopting fresh start accounting for reorganizations.

If an organization decides to elect the accounting alternative for accounting for identifiable intangible assets, it also must adopt the accounting alternative for goodwill. However, a nonprofit that elects to adopt the accounting alternative for goodwill isn’t required to adopt the accounting alternative for accounting for identifiable intangible assets.

Effective date and transition

Nonprofits can immediately elect to use these alternative reporting methods. If elected, the goodwill accounting alternative should be applied prospectively to all existing goodwill and for all new goodwill generated in acquisitions. And the alternative for accounting for identifiable intangible assets should be applied prospectively upon the occurrence of the first transaction within the scope of the alternative. Contact us for more information. Our accounting professionals can help determine if these alternatives are right for your organization.

© 2019