This June, I had the opportunity to speak at the AICPA & CIMA Not-for-Profit Industry Conference about common errors in financial statements and how to avoid them. Many of the most common errors relate to presentation and disclosure requirements that have been around for a while, but simply get overlooked or have not been revisited in quite some time. The objective of not-for-profit (NFP) financial reporting is making the information understandable to the donors and constituents of the NFP organization. To that end, it is helpful to review the overall presentation of the financial statements and the disclosures as a reader unfamiliar with the NFP might and to think about what questions they might have. Certain common errors, particularly pertaining to disclosures, may be identified during such an exercise. The common errors noted below are broad brushstrokes intended to spark additional conversation among NFPs and financial statement preparers.
Statement of Financial Position
The primary purpose of the statement of financial position is to provide relevant information about the NFP’s assets, liabilities, and net assets and about their relationships to each other at a moment in time. Accordingly, NFPs are required to present the financial statements and disclosures in a way that helps the reader to understand the information about the liquidity and availability of assets. A common error is presenting cash, investments, or other assets subject to donor-restrictions for long-lived assets or long-term purposes, such as endowment, within the same line of the statement of financial position as cash, investments, or other assets available for the NFP’s operations. Another common error is not sequencing assets and liabilities in order of liquidity, with those line items nearest to conversion to cash at the top of each section (assets and liabilities), and those items of a long-term or perpetual nature at or near the bottom. If right-of-use assets and lease liabilities are applicable to the NFP, such items should also be sequenced in order of liquidity. Presenting a classified statement of financial position is another way to communicate liquidity and availability of assets but is not required. Common errors in such presentations include omitting the required subtotals for current assets and current liabilities or not properly separating line items between current and noncurrent.
Statement of Activities
The focal point of the statement of activities is the presentation of revenue, gains and losses as either with donor restrictions or without donor restrictions. Expenses are reported as without donor restrictions. Aside from requirements to present the total change in net assets with donor restrictions, the change in net assets without donor restrictions, and the total change in net assets, there is flexibility within the presentation of the statement of activities.
Certain NFPs choose to present an intermediate operating measure, and in that case, there are certain items that are required to be reported within the operating measure. Such items include impairment loss recognized for long-lived assets to be held and used, costs associated with exit or disposal activity not involving discontinued operations, gain or loss on sale of long-lived assets not involving discontinued operations, and the service cost component of defined-benefit pension and postretirement plans. Conversely, components of net periodic pension cost and net periodic postretirement benefit cost, other than the service cost component, are reported outside of the operating measure. A NFP’s use of an operating measure is subject to additional disclosure requirements, if the nature of the items included in or excluded from operations is not readily apparent from the details on the face of the statement of activities.
Common errors in the statement of activities often relate to errors in the underlying accounting for transactions. Examples include improperly recognizing conditional promises to give as receivables and contribution revenue before the conditions are substantially met or releasing donor restrictions prior to the time or purpose restriction being met. NFPs may elect a policy to report contributions and investment return with donor restrictions that are met in the same period the revenue is recognized as increases in net assets without donor restrictions, but erroneously not follow that same election in the presentation of the statement of activities. Lastly, noncash gifts may not be properly recognized or reported in the statement of activities.
Analysis of Expenses
NFPs are required to present an analysis of expenses by both nature and function (matrix) in either the statement of activities, a statement of functional expenses, or in the notes to the financial statements. This information is intended to help donors, creditors, and others in assessing the NFP’s service efforts, including the costs of its services and how it uses resources. Common errors in the analysis of expenses by nature and function include:
1) improperly using categories of expenses that are not natural expense categories, proper examples of which are salaries, payroll taxes, utilities, supplies, rent, insurance, depreciation, etc., and
2) mischaracterizing expenses into the wrong functional categories of program, management and general, or fundraising.
Accounting principles generally accepted in the U.S. (GAAP) provide some guidance in determining the functional allocation of expenses. NFPs should look to that guidance when reviewing the analysis of expenses. Additionally, some NFPs erroneously try to include losses in the analysis of expenses, which do not belong and instead are reported in the statement of activities. On the other hand, certain costs that were netted on the statement of activities (cost of sales, cost of direct benefits to donors, etc.) should be presented within the analysis of expenses by nature and function.
Statement of Cash Flows
Common errors in the statement of cash flows primarily relate to misclassifying activities between operating, investing, and financing activities. However, one type of error lies in the presentation of the activity and totals in the statement of cash flows. NFPs are required to present the change in cash and cash equivalents and restricted cash and cash equivalents within the statement of cash flows. GAAP does not define restricted cash, so the NFP should disclose what is considered restricted cash and cash equivalents. Also, if the amount of cash and cash equivalents and restricted cash and cash equivalents is presented on multiple lines on the statement of financial position, a reconciliation between the total on the statement of cash flows and the amounts on the statement of financial position should be presented on the face of the statement of cash flows or disclosed in the notes to the financial statements.
Disclosures
In terms of the disclosures, most common errors relate to missing information. The nature of activities footnote is often missing required disclosures of accounting policy elections when GAAP provides a choice between alternatives. In addition, accounting policies should be present for any line item in the statement of financial position that is significant. The notes should agree or be easily reconciled back to the related totals on the face of the financial statements, as applicable. A disclosure checklist is a valuable resource to ensure all required disclosures have been made.
FINAL REVIEW
All financial accounting standards have a materiality component. As a final review, it is helpful to review each material line item within the financial statements for proper presentation and disclosure. For instance:
- Are existing disclosures still appropriate?
- Are there any new line items that require disclosures?
- Have significant accounting policies adopted in the current year been properly disclosed?
The result of this review is to enhance financial reporting – that original goal to make the information understandable to the donors and constituents of the NFP organization.
Click here to watch the webinar recording on this topic.
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