Viewpoints
Rules! Rules! Rules! - Why So Many Rules
Gerald Archibald
Originally Published In:
ROCHESTER BUSINESS JOURNAL
March 2007
Author: Gerald J. Archibald, CPA
“The business of government is to keep the government out of business – that is, unless business needs government aid.” Will Rogers
“Do we really need to do that?”
“Whatever happened to Al Gore’s initiative to cut government red tape?”
This interchange took place recently with a non-profit organization Board Chair. Her view of the messages I was delivering to their Board were not viewed in a positive and productive light.
As I often say, I don’t make the rules. So, please, don’t shoot the messenger!
This column addresses a relative flurry of activity in the area of non-profit financial reporting changes that you may or may not view in the same way as the Board Chair referred to above. Financial reporting changes required by the Financial Accounting Standards Board (FASB) and the Auditing Standards Board (ASB) continue to demonstrate that the non-profit sector is being viewed, in large measure, in a similar fashion to the for-profit sector, including publicly traded companies.
The basic stated objective of FASB and ASB can best be summarized in three words. ACCOUNTABILITY. TRANSPARENCY. CLARITY. As you read the financial reporting and auditing changes described below that may have significant impact on your organization, keep these three words in mind. These words reflect the mantra of government funders, legislators and the contributing public. The following definitions of these three concepts describe the objectives for your organization to achieve an effective state of operation.
ACCOUNTABILITY – Management and Administrative personnel of the non-profit organization must be accountable to the Board of Directors. Accountability extends to each individual staff member as well. There are many examples in recent non-profit scandals in which accountability between management staff and the Board was not effectively maintained.
TRANSPARENCY – This is a favorite word for legislators and government officials in describing the objective for Board and Management interactions. Ideally, Board members should feel confident that the information presented by Management is comprehensive, accurate, unfiltered and reflecting reality.
If there is any indication or suspicion of sugar coating, sweeping issues under the rug, filtering data and painting a fact pattern lacking clarity, the Board has not achieved the desired state of transparency with respect to Board and Management interaction.
CLARITY – Clarity is a pervasive theme of the financial reporting and auditing requirements described below. Essentially, the auditing profession has been given a swift kick in the backside since the passage of the Sarbanes Oxley Act in 2002, along with subsequent reform initiatives and proposals at the State and Federal levels.
The message is this. Auditors, in many cases, have not achieved clarity with respect to their communications to non-profit client Boards and Management. Without clarity, in the form of effective communication among all stakeholders, the organization exposes itself to a significant risk of errors, omissions, misappropriations and non-compliant activities.
Think of these three words and concepts as a three legged stool. Lacking any one of the three will create instability in your organization. If your organization needs work in any of these areas, address it now.
I recently attended the annual Non-Profit Conference in New York City presented by the New York State Society of CPA’s. I must say that some of the new reporting requirements described below will have you shaking your head. For me, the conference instilled a similar thought. Why can’t I be closer to retirement age? Alas, with two kids in college and, hopefully, a number of productive years in front of me, retirement is NOT an option.
COMBINATIONS (MERGERS AND ACQUISITIONS) OF NOT-FOR-PROFIT ORGANIZATIONS – Two exposure drafts for dramatically changing the financial reporting requirements associated with mergers and acquisitions in the non-profit industry were issued in October 2006. While not yet effective, it is anticipated that the requirements of the exposure drafts will be finalized during 2007.
In a nutshell, the key components of these new requirements are as follows:
1) Mergers of equals are no longer allowed. In other words the “pooling of interests” method of accounting is dead for the not-for-profit sector.
2) Every merger will have to identify which organization is the acquirer and which organization is the acquiree. This is not an easy thing to accomplish in the typical non-profit merger discussions.
3) Assets being acquired and liabilities assumed must be measured at fair value, not at historical cost. (See further discussion below on fair value measurements.)
4) The difference between the identifiable assets at fair value and the liabilities assumed plus consideration paid will result in substantially different financial reporting.
5) An excess of assets at fair value over liabilities plus consideration paid should be recorded as a contribution received by the acquiring organization.
6) If the assets acquired at fair value are less than liabilities plus consideration paid, the difference will be recognized as goodwill, an intangible asset, subject to an annual assessment of value.
These new requirements for mergers and acquisitions in the non-profit sector may result in greater difficulty in consummating transactions where, in the past, there was an expectation that the organizational combination represented a merger of equals. This may be viewed by many in the non-profit sector Board and Management arena, as the proverbial tail wagging the dog.
CONSOLIDATED FINANCIAL STATEMENTS – This is a project that has been ongoing since 1991. A glacier pace is a very complex area. The latest exposure draft of proposed rules was issued in June 2005.
Essentially, the requirements, when adopted, will require the following:
1) All not-for-profits in which a parent organization has a controlling financial interest in another not-for-profit organization should be consolidated. Separate company financial statements will not be allowed unless a consolidated financial statement is prepared for all entities in the controlled and affiliated group of non-profits.
2) The usual condition for defining “ownership” is having a controlling financial interest and a majority voting interest in the affiliate organization.
3) Once these provisions are adopted, it will potentially modify financial reporting relationships for separate company foundations, real estate holding companies, limited partnerships, real estate development projects and other affiliated activities to the sponsoring/controlling organization.
The best thing I can say here is that since this project has been ongoing for more than 15 years, it may be some time before the exposure draft requirements are formally adopted.
The FASB continues to issue accounting pronouncements and new financial reporting rules at a record pace. There are three Financial Accounting Standards (FAS) that are applicable beginning with 2006 or 2007 audit reports and financial statements.
FAS NO. 154 – ACCOUNTING CHANGES AND ERROR CORRECTIONS - Effective for the first time in calendar year 2006 audits, this pronouncement redefines accounting changes and error corrections and how they are to be reported. There are four types of accounting changes defined, as follows:
- Change in Accounting Principle (e.g. inventory valuation method)
- Change in Accounting Estimate (e.g. change in depreciation method)
- Change in Reporting Entity (e.g. presenting consolidated statements in place of individual entity statements)
- Correction of Errors (e.g. mathematical mistakes or GAAP errors)
The major change resulting from this statement is that voluntary changes in accounting principles must be applied retroactively (i.e. prior year financial statements need to be restated) versus the prior method, which allowed the cumulative effect of the change to be recognized in the current year statement of activities (i.e. profit and loss statements).
If you have a voluntary change in accounting applicable under this standard, you should be contacting your audit firm for purposes of defining the work necessary to apply the effect of this new pronouncement.
FAS NO. 157 – FAIR VALUE MEASUREMENTS - This statement establishes a consistent framework for measuring fair value. This is particularly important given the discussion above related to mergers and acquisition accounting. This statement is effective for financial statements beginning in calendar year 2008.
Fair value is defined 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. This statement clearly defines the circumstances and issues that need to be considered in defining fair value, measurement date and market participants.
FAS NO. 158 – EMPLOYERS’ ACCOUNTING FOR DEFINED PENSION AND OTHER POST RETIREMENT BENEFITS - This statement was issued in September 2006 and represents a significant change in the reporting requirements for organizations which sponsor a defined benefit pension plan. This statement does not change how plan assets and benefit obligations are measured under previous statements number 87 and 106. However, the sponsor employer now must recognize the over funded or under funded status of its defined benefit retirement plans as an asset or liability on its balance sheet, even if the plan is fully funded.
This is a HUGE change for pension plan and post retirement reporting. The effect of the change required by Statement No. 158 will be reported in a footnote disclosure in calendar year 2006 financial statements, unless the provisions have been retroactively applied. The statement requires the recognition of the funded status of the plan on the balance sheet for financial statements issued after June 15, 2007.
There are a number of implications for non-profit defined benefit plan employer sponsors resulting from moving the plan funding status from a footnote disclosure to balance sheet recognition. First and foremost, debt covenant provisions of loan agreements may be significantly affected. In addition, if the plan is under funded and requires the recognition of a liability, as is true with many plans these days, the fiscal credit worthiness of the organization could be substantially impacted. Many tax-exempt employer sponsors have frozen or terminated their defined benefit pension plans. Regardless of your plan’s status, the requirements of this statement should be discussed with your actuary and auditor during the 2006 audit process to determine the most appropriate timing and information necessary for adopting the financial reporting requirements required by this pronouncement.
After the pension plan reporting change, all other changes seem to pale in comparison. However, one other recent change in financial reporting requirements is worthy of note. During 2006, the Emerging Issues Task Force (EITF) addressed the issue of sabbatical leaves, which are most common in educational institutions. (To some extent in corporate America as well) The clarification issued related to FAS No. 43, Accounting for Compensated Absences. In summary, the requirement to recognize sabbatical leaves and similar benefits should be recognized currently on an estimated basis, if they become available after a set period of time. In English, the value of future sabbatical leaves and other similar benefits provided to employees must be included in the calculation of the compensated absences liability each year based on the present value of the projected future costs. They should not be reported on a pay as you go or as used basis.
The complexity of accounting and financial reporting standards continues to boggle my imagination and much of the CPA profession. The challenge for your organization Board and Management is to be absolutely sure that your external audit firm is knowledgeable and up-to-date with the constantly changing financial reporting environment.
WHEW! This was a tough column to write and probably a more difficult column to read. If any of these provisions affect your organization, I strongly recommend that you contact your CPA advisor and/or actuary immediately.
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