Be Creative

It is very easy as an accountant to lose sight of the big picture.  For those of us that work in U.S. or in another country away from the primary ministry as a part of a large organization, we generally work in cubicles, take few if any trips to “the field,” and have little interaction with the ministry of the organization other than anecdotal stories and expense invoices.  For those that do work in ministry countries, you may also be living in the capital city, working in a cube, holding a staring contest with a computer monitor.

In our world of Audit Risk Alerts and GAAP compliance, we can easily begin to think that following accounting guidance and producing sleek financial statements is the end goal.  We lose sight of the forest for the trees.  We push compliance to the detriment of the efficiency of the organization and the sanity of our coworkers.  Compliance is important.  GAAP must be followed.  I agree with both of those statements, and work hard at my organization to ensure that both stay true. But as accountants, and generally back office staff, we must work hard to remember why we are doing this as our visibility is limited.

Our ministry staff are working hard, overwhelmed with the burdens that I’m sure they face on a daily basis.  Our organization works internationally, with the poorest of the poor.  Our staff work in areas like South Sudan, and the DRC.  They are working with child soldiers, starving families, AIDS orphans, and victims of water-born illnesses.  In the midst of that they must also file expense reports, donor reports, grants reports, etc.  The question I ask is, how do we make this easier for them?  What can we do to help them have more time to concentrate on the program work they are doing?

I think accountants have the opportunity to be the most creative people in the organization (and in a good way, not the go-to-jail-for-fraud way) and this is why:  Being creative in an open space is easy.  It’s easy to “think outside the box” when there is no box to begin with.  Therefore, people in marketing and art and design departments of organization often get the credit for creativity.  In accounting and auditing, we are in a very constrained box.  To develop a truly creative, innovative idea that fits within the box we must use, we must be really creative.  We must think creatively inside the box.  This higher level of creativity is what gives accountants the opportunity to be the most creative employees.

By being creative in how we work, we can think about the end goal: the ministry and programs of the organization.  We can redesign processes, cut out unneeded burden, keep our financials in compliance so there are no unintended consequences, and keep our program workers focused on what they really need to be working on.

In conclusion, I challenge myself and the readers in two things:

(1)  Get to know your programs.  Invite members of your programs staff to speak to your accounting department.  Volunteer in local programs.  If possible take trips to field sites.  Ensure that you and your staff know what the organization does and what you are all working for.

(2) Be creative.  This isn’t something that is usually said to accountants, and it comes with a word of caution.  Don’t get so creative that you lose site of the rules and regulations that we must follow.  Getting your organization in trouble with auditors or the IRS can greatly diminish the impact of your organization.  But find ways to innovate inside the box.

Overhead rate is a poor measure of efficiency

There is no financial metric more scrutinized in the not-for-profit world than overhead percentage. As a result I am always hesitant to write on the topic because any article on overhead tends to be perceived as one of two messages: “Overhead rates are too high, and not-for-profits are not to be trusted” or “Overheads don’t really mean anything, so stop trying to compare organizations and just give us money anyway”. The truth is that organizations should welcome comparisons to peers. Such comparisons allow donors to make wise decisions, which results in funds flowing to the best managed not-for-profits. But, is overhead the best measure of quality management?

 
I like to point out that the effectiveness (not efficiency) is usually a donor’s primary concern when giving. At least this is true for me. Of course I would like the organizations to which I give money to be both effective and efficient. However, if you made me choose, I’d rather an organization make an inefficient but real change, than operate efficiently but fail to make a substantive change with their programs. The problem is that effectiveness is difficult to measure and much harder to compare across organizations. How do you compare teaching a child to read, saving a forest, and preventing a disease through immunization? In which case does a dollar achieve the most good? And even more challenging; how do you compare program quality across these categories? Absent comparable effectiveness measurements, donors and not-for-profits turn to overhead as a measurement of quality management. Overhead doesn’t measure effectiveness, but at least it measures efficiency . . . or does it?

 
I am participating in a project to measure the efficiency of the finance function across many of our organization’s ministry national offices. To do so, we’ve defined some efficiency metrics which allow us to compare our offices. These metrics include items such as cost per paycheck generated, cost per invoice paid, cost per employee expense report, etc. The common theme in these efficiency ratios is that the cost is divided by the outcome achieved. This allows for meaningful comparisons across offices, and useful evaluations of potential process improvements.

 
In doing this work I was struck by how different an overhead rate is from the efficiency metrics we are using. Overhead is not the measurement of cost against an outcome (cost per life transformed, cost per tree saved, cost per beneficiary trained), rather it is a ratio between types of costs (percentage of costs which are general and administrative, as compared to costs which are directly related to programs). This ratio among costs fails to capture actual efficiency and can lead to some surprising results. Consider a food shelter that is able to replace hired food servers with volunteers. The food servers are directly related to program activities, thus when they were paid the costs were programmatic. Removing these program costs increases the shelter’s overhead ratio. This works in reverse as well. Imagine a charity finds three vendor bids for a product needed for distribution in its programs. The organization could reduce overhead by intentionally purchasing from the more expensive vendor.

 
Now, these examples may be a bit of a stretch. However, I think you see my point. The overhead ratio rewards inefficiency in program costs, which are the majority of most not-for-profits’ costs. I certainly do not believe organizations are intentionally choosing inefficient program costs to manipulate overhead. But, I think it is possible that the focus on overhead rates can blind management to potential efficiency gains in program costs. Ironically, if donors and managers have been focused for years on managing to a low overhead rate, many organizations may have already realized the big efficiency wins in management and general expenses. For these organizations improvements in overall efficiency may yield higher overhead rates.

 
The strongest advantage of overhead as a metric is that it can be used to compare different types of nonprofits. Hospitals, schools, conservation groups, and homeless shelters all can be compared on overhead rate. Unfortunately this strength breaks down on more detailed inspection. One of the more interesting things I have learned since I started working for a nonprofit is that overhead closely corresponds with the type of nonprofit organization (or at least their funding source). Organizations with a large GIK component to their ministry often have very low overhead rates due to the value of the goods they distribute. Child Sponsorship organizations tend to have higher overhead rates due to the additional administrative effort required to connect each sponsor and child. (There are arguably programmatic and stability advantages to this higher cost). Grant funded organizations tend to have overhead rates which fall in the middle. In other words, the type of donations received can have a bigger impact on overhead rate, than the quality of an organization’s management.

 
So, what should we be measuring? There is clearly need for comparisons among not-for-profits. There are also benefits from these comparisons both for donors and management. But there are clear flaws in overhead as the comparison tool of choice. I think it would be wise to evaluate similar types of not-for-profits based on a grouping by mission (for example Relief & Development, Conservation, Medical Research, etc.). For each grouping an efficiency measure could be determined by dividing total costs by a common outcome metric. For example, animal shelters could report costs per animal served. Then efficiency could be better gauged for similar organizations.

 
I also think that breadth of analysis can be a solution as well. Part of the problem with overhead is that it is often viewed as the defining, authoritative metric. If other metrics are considered as well (unrestricted undesignated net assets, growth rate adjusted for organizational size, liquidity, etc.) a more complete and useful comparison emerges.

COSO exposure draft (to update the internal control integrated framework)

Has anyone read through all the 168 pages of the COSO exposure draft? I really wanted to read through all pages and provide comments on the draft prior to the March 31, 2012 comment deadline, but alas, life got in the way and I have made it through only one-fifth of the document.

In search for a quick ‘cliff notes’ (yes, this dates me!) version of the exposure draft, I came across many good comments. Here’s a selection of a few of them I’d like to share with you:
• Chief Audit Executives Roundtable on COSO exposure draft
• Norman Marks comments on the COSO draft
• FEI Financial Reporting Blog

In reading through the exposure draft, I have wondered why the COSO original cube has not been combined with the ERM COSO cube. In my line of work, it seems that the ERM COSO cube would be applicable and appropriate in almost all situations, which in my opinion, would render the original COSO cube irrelevant.

The COSO ERM framework (released in 2004) states that:
“The ERM framework encompasses internal control, forming a more robust conceptualization and tool for management. Internal control is defined and described in Internal Control – Integrated Framework. Because that framework has stood the test of time and is the basis for existing rules, regulations, and laws, that document remains in place as the definition of and framework for internal control. While only portions of the text of Internal Control – Integrated Framework are reproduced in this framework, the entirety of that framework is incorporated by reference into this one.”

As noted by Norman Marks, the update of the COSO internal control framework through the exposure draft was an opportunity to update risk management language in accordance with other recognized international risk management standards (such as ISO 31000) but this opportunity was missed with this exposure draft. The exposure draft addresses the relationship of the exposure draft with the COSO ERM framework by saying (on page 161) that “Enterprise risk management is broader than internal control, expanding and elaborating on internal control and focusing more fully on risk Internal control is an integral part of enterprise risk management. The COSO ERM framework remains in place for entities and others looking more broadly at enterprise risk management.”

When life slows down a little, I will follow up this post with some of my personal observations of the COSO exposure draft. I have some good (and long) reading ahead of me

For those of you who have read through the exposure draft, what are your thoughts?

Generally, it depends…

Often in our line of work we need to give an opinion about how certain activities should be accounted for.  Our customers regularly provide as little information as possible while at the same time wanting a firm conclusion.  However, our opinions are only as good as the information we use to formulate them.  So when I’m asked a question about how an activity would be accounted for, I often start out my response with “Generally, it depends.”

There can be black and white conclusions, but the facts and circumstances surrounding the transactions are the key to determining the appropriate accounting treatment.  Change one element, and your conclusion could vary widely. 

Webster defines accounting as the system of recording business and financial transactions and analyzing, verifying, and reporting the results.  This reinforces that accounting is not so much about the math, its about the process of recording and reporting.  That means we must exercise daily professional judgments in determining what and when to report. 

How can we help our customers navigate business decisions when the reporting implications have so many variables?  It is important to coach your customers to bring you into the conversation early.  This will help you get enough of the right information along the way to draw accurate conclusions about how to record and report the activities.   Participation in these conversations will also provide you an opportunity to help your customers make informed decisions.

When in doubt, make sure you get the facts, until then, well, it all depends.

A Good Audit Experience, Part II

Yesterday, I discussed some tips for NFP accounting departments for having a good audit experiences.  Today I wanted to give some tips to the external auditors, for working through their audits with clients.

Tips for the external auditors

1. Clearly communicate issues and errors immediately.  Few things are more frustrating for a client then to have a problem, issue, or error reported late in the audit process.  If these issues are raised early, the client can manage expectations, and often can provide additional information/context which would mitigate the error.
2. Be courteous of your client’s time.  Accounting departments at NFPs are generally short staffed.  Additionally, the latter half of the calendar year (when many audits take place) is the busiest time for many NFPs.  Understand that your clients are busy and have limited time available.  Clearly communicate your time needs to your clients.  Schedule interviews and walkthroughs ahead of time.
3. Be proactive.  Schedule audit dates well in advance.  Send out request lists in advance.  Offer things to the client that they can get done early.  Keep the client informed of new accounting issues that you know will affect them.
4. Be open and responsive.  The financial statements are those of the organization, and the organization knows how they run best, better than anyone.  Be willing to take the time and listen to the client’s explanations and expectations.  Give clients a chance to respond to errors, adjustment, and suggested changes.
5. Know the business.  Each organization is unique.  Not for profits span a variety of industries, from hospitals, to universities, to relief and development organizations.  Get to know not just your client’s industry, but how they run their business.  This will greatly increase your ability to have a successful relationship with your client, identify audit and business risks, and add the most value to them.  This will enable you to exercise good judgment when evaluating the client, rather than simply applying stock audit procedures.
6. Be creative.  You may not be able to get exactly what you want, or perform an audit procedure exactly the way the canned procedures states, especially if it is a new request.  Each client is unique.  New systems to track and report take time to put into place.  But if you think creatively, you can often identify information which provides good indicators to answer your questions and complete your procedures.
7. Add value.  Audits can often seem to clients to be a hassle and a waste of time.  Change this attitude by adding value to the audit.  Partner with the organization, encourage them to discuss issues with you, provide access to CPE.  Concentrate on the important things.  Clients are generally not going to what to deal with small, trivial issues or “reviewer’s preference.”  When presenting issues to the client, ensure its importance; clearly explain the effect on the financial statements and the audit.
8. Reversing entries ≠ fraud.  On most accounting systems, if an error is made to an entry, the only way to correct it is to post a reversing entry, then the correct entry.  Accounting systems are unforgiving.  Because of this, reversing journal entries are normal occurrences and generally not an indication of fraud.  Additionally, month end accrual entries are typically automatically reversed the next day.
9. Communicate regularly.  Hold regular status meetings with your client when the audit is taking place.  During the off-season, keep in touch with your client about the audit, and new accounting issues that need to be addressed.
10. Own the project management and timelines. (You will notice that this is also in the client’s tips). It is in both parties’ interest to create and stick to an efficient audit schedule. With both sides managing the timeline, due dates are easier to keep.  Schedule the audit well before you are to arrive at the client site (> six months).  Plan dates that you will be onsite and in the office.  Help the client determine the date that you will issue.  Plan for and schedule time for manager, partner and concurring reviews.

An audit can be a good experience for both sides.  We hope these tips help your next audit be a good experience for all.

A Good Audit Experience, Part I

Within our group here, we have many years of experience being external financial statement auditors and many years working in non-profit accounting, preparing financial statements, being audited, and conducting internal audits.  Seeing things from both sides of the table, we thought we’d offer some insights into working with auditors and not for profits, in order for both sides to have a good audit experience.  I’ve broken this up into two posts, to make it a bit more digestible.

Tips for the NFP accounting department (the client)

1. Don’t fear audits.  When working as an auditor, I would often get the reaction from clients that we were someone to be feared and cautious around.  Auditors are there to do a job that you have hired them for.  Most of them are friendly, outgoing, fun-loving 20-somethings (and looking younger by the day).  There are no tricks and auditors will generally give you ample opportunity to explain yourself.  Be friendly and build good relationships with your auditors.
2. See the auditors as partners.  Auditors have access to accounting resources, often well beyond what is available at a typical not-for-profit.  For instance, auditors visit several organizations throughout the year and therefore see the way that many orgs approach the same thing.  Additionally, they are backed by the other employees and partners of the audit firm who often have combined decades of experiences.  Many audit firms have members that are on FASB committees or other working groups, are presenting at conferences and teaching CPE.  The combined knowledge of the auditors is great.  Use this available resource to shore up your accounting practices, and interpret and apply new accounting standards.
3. Be pro-active in communicating with your auditors. Stop by; see if they have any questions.  Schedule regular status meetings.  Bring issues to them. This may seem counter intuitive, but it builds trust and ensures any issues which arise are resolved quickly and don’t spin out of control.
4. Be sure of your documentation and understanding.  The financial statements are yours, the organization’s.  Make sure that you understand the financial statements and therefore any changes that the auditors propose.  Also, much audit work is based on the documentation provided to the auditors.  When designing or evaluating your internal processes, make sure that each process and each transaction is well documented so that there will be an audit trail to follow.  An easy to follow audit trail will likely result in fewer questions from the auditors and answering questions will be easier.
5. Provide what they need.  Auditors generally want the audit to be done as quickly as you do.  Since the audit is dependent upon information that you provide, the timeliness of the audit often depends on how quickly and fully the client provides information requested.  To make this easier, obtain the PBC or Audit Request List from the auditor at least a couple months ahead of the audit.  Review the list and assign tasks to applicable people in your departments.  Finally, have the documentation ready for the auditors when they arrive on site.  Additionally, if there are known samples that the auditors will be choosing, provide the listings that they will choose from in advance, so that you can have the sample documentation ready when they arrive.  Ask the auditors if there is anything else you can provide in advance.
6. Own the project management and timelines. (You will notice that this is also in the auditor’s tips). It is in both parties’ interest to create and stick to an efficient audit schedule. With both sides managing the timeline, due dates are easier to keep.  Schedule the audit well before the auditors are to arrive (> six months).  Plan dates that they will be onsite and determine the date that you will issue.
7. Feel free to push back.  Sometimes, the auditors will request something that was not planned, that would require a large amount of work to prepare, or seems out of line with the audit.  If you have a legitimate concern with an audit request, feel free to push back in a cooperative manner.  Explain your position, why you think the request is unnecessary, and ask the auditors what they are trying to achieve.  When you know what they are trying to achieve, you can often find an alternative that would be more useful.  Additionally, during a time when the audit is not occurring, schedule time to meet with the auditors to go over the Request List and suggest changes as necessary.  The audit will still have to occur, and the auditors will need to do their necessary procedures, but take the opportunity to make sure the audit goes well for both parties.
8. Don’t take it personally. The auditors are not auditing you personally.  While you may be involved in key transactions, or in audit findings, it is not a mark against you.  The auditors are doing their job, working through procedures, and are not attempting to comment on anyone personally.
9. Keep up to date.  Accounting rules are constantly changing so keeping up to date on changes and standards can seem daunting.  However, there are many resources available.  Most major CPA firms provide webcasts and CPE trainings that are often free to attend.  The AICPA publishes yearly audit and accounting guides and industry updates that can be purchased from their website.  Keeping up to date on issues will allow you to respond effectively and efficiently.

(Tomorrow, tips for the external auditors)

internal audit’s contribution to value

The decline in the economy is impacting most organizations. Tough economic times are causing the ‘value’ question to be asked about many aspects of and groups within an organization. It is always a good practice for management to evaluate its organization and to understand the role and criticality of its people, processes and technology. It is a potentially time consuming and expensive exercise and the cost/benefit of performing this exercise has to be carefully weighed. Scarce resources force the hand to make this exercise necessary.  It can be akin to a zero based budgeting exercise or an effort to lean a process and remove unnecessary areas. 

Naturally, the value question will also be asked about the internal audit department. Some in the organization will jump at this opportunity to say “off with their heads!” All joking aside, in my experience I have seen this resistance and aversion to internal audit and have strived to not take this personally. Thankfully the stereotypical auditor is not innately a people pleaser. A comment was recently made to me during an audit that implied I needed to make good recommendations in order to justify my existence in the organization. I won’t tell you what my response was to that comment. You can fill in the blank. 

So, what do internal auditors bring to the table?

Are internal auditors 

a) enforcers, 

b) evaluators, or 

c) collaborators

Often we are seen as enforcers - making people do things they don’t necessarily want to do; or evaluators - the more extreme term being that of ‘judge’. Our role is seen as those that make judgments on someone else’s work and this judgment can come across as critical, potentially damaging and at its extreme, condemning. By nature of internal audit, we have to make judgment, or the technical term of forming an ‘opinion’ of the process we are evaluating. 

With such a perception even often prior to the start of any internal audit work, it is natural for a first response to audit to be self-preservation and protection, and it can be challenging to gain trust. The inclusiveness of being invited into a conversation and to the table prior to management decision making is even more of a stretch. Can internal audit hand in hand ‘judge’ what has happened in the past and add value to future decision making? In addition to being viewed as enforcers and evaluators, what would it look like if internal auditors were also seen as collaborators?

Technically, internal audit is an objective assurance and consulting activity. One of the definitions of assurance by Merriam-Webster is something that inspires or tends to inspire confidence. Simply, I like to think of it as helping to ‘make sure’ that internal controls and processes are right. We are providing assurance that internal controls are in place and working. Audit’s focus should be on controls that facilitate management’s achievement of objectives.

As auditors, if we focus first on objectives, and not risk and not controls; we will be focused on what the business is focused on – their goals, what they are trying to achieve. The risk and control assessment will be a natural secondary consideration when objectives are considered first.

An internal auditor’s work should be aligned with business objectives. As stated in the IIA’s international standards for the professional practice of internal auditing (IPPF), the purpose of an audit is (i) effectiveness and efficiency of operations, (ii) compliance, (iii) safeguarding of assets and (iv) reliability and (v) integrity of financial and operational information. It is a foundational aspect of doing business to comply with applicable laws and to have financial and operational information that are reasonably accurate. Additionally, any reasonable manager will naturally strive to safeguard their assets. The component of effectiveness and efficiency of operations is a more subjective measure but typically corresponds to effectiveness of meeting organizational goals/objectives and doing so in a manner that provides the best value for the resource expended. 

Compliance, reasonably accurate financial and operational information and safeguarding of assets are necessary foundations for doing business. They are basic building blocks for good governance. However, these factors alone are typically not the critical success factors or unique characteristics that set a business or organization apart from its peers or give it a competitive advantage. Often, these criteria are components of effectiveness and efficiency of operations, which are driven by key organizational goals. 

The question then from an auditing standpoint is – how would you evaluate the effectiveness and efficiency of operations given the often subjective nature of this aspect of a business? It is typically in this area of effectiveness and efficiency of operations that auditors can provide the most value to management. 

An example is provided below:

-Management desires to enter into a partnership that has potential to bring in significant revenue to the organization

-The recording of this revenue is straightforward: if the money is received revenue is recorded, but if it is not received, revenue cannot be recognized. Therefore in this example compliance with GAAP is not a concern

-Other types of compliance are specific to any contracts and agreements that might exist between the parties

-Safeguarding of assets is also not a high risk due to few cash based transactions

-What are management’s drivers for decision making in this situation and related risks? A few things that come first to mind are (i) revenue, (ii) ability to deliver on the contractual promises, (iii) reputation, and (iv) potential for this partnership to open doors for future opportunities 

-How can audit contribute to this transaction? The first obvious answer is that we cannot make the decision – that is management’s role. If we were involved in assessing the decision, which is typical of audit efforts, we could start with the typical compliance related aspects such as (i) ensuring revenue recorded is actual revenue, (ii) ensuring the contract was properly executed with all the appropriate approvals, and (iii) ensuring that it is an arms-length transaction. 

-However, what about other aspects of the organization such as consistency of the decision making with organizational objectives? How would we evaluate management’s assessment and balancing of the risk and opportunity? If some aspects of the potential partnership further the organization’s objectives while other aspects potentially hinder the organization’s objectives, what factors will be weighted higher to strongly influence the decision? How does management formally or informally set risk tolerances? Are processes in place to fulfill on the promises made as part of the partnership? These are some questions that an auditor could ask and assess when evaluating this potential partnership that could add value from the perspective of helping the organization gain clarity on their stated objectives, help ensure alignment of internal decision making with organizational objectives and facilitate organizational cohesion and unity around objectives.

There is a diagram on page 4 in PWC’s excellent article – Building a strategic internal audit function. This diagram has been a great visual aid for me in my role and provides greater clarity on the range of internal audit roles and contribution within an organization. 

In summary, internal auditors are risk and control experts. First and foremost we provide value specific to the foundational aspects of business – compliance, reasonably accurate information and safeguarding of assets – if it is lacking. In more mature organizations, we also contribute to product and process improvement and ideally will also influence improved governance and risk management.

Recognizing Contributed Services

In my work, I am often asked if we can book revenue for services performed by donors or volunteers.  The short answer is usually no, but we’ll look into the GAAP guidance to see exactly why that is.

(Though we don’t typically talk taxes in this blog, if you are interested in the rules surrounding contributed services by individuals, you should check out IRS Publication 526.  Services are not deductible by the individual, but direct expenses associated with serving may be)

The Accounting Standards Codification addresses contributed services in ASC 958-605-25-16 and 17 which is summarized here:

In order for contributed services to meet the requirement for recognition of revenue, they must meet one of two criteria:

1. They create or enhance non-financial assets.
2. They require specialized skills, someone with those skills performed the service, and the organization would have otherwise purchased the services.

If one of these two criteria is not met then revenue cannot be recognized.

First we’ll look at the first criterion:  “They create or enhance non-financial assets.”  An example of this is given in ASC 958-605-55-53 to 55-55.  An institute is constructing a building.  They have already purchased and obtained the necessary architectural plans, materials, permits and so forth.  A construction company then constructs the building for no cost to the institute.

In this case, the situation meets the first criteria above in that it is creating a non-financial asset for the institute (it may also meet the second criteria, but we’ll get to that later).  Now that the institute has determined they have revenue to recognize, they must assign a value to that revenue.  ASC 958-605-30-10 gives additional information for valuation.  Contributions that create or enhance non-financial assets can be valued at the either at the fair value of the services received or at the fair value of the asset enhancement resulting from the services.

In this example, the resulting value of the building (less the cost of the architectural plans, materials, permits, and etc purchased) could be used to value the services, or the cost that the construction company would have charged for the services.

Next, we’ll look at the second criterion: The services contributed “require specialized skills, are provided by individuals possessing those skills, and would typically need to be purchased if not provided by donation.  Services requiring specialized skills are provided by accountants, architects, carpenters, doctors, electricians, lawyers, nurses, plumbers, teachers and other professionals and craftsman.”

This criterion is pretty restrictive and would be difficult to meet, but it is also the criterion that I most often refer to when fielding questions.  Most non-profit organizations receive many hours of volunteer help of all kinds, but more often than not, these volunteers are probably providing services that are not considered specialized professional skills or crafts, and would not otherwise be purchased by the organization.

The ASC gives an example in 958-605-55-57 to 55-59 of a situation that meets this criterion.  A university has both paid and unpaid faculty members.  All faculty are utilized in the same way and evaluated under the same requirements regardless of compensation.  In this case, teaching is a specialized skill, professionals with that skill are providing the service, and the university would otherwise need to pay for the services.  The university could then record revenue for these services, and could reference similar staff salaries when valuing the services.

The best real world example of contributed services may be on the financial statements of the United Way (see Note 23).  As you’ve probably noticed, the United Way receives a large amount of television advertising during NFL broadcasts, including the Super Bowl.  The value of this air time from the NFL and others is significant and the benefit to the United Way is equally significant.  However, because of the high cost of the service provided, the United Way would not otherwise purchase the services on their own if they were not donated.  Though this is a specialized service to the United Way, it does not fully meet the second criteria and therefore, is not recorded as revenue.

If contributed services are provided to the organization and meet one of the two criteria, then revenue can be recognized.  In the case of the first criteria, revenue and the associated asset would be recorded at the fair value of the services provide.  In the case of the second criteria, revenue and expense would be recorded, again at the fair value of the services provided.

It is also worthy to note, that because contributions of services do not qualify as deductible by the individual providing the service, organizations should not issue receipts of donation for the services.  An organization may wish only to express appreciation for the contribution.

In conclusion, it’s good to keep in mind the accounting standards and refer back to them to answer accounting questions.  Often the answer is readily available.

What are the differences between IFRS and U.S. GAAP?

When I first realized the possibility of U.S. organizations converting to IFRS, my mind went quickly to one question: “What are the specific differences between US GAAP and IFRS?” I suspect that I am not alone. However, I have had trouble getting a straight answer to this question. This is probably for several reasons. First, most CPA’s are experts in one set of guidance (likely U.S. GAAP) and so we are all in the process of learning a new set of standards and so none of us feel prepared to speak authoritatively to the differences between sets of standards. Adding to this uncertainty is the fact that a “small” difference for most organizations can be huge for a specific company or industry. In addition, preparing this analysis would be a lot of work and the differences are also changing as FASB works with the IASB to converge key differences between current IFRS and US GAAP.

Fortunately as part of their assessment of IFRS as a potential reporting standard for public companies the US Securities and Exchange Commission (SEC) has reviewed and summarized these differences. Here is their report.  It is worth noting that the scope of this report excludes ongoing convergence projects as these were in process at the time of the assessment.

Here are some note-worthy differences to not-for-profits which stood out to me as I read through the document:

• Industry specific guidance – There is no doubt that the biggest impact on nonprofits is the lack of industry specific guidance. There is no equivalent to ASC 958 (FAS 116 & 117) in IFRS. This leaves significant portions of current US GAAP non-profit reporting unaddressed. There is room for voluntary application of concepts such as fund accounting.  (See this post, for my analysis of how this might work under IAS 8). I personally believe there are benefits to fund accounting, but there is a risk that the information value achieved through voluntary application of fund accounting would be traded for audit and reporting efficiency leading to lower costs.  The lack of specific industry guidance has other impacts as well. For example, there is no special guidance for tax exempt debt instruments sometimes utilized by healthcare organizations.
• Correction of errors – U.S. GAAP requires previously issued prior period financial statements to be corrected and re-issued when a material error is identified. Under IFRS when a material prior period error is identified, it must be corrected retrospectively in the first set of financial statements authorized for issuance after the discovery of the error. In other words past issued financial statements do not need to be restated and reissued.
• Cash and Cash Equivalents – Both sets of standards define Cash and Cash Equivalents similarly (IAS 7 & ASC Topic 305). However U.S. GAAP is more prescriptive than IFRS and so under IFRS it is possible that some investments (perhaps money market funds) may be deemed as investments rather than Cash Equivalents. Similarly an organization applying IFRS may deem certain investments with original maturities greater than 3 months as Cash Equivalents
• Inventory – IFRS does not permit the LIFO method of inventory valuation. All other methodologies allowed under U.S. GAAP (FIFO, weighted average cost) are allowed under IFRS as well.
• What does “probable” mean? – Here is a debate for you super accounting geeks. IFRS (IAS 37) says “probable” means “more likely than not to occur”; which basically means probability greater than 50%. However, US GAAP (ASC Topic 450) defines “probable” as “likely to occur”; which is generally interpreted as somewhat greater than 50%. Thus if some future event is 52% likely to occur it may be probable in Europe but not in America.
• Accruing contingent liabilities – When accruing contingent liabilities, IAS 37 directs organizations to accrue the “best estimate” as the “expected value”. If a range of equally possible amounts exists, a midpoint should be accrued. Under U.S. GAAP the minimum value of a range is to be accrued, if no amount within the range is a better estimate than any other amount.
• Uncertain tax positions – U. S. GAAP requires organizations to disclose uncertain tax positions at the specific tax position level. IFRS does require general disclosure of uncertain tax positions but the disclosure does not need to be at the specific tax position level.

These are just the items which stood out to me as I read through the SEC analysis. I do recommend you look though the detailed document if your organization is transitioning to IFRS.

Revenue recognition exposure draft (topic 605) – impact to non-profits

Welcome back from the holidays.  Did you finally make time to read through the 217 page revised revenue exposure draft issued recently on November 14, 2011?  Ok, me neither.  But with the help of a colleague, I made some progress skimming this draft, and I want to share some initial thoughts with you.

 Our skimming focused on revenue recognition for government grants which historically have been accounted for as exchange transactions.  This is because contributions are out of scope for this proposed standard (as are any other contracts which are in the scope of other standards, for example, insurance contracts or lease contracts).

The new draft standards main provisions are:

• Step 1: Identify the contract with a customer.
• Step 2: Identify the separate performance obligations in the contract.
• Step 3: Determine the transaction price.
• Step 4: Allocate the transaction price to the separate performance obligations in the contract.
• Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

So, does this standard apply to government grants?  First, I wonder if government grants accounted for as exchange transactions could also be out of scope for this proposed standard – do they fall under the scope of other standards, maybe ASC 958-605?  I haven’t had time to research that yet, but if they are scoped out because they are in the scope of other standards, language within this exposure draft seems to conflict with this conclusion.  This exposure draft notes that when a not-for-profit entity enters into a contract with a customer for a social benefit or charitable purpose, not-for-profit entities should be exempt from applying certain tests within this standard.  On the surface, this reference to contracts for social benefit or charitable purpose sounds like the FASB is scoping government grants into this draft by the fact that they are exempting certain steps for these specific contracts.

So what if government grants are under this draft standard?  Does that mean sweeping changes for government grant revenue recognition?  I’m not so sure that it does.  Here are some initial thoughts on where the steps lead when applied to government grants: 

 Step 1: Identify the contract with a customer

• No news here, this is pretty straightforward.

 Step 2: Identify the separate performance obligations in the contract.

• There is a difference between distinct services or bundled services…I’m not sure yet where I land on this yet.  Do you?

 Step 3: Determine the transaction price.

• Paragraph 31 of the exposure draft says “An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer.  An asset is transferred when (or as) the customer obtains control of that asset.” On the surface, I don’t see how the government obtains control of a social benefit service.  This feels a bit like forcing a round peg in a square hole…

 Step 4: Allocate the transaction price to the separate performance obligations in the contract.

• It looks like performance obligations for government grants are satisfied over time.  Paragraph 35-36 note that Performance obligations are satisfied over time if an entity’s performance does not create an asset with an alternative use to the entity and either one of the following is met:

1. The customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs.
2. The entity has a right to payment for performance completed to date, and it expects to fulfill the contract as promised.

 Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

• The control reference surfaces again here – “an entity shall exclude from a measure of progress any goods or services for which the entity does not transfer control to the customer.”  Transfer of control of a social benefit service may be difficult to define, I wonder whether there is any impact to the timing of government grant revenue recognition?
• There are two methods noted under step 5 for revenue recognition.  Measuring progress towards satisfying a performance obligation may include an output method or input method.  The input method includes recognizing revenue on a basis of the entity’s efforts or inputs to the satisfaction of a performance obligation (for example, costs incurred).

Where does that leave us?  With several questions to consider…

• Do exchange transactions fall within the scope of another standard?
• How do we define when our “customer” (the government) obtains control of the promised service (asset)?
• What about situations where we don’t fulfill the performance obligations(s) or only partially fulfill them? 
• What about situations where someone else outside of the organization is fulfilling the grant, i.e. subgranting?

If you can connect the dots on the control phrases without any unforeseen problems, it would seem as though revenue may be recognized over time, and that it may be recognized as costs are incurred (or expended for grant purposes).

 I’m sure we’ll all understand more as we unpack this exposure draft.  In the meantime, I’m going to continue reviewing this exposure draft to determine whether its necessary to comment before the March 13 deadline.  My one request today?  I would like to request FASB not make the same oversight in this Revenue Recognition standard they made in the Fair Value standard – my request is to please include examples for non-profits!