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IFRS Update . . . again

The problem with having a specific interest in new accounting guidance early in the process is twofold, first, you can be tempted to overreact to each pulse and zig in the conversation. Second, you can get so tired of the back and forth you can lose interest in the issue entirely. I feel I am nearing this second phase with IFRS adoption/convergence in the US. Over the course of the last several years I’ve shared several of my thoughts on how this conversation is going and what the impact might be for not-for-profits. However after years of delay and non-events . . . I’m beginning to lose interest.

However, while I’m tempted to tune out IFRS news and dismiss the efforts because they have not yet lead to a single global standard, I think this attitude is premature and fails to celebrate the successes made. In this spirit I share the following article:

IFRS Foundation Trustee: Don’t wave white flag on cooperation

I was particularly struck by this line by James Quigley: “If the ambition is a single set of high-quality, globally accepted, and, in my view, principle-based standards, we’re closer now than we were five years ago, and five years from now, we’re going to be closer again.”


Reporting on Capital Expenditures . . . or . . . Budgeting Fixed Assets

Last week I was having an interesting conversation with a friend in our budget and analysis department. We were discussing the best way to budget and report on capital purchases. I realized that we can’t be the only accountant and financial analyst to struggle with the best way to treat fixed assets. I also expect many of you have mastered this years ago; but I’m sharing the basics of our conversation here in the hope that some of you also find it useful or interesting.

The concept of capitalizing fixed assets and recording regular depreciation is well established in GAAP accounting. Most accountants can flash back to their first accounting professor using equipment to demonstrate the matching principle. Likewise we would all have some explaining to do to our auditors if we told them we didn’t capitalize fixed assets. GAAP reporting is understood (at least by accountants) . . . so I’m setting it aside for this conversation.

The conversation gets more interesting when we talk about how an organization chooses to budget and report on fixed assets internally. My conversation contrasted two methods of planning and reporting on fixed assets for management purposes. The first is to mirror GAAP accounting when budgeting. Under this approach fixed assets are tracked by department, and budget managers see ongoing depreciation expense in their monthly reporting. The second method is to expense all fixed assets at time of purchase (for budget and internal reporting purposes). Department managers would budget the full amount of the initial purchase, but would not consider ongoing depreciation.

Let’s explore this capital expenditure method a little more. I like this method because it is simple and easy for non-finance managers to understand. Shocking as it is to my little accounting soul, it turns out that not every manager would automatically think to budget depreciation for the next five years after purchasing a new copier. The capital expenditure method allows managers to budget as money is spent. This brings me to the next advantage. Generally the capital expenditure method follows cash flow. This is how most people think when budgeting.

Not surprisingly, what is easy for non-accountants requires some extra work from the finance side of the house. In case you were wondering how this method is compliant with GAAP reporting, here is how it works: When a fixed asset is purchased, it is booked as debit to a capital expenditure account and to the purchasing manager’s department/cost center (Debit expense, Credit Cash). At least once a month all activity in the capital expenditure account is credited, using a non-reporting department/cost center. The offsetting debit goes to fixed assets (Debit fixed asset, credit expense). Accounting tracks and records depreciation expense as usual, recording the expense to the same non-reporting department/cost center. We call this department “accounting use only” and both the budget and accounting teams know that its sole purpose is to re-class capital expenditures to the balance sheet and record depreciation.

The “mirror GAAP” method of budgeting for fixed assets also has some advantages. We already discussed how this method has straight forward accounting. In addition mirroring GAAP highlights capital assets and their long term nature to budget managers because depreciation expense continues to impact their budgets and reports for years after an initial purchase. For this reason this approach works well in organizations that have developed a robust capital budgeting program, to track, prioritize, approve, fund, and monitor long term investments in the business.

I see two potential disadvantages to the GAAP style approach to budgeting for fixed assets. The first is that expense trails cash flow. This can lead to liquidity challenges. Now liquidity can certainly be tracked (and arguably should be tracked) and managed independently of the budget and reporting of expenses. However, human nature often seeks to pay for today’s purchases with future budgets. (Examples include J. Wellington Wimpy – “I’ll gladly pay you Tuesday for a hamburger today” . . . and the national debt of every democracy I’m familiar with). Therefore, caution should be exercised to make sure that the organization has revenue or reserves to cash flow expenditures which will be charged against future budgets.

The second potential disadvantage is that if managers’ budgets continue to be impacted by ongoing depreciation, this may lead them to make future decisions based on sunk costs. Although, as I think about it further, it is probably unfair to bring this into the conversation. After all if your managers make decisions based on sunk costs, the fault is probably with the managers, and not the reporting model.

Both models can be appropriate for different organizations at different times. Factors to consider in choosing between them include:
• The level and importance of capital expenditures to the organization
• The maturity and sophistication of the organizations budget managers
• The maturity and sophistication of the organizations accounting team
• How the organization manages its cash flow, and its general liquidity position.


The Future of Not-For-Profit Financial Statements

There are several recent developments which are likely going to have a significant impact on how nonprofit financial statements will look in the future: The establishment of the Private Company Council, the future of IFRS, and new projects added to the FASB agenda as a result of the efforts of the Not-for-profit Advisory Council.

I wrote previously about the debate about how FASB and the FAF should accommodate the needs of private companies. After the debate, letter writing campaigns, and press releases, the conversation settled down to what seems like a compromise: There is a new Private Company Council (PCC) which does not have any FASB member on it. This PCC will examine current and new GAAP standards looking for changes, exceptions and practical expedients for private companies. The PCC’s recommendations are subject to a simple majority approval by the FASB. It is important to note that Not-for-profits are not considered private companies and will not directly be affected by the work of the PCC. However there are two ways the PCC could impact NFP financial reporting. First, I suspect that the work of the PCC will highlight the resource constraints of private companies which will also bring attention to NFP resource constraints. Second, I think that the PCC work will result in practical expedients which will be logical for FASB to extend to NFPS as well.

Another area of change has been the broader talk of US entities moving to IFRS. It seems like it has been years that we have been waiting for the SEC to state a clear direction for public companies. We are still waiting, but there has been a shift in the perceived direction of the conversations. (Here is a great article on the latest IFRS developments, if you are interested) While it may still be possible that the US will go to IFRS at some point, if we do I think that we will likely retain a strong “US flavor”. It is likely that the FASB will retain independent standard setting authority. This may mean that some of the areas where US GAAP has more detailed guidance will remain in effect. ASC 958 for nonprofits is a great example of this.

The most industry specific changes are likely to come from the latest work of the FASB’s Not-for-profit Adversary Council (NAC). The NAC just completed a review of the not-for-profit financial reporting model. There has been some thought in the industry that FAS 116 & FAS 117 should be reviewed and perhaps refreshed or updated. The NAC divided their efforts into three areas:

  • Reporting Financial Performance – This group focused on reporting the results of the period paying particular attention to the statement of activities and statement of cash flows. The group agreed that there was room to improve the reporting of finance performance. One topic often raised for discussion is the idea that NFP’s should have some sort of operating measure (like net income) rather than merely reporting changes in net assets. The challenge with this concept is to find an operating measure(s) which is relevant across the diversity of NFPs. What is meaningful for a university is likely not as relevant for a conservation organization or food bank.
  • Liquidity and Financial Health – There is general agreement that liquidity information is both important, and not as clear as it could be under current GAAP. The NAC recommended that the FASB revisit the current net asset classifications and also consider alternate methods of improving liquidity information.
  • “Telling the Story” – Donors are very interested in what an NFP does, and how effective it is. These interests sparked a conversation about whether GAAP should require some form of MD&A for not-for-profits to expand the story of the organization in the financial statements. Of course organizations can voluntarily do this now, and many organizations produce annual reports highlighting programmatic accomplishments. However, the question is if there is value in standardizing and requiring this information under GAAP.

As a result of the NAC’s recommendations the FASB has added three new NFP standard setting projects on its agenda. These are:

  • Reexamine net asset classifications and improve liquidity information
  • Improve reporting of financial performance
  • Streamline and improve NFP-specific disclosures

In addition, the FASB has committed to do further research on the concept of an MD&A for NFPs. This research may or may not result in a future standard setting project.

So, it appears we are in the beginning of a season of change in nonprofit financial reporting. Now is a great time to make yourself heard. Be aware of these projects, and provide feedback and comments as you have them.


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.


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.


FAF says “no” to separate private company standard setting board

I’ve written previously  about the debate over private company reporting and the AICPA’s lobbying of the Financial Accounting Foundation to adopt the Blue Ribbon Panel’s recommendation for a separate standard setting board for private company GAAP.

On October 4, 2011 the FAF came back with an answer: “No”. The FAF instead opted for a separate “Private Company Standards Improvement Council” which would recommend changes to current GAAP for private companies to the FASB. The FASB would than make any changes to GAAP. This model is similar to the EITF model to handle emerging technical issues. Rather than restate or summarize this statement I thought it might be helpful to provide:

A link to the FAF executive summary of their recommendation  

A link to the AICPA’s response.

This story is not necessarily over. The FAF recommendation is open to public comment and as a result it is likely that there will be continued pressure on the FAF to revise their decision. However, the AICPA and private companies have made their voice heard already. I wonder if FAF would actually change its mind, since they resisted the first wave of public outcry for a separate board.


A Summary of Foreign Currency Accounting

Foreign currency accounting and reporting can be broken into two categories: foreign currency transactions and foreign currency translation. Transaction guidance covers how to account for transactions denominated in a foreign currency. Translation guidance describes how to convert an entire set of books to a new reporting currency (for example when consolidating a foreign subsidiary)

Key Definitions

Functional Currency – the currency in which most of en entireties transactions are denominated.

Reporting Currency – The currency in which an entity reports its financial statements

Local Currency – the currency of a particular country being referenced.

Foreign Currency Transactions (ASC 830-20)

Most entities report in their functional currency. In these cases, when the organization enters into a transaction denominated in a currency other than its functional currency, it must initially measure the related assets, liabilities, revenue or expenses in its functional currency at the date the transaction is recognized using the exchange rate in effect that date.

When an organization has assets or liabilities which are denominated in a currency other than its reporting currency, fluctuations in exchange rates lead to foreign currency transaction gains or losses. Let’s take a look at an example: Imagine a US based company whose functional and reporting currencies are both the US Dollar has one bank account denominated in Canadian Dollars. Every month when the company closes its books it will mark the Canadian Dollar bank account to USD using the rate at the end of the month. This will almost certainly result in a gain or a loss even if there was no other activity in the account.

Foreign Currency Translations (ASC 830-30)

When consolidating foreign subsidiaries, a different type of foreign currency gain/loss occurs.  When subsidiaries are converted to reporting currency year over year there is also a gain or loss which occurs due to the fluctuation of exchange rates.

GAAP instructs practitioners to convert balance sheet accounts using the exchange rate at the balance sheet date. Income Statement transactions are to be converted using the exchange rate in effect on the recognition date for each transaction. (The FASB acknowledges that not all organizations have the systems, and processes in place to capture transaction date exchange rates for all income statement items. As a result, it is acceptable to utilize an appropriated weighted average exchange rate for the reporting period when converting income statement items).


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