The City of Rochester, NY, is like most “Rust Belt” cities. It was once a global center of manufacturing, but since the mid-1980s, it has shed thousands of manufacturing jobs. Tax revenues have lagged, and the City’s overall financial position has slowly eroded. The mayor and other local leaders have invested substantial public resources in local programs for the past two decades to promote economic and community development.

Communities like Rochester face a financial dilemma. Some local leaders believe the city should do much more to promote economic and community development. Despite its financial problems, Rochester does have one key financial strength: a comparatively low debt burden ($775/capita). Unlike many of its peers, it has not issued a lot of bonds or other long-term debt that it will need to repay over time. Some leaders believe it could borrow money to invest in infrastructure projects that would spur economic growth, grow the tax base and, in effect, pay for themselves. Or at least that’s the theory.

Others disagree. They concur that the city has carefully managed its borrowing and does not owe investors much money. However, they point out that Rochester has an enormous amount of “other” long-term debts ($3,927/capita). Principal among them is “other post-employment benefits” or OPEB. Like many of its peers, Rochester allows its retired city workers to remain on its health insurance plan. Moreover, it pays most of the insurance premiums for those retirees and their families. Many thousands of retired City workers are expected to take advantage of this benefit for years to come.

Under governmental accounting rules, the money Rochester expects to spend on OPEB benefits over the next 30 years must be recognized as a long-term liability today. Those rules follow from the idea that employees earn OPEB benefits as part of their salary. Once earned, those benefits become a liability that appears on the City’s balance sheet. Rochester can change those benefits at any time, but until they do, they remain a long-term obligation of the government.

This anecdote highlights one of the key points of this chapter: How we account for – or “recognize” – financial activity can have a major impact on how an organization perceives its financial strengths and weaknesses and how it might choose to manage its finances in response. That is why all public managers must not only know how to analyze financial statements but also understand the origins of the numbers that appear in those statements. In other words, they need to know a bit of accounting. That is the focus of this chapter.

CORE CONCEPTS OF ACCOUNTING

Now that we’ve toured the basic financial statements let’s take a step back and review how we produce those statements. Financial statements are useful because they’re prepared according to generally accepted accounting principles (GAAP). To understand financial statements, you must know a few of those principles and how typical financial transactions shape the numbers you see in those statements. This section covers both these topics.

THE ACCRUAL CONCEPT

Most of us organize our personal finances around the cash basis of accounting. When we pay for something, we reduce our bank account balance by that amount. When we receive a paycheck, we increase our bank account balance by that amount. In other words, we recognize financial activity when we receive or spend cash.

Many small organizations also use cash basis accounting. Many small non-profits and governmental entities (e.g., irrigation districts and mosquito abatement districts) keep separate books to track revenues received and other operating expenses paid.

But for larger and more complex organizations, cash basis accounting tells an incomplete story. For instance, imagine that Treehouse (the organization in our previous examples) plans to purchase $20,000 of furniture for its main office. Treehouse will purchase that equipment on credit. That is, they will order the equipment, the supplier will deliver that equipment and send an invoice requesting payment, and a few weeks later, Treehouse will write the supplier a check and pay off that invoice.

This transaction will have an impact on Treehouse’s balance sheet. It will draw down its cash and report a fixed asset that will stay on the organization’s balance sheet for several years. Treehouse’s stakeholders should know about this transaction sooner rather than later.

But on a cash basis, those stakeholders will not know about this transaction until Treehouse pays off the invoice. That might be several weeks away. If it is toward the end of the fiscal year – and several large purchases happen toward the end of the fiscal year – those transactions will not appear on Treehouse’s financial statements until the following year. That is a problem.

That is why most public organizations use the accrual basis of accounting. On an accrual basis, an organization records an expense when it receives a good or service, whether or not cash changes hands. In this case, as soon as Treehouse signs the purchase order for the equipment, that purchase will appear as a $20,000 increase in non-current assets on its balance sheet. It will also record – or recognize, in accounting speak – an account payable for $20,000. On the accrual basis of accounting, we can see how this transaction will affect Treehouse’s financial position now and in the future.

Keep in mind that accrual accounting assumes the organization is a going concern. That is, it assumes the organization will continue to deliver services indefinitely. If we are not willing to make that assumption, then accrual accounting does not add value. In some rare cases, the audit report will suggest that the auditor believes the organization is not a going concern. In other words, the auditor believes the organization’s financial position is so tenuous that it might cease operations before the close of the next fiscal year.

We can apply similar logic to the revenue side. Imagine that Treehouse staff run a day-long outreach program at a local school. The program sensitizes public school teachers about the unique challenges facing children in the foster care system. They typically charge $2,500 for this type of event. Assume that Treehouse staff deliver the program and then send the school district a bill for their services. Treehouse used a lot of staff time, supplies, travel, and other expenses to produce this program, but they might not get paid for it for several weeks.

On a cash basis, it will be several weeks before we know about expenses incurred and that Treehouse has earned $2,500 in revenue. But on an accrual basis, Treehouse would recognize expenses incurred and the revenue earned immediately after delivering the program.

In accrual accounting, revenues are recorded when entitled, irrespective of receipt of payment, and expenses are recorded when resources are used, irrespective of when payment is made.

These two simple transactions illustrate a key point: If the goal of accounting and financial reporting is to help stakeholders understand an organization’s ability to achieve its mission, then accrual accounting is far better than cash accounting. That’s why the accrual concept is a central principle of GAAP. From this point forward, we will focus exclusively on how to apply accrual accounting to public organizations.

This transaction decreases both sides of the equation. The decrease in cash balances represents payments to the supplier (accounts payable).

Organizations execute a wide variety of transactions in their day-to-day operations. For most transactions, you can identify the correct accounting recognition by asking a few simple questions:

1. Did the organization deliver a good or service?
2. Did the organization receive a good or service?
3. Did the organization make a payment?
4. Did the organization receive a payment?

If the organization delivers or receives a service, the transaction affects revenues and expenses. Note that revenues will increase net assets, and expenses will decrease in net assets. If the organization delivered or received a good, the transaction likely affects assets, liabilities, or net assets (as either revenues or expenses). More importantly, whether or not the transaction affects a liability has to do with whether a payment was made or a payment was received.

The chart below presents these concepts as a flow chart. Take Transaction 1 as an example. Recall that Treehouse agreed to purchase furniture and equipment and pay for it later. Has it received a good or service? Yes, it has received a good, but it has yet to make payment; as a result, we report an increase in equipment and a corresponding increase in accounts payable.

To reference the flow chart, identify whether the organization was receiving or delivering a good or service and whether payment has been made. We know Treehouse received the equipment order, but payment has yet to be made. Therefore, this transaction starts on the bottom left corner of the chart at “Receive a Good.” We know goods have been received, but payment has not been made. We, therefore, follow the “Payment Not Delivered” line of the flow chart. We would recognize this transaction as an increase in equipment and accounts payable since Treehouse will pay for this equipment later.

With this framework, we can do accounting recognition for most basic transactions. That said, governments and non-profit organizations have unique rules that apply just in those contexts. We will cover nuanced accounting rules in the discussion that follows. That said, always remember:

TRANSACTIONS THAT AFFECT THE BALANCE SHEET

Transaction 1 and Transaction 2 are good examples of financial activity that affects the balance sheet. You should be aware of a few others. Some transactions affect only the asset side of the equation. For instance, imagine if Treehouse had purchased the equipment with cash rather than on credit.

Transaction 1b: Treehouse pays for the purchase of $20,000 in furniture and equipment in cash.

In Transaction 1a, Treehouse purchased office furniture on credit, so we recognized in that transaction an increase in a liability account – accounts payable. In Transaction 1b, Treehouse paid for the purchase of equipment in cash. The transaction resulted in a decrease in cash and an increase in equipment. As we noted earlier, the net effect of any transaction on the fundamental equation must be zero, even when no liability account or net asset account was affected. Now assume the transaction was as follows:

While we report two separate transactions here – the first being the purchase of equipment on credit and the second being the payment to the supplier – the net effect of this transaction would be an increase in equipment and a decrease in cash – the same as what we reported in Transaction 1b.

Like most organizations, Treehouse likely purchases a wide variety of services that it uses later. Examples include insurance, certifications, subscriptions, and professional association memberships. Treehouse will purchase these services in advance and then use or “expense” them throughout the fiscal year. These are known as pre-paid expenses. For example:

Transaction 3: Treehouse pays $1,500 for three of its staff to renew their annual memberships to the National Association for Social Workers. 

In Investments, we record the sale of these assets at historical cost ($192,219) and deposit the proceeds from the sale of the asset in Cash ($268,0385). On the Net Asset column, we report realized gain from the sale of the stock (i.e., $268,038 – $192,219=$75,810).

Fair value accounting is a bit more complex – and interesting! – than historical cost because it requires organizations to restate the value of their financial assets at the end of every fiscal period. For Treehouse, this means it would restate the value of all financial investments at the end of each year, even if it did not sell these investments.

If the stock’s price at the time of the re-statement is higher than the previously recorded price, Treehouse will record an increase in investments on the balance sheet and an unrealized gain on the income statement. If the stock’s price at the time of re-statement is lower than the previously recorded price, Treehouse will need to record a decrease in investments on the balance sheet and an unrealized loss in the income statement.

Transaction 6: Treehouse recognizes unrealized gains and losses in Amazon and Boeing stock at the end of FY 2020.

Unrealized gains and losses do not directly affect the amount of cash reported – hence why they are euphemistically referred to as paper gains and paper losses. Notwithstanding, unrealized gains or losses matter, as they represent a real change in the value of financial assets and the resources in an organization. If Treehouse’s holdings of Amazon stock contribute substantial unrealized gains for several years, management might consider selling its holdings to realize gains and invest in programs, equipment, or facilities.

Public organizations frequently borrow money to finance the purchase of equipment, pay for renovations to property, purchase new property, or cover operating expenses. Loans include lines of credit, notes payable, mortgages, and municipal bonds. A line of credit is an agreement between an organization and a bank that allows that organization to borrow money on short notice at a pre-determined interest rate. A line of credit can be especially useful if an organization has unpredictable cash flows. Notes payable are short-term loans with maturities ranging from 18 months up to 60 months. A mortgage is a loan secured with real estate. Unlike mortgages, municipal bonds and notes are unsecured or secured with pledged revenues, not property. Like mortgages, municipal bonds have a longer maturity of up to 30 years.

Borrowers have to pay interest on the loans at a fixed rate. There are exceptions. Interest rates on lines of credit and some municipal bonds are variable or floating rates (e.g., prime rate + 4.00%).

The initial accounting recognition of a loan is simple. The borrowed money, or loan principal, is recognized as a liability that offsets the cash received from the loan:

Transaction 7: Treehouse borrows $30,000 from a local bank to finance the purchase of a van. The loan is for five years at seven percent annual interest, and interest is paid annually. Treehouse purchased the van immediately after the loan closed.

The purchase of a van results in an increase in a non-current asset (equipment). However, the full loan amount is not a current liability – only the amount due in the next 12 months is reported as a current liability – and the remainder is a non-current liability. As a result, the non-profit is not less liquid, as only the current portion of the loan is considered a current liability. On the asset side, cash remains unaffected, as all the proceeds from the loan were used to purchase the equipment.

Transactions related to repaying debt present some special accounting considerations. Consider the previous example. Treehouse has agreed to pay interest on the loan each year the loan is active. The $30,000 loan principal is a liability; the interest on that loan principal is not. Payment of interest on the loan is an expense. Treehouse will be paying the bank (or lender) for access to credit, which in essence, is a “service.” For that reason:

Transaction 8: Treehouse makes its first annual principal and interest payment on the loan described in Transaction 7.

Since the $30,000 loan is paid off annually over five years, the annual payment on the principal is $6,000, or $30,000/five years). The interest rate on the loan is seven percent, so interest expense is equal to $2,100, or $30,000 X 0.07.

In year 2, the current portion of the loan would be $6,000, and the non-current portion would be $18,000. The total loan outstanding would be $24,000 (i.e., $30,000 – $6,000 or $6,000 + $18,000).

Treehouse would pay $7,680 to cover a $6,000 payment on the loan principal and $1,680 of interest expense (i.e., $24,000 X 7%).

If Treehouse did not make its interest payments on time, the expense would be recognized as a liability. The non-profit would also need to recognize as an expense (if paid) or liability (if unpaid) if the lender imposes additional fines or penalties as a result of non-payment.

TRANSACTIONS THAT AFFECT THE INCOME STATEMENT

Treehouse’s mission demands that it focus most of its efforts on delivering services. As a result, most of its day-to-day financial activity will involve revenues and expenses. Revenues and expenses affect the income statement.

For instance, recall from the earlier discussion that Treehouse delivers outreach programs at local schools. When one of those programs is delivered, it records revenue.

Transaction 9a: Treehouse delivers an outreach program at a local school and sends that school district an invoice for $2,500.

Here Treehouse has earned revenue because it delivered a program. It recognizes those earned revenues as “program revenue.” Program revenues represent an increase in net assets “without donor restrictions.” Restrictions would apply for public support, including donations, in-kind contributions, and foundation grants—more on this below.

Did it receive a payment? No. We, therefore, need to recognize a receivable on the asset side. The receivable is an accounts receivable since revenue is earned. For donations, the receivable would be pledges receivable; for grants, the receivable would be grants receivable.

Three weeks later, when Treehouse collects payment, it will convert that receivable into cash. That transaction is as follows:

Transaction 10: Treehouse receives payment from the school district for the outreach program delivered three weeks ago.

Transaction 10 does not affect the income statement but remember that the transaction that resulted in the original accounts receivable did.

Note, if Treehouse had received payment immediately at the end of the session, then:

Transaction 9b: Treehouse delivered an outreach program at a local school and received a payment of $2,500.

In Transaction 9, Treehouse earned revenue. Of course, that revenue did not just appear. Treehouse incurred various expenses – staff time, travel, supplies, etc. – to deliver that service. When should it recognize the expenses incurred to deliver that program? One of the core principles of GAAP is the matching principle. That is, when we recognize revenue, we should recognize expenses that were incurred to produce that revenue. This is not always clear for services. Services are driven by personnel, and we incur personnel expenses constantly. Services also require equipment, certifications, and other assets where it is not always clear what it means to “use” that asset.

The matching principle is more applicable when the transaction involves a good rather than a service. When an organization sells a good, it presumably knows what it costs to produce that good. Those costs, known generally as the cost of goods sold, are immediately netted against the revenue collected from the transaction. That is why, in the flow chart above, you see some additional recognition related to delivering goods.

That said, public organizations encounter a few typical transactions that account for many of their expenses. First and most important is when Treehouse pays its staff and recognizes salary expenses.

Transaction 11: Treehouse recognizes and pays bi-weekly payroll of $15,000.

Payroll is critical because personnel is the largest expense for most public organizations. From the organization’s perspective, payroll is an expense because it receives services from its employees. That “service” is their day-to-day work. This is different than if the organization hired the one-time services of, say, a plumber from another company to fix some leaky pipes. But the accounting recognition is essentially the same.

Keep in mind that there is frequently a lag between when wage expense is recognized and when payroll is remitted. The first transaction recognizes the expense; the second transaction recognizes payment on an outstanding liability. The initial transaction would be reflected in the income statement; the subsequent transaction would not.

Treehouse incurred other expenses to deliver the school outreach program. The program was held at a school 100 miles from the non-profit’s headquarters. The two staff members who delivered that program rode together to that off-site location in their personal vehicles. They will expect to be reimbursed. Many non-profits and government organizations follow the federal government’s guidance and reimburse mileage at a fixed rate of 57.5 cents per mile.

Transaction 12: Treehouse pays mileage expenses of 57.5 cents/mile for a 100-mile round trip for two staff members.

To deliver the outreach program, staff used up $100 of construction paper, colored pencils, and other supplies. Recall that supplies are an asset. To account for the full cost of the outreach program, we should also recognize that Treehouse “used up” or “expensed” these assets. For example:

Transaction 13: Treehouse expenses $100 in supplies related to its outreach program.

Recall that Treehouse also pre-pays for many of its ongoing expenses, such as insurance and certifications. The choice of when to expense pre-paid items is admittedly arbitrary. Most organizations have accounting policies and assumptions that state when and how this happens. Most will record those expenses monthly or quarterly. Recall that Treehouse pre-paid $1,500 for some annual professional association memberships. Assume that it expenses those memberships quarterly. At the end of the first quarter, since the membership was paid, it would record:

Transaction 14: Treehouse records quarterly professional association membership expenses. Recall that annual association dues are $1,500.

Remember that after this first portion is expensed, $1,125 in pre-paid association membership expenses remains on the balance sheet. In other words, this transaction expenses one-quarter of the original $1,500 asset.

Another crucial set of accounting assumptions is around depreciation. To deliver services, Treehouse must use up some portion of its building, vehicles, audiology equipment, and other capital items. Like with salaries and pre-paid expenses, it’s not always clear when and how those assets are “used up.” Some of that use is normal wear and tear. Some of it might happen if the asset bears a particularly heavy workload. Some capital items might be largely out of use, but they will lose value because, each year that goes by, they’ll become harder for Treehouse to sell should they choose to liquidate them.

Without a detailed way to measure that wear and tear, accountants typically deal with depreciation by simplifying assumptions. One of the most common is to use straight-line depreciation, also known as the straight-line method. Under the straight-line method, when an organization purchases a new capital asset, it determines the length of time it can use that asset to deliver services. This is known as the useful life. The organization must also determine the value of that asset once it is no longer useful for delivering services. This is the salvage value, residual value, or value at write-off. If we subtract the salvage value from the historical cost and divide it by the useful life, we get the annual depreciation expense.

For example, let’s return to Treehouse’s office furniture. Recall that it purchased that furniture for $20,000. Say that equipment has a useful life of 10 years. Also, assume that at the end of its useful life Treehouse will be able to sell it for $2,500. To calculate the annual depreciation expense using the straight-line method, we take the purchase price of $20,000, subtract the salvage value of $2,500, and divide the difference by 10. The estimated depreciation expense would be $1,750 per year. Using this assumption, we could record the following transaction:

Transaction 15: Treehouse records an annual depreciation expense of $1,750 on its equipment.

After this first recording for depreciation expense, the value of the equipment reflected in the Balance Sheet will be $18,250 (i.e., $20,000 – $1,750). We refer to the value of assets, net of depreciation, as the “book value.”

Other methods of calculating depreciation expense include accelerated method, declining balance, and sum-of-the-years method. Underlying assumptions in each method produce different estimates of depreciation expenses.

This same concept of spreading out the useful life also applies to intangible assets. Say, for example, Treehouse purchases some specialized case management software that allows it to store client records safely. That software requires Treehouse to purchase a five-year license. That license is an intangible asset, and the non-profit expects to utilize the software over the next five years. In this case, Treehouse would amortize the intangible asset – i.e., recognize that the value of the intangible asset decreases every year. The expense associated with using that intangible asset is referred to as amortization expense. If Treehouse purchased a five-year license for $5,000, it would record a $5,000 software license as an asset at that purchase. After that, if it amortized that license in equal annual installments, the effect on the fundamental equation is as follows:

Transaction 16: Treehouse purchased a records management software for $5,000. Assuming a useful life of five years, the annual amortization expense is estimated to be $1,000.

Following this first amortization expense, the license would remain on Treehouse’s balance sheet at $4,000.

Finally, we must consider what happens if Treehouse is paid for a service before it delivers it. This is known as deferred revenue or unearned revenue. Deferred revenue is a liability because it represents a future claim on Treehouse resources. By taking payment for a service not yet delivered, Treehouse is committing future resources to deliver that service. Once it delivers that service, it incurs expenses and removes that liability.

For example, imagine that Treehouse arranges a $1,500 outreach program with a different school district. That school district is nearing the end of its fiscal year, so it agrees to pay Treehouse for the program several weeks in advance. Once it receives that payment, it would recognize that transaction as follows:

Transaction 17: Treehouse takes a $1,500 payment for a school outreach program to be delivered in the future.

This initial transaction does not affect the income statement. However, when Treehouse delivers the program a few weeks later, it records the following:

Transaction 18: Treehouse delivers the school outreach program for which it was paid previously.

The key takeaway from all these income statement transactions is simple: For Treehouse to be profitable, it must take in more revenue from its programs and services than the total payroll and other expenses it incurs to deliver those programs. If revenues exceed expenses, then its net assets will increase. If expenses exceed revenues, then net assets will decrease. That is why, as previously mentioned, change in net assets is the focal point for much of our analysis of an organization’s financial position.

RECOGNITION CONCEPTS FOR SPECIAL CIRCUMSTANCES

PLEDGES AND DONOR REVENUES

Non-profits aren’t traditionally paid for their services. In fact, large parts of the non-profit sector exist precisely to provide services to those who cannot pay for those services. People experiencing homelessness, foster children, and endangered species come to mind immediately. Non-profits depend on donations and contributions to fund those services.

At the outset, it might seem like the accrual concept breaks down here. How can a non-profit recognize revenue if the recipients of its services do not pay for those services? In non-profit accounting, we address this problem by simply drawing a parallel between donations and payments for service. Donors who support a non-profit are, in effect, paying that non-profit to pursue its mission. Donors may not benefit directly from their contribution, but they benefit indirectly through tax benefits and a feeling of generosity. Those indirect benefits are substantial enough to support the accrual concept in this context.

Practically speaking, we address this with a category of net assets called “donor revenue” and a category of assets called “pledges receivable.” For example:

Transaction 19: Treehouse received pledges of gifts in the amount of $2,500 to be used as its Board of Directors considers appropriate.

Most donor revenues happen through the two-step process suggested here. A donor pledges to donate which is recognized as pledges receivable. GAAP stipulates that a signed donor card or other documented promise to give constitutes a pledge that can be recognized. Once the donor writes Treehouse a check for the pledged amount, Treehouse will book the following:

Transaction 20: Treehouse collects the $2,500 pledge recognized in Transaction 19.

NET ASSETS SUBJECT TO DONOR RESTRICTIONS

One of the big financial questions for any non-profit is how much control it has over where its money comes from and where it goes. In a perfect world, non-profit managers fund all their operations through unrestricted program revenues and donations. It is much easier to manage an organization when no strings are attached to its money.

Most non-profit managers aren’t so lucky. Virtually all non-profits have some restrictions on when and how their organization can spend money. Donors who want to ensure the organization accomplishes specific goals will restrict how and when their donation can be spent. Governments do the same with restricted grants or loans. Some resources, namely endowments, can’t ever be spent.

Restricted resources usually appear as “net assets with donor restrictions.” Consider this example:

Transaction 21: Treehouse receives a cash donation of $5,000. That gift was accompanied by a letter from the donor to Treehouse’s executive director requesting that the donation be used for staff development.

This is a typical revenue subject to donor restrictions. The donor has specified how Treehouse will use these donated resources. We’d see a similar restriction if the donor had specified that the donation could not be spent for some period of time.

Previously, net assets with donor restrictions were reported as either temporarily or permanently restricted net assets. Temporarily restricted net assets were restricted with respect to time or use. Permanently restricted net assets were permanently restricted and could never be spent. Recent changes in financial reporting altered the reporting of restricted gifts and aggregated these two categories, now reported as “Net Assets with Donor Restrictions.” While this change altered the presentation of financial information in the audited financial statements, it did not alter donor intent. In other words, if a donor had provided a gift to be used in perpetuity, the accounting rules do not alter that donor’s intent. They change how we report that information. The focus is now on all assets subject to donor restrictions – irrespective of whether they are time-restricted, use-restricted, or the corpus is restricted in perpetuity.

Our accounting recognition for net asset restrictions is not unlike other transactions that affect the income statement. The main difference is that with restricted net assets, we have to take the additional step of “undoing” the restriction once the donor’s conditions have been satisfied. For instance:

Transaction 22: Treehouse staff attend a national training conference. Travel, lodging, and conference registration expenses were $3,990. Staff are reimbursed from the resources donated in Transaction 21.

The first part of this transaction converts donations subject to restrictions to unrestricted revenue. This is reported in the income statement as “released from restrictions.”  Treehouse can do this conversion because it has met the donor’s condition: staff attended a professional development conference. The second part of the transaction recognizes the professional development expenses. Not all expenses are reported under “Net Assets Without Donor Restriction.” No expenses are reported in the “Net Assets with Donor Restrictions” column. Why? All expenses originate within the organization and, therefore, cannot be restricted by an external third party. Revenues, on the other hand, are resources provided to the organization and therefore, can be restricted. After the transaction, $1,010 of the original gift remains in Treehouse’s balance sheet and income statement as “Net Assets with Donor Restriction.”

While we often think of restricted gifts as contributions, restricted gifts do include property and equipment. Following FASB’s Accounting Standards Update (ASU) 2016-14, assets should be released from donor restrictions when they are placed in service rather than releasing donor restrictions over estimated useful life (unless otherwise stipulated by the donor). In other words, if the gift of a vehicle or building is being used as intended by the donor, that asset is reported under “Net Assets without Donor Restriction.”

Net assets restricted in perpetuity (previously classified as permanently restricted net assets) most often appear as endowment investments. Endowment investments represent a pool of resources that exists to generate other assets to support the organization’s mission. By definition, the donation that comprises the original endowment – also known as the corpus – cannot be spent. In practice, the accounting recognition for the formation of an endowment looks like this:

Transaction 23: An anonymous benefactor donates 3,500 shares of Vanguard’s Global Equity Investor Fund (a mutual fund) to Treehouse. The gift stipulates that the annual investment proceeds from that stock support general operations and that Treehouse cannot, under any circumstance, liquidate the endowment. At the time of the gift, the investment had a fair market value of $100,000.

Once the endowment is established, it generates investment earnings that are not subject to donor restrictions unless otherwise stipulated by the donor. Income from endowment investments is recorded as “distribution from endowment” or “endowment investment income.”

Transaction 24: At the end of the Endowment’s first fiscal year, Treehouse receives a dividend check from Vanguard (the mutual fund manager) for $4,500. 

If the anonymous benefactor designated the income from the mutual fund to be used for a specific program or activity, the investment income would be reported under “Net Asset with Restriction.”

Remember, not all investments are endowment investments. The non-profit could report an investment portfolio significantly larger than its endowment, especially if income from the endowment exceeds distributions or the non-profit has diverted excess cash to investments over time. While unrestricted investments are reported together with restricted investments, restricted investments remain subject to donor restrictions.

Even though the format of the financial statements – Net Assets without Restrictions and Net Assets with Restrictions – simplifies the presentation of financial information, non-profits must report in detail about the nature and purpose of Net Assets with Donor Restrictions.

IN-KIND CONTRIBUTIONS

In addition to donated revenue, non-profits also depend on donations of goods and services. These are called in-kind contributions. According to GAAP, a non-profit can record as an in-kind contribution to specialized services that it would otherwise purchase. This usually means professional services like attorneys, counselors, accountants, or professional development coaches. We recognize in-kind services once they’ve been received, and all the recognition happens in the net assets part of the fundamental equation. For instance:

Transaction 25: A local attorney agrees to represent Treehouse “pro bono” in a lawsuit filed by the family of a former client. The attorney’s regular rate is $500/hour, and the case requires ten billable hours. Without these pro bono services, Treehouse would have had to hire outside counsel.

If in-kind contributions don’t result in a net increase or decrease in net assets, then why do we bother recognizing them? Because recognizing them helps us understand the organization’s capacity to deliver its services. If it had to pay for otherwise donated goods and services, those purchases would undoubtedly affect its financial position and its service-delivery capacity.

Some in-kind contributions produce both an in-kind contribution and a donated asset. This is especially important for services like carpentry or plumbing. For example:

Transaction 26: A local contractor agrees to donate the labor and materials to construct a new playground at Treehouse. Total labor expenses for the project were $3,000, and the contractor purchased the new playground equipment for $8,000. 

The contractor’s donated labor is reported as a revenue and an expense, whereas the donated equipment is reported as an asset and revenue. The asset would then be depreciated over its useful life.

BAD DEBT

Unfortunately, pledges do not always materialize into contributions. Sometimes the donors’ financial situation changes after making a pledge. Sometimes they have too much wine at a gala event and promise more than they can give. Sometimes they change their mind. For these and many other reasons, non-profits rarely collect 100 percent of their pledged revenues.

Most non-profits re-evaluate at regular intervals – usually quarterly or semi-annually – the likelihood they’ll collect their pledges receivable. Once they determine that a pledge cannot or will not be collected, the amount of pledges receivable must be adjusted accordingly. The accounting mechanism to make this happen is an expense called “bad debt.” Bad debt is a specific type of reconciliation entry known as a contra-account. Like with depreciation, amortization, and other reconciliations, contra-account entries do not affect cash flows. They are “write-off” transactions to offset the reduction of an asset, in this case, pledges receivable. Consider this example:

Transaction 27: Treehouse determines it will not be able to collect $3,000 of pledges made earlier in the fiscal year.  

When is a pledge deemed uncollectable? That depends on the organization’s policies. GAAP rules only state that an organization must have a policy that dictates how it will determine collectability. To that effect, non-profit policies state that a pledge is uncollectable after a certain number of days past the close of the fiscal year or if the donor provides documentation that the pledge is canceled.

Among non-profits, pledges receivable is the most common type of asset to be offset by bad debt expense. However, be aware that bad debt is not unique to non-profits or pledges receivable. For-profits and governments can and often do record bad debt expenses. Those expenses can apply to any receivable, including accounts receivable for goods and services previously delivered or grants receivable from a donor or a government.

RECOGNITION CONCEPTS FOR MODIFIED ACCRUAL ACCOUNTING

Governmental funds, and the modified accrual basis of accounting on which they are prepared, focus on expendable financial resources. Taxpayers want to know that their government used its current financial resources to meet its current financial needs. This is, once again, a core part of how accountants think about inter-period equity. If a government pushes costs into future fiscal periods, future taxpayers will have to pay more taxes or expect fewer services.

For this reason, when thinking about the fund financial statements, we need to re-think how we recognize certain revenues. Instead of focusing recognition on when a government “earns” revenue, we focus instead on when the government has an inflow of financial resources. As a corollary, this focus on financial resource inflows means we naturally focus on resources that are available to pay for obligations or will become available soon. Specifically, GAAP for governments requires that for revenue to be recognized in the current fiscal period, it must be measurable and available.

• Measurable means the government can reasonably estimate how much it will collect. For taxes like property taxes, this is easy. They’re measurable because the government determines what a taxpayer owes and then sends a bill. But for sales taxes, income taxes, or other revenues, measurable might require some reasonable estimates.
• According to GAAP, available means revenue is recognized during the fiscal period for which it’s intended to pay liabilities or up to 60 days after the close of that fiscal period. Again, this is not always clear. For instance, when does an intergovernmental grant become available if it requires the government to perform certain services or incur certain expenditures?

These adaptations to GAAP are collectively known as modified accrual accounting or euphemistically as fund accounting.

Here are a few hypothetical transactions to illustrate those concepts. We’ll recognize all these transactions in the fund financial statements and, thus, on the modified accrual basis. If we recognized these transactions in the government-wide statements, the normal accrual concepts would apply. To simplify, we restate the fundamental equation as

Assets = Liabilities + Fund Balance.

In Chapter 1, we said the property tax is the local revenue workhorse. So, let’s start there. Let’s assume Bothell sends out its annual property tax bills in January. Those bills are based on the City’s assessed value, property tax rates, and applicable tax preferences. After running calculations, Bothell determines it will send out $515 million in property tax bills. From past experience, it also knows it will only collect a portion of those bills.

Property taxes are imposed non-exchange revenues, meaning they are not related to a specific transaction. As such, they become measurable and available when the government imposes them. As soon as property taxes are imposed, Bothell has a legal claim to them and can expect to receive a payment within 60 days. In this case, to impose them means to levy them or to send out property tax bills.

Transaction 28: In January 2019, Bothell levies property taxes of $515 million for the year. It is estimated that $15 million will be uncollectible. 

This recognition records Bothell’s property tax levy. What happens then when Bothell collects these property taxes?

Transaction 29: Throughout 2019, Bothell collected $410 million in property taxes. It collects $30 million of the remaining 2019 taxes during each of the first two months of 2020 and estimates that the $15 million balance will be uncollectable. 

Note of the $515 million in property tax revenue, $410 million is collected in the year and $60 million will be collected in the first 60 days (i.e., $30 million/month x two months).

We recognize these collections in four different parts. Part a) recognizes the collection of property taxes throughout 2019 and during the first two months of 2020. Bothell collected $30 million in each of the first three months, but according to GAAP, only the first 60 days are available. Part b) converts deferred revenues into property tax revenues for the taxes collected during 2019 and does the same for the taxes collected during the first two months of 2020. Part c) recognizes a write-down of the uncollectable property taxes.

Note that this recognition approach would also apply to the other non-exchange revenues, including fines and fees. Those revenues are also recognized when they are levied or imposed.

Sales and income taxes are the most common type of derived taxes, meaning the taxes collected are derived from another transaction. For derived taxes, the revenues become measurable and available when the underlying transaction occurs. For sales taxes, those transactions are taxable retail sales. For income taxes, it’s a bit more abstract. The “transaction” in question is when an employer pays wages to an employee, and that transaction denotes the earnings on which the income tax is based.

Let’s look at a hypothetical sales tax recognition in Bothell:

Transaction 30: In December 2019, merchants in Bothell collected $20 million in local sales taxes; $12 million was collected prior to December 15 and must be remitted by February 15, 2020, and the remaining $8 million must be remitted by March 15, 2020. How should Bothell recognize these December 2019 sales?

According to GAAP, Bothell should recognize the assets from derived revenues during the period when the underlying transaction takes place. That’s why it records all $20 million as sales taxes receivable. At the same time, it will only collect $12 million within 60 days of the end of the fiscal year, so only that portion is considered available and should be recognized now. The remaining $8 million will become available later, so for now, it’s considered deferred revenue. We would see a similar pattern with income taxes and other derived revenues.

A government recognizes an inter-governmental grant when it has satisfied all the eligibility requirements. Only then are grants considered measurable and available.

Transaction 31: In October 2019, Bothell was notified that it would receive a $15 million grant from the state’s Clean Water Revolving Fund. The funds, transmitted by the state in December 2015, must be used for stormwater infrastructure upgrades but may be spent at any time. 

The State has placed a purpose restriction on this grant. Purpose restrictions do not affect the measurability or availability of the grant revenues. That said, because they are subject to a purpose restriction, Bothell should recognize these revenues in a special revenue fund.

Many intergovernmental grants take the form of reimbursements. In this case, the revenues are not available until the government incurs the allowable costs stipulated by the grant.

Transaction 32: In December 2019, Bothell was awarded a grant of $400,000 to train community police officers. During the year, it spends $300,000 in allowable costs, for which it is reimbursed $250,000. It expects to be reimbursed for the $50,000 balance in January 2020 and to expend – and be reimbursed – for the remaining $100,000 of its grant throughout 2020. It must incur allowable costs to remain eligible for the grant.

We recognize police officer training expenditures first, as the grant is on a reimbursement basis. The second transaction recognizes reimbursement on the grant. Note the reimbursement falls short of total expenditures, so the balance on the grant receivable is $50,000.

For this grant, Bothell must first incur the requisite expenditures before it recognizes the grant revenues. In part a) it incurs those expenditures. In part b) it recognizes that it was reimbursed $250,000 cash. The city records grants receivable for the portion it expects to collect within 60 days of the end of the fiscal year and records the $300,000 in grant revenue (Community Policing Special Revenue Fund) – the amount of the grant it expects to be reimbursed.

And finally, let’s look at another unique revenue recognition treatment: sales of fixed assets. It’s not uncommon for governments to sell buildings and other fixed assets. In the fund financial statements, the value of such a sale is equal to the sale proceeds. This seems simple, but it’s quite different from the government-wide statements, where we’d recognize the difference between the sale proceeds and historical cost plus accumulated depreciation.

Transaction 33: On December 31, 2019, Bothell purchased a new police car for $40,000. On January 2, 2020, the vehicle was damaged in an accident. The city is able to sell the nearly demolished vehicle for $5,000.  

 It might seem strange that $35,000 worth of a $40,000 vehicle was lost, but the only impact on Bothell’s governmental fund statements is an increase in cash. And yet, that’s precisely how we would recognize this transaction on the modified accrual basis. Why? Recall that we do not recognize fixed assets in the governmental fund statements because those funds are focused on near-term financial resources. Fixed assets are, of course, a long-term financial resource.

Fortunately for the readers of Bothell’s financial statements, Bothell would recognize the sale of the $35,000 of asset value in the Statement of Net Position.

RELATED CASE STUDIES

Case 4.1: Safe Place for Youth (SPY)
Case 4.2: Rain Shadow Meals on Wheels
Case 4.3: St. Katherine’s Therapeutic Riding Center
Case 4.4: City of Davidson
Case 4.5: Promoting All Students’ Success (PASS)
Case 4.6: Yakima Valley Medical and Dental Clinic