Revenue Recognition and the Non-Profit

Revenue recognition has been a hot topic in the accounting world for what seems like a decade now.  In various contract arrangements and sales, it is possible to manipulate earnings pretty dramatically through the timing of recording revenues.

Fortunately, when you work with non-profit organizations, a lot of that hubbub can go largely ignored.  Non-profits deal with (and manipulate) revenue in their own manner, primarily through the application of FASB 116 and 117 or under the codification 958-605.

As with anything, there are complicated issues in non-profit revenue recognition, especially when dealing with split interest agreements, but there is a concept that underlies all of the standards that is easy to grasp.  And once a person knows what to expect, they can move forward from there.

Exchange vs. Non-Exchange Transactions

Arguably, the most important step in recognizing revenue in a non-profit organization is determining whether or not the transaction is an exchange or a non-exchange transaction.

Exchange transactions are very similar to a sale in the for profit world.  You provide a product or service in exchange for a fee or revenue.  The revenues are recognized when they are earned and realizable.  Many program service revenues, like a concert or clinical services, fall in this category.

Earned is generally defined as the exchange has occurred and realizable means that you are likely to be paid for it.

An example would be in the case of a mental health organization where a clinician meets with a client for 30 minutes.  The exchange has occurred, so the revenue can be recorded.  The amount realizable, however, has to be limited to the extent of the insurance contract rate.  So, if your rate is $45 for a half hour, but insurance or the state only allows $36, then you would record net revenue of $36.  The receivable for that service can come from a combination of sources and would be analyzed for collectibility in a separate accounting task.

Pretty easy, right?  Okay, not so easy, but at least familiar to those who work in for profit industries.

Non-exchange transactions are where things get goofy.  Most contributions and support are considered to be non-exchange transactions.  Basically, the person contributing the money gets no service or product in return for giving you these funds.

I can hear Executive Director's and accountants and program manager's everywhere saying, "Wait a minute!  We provide a service!  We are making the community a better place!  Plus, in the case of that one grant from United Way, we have to spend it on a specific program, so that is an exchange."

I hear you, but that is not exactly the right way to look at it.  The fact is that United Way could give you money and tell you exactly how they want you to spend it, but United Way is not the one receiving a benefit.  They have restricted the use of the funds, but they will get no exchange in return for giving you this money.

And because there is no exchange, GAAP (in the U.S.) says you need to record receipt of the funds immediately upon notification that you received it.  And that is where people get grouchy around non-profit accounting.

Most grants are applied for and awarded for future fiscal years or projects. And when you record the revenue upon receipt (notification of the award), the expenses are not there to match it.  This is going to cause a revenue/expense mismatch in your financial reporting that is non-intuitive to those who work primarily in for profit accounting models.

The required handling of this mismatch is to show that award or contribution as a temporarily restricted revenue.  This means that you record the grant, but you do it in a different bucket.  You say, we got this money this year, but it can not be used until either time or purpose restrictions have been satisfied.

If the grant is used in the following period in the manner the donor required, then those funds would be released from restriction to match with the expenses of the program.

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This particular post is not meant to be a comprehensive explanation of how we show all these transactions (I hope to cover that in more detail and smaller chunks at a later time) - it is merely an introduction to the concepts needed to record revenue in a non-profit.  As, such here is a quick review:

Non-exchange revenues:  When you receive revenue for which the grantor or contributor receives no direct services or products.   Recorded upon notification.

Temporarily restricted:  A way of recording non-exchange revenue to show that it relates to a future period and/or a specific purpose.  Note:  ONLY  a donor can impose a restriction.  If a board or management wishes to set aside funds for a future purpose, that is generally a designation and remains in the unrestricted bucket.

Release of restrictions:  The moving of a temporarily restricted item to unrestricted revenue to match the expenses and satisfaction of the restriction.  Note:  Expenses are always unrestricted.

As I mentioned above, this gets even more complicated when dealing with split-interest agreements and reimbursement grants, but that is beyond the scope of this post.  If you can approach the influx of funds with the question of whether or not they are exchange or non-exchange and if non-exchange, whether or not the funds are unrestricted or restricted, you will be on the right path to correct revenue recognition procedures.

Allocations Part II

Last week, I began the unenviable task of explaining expense allocation reporting in non-profit organizations.  I mentioned that there are four common entries and I described DIRECT ALLOCATIONS and SALARY ALLOCATIONS.  Today, I would like to wrap up this topic by writing a bit about the other two types of allocation entries.  If you have a chance to look at Part I, it is helpful to understanding this discussion.

GENERAL EXPENSE ALLOCATIONS

General expense allocations refer to expenses that are not easily identifiable to a program.  Examples include copier leases, office supplies and insurance costs.

Note that worker's compensation insurance would fall in this area even though it is an employee expense - it is not an expense that can normally be broken out by individual and so it would not be considered under the salary allocation entry.

These expenses are typically accumulated on a monthly basis and recorded as either an unclassified or an administrative cost.  As part of closing out the month's reporting, these costs would then be allocated out to the various programs.

The preferred method used for allocating these costs is generally effort reporting.  Effort reporting takes into account the amount of time that employees spend on a program and applies that effort to the general expenses.

The theory behind this method contemplates that an employee is spending 50% of their time doing the After-School work and so they must be using 50% of the copier costs on After-School work.  This method, applied consistently, will survive an audit of cost allocation.

Effort reporting is NOT the same as salary allocations, but you do start in the same place - with the timesheets.  If you remember, we used the hours on the timesheets to generate the percentages for each individual's payroll costs.  The total percentage used for payroll can NOT be used for general expense allocation because it is skewed based on different salary levels.  The total hours in a program can be used.  Here is an example to explain what I am talking about:

S is the Executive Director and makes $4,000 per month.  She spends 80 hours (50%) in Programs and 80 hours (50%) in Fundraising.
T is the Program Manager and makes $2,000 per month.  She spends 128 hours (80%) in Programs and 32 hours in Fundraising (20%).

For Salary Allocations, you would do this:
Payroll Expenses would be allocated 60% to Programs and 40% to Fundraising.

The program expense is S's salary of $2,000 (50%) plus T's salary of $1,600 (80%) to equal $3,600 (or 60% of $6,000 in Payroll Expense).

This fundraising expense is S's salary of $2,000 (50%) plus T's salary of $400 (20%) to
equal $2,400 (or 40% of $6,000 in Payroll Expense).

The Salary Allocation is 60/40 because the Executive Director makes more than the Program Manager and skews the salaries.  You have no choice but to take actual payroll costs on the Salary Allocations, but you do not want to apply this skewing to other costs.  The copier does not cost more to use when the Executive Director is doing it.

For General Expense Allocations, you would do this:
General Expenses would be allocated 65% to Programs and 35% to Fundraising.
This is comprised of the total of S and T's Hours = 320.  Of those hours, the total Program Hours are 208 and the total Fundraising Hours are 112.

While a 5% difference does not seem like much - keep in mind this is a very limited example.  When you pull it out to the population, the difference can be larger.

Volunteers
I have used Volunteer hours when calculating general expense allocations, if it makes sense.  If your volunteers are on-site doing program related work that use up general expenses, then why not include them in the effort reporting?  You can't put them in salaries, but you do want to be reasonable about just how much that copier is getting used for your program.

Let's look at the above example and add in the hours for the Volunteer that runs the After-School program.  If their hours are 20 per month, you now have 340 total hours - 228 to Programs and 112 to Fundraising.  Or a general expense allocation split of 67% Program and 33% Fundraising.

Volunteer time makes sense for some organizations, but not all.  If you decide to use it, you should be prepared to explain why it makes sense and to demonstrate that you used a complete tally of volunteer time (not just the program hours).  Again, timesheets are useful for providing the substantive back-up.

OCCUPANCY ALLOCATIONS

The fourth most common allocation entry is occupancy.  Occupancy costs include rent, interest on a mortgage, utilities, depreciation and sometimes maintenance expenses.

The preferred method for allocating occupancy costs is based on the square footage that a function literally takes up within the office.  If a program is off-site completely, then the allocation might be the costs of the off site location or it might have to come from an application of the general expenses allocation method to occupancy.

Getting a layout of your office is the first step to figuring out how you want to allocate.  Sit down with that layout and calculate the square footage of each area to each function.  Apply that percentage to the occupancy costs on a consistent basis and you're done.

This allocation should be re-visited at a minimum on an annual basis, but may require a more periodic review.  Especially if there is a major shift in office layout or new programming is added.

BONUS ALLOCATION DISCUSSION - ADMINISTRATIVE COST ALLOCATION

After all other allocations are completed, you may want to perform an allocation of administrative costs to the various programs.  Note that this would be for funders that allow it and for internal management reporting purposes.  A full allocation method like this would present a program's contribution to the overhead of the non-profit.  On tax returns for non-profits, general and administrative expenses must remain separate.

This is very easy to do - again, after everything else is allocated, just take your general and administrative expense total and apply it using the formulas that you used to do the general expense allocations.  With one tweak.

If your General Expense Allocation was 10% Administrative, 10% Fundraising and 80% Programs; then you would want to allocate all Administrative between Fundraising and Programs.  Your allocation would be based on Fundraising being 10 of 90 or 11%.  The allocation to Programs would be 88% or 80 of 90.

General Expense allocation is normally shown as a separate income statement line item - it is a lump adjustment at the bottom of reporting and it should add up to zero for top-level and tax reporting.

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I know all of this is a lot to think through objectively while staring at a computer screen, but it is the way we do it.  And once you get these allocations set up and start running through them a few times, it becomes very systematic and can easily be done by a solid general ledger accountant.

Knowing that your allocations are correct and supportable will give you credibility within your organization and within the various funding communities that you operate.  It will also give you a lot of information for when you are building budgets.  Allocations are worth understanding, setting up properly and vigorously maintaining.

Charting Your Accounts - NonProfit Version

It seems like a good time to talk about the chart of accounts.

Oh, I know it's not sexy.  And it's not really that fun.  Personally, I  try to have a career goal of never changing a chart of accounts again.  Yet, if you plan your chart of accounts properly, it really can be used for a long time to come.

I have to admit, since I started serving non-profit organizations almost exclusively, I have struggled with the allocation of costs.  There are allocations that are required for grant reports, for tax returns, for financing compliance, for management reporting and sometimes just because a Board member wants to know a random bit of information.

I have spent hours on the phone with colleagues trying to determine if I was really doing these allocations right, when I am making entries that have $0.20 in them.  I am.  Unfortunately.

I have learned, however, the more allocations you can do through initial transaction entry, the better off you are.  And a flexible chart of accounts consistently used aids that process.

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Lets take a look at the basics of a chart of accounts.  Note that this is a discussion of the actual account numbering; it is not about categorizing the chart into revenues or expenses or what have you.  I consider the categorizing a function of reporting and it is beyond the scope of this post.

NATURAL - Your first numbers should match the natural expense categories.  This is expected and necessary if you have to file a tax return or undertake a financial audit.  A natural expense would be Salary.  Or insurance.  Utilities, etc.  It is common for people to use four or five numbers for this category.  Example:  Repairs - 6120.

SUB-NATURAL - This category is not used often, but I have worked with it before and I really love it.  This is when you take a natural expense and give it a sub-category.  Two numbers is generally sufficient for this category.  Example:  Carrying on with Repairs, you might have Repairs on the HVAC System - 6120.02.  Note that you could now do reporting on all repairs or just on repairs related to HVAC.

PROGRAM - This is where you start breaking out different departments or functional areas of expense.  In non-profits, this could be administrative, fundraising and various programs.  Having this segment allows you to report by functional expense and accumulate your administrative or overhead costs for allocation purposes.  Most small and medium size businesses are okay with two numbers here.

Example:  Repairs on the HVAC system at the administrative office would look like this - 6120.02.99.  Repairs on the HVAC system related to a program could be - 6120.02.05.

A note about QuickBooks: 
QuickBooks is a common accounting software that has a some very frustrating limitations to its chart of accounts structure. You can't add dashes or dots in the basic versions and the most numbers you can use is seven. Seven.

With only seven numbers and no breaks, it is hard to properly separate programs (departments) and funders.  In QuickBooks, I generally use classes to track programs, since I am already up to 5 or 6 of the allowable account numbers. However, classes add a complicated element to data entry, as they must also be used consistently to work properly.  If you have too many, you risk errors and "messes."

ACTIVITY - Activity and program could be the same, but it might be used as a sub-program.  For example if you are a theater arts business, your program could be Plays and an activity would be The Taming of the Shrew.  It makes sense in this case to track activities, but unless you are going to recycle charts of accounts (which is not recommended), you will need a lot more number spaces here - three at a minimum, but more likely four.  Example:  Repairs on the HVAC system at our play, the Taming of the Shrew (keep an open mind here as I try to keep my examples consistent) - 6120.02.05.1420.

You will notice that we have gone way beyond QuickBooks limitations at this point.

LOCATION - Location may be more important to your business than activity or it may be an additional area of interest.  Location notifiers are probably sufficient with two digits.  Example:  Repairs on the HVAC system at our play, the Taming of the Shrew, which is held at the downtown community theater - 6120.02.05.1420.06

SOURCE - And finally, we reach the really important area.  Source is when you might want to track funding sources for a program or activity.  This is vital for grant reporting, but is similar to activities in that you may need a large number of digits - I would say at least three.  Example:  Repairs on the HVAC system at our play, the Taming of the Shrew, which is being shown at the downtown community theater and which was funded by the National Endowment for the Arts - 6120.02.05.1420.06.150.

I use customers in QuickBooks a lot to track this information, but it does cause problems as it is very hard to keep it consistent.  Others find job tracking to be helpful here, but again, there are limitations.

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Let's see what we have ended up with, assuming we want everything:  6120.02.05.1420.06.150

Okay, I admit that this account number has gotten a bit ridiculous, but if you look at it, you could run reports on several different aspects just from a download to Excel.

All of these segments are sortable!  It's the Holy Grail of accounting reporting!  You can report on any of the following:

Repairs
HVAC Repairs
Plays
The Taming of the Shrew
Any plays held at the Downtown Community Theater
Expenses funded by The National Endowment for the Arts

It is amazing!  But...

Let's get back to reality.

You likely do not need all of these segments, but you do need some of them.  Regardless of how many you do use, any account separation will give you flexibility as your organization changes and grows.

I beg you - don't just randomly accept the canned chart of accounts that comes with the accounting software.  Take some time, approach it thoughtfully.  Look at your current reporting needs and structure your accounts accordingly.

It will be worth it in the end.