In Brief

FASB’s new revenue recognition standard will become effective for most not-for-profit (NFP) entities in 2019. Although this date may seem distant, the new standard will require a considerable transition effort in advance. The author focuses on the key accounting and auditing concerns that NFPs must address under the new standard, including a hypothetical example that illustrates some of the unique complexities the standard presents for the NFP environment and a discussion of significant challenges the new requirements are likely to pose for NFP auditors.

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Financial reporting for not-for-profit (NFP) entities is about to experience a sea change under three new accounting standards. Issued by FASB after more than a decade of deliberation, two will be effective for most NFPs in 2019—Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606), and ASU 2016-02 Leases (Topic 842). The third, ASU 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities, is effective for 2018. While each will dramatically alter NFP financial statements and demand considerable transition effort, the new revenue recognition standard is probably the most radical. The new revenue recognition standard creates a completely new accounting model for the core activity of every organization: the generation of the resources needed to carry out its mission.

This article focuses on the key considerations for NFPs under the new revenue recognition standard and the critical implications for their CPAs. While its title may suggest otherwise, NFPs are not excluded from the standard’s scope. Moreover, although it is sometimes assumed that NFPs are supported primarily through charitable giving, the reality is quite different. The largest category of financial support for many NFPs is revenue generated through fees for goods and services from private sources. For example, in a 2015 analysis of the nonprofit sector, the Urban Institute reported that these fees accounted for nearly half of all the revenues of public charities (Brice S. McKeever, The Nonprofit Sector in Brief 2015: Public Charities, Giving, and Volunteering, October 2015, http://urbn.is/2mfvTag).

Like their commercial counterparts, NFPs will find many of these steps somewhat difficult, particularly allocation of the transaction price. Fees in the form of membership dues, for example, may obligate the NFP to provide numerous types of benefits at various points in time, and revenue recognition is likely to be highly sensitive to the judgments and estimates needed to make these determinations. Fortunately, certain aspects of current GAAP’s existing NFP guidance applicable to these types of fees will remain, and it should prove to be even more useful under the new model. In particular, FASB notes that NFPs often refer to their donors as “members” (ASC 958-605-55-9). In some cases, the amounts that these individuals or entities pay as dues are nonreciprocal transfers, the key characteristic of a contribution. But in many instances, dues entitle the member to certain benefits, so the payment or a portion thereof represents an exchange transaction that will be subject to the new standard. FASB has previously identified indicators to help differentiate contributions from exchange transactions generally (ASC 958-605-55-8), as well as similar guidance specifically applicable to membership dues (ASC 958-605-55-12). These provisions will continue in a renamed ASC subtopic after the new revenue recognition requirements become effective.

The core principle of the new standard is that revenue recognition should “depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services” (ASC 606-10-05-3). To accomplish this objective, reporting entities are to apply a five-step approach:

The new revenue recognition framework supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific guidance throughout the Accounting Standards Codification (ASC). For NFPs, this industry guidance is currently found in subtopic 958-605, Not-for-Profit Entities—Revenue Recognition. As explained below, some of this guidance will remain in force, mainly the portions relevant to contributions; however, with certain limited exceptions, all revenue generated through exchange transactions (“contracts with customers”) will be subject to the standard. In the NFP environment, this revenue commonly comes from such sources as membership fees, sales of products and services, naming rights, sponsorships, and special events. These transactions, however, often include a contribution element that complicates implementation of the new standard. Therefore, NFPs will have to separate the exchange component, a task that will require considerable judgment.

Illustration: Museum Revenues

The example below illustrates some of the more significant potential reporting differences under the new standard. It assumes a museum with members who each pay $60 in annual dues, in exchange for such benefits as designated museum parking, a monthly newsletter, and access to the museum’s archives. The museum has determined that the fair value of these benefits is $60. Therefore, consistent with current GAAP (ASC 958-605-25-1), the museum has been reporting the entire $60 as dues revenue over the one-year membership period, based on the conclusion that the receipt includes no contribution component and instead represents a reciprocal transfer.

Under the new standard, the benefits specified in the membership agreement embody goods and services that the museum has promised to transfer to members. These promises are termed “performance obligations,” and the $60 transaction price must be allocated to each, a task that may prove challenging for many NFPs. For the sake of simplicity, this example assumes that the museum decides to view the member benefits as a bundle of goods and services, and regard them as a single performance obligation. In reality, many of these benefits would likely be considered individually distinct under the standard because they are not interdependent and each can be used on its own or remain unused at the member’s discretion (ASC 606-10-25-19). In order to illustrate the challenges of allocating transaction prices, other performance obligations are introduced into the example, as further described below.

Allocation of the transaction price to performance obligations. In an effort to increase its support base, the museum launches a fall membership drive with two new promotional benefits to be included in the $60 dues: 1) a single free admission to the museum, the usual entrance fee being $15, and 2) a $25 discount on any purchase of $100 or more in the museum gift shop. Under the new standard, the membership contract will now include two additional performance obligations, and these will require allocation of the $60 transaction price. To illustrate the major financial statement effects when contracts overlap two fiscal periods, the example assumes that in response to the fall drive, a member pays the museum $60 in October 2021 and uses the free admission in January 2022. It further assumes that during the January visit to the museum, the member makes a $100 purchase in the gift shop and receives the $25 discount. In applying current GAAP, the museum concludes that any revenue associated with these promotional benefits is not earned unless the member uses them, so no revenue is recognized until January. Application of the new revenue standard’s final step—recognizing revenue as performance obligations are satisfied—also results in January recognition. The steps under the new model leading up to this result, however, produce different financial statement effects. Having previously identified three performance obligations, the museum must allocate the $60 contract price to each on what the new standard terms a relative “stand-alone selling price” basis (ASC 606-10-05-4d). This value is defined as “the price at which an entity would sell a promised good or service separately to a customer” and must be based on observable evidence (ASC 606-10-32-32). When a directly observable price does not exist, this price must be estimated using a method that maximizes the use of observable inputs (ASC 606-10-32-33). Development of stand-alone selling prices for two of the three performance obligations—member services and museum admission—is relatively straightforward. With respect to the former, the museum has previously determined that the member services included in the basic dues have a $60 fair value, and it uses this amount as their estimated stand-alone selling price. With respect to the latter, directly observable evidence is available for the museum admission’s stand-alone selling price, specifically, the normal $15 entrance fee. Estimating a stand-alone selling price for the third performance obligation, the gift shop discount, is somewhat more involved. Under the logic of the new standard, it represents an option to purchase goods at a price lower than that normally charged and thus provides the member with a material right (ASC 606-10-55-42). In many instances, estimation of the stand-alone selling price of such an option will prove challenging. At a minimum, it requires assessment of the likelihood that the option will be exercised (ASC 606-10-55-44b). If the museum believes it reasonably certain that the member will make a purchase of at least $100, the discount’s estimated stand-alone selling price is $25, calculated as the $25 discount multiplied by a 100% probability that it will be used. If the museum believes the likelihood of a member making such a purchase is less than certain, the discount’s estimated stand-alone selling price would accordingly be lower. Additionally, a discount expressed as a percentage rather than a fixed amount could add complexity to the estimation. Of course, the one-time free museum admission could be viewed in the same way, that is, as an option to buy additional goods and services at a price lower than normally charged. As indicated above, however, this right has a directly observable stand-alone selling price ($15). Nevertheless, uncertainty about whether it will be exercised could lead to a modification of this amount. With these three prices now determined, the museum follows the new standard’s requirement to allocate the $60 transaction price to each performance obligation on a relative stand-alone selling price basis. In effect, this process assigns a discount to each obligation whenever the sum of the stand-alone selling prices of the goods and services promised exceeds the consideration received. An important feature of the new standard is that, in the absence of observable evidence that the implied discount applies only to certain performance obligations in the contract (as determined using the standard’s criteria), it must be proportionately allocated to all of them (ASC 606-10-32-36). In this example, the museum lacks such evidence, having never before offered the two promotional benefits. In fact, it has evidence to the contrary, given that members now receive these new benefits in addition to those already provided in the annual dues and the basic benefits have a previously determined value equal to the full amount of the transaction price ($60). The allocation process assigns proportional values to the three performance obligations using percentages of 60%, 15%, and 25%, and a separate “contract liability” is created for each. The new standard defines this term to mean “an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration” (ASC 606-10-45-2). It permits the use of alternative descriptions in the statement of financial position, and a reporting entity might choose to continue labeling these amounts as “deferred revenue,” as commonly seen in many NFP financial statements. Nevertheless, the new term is used throughout this example for emphasis.