With FASB ASU No. 2016-14 now in full effect, not-for-profit entities (NFPs) are required to disclose both qualitative (narrative) and quantitative (numeric) information about their liquidity and availability. In explaining its reasons for the additional disclosure requirements, FASB states that “the Board concluded that the additional information and transparency about the nature and extent of available resources and the extent of external and internal limits placed on their availability make a significant improvement to financial reporting by NFPs.” However, for many NFPs and their auditors, applying the concept of liquidity to NFP financials may be unfamiliar.
Without proper understanding of the concept of liquidity as spelled out in the ASU, NFPs could apply a too-narrow definition of the term, leading to disclosures that produce unwarranted going concern determinations or erroneous conclusions about the NFP’s financial well-being.
The basics of liquidity
The most basic measure of liquidity, according to the standard, is the “availability of resources to meet cash needs for general expenditures within one year of the date of the statement of financial position.” FASB does not define general expenditures in the ASU but suggests the kinds of limitations that would preclude assets from being considered available for general expenditure. The following are examples of such limitations:
- Donor restrictions on the use of assets for particular programs or activities
- Donor restrictions on the time period in which assets are used
- Board designations that commit certain assets to particular purposes
- Loan covenants that require certain reserves or collateralized assets to be kept on hand
- Compensating deposit balances required by certain financial institutions
Although common sense tells us that having more assets available for use without limitations allows for greater flexibility to meet unforeseen financial circumstances, it does not immediately follow that an NFP that shows a relatively small portion of its assets as “available for general expenditure” is experiencing financial difficulty. Nonprofit business models routinely make use of assets received with donor restrictions in ongoing programmatic and operational activities. In those cases, assets that appear to have limitations per FASB’s definition are, in fact, being put to immediate use paying for day-to-day operations.
Understand nonprofit business models
Many nonprofits today are sophisticated about the way they allocate core supporting service expenses to their program areas. With proper allocation methods in place, restricted grant funds are regularly released from restriction and applied to both direct program costs and the accompanying shared expenses that support those programs. A well-designed accounting system, coupled with solid liquidity management, will allow an NFP to accurately estimate what portion of its assets with donor restrictions is likely to be released from restriction and made “available” in the coming year. The liquidity and availability note disclosure could include both a narrative description of the NFP’s methods for managing revenue with donor restrictions and a table that lists the dollar amounts expected to be released from various sources.
Many NFPs also regularly receive individual contributions or general operating grants that come without donor restrictions. “Available” resources for liquidity-disclosure purposes would include only the portion of these general operating funds for which a formal commitment had already been received as of the statement of financial position date. But given the regularity of these kinds of contributions, it could be appropriate to disclose an estimate of how much of this type of funding is expected to be received in the coming 12 months. To document these estimates and establish better ongoing liquidity management, NFPs should consider developing a rolling 12-month (or longer) cash flow projection. This valuable cash management tool, for many NFPs, will add sophistication to their liquidity management processes and provide a better picture of financial viability.
Other tools to manage liquidity
Along with information about expected restriction releases and estimates of future general operating revenue, there are other liquidity management resources that could be used and disclosed under the new standard. The narrative disclosure should give financial statement users insight into an NFP’s liquidity management effectiveness and the full range of assets available for use. NFPs may also choose to describe the following:
- Their use of lines of credit
- Already-established operating reserve policies
- How they manage cash based on major receivables cycles
- Any other ways they monitor liquidity and maintain financial flexibility
Liquidity concern versus going concern
An NFP’s lack of clarity about liquidity measures or incomplete narrative discussion of liquidity and availability in the footnotes could lead financial statement users to make inaccurate conclusions about the organization’s financial health — even to the point of incorrectly identifying a going concern issue. CPAs can avoid any confusion themselves and best aid NFP clients by taking a broad view of liquidity and obtaining a thorough understanding of nonprofit business models. Using the basic requirements in ASU 2016-14 as the starting point, a well-informed CPA can make all the difference in helping NFPs and financial statement users sort out what is a legitimate liquidity concern from what could be mischaracterized as a going concern issue.