Nonprofit Accounting, Part 2 (#303)
/In this podcast episode, we continue with the discussion of accounting issues that are unique to nonprofit entities.
Pass-Through Contributions
In this episode, I’ll go into some accounting issues that you just don’t see outside of a nonprofit. The first of these is pass-through contributions. This is when a nonprofit raises money on behalf of other nonprofits – and then it passes through all the funds it receives. For example, a nonprofit might have a separate foundation whose sole purpose is to raise money for the nonprofit. The accounting by this pass-through organization is to record an asset in the amount of the donation, and a liability to pass it through. The pass-through entity never records any revenue.
However, there’re two cases where the pass-through entity could record the donation as revenue, and then the funds transfer to the nonprofit as an expense. In the first case, the donor grants variance power to the pass-through entity, which gives it the unilateral power to direct where the funds go. This power allows the pass-through entity to override the wishes of the donor, so a lot of donors aren’t going to agree to it.
The other situation in which the pass-through can record a donation as revenue is when it’s financially interrelated with the nonprofit to which the funds are being sent. This is the case when one of the parties can influence the financial and operating decisions of the other. I only bring this up because pass-through entities are really common among nonprofits, so their accountants have a deep knowledge of all the associated reporting rules.
Accounting for Government Grants
And then we have government grants. When a nonprofit receives a grant, this is basically a contribution, since the money doesn’t have to be repaid. If a grant is paid in advance of a nonprofit actually doing anything, then the money is booked into a net assets with donor restrictions account. When funds are spent against these grants, an equal amount of money is released from the net assets account. This means that the amount spent matches the amount released.
An alternative approach is for the nonprofit to spend the money first and then apply for a drawdown of a matching amount from the grant.
Depending on the terms of a grant, a nonprofit might only be able to charge the direct costs of an activity against it. That means the cost of the materials and staff directly related to the program that a grant is funding. But in some cases, a nonprofit can also charge an additional amount against the grant, which is called the indirect rate. It’s basically an overhead charge. There are a couple of ways to derive the indirect rate, which are defined by the Office of Management and Budget. If you really want to get into that, then look up their Circular 122 for more information.
The indirect rate is a big deal, because it allows a nonprofit to get paid for some of its general expenses. This gets back to my earlier point in the preceding episode about the pressure that accountants are under to record as many expenses as possible as program expenses, because doing so can attract donors. When they can’t do this, then the indirect rate applied to grants provides nonprofits with a good way to pay for some of those non-program expenses. This is one of those rare areas where proper accounting can improve the financial health of a nonprofit.
Accounting for Donations
Let’s switch to another area. Donors contribute all kinds of assets to nonprofits. Let’s say somebody donates a delivery van to a nonprofit. How do you account for that? The van is recognized at its fair value as of the date of receipt. There’re three ways to derive the fair value. For the van, the most likely approach is to use market prices, since there’s a large market for used vehicles.
If it were some other type of asset for which there isn’t much of a resale market, then you might need to derive a fair value based on the discounted cash flows that can be generated by the asset – such as when a rental property is donated. Or, you could derive its current replacement cost, which is essentially the cost to buy or build a substitute asset.
A pretty common donation is stock. You should account for this at its fair value on the date of receipt, which means using the price at which the stock is trading on that date.
From the accountant’s perspective, it can make sense to create a policy for how to recognize the fair value of assets, so that there’s a standardized approach to doing it. This shouldn’t be too hard, since the typical nonprofit is going to receive roughly the same types of assets from donors on a recurring basis.
For example, a land preservation nonprofit is probably going to have a lot of land donated to it, so it needs to have a rock-solid process for valuing donated land. It probably doesn’t have to worry about valuing donated machine tools, because it isn’t going to receive any.
Accounting for Donated Works of Art
What about donated works of art? It’s still an asset, so it’s recorded at its fair value, and that’s the amount also recorded as revenue. Usually, an appraiser has to be brought in to determine the fair value.
Now, let’s say there’s some damage to a donated painting. In that case, you can capitalize the cost of major restoration work. The painting is not depreciated, since it’s supposed to have an indefinite life. More on that in a moment. But the cost of the restoration can be depreciated, where the useful life goes until the date of the next scheduled restoration. So if that’s going to happen 50 years from now, then that’s the period over which you depreciate the cost of the restoration.
I just mentioned that artwork is not depreciated. That’s not entirely true. There’s no depreciation when the intent is to preserve it forever, and the nonprofit has the ability to do so, such as by setting up a protected environment, maybe with controlled temperature and humidity levels. This places the accountant in the extremely odd position of deciding whether works of art need to be depreciated. I’ve never seen a business school offer a course in art preservation, so it’s safe to say that no accountants on the planet are qualified to do this. And yet, the judgment is supposed to be made. This probably calls for an annual meeting with those people on staff who actually know about it, to talk about whether any artwork is degrading. If so, some depreciation is in order. And document that meeting, because the auditors will want to look at it.
Things get a bit more complicated if a work of art is considered to be part of a collection. In that case, an alternative approach is to not record the artwork at all. If you do that, and then contribute the work of art to another nonprofit, then you can’t record an expense. But, if you had recorded the artwork as a fixed asset, then you can record the donation as an expense.
And for a quick aside on works of art, I grew up in the town of West Newbury, in northeastern Massachusetts. About 20 years ago, the pastor of All Saints Episcopal Church in West Newbury discovered a Renaissance painting sitting in its attic that was worth $1.1 million. The point being, get everything appraised.