We are pleased to share this article written by Pesh Framjee exploring revenue recognition for NFPs/NPOs.
Note: the opinions expressed are his own.
The International Financial Reporting for Non–Profit Organisations (IFR4NPO) project is developing the world’s first Internationally applicable Financial Reporting guidance for non-profit organisations. A number of sector-specific challenges are being addressed by the IFR4NPO project. The issue of income recognition with non–profits and public benefit entities has been the cause of much debate in the sector. In this article, I explain why and how the thinking has developed in the UK, and how this is being interpreted. Much as this article focuses on how the UK accounting standard FRS102 has developed and how the Statement on Recommended Practice on Accounting and Reporting by Charities (SORP) has considered these matters, I believe there are important lessons for this international project.
In 2007, the UK Accounting Standards Board (ASB) published the ‘Interpretation for Public Benefit Entities of the Statement of Principles for Financial Reporting’ (the Interpretation). It sets out the principles that should underlie the preparation and presentation of general purpose financial statements of Public Benefit Entities (PBEs). The Interpretation was a valuable move forward in laying down principles for PBE financial reporting. However, this was not a Financial Reporting Standard (FRS).
In 2011 ASB issued for consultation Financial Reporting Exposure Draft (FRED) 45, the Exposure Draft of the Financial Reporting Standard for Public Benefit Entities (FRSPBE). There were many responses to the consultation which ended in July 2011. In January 2012, the ASB published three new FREDs: 46, 47 and 48, setting out revised proposals for the future of financial reporting in the UK and the Republic of Ireland.
The ASB decided not to issue a separate FRSPBE and incorporated the special considerations for PBEs into FRS102. Those paragraphs that apply solely to PBEs are identified by the prefix ‘PBE’.
The Interpretation recognised the importance of the difference between conditions and restrictions and explained:
‘There are differences between conditions and restrictions. Restrictions limit the use that may be made of the resources in the future. Conditions must be fulfilled before the entity takes unconditional control of the resources. The existence of restrictions does not impact the initial recognition of the resources as revenue (unless the restrictions are so severe that it is determined that the reporting entity does not control the resources). The existence of conditions might indicate that the receipt of the resources should result in the recognition of liability until the conditions have been met.
‘Where the conditions are within the reporting entity’s control and it is virtually certain that the conditions will be met, the resources should be recognised as a gain. Where it is not virtually certain that conditions within the reporting entity’s control will be met, any resources received in advance should be recognised as a liability until such time as it becomes virtually certain that they will be met.’
In trying to address the confusion between restrictions and conditions the FRED provided definitions that were seen to be problematic in practice, but this was remedied by simply improving the drafting. It was clarified that there was no intention to change the definition of restricted income, and the principle that a restriction simply directs the application of the income but does not prevent it from being recognised as income was reinforced
The FRED defined a restriction as: ‘a requirement that limits or directs the purposes for which a resource may be used but does not require that resource to be returned to the donor if the resource is not used as specified’. The FRED then explained that a performance condition is a requirement that specifies that the resources is either to be used by the recipient as specified or if not so used, to be returned to the donor’.
In effect, the FRED implied that the only real difference between a ‘restriction’ and a ‘performance condition’ is the repayment requirement. This would have meant that any restriction imposed on a donation, legacy, grant or gift which has a repayment clause was now to be treated as a performance condition.
If this nuance about repayment had made it to FRS102 it would have fundamentally changed how PBEs account for restricted income with, in the view of most respondents, many unfortunate consequences. So it is important that this is carefully considered when the IFR4NPO is being drafted.
Non-profit accounting ought not to depart from generally accepted accounting principles, which recognise that:
Much of the income raised by NPOs has a proviso that it may have to be returned. This means that there is nearly always an inherent potential for repayment. This is particularly the case with appeals and grants. Under the definitions in FRED45, this would have meant that such income could not be recognised, since the requirement that it could need to be returned would have been seen as a performance condition that prevented recognition until there was no possibility of it being returned.
Many funders include clauses in their funding which require the funds to be expended on a specified purpose – in effect creating restricted income. They often also have a clause that allows them to carry out an audit of the expenditure and claw back the funding. This audit and claw back may happen some years after the income was received or the expenditure was incurred. So, treating the possibility of return as a performance condition could mean that it should not be recognised even if expended, as there was still a possibility of income having to be returned. NPOs have typically recognised the income when receivable unless they believed a repayment was probable in which case they set up a provision for repayment and/or deferred income recognition.
For an NPO, the receipt and acceptance of restricted income involve a responsibility to use the resources to fulfil the specified objectives. The direction as to its use, even with the provision that it may have to be returned in certain circumstances, merely focuses the responsibility on specific use.
FRS 102 and the SORP clarify that income with restrictions is income and should be recognised as such without attempting to set up liability or deferral. The receipt of restricted income should not affect liabilities unless it is probable that the income is to be returned. It is important to understand that the responsibility imposed by restricted income is fundamentally different from the responsibility imposed by incurring a liability such as a creditor’s claim.
Deferring the recognition of restricted income by creating a liability, simply because it may have to be returned would seem to fall foul of the requirement that an entity should only recognise a liability if:
The key issue is in b) above – is it probable (more likely than not) that the NPO will have to return the income? If in fact, the NPO believes that this might be the case, then indeed, it should not recognise the element of income that is likely to be returned. In most cases where funds are received with restrictions on their use, it is highly probable that economic benefit will flow to the entity and usually a very low probability that repayment will be made, even if there is a clause that may require repayment in certain circumstances.
Many NPOs are concerned that all this could lead to a very lumpy recording of income and expenditure and want to match income with expenditure. It is important to recognise that this is not only a challenge with restricted income but would be a concern more generally.
For example, if an NPO receives an unrestricted general grant or donation in the last part of its financial year it would be required to recognise it in that year although the expenditure may be made in future accounting periods, so a mismatch is inevitable. The solution here should focus more on education about the interpretation of financial statements of NPOs.
FRS 102 and other global accounting standards make the distinction between exchange and non-exchange transactions. Exchange transactions include contracts for services and performance-related grants. A non-exchange transaction is often defined as a transaction in which one party gives something of value without directly receiving equivalent value in exchange. Non-exchange transactions include gifts even if they are restricted. Some income transactions can comprise both exchange and non-exchange elements. Entitlement to income from contracts and performance-related grants will arise when the NPO has earned the right to the income. Therefore, with an exchange transaction, income is recognised in line with performance.
A restriction on the use of a grant will not in itself create a performance-related condition. A restriction simply creates a requirement that limits or directs the purpose for which a resource may be used but it does not prevent the recognition of income where it does not require a specific level of performance or output from the NPO.
A performance-related grant is one where the grant has characteristics similar to those of a contract, in that:
Where entitlement to grant income is subject to performance conditions, income is recognised as the performance conditions are met. In effect, a performance-related grant is analogous to a contract for the supply of services. Income from the supply of services is recognised in line with the delivery of the contracted service provided that the stage of the completion, the costs incurred in delivering the service and the costs to complete the requirements of the contract can all be measured reliably.
All this is often clear in theory but obscure in practice. In some cases, it is difficult to understand the nature of the funding agreement. Reading these agreements, it is possible to start off thinking it’s a contract, then halfway through it seems to be a grant and by the end, it appears to be a bit of both. It is often best to settle for what makes the most sense! In recognition of this, preparers of accounts need to focus on the substance rather than the legal form. This also begs the question of how performance can be measured. An NPO must select a method to measure the stage of completion of a service contract that provides the most reliable estimate of the right to receive payment for the work performed.
This may lead to particular challenges where the work is not properly defined or where it is difficult to assess the extent of performance – for example with contracts to carry out research or where there are multiple deliverables all bundled up into one contract or funding arrangement. In my experience, a common sense approach without being too pedantic works best. The question is: does the chosen method make sense and does it reflect the substance of the arrangement?
Possible methods to measure performance include:
It may also be appropriate to recognise income based on the time spent in providing a service as a proportion of the total time to be spent to fulfil the contract when this provides the most reliable estimate of an NPO’s entitlement.
However, it is important to note that simply incurring costs in relation to a contract does not in itself justify the recognition of income. For example, if an NPO has completed 50% of the work but incurred a greater proportion of costs and is not in a position to claim cost overruns leading to a “loss” on the contract, it should take this into account when recognising income.
With exchange transactions of the kind discussed above, the expenditure matching criterion is used where the costs incurred and the costs to complete the transaction can be measured reliably. If the costs incurred and the costs to complete cannot be measured reliably then usually NPOs treat the receipt as an advance payment and the income is deferred.
There are specific circumstances when it may be appropriate to recognise income in line with expenditure. But beware: it should not be adopted on the basis of trying to match income and expenditure. The “matching” concept which was much favoured by accountants has, for some time, been seen as inappropriate and contrary to accounting standards. FRS102 makes this quite clear, stating:
“Generally this FRS does not allow the recognition of items in the statement of financial position that does not meet the definition of assets or of liabilities regardless of whether they result from applying the notion commonly referred to as the ‘matching concept’ for measuring profit or loss”
However, in certain circumstances, a form of matching can be adopted. This could be when the grant is performance related or the income is under a contract that requires the delivery of some service. The rationale for this treatment is based on the view that the funding is tantamount to a performance-related grant (as discussed above) and that the most reliable method of assessing performance is considering the proportion of costs incurred for work performed to date compared with the total estimated costs to completion.
This may be the case even if there are specific deliverables which may have achieved different levels of performance, or the nature of the deliverables does not allow easy quantification of performance. For example, a funder might ‘require’ the NPO to sign up a specified number of people to a scheme and then deliver a certain level of training. At the year-end date, it might have signed on 70% of the required number of people and delivered 40% of the training – what is the level of consideration that it has earned?
In such cases, expenditure may be the best proxy for performance so income can be recognised in line with expenditure when the measurement criteria discussed above are met. However, where there are other performance criteria specified in the funding agreement that can be measured, using expenditure as a proxy for performance may not be the best approach.
There is also the issue of whether funding agreements are sufficiently material to the activity of the period that failing to record turnover and attributable profit would lead to a distortion of the period’s turnover and results such that the financial statements would not give a true and fair view.
The thinking is, that owing to the length of time taken to complete some contracts or funded projects, deferring recording income until completion may result in the accounts not reflecting a fair view of the results of the activity during the year. Instead, they would be based on the results relating to contracts that have been completed in the year. In certain cases, it is appropriate to take credit for ascertainable turnover and “profit” while contracts/ projects are in progress. NPOs need to record income and related costs as contract activity progresses. Income should be ascertained in a manner appropriate to the stage of completion of the contract.
A time restriction, unlike a purpose restriction, often does lead to the deferral of income. This is because a timing restriction is similar to a condition if incoming resources are subject to donor-imposed conditions that specify the time period in which the expenditure of resources can take place. Such a pre-condition for use limits the NPO’s ability to expend the resource until the time condition is met. For example, the receipt in advance of a grant for expenditure that must take place in a future accounting period should be accounted for as deferred income and recognised as a liability until the accounting period in which the recipient NPO is allowed by the condition to expend the resource.
This approach is applied where the donor specifies when the funding can be used and in such cases, a time restriction may require deferral of income. in this case there are specific conditions on when the funds can be used, and it is not usually within the NPO’s discretion to make use of the funds at an earlier stage. The nature of the agreement limits the NPO’s ability to expend the resource until the time condition is met.
If an NPO decides it cannot start or complete a funded project until a later accounting period, this would not be a basis for income deferral. That said, it is important to look beyond the obvious. For example, it may be clear from the funding application that the NPO had asked for funding to cover a specific time period. The NPO may have submitted a three-year budget with the application indicating how much will be spent each year. For example, in some cases, it is clear that the grant is intended to meet the salary of an employee or pay the rent over the next three years.
In such cases, the grant agreement may stipulate that a specific amount of the grant relates to those three years. In many cases, the agreed yearly amount or budget is specified with a clause that this cannot be varied without the funder’s agreement. Time-related conditions may be implied, for example when a multi-period grant is approved and is to be paid on the basis of agreed annual budgets, the NPO may not be entitled to spend part or all of that income in advance of its budgeted year(s) without the further prior approval of the grant-maker.
Therefore, If the application or the funding agreement specifies the period covered by the grant it may be correct to recognise the income over this period.
It is possible to ensure that income recognition principles allow flexibility and consider the substance of the transactions of NPOs, as shown in FRS102 and the SORP. It is possible to think beyond the obvious with income recognition in a way that makes sense for a NPO’s circumstances. There is no stereotyped answer and it is important to ensure that the accounting fits the reality of the many different funding and donative arrangements that exist in the NPO sector.
Pesh Framjee
Pesh is a member of the Practitioner Advisory Group that provides advisory input and feedback in the development of the world’s first Internationally applicable Financial Reporting guidance for non-profit organisations https://www.ifr4npo.org/.
He was a member of the ASB’s Committee on Accounting for Public Benefit Entities and was a member of the SORP committee for over 22 years.
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