Why Not-for-Profits Should Report Their Commitments: Current GAAP Financial Reports Provide Little Understanding of Future Obligations

WHY NOT-FOR-PROFITS SHOULD REPORT THEIR COMMITMENTS Current GAAP financial reports provide little understanding of future obligations. Accountants cannot apply commercial concepts to noncommercial activities without great risk of misleading themselves. The differences between the two kinds of enterprises have serious implications for financial reporting. Some common threads run through all accounting and relate to all entities for which financial reporting is needed. At the same time, some organizations are different from those for which generally accepted accounting principles were developed. Not-for-profit organizations fall into this category. In sincere attempts to apply present GAAP to these entities, some well-intentioned people have produced financial statements that boggle the mind and turn readers away uninformed. An earlier article (JofA, Aug.89, page 60) notes the GAAP concepts of assets and liabilities do not provide for adequate reporting of some of the valuable properties owned and used by not-for-profit organizations. This article discusses why adequate financial reporting for not-for-profit organizations requires that "commitments" receive much more attention than is now provided in GAAP.(*) FUNDAMENTAL DIFFERENCES BETWEEN ORGANIZATIONS A commercial enterprise is started by investors who provide funds in exchange for an equity interest in the enterprise. The investors expect the entity to be operated for their financial benefit and to provide them with withdrawable or otherwise realizable gains. To do so, the enterprise attempts to create and sell a product or service at a price exceeding all costs of production and sale. If operations are successful and a profit results, that profit accrues to the equity holders. By recovering its costs through the sale of its product or service, the enterprise also maintains its capital and continues its operations. A not-for-profit organization is begun by people "investing" funds in exchange for no equity interest. These "investors" know the organization won't be operated in their financial interest. Once established, the not-for-profit organization obtains and distributes products or services in accord with its stated purposes--but at no cost to those who receive the products or services. The organization thus depletes its resources and must seek additional contributions to continue its operations. Remember the not-for-profit organization has no equity interests and no profits. Moreover, distributing the product or service does not replenish the organization's capital to permit continuing operations. From an accounting point of view, these are monumental differences. Much of present accounting theory, for example, is concerned with issues of income measurement, capital maintenance and distinctions between liabilities and equity. DIFFERENCES IN CASH FLOWS Now consider the possible sources and uses of cash for these two types of enterprises. For-profit companies depend on investments and revenues from sales for an inflow of cash; not-for-profits depend on contributions. For-profit companies expend cash to produce or purchase products for sale and to distribute to equity interests. Not-for-profits spend cash to produce or purchase products for free distribution and never make payments to equity interests. Of course, both for-profits and not-for-profits may obtain cash by borrowing and may use cash to repay debts. What's the impact of these differences? A commercial company strives to transfer funds from its customers in to its equity holders; a not-for-profit transfers resources from its contributors out to its "clients." CAN FINANCIAL REPORTING IGNORE THESE DIFFERENCES? The conventional CPA responds: "I know all this. Can't I just assume contributions-in are the equivalent of sales and contributions-out are the equivalent of cost of goods sold so I can prepare an operating statement and a balance sheet in compliance with sound business principles? …

Field of study: Business