In his 5th installment, Ron Bauers discusses the three methods of accounting: pure cash, accrual, and modified cash, and the three types of net assets: unrestricted, temporarily restricted, and permanently restricted. He then goes on to explain fund accounting, which requires an organization to divide resources among two or more fiscal and accounting entities, and comments on the complexity of net asset and fund accounting.
The basic purpose of accounting is to determine income by matching, in a given accounting period, revenues earned to the expenses incurred to earn those revenues. In the recognition of revenues and expenses, three basic methods are utilized to record the transactions:
With the pure cash method of accounting, revenues and expenses are only recorded when cash is exchanged, i.e., cash is received or paid. This method is typically used by a small business, such as a sole proprietor or a normal individual for a tax return.
With the accrual method of accounting, revenues are recorded when they are earned, and expenses are recognized in the period incurred. It does not matter when cash is received or paid.
The third accounting method, the modified cash method, is a mixture of the pure cash and accrual methods. Modifications usually involve the recognition of depreciation on fixed assets and the recording of inventory. This method is commonly used by doctors, lawyers, accountants, and other entities that find that this method reports net income more accurately for their organization.
Only the accrual method of accounting is acceptable under generally-accepted accounting principles (GAAP). The cash methods are not theoretically sound because of the high volume of credit transactions, and the cash methods do not accurately measure the effects of these transactions. The accrual method reflects the importance of credit transactions — this allows users of financial statements to estimate the amount and timing of future cash inflows and outflows associated with the income earned.
According to Statement No. 117, Financial Statements of Not-for-Profit Organizations (1996), FASB requires the issuance of three financial statements:
This financial statement requirement was not new, but No. 117 also requires that organizations must classify their net assets into three categories based on the existence or absence of donor-imposed restrictions, called the net asset approach. The three categories are:
This classification is dependent upon the restrictions placed on resources by the donor.
Unrestricted net assets are not restricted by any donor and may be utilized at will by the organization to fund operations.
Temporarily-restricted net assets represent resources that have been restricted by a donor for a specific purpose(s), time period(s) or event(s). When the restriction has been satisfied, the funds may be utilized to support operations in the current operating period.
Permanently-restricted net assets are resources that have been restricted by the donor in perpetuity. The most common permanently-restricted net assets are endowments, which usually consist of investments in debt or equity securities. Usually the organization may utilize the income, dividends and interest, and the capital gains on those investments, for operations. However, the principal is restricted in perpetuity and may not be utilized to support operations unless permission is received from the donor.
Fund accounting requires an organization to divide resources among two or more fiscal and accounting entities. Each fund will contain resources and obligations but the funds are segregated according to legal or contractual restrictions or agreements, or for specific activities. Each fund consists of self-balancing accounts that allow the preparation of financial statements. There is no limit on the number of funds utilized, as long as the purpose of the fund is reasonable and/or mandated.
Fund accounting allows for the control and accountability of restricted resources to better evaluate the performance of the organization. The Governmental Accounting Standards Board (GASB) mandates that governmental entities utilize fund accounting, but FASB does not require the use of fund accounting as of Statement No. 117. However, many not-for-profit organizations use fund accounting for internal accounting and management control. It is not uncommon to see a current or general fund used to account for normal operations, a plant or capital asset fund used to account for fixed assets (such as buildings, etc.), and an endowment fund to account for the endowment investments.
The complexity of net asset and fund accounting is vast, and the information provided in this discussion is very, very basic. It seems that even with all the years of experience I have had with governmental and not-for-profit accounting, it never surprises me to see something different that complies with the GASB or FASB standards.
A common misconception that novices have about net asset and fund accounting is the reasons for transferring and shifting of resources among categories to properly account for the resources. Transferring of resources does not imply any wrong doing or deception but is merely the proper accounting treatment for that fiscal period. It is the responsibility of the financial statement user to know how to read and understand financial reports to analyze these transaction(s).
Until the next installment, here are two things you can do for yourself: