In June 2018, the Financial Accounting Standards Board (FASB) issued new guidance that will change the way we think about revenue recognition as it applies to contracts with government agencies.
Prior to the new guidance, Generally Accepted Accounting Principles (GAAP) did not specifically address whether a contract with a government agency was a nonreciprocal transaction, like a contribution, or an exchange transaction, like a fee for service. Accountants apply general guidelines to the terms and conditions of the contracts to come to a conclusion as to the nature of the transaction and results vary. However, many organizations and accounting firms interpreted GAAP in such a way that most contracts with government agencies are currently considered exchange transactions. The rational for this interpretation, in most cases, is that the government agency is contracting with the not-for-profit to provide services to the government’s constituency and therefore are indirectly receiving value in exchange for the resources provided. This is opposed to the government providing funding in a philanthropic or charitable way. Interpreting government funding as an exchange transaction results in not-for-profit organizations recognizing income under the contract as service is provided and costs incurred. Generally, this results in monthly income matching with costs incurred in that month.
Most people would agree that this is a rational accounting methodology. So why the need for change? The change is a result of the issuance of Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers which covers revenue recognition related to contracts with customers. If government grants are considered contracts with customers, the provisions of ASU 2014-09 would need to be applied to the terms of the contract and in some cases would result in a significant change to how and when income could be recognized. Also, as noted above, not all accountants interpreted government contracts as exchange transactions so the impact could cause even more diversity in practice making comparing financial statements across not-for-profit organizations difficult.
Seeing this potential, the FASB issued ASU No. 2018-08, Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made. Note that this is a clarification of an existing standard and not a completely new standard and that it does not relate solely to contacts with government agencies but to all contributions made and received. In fact, the title does not even imply it related to contracts with government agencies. However, in reading the interpretations, you will quickly see that it is directly related to how government funding is recorded.
ASU 2018-08 explicitly states that societal benefit—even if it furthers the resource provider’s charitable mission—is not commensurate reciprocal value. In other words, when services provided to the public are funded by a government agency, the government agency is not the recipient of the value and therefore is not the “customer.” The government agency cannot be consider analogous to the people it serves. Therefore, unless the not-for-profit is providing service directly to the government itself, it is not engaged in an exchange transaction. The standard does clarify that if the transfer of assets represents a payment from a third-party payer (e.g., a department of education) on behalf of an existing transaction between the recipient and an identified customer (e.g., between a private college and a student eligible for financial aid), other existing guidance would apply.
If most government contracts are not exchange transactions then they are nonreciprocal transactions and should be accounted in the same way as other nonreciprocal transactions (i.e. contributions). This could mean recording the full amount of the government contract upon issuance of the contract as a restricted (assuming the contract contains restriction) contribution. Consistent with current GAAP, contributions are recorded when received or promised unless they are conditional. The ASU further clarifies that definition of condition which is critical.
For a contribution to be conditional under ASU 2018-08, there must be 1) a right if return or release and 2) a barrier the not-for-profit must overcome to be entitled to the funding.
A right of return or release mean that the funder may cancel their promise to pay or request refund of previously provided funding if certain conditions are not met. Most government contracts contain a right of return of release. Whether or not a contract contained a barrier can be more difficult to determine. Therefore, FASB has provided the following indicators that a barrier may exits.
- The not-for-profit is required to achieve a measurable outcome (e.g., help a specific number of beneficiaries or produce a certain number of units).
- The not-for-profit is required to overcome a barrier related to the primary purpose of the agreement. (Note: This excludes trivial or administrative requirements such as submitting reports)
- The not-for-profit has limited discretion over how the resources are spent (e.g., a requirement to follow specific guidelines about incurring qualifying expenses in accordance with approved budgets).
Armed with the clarified guidance, let’s look at one possible scenario involving a government grant. ABC not-for-profit have a grant from their city to provide overnight shelter to homeless families within their city. The contract contains: a budget outlining how the funding is to be spent, right to cancel the contract and request return of funds should be shelter not operate under the terms of the contract, minimum hours of operations, and provision for payments monthly on a cost reimbursement basis.
First, the services of the shelter are provided to the people of the city and not to the city itself so this is not an exchange transaction but a nonreciprocal transaction falling under the ASU 2018-08 guidance. Next, the contract does contain the right of return clause. Lastly, there is a barrier (provision of services and expenditure in accordance with the budget) that must be overcome. ABC not-for-profit will recognize income under this contract on a monthly basis as it meets the conditions of operating the shelter for the minimum number of hours and submitting a request for reimbursement of cost incurred in accordance with the budget.
Note that this is the same income recognition pattern that would have occurred under the prior guidance should the contract have been considered an exchange transaction. However, as a nonreciprocal transaction, the income is subject to contribution accounting which includes presence or absence of donor imposed restrictions. In this case the government agency is considered the donor and the contract clearly contains restrictions on the use of the funding. Therefore, the income is considered “with donor restriction”. This restriction is often met simultaneously with the condition. However, if the not-for-profit organization’s policy is to report all contributions with donor imposed restriction within the “with donor restrictions” net asset class, then the government grant income would need to be reported in the same manner.
Although ASU 2018-08 has its biggest impact on how we consider contracts from government agencies, the guidance must be applied to all contributions. While individual donors rarely, if ever, retain a right of return or release, many foundations grants contain this language. There may be many foundation grants that would have previously been recorded as a contribution with donor restriction when the award letter was received that will now be considered conditional and not recorded until such conditions are met.
The new guidance in ASU 2018-08 is applicable to not-for-profits as resource recipients for annual periods beginning after December 15, 2018 (i.e. 2019 calendar years or 2020 fiscal years) unless the not-for-profit is a conduit bond obligor in which case the guidance is applicable to periods beginning after June 15, 2018. However, early adoption is permitted.