Audit | Tax | Advisory

The Proposed Financial Reporting Standard Issues for Public Benefit Entities

Pesh Framjee Head of Not for Profit at Crowe Clark Whitehill

Special Advisor to the Charity Finance Group (CFG)Member of the Charity SORP Committee

Three new Financial Reporting Exposure Drafts (FREDs)

FRED 46 ‘Application of Financial Reporting Requirements’ (draft FRS 100)

FRED 47 ‘Reduced Disclosure Framework’ (draft FRS 101)

FRED 48 ‘The Financial Reporting Standard applicable in the UK and Republic of Ireland’ (draft FRS 102)

Key changes to framework proposals

Replacing all current accounting standards with a single FRS.

Introduction of a reduced disclosure framework

Retaining the financial reporting standard for smaller entities (FRSSE).

No tier system

Allowing accounting treatments permitted under current accounting standards

Financial Reporting Standards for Smaller Entities

An entity is small if it meets 2 of the 3 criteria:

1. Fewer than 50 employees

2. Turnover below £6.5m

3. Assets less than £3.26m

• Could be a limited change option

• Issues with the definition of turnover

• Where an item is not covered by FRSSE have to turn to the FRS

• FRSSE will be maintained and will have to be updated

• SORP will have to cover both the new FRS and the FRSSE

Timetable

The exposure drafts are open for comment until 30 April 2012

Subject to the feedback received it is expected to issue the final standards by the end of 2012.

The ASB is proposing that the revised proposals should take effect from for accounting periods beginning on or after 1 January 2015 with earlier adoption permitted

SORPs cannot be fully developed or consulted on until the FRSs are issued

Charity Regulations cannot be changed until SORPs in place

Need to consider comparative information so will impact on earlier accounting periods

Statement of Principles

In 2007 the ASB published the Interpretation for Public Benefit Entities of the Statement of Principles for Financial Reporting which sets out the principles that should underlie the preparation and presentation financial statements of public benefit entities

Overall

There is much in the FRED that will be of value to PBE’s and the general principles are well recognised and strong

Regrettably there continues to be much scope for confusion in key areas for PBEs

The requirements that are PBE specific often do not recognise important trust and charity law requirements and appear to conflict with other key parts of the FRED

Some easy fixes but your response is really needed.

Areas of Concern

Major concerns (but easy fixes)

1. The recognition of restricted income

2. The recognition of grants receivable

3. The recognition of funding commitments

4. The valuation of gifts in kind

Some other areas which can be lived with

Income recognition – Restricted income

Non Exchange Transactions (PBE 34.63)

“A non-exchange transaction is a transaction whereby an entity receives value from another entity without directly giving approximately equal value in exchange or gives value to another entity without directly receiving approximately equal value in exchange”

• Donations, legacies, donated goods and services etc

• Grants?

FRED 48’s definitions are the root of the problem

Restriction: “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”

Performance Condition: “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”

The derogation that states that restricted income can not include funds that have to be returned to a donor if they are not used as specified flies in the face of well recognised principles of charity accounting and charity law.

Mixes up a restriction with a condition

“PBE34B.13 Some resources are given with performance conditions attached which require the recipient to use the resources for a particular purpose in order to be entitled to retain the resources. An entity will not recognise income from those resources until these performance conditions have been met.”

• Purpose restrictions are not performance conditions.

• A better definition for performance condition – ‘a condition that requires the provision of specified service or goods where the entitlement to payment is conditional on the specified good or services being provided’

• There are other conditions that are not performance related

Why does this matter?

“PBE34.65 An entity shall recognise receipts of resources from non-exchange transactions as follows:

Transactions that do not impose specified future performance conditions on the recipient are recognised in income when the resources are receivable.

Transactions that do impose specified future performance conditions on the recipient are recognised in income only when the performance conditions are met.

Where resources are received before the revenue recognition criteria are satisfied a liability is recognised.”

• Flawed definitions will change how charities account for income

• The general income recognition principles have not changed, why should the income recognition principles for PBEs change so dramatically?

Repayment possible if income not used as specified

FRED says this will not be restricted income and will therefore not be accounted for when receivable

Income recognition needs to be deferred and a liability set up if income has already been received

• Almost all income received by a charity has the possibility albeit remote of it being repaid

• The receipt of restricted income does not really affect the liabilities unless it is probable that the income is to be returned.

• Unspent restricted income increases the net assets of a charity and the concept of trying to set up a matching liability on the basis that it may in rare circumstances require repayment could be seen as an artificial measure to reduce the stated net assets.

Income recognition – Grants

What distinguishes a grant from a donation?

“24.1 This section specifies the accounting for all grants by government and others. A government grant is assistance by government in the form of a transfer of resources to an entity in return for past or future compliance with specified conditions relating to the operating activities of the entity.”

• There has long been a view that there is no discernible distinction between a grant and a donation

• Some may call gifts from a corporate body or a charitable trust grants whilst others call them donations

• However, the definition above would imply that a grant must be a conditional donation – unless government grants are to be defined differently to other grants

• This itself, appears to be incorrect as many grants are pure gifts and are unconditional

Grant recognition - Performance model (24.5B)

a) A grant that does not impose specified future performance conditions on the recipient is recognised in income when the grant proceeds are receivable.

b) A grant that imposes specified future performance conditions on the recipient is recognised in income only when the performance conditions are met.

c) Grants received before the revenue recognition criteria are satisfied are recognised as a liability.

This will only work if the problems with the definitions of restrictions and performance conditions are sorted out

Grant recognition – Accruals model (revenue)

24.5D Grants relating to revenue shall be recognised in income on a systematic basis over the periods in which the entity recognises the related costs for which the grant is intended to compensate.

• Consider a charity that receives a grant for its work in Africa – 24.5D would mean that it does not recognise the income until it has recognised the related costs.

• In the meantime it has to treat the income as a liability but in fact this does not meet the definition of a liability.

• Does it also have to do this with a donation?

• Most income would not be recognised under the normal income recognition rules but would be deferred

• Impact on cost ratios

Grant recognition – Accruals model (grants for assets)

“24.5F:Grants relating to assets shall be recognised in the income on a systematic basis over the expected useful life of the asset”

• The proposals mean that if a charity was left a building that it would be using it would be required to recognise the income when the gift was received.

• However if it was gifted the money to buy the building the income could be deferred over many years.

• What about mixed funding?

• The creation of a liability to match the asset would mean that no fund (general, restricted or permanent) would be identified against it

• Impact on cost ratios

Grant or donation

What about a capital appeal to build a new hospice? When should the income be recognised?

When the income is received?

When the hospice is built or

over the useful life of the hospice?

What happens when the asset is part funded by government grant and individual donations (eg Great Ormond Street Hospital)

Interim solution

ASB recognises inconsistencies

The principle based approach originally recommended would have been in line with Charity SORP

Now awaiting a research project

Hope that the SORP will not have to change its recommended treatment

Funding commitments

Funding Commitments

“34.56 When applying these paragraphs, the requirements of Section 2 Concepts and pervasive principles’ and Section 21 (Provisions) shall also be taken into consideration.”

• There is a strong body of opinion that funding commitments should be accounted for under the general rules for accounting for liabilities and that a special section which appears to depart from this is not warranted.

• Sector specific SORPs can provide additional guidance where needed.

Can have a liability even where there is no enforceability

“2.20 An essential characteristic of a liability is that the entity has a present obligation to act or perform in a particular way. The obligation may be either a legal obligation or a constructive obligation.”

• “An entity may be commercially obliged to adopt a certain course of action that is in its long term best interests in the widest sense even if no third party can legally enforce that course

• In these circumstances the accounting should reflect the substance over the form.” (FRS 5)

Recognition of funding commitments

“34.57 An entity shall recognise a liability, where it has made a commitment that it will provide resources to another party, if, and only if:

(a) the obligation (which may be constructive) is such that the entity cannot realistically withdraw from it; and

(b) the entitlement of the other party to the resources does not depend on the satisfaction of performance conditions.”

• Need to get the definition of a performance condition right

• Should make a distinction between events within and outside the control of the reporting entity

Form over substance?

“34A.2 A promise to provide cash conditional on the receipt of future income does not give rise to a liability as the entity cannot be required to fulfil it if the future income is not received.”

Should not lose sight of the fundamental definition of a liability as set out in the FRED – need to consider:

• Substance over form

• The concept of a constructive obligation

• More compelling criteria to define a liability rather than the inclusion or such a clause

• The probability of the transfer of economic benefit

Is the focus on availability of funds correct?

• Despite such general caveats it is in fact usually highly probable that there will be an out flow of funds. Therefore the definition of a liability is met.

• The substance of the transaction is often the same

regardless of such caveats • Charities strongly expect to have the necessary

funding and to make the payment.

• Therefore the charity SORP specifically mentions that a condition that states that payments are dependant of future funding does not prevent the recognition of a liability.

Operational realities

“21.6: The condition in paragraph 21.4(a) (obligation at the reporting date as a result of a past event) means that the entity has no realistic alternative to settling the obligation. This can happen when the entity has a legal obligation that can be enforced by law or when the entity has a constructive obligation because the past event (which may be an action of the entity) has created valid expectations in other parties that the entity will discharge the obligation.”

• The existing framework provides the flexibility for charities to focus on their operational realities

• Many charities do not account for multi year grants on the basis of their operating practice.

• Why should such an availability of funding clause define the accounting?

Gifts in kind and fair value

Measured at Fair Value

Fair Value - “The amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged between knowledgeable, willing parties in an arm’s length transaction.”

PBE34B.15: ‘Paragraph PBE34.71 requires resources received to be measured at their fair value. These fair values are usually the price that the entity would have to pay on the open market for an equivalent item.’

• ASB considered and rejected the “service potential” approach

• Unhelpful references to “cost to donor” – rejected in SORP 2005

• SORP focuses “value to the charity.” (SORP: 130)

Valuation of gifts in kind

The ASB discussed whether: “using a fair value would overstate the value of a donation where the entity is unable to exploit fully an asset and the equivalent service potential could be derived from a lower value asset.

They recognised that: “Being able to achieve the same service potential from a lower value asset might suggest that the value of the donated asset should be at the lower value.”

They concluded that: “Donated assets should be valued at their fair value. This reflects that the circumstances described above would rarely occur. In many cases, an entity would be able to sell the donated asset and if appropriate, purchase a cheaper asset with the equivalent service potential”.

Do these situations “rarely occur”

• In reality these situations are common when gifts in kind are received

• In most cases where donors provide a gift in kind for use or distribution by a PBE, the PBE is not usually able or expected to convert it into cash.

• Consider donated office space, assets for distribution, donated professional services etc

• It is important that the ‘fair value’ reflects the price that the PBE would pay for the equivalent service potential.

Gifts in kind - goods

FRED 48Recognition

FRED 48Measurement

SORPRecognitio

n

SORPMeasurement

Gifts for resale

When received (but can use cost v benefit)

Estimated resale value less costs of sale

When sold Value realised treated as income

Gifts for own use

When received

At fair value (open market value)

When received

Value to the charity

Gifts for distribution

When received

At fair value When distributed

Value to the charity

Any further clarification

Pesh Framjee

Head of Non Profits

Crowe Clark Whitehill

St Bride’s House

Salisbury Square

London EC4Y 8EH

UK

nonproftis@crowecw.co.uk

Pesh.framjee@crowecw.co.uk