Essay 13

REVENUE RECOGNITION – CONTRIBUTIONS AND GRANTS

Part 1 – The Rules

Since 2018 the contribution and grant revenue landscape under GAAP—Generally Accepted Accounting Principles—has changed dramatically. The decision tree that describes the rules for recognition of grant and contribution revenue contains ten elements with a number of terms that require explanation. Both new and experienced practitioners who follow GAAP struggle to structure their accounting and reporting for contribution revenues to satisfy management, board, and auditors.

In my retirement I serve as treasurer for a $20,000 community orchestra in which I also play viola. We and many other small nonprofits are not required by either our state or our funders to produce audited GAAP financial statements. This series is not for us, but any nonprofit with an audit requirement must negotiate that decision tree. Everything that follows in this three-part series is about when grant and contribution revenue is recognized. When your grant and contribution revenue is spent in the year of receipt your revenue is unrestricted and you are home free. Unfortunately, revenues and the related expenses often cross fiscal years and then the fun begins.

CONTRIBUTION REVENUE VERSUS EXCHANGE TRANSACTION REVENUE

Let’s start by eliminating revenues that are not classified as grants or contributions. Suppose the ABC nonprofit runs two programs: a food pantry and a family counseling program. The food pantry distributes food to community members in need. Licensed social workers in the counseling program provide hour-long one-on-one counseling sessions with individuals and families according to a sliding scale fee schedule. The fee income is not sufficient to cover all costs of the counseling program.

Every time ABC receives a check, the business office must assign a revenue code. Let’s assume that there are three choices:

1. Counseling fee income
   1. Payments from clients for their counseling sessions.
   2. Payments from a third party, such as Medicaid, for a specific individual’s counseling sessions.
2. Unrestricted contribution income—contributions to the organization with no indication of how the funds are to be used.
3. Restricted contribution income—contributions that direct the organization to use the funding for either the pantry or the counseling program. In both cases the money may be spent for any component of the named program, whether it be salaries, office supplies, utilities, or any other expense associated with that program. This type of restriction is not to be confused with a “barrier” which we will cover in depth below.

The first is fee-for-service income which results from an exchange transaction. Counseling sessions are entered into by two parties who each derive an identifiable benefit from the transaction. The terms “reciprocal” and “exchange” are used interchangeably for this type of revenue.

The second and third are examples of contribution income.

Exchange transaction revenue comes with its own set of accounting standards, most recently ASU 2014-19 topic 606 “Revenue from Contracts with Customers.” For guidance see Douglas E. Cook MPA CPA “A Primer on Nonprofit Contributions and Revenue from Contracts with Customers” Blue Avocado January 13, 2021.

Now let’s get back to the topic at hand: accounting for contribution revenue, including grants.

GAAP HAS A LOT TO SAY ABOUT CONTRIBUTION REVENUE

Let’s say that ABC receives a $25,000 donation on December 28, 20×1 for the counseling program. What to do with this check? The program is now at breakeven and the $25,000 cannot be spent in three days. The CFO wants to defer that $25,000 to next year. Recording the revenue today will generate a $25,000 surplus in the counseling program and the matching principle will be sacrificed.

And yet GAAP says that unconditional contributions must be recorded when promised or received. A check with no donor stipulations is an example of #2. Our $25,000 check is an example of #3. Both checks are treated as unconditional contributions under GAAP.

The “matching principle” is one of the first that we learn when we take up accounting. Revenues and expenses are recorded in the period in which the activity takes place. Without this principle the income statement verges on being meaningless. In 20×2 the $25,000 will be spent on much needed items such as training, a vehicle, technology, etc., but the program will end the year with a $25,000 deficit. During 20×2, as the deficit gets larger and larger each month, a conscientious board will be obliged to ask why the program is in trouble.

The FASB—Financial Accounting Standards Board—is today the source of virtually all standards that comprise GAAP. The famous FASBs 116 “Accounting for Contributions Received and Contributions Made” and 117 “Financial Statements of Not-For-Profit Organizations” were issued back in 1993. 116 lays down the law about when unconditional contributions and promises to give must be recorded, and 117 addresses how they are presented in the financial statements.

Here is a first look at the crucial concepts contained in 116 and 117. Part II of this series will continue the discussion in more depth.

• Contributions are, by definition, nonreciprocal, unlike exchange transactions.

Aside from a tax deduction and a good feeling, the donor does not expect anything in return for the gift.

• Unconditional contributions are either unrestricted or restricted
  • An unrestricted donation comes with no strings attached. The organization may use it for any purpose within the bounds of the mission.
  • An unrestricted donation is classified as unconditional.
  • A donation with a time or purpose restriction is also classified as unconditional. The $25,000 gift had a purpose restriction. The donor specified that it must be used for the counseling program.
  • Conditional contributions are not covered in FASB 116. ASU 2018-08, discussed below, introduces and defines conditional contributions.
• All unconditional contributions are recognized in the year of receipt.

116 says that an unconditional donation received in December of 20×1 must be recorded in 20×1. If the money is restricted and cannot be spent for the donor’s intended purpose by the end of the year the revenue will be labeled “donor restricted” in the financial statements.

WHAT ALL THIS MEANS FOR THE CFO

Back in 1995 it took me a couple of audit cycles to absorb the seemingly obvious fact that restricted revenue can only be recorded once. The $25,000 received in 20×1 will be revenue in 20×1 and will not be there for you in 20×2 when you pay for the training, vehicle, or technology. Yes, under 117, your 20×1 audited financial statements will disclose that the revenue is restricted, but the fact remains that it is closed out to net assets in 20×1 and cannot be brought back in 20×2.

Why did the FASB issue this rule? The sacrifice of the matching principle is a rather steep cost for us CFOs, but readers of a nonprofit’s financial statements certainly benefit from knowing about the resources available to the organization.

GRANTS ARE CONTRIBUTIONS

The word “grant” does not appear anywhere in FASB 116 or 117; we wouldn’t expect it to because our intuitive sense is that a grant is a different animal from a contribution. The grantor does indeed expect something in return from the grant recipient. Most grants come with applications, contracts, and reporting requirements. Furthermore, we assume that unused funding must be returned when the expenses of the project fall short of the promised revenue.

In 2018 the FASB’s Accounting Standards Update (ASU) 2018-08 “Not-For-Profit Entities (Topic 958): Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made” was added to the GAAP canon. One of the purposes was to broadcast to the community that grants are indeed contributions and therefore come under the umbrella of 116 and 117.

The ASU helps us to understand this point by explaining why a grant is not an exchange—or reciprocal— transaction any more than an individual contribution is. Payment of a fee for a counseling session is an exchange contract, but grant funding does not function in this way, says the FASB. The value to the grantor cannot be quantified. Sometimes the general public, which is not a direct party to the agreement, is the beneficiary of the funding. The fact that the funding is associated with a host of administrative tasks does not alter its essential nature.

Project grant funding is restricted, for sure, but so is a $100 check on which the donor writes in the memo line “for the food pantry.” The $100 check for the pantry and a grant that promises to provide $10,000 for the uncovered costs in the counseling program are both unconditional contributions with a restriction.

ASU 2018-08 HAS FOREVER CHANGED ACCOUNTANTS’ UNDERSTANDING OF GRANT REVENUE

Before ASU 2018-08, the common practice, especially for large grant contracts, was to disregard FASB 116 and 117 and hold off on recognizing grant revenue until it could be matched with the expenses. Today CFOs struggle to apply the rules to the wide variety of time frames and conditions that may accompany a grant award. Parts II and III discuss the practicalities of recording grant revenue and offer some suggestions for coping with the loss of the matching principle when revenue is recognized before the expenses are incurred.

The story does not end here, however. Even though under GAAP all grants are contributions, ASU 2018-08 explains that when a grant is considered conditional, a new set of rules comes into play.

GRANTS ARE UNCONDITIONAL OR CONDITIONAL

The $25,000 check in our example was a donation, but suppose ABC had applied to a local foundation for $25,000 for counselor training for the 20×2 year and the award letter and check arrived on December 28 of 20×1. Despite the fact that counselor training is specified in the award letter, this is classified as an unconditional grant and is treated as a contribution with restrictions that must be recorded in the year of receipt.

With a few alterations to the grant agreement the grant would have been classified as conditional. The foundation might have stipulated that the funding was payable only after the counselors attended a specified conference. In this case the check was a cash advance and would have been recorded as deferred revenue (a liability), and revenue would not be recorded until the foundation was shown proof that the counselors had attended the conference. If the entire $25,000 was not spent on the conference, the remainder would be returned to the foundation.

ASU 2018-08 spells out the elements of a conditional grant:

• The grant agreement specifies that unused funding must be returned—“right of return.”

AND

• The grant agreement includes a “barrier.”

A barrier is more limiting than a time or purpose restriction and can therefore be thought of as a condition, but the right of return must also be present to bump the grant into the conditional realm.

Examples of barriers most commonly found in grant contracts:

• Matching funds: the grantor promises to make a specified contribution after the grantee has raised a specified amount for the project.
• A performance measurement states that a specified amount of funding will be provided after:
  • 1000 meals are provided
  • 50 youth mental health assessments are performed
• A specific individual must be hired or specific protocols followed.
  • A specific individual will be hired to provide a training
  • Green building standards will be followed for a capital project

The essential point here is that the organization is not entitled to conditional grant funds until a specific requirement is met. The organization must earn the revenue by overcoming the barrier. A cash advance is unearned and the obligation to pay does not exist until the meals are provided, the assessments are performed, the individual hired, etc. In our example, a request for counselor training is not limited enough to meet the definition of a barrier, but a requirement to use the funding only to attend a specific conference is. The matching principle is back in business when the grant is deemed to be conditional.

GRANT REQUIREMENTS THAT ARE NOT BARRIERS

• Administrative requirements: Operationally, grants differ significantly from contributions. Grants come with applications, budgets, reports, requests for payment, etc. The funder usually expects the grantee to request permission to deviate from the budget. None of this administrative activity constitutes a barrier. A $500,000 grant for a library outreach program rife with paperwork and reporting requirements will be unconditional if there are no additional limitations, and no metrics are identified.
• “Spending the money”: A requirement to return unused funding is an element of a conditional grant, but it is not a barrier. In the past, CFOs believed that right of return was sufficient to deem the grant funding to be contract revenue which could be recognized when earned.
• Multiple year timeframes: A five-year grant with no barrier is unconditional with a time restriction. Yes, you will have to record five years’ worth of income in the year that you received official word that your grant application has been approved.

POP QUIZ

Instead of saying “for the food pantry,” suppose our $100 donation check says in the memo line “to purchase 25 pounds of chicken.” Is the donation conditional or unconditional? To keep this simple let’s assume that the food pantry is delighted to have $100 to buy chicken.

Answer: unconditional. The note on the check meets the definition of a barrier, but the donor has not specified that the money must be returned if the chicken is not purchased. You may think that the right of return is implied. Indeed, a conscientious nonprofit will contact the donor and propose an alternate use of the money if raw chicken is not one of the offerings at the food pantry. But technically speaking, this is an unconditional donation. It will be recorded as income in 20×1. If the purchase does not occur until 20×2 it will be designated as donor restricted on the 20×1 financial statements.

GOVERNMENT GRANTS

Most government grants stipulate that the entity must follow specific guidelines pertaining to qualified, allowable expenses. All Federal grants require that OMB standards for expenses be followed, and state and local contracts will likely reference a collection of rules that must be followed. This requirement is recognized by GAAP as a barrier because it limits the discretion of the organization in carrying out the funded activities.

The limited discretion barrier applies to just about any government grant. Since right of return is also fundamental to government contracts, the chances are high that your government contracts will be treated as conditional.

RECAP

1. Contributions are, by definition, nonreciprocal transactions.
2. Unconditional contributions are either unrestricted or carry a time and/or purpose restriction.
3. A restriction is not a condition.
4. Unconditional contributions are recognized as revenue when received or promised.
5. Virtually all grants are contributions rather than exchange contracts.
6. Grants are conditional if the agreement specifies a right of return and a barrier.
7. Conditional contribution revenue is recognized as expenses are incurred.
8. Most government grants are conditional.

My purpose here has been to lay out the GAAP rules and underlying concepts regarding contributions. Part II explores the treatment of contribution income in the financial statements and offers suggestions on navigating the rather choppy waters of revenue recognition.