FINANCIAL REPORTING

The Balance Sheet – Part 2 – Net Assets

In our examination of the asset and liability sections of the balance sheet we learned the accounting equation TOTAL ASSETS = TOTAL LIABILITIES + NET ASSETS. We can rewrite the equation as NET ASSETS = TOTAL ASSETS – TOTAL LIABILITIES.

On a nonprofit balance sheet, net assets, also known as “net worth” or “fund balance,” is the value of your assets that remains after you have subtracted all of your liabilities. Suppose JKL nonprofit starts out its first year with unrestricted donations of $100,000 cash and purchases equipment with a $20,000 loan. Operations have not started, and its only expense for 20×1 was $1,000 in interest for the loan. No principal was paid on the loan. JKL’s financial statements (ignoring depreciation) for the first year are shown below. If JKL closed down on 12/31/x1 the net assets of $99,000 would be returned to the donors or turned over to another nonprofit with a similar purpose per nonprofit law.

We can see that net assets is equal to total assets minus total liabilities and thus the balance sheet is in balance. But there is more to net assets than just a number that we plug in to make the numbers balance out. Net assets is the sum of the surpluses and deficits that occurred every year since inception of the organization. You can see from our example that JKL’s net assets in its first year are equal to its net income. In year two net assets will equal net income for year one plus net income for year two.

In case it is not intuitive that cumulative net income is equivalent to assets minus liabilities, let’s dig a little deeper by taking a look at how net assets get to the balance sheet.

It helps to remember that every balance on the balance sheet, including net assets, comes from the general ledger, and every single transaction that goes into the accounting system is two-sided – hence the term “double-entry bookkeeping.” Our general ledger software shields us from the dreaded debits and credits, but there is an invisible, green-visored accountant hunched over a desk in the virtual back office who never forgets to include both sides of every transaction. When JKL received the donation, both cash and revenue were increased. When the interest was paid, both cash and expense were decreased. Cash affects assets, and revenue and expense are eventually closed out to net assets. When the loan was taken out cash and liabilities were both increased; these will offset each other when liabilities are subtracted from assets. When the cash was used to purchase equipment JKL simply exchanged one asset for another. The end result is that all changes in assets and liabilities either offset each other or are reflected in net income.

But net income is reported on the income statement; how does it get over to the balance sheet you ask? Well, our invisible accountant takes care of that at year-end by zeroing out all of the revenue and expense accounts, with the offset to net assets. Here are the closing entries for JKL where we have one revenue account, one expense account, and a net asset account.

The net effect is an increase to net assets of $99,000.

No entries other than year-end close entries touch the net asset account so year after year the net asset balance in your general ledger will reflect accumulated net income (or deficit) only.

A CLOSER LOOK AT NET ASSETS

We have been following the fortunes of our fictional nonprofit, Fair Haven Animal Refuge (FH), during our investigation of the income statement and balance sheet. We looked at the asset and liability section of their balance sheet. As an ongoing organization, FH has been reporting revenues and expenses annually on the income statement and the net income or deficit has been accumulating in net assets, which were $251,000 at 12/31/x1. Here is FH’s balance sheet as of 12/31/20×2.1

We know that the purpose of financial statements is to inform management, board and other readers about the financial health of the organization. What does FH’s net asset balance tell us? There is valuable information here, but the net asset balance is tricky to interpret. We know that it is the sum of all of the surpluses and deficits since inception, so from a financial stability perspective we are looking for a positive number; the higher the better.

You might think that the net asset balance would give you an idea of the resources available for emergencies or to pay for short- and long-term obligations or projects. Although net income, net assets, and cash are equal on JKL’s balance sheet, in real life net income on a financial statement prepared according to generally accepted accounting standards (GAAP) is by no means equal to cash because it can include non-cash income and expense items. Often called “non-operating” items, these may be depreciation, gain or loss on disposal of fixed assets, or adjustments to record investment balances at market value, to name a few. Additionally, over the years, cash received and recorded as revenue may have been used to purchase property and equipment, which are not liquid assets. Yes, fixed assets are often acquired with loans, but in the nonprofit world, they are often acquired with grants and donations as well.

For the moment we will ignore the donor restricted column on Example 7. Looking at the lefthand column we see that FH started out the year with net assets of $251,000 and added $5,000 of net income to arrive at total unrestricted net assets of $256,000. To know what portion of the $251,000 is available cash, we would have to look at all of FH’s prior years’ cash flow statements to see how cash was used and we would need to see which non-cash items were reported on the income statements. The financial statement reader is far better off looking at today’s working capital to assess FH’s ability to pay its bills.

DONOR RESTRICTIONS

The middle column in the example above spells out the receivables and net assets that are associated with donor restricted revenues. In our series of articles on revenue recognition, we discussed the GAAP rules for recording grant and contribution income. These require that unconditional grant revenue be recorded upon notification of the grant award. FH received an unconditional five-year grant of $100,000 in March of 20×2, which it recorded as income. It spent $20,000 for the intended purpose in 20×2 and recorded receivables of $80,000. You might ask: If the grant was for $100,000, where is the $20,000 for the first year? Answer: It is included in the $805,000 of revenue in the “without donor restrictions” column. According to GAAP, in the year that the grant funding is spent for the intended purpose it is treated as unrestricted. Of the remaining $80,000, $20,000 in cash will be received and spent in 20×3 and $60,000 in cash will be received and spent in 20×4 through 20×6. These are recorded in the “with donor restrictions” column. If you are wondering why an “unconditional” grant is “donor restricted” on the balance sheet click here.

The $80,000 has given a nice boost to total net income and total net assets in 20×2. But, assuming that all other revenues and expenses remain the same, and unless new grants are added each year, total net income and total net assets will decrease each year between 20×3 and 20×6 by $20,000 as the expenses of the grant project are incurred. If the grant is renewed in 20×7 the cycle will start over again. This process is contrary to the fundamental accounting concept of matching revenues and expenses in the same year, but GAAP demands it and we obey.

BOARD-DESIGNATED RESERVES

Reserves are unrestricted cash balances built up in surplus years. Many organizations that have unrestricted reserves will opt to carve out a “board-designated fund” from their net asset balance. The purpose is to inform the reader and to remind board and management that unrestricted cash was generated in surplus years and has been set aside for purposes subject to board approval.

Going back to JKL, suppose that management and board plan to start providing services in 20×2, but the board wants to set aside $20,000 of net assets for technology upgrades sometime in the future. Net assets of $99,000 were generated by the cash donation, and there are no donor restrictions, so $20,000 can be board-designated. The balance sheet would look like this:

This tells the reader that of the total net asset balance of $99,000, $20,000 is earmarked for a future project. In this first year, we can see plainly that cash is equal to net assets. Does that mean that JKL can go out and buy $99,000 of equipment? No! A cash cushion is needed for day-to-day cash flow. Once operations begin, cash will be needed for payroll and routine expenses. Receivables may not turn over quickly enough to stay current on bills without this cushion. The board has determined that $79,000 is needed for operating cash flow so only $20,000 is designated.

The board-designated fund is not to be confused with cash or an investment account. It is simply a signal to the reader of the balance sheet that over the years unrestricted assets have been built up through surpluses and the board has created self-imposed restrictions on a portion of those assets. The board-designated amount can be increased, decreased, or eliminated at any time at the board’s discretion.

Board-designated net assets are a sign of good financial health. Organizations that operate close to breakeven are to be commended for living within their means, but reserves are a must to survive a catastrophe such as a flood or pandemic, and to invest in infrastructure and future growth.

For more on the accounting and reporting of reserves click here.

TO CONCLUDE

Net assets is the section of the balance sheet that most readers, and even managers and CFOs, understand the least. It is a critical component of the accounting equation that must be there for the balance sheet to balance. The entire history of the organization’s surpluses and deficits boils down to the net asset balance, but it can only be understood by reviewing the financial statements in their entirety.

Endnotes

  1. Accountants specializing in nonprofits know that “net assets beginning of year” and “net assets end of year” belong on the Statement of Activities. I included this calculation on the balance sheet for illustrative purposes. ↑