In June 2018, the Financial Accounting Standard Board (FASB) issued clarifying guidance to FASB ASC 606 Revenue from Contracts with Customers. The update impacted all entities that make or receive grants and contributions. Here we focus on the impact of the clarified guidance for recipients of Federal Grants or Awards (Federal Financial Assistance).
Treatment Under Previous Accounting Guidance
Prior to FASB ASC 606, there were two methods used in practice to recognize revenue from Federal Financial Assistance (FFA). The first treated FFA as unconditional contributions restricted as to purpose. The more common method treated FFA as conditional contributions resulting in the recognition of revenue as reimbursable expenses were incurred.
Under the “unconditional contribution method”, an organization recognized a contribution receivable upon receipt of FFA with a corresponding increase in temporarily restricted revenue. As allowable expenses were incurred, the organization released restrictions equal to the amount of reimbursable expenses incurred. At the end of the award period, if the award was completely spent, the receivable and restricted net assets were equal to $0. However, in certain circumstances, if the full amount of the award was not spent within the period of performance, the organization posted adjustments to revenue and receivables reducing both accounts to $0.
Under the “conditional contribution method” a recipient of FFA recognized a purpose restricted contribution as conditions were met. Within the framework of FFA, this generally meant upon the incurrence of allowable costs in furtherance of the federally funded program.
Simultaneous Release Option
GAAP allows an organization to report restricted contributions that are met in the same period in one of two ways. The organization has the option to report the revenue as temporarily restricted with a corresponding release from restrictions, or to report those contributions as unrestricted (known as the simultaneous release option). Most organizations elect to use the simultaneous release option. This policy decision must be disclosed in the notes to the financial statements and applied consistently.
The application of the simultaneous release option results in presentation of revenue in a manner that would be achieved in a cost reimbursable contract. Given the similar presentation, many in the profession have treated FFA as cost reimbursable exchange transactions. The new guidance, however, makes it clear that FFA should not be considered an exchange transaction.
Diversity in Application Led to Diversity in Timing of Revenue Recognition
Varying interpretations of FASB ASC 605 led to divergent methodologies of revenue recognition. This diversity in practice generally relates to the interpretation of what constitutes a condition. The disagreement largely centered around whether the federal cost principles and post award requirements imposed via the Uniform Guidance (previously OMB Circulars A-110, A-122 and the Common Rule) should be considered conditions or lesser requirements akin to administrative burdens.
The difference in these interpretations led to one of two treatments:
- Revenue was recognized upon receipt of FFA. In this method, revenue is recognized as a component of temporarily restricted net assets when received. In subsequent periods net assets are released from restrictions and transferred to unrestricted. In practice, this leads to periods in which there are large increases in net assets in the first year of an award and gradual declines in subsequent periods.
- Revenue was recognized as reimbursable expenses were incurred. In this method, revenue and expenses are generally equal. As a result, large variances in net assets between periods are not encountered.
Treatment Under the Current Guidance
The clarifying guidance to ASC 606 eliminates much of the confusion surrounding the classification of a transaction as a contribution or an exchange transaction. The guidance includes as a test whether or not the grantee and grantor receive commensurate value. If the grantor/grantee receive commensurate value, the transaction is a reciprocal exchange transaction. Lacking commensurate value, the transaction is a nonreciprocal contribution. The clarifying guidance however, indicates that benefits to public or the common good are not to be considered commensurate value. Excluding these societal benefits from the measurement of commensurate value generally results in FFA being considered contributions.
Conditional or Unconditional
The clarifying guidance identifies the process for determining whether a contribution should be considered conditional or unconditional. If the answer to both of the following questions is a yes, the contribution is conditional.
- Does the contributor maintain a right of return to assets provided or a release from its obligations under the agreement?
- Is there a barrier that must overcome in order to be entitled to resources provided?
The FASB also provided guidance to clarify the definition of a barrier. A barrier exists if any of the following are true:
- There is a requirement to achieve a measurable outcome
- There is requirement to overcome a barrier related to the primary purpose of the agreement
- There is limited discretion over how resources are spent (e.g., a requirement to follow specific guidelines about incurring qualifying expenses)
Most federal grant recipients understand that unspent funds must be returned to the federal government and that in order for an expense to be considered allowable, it must meet the requirements of the applicable federal cost principles. Accordingly, FFA should be treated as conditional contributions. Under this treatment, revenue should be recognized to the extent that qualifying expenses have been incurred.
Restrictions on Use
Substantially all FFAs come with restrictions on the use of the funds. Federal awards must be expended for their intended purpose. Accordingly, we can conclude that revenue recognized under an award based on qualifying expenses incurred is restricted revenue. However, the same policy decision related to the simultaneous release or restrictions must be followed under the revised guidance. A nonprofit organization that chooses to use the simultaneous release method would recognize revenue as a component of unrestricted net assets.
The new standards aim to eliminate the diversity in practice and as a result will greatly enhance transparency in financial reporting for nonprofit organizations. The clarified standards result in revenue being recognized only as reimbursable expenses are incurred. The only real diversity in practice will relate to the use of the simultaneous release option. Given that the FASB’s recent pronouncements have focused heavily on reducing diversity in accounting treatments, this may not be the last we hear about this topic.