Regulations regarding recognition of revenue by not-for-profit organizations, effective since April 1, 1997, are complex and often misunderstood. Confusion can arise at the time annual financial statements are prepared, especially where revenue recognized in the audited statements is significantly different from that expected by management. This article will attempt to shed some light on revenue recognition requirements to help you better understand and anticipate how revenue will be reported in your external financial statements.
Types of Revenue
Revenue in the not-for-profit sector can be divided into two major categories. The first is revenue earned by an organization through the provision of services and the sale of goods. The second is revenue received from contributions for which no direct provision of services or goods is expected.
Revenue in both the for-profit and not-for-profit sectors is recognized when goods have been delivered or services rendered and when payment for the good or service can be reasonably assumed. Earned revenue can come from sources such as the sale of goods, the provision of services or the use by others of an organization’s resources yielding rent, interest, or royalties.
A membership organization charging its members fees for services rendered would recognize the fee revenue as earned over the membership period. An organization with a June 30 year end charging membership fees on a calendar basis would determine what portion of the services had been rendered by June 30. If payment for a full calendar year of services had been received before June 30 then the portion of fees to be earned between July and December would be deferred to the following year.
Contribution revenue is unique to the not-for-profit sector. Contributions are transfers of money and other assets to a not-for-profit organization with no expectation of service being provided directly to the person making the contribution. Contributions can be government grants, donations of cash and other assets, or cancellation of liabilities. It is the timing of recognition of contribution revenue that typically creates confusion.
Methods of contribution revenue recognition
In Canada not-for-profit organizations may use the following two methods to recognize revenue from contributions:
- Deferral method: Under the deferral method, revenue is recognized when expenses directly related to the revenue are incurred.
- Restricted fund method: The restricted fund method is a specialized type of fund accounting whereby funds are segregated by type of donor restriction, typically into restricted, endowment and unrestricted funds. Note that the restricted fund method is not the same as an organization reporting on a program-by-program basis. Rather, the grouping is based on the type of restriction the contributor places on the resources. Under the restricted fund method contribution revenue is generally recognized in the period contributions are received.
Types of contributions
There are three main types of contributions: restricted, endowment and unrestricted. Following is a description of each type of contribution restriction and the difference between for accounting purposes reporting with the deferral and restricted fund methods. The proper classification of donor restrictions is critical to determining how contributions are accounted for. Most restrictions will be explicitly stated by the contributor at the time of giving.
A restricted contribution is a contribution that comes with a specific condition or restriction imposed by the donor. The organization must use a restricted contribution for the purpose specified by the donor. For example, a donor may give a contribution specifically for purchase of a capital asset or for use in a specific type of program. Failure to do so would typically result in the funds being refunded to the donor.
- Deferral method
Restricted contributions, under the deferral method, are recognized as revenue in the period in which the related expenses are incurred. Contributions for expenses not yet incurred are, therefore, deferred to a later date. For example, donations for capital assets such as computer equipment or a building must be recognized over the same period that the assets are charged to expenses. Consider the case of a contribution to an organization for the purchase of a computer. For accounting purposes computers are often assumed to have a life of three years. The organization would both write-off the computer over a three year period and recognize the contribution as revenue over the same three year period. Similarly, purchase of a building with an expected life of forty years would result in contributions for the purchase of the building being deferred in the year of donation and then recognized over a forty year period.
There is another significant rule under the deferral method. Donations of land and other assets that will not be amortized at any time are never recorded as revenue. They are instead recorded as a direct increase in net assets, similar to an endowment contribution.
Restricted fund method
Restricted contributions are recognized as revenue in the year received. As an example, a donation of a million dollars to a building fund would be recorded as revenue of the building fund in the year received.
Restricted contributions received for which there is no designated fund should be recognized in the general fund under the deferral method. As a result, revenue may be recognized under both the restricted fund and deferral methods in a single set of financial statements. It is crucial that you read the notes to the financial statements to ensure that you fully understand which methods are being used.
An endowment is a special type of restricted contribution. Typically, an endowment contribution specifies that resources contributed be maintained permanently by the not-for-profit organization. Interest earned by endowment contributions may usually be used by the organization either for a purpose specified by the donor or for general purposes. A contribution to a scholarship fund is an example of an endowment contribution. Original donations are usually kept in perpetuity and interest earned on donated assets is used to fund the scholarships.
Under the deferral method endowment contributions are reported as direct increases in net assets. As with donations of land, endowment contributions are not recorded as revenue at all under the deferral method. For example, an organization receiving a million dollars for a scholarship endowment would record the million dollars as a direct increase in the net assets (e.g. accumulated surplus) in the year the donation is received.
Restricted fund method
Endowment contributions are recognized as revenue of the endowment fund in the year received. If an individual donates $500,000 to a scholarship endowment fund then, under the restricted fund method, this amount would be recognized as revenue in the year of the donation. This treatment is significantly different than that under the deferral method where the endowment contribution is never recognized as revenue.
Unrestricted contributions are donations that fit in neither the restricted nor the endowment categories. A typical example of an unrestricted contribution is that of a cash donation made by an individual to an organization for general use.
Under the deferral method unrestricted contributions are recognized as income in the period they are received. An organization with a December 31 year end receiving an unrestricted contribution in December would recognize it as revenue in the year of receipt regardless of whether or not the amount was actually spent by the year end.
Restricted fund method
Unrestricted contributions are recognized as revenue of the general fund in the year received. This is similar treatment to that under the deferral method.
Revenue from the provision of services and the sale of goods is accounted for by not-for-profit organizations in the same way that it is in the for-profit sector. Contributions made, for which the donor does not expect to directly receive anything in return, may be accounted for under either the deferral or the restricted fund methods by not-for-profit organizations. The timing of recognition of contribution revenue depends on whether there are externally imposed restrictions placed on the contributions. For both the deferral and restricted fund methods, unrestricted contributions must be recognized as revenue in the period received.