Overview of Section F6: NFP Accounting

Section F6 of the FAR CPA Exam focuses on the accounting and financial reporting standards for Not-for-Profit (NFP) organizations. While carrying a lower weight compared to some other sections (typically 5-15%), these unique standards, primarily set by FASB, are distinct from both commercial and governmental accounting and require specific attention. The emphasis is on accountability to donors and the public regarding the use of resources to fulfill the NFP’s mission.

NFP accounting sits at an interesting crossroads between commercial and governmental accounting but follows its own unique path. The Financial Accounting Standards Board (FASB) governs the accounting standards for NFPs through the Accounting Standards Codification (ASC), primarily in the 958 series. Unlike governmental entities, which follow GASB standards, private NFPs adhere to FASB guidance, creating a crucial distinction candidates must understand.

Most CPA candidates will have limited exposure to NFP accounting principles before exam preparation, making this section particularly challenging. The unique terminology, specialized financial statements, and donor-centric focus require dedicated study and practice with NFP-specific problems.

Historical Context and Recent Updates

The accounting landscape for NFPs underwent significant changes with the implementation of Accounting Standards Update (ASU) 2016-14, “Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities.” This update streamlined the previously complex three-class net asset structure (unrestricted, temporarily restricted, and permanently restricted) into the current two-class system, simplifying financial reporting while maintaining the critical distinction between restricted and unrestricted resources.

More recently, ASU 2018-08 clarified the scope and accounting guidance for contributions received and contributions made, addressing longstanding challenges in distinguishing between contributions and exchange transactions. This update provided a more robust framework for determining whether a transaction is conditional or unconditional, which directly impacts the timing of revenue recognition.

The CPA exam regularly tests candidates’ knowledge of these updates and their practical applications in NFP accounting scenarios. Understanding both the historical context and recent developments provides critical context for interpreting exam questions accurately.

Net Asset Classification: The Foundation of NFP Accounting

A defining characteristic of NFP accounting is the classification of net assets based on the existence or absence of donor-imposed restrictions. Candidates must understand the two primary classes:

  1. Net Assets with Donor Restrictions: Resources subject to limitations imposed by donors, either for a specific purpose (purpose restriction) or a future time period (time restriction), or resources required to be maintained in perpetuity (e.g., permanent endowments).

  2. Net Assets without Donor Restrictions: Resources available for the NFP to use at its discretion to meet operating needs.

The classification drives how transactions are recorded and reported throughout the financial statements. Consider a hospital foundation that receives three different donations: an unrestricted cash gift of $50,000, a $100,000 donation restricted for pediatric equipment purchases, and a $1,000,000 endowment gift where the principal must be maintained in perpetuity while the earnings support medical research. Each would be classified and reported differently based on the presence and nature of donor restrictions.

Within the “Net Assets with Donor Restrictions” category, further distinction exists between:

  • Purpose restrictions: The funds must be used for specified programs, services, or items (e.g., scholarships, building projects, specific research initiatives).
  • Time restrictions: Funds that become available for use only after a specified time has elapsed (e.g., multi-year pledges, time-restricted gifts).
  • Perpetual restrictions: Resources that must be maintained permanently, typically endowments where only investment income may be spent.

The Board of Directors may also designate portions of net assets without donor restrictions for specific purposes (e.g., creating a board-designated endowment or capital project fund). However, these designations remain part of net assets without donor restrictions since they represent internal management decisions that can be reversed, unlike externally imposed donor restrictions.

For exam purposes, you’ll need to recognize that only donor-imposed restrictions affect net asset classification. Board designations, while disclosed in the notes to financial statements, do not create a separate class of net assets.

Contributions and Revenue Recognition

Revenue recognition for NFPs follows specific guidance, particularly concerning contributions versus exchange transactions. This distinction represents one of the most challenging aspects of NFP accounting and appears frequently on the exam.

Contributions

Contributions are nonreciprocal transfers and are generally recognized as revenue when received or unconditionally pledged, classified based on donor restrictions. Key characteristics of contributions include:

  1. Nonreciprocal nature: The donor does not receive commensurate value in return.
  2. Voluntary transfer: Not resulting from legal obligation.
  3. Entity-specific: Made to a particular entity rather than to the market.

Contributions fall into several categories that affect their accounting treatment:

  • Unconditional contributions: Recognized immediately as revenue or support in the appropriate net asset class.
  • Conditional contributions: Recognized only when the conditions have been substantially met. Common conditions include matching requirements, measurable performance-related barriers, or right of return provisions.
  • Pledges (promises to give): Recognized at fair value when the pledge is made if unconditional. Conditional pledges are not recognized until conditions are met.
  • Donated services: Recognized only if they create or enhance non-financial assets or require specialized skills, are provided by individuals possessing those skills, and would typically need to be purchased if not donated.
  • Donated assets: Recognized at fair value on the date of donation.

The exam frequently tests recognition timing and classification through scenarios. For example, if a donor pledges $100,000 to be paid over five years for general operations, this unconditional, unrestricted promise would be recognized immediately at its present value, with the discount amortized over the pledge period. However, if the same pledge was conditioned on the NFP raising matching funds, recognition would be delayed until the matching requirement was met.

Exchange Transactions

Exchange transactions involve reciprocal transfers where each party receives and sacrifices something of approximately equal value. Common NFP exchange transactions include:

  • Membership dues providing substantial benefits to members
  • Tuition and student fees
  • Patient service revenue in healthcare NFPs
  • Ticket sales for performances
  • Fees for services

These transactions follow guidance similar to commercial entities under ASC 606, with the five-step revenue recognition model:

  1. Identify the contract
  2. Identify performance obligations
  3. Determine transaction price
  4. Allocate price to performance obligations
  5. Recognize revenue when/as performance obligations are satisfied

However, transactions can contain both contribution and exchange elements, requiring careful analysis. For instance, if a member pays $250 annual dues but receives benefits worth $75, the transaction has both exchange ($75) and contribution ($175) components.

Distinguishing between exchange transactions and contributions depends on analyzing whether the resource provider (e.g., donor, grantor) receives commensurate value in return. The CPA exam regularly presents scenarios requiring this judgment.

Special Considerations for Government Grants

Government grants present unique challenges in classification. Whether a government grant represents a contribution or an exchange transaction depends on the grant’s substance rather than its form. If the government is primarily providing resources to help the NFP provide a public service (rather than acquiring goods or services for its own use), the grant typically qualifies as a contribution.

However, many government grants contain barriers to entitlement that must be overcome before recognition. These barriers might include:

  • Specific service-level requirements (e.g., providing a certain number of meals to homeless individuals)
  • Qualifying expenses (e.g., reimbursement-based grants)
  • Limited discretion about how funds must be spent

Recent FASB clarifications have emphasized that matching requirements, routine administrative requirements, and timing restrictions alone do not create conditions that preclude revenue recognition. However, the presence of a right of return/release from obligation combined with measurable performance barriers does create a condition.

For exam purposes, candidates should analyze whether a barrier exists and whether the agreement includes a right of return of assets transferred or a right of release of the promisor’s obligation. The combination of both elements makes a contribution conditional.

Required Financial Statements for NFPs

NFPs are required to present a specific set of financial statements that differ in important ways from commercial entities. Understanding these differences is essential for CPA candidates.

Statement of Financial Position

Similar to a commercial balance sheet, the Statement of Financial Position presents assets, liabilities, and the two classes of net assets (with and without donor restrictions). Key differences include:

  • Presentation of the two net asset classes, often in separate line items
  • Absence of owner’s equity accounts (no capital stock, retained earnings, etc.)
  • Often includes more detailed disclosure of restricted assets
  • May use a classified or unclassified format

The statement must clearly distinguish between unrestricted resources available for general operations and those subject to donor restrictions. For example, cash restricted for long-term purposes (such as endowment or capital projects) should be separately presented from operating cash.

The ordering of assets may follow liquidity (most to least liquid) or a classified approach (current/non-current). Recent FASB updates have emphasized the importance of liquidity information, requiring additional qualitative and quantitative disclosures about how an NFP manages its liquid resources.

Statement of Activities

The Statement of Activities reports changes in both classes of net assets for the period. It presents revenues, gains, expenses, and losses, including the critical concept of ’net assets released from restrictions’ which reclassifies net assets from donor-restricted to unrestricted as restrictions are satisfied.

Unlike a commercial income statement focused primarily on profitability, the Statement of Activities emphasizes:

  • Changes in each net asset class
  • Fulfillment of donor restrictions
  • Support and revenue by source
  • Functional classification of expenses

Several formats are acceptable:

  • Single-column format showing changes in each net asset class
  • Multi-column format with separate columns for each net asset class
  • “Pancake” format with separate sections for each net asset class

The “net assets released from restrictions” line item represents a reclassification rather than new revenue, showing when donor-imposed restrictions have been met through the passage of time or fulfillment of purpose restrictions.

For example, when a university spends restricted scholarship funds for their intended purpose, the expenditure decreases both cash and net assets with donor restrictions, while simultaneously increasing net assets without donor restrictions through the “release from restriction” mechanism.

Statement of Cash Flows

NFPs present a Statement of Cash Flows with a similar format to commercial entities (operating, investing, financing sections), but specific guidance applies to classifying certain transactions:

  • Contributions restricted for long-term purposes (endowment, fixed assets) are financing activities
  • Interest and dividends restricted for reinvestment may be operating or financing cash flows
  • Purchase of long-lived assets using restricted contributions is an investing outflow without a corresponding operating adjustment

NFPs may use either the direct or indirect method, though the indirect method is more common in practice. When using the indirect method, the reconciliation begins with the change in total net assets rather than net income.

Statement of Functional Expenses

Expense reporting is another key area. NFPs must report expenses by their functional classification (program services vs. supporting activities like management/general and fundraising) either on the face of the Statement of Activities or in the notes. Analyzing expenses by their natural classification (salaries, rent, utilities) is also required, often presented in a separate statement or note disclosure (Statement of Functional Expenses).

Voluntary health and welfare organizations are required to present a separate Statement of Functional Expenses, while other NFPs have flexibility in how they present this information. This statement typically uses a matrix format with natural expense categories on one axis and functional classifications on the other.

The allocation of costs between program and supporting functions often involves judgment and consistent application of cost allocation methodologies. Common allocation bases include square footage (for occupancy costs), time studies (for personnel costs), and direct identification where possible.

Joint costs of activities that include fundraising, such as direct mail campaigns that include both program content and fundraising appeals, require special consideration under ASC 958-720. These costs can be allocated between program and fundraising if specific criteria are met (purpose, audience, and content criteria).

Special Topics in NFP Accounting

Endowment Funds

Endowment accounting represents a specialized area frequently tested on the exam. Endowments typically fall into three categories:

  1. Permanent (true) endowments: Donor stipulates that principal must be maintained in perpetuity
  2. Term endowments: Principal may be spent after a specified period or event
  3. Board-designated (quasi) endowments: Created by board decision rather than donor restriction

The Uniform Prudent Management of Institutional Funds Act (UPMIFA) governs the management and expenditure of donor-restricted endowment funds in most states. Under UPMIFA, institutions may spend a prudent portion of an endowment fund, including realized and unrealized gains, not just traditional “income.”

For permanent endowments, investment returns are classified based on:

  • Donor stipulations
  • Relevant law (UPMIFA)
  • The organization’s interpretation and spending policies

The accounting can become complex when investment returns fall below the original gift amount (underwater endowments). Recent FASB updates require enhanced disclosures about underwater endowments, including fair value, original gift amount, and spending policies.

Split-Interest Agreements

Split-interest agreements represent arrangements where donors contribute assets while retaining or designating others to receive a portion of the economic benefits. Common forms include:

  • Charitable remainder trusts: Donor or beneficiary receives income for a period, with the remainder going to the NFP
  • Charitable lead trusts: NFP receives income for a period, with the remainder returning to the donor or other beneficiaries
  • Charitable gift annuities: Fixed payments to donor/beneficiary with remainder to NFP
  • Pooled income funds: Donor contributes to a pool and receives income proportionate to their share

The accounting for these arrangements varies based on whether the NFP serves as trustee and whether the arrangement is revocable. Generally, the NFP recognizes an asset for the fair value of the investment, a liability for the present value of expected payments to beneficiaries, and contribution revenue for the difference.

The exam may test candidates’ ability to calculate the present value of future cash flows and determine appropriate classification and recognition timing for these complex arrangements.

Agency Transactions

Agency transactions occur when an NFP receives assets from a donor and agrees to transfer those assets to a specified beneficiary. In these cases, the NFP acts as an agent, trustee, or intermediary rather than as a recipient of a contribution.

The key accounting distinction: in agency transactions, the NFP does not recognize contribution revenue when it receives the assets nor expense when it disburses them. Instead, it records an asset and a corresponding liability.

For exam purposes, candidates should evaluate whether the NFP has variance power (discretion to redirect the assets) or has been granted explicit unilateral rights to redirect the assets to another use. The absence of such discretion typically indicates an agency relationship.

Mergers and Acquisitions

NFP combinations, whether mergers or acquisitions, follow specific guidance that differs from commercial entities. In an NFP merger, a new entity may be formed or one entity may survive while another ceases to exist. The carryover method records assets and liabilities at their carrying amounts in the merging entities’ books.

In an NFP acquisition, one entity obtains control over another’s net assets. The acquisition method requires the acquirer to recognize identifiable assets acquired and liabilities assumed at fair value, with any excess considered an inherent contribution.

NFP consolidation principles generally follow commercial accounting but with NFP-specific considerations. Consolidation is required when an NFP has both:

  • Control over another entity through majority voting interest or other means
  • Economic interest in the controlled entity

Control may exist through means other than voting interests, such as:

  • Appointment of board members
  • Contract or agreement
  • Sole corporate membership

The exam may present scenarios requiring judgment about whether consolidation is appropriate based on the specific relationship between related entities.

Preparing for F6 Questions on the CPA Exam

Section F6 requires candidates to grasp the specific terminology, net asset classifications, and financial statement presentation unique to the NFP sector. While sharing the accrual basis with commercial accounting, the focus on restrictions and functional expenses necessitates dedicated study.

When preparing for NFP accounting questions, candidates should:

  1. Practice classification scenarios: Given various donation types, determine proper net asset classification and recognition timing.

  2. Understand restriction releases: Analyze when and how donor restrictions are satisfied and the corresponding reclassification entries.

  3. Distinguish contributions from exchange transactions: Apply the criteria for determining whether a resource provider receives commensurate value.

  4. Master the unique financial statement formats: Recognize how net asset classes are presented and how restricted funds flow through the statements.

  5. Study specialized topics: Pay particular attention to endowments, split-interest agreements, and agency relationships.

Questions often present scenarios requiring application of multiple concepts. For instance, a question might describe a complex donation with both conditional elements and donor restrictions, requiring candidates to determine both when to recognize the contribution and how to classify it.

The exam emphasizes not just mechanical accounting treatments but also the conceptual framework underlying NFP reporting. Understanding why NFP financial reporting differs from commercial entities (focus on stewardship and accountability to donors rather than profit generation) provides important context for answering conceptual questions.

Remember that NFP accounting questions may be integrated throughout the FAR exam, not just in standalone testlets specifically labeled as covering non-profit topics. Maintaining awareness of when to apply NFP-specific guidance versus general accounting principles is critical for success on the exam.

Key Differences from Commercial and Governmental Accounting

Understanding how NFP accounting differs from both commercial and governmental frameworks helps candidates avoid common mistakes:

Versus Commercial Accounting:

  • Net asset classification versus equity structure
  • Contribution revenue recognition versus exchange-based revenue
  • Mission-focused versus profit-focused financial reporting
  • Functional expense reporting requirements not found in commercial accounting

Versus Governmental Accounting:

  • FASB standards versus GASB standards
  • Net asset classes versus fund accounting
  • Accrual basis versus modified accrual basis for certain governmental funds
  • Different treatment of capital assets and long-term debt

The unique position of NFP accounting within the broader accounting landscape requires candidates to mentally “switch gears” when approaching NFP problems, avoiding inappropriate application of commercial or governmental concepts.

The FAR CPA Exam will test not only technical knowledge but also the ability to apply professional judgment to complex NFP scenarios. By understanding both the rules and the underlying principles, candidates can navigate these challenging questions successfully.