Activities with Related Entities: Are You Properly Reporting Them?
It's no secret that the number of not-for-profit organizations is growing while the number of grant dollars is shrinking. Shifting from competing for grant funds to cooperating with other organizations can create substantial value for not-for-profits and the people they serve. Among the ways that organizations can work together are:
- Purchasing goods and services together;
- Sharing facilities;
- Combining fund-raising activities;
- Sharing staff members and staff training;
- Combining activities that advocate for their mutual beneficiaries;
- Sharing the costs of community needs surveys;
- Combining marketing of programs;
- Forming a new organization to deliver a program or to deliver administrative services;
- Merging together to create one integrated organization; and
- Combining to create a parent-subsidiary relationship.
In addition to its many benefits, cooperation with another organization has its challenges. For example, an organization needs to motivate employees, ensure the quality of goods and services, identify and respond to risks associated with new programs, and manage the chance of diluting the organization's brand. This article only discusses financial reporting challenges.
When two organizations work together to achieve their missions, the way financial information about the cooperative activity is reported depends on which of the various pathways to cooperation the two organizations take. Chapter 3 of the AICPA Audit and Accounting Guide Not-for-Profit Entities (Audit Guide) discusses reporting relationships between the two entities when the purpose of the relationship is to provide goods or services that accomplish the organization's mission or the organization's administrative purposes. This article helps your organization find its way through that complex guidance. (Chapter 4 of the Audit Guide discusses reporting when the objective of the relationship between the entities is investment return and the other entity is not required to be consolidated. Those relationships are not discussed in this article.)
For ease in communicating, this article will use the following terms:
- The reporting organization is the organization that's trying to determine how financial information about the cooperative activities is reported in its financial statements.
- The entity that is carrying out cooperative activities may be a separate legal entity, but can be an activity shared by two entities that is not housed in a separate legal entity.
- The other entity is the entity with which the reporting organization cooperates in performing the cooperative activity.
Was a New Legal Entity Created to Carry Out the Cooperative Activity?
If a cooperative activity isn't housed in a new legal entity, then the reporting organization most likely is a participant in a collaborative arrangement. A collaborative arrangement is a contractual arrangement that involves two (or more) parties in a joint operating activity. The parties are both active participants in the activity, and are exposed to significant risks and rewards dependent on the commercial success of the activity.
When involved in a collaborative arrangement, the reporting organization should report costs incurred and revenue generated from transactions between the cooperative activity and third parties (that is, parties that don't participate in the arrangement) in its statement of activities on a gross basis if it is deemed to be the principal participant for a given transaction. The guidance in Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 605-45 is used to determine whether the reporting organization or the other entity is the principal participant for a given transaction.
In some cases, a new legal entity is not created and the governing body of the reporting organization cedes control of its operations to the other entity as part of its decision to engage in the cooperative activity.
For example, as part of the negotiations establishing a cooperative activity, the reporting organization might allow the other entity to appoint three of the five members of the reporting entity's governing board — if a simple majority is required to approve board actions, the other entity would control the reporting organization because of its majority voting interest in the board. If the other entity obtains control of the reporting organization, the reporting organization (including the cooperative activity) is consolidated with the other entity beginning on the acquisition date. If the reporting organization will present its own separate financial statements after the other entity obtains control of it (for example, because of certain lender or grantor requirements), the reporting organization should decide whether to establish a new basis for reporting its assets and liabilities based on the other (acquiring) entity's basis.
In other cases, a new legal entity is not created and the governing body of the other entity cedes control of its operations to the reporting entity as part of its decision to engage in the cooperative activity. If the reporting organization is required to consolidate the other entity, the reporting organization should account for its interest in the other entity and the cooperative activity by applying an acquisition method described in the "Acquisition by a Not-for-Profit Entity" subsections of FASB ASC 958-805.
If a new legal entity was created to carry out the cooperative activity, the reporting organization should determine whether it has combined with the cooperative activity or the other entity in a merger or acquisition transaction. If the governing boards of both the reporting organization and the other entity cede control of themselves to the new legal entity, the reporting organization ceases to exist, and it must determine how to report the creation of the new legal entity housing the cooperative activity. If only the governing board of the reporting organization cedes control to the new legal entity, the new legal entity becomes the acquirer.
Similar to the situation in which the other entity acquired the reporting organization, the reporting organization should decide whether to establish a new basis for reporting its assets and liabilities based on the new legal entity's basis if the reporting organization will present its own separate financial statements after the new legal entity obtains control.
In most cases, the creation of a new legal entity is neither a merger nor an acquisition. The new legal entity is created to house only the cooperative activity and not the activities of the reporting organization or the other entity. To determine the proper accounting, it is necessary to determine whether the reporting organization controls the cooperative activity.
Benefits, But Reporting Challenges
The benefits of working with another entity to perform a cooperative activity usually are worth struggling through the necessary financial reporting challenges. This article is a simplification of a complex area. Your organization should work with its accountants and auditors to determine the appropriate accounting and disclosures.