Each year, our editors review numerous

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1 The PPC Nonprofit Update, JulY 2010, Volume 17, No. 7 THE PPC NONPROFIT UPDATE Don t Make These Common Financial Statement Errors Each year, our editors review numerous nonprofit organization financial statements and each year there are some common errors that we run across. As you prepare June 30th year-end financial statements, take a look at our hit list and make sure your financials are ready for prime time. Property, Plant, & Equipment Some nonprofit organizations have more PP&E than others, but they all have required financial statement disclosures. The disclosures are from FASB ASC A large number of nonprofit organizations continue to fail to disclose the organization s capitalization policy basically, the minimum dollar amount for capitalizing and depreciating an asset. Also, the financial statements should include the organization s policy on implying time restrictions on gifts of long-lived assets. Subsequent Events Review This disclosure is a little newer, but it s been in place for almost a year now (for financial periods ending after June 15, 2009). FASB ASC requires a nonprofit organization to disclose the date through which subsequent events have been evaluated and whether that date is the date the financial statements were issued or were available to be issued. It doesn t matter if there weren t any subsequent events disclosed in the financial statements; the financials still need to disclose the information about the review. (See our article in the August 2009 edition of The PPC Nonprofit Update.) Uncertain Tax Positions ASU provides guidance on uncertainty in income taxes for taxexempt nonprofit organizations and other entities. For entities that have already adopted the accounting for uncertainty in income taxes guidance, ASU is effective for periods ending after September 15, For entities that had not yet In this Issue: Don t Make These Common Financial Statement Errors AICPA Updates Not-for- Profit Entities Guide Auditing Brief Is an IRS Audit in Your Future? Foreign Tax Credit Can Reduce UBIT Tax Brief This newsletter is also available online. Please call (800) , or order online at ppc.thomsonreuters.com.

2 2 The PPC Nonprofit Update, JulY 2010, Volume 17, No. 7 adopted the original guidance, ASU is effective when the accounting for uncertainty in income taxes guidance is adopted, which is generally for financial statements of years beginning after December 15, (See our article in the December 2009 edition of PPC s Nonprofit Update.) The ASU clarifies what a tax position may be for a nonprofit organization. FASB ASC requires disclosure of: z policy for classifying interest and penalties recognized in the financial statements that are associated with its tax positions, z total amounts of interest and penalties recognized in the statement of activities and the statement of financial position, z information about positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within 12 months of the reporting date, and z the tax years that remain subject to examination by major tax jurisdictions. Long-term Promises to Give If the nonprofit organization has long-term promises to give that are measured at present value, then the resulting discount should be disclosed either on the face of the statement of financial position or in the notes to the financial statements. A related disclosure that gets missed is the amounts of promises receivable in less than one year, in one to five years, and in more than five years. Disclosures related to unconditional promises to give are from FASB ASC Interest Paid FASB ASC requires the financial statements to disclose interest paid (net of amounts capitalized). Some financial statements omitted this disclosure. Summarized Financial Information Many nonprofit organizations choose to present only summarized financial information for the prior period. Because the summarized financial information doesn t include all the detail required by GAAP, FASB ASC and FASB ASC require the financial statement titles to indicate the prior year information is summarized and the financial statement notes to describe the nature of the summarized financial information. Contributed Services Almost every nonprofit knows that volunteers are a vital part of an organization s mission. Don t forget to tell the financial statement readers about contributed services. FASB ASC requires the disclosure of: z the activities or programs for which contributed services were used; z the nature and extent of those services; z the amount recognized as revenue during the period; and z if practical, the fair value of contributed services received but not recognized as revenues in the financial statements. Fund-raising Expenses Some nonprofit organizations may not have fundraising expenses. For everyone else, there are required disclosures that sometimes get missed. They are: z The total cost of all fund-raising activities, whether expenses are classified by function or object (required by FASB ASC ). z The method used to compute the ratio of fund-raising expenses to funds raised, if such a ratio is disclosed in the organization s financial statements (required by FASB ASC ). Concentrations of Risk FASB ASC includes disclosure requirements related to risks and uncertainties. One that nonprofit organizations may overlook is the requirement to consider whether to disclose concentrations in the market or geographic area in which the nonprofit organization operates. Endowment Funds All nonprofit organizations that have endowment funds are subject to disclosure requirements at FASB ASC B. The disclosures include organization policies related to endowments, a reconciliation of beginning and ending balances, and information about deficiencies in individual endowments. Trade Receivables Nonprofit organizations may have trade receivables. FASB ASC through 50-8 includes disclosures related to these receivables. (They don t apply to promises to give.) Restrictions on Net Assets Nonprofit organizations remember to disclose the total temporarily and permanently restricted net assets either on the face of the statement of financial position or in the notes to the financial statements. Where the

3 The PPC Nonprofit Update, JulY 2010, Volume 17, No. 7 3 disclosures can sometimes fall short is FASB ASC s requirement to also disclose information about the amount and types of the different restrictions. PPC s Guide to Preparing Nonprofit Financial Statements and disclosure checklist tools will help you prepare nonprofit financial statements skillfully and in accordance with GAAP. AICPA Updates Notfor-Profit Entities Guide The AICPA has updated its Audit and Accounting Guide, Not-for-Profit Entities, with conforming changes as of March 1, 2010 (Audit Guide). The Audit Guide applies to not-for-profit entities that meet the definition of a not-for-profit entity included in the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) glossary. The Audit Guide does the following: z Identifies certain requirements in the FASB ASC. z Describes the AICPA s understanding of customary or sole industry practice concerning certain issues. z Identifies various other, but not necessarily all, industry practices concerning certain accounting issues without expressing the AICPA s views on them. z Provides guidance that has been supported by the AICPA on the accounting, reporting, or disclosure treatment of transactions or events that are not prescribed by the FASB ASC. Authoritative Nature Auditing guidance included in an AICPA Audit and Accounting Guide is recognized as an interpretive publication pursuant to AU 150, Generally Accepted Auditing Standards. Interpretive publications are recommendations on the application of Statements on Auditing Standards (SASs) in specific circumstances, including engagements for entities in specialized industries. The auditor should be aware of and consider interpretive publications applicable to his or her audit. If an auditor does not apply the auditing guidance included in an applicable interpretive publication, the auditor should be prepared to justify how he or she complied with the SAS provisions addressed by such auditing guidance. The FASB ASC is effective for financial statements issued for interim and annual periods ending after September 15, As of that effective date, all accounting literature not included in FASB ASC is considered nonauthoritative. Contents Relevant accounting and auditing guidance contained in official pronouncements issued through March 1, 2010, have been considered in the development of the most recent edition of the Audit Guide. This includes relevant guidance issued through FASB Accounting Standards Update (ASU) , Consolidation (Topic 810), and SAS 120, Required Supplementary Information. What the Audit Guide Does Not Cover This Guide does not discuss the application of all GAAP and all GAAS that are relevant to the preparation and audit of the financial statements of NFPs. This Guide is directed largely to those aspects of the preparation and audit of financial statements that are unique to NFPs or are considered important to them. Changes from the Prior Edition As is typical, this edition of the Audit Guide includes a table, Appendix D, that contains a schedule of changes identifying areas in the text and footnotes of the Audit Guide that have been changed from the previous edition. The March 2010 edition of the Audit Guide is available on Checkpoint or from the AICPA at (888) or Auditing Brief OMB RELEASES DRAFT OF THE 2010 COMPLIANCE SUPPLEMENT. Due to delays in finalizing the 2010 edition of the OMB Circular A-133 Compliance Supplement (Compliance Supplement), the Office of Management and Budget (OMB) recently made a draft version of the new Compliance Supplement available to auditors to use in planning their single audits. It can be accessed from the Government Audit Quality Center interest area at OMB currently expects to release the Compliance Supplement by June 30, 2010.

4 4 The PPC Nonprofit Update, JulY 2010, Volume 17, No. 7 Is an IRS Audit in Your Future? The IRS is beefing up the Tax Exempt and Governmental Entities (TE/GE) Division with 155 new employees. Approximately 100 will work in examinations. More than 30 audits of colleges and universities are now underway. Examinations of other types of exempt entities will begin as the data in the 2008 Form 990s is evaluated. In addition, TE/GE expects to conduct about 500 audits of randomly selected exempt organizations as part of a National Research Program to gauge the degree of compliance with employment tax rules. Consequently, more exempt organizations are likely to receive inquiries from the IRS in the near future as part of a compliance check or a notice that it has been selected for examination (i.e., audit). Compliance Checks The TE/GE Division maintains an active compliance check program. A compliance check is a review to determine if an organization is adhering to recordkeeping and information reporting requirements. It isn t an examination because it does not directly relate to determining a tax liability for any particular period. Exempt Organization (EO) specialists conduct the checks through letters and phone calls to the organization (or its representative). A specialist may inquire about an item on a return, determine if specific reporting requirements have been met, or whether the organization s activities are consistent with its stated exempt purpose. An organization can decline to participate in a compliance check without penalty. However, a refusal to respond may prompt the opening of a formal examination. Examination Formats An examination is more than simply a certification of the numbers on the return. It includes a review of an organization s operations and activities to verify the fulfillment of an exempt purpose. Documents requested at the outset of an examination typically include legal organizational documents and current bylaws; printed literature describing the organization s activities; a minute book; books and records of assets, liabilities, receipts, and disbursements; employment tax returns; and other relevant tax returns (IRS Fact Sheet ). There are two types of examinations: correspondence examinations and field examinations. A correspondence examination, which is limited in scope and focuses on one or two items on a return, is conducted by an EO specialist via letters and phone calls with the organization s officers or representative. However, if complex issues surface or the organization is unresponsive, the examiner may require that records be brought to an IRS office or may convert the correspondence examination into a field examination. A field examination is conducted by a revenue agent at the organization s office. It will either be an EO Team Examination Program (TEP) or an EO General Program (GP). TEP examinations are used when the organization is large and/or complex, requiring a team of specialized revenue agents, or when coordination between the IRS and other governmental agencies is necessary. In the remaining situations, a GP audit is conducted by an individual revenue agent. What Triggers an Audit? An audit can arise for one or more of several reasons: (1) random luck of the draw, (2) responses to compliance check questions that suggest an in-depth investigation is warranted, (3) disclosures in Form 990 (discussed further below), (4) a whistleblower s evidence, (5) unfavorable publicity in the media, or (6) a complaint filed with the IRS regarding alleged abuses of tax-exempt status from the general public, members of Congress, or federal and state government agencies. Form 990 data may reveal filing deficiencies, lack of good governance practices, inurement of private benefit through related-party loans, leases, sales transactions, or one of several other potentially significant issues. For example, an organization s Form 990 may report income from sources that could be unrelated business income (such as from a controlled entity or an S corporation, advertising, or debt-financed income). The absence of a Form 990-T may prompt the IRS to commence an audit. A Stitch in Time An organization should seek to be audit ready before it is ever targeted for examination. Below are a few prudent defensive measures an organization should consider. Documentation. Contemporaneously document and support positions taken in Form 990 (e.g., the determination of key employees, reasonable compensation, disqualified or related persons, and controlled entities) or Form 990-T. Minutes. Make sure the minutes reflect all proceedings of the organization s governing body and of any committee having the power to bind the organization.

5 The PPC Nonprofit Update, JulY 2010, Volume 17, No. 7 5 Disqualified Person Transactions. Consistently review transactions with disqualified persons for excess benefit implications, especially those that could result in automatic excess benefits. An economic benefit that should be treated as compensation but is not is an automatic excess benefit, even though the recipient s total compensation would have been reasonable had the economic benefit been included. There must be a clear indication of intent to treat an economic benefit as consideration for services [IRC Sec. 4958(c)(1)]. Therefore, an economic benefit intended to be compensation must be treated as such in the organization s books, records, and relevant tax returns. For example, the value of the personal use of the organization s property (such as an automobile) by a disqualified person will normally be an excess benefit unless there is written contemporaneous substantiation that such value was intended as compensation. (There is substantiation if the value is reported as compensation to the individual on Form W-2 or Form 1099.) It will be too late to concede that a benefit should be treated as compensation once it is challenged by the IRS. However, an organization can establish intent by amending a prior Form 990 (or 990-EZ) at any time before the IRS begins examination of it or the disqualified person [Reg (c)(3)]. In addition, an organization is deemed to have clearly indicated its intent to provide an economic benefit as compensation for services if its failure to report as such initially was due to reasonable cause [Reg (c)(3)(i)(B)]. Alternatively, there is clear and convincing evidence of intent if the recipient (disqualified person) reports the benefit as income on Form 1040 for the year the benefit is received, including an amended Form 1040 filed prior to the earlier of (1) the date the IRS begins an examination of the disqualified person or the applicable taxexempt organization for the taxable year in which the transaction occurred or (2) the first written documentation by the IRS of a potential excess benefit transaction [Reg (c)(3)]. Employee/Independent Contractor Classification. In view of the IRS payroll tax compliance initiative, verify that independent contractor classifications are defensible. See the February 2010 issue of The PPC Nonprofit Update for an article that discusses the rules governing a worker s employment status. Key Policies. Adopt certain written policies and practices if they are not already in place. These include policies governing (1) the activities of local chapters, branches and affiliates, if any; (2) conflicts of interest; (3) reporting violations of the organization s operational rules and procedures (i.e., whistleblowing); (4) document retention and destruction; and (5) independent review of the organization s top management official, other officers, and key employees compensation. Although not mandatory, the IRS considers these policies to be the cornerstones of good governance. Moreover, the IRS has developed Form 14114, Governance Check Sheet, which must be completed by the examining agent to capture data about governance practices and related internal controls during the audit of a public charity. (See the February 2010 issue of The PPC Nonprofit Update for a further discussion of this Check Sheet.) Consequently, adopting these policies means the organization can provide affirmative responses to the relevant questions in Form 990, Part VI, Section B, Policies, which could reduce the likelihood of a future audit. Note: Samples of these policies, as well as several others, including credit card usage, expense reimbursement, and gift acceptance, are provided in PPC s Nonprofit Tax and Governance Guide: Helping Organizations Comply. Managing the Examination An organization (or its tax counsel) should observe several fundamental guidelines in dealing with an IRS agent during the examination process. These include: z Prompt responses to IRS correspondence or document requests, so that the organization is not responsible for extending the audit process. Promptness can also create a favorable impression of the organization. z Responses, while prompt, should be thorough and carefully prepared. Partial or sloppily prepared responses typically lead to more probing inquiries. z Documents furnished should be organized in the same sequence as the auditor s document request. The relevance of each document should be explained in a transmittal letter rather than simply dumping them on the auditor. Moreover, when specific information sought by the auditor is contained in a lengthy document, it is a good idea to reference its location. z Coordinate all document and information requests by the auditor through a designated person or persons (either an employee or outside tax counsel). If handled by an employee, all documents and information should be reviewed by counsel before being provided to the IRS, and a list of the documents carefully maintained. This will ensure that counsel knows precisely what has been furnished during the examination. z Provide only the documents requested and respond only to the specific questions asked. Volunteering information beyond what is required in an attempt to appear helpful or friendly is apt to lead to further questions or requests.

6 6 The PPC Nonprofit Update, July 2010, Volume 17, No. 7 z Employees should be courteous and respectful to the auditor to avoid a personal confrontation. z Each employee interviewed by the auditor should document the auditor s questions and the employee s answers immediately after the interview. Under the best of circumstances, an IRS examination is disruptive to an organization s normal activities. Following the suggestions outlined in this article can help minimize the length and depth of the disruption. Foreign Tax Credit Can Reduce UBIT Many exempt organizations are now investing endowment funds in publicly traded partnerships (PTPs). PTPs frequently produce unrelated business income or loss (UBI) from debt-financed investments and/or from business activities. PTP activities, especially securities investment activities, often incur foreign income taxes. Both UBI and foreign tax payments flow through to the exempt investor partners. IRC Sec. 515 allows exempt organizations to reduce their UBI tax by the amount of their foreign taxes to the extent provided in IRC Sec. 901 (unrelated business taxable income being substituted in IRC Sec. 901 for taxable income). Private foundations that incur foreign taxes but do not have UBI can take the foreign taxes as a deduction in calculating their net investment income under IRC Sec. 4940(c), but not as a credit against the excise tax on net investment income imposed by IRC Sec. 4940(a). The foreign tax credit can easily be overlooked since it may arise from investment activities that do not generate UBI. Tax Brief YOUR COMMENTS PLEASE. The IRS is seeking comments on the application of four new requirements that are imposed on exempt hospitals by IRC Sec. 501(r)(3) (6), as enacted by the Patient Protection and Affordable Care Act (Notice , IRB). Pursuant to these rules, hospitals must (a) conduct a community health needs assessment every three years and implement a strategy to meet these needs; (b) establish a financial assistance policy and an emergency medical care policy; (c) limit amounts charged for emergency or other medically necessary care that is provided to certain individuals; and (d) forgo extraordinary bill collection before determining if the individual is eligible for financial assistance. Comments must be submitted by July 22, The PPC Nonprofit Update is published monthly by Thomson Reuters/Tax & Accounting, P.O. Box 966, Fort Worth, Texas , (800) COPYRIGHT 2010 BY THOMSON REUTERS/ PPC. Reproduction is prohibited without written permission of the publisher. Not assignable without consent. This publication is designed to provide accurate information regarding the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, investment, or other professional advice. If such assistance is required, the services of a competent professional should be sought. Reports on products or services are intended to be informative and educational; no advertising or promotional fees are accepted. Tax & Accounting Research and Guidance P.O. Box 966 Fort Worth, Texas PRSRT STD U.S. POSTAGE PAID Thomson