Start Creating a Liquidity Policy Now

Wendy Thompson

Numerous changes are coming for nonprofit financial statements with ASU 2016-14 Not-for-Profit Entities Presentation of Financial Statements of Not-for-Profit Entities. One of those changes is a required footnote on liquidity, which will be effective for years beginning after December 15, 2017.

There is an unwritten premise within this standard that nonprofits are already managing their liquidity. We believe many nonprofits are managing their liquidity, but may not be doing so in a formal, documented manner or following a formal liquidity policy. That may lead to confusion when creating the liquidity policy footnote. Note that the liquidity policy footnote does not need to be comparative in the first year that it is implemented; in subsequent years it may be comparative.

Reconciling financial assets

As part of the footnote on liquidity, a nonprofit will need to provide information reconciling financial assets at year-end to those financial assets available to meet cash needs for general expenditures within one year. This starts with all financial assets. Those are assets that are cash, evidence of an ownership interest in an entity, or a contract that conveys to one entity the right to do either of the following: a) receive cash or another financial instrument from another entity or b) exchange other financial instruments on potentially favorable terms with the second entity. This means for most nonprofits that financial assets include cash, investments (whether restricted or not), accounts receivable, contributions receivable, and notes receivable. This does not include all current assets (for example inventory and prepaid expenses are not financial assets), nor is it only current assets (for example investments or the beneficial interest in a trust may be long-term, but they are still financial assets).

In coming up with the financial assets available to meet cash needs for general expenditures within one year, back out numerous items.

  • Which financial assets are restricted by the donor with a time restriction? For example, contributions receivable in more than one year are part of financial assets but backed out in determining financial assets available to meet cash needs for general expenditures within one year.
  • Also backed out are financial assets that are restricted by the donor for purpose restrictions that are narrower than general expenditures. So a contribution receivable due within one year, but restricted for XYZ program only, would be backed out.
  • If the nonprofit can’t truly access the financial asset, that would also be backed out. For example, a nonprofit may have a beneficial interest in assets of another which is a long-term financial asset that is not per se restricted; however, it is in a separate legal entity whereby the nonprofit cannot simply request that entire amount and receive it.
  • Board designations also must be backed out. For example, if the board has designated certain investments to be a quasi-endowment, those investments must be backed out.
  • Also, the board may have set aside amounts for a liquidity reserve. Unless they have taken formal action to appropriate the use of that liquidity reserve in the next fiscal year (i.e., budgeted to use it), it is backed out from financial assets available to meet cash needs for general expenditures within one year.

More about board-designated liquidity reserves

The board-designated liquidity reserve is very confusing, so let’s explain it a little more. The board takes action to designate an amount as a liquidity reserve. Because it is board-designated, it is not to be used (based on the board’s policy) to fund current expenditures; it is to be set aside and hopefully grow so that if something occurs in the future, there is a rainy day fund. It is board-designated, so at any time the board can undo their designation. However, the standards are taking the perspective that unless the board has appropriated the liquidity reserve (so budgeted to use that reserve in the next fiscal year), it is not available to meet needs for general expenditures in the next year. Setting aside a board-designated amount for liquidity reserves will make your quantitative liquidity disclosure look worse!

Provide qualitative information too

However, in addition to the quantitative information on liquidity, a nonprofit shall disclose qualitative information that is useful in assessing the entity’s liquidity and that communicates how the nonprofit manages its liquid resources available to meet cash needs for general expenditures within one year of the date of the statement of financial position.

This is where a nonprofit tells its story about how it ensures it can pay its bills as they come due. This is where the nonprofit can explain that they have a liquidity reserve which to date has not been appropriated, but because it is invested in highly liquid assets, it could be appropriated at any point in time if necessary to pay bills as they become due. This is where the nonprofit can describe that they have access to a line of credit that can be drawn upon as needed to pay bills when they become due. The nonprofit can explain how it invests extra funds and how it determines whether to purchase short-term investments that are easily sold or longer term investments that have more criteria for redemption (such as alternative investments or longer term CDs). This is also where the nonprofit can explain that although some of the assets do not meet the requirements to be included in financial assets available to meet cash needs for general expenditures within one year, they still are expected to help pay the next year’s expenses. For example, explain that contributions receivable are subject to restrictions on use, but the budget calls for expenses related to those restricted resources to be paid during the year.

How does the liquidity disclosure compare with the going concern disclosure?

There is a relationship between this liquidity disclosure and FASB’s new going concern disclosure. The liquidity disclosure is technically how the nonprofit will pay general expenses in the next year (after the balance sheet date), whereas the going concern disclosure is how the nonprofit will pay bills as they become due within one year of the date the financial statements are available to be issued. However, the policies that assist with liquidity necessarily assist in showing that the entity is a going concern.

Setting goals and policies for liquidity

How should the nonprofit be managing liquidity? What should be in the liquidity policy? Whether or not the board officially designates a reserve for liquidity, in managing liquidity, it is a good idea to have a goal for a certain number of month’s expenditures to have available on hand in cash, cash equivalents, or highly liquid investments. The number of months varies greatly based on the nonprofit. How consistent are the revenues both from year to year and from month to month? The more consistent monthly and yearly the revenues are, the more likely this goal is to be two to three months’ of expenses. The more variable the revenues are from year to year, or even month to month, the longer the period for the goal.

All nonprofits should create a budget. However, liquidity management is more than just budgeting. It is looking on a month-by-month basis to budget for cash inflows and outflows and seeing which months have negative cash flows, and therefore need to rely on some cash reserves, and which months have extra cash that could be invested. In calculating this cash flow projection, management needs to address how to survive those times with negative cash flows, whether line of credit, utilizing liquidity reserves, reducing expenditures, etc. Management also needs to address what to do with excess cash; should it go into a CD, short-term investments, long-term investments, etc.?

Get a head start now

Having policies on how many months of expenses to have on hand in liquid reserves, policies on how to create cash flow budgets and the frequency of creating them, how to weather negative cash flows, and how to invest extra cash will strengthen the nonprofit’s financial position and also their disclosure related to liquidity. Nonprofits who have these policies will have a good head start on writing their liquidity disclosure and explaining any unfavorable numbers that may appear in the quantitative liquidity disclosure.

Wendy Thompson

Wendy Thompson

CPA

Wendy Thompson, CPA, is Yeo & Yeo’s Training Manager and a member of the firm’s Nonprofit Services Group, Audit Services Group, and the Compilation and Review Team. She conducts training seminars for the Michigan Association of Certified Public Accountants (MICPA) and serves on the MICPA’s Nonprofit Task Force. Contact Wendy via e-mail at wentho@yeoandyeo.com or call 989.793.9830.