Nonprofit Accounting Basics

Who is Reviewing Your Key Contracts?

Ensuring that the appropriate individuals are reviewing key contracts is essential to identifying, quantifying, and, if necessary, reporting financial liabilities in a timely manner. Depending on the nature of the contract, key individuals may include your in-house or external legal counsel, tax advisor, the Chief Financial Officer or Controller, and the Chief Executive Officer. For example, an Organization’s meetings department may unknowingly enter into a contract that triggers unrelated business income by offering promotional advertising space as a component of the agreement. Had the finance department been given an opportunity to review the contract beforehand, the taxable component of the sponsorship arrangement would have been identified, included in the unrelated business income calculation, and appropriately factored into the Organization’s financial reporting package. Instead, this transaction is identified as part of the auditor’s sponsorship revenue testing. In addition, it is discovered that several other similar contracts were executed by the Organization without identifying the unrelated business income component and, as a result, the final tax on the Form 990-T is increased.

Key employment contracts is another area that has historically been subject to liabilities and risks that may not be identified and recognized in the Organization’s financial statements in a timely manner. The details of an employment contract may be discussed and ultimately executed between the executive and a member of the Board of Directors, with the involvement of an attorney. However, we have noted instances where an Organization’s finance department was not privy to the contract, which may have contained post-retirement health benefits and guaranteed fixed retirement payments, all of which should have been accrued as earned, as opposed to when paid.

As a result, the Organization had significant adjustments to its financial statements. The above examples highlight two situations where tax and accounting events could have been appropriately identified and accounted for, had the proper individuals been involved in the contract review process.

Other examples of contracts and agreements where unrecorded financial transactions have been subsequently identified, include:

  • Hotel contracts that contain penalties for the Organization’s failure to fill a minimum number of rooms
  • Royalty agreements that contain potential taxable events
  • 457 deferred compensation agreements that require assets and liabilities to be recorded by the Organization
  • Unconditional long-term promises to receive funds from a donor (pledges)
  • Unconditional long-term promises to provide funds to a recipient (scholarships)
  • Split interest agreements where the donor will receive an annual fixed payment for life
  • Software consulting agreements which contain both capital asset costs as well as period expenses
  • Equipment leases that may be capital leases, not operating leases
  • Facility leases that contain unrecorded incentives such as build-out costs and periods of free or reduced rent
  • Investments in for-profit entities that may need to be reflected under the equity method of accounting or possibly consolidated depending on the level of the Organization’s ownership interest

A sample contract review policy may involve the following individuals, depending on the complexity of the contract and size of your Organization:

  • Review by Chief Financial Officer and / or Controller
  • Review by the Chief Executive Officer
  • Review by in-house and / or external counsel
  • Consultation with your tax advisor

It is important to consult the appropriate individuals early on in the process as opposed to once the contract or agreement has been executed. Each individual’s review should be documented in the Organization’s files to support the execution of this internal control and to summarize and address any potential issues. In addition, copies of all contracts should be filed in one location for easy access and review. Many organizations keep signed copies in a centralized secured network drive that is restricted to authorized users. Having a comprehensive set of contract review policies in place will prevent an Organization from encountering surprises down the road that may impact its financial and operational results.