June 2016

Duck Testing…

Some Background

In 1973, the Securities and Exchange Commission designated the Financial Accounting Standards Board (FASB) as the organization responsible for setting accounting standards for public companies in the U.S.  Its primary purpose is to establish and improve Generally Accepted Accounting Principles (GAAP).¹ Although intended for publicly traded companies, because of expectations from lenders, sureties, or other stakeholders, GAAP has been applied to virtually all non-profits, colleges, and universities in the U.S. as well.

Today's Subject: Contingent Liabilities

A contingent liability is a potential obligation that may be incurred, depending on the outcome of a future event.  Additionally, a contingent liability is one where the outcome of an existing situation is uncertain, and this uncertainty will be resolved by the future event.²

GAAP recognizes three categories of contingent liabilities:³

"High Probability"

A contingency that is both probable of actually occurring and one where the costs can be reasonably estimated.  For high probability contingent liabilities, the company must disclose the estimated amount of the potential loss and also describe the contingency in the footnotes of its financial statements.

"Medium Probability"

A contingency that falls short of either but not both of the parameters of a high probability liability.  These liabilities must be disclosed in the footnotes of the financial statements if either of two criteria are true.

“Low Probability”

Lastly, GAAP qualifies other contingent liabilities as "Low Probability."  The likelihood of these contingent liabilities actually triggering a cost is very low, and therefore accountants are not required to report them in the financial statements.

Facilities Management in Higher Ed

Lately, we have seen many higher education institutions incur some pretty pernicious contingent liabilities.

Much of my consulting work is with small to medium private colleges and universities, and I see great financial stress on this sector of higher education.  For many, if not most, it’s a very tough business enterprise.  With limited income sources and pressing financial needs, “keeping the doors open” is an activity unsuited to the faint of heart.

When a major expense is pending or contemplated, money is pursued from all possible sources.  Tuition, borrowing, endowment income, gifts, and commercial ventures are all evaluated for their potential.

Now, there are some new sources: major dining and facilities maintenance service providers.  Typically, with these enterprises, an agreement is reached whereby the company will “donate” a gift to the College or University in exchange for agreement to a multi-year service contract.  However, the institution typically incurs a “contingent liability” to the company in the event the contract is terminated before the end of the stipulated period.  Should that occur, the obligation is usually for a prorated return of the “gift”.  Notably, gifts of this nature are routinely $1 Million or more.

Because most accountants will define this contingency as “Low Probability”, all the College or University discloses in its financial statement is the gift income – no liability, and no footnotes.

Why would any forward-thinking financial officer do this?  Maybe:

• The need may be pressing; and no donors, with fewer conditions, are apparent.
• The amount of money required may be more than current benefactors are capable of.
• The College or University may be concerned about jeopardizing its bond rating with additional borrowing.
• More debt service expense may not be supported by projected income sources.

But what are the downsides?  A few of the many:

• The non-disclosed full gift expense, with interest, is invariably embedded in the total cost of the vendor’s service contract.  Anecdotal comments from insiders in service industries report that actual interest charged is between 10 and 20%.  The “gift”, for all intents and purposes, is a loan.
• The service provider loses incentive to perform, to retain the client.  For example, menu selections may suffer, or preventive maintenance may fall off.  These can be hard to discern at first, becoming more apparent in time.
• In the event of ultimate client dissatisfaction, with a decision to terminate the multi-year agreement, the contingent liability becomes real.  It must be paid.  Often this repayment can only be done by replacing the gift-giving service provider with another contractor willing to be equally generous.

What does this have to do with ducks?

My “duck” for the day is the inherent “liability” of the business ramifications of accepting “gifts” from suspect sources.  Ignore the adjective in the accountant’s descriptions above. Ignore the GAAP waiver on reporting those that are “low”.  They’re all “liabilities” in virtually any sense imaginable. 

Admittedly, I sit in the comfortable position of spectator and critic, watching and advising those in the unenviable position of keeping their organizations afloat.  Perhaps it’s too easy to say “Don’t do it.  Just don’t do it.”  I wish I were more successful in having my advice heeded.

Maybe I need to find better analogies.  Are you swimming with sharks?

¹ https://en.wikipedia.org/wiki/Financial_Accounting_Standards_Board
² http://www.investopedia.com/terms/c/contingentliability.asp
³ http://www.fool.com/knowledge-center/2015/10/25/gaap-guidelines-for-contingent-liabilities.aspx

Missed earlier newsletters? Find them here:

April 2016  “Once Upon a Time...”
January 2016  “I want to take you higher”
November 2015  “Moderating in all Things?”
July 2015  “Alphabet City”
May 2015  “Acey Trey Trey Trey?”
January 2015  “Nature or Nurture?”
August 2014  “Acey Trey Trey?”
June 2014  “The Seven Deadly Sins”
March 2014  “Thar She Blows!”
November 2013  “Giving Thanks”
September 2013  “Back to School?”
June 2013  “What Time is It?”
March 2013  “Acey Deucey?”
January 2013  “A Swamp Full of Alligators”
October 2012  “Plan to Live Forever, Part Deux”
July 2012  “A Midsummer Dream”
May 2012  “Are you Virtually Working?”
March 2012  “Your Huddled Masses”
January 2012  “Observing Observations”
October 2011  “I Want What I Want”
August 2011  “A Beach Read”
May 2011  “NeoLuddite or Technophile?”
March 2011  “Do Your Silos Leak?”
January 2011  “Plan to Live Forever!”
November 2010  “May I Have A Plan, Master?”
September 2010  “How do we choose?”
July 2010  “Good People Behaving Badly”
May 2010  “LEED: LEADing or Dead Weight?”
March 2010  “Why does it cost so much?”
January 2010 “Design/Builders show us your softer side.”
November 2009 “What the Facilities?”
September 2009 “Why Do Architects Make Good Owner’s Reps?”