When Should a Nonprofit Consolidate Financial Statements with Affiliated Entities?

Many nonprofit organizations have affiliated or controlled entities – ranging from single-member LLCs established for legal reasons to other nonprofit organizations they have control over. 

In many instances, these inter-entity relationships can result in nonprofits being required to produce consolidated financial statements. These statements combine the financial information of all related entities into one document, providing a clear overview of the scope of a nonprofit organization’s activities. 

The facts and circumstances of each relationship with an affiliated or controlled entity determine whether a nonprofit must consolidate its financial statements. Assessing these relationships to determine whether consolidation is required can be complex, and it is important that leaders understand exactly what determines the need to consolidate the financial statements of multiple entities.

In this article, we explore the factors that determine whether a nonprofit must consolidate the financial statements of multiple entities and outline some of the key misconceptions that exist in this field.  

What Are Consolidated Financial Statements?

Nonprofit leaders and board members will be familiar with the key nonprofit accounting statements: the Statement of Financial Position, the Statement of Activities, the Statement of Functional Expenses, and the Statement of Cash Flows. 

The purpose of consolidated financial statements is to group this information for all related entities, including subsidiary entities, affiliated entities, and so on. This provides board members, donors, and other interested parties with a clear view of an organization’s financial performance and an understanding of the different entities that contribute to that performance. 

Organizations required to produce consolidated financial statements must also document any inter-entity transactions between the subject entities and eliminate revenue and expenses as well as assets and liabilities associated with these transactions. Inter-entity balances are required to be eliminated from the consolidated financial statements.

Many organizations also choose to provide supplemental information to their financial statements that displays the financial performance of each individual entity. Since this information is supplemental, organizations enjoy flexibility in how they display it. In many instances, consolidated financial statements include supplemental statements that break out the performance of each entity into separate columns on each financial statement. 

What Factors Determine Whether a Nonprofit Must Consolidate Financial Statements?

The terms of the relationship between a nonprofit and any related entities determine whether financial statements must be consolidated.

Two main factors contribute to the determination: control and economic interest. If an organization is determined to have both control and economic interest in another entity, it must consolidate its financial statements. 

If these conditions aren’t met, nonprofit organizations are allowed to combine the financial statements of related entities if it reflects more accurately the complete financial conditions and mission of the organization.

What Constitutes Control?

An organization is considered to have control over another entity in either a direct or an indirect manner. 

When a nonprofit is the sole member of a subsidiary LLC, it is considered to have direct control. Many nonprofit organizations establish single-member LLCs as subsidiaries for legal purposes. In Georgia, for example, many nonprofit entities have a single-member LLC subsidiary for the specific purpose of receiving and selling tax credits received for certain filming costs incurred.

Indirect control occurs when a nonprofit organization has a majority voting interest in another entity. In some instances, there may be a shared board, or majority control over the board, but the key to this determination lies in the bylaws of the entity. Organizations should assess these bylaws with their financial and legal advisors to determine whether they have the ability to appoint the majority of board members. If so, they have control over that entity. 

What Constitutes Economic Interest?

An organization is considered to have an economic interest in another entity when the entity holds or expends significant resources on behalf of the organization. This can take the form of producing income or providing services. 

An organization also may be judged to have an economic interest in another entity if it guarantees the debts of that entity.

Best Practices When Consolidating Financial Statements

With the right accounting environment, the process of creating consolidated financial statements can be relatively straightforward. 

It is best practice to maintain separate accounts for all entities and then aggregate these into consolidated financial statements. This allows board members to understand how different entities are performing and allows for an easier Form 990 filing process (if the affiliated entity is also a nonprofit). Alternatively, organizations can maintain one accounting environment and tag transactions related to each entity. 

Many organizations look to avoid consolidation where possible: it’s a process that creates additional work and expense and may skew the financial statements of the primary organization. Experienced nonprofit accounting advisors can help organizations create a governance and economic interest strategy that may allow them to avoid the need to create consolidated financial statements. 

This is a relatively complex topic and it’s important that nonprofit organizations retain qualified professional advisors to help them determine when to consolidate their financial statements. This determination can change from year to year as the facts and circumstances of relationships change. Nonprofit leaders should tackle any changes proactively so that their accounting environment can be designed in a way that supports an efficient consolidation process. 

Smith + Howard: Experienced Advisors to Nonprofit Entities

Determining whether your nonprofit must consolidate its financial statements with those of affiliated entities can be a nuanced decision that requires careful analysis. By partnering with a firm well-versed in the intricacies of nonprofit accounting, you give your organization the best possible chance of success. 

At Smith + Howard, our experienced nonprofit accounting professionals have a decades-long track record of serving clients in the nonprofit sector. Our team is equipped to prepare consolidated financial statements and provide ongoing guidance to nonprofit organizations on the facts and circumstances that may trigger the need to consolidate this reporting. 

To learn more about how Smith + Howard can support the accounting needs of your nonprofit, contact an advisor today.