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NACUBO Webcast Addresses Underwater Endowments

From “Business Briefs” department in April 2009 issue of Business Officer

Market conditions continue to affect the value of endowment investments, causing many to be “underwater.” That is, many funds are now below the donor-restricted endowment gift amount. These market declines will affect financial reporting, spending decisions and policies, and governing board communications. A recent NACUBO webcast, “Understanding Underwater Endowments,” highlighted financial accounting and reporting requirements and distinctions between the environments of UPMIFA (Uniform Prudent Management of Institutional Funds Act) and UMIFA (Uniform Management of Institutional Funds Act).

Here are some questions and answers of particular interest that followed the webcast:

What does it mean that UPMIFA eliminated historic dollar value, while UMIFA uses it as a floor to spending?
UMIFA expressly permits prudent expenditure of both appreciation and income and replaced the old trust law concept that only income (interest and dividends) could be spent. Consequently, asset growth and income could be appropriated for program purposes subject to the rule that a fund could not be spent below historic dollar value. (Historic dollar value is defined as the aggregate of the original gift corpus plus subsequent donor contributions to the fund and other additions to the fund required by the donor or by law.) UPMIFA builds upon UMIFA’s rule on appreciation, but eliminates the concept of historic dollar value. UPMIFA states that the “institution may appropriate for expenditure or accumulate so much of an endowment fund as the institution determines to be prudent for the uses, benefits, purposes, and duration for which the endowment fund is established.”

Can you continue to spend from an underwater endowment in a state that has adopted UPMIFA?
UPMIFA allows a governing board to be flexible when evaluating organizational needs and making spending decisions—as long as the board prudently considers the duration and preservation of the fund. This is a legal question, not really an accounting question.

Without giving legal advice, one could say that if you are in an UPMIFA state where spending from underwater funds is considered prudent (as determined by your governing board) for the donor-designated purpose—and not expressly prohibited by the donor—then you can spend from endowments that are underwater. The answer involves judgment, prudent actions to preserve the endowment, and an understanding of the entire financial picture and financial needs of the institution.

It is wise to consult with your institution's legal counsel; and your board will need to determine if it is prudent to spend from an underwater endowment.

What about spending from underwater endowment funds in a state guided by UMIFA?
If you are in a UMIFA state, the historic dollar value limitation on spending is still in place. Appreciation available for appropriation is determined on an endowment fund by endowment fund basis. So you probably cannot pay out or spend from endowment funds that are underwater. You will need to determine whether any funds above water can tolerate a bit more spending and whether the restrictions on those funds align with your spending needs. You should also look to quasi endowments and other unrestricted dollars to support spending needs.

If you are in a UMIFA state and you spend temporarily restricted funds, resulting in the endowment ending up underwater, must you take the difference from unrestricted funds in the same year?
The applicable accounting guidance comes from SFAS 124, paragraph 12: “In the absence of donor stipulations or law to the contrary, losses on the investments of a donor-restricted endowment fund shall reduce temporarily restricted net assets to the extent that donor-imposed temporary restrictions on net appreciation of the fund have not been met before the loss occurs. Any remaining loss shall reduce unrestricted net assets.”

For institutions governed by the Governmental Accounting Standards Board (GASB), how is the spending of corpus (or historic gift amount) reflected on the financial statements? Are public institutions required to show a reduction of unrestricted net assets to cover the underwater portion of true endowment funds at year-end under UPMIFA?
Per GASB Statement 31, increases in fair value, as well as certain decreases, should be reported as changes in unrestricted net assets unless restricted by donor, contractual, or other legal requirements. A major difference between the FASB and the GASB is that the GASB allows decreases in donor-restricted endowments to directly reduce the restricted nonexpendable net asset class. The issue is whether spending from a nonexpendable net asset class can occur. The GASB believes it does not need to issue UPMIFA-specific guidance because its framework allows for the proper accounting and reporting under this law. Consequently, public institutions in UPMIFA states reflect the results of governing board-directed spending decisions (as well as valuation increases or decreases) as changes in restricted nonexpendable net assets.

Although the GASB did not think additional accounting guidance was necessary due to UPMIFA, the FASB issued FSP FAS 117-1 in August 2008. How does the FASB Staff Position affect the accounting and reporting of donor-restricted endowments under UPMIFA?
According to FSP 117-1, and consistent with guidance in Statement No. 117, a portion of a donor-restricted endowment must be classified as permanently restricted net assets. The portion classified as such must be in accordance with either the donor stipulations or the amount the organization’s governing board determines must be retained permanently under relevant law. Because UPMIFA states that donor-restricted endowments are restricted until appropriated for expenditure, the FSP clarifies that there is a time restriction on the portion of a donor-restricted endowment fund that is not permanently restricted. The FSP also modifies a requirement in paragraph 17 of Statement 116, commonly known as the “deemed spent” rule. That is, donor-imposed restrictions are no longer considered fulfilled when a similar expense is incurred. Consequently, independent institutions in UPMIFA states will likely have significant reclassifications from unrestricted net assets to temporarily restricted net assets for amounts that were previously considered to be deemed spent.

Regardless of the status of the uniform law in your state, the FSP imposes additional financial statement disclosures for all independent institutions—and the foundations affiliated with public institutions—with endowments.

Many bond covenants require a minimum unrestricted endowment. Under the new rules and classifications related to temporarily restricted funds, how should this be handled?
Institutions should evaluate the language used in their bond covenants. Quite often the covenant language requires the terms “expendable net assets,” or “expendable endowment dollars.” Consequently, if the language is broader than “unrestricted,” institutions will be in compliance. Terminology should be evaluated and, if necessary, renegotiated. We’ve heard from several institutions that this was not a huge challenge because key ratios, such as primary reserve, viability, and return on net assets, are essential indicators of financial health in many bond covenants and are not affected by a shift from unrestricted to temporarily restricted net assets.

Our endowment funds are held in a separate foundation that lacks sufficient unrestricted funds to cover underwater endowments. Are we required to transfer from the school's unrestricted funds to make up the difference?
For financial accounting and reporting, the foundation will show negative unrestricted net assets on the statement of net assets—and this is acceptable. You may need to review agreements in place between the institution and the foundation concerning funding requirements (if any).

Under UPMIFA, if the board decides to define “permanently restricted” in a manner that leads to an amount greater than historic dollar value, is it feasible that a fund could be underwater even though it is not below the traditional definition of HDV (donor gift plus additions designated by the donor)?
Per paragraph 5 of FSP FAS 117-1, “a not-for-profit organization that is subject to an enacted version of UPMIFA shall classify a portion of a donor-restricted endowment fund of perpetual duration as permanently-restricted net assets.” In the absence of such stipulations, the organization's governing board determines—consistent with the relevant law—what must be retained (preserved) permanently.

If the governing board requires that an amount greater than explicit donor stipulation be retained to preserve the permanent nature of the fund, the endowment fund is below the board’s established criteria and underwater for accounting purposes. However, because UPMIFA legally eliminates the construct of historic dollar value, your scenario creates an accounting or bookkeeping benchmark only. Decisions to spend below this accounting line are legal decisions and not accounting decisions. If spending occurs and the governing board would like to maintain the created benchmark, then accounting entries continue to follow the guidance in SFAS 124. That is, amounts spent reduce temporarily restricted net assets (to the extent that amounts are available) and then come from unrestricted net assets.

Under UPMIFA, could you use corpus if the governing board makes such a decision?
Yes, this is a judgment call and acceptable as long as the board believes it is prudent to spend from corpus. However, spending should always follow purpose restrictions.

NACUBO RESOURCE For more information or to register for the recorded program “Understanding Underwater Endowments,” go here.

NACUBO CONTACT Sue Menditto, director, accounting policy, 202.861.2542.