And the Beat Goes On...
Swamped with a multitude of operational responses to the economic crisis, business officers also had to find time to work on new FASB and GASB accounting requirements. The result: a year that gave business officers no rest.
By Sue Menditto
It's been almost 15 months since a global economic collapse drastically reduced credit availability, the size of endowment funds, and state appropriations. These major events and related repercussions have significantly affected the business office and the larger higher education community. From a financial accounting and reporting perspective, Governmental Accounting Standards Board (GASB) and Financial Accounting Standards Board (FASB) positions and standards in the pipeline still must be implemented—despite the extra work caused by an unexpected catastrophe. In addition, a steady beat of new guidance continues to be proposed. There has been no rest for the weary business officer.
Following is a discussion of the major activities of the GASB and the FASB, which have kept finance offices scrambling.
Assets and Liabilities: Beyond the Basics
Whether you are a new accountant or a seasoned controller, it is essential to understand how assets and liabilities are measured and reported and how they affect your institution's financial health. In that regard, the GASB has continued to focus on defining and quantifying assets and liabilities that have previously been unrecorded. FY09 effectively concluded implementation of GASB Statement No. 45, “Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions,” for the vast majority of public institutions. In addition, all public institutions had to address implementation of GASB Statement No. 49, “Accounting and Financial Reporting for Pollution Remediation Obligations.”
For institutions with other postemployment benefits (OPEB) or pollution-related obligating events, new liabilities are now part of the statement of net assets, and related disclosures continue to expand the footnote section of audited financial statements. Whether it's OPEB or a potential pollution-related event, the statement of net assets reflects as much as is known today about possible constraints on future resources.
Considering the economic collapse in 2008, the GASB's systematic approach to evaluating the information to be reported and disclosed to financial statement users appears appropriately farsighted. Although governments do not have the going-concern issues that businesses and nonprofit organizations do, in today's world of complex financial arrangements the GASB thought it important to convey a complete picture of a governmental organization through the external general-purpose financial statements. The board was concerned that off-balance sheet arrangements make it difficult to understand a government's true financial position, and that ultimately, accountability is enhanced when stakeholders have the best possible information.
Similarly, the FASB has been requiring liability recognition for the promise of benefits in retirement (FASB Statement No. 158, “Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans”) and contingent liabilities like environmental hazards (FASB Interpretation [FIN] 47, “Accounting for Conditional Asset Retirement Obligations”) or income taxes (FIN 48, “Accounting for Uncertainty in Income Taxes”).
The top concern about postemployment benefit obligations promised by both public and independent institutions is whether or not such obligations will be funded. Although recently implemented accounting guidance shines a light on the unfunded liability, incremental funding allows dollars to accumulate over time and has a beneficial effect on the long-term obligation. And, while NACUBO has not studied the funding trend, it's likely that endowment and state-appropriation declines may constrain an institution's ability to achieve an optimum funding level for these future obligations.
Market Reach and Derivative Growth
A 2003 GASB technical bulletin superseded a 1994 technical bulletin on derivative disclosures, because the use of these instruments had grown so extensively.
Governments do not operate in a vacuum. World market conditions influence capital, interest rates, and risk. Governmental organizations participate in the market and respond to market and economic circumstances. For years, state governments, municipalities, and public institutions have managed price and interest-rate variations through the use of derivative instruments. As demand for derivatives has grown in both the public and private sectors, so has the breadth and complexity of the instruments.
Consequently, the GASB became concerned years ago that governmental organizations—like public institutions—were participating in significant transactions involving complex instruments that were not recorded nor properly disclosed in the financial statements. A 2003 technical bulletin superseded a 1994 technical bulletin on derivative disclosures, because the use of these instruments had grown so extensively. Subsequently, a related project began in 2003 and culminated in the accounting standard GASB Statement No. 53, “Accounting and Financial Reporting for Derivative Instruments,” in 2008. The standard is effective for FY10 financial reporting for public institutions.
The GASB's approach to derivatives. The GASB's objective concerning derivatives was to communicate the significance of these instruments to a government's net assets, provide important information about the risks of these instruments, and address the impact of future cash flows. Basically, derivative instruments are financial contracts, the values of which are based on the relative worth of their underlying assets. Many institutional treasury departments have been using derivatives for years—the controllers' area needs to know the type of instrument and intended purpose before much of the work can begin. Consequently, the business office must develop an understanding and an inventory of derivatives.
GASB 53 requires public colleges and universities to evaluate derivatives used to hedge risk. A hedge is a position established—for example, through the use of a financial instrument—to attempt to minimize the risk of another financial instrument. A basic example of a derivative used as a hedge is an interest rate swap on variable rate debt. An institution with variable rate debt may seek to protect against the risk that the variable rate on the debt will increase to a point where the debt service is no longer affordable. As a hedge, the institution enters into a separate variable-to-fixed interest rate swap for all or a portion of the debt. The interest rate swap arrangement requires a fixed interest rate payment in exchange for a variable rate payment stream from the counterparty to the swap. The variable payment received by the institution is typically indexed in a manner similar to the variable rate on the debt. This effectively creates fixed-rate debt for the institution.
In this interest rate swap example, because the institution entered into the swap agreement to hedge variable-rate debt, GASB 53 requires that the effectiveness of the hedge be assessed. The GASB prescribes that either a qualitative or quantitative method be used and describes several types of suggested methods in the standard (e.g., consistent critical terms, synthetic instrument, linear regression, dollar offset, and so on). The methodologies can be complex, and institutions may need to attempt several methods to gauge effectiveness. In fact, many public institutions may want to consider using outside professionals for a thorough assessment.
Again, in the above interest rate swap example, if the swap is assessed as an effective hedge, the swap's interest payments and receipts net against the variable rate debt instrument's interest expense. All derivative instruments must be measured at fair value. However, fair value adjustments for derivatives proven to be effective hedges are recorded as either deferred charges or credits on the statement of net assets. Derivatives that are not hedges—for example, interest rate swaps purchased for speculative purposes—will have both transaction settlements (e.g., interest payment and receipts in a swap arrangement) and fair value adjustments reflected as investment income or losses on the statement of revenue, expenses, and changes in net assets.
Although one of the GASB's objectives concerning derivative instruments is to illuminate the significance of such instruments and help financial statement readers understand the risks through disclosures, deferring fair value adjustments for effective hedges is consistent with the board's long-term view of governmental entities. The board did not want the financial statements to reflect fair value volatility for hedges; and, theoretically, balance sheet deferrals for effective hedges should be fairly close to zero by the end of the instrument's contractual term.
The FASB's take on derivatives. Although it is rare for independent institutions to qualify for hedge accounting under FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities,” the FASB requires that all fair value changes of derivative instruments adjust income—and consequently impact the statement of activities of nonprofit organizations such as independent institutions. Unlike the GASB, the FASB does not prescribe methodologies for assessing the effectiveness of hedge derivatives.
New disclosures about derivatives and hedging. In the current fiscal year (FY10), both independent institutions that follow the FASB and public institutions that follow the GASB will be implementing new disclosures about derivative instruments and their hedging activities. The additional disclosures for independent institutions must address the purpose of the derivative, the risk the instrument seeks to modify, the reason the risk needs to be modified, and information about counterparty credit and cash flow risk.
Additional disclosures for public institutions concern methods used to evaluate hedge effectiveness, information about counterparty credit risks, the organizational strategies related to hedging risks, characteristics of hedged debt, and counterparty and underlying asset risks related to investment derivatives.
Fair Value Accounting
FASB proposals and standards have been delving deeper into fair value measurement inputs and considering the type of information that will enhance financial statement users' understanding of complex assets and liabilities. The GASB is not as far along as the FASB on addressing the practical implications of fair value accounting for various assets and liabilities that lack readily quoted market prices. The most significant items recorded at fair value in higher education are investments, pledges, and complex deferred-giving arrangements.
In June 2009, the GASB issued its “Financial Instruments Omnibus” exposure draft. The objective was to consider potential revisions to existing standards (Statements 25, 31, 40, and 53) regarding investment reporting and disclosure requirements to address significant issues that have been identified in practice. The GASB has not spent time addressing valuation issues inherent to alternative investments, which are meaningful to approximately 25 percent of public institutions that hold their own endowment portfolios.
The FASB, on the other hand, has covered a lot of territory in the area of fair value measurement and disclosure. With the market collapse in 2008, many media outlets and citizens criticized the FASB's pervasive use of fair value accounting. FASB Statement 157, “Improving Disclosures About Fair Value Measurements (SFAS 157),” was mentioned in more than one opinion column as being partially responsible for the market collapse. The stock market's ups and downs typically reflect the future earnings potential of publicly traded companies that participate in one of the market index groups. Because fair value accounting allows unrealized gains and losses to affect earnings, many asserted that the recognized losses resulting from adjusting inflated assets downward perpetuated market declines, and that perhaps markets would not have plummeted—or at least would have had a chance to recover—were it not for the FASB's fair value accounting requirements.
Newer FASB pronouncements, such as the sensitivity analysis and disclosure proposal, are influenced by the underpinnings of International Financial Reporting Standards.
Higher education feels the effects. In 2009, higher education institutions were not immune to concerns over how global market conditions and liquidity restrictions might influence the fair value of instruments without readily determinable market prices. At stake: billions of endowment dollars held in alternative investments. Over the past decade higher education institutions, and the foundations affiliated with public institutions, have increased the percentage of endowment assets invested in alternatives. With the market ticking downward during FY09, institutions and foundations preparing to implement SFAS 157 had to pay close attention to debates by the FASB, its Valuation Resource Group, and the American Institute of Certified Public Accountants (AICPA) surrounding valuation issues related to distressed markets.
In October 2008, FASB Staff Position FAS 157–3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” was drafted, exposed, and issued within two weeks to respond to practice issues of fair value measurement resulting from the credit crisis. The pronouncement reaffirmed the definition of fair value in SFAS 157 and asserted that, even in times of market upheaval, it is not appropriate to conclude that all market activity represents forced liquidations or an automatic conclusion that any transaction price is determinative of fair value. Rather, investment objectives, judgment, and evaluation of the measurement inputs defined in SFAS 157 must be considered.
NACUBO council works with the FASB on clarifications. Several months later, a liaison meeting with the FASB and the NACUBO Accounting Principles Council helped influence board deliberations regarding the application of SFAS 157 to alternative investment valuation. Briefly, SFAS 157 does not expand the use of fair value but rather defines fair value, provides a measurement approach, and specifies disclosures for assets and liabilities already measured at fair value. Further application guidance was needed for alternative investments, because the distressed economic climate resulted in assorted entry and redemption restrictions being imposed on various alternative investments. The restrictions led many to question whether the net asset value (NAV) determined by fund managers was a true measure of fair value in light of current or pending entry or exit restrictions. NACUBO asserted that factors, such as (1) the strategic long-term intent to hold investments, (2) the protection that lock-up provisions may offer against nonessential sales, (3) the realities of a limited hypothetical market of buyers, and (4) the lack of clarity around features that could require a fair value adjustment, could lead to subjective adjustments to material amounts of alternative investments—a less desirable solution than using reported NAV.
A FASB Accounting Standards Update (ASU) issued in September 2009 clarified that entities would be permitted to use NAV as a practical expedient on an investment-by-investment basis, and to apply the expedient consistently to its entire position in a particular investment. This guidance was based on the assumption that investment fund managers providing net asset value information would have NAVs audited using industry standards. In addition, the ASU allowed the rolling forward of NAV if it was not provided as of the reporting entities' measurement date. This was good news for higher education, because most of these funds providing NAV operate on a calendar year.
Since the release of the AICPA's “Alternative Investments—Audit Considerations: A Practice Aid for Auditors,” in July 2006, institutions have gone to great lengths to justify the value of alternative investments to their auditors. Although the allowed used of NAV as a practical expedient for fair value eases the burden of justifying the reported fair value to auditors, SFAS 157 adds significant new disclosure requirements designed to help financial statement readers understand how assets and liabilities are categorized along a continuum from observable to unobservable market valuation inputs. For all assets and liabilities measured by using fair value, independent institutions must disclose in a table—by asset and liability type—fair value amounts determined by using Level 1, Level 2, or Level 3 inputs, briefly described as follows:
Level 1 inputs—observable inputs such as quoted prices in active markets.
Level 2 inputs—inputs observable either directly or indirectly, but on other-than-quoted prices in active markets.
Level 3 inputs—unobservable inputs for which there is little or no market data.
Net asset value is considered a Level 3 input. For recurring fair value measurements using Level 3 inputs, institutions must also provide a reconciliation of the beginning and ending balances for each major category of assets and liabilities. The reconciliation must separately present changes during the period attributable to gains or losses, purchases, sales, issuances, and settlements, and transfers in and/or out of Level 3.
Again, the FASB continues to seek a deeper analysis of measurement inputs. A recent FASB Exposure Draft would require a sensitivity analysis for Level 3 input disclosures. FASB would require organizations to disclose movement among all input categories and an assessment of how changes in one or more significant inputs for use in the Level 3 category might influence reported market value. The proposal would add to the length of already extensive disclosures, burden the business office with widespread additional analysis, potentially confuse statement readers by revealing less reliable valuation inputs, and require a change before assessing the experience with already new measurement requirements and disclosures.
Newer FASB pronouncements, such as the sensitivity analysis and disclosure proposal, are influenced by the underpinnings of International Financial Reporting Standards (IFRS), which tend to be more conceptual or “principles based” than FASB standards. Although the not-for-profit industry has been scoped out of IFRS convergence efforts with the FASB, some of the fair value underpinnings found in the international framework have bled into asset and liability measurement and disclosure requirements. Higher education will continue to monitor how proposed accounting pronouncements based on IFRS, and intended for business enterprises, may indirectly impact the nonprofit sector and higher education. NACUBO is optimistic that higher education (and other nonprofit entities) will be scoped out of the sensitivity analysis proposal.
In addition to the significant and extensive disclosures addressing fair value measurement inputs, independent institutions and the not-for-profit foundations affiliated with public institutions had to prepare pages of new disclosures in their FY09 financial statements as a result of the requirements of FASB Staff Position (FSP) FAS 117–1, “Endowments of Not-for-Profit Organizations: Net Asset Classification of Funds Subject to an Enacted Version of the Uniform Prudent Management of Institutional Funds Act, and Enhanced Disclosures for All Endowment Funds.”
The disclosures apply to all nonprofit organizations, whether or not their states have adopted a version of the Uniform Prudent Management of Institutional Funds Act (UPMIFA). Required disclosures include endowment fund by net asset class for both donor-restricted and board-designated endowments, endowment activity by net asset class displayed for each year of presented financial statements, and related spending and investment policies. Organizations in an UPMIFA state must also disclose the governing board's interpretation of the relevant law and the related amounts designated as permanently restricted net assets.
The Essential Horizon
Because of new guidance, public institutions will evaluate whether unrecorded intangible assets exist, record and report those assets as capital assets, and amortize them over their estimated useful life in FY10. Service concession arrangements—or public-private partnerships—are on the horizon for assessment, recognition, and disclosure in FY12 financial statements. Meanwhile, the GASB is revisiting the way in which the reporting entity is defined, in its Statement No. 14, “The Financial Reporting Entity,” and proposed accounting changes could influence component unit reporting and disclosures.
The FASB released its long-awaited codification in July 2009. With FY09 audits and financial statements finalized, independent institutions will need to begin understanding how the codification works and how this unified body of generally accepted accounting principles affects our profession. NACUBO will cover this topic during a January 28 webcast designed exclusively for higher education. Watch www.nacubo.org for upcoming details on the program
The technical agendas of both standards boards include more and more projects. As a result, higher education
accounting professionals will be required to deal with ongoing change and additional reporting and disclosure requirements. With all this on the horizon, it's clear that the beat will go on—and there is no anticipated rest for the weary.
SUE MENDITTO is director, accounting policy, for NACUBO.