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Through its Accounting Principles Council, NACUBO participates in the AICPA Not-for-Profit Expert Panel, which addresses issues unique to independent institutions.

By Karen Craig

*This spring, the American Institute of CPAs (AICPA) is expected to issue an overhauled version of the Audit and Accounting Guide for Not-for-Profit Entities (NFPs). The guide is only one of several projects addressed by the AICPA Not-for-Profit Entities Expert Panel in 2011 that are likely to affect accounting by independent institutions in the coming year.

The expert panel was established in 2002 to—among other things—help CPAs who work in or serve the not-for-profit sector to anticipate industry developments. Its members monitor emerging trends and technical activities specific to NFPs and provide nonauthoritative guidance in areas where it determines clarification is needed. Members of the expert panel are mostly practitioners, with a few business officers from NFPs. Through its Accounting Principles Council, NACUBO participates in the expert panel to ensure that the issues unique to independent institutions of higher education are addressed.

The Audit and Accounting Guide for Not-for-Profit Entities was originally issued 15 years ago in conjunction with the effective dates of Financial Accounting Standards Board Statement No. 116, “Accounting for Contributions Received and Contributions Made,” and FAS No. 117, “Financial Statements of Not-for-Profit Organizations.” Since then, the guide has been updated only for conforming changes. The overhaul project is focused on providing direction on technical issues specific to NFPs, with the goal of reducing inconsistency in accounting practices across the industry and addressing current and emerging topics relevant to NFP reporting guidance.

The Fair Value Question

In addition to the guide overhaul, the expert panel tackled a number of issues in 2011. Chief among the projects was issuance of a financial reporting white paper, “Measurement of Fair Value for Certain Transactions of Not-for-Profit Entities.” The white paper, which is likely to impact institutions in their FY12 audits, addresses the challenges of assessing the fair value of certain financial instruments unique to not-for-profits.

Many independent colleges and universities have struggled with these measurements since the implementation of FAS No. 157, “Fair Value Measurements”—now FASB Accounting Standards Codification (ASC) Topic 820. Specifically, the white paper addresses measuring the fair value of unconditional promises to give, beneficial interests in trusts, and split-interest agreements. Measuring the fair value of such instruments can be particularly challenging because markets for the assets and liabilities do not exist.

The white paper addresses the appropriate unit of account to use for these instruments as well as valuation approaches and techniques, and considerations for determining an appropriate discount rate. The paper also indicates that a present value (PV) technique, which is an application of the income approach, is likely to be the most prevalently used technique in measuring the fair value of unconditional promises to give, beneficial interests in trusts, and split-interest agreements.

The paper discusses two PV techniques: the discount rate adjustment (DRA) technique and the expected present value (EPV) technique. The DRA technique is the most commonly used present value technique in which a single set of most likely cash flows is discounted by a risk-adjusted rate. In contrast, when an EPV technique is used, the various possible cash flow outcomes are probability weighted and then adjusted either directly, by subtracting a cash risk premium, or through the discount rate, to reflect general market risk. While it would seem that all three methods should yield the same result, institutions should consider the ease and practicality of using the methods based on the facts and circumstances specific to the asset or liability being measured.

With regard to discount rates, the white paper acknowledges that determining the appropriate discount rate to use when measuring the fair value of assets and liabilities under FASB ASC 820 has been an area of frustration for many NFPs. In attempting to address those concerns, the white paper suggests a continuum on which the discount rate will likely fall. The low end of the spectrum (the minimum appropriate discount rate) would be the risk-free interest rate, and the high end would be an unsecured borrowing rate. Where the rate falls on that continuum would depend on the extent to which risks and uncertainties are factored into the projected cash flows. The more that the cash flows are adjusted for risk, the lower the discount rate would be, and vice versa.

Other Reporting Issues

The expert panel also identified a number of areas of inconsistency or misapplication of GAAP and developed recommendations for resolution. The panel presented these issues and recommended actions to the Financial Reporting Executive Committee (FinREC) of the AICPA, where they were approved. The issues papers will soon be forwarded to FASB for consideration, most likely by its Emerging Issues Task Force.

A number of the issues addressed are likely to impact independent colleges and universities, including the following four.

Reporting beneficial interests in trusts. GAAP requires that an organization recognize its beneficial interest in a trust if its rights are irrevocable. Specifically, the standards state that an NFP should recognize a contribution when it is notified of the split-interest agreement's existence. If a third party maintains control of the donor's contributed assets, the NFP may not be able to obtain the quantifiable information necessary to measure fair value. This could result in a qualified audit opinion if the amount of the trust is estimated to be material.

The expert panel felt that this guidance was inconsistent with other accounting concepts, specifically those regarding contingent liabilities, which require recognition only when the amount is probable and reasonably estimable. Therefore, the expert panel is requesting that FASB change the requirement so that the beneficial interest in a third-party trust is required to be recognized only if the NFP has sufficient information to reasonably estimate the fair value of the interest.

Treatment of donated securities in the statement of cash flows. Many NFPs are dependent on contributions from donors and, while many donations are made in the form of cash, some are made in the form of appreciated securities to accommodate a donor's tax goals. NFPs that accept such securities typically have institutional policies requiring immediate sale of them to limit the impact of market movements on the value of the donation. Practice for reporting donated securities in the statement of cash flows is mixed. Some NFPs report such amounts as operating cash flows while others report them as investing cash flows.

The expert panel believes that these transactions should be reported as operating activities for several reasons. Among them are that the NFP's institutional policy and practice is to immediately liquidate donated securities; donors understand that their gifted securities will be liquidated and have no expectation that the actual gifted securities will be added to the institution's investment portfolio; and contribution revenue related to receipt of donated securities is based upon the proceeds received from the liquidation of the securities.

The expert panel has recommended that the FASB clarify the guidance for reporting donated securities so that they are treated as operating activities in the statement of cash flows for organizations with a policy in place to sell the securities within a short time of receiving them.

Reporting investment expenses. Current GAAP allows an NFP to report investment expenses either gross or netted against investment returns in the statement of activities. If an organization chooses net reporting, it must disclose gross investment expenses in the notes to the financial statements. Practice differs, however, as to the components included in investment expenses. Embedded investment expenses (those that are deducted by the investment manager before remitting returns to the investor) are often significant and difficult to quantify. As a result, they are typically not included in investment expense. The expert panel believes that net investment return is more meaningful than its components (gross income, dividends, gains, and losses, less expenses), and has recommended that the FASB amend its guidance to require all NFPs to present total investment returns net of investment expenses in the statement of activities.

Subsector specific guidance for other investments. Current guidance for subsequent measurement of other investments (i.e., investments in real estate, venture capital funds, partnership interests, gas and oil interests, and so on) is determined, in part, by whether an organization is an institution of higher education, a voluntary health and welfare organization, a health-care organization, or another type of NFP. The subsector guidance, which requires an organization to use the same measurement attribute for all of its other investments, dates back to the 1980s and is outdated and unnecessarily complex. Most NFPs, particularly institutions of higher education and foundations that have more diverse portfolios, choose fair value for subsequent measurement of their other investments.

For difficult-to-measure investments, however, many NFPs use surrogates for fair value measurement. Those surrogates include roll-forwards of a prior period's fair value measure, equity method accounting, periodic appraisals (e.g., property appraised every five years, with the appraisal used as fair value for the five-year period), or cost adjusted by an index. The surrogates may not be adequate fair value measurements for compliance with FASB ASC 820, “Fair Value Measurements.” Because of the requirement to measure all other investments using the same measurement attribute, however, organizations are unable to change to cost-based measures.

The expert panel believes that the subsector requirements are overly complex and has recommended the elimination of the requirement to measure all other assets on an aggregated basis to simplify and improve the usefulness of reporting, while retaining the ability to use fair value, which is the more relevant measure for investments.

For 2012, the top priority of the Not-for-Profit Expert Panel is to continue its overhaul of the Audit and Accounting Guide for NFPs. In addition, it will participate with other industry expert panels to comment on exposure drafts issued by the FASB including those related to consolidation, revenue recognition, and leases. The expert panel will also monitor the activities of the FASB Not-for-Profit Advisory Committee as it works with the FASB to revisit and revise the financial reporting model for NFPs.

KAREN CRAIG, Shell Beach, California, is an accounting project consultant and adviser for NACUBO.