Financial Reporting

Key developments impacting nonprofits.

Gregg Capin and Dan Busby | posted 12/04/2009

Recent accounting standards for nonprofit organizations provide new guidelines for financial reporting. Additionally, a number of tax and legal issues are or may be impacting nonprofits. This article provides an overview of three of these issues.

New Rules for Fair Value Measurement

Financial Accounting Standards Board (FASB) Statement No. 157, Fair Value Measurements (FAS 157), defines fair value and establishes a framework for determining and disclosing it.

Many organizations have questions about how to implement the new standards. It's important to note that while the standards for determining fair value have become more rigorous and may require changes to your current practices, the new guidelines are intended to provide more consistency and comparability in financial reporting.

Defining Fair value

Before the FASB released FAS 157, several definitions of fair value were used, resulting in inconsistent and incomparable reporting. FAS 157 defines fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date" (para. 5). This is a change from the historical use of the term entry price, the price paid to acquire an asset or take on a liability.

Determining Fair value

Under FAS 157, fair value is not an entity-specific measurement, but rather is determined by what a market participant would view as the "highest and best" use of an asset (how they would maximize its value). Restrictions specific to the entity do not affect fair value, but restrictions that are an attribute of an asset do. The fair value of liabilities needs to include market assumptions and be based on relative credit standing.

Valuation techniques consistent with the market, income, and cost approaches need to be used. While these approaches have been used in determining value for years, they now must be applied from the perspective of a market participant, not of the entity. You can use one technique or a combination, as long as you do so consistently and the result is deemed to be most representative of fair value in that situation.

FAS 157 establishes a hierarchy of the types of data, or input, used to determine fair value. The hierarchy is intended to maximize the use of the best and most reliable inputs:

• Level 1 inputs: The unadjusted quoted prices for identical assets or liabilities in active markets. If a Level 1 input is available, you must use it.

• Level 2 inputs: Observable inputs other than Level 1 prices, such as quoted prices for similar assets and liabilities in active markets, quoted prices for similar or identical assets and liabilities in inactive markets, and inputs other than quoted prices that are observable or derived or corroborated from observable market data.

• Level 3 inputs: Inputs that are unobservable due to limited market data. These inputs are based on the entity's own data and assumptions.

Under the new standard, the use of observable inputs (Level 1 and Level 2) should be max-imized.

Key Considerations for Nonprofits

Fair value determination holds special challenges for nonprofit entities. Some key points to consider:

• Contributions (pledges) received or made: May use the expected present value or discount rate adjustment technique (as discussed in Appendix B of FAS 157), along with an appropriate discount rate, to determine fair value.

• Split-interest obligations: May use market-based assumptions, including an appropriate discount rate, to determine fair value.

• Other non-financial assets: Value using the exit price with emphasis on highest and best use, considering the quality and quantity of the items. Consider the effect of donor restrictions pertaining to the asset.

Note that you may only be required to report contributions, split-interest obligations, and other non-financial assets at fair value when gifted, if they are not carried at fair value in future periods.

Many organizations have questions about how to implement the new standards.

Required Disclosures

FAS 157 outlines expanded disclosures for assets and liabilities carried at fair value. These are designed to help the readers of your financial statements understand the extent to which fair value was used. Level 3 inputs require the most extensive disclosures, including specific information about inputs and assumptions.

Fair Value Options

Financial Accounting Standards Board Statement No. 159, the Fair Value Option for Financial Assets and Financial Liabilities (FAS 159), builds on FAS 157 with further guidelines on fair value. The statement was issued to help entities avoid the intricacies of hedge accounting, provide international convergence, and promote the use of fair value accounting for financial instruments.

FAS 159 allows entities to carry select assets and liabilities at fair value. This can be elected on an instrument-by-instrument basis and is irrevocable. After the initial year (fiscal year 2008-2009), it applies only to new instruments.

For nonprofit entities, FAS 159 allows items such as split-interest obligations to carry fair value. It also provides administrative ease compared with using the effective interest method and avoids additional volatility and disclosures.

New Rules for Endowments

There are new legal and financial rules for entities with endowment funds, due to the 2006 Uniform Prudent Management of Intuitional Funds Act (UPMIFA) and the August 2008 FASB Staff Position Number 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 (FAS 117-1).

UPMIFA is a model act governing the management, investment, and expenditure of endowment funds. It updates the 1972 Uniform Management of Institutional Funds Act (UMIFA). It has been enacted by most states and applies retroactively to donor-restricted endowment funds only.

The key provisions of UPMIFA include the following:

• Entities are no longer precluded from spending a donor-restricted endowment fund once it drops below the historic value threshold. In place of the limit, UPMIFA provides more explicit guidance on prudent endowment spending to achieve long-term results.

• Unless stated otherwise in the gift instrument, the assets in an endowment fund are donor-restricted (time-restricted) until "appropriated for expenditure."

• Portfolio managers are not limited in the kinds of assets they may seek for the portfolio, which is more flexible than the rule under UMIFA.

• Investment expenses must be managed prudently in relationship to the assets, the purposes of the institution, and the skills available to the institution. This was not addressed in UMIFA.

Guidance on Net Asset Classification

FAS 117-1 was written to provide further guidance on classifying the net assets (equity) associated with donor-restricted endowment funds held by organizations subject to enacted UPMIFA.

Basic net-asset classification remains largely unchanged by FAS 117-1. The major changes in the amendment include the following:

• Amounts not classified as permanently restricted net assets (a fund of perpetual duration, generally with historic dollar value) are now time-restricted until appropriated. This excludes underwater funds (funds that have dropped below historic dollar value).

• The "deemed spent" rule no longer applies to unappropriated amounts.

• UPMIFA implies a time restriction until funds are appropriated.

• Amounts in excess of the portion classified as permanently restricted will be classified entirely as temporarily restricted, not as a mix of temporarily restricted and unrestricted net assets.

• The only balances in donor endowments that will be classified as unrestricted are negative balances in underwater situations.

Net Asset Disclosures

FAS 117-1 also requires extensive disclosures about donor-restricted and board-designated endowment funds for all organizations with endowments, including those not yet subject to UPMIFA. These disclosures must include a description of the following:

• The governing board's interpretation of relevant law underlying net asset classification

• Endowment spending or distribution policy

• Endowment investment policy

• Return objectives and risk parameters

• How the objectives relate to spending policy

• Strategies for achieving objectives

This information is designed to help readers of financial statements understand the makeup of endowment funds and how net assets have been classified.

Health-care reform

Between now and the end of 2009 (and perhaps beyond), health-care reform will dominate Capitol Hill. If significant reform is adopted, some of the funding sources may impact nonprofits and their employees in the following ways:

• Capping itemized deductions, including charitable contributions

• Limiting or repealing the tax exclusion for employer-provided health coverage

• Increasing payroll taxes

• Placing a levy on employers not providing health insurance

• Modifying health savings plans (HSA)

• Modifying or repealing the exclusion for employer-provided reimbursement of medical expenses under flexible spending accounts (FSAs)and health reimbursement arrangements (HRAs)

• Ending the reimbursement of over-the-counter medicine under an FSA, HRA, or HSA

While the standards may necessitate changes to your current practices, the new guidelines are intended to provide more consistency and comparability in financial reporting.

If changes in the tax law reduce the value of fringe benefits, this will put the pressure on nonprofits to provide further compensation.

These are but a few of the key IRS oversight, accounting, tax, and legal issues on the horizon for nonprofits. We will be teaching a workshop at the 2010 CLA National Conference in San Diego, April 19β1, 2010, entitled "21st Century Financial Management." It will provide a more in-depth overview of these and other key issues and the impact of those changes on financial reporting.

Gregg Capin, CPA, is a partner with Capin Crouse LLP, a CPA firm specializing in service to nonprofit organizations through audit, tax, and advisory services (CapinCrouse.com).

Dan Busby, CPA, is the president of the Evangelical Council for Financial Accountability (ecfa.org), an accreditation agency dedicated to helping Christian ministries earn the public's trust through adherence to the Seven Standards of Responsible Stewardship.

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