DATELINE: February 25, 2008, Chicago
[I have written a 45-page article that will be appearing in the April edition of the Exempt Organization Tax Review (early April), together with a 10-page comment letter to the FASB. These two offerings take a much more deliberative and organized approach than this post, which was essentially a one-afternoon effort to get some thoughts on paper]
The last year has seen significant efforts to improve nonprofit transparency. The IRS is in the process of finalizing the redesigned Form 990. Its efforts have almost uniformly been applauded as an excellent step toward improving transparency. Our friends in the accounting profession have now weighed in, hoping to improve the public’s understanding of nonprofit endowments. Regrettably, the new proposal does anything but make endowment accounting more transparent.
I. INTRODUCTION. In an effort to clarify the accounting treatment applied to nonprofit endowment funds, the Staff of the Financial Accounting Standards Board (FASB) issued Draft Staff Position 117-a on February 22, 2008,. This was necessary because 14 states and the District of Columbia have adopted the Uniform Law Commission’s recently promulgated Uniform Prudent Management of Institutional Funds Act (UPMIFA), with virtually all states expected to adopt it within the next few years. During the first two months of 2008, 14 states legislatures began consideration of UPMIFA-based legislation.
If Draft FAS 117-a doesn’t at first sound like a snoozer, we don’t know what does. As it turns out it could prove to be an explosive proposal, once it is finalized. To see why, you only need recall recent pronouncements from Senator Grassley and other legislators regarding college endowments, calling into question what they have characterized as paltry spending rates on college endowments, particularly in light of ever-increasing college tuition, room, and boarding costs. Like many other critics of endowment spending, the legislators have argued that a larger portion of endowment funds and income should go to assist needy students today. They have threatened a legislative fix to the perceived problem if institutions do not increase spending—although Senator Grassley has already indicated that he is pleased with how some universities have responded to his concerns.
The accounting rules that the FASB is now considering bear directly...
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on how elected officials and the public will view university, museum, hospital, and foundation wealth as reflected by their endowments. Under one approach, endowed institutions will look as if they are awash in spendable cash and marketable securities, which will inevitably result in legislative pressure to increase endowment spending. Under an alternative approach, the financial statements will present a less rosy picture in terms of freely expendable resources. Placed in this context, endowment accounting becomes a sexy topic. It impacts on just how much debt Junior and his parents must incur to finance Junior’s college education.
Unfortunately, the staff’s proposed position is so poorly conceived that it is virtually impossible to ascertain what it means. More important, the draft almost uniformly arrives at the wrong answer for each issue it addresses, assuming we have correctly ascertained what the staff means.
More significantly, the staff has refused to accept that UPMIFA changed the framework that the legal system applies to endowments. Historic value is no longer relevant, having been replaced by rules that rely on total return to calculate income in the absence of more specific instructions from donors. Yet, the staff continually returns to concepts rooted in historic value. If Draft FAS 117-a is adopted in its present form, the overall effect will be to overstate the portion of endowment that the board has discretionary authority to spend.
We are deeply troubled by the staff’s outright refusal to recognize a fundamental change in the law. There is no excuse for this recalcitrance. The end result: A final rule based on Draft FAS 117-a will produce materially misleading financial statements.
I. REQUIRED PROCESS CHANGES. Setting aside the substantive concerns we have with the draft’s positions, the mechanics of the pronouncement are problematical. There are no examples to illustrate the proposed rules. Every time we have heard someone speak about the issues posed by endowments, they have used examples to facilitate the discussion. The staff should have followed that practice.
We also are troubled by the reference and reliance on EITF Abstracts, Topic No. D-49, which is a March 21, 1996 staff response to a technical inquiry. When a rulemaking body takes on the task of rewriting the rules, it should do so by writing a comprehensive set of rules that supersedes all prior lower-precedential pronouncements. Readers should not have to piece together meaning through an examination of disparate pronouncements issued over an extended period of time.
Even more puzzling to us is the staff’s decision in Draft FAS 117-a to amend FASB Statement No. 117. We are not versed in the precedential hierarchy of all the various FASB pronouncements, but our understanding is that FASB statements represent the highest level of authority. In the law, district courts don’t modify U.S. Supreme Court precedent. We have some trouble understanding why that same deference does not apply to FASB statements. If those statements are to be amended, that process should originate with the FASB board, not the staff. Moreover, if the issue is important enough to warrant amending a FASB statement, the statement should be revised so that the positions of the FASB are stated in one location. Those who must apply accounting principles should not be burdened with the task of stitching together a patchwork of rules.
In the introduction to Draft FAS 117-a, the staff indicates that it does not just want criticism, but it also wants alternatives. Here are two alternatives. Use examples and codify.
II. GUIDING PRINCIPLES. In considering what approach should have been taken in Draft FAS 117-a, we keep coming back to the following four principles:
Principle 1: An accountant is an accountant, and a lawyer is a lawyer. By this we mean, lawyers define reality by examining how the law characterizes a particular set of facts. Accountants, on the other hand, are charged with making sure that the financial statements reflect reality. Accountants should not impose accounting principles that define reality. That only results in misleading financial statements.
Principle 2: An endowment fund is an endowment fund. For historical reasons, there was a need to distinguish between the donor’s contribution of restricted funds and the appreciation on those funds. Despite that quirk of history, which will be eliminated in each state that replaces the Uniform Management of Institutional Funds Act (UMIFA) with UPMIFA, trustees always had fiduciary duties with respect to the entire fund. That is true with respect to the original donation and any net appreciation. The accounting principles should stop trying to carve principal up into historical and investment gain principal.
Principle 3: A restriction is a restriction. Principle 3 is a corollary to Principle 2. The fundamental flaw in Draft FAS 117-a is its continued reference to donor-imposed restrictions. That reference should be to legally-binding restrictions or externally-binding restrictions. By focusing exclusively on donor-imposed restrictions, the staff continues to focus on historic value despite UPMIFA’s elimination of that concept. Restrictions imposed by state law on an organization’s ability to spend portions of an endowment fund are no less legally binding than those imposed by a donor.
To be clear, we recognize that quasi-endowment or board-designated endowment do not result in the reclassification of unrestricted assets as restricted ones. That is why we believe the terms legally-binding and externally-binding both are better choices for describing the types of restrictions that result in temporarily or permanently restricted assets. These are restrictions that are imposed on the board by entities external to it—state law or the donor’s gift instrument. When the board determines what it can spend within the limits of prudence, that is not an internal or discretionary decision. The board may be making the decision internally, but it is a legally required and binding decision that is governed by external standards. In short, that decision is not in any way similar to the one made by a board when it sets asides reserves in the form of board-designated endowment. Unfortunately, Draft FAS 117-a focuses on who makes the decision rather than on whether the decision is binding. As a consequence, it incorrectly concludes that the board’s decision to designate endowment as quasi endowment is no different than setting a spending rate through the exercise of its fiduciary duties. In both cases, the board may be making the decision, but the legal consequences of each decision are different.
Principle 4: An endowment is not a monolith. An organization’s endowment is comprised of numerous separate accounts, each created by an individual donor. Although the financial statements may aggregate funds with the same characteristics for presentation, the nonprofit’s and the board’s legal duties run to each separate fund, not to what the accountants refer to as total net assets or total permanently restricted net assets.
With the forgoing principles in mind, we will now offer a series of examples to illustrate how we believe Draft FAS 117-a would operate if adopted in its present form and to permit us to critique the results that Draft FAS 117-a reaches.
III. THE LEGAL RESULT UNDER UPMIFA. Draft FAS 117-a and UPMIFA pose a chicken and egg problem. The accounting word needs to be able to prepare and certify financial statements. Hence, the need for FASB to be responsive to what appears to be the widespread and quick adoption of UPMIFA. That poses one significant problem: Before FASB can intelligently set the accounting rules applicable to endowments, it must understand what UPMIFA mandates.
We suspect that although most legal experts agree on the general consequences that flow from UPMIFA, they may differ on how it applies to actual facts. To address those uncertainties, the FASB staff should have clearly articulated what it believes UPMIFA mandates. We believe some numerical examples would have been helpful. With that need in mind, we offer four examples illustrating how we believe UPMIFA operates. In these examples, we use a simplified method to calculate what portion of the endowment can be spent each year. In practice, boards will likely apply spending rates to endowment value by adopting a moving-average determination of value that uses a specified number of prior years.
Example 1—Legal: Donor X gives $1 million to Crimson University, providing that principal must be maintained in perpetuity, but that Crimson can spend the income. The donor does not address the treatment of appreciation or depreciation in the value of the fund.
In Year 1, the Donor X Fund earns $30,000 in dividend income and the value of its marketable securities increases to $1,100,000, so the fund’s net assets are $1,130,000 at year-end. The trustees of Crimson University have adopted a 7% spending rate, set in accordance with Section 4 of UPMIFA. Assume the state with jurisdiction over the fund has enacted UPMIFA, but without adopting Section 4(d). In this case, Crimson can spend $79,100 (7% of $1,130,000) as a legal matter. Note that Crimson need not trace the amount it spends to dividends, interest, or net investment appreciation. Sourcing is no longer relevant unless the donor imposes her own sourcing regime on the gift.
The accounting rules SHOULD treat $79,100 as being unrestricted funds, but the remaining $1,050,900 as restricted.
Example 2—Legal: Donor X gives $1 million to Crimson University, providing that principal must be maintained in perpetuity, but that Crimson can spend the income. The donor does not address the treatment of appreciation or depreciation in the value of the fund.
In Year 1, the Donor X Fund earns $30,000 in dividend income and the value of its marketable securities declines to $800,000, so the fund’s net assets are $830,000 at year-end. The trustees of Crimson University have adopted a 7% spending rate, set in accordance with Section 4 of UPMIFA. Assume the state with jurisdiction over the fund has enacted UPMIFA, but without adopting Section 4(d).
In this case, Crimson can spend $58,100 (7% of $830,000) despite the fact that its total return is negative ($170,000 overall loss) and its income from dividends and interest is just $30,000. There is one important caveat: This example assumes 7% is prudent under these circumstances. Crimson’s board might look at general economic conditions, the desire to preserve the fund, and its other resources, and then properly conclude that no funds should be spent (a 0% spending rate). In that case, Crimson can spend none of the $830,000.
When 7% is the prudent spending rate, the accounting rules SHOULD treat $58,100 of the fund’s value as unrestricted assets and the remaining $771,900 as restricted. The accounting rules SHOULD do nothing that would suggest that Crimson University’s unrestricted resources or other restricted funds somehow have an obligation to restore the fund’s balance to $1 million. If 0% is the prudent spending rate, then the full $830,000 is restricted. Once again, the accounting rules SHOULD do nothing that suggests that there is an obligation to restore the fund to $1 million. Historic value is no longer a relevant consideration.
Example 3—Legal. Donor X gives $1 million to Crimson University, providing that principal must be maintained in perpetuity, but that Crimson can spend the income. Donor X specifically defines income as including net appreciation. He also provides that if the Donor X Fund’s value drops below $1 million, no portion of the income is to be spent until the fund is restored to $1 million. In Year 1, the Donor X Fund earns $30,000 in dividend income and the value of its marketable securities decreases to $800,000, so the fund’s net asset value is $830,000 at year-end. The trustees of Crimson University previously adopted a 7% spending rate, set in accordance with Section 4(a) of UPMIFA. Assume the state with jurisdiction over the fund has enacted UPMIFA, but without adopting Section 4(d).
Although the trustees deem an overall spending rate of 7% to be prudent, they cannot spend any portion of the Donor X Fund. The $30,000 of dividend income may be income, but Donor X has specifically stated that the $30,000 must be used to restore the fund to $1 million. The donor’s expressed wishes always trump the default rules of construction in Section 4 of UPMIFA.
Let’s assume that there is a second fund, the Donor Y Fund. It has $1 million in bonds, earning 9% per annum. The donor has specified that the bonds must be Triple A rated and insured. She has also specified that each bond must be held to maturity. The bonds earn 9%. In Year 1, Crimson can spend $70,000 of the interest income, assuming the 7% spending rate applies to all endowments.
Under UPMIFA, an endowment fund is not a monolith, although all the individual endowment funds may be managed jointly. Each restricted gift represents a separate fund. That has important implications in this example. The Crimson board may adopt an overall 7% spending rate, but it cannot legally spend all of the Donor Y Fund’s interest income (9%) to arrive at an average spending rate for the Donor X and Donor Y Funds that is closer to the overall 7% spending rate adopted by Crimson’s board.
The accounting rules SHOULD show the Donor X Fund as having $830,000 in restricted assets and the Donor Y Fund as having $1,020,000 in restricted assets and $70,000 of unrestricted assets.
Example 4—Legal. Donor X gives $1 million to Crimson University, providing that principal must be maintained in perpetuity, but that Crimson can spend the income. Donor X does not address the treatment of appreciation or depreciation in the value of the fund.
In Year 1, the Donor X Fund earns $30,000 in dividend income and the value of its marketable securities increases to $1,100,000, so the fund’s net assets are $1,130,000 at year-end. The trustees of Crimson University have adopted a 5% spending rate, set in accordance with Section 4 of UPMIFA. The state with jurisdiction over the fund has adopted Section 4(d) of UPMIFA, which provides in relevant part as follows:
The appropriation for expenditure in any year of an amount greater than seven percent of the fair market value of an endowment fund, calculated on the basis of market values determined at least quarterly and averaged over a period of not less than three years immediately preceding the year in which the appropriation for expenditure is made, creates a rebuttable presumption of imprudence. For an endowment fund in existence for fewer than three years, the fair market value of the endowment fund must be calculated for the period the endowment fund has been in existence.
This subsection does not:
(1) apply to an appropriation for expenditure permitted under law other than this [act] or by the gift instrument; or
(2) create a presumption of prudence for an appropriation for expenditure of an amount less than or equal to seven percent of the fair market value of the endowment fund.
In this case, Crimson can spend $56,500 (5% of $1,130,000) as a legal matter.
The accounting rules SHOULD treat $56,500 as being unrestricted funds, but the remaining $1,073,500 as restricted. The rules should not treat $79,100 as unrestricted. Section 4(d) creates a rebuttable presumption of imprudence for spending above 7%, but that rebuttable presumption does not mean that anything below 7% is automatically prudent, as is made clear by Section 4(d)(2).
IV. THE ACCOUNTING RESULT UNDER DRAFT FAS 117-a. The results reported pursuant to Draft FAS 117-a should track the legal consequences of state-law restrictions. As already noted, Draft FAS 117-a contains no examples and is poorly drafted. Consequently, we can only guess at what results Draft FAS 117-a would produce if finalized in its present form.
A. The Four Views. Appendix A, Basis for Conclusions, which summarizes the potential approaches to dealing with endowment accounting, offers four views of how donor-restricted endowments should be treated for purposes of financial statement disclosure. We do not understand why this information was placed in an Appendix because this discussion is so vital to understanding the operative provisions in Draft FAS 117-a.
Under View 1, none of a donor-restricted fund is treated as permanently restricted because historic value has been eliminated. This view is wrong from “a material reflection” standpoint because it ignores legal limitations imposed on fiduciaries.
Those holding View 2 take the opposite position. They argue that the entire fund should be treated as permanently restricted. We agree with this view, with one exception. We believe that the fund must be reduced by the amount the board deems prudent to spend each year, regardless of whether those funds are transferred to the nonprofit’s operating bank accounts.
View 3 is similar to View 2. Those holding View 3, however, propose changing the net asset classification model, possibly merging the permanent and temporarily restricted asset categories. They would provide for a more nuanced breakdown of restricted assets, either in footnotes or as part of the core statements.
Finally, there is View 4, which is the one the staff claims to have incorporated into Draft FAS 117-a. Those holding View 4 believe that some portion of an endowment fund should be classified as restricted. After reviewing Paragraph 22 of FASB Statement No. 117, which focuses on the obsolete concept of investment gains, those holding View 4 conclude, in the words of the staff,
[] if the governing board determines that a portion of a donor-restricted endowment fund must be retained permanently in accordance with explicit donor stipulations or the relevant law (as opposed to being simply good organizational policy to retain), that portion would be classified as permanently restricted net assets.
On the surface, this view looks quite similar to View 2. As is often the case, the devil is in the details. Is UPMIFA a law that requires that a portion of the endowment be retained? We think so, but Paragraph 9 of Draft FAS 117-a suggests otherwise, stating
Laws that refer to actions that are entirely within the purview of an existing organization’s governing board, such as acting to appropriate or exercising prudence in doing so, do not, in themselves, create or extend donor-imposed restrictions. Similarly, laws that provide additional guidance on what constitutes prudence, rather than establishing absolute ceilings on spending, do not, in and of themselves, extend donor-imposed restrictions.
[italics added]
As we read UPMIFA, it is exactly the sort of statute described in the quoted passage. In our view Paragraph 9 and the staff’s comments regarding UPMIFA contradict each other in terms of whether the application of Section 4 of UPMIFA increases permanent endowment. We are not going to mince words. Draft FAS 117-a was proposed to respond to what is likely to be the adoption of UPMIFA in virtually every state. There are likely to be some variations in how individual states formulate Section 4, but these are likely to reflect two or three discrete patterns. Consequently, rather than floating open-ended terminology, the staff simply should have stated how nonprofits are to apply Draft FAS 117-a to endowments governed by UPMIFA.
Unfortunately, the staff has proposed a puzzle, filled with theory which at best adds to the confusion surrounding accounting for endowments. The FASB should immediately withdraw Draft FAS 117-a because it is so fundamentally flawed both in its execution and the outcomes that it reaches. The FASB should order the staff to then develop language that says what it means and means what it says. No wonder U.S.-based multi-national corporations have asked to prepare their financial statements using international accounting rules rather than U.S. GAAP.
B. Applying Draft FAS 117-a to the Four Examples (As Best We Can). With that introduction, let’s now examine the results that Draft FAS 117-a produces when applied to our four examples.
Example 1—Accounting. Donor X gives $1 million to Crimson University, providing that principal must be maintained in perpetuity, but that Crimson can spend the income. The donor does not address the treatment of appreciation or depreciation in the fund’s value.
In Year 1, the Donor X Fund earns $30,000 in dividend income and the value of its marketable securities increases to $1,100,000, so the fund’s net assets are $1,130,000 at year-end. The trustees of Crimson University have adopted a 7% spending rate, set in accordance with Section 4 of UPMIFA. Assume the state with jurisdiction over the fund has enacted UPMIFA, but without enacting Section 4(d). In this case, Crimson can spend $79,100 (7% of $1,130,000) as a legal matter.
The accounting rules SHOULD treat $79,100 as being unrestricted funds, but the remaining $1,050,900 as restricted. It does not appear that the rules reach that result. Paragraph 9 of Draft FAS 117-a provides in full as follows:
Contractual and legal provisions often impose constraints on an organization’s use of particular assets, but those constraints generally do not create a donor-imposed restriction or temporarily restricted net assets or permanently restricted net assets, as defined in FASB Statement No. 117, Financial Statements of Not-for-Profit Organizations. Only legal restrictions that extend a donor-imposed restriction create temporarily or permanently restricted net assets. Laws that refer to actions that are entirely within the purview of an organization’s governing board, such as acting to appropriate funds or exercising prudence in doing so, do not, in and of themselves, create or extend donor-imposed restrictions. Similarly, laws that provide additional guidance on what constitutes prudence, rather than establishing absolute ceilings on spending, do not,
in and of themselves, extend donor-imposed restrictions.
[italics added]
As we read its last two sentences, Paragraph 9 would ignore Section 4(a) of UPMIFA because UPMIFA is a law that refers to exercising prudence in appropriating funds. As a consequence, Draft FAS 117-a would result in an additional $50,900 being classified as unrestricted despite legal restrictions prohibiting Crimson from using that money.
This result is wrong if the overarching goal is financial statements that are not materially misleading. It overstates the amount of assets that a nonprofit can use to provide financial aid, reduce tuition, buy art, or hire new doctors. Were the board to spend those funds, it would violate its fiduciary duties. Moreover, this result is potentially misleading to creditors, who might seek to take a security interest in that additional $50,900 in funds. Under the laws of certain jurisdictions, the nonprofit might not even be able to grant a valid security interest in those funds, although that question is beyond the scope of this commentary.
The question: Why did FASB’s staff reaches this erroneous result? There are two reasons. First, by focusing on and only recognizing donor-imposed restrictions, the staff is trying to get back the comfort that historical value provided to accountants. It’s time for Linus to face reality: Lucy took the blanket and burnt it along with historical value.
Second, but related to the desire to continue to focus on historical value, this result avoids judgment calls. A rule that classifies all income, including net appreciation, as unrestricted is easy to apply, but the fallacy underlying that approach is that both law and accounting require and rely on judgments all the time. In the law, we ask whether a potential tortfeasor acted reasonably, whether all material facts have been disclosed in a security offering document, and whether compensation is reasonable. The accountants make similar judgments. For example, they ask whether a reserve for bad debts is reasonable, whether property is obsolete, whether an interest in an entity is significant enough to warrant applying the equity method to it, and whether a contingent liability must be recognized in the financial statements. At the end of the day, both lawyers and accountants continually make and rely on judgments, but accountants only appear to be willing to reflect judgment calls in financial statements when the accountants make the calls. Why not reflect the judgments made by nonprofit boards in exercising their fiduciary duties? The FASB’s staff has not answered this question. It must if it is going to reach the result that it does in Draft FAS 117-a.
Example 2—Accounting. Donor X gives $1 million to Crimson University, providing that principal must be maintained in perpetuity, but that Crimson can spend the income. The donor does not address the treatment of appreciation or depreciation in the value of the fund.
In Year 1, the Donor X Fund earns $30,000 in dividend income and the value of its marketable securities declines to $800,000, so the fund’s net assets are $830,000 at year-end. The trustees of Crimson University have adopted a 7% spending rate, set in accordance with Section 4 of UPMIFA. Assume the state with jurisdiction over the fund has enacted UPMIFA, but without enacting Section 4(d).
In this case, Crimson can spend $58,100 (7% of $830,000) despite the fact that its total return is negative (a $170,000 overall loss) and its income from dividends and interest was just $30,000. There is one important caveat: The example assumes 7% is prudent under these circumstances. Crimson’s board might look at general economic conditions, the desire to preserve the fund, and its other resources, concluding that it is now prudent to refrain from spending any portion of the Donor X Fund. In that case, Crimson can spend no portion of the $830,000.
We are not entirely sure how the staff would treat these facts. The donor has said to spend income, so we suspect that the staff would reclassify $30,000 dividend income as unrestricted assets. What causes us pause is language in Paragraph 7 of Draft FAS 117-a, which provides as follows:
However, consistent with the organization’s fiduciary duty for a fund of permanent duration, the amount of permanently restricted net assets should not be reduced by (a) losses on the investments of the fund, except to the extent that losses are related to specific investments that the donor requires the organization to hold in perpetuity, or (b) an organization’s expenditures from the fund.
This statement is rooted in historical value, which as we have already noted and will again, no longer exists as a guiding construct. The fund is the fund and each fund must stand alone. Those guiding principles should result in the Donor X Fund being reduced to its market value to reflect the loss. The language in Draft FAS 117-a, however, suggests that some unrestricted assets should be reclassified as restricted, or as some accountants have done in the past, that an inter-fund liability be created, showing the unrestricted assets as owing money to the now underwater restricted fund—notwithstanding that the notion of underwater endowment went by the wayside when historical value was eliminated. If the accounting profession uses this language to reduce the unrestricted assets or books an inter-fund liability, it will result in misleading financial statements. This is not just a question of debits and credits. In a time of economic downturn, the accounting profession will be telling university students that there are less funds available for general operations than there actually are.
Example 2 raises a second issue under Draft FAS 117-a. The second portion of the example indicates that the board arrived at a new spending rate (0%) in light of changed circumstances. It is seriously open to question whether the accountants will respect that decision in view of the first sentence of Paragraph 7 to Draft FAS 117-a, which provides:
A governing board’s interpretation of the relevant law should be applied to all donor-restricted endowment funds and should be consistent from year to year.
Before discussing the accounting treatment that might flow from this statement, we should first note why the statement is wrong. It views the governing board as a monolith, but it is not. The current governing board can set a specified spending rate: let’s say 6% per annum. Over time, the board’s composition will change. Under the law, the first generation board members cannot bind third generation members in terms of how the third generation members discharge their fiduciary duties. More importantly, the first generation members should not be permitted to bind future boards. Times and circumstances change. The institution’s resources, plans, mission, and risk tolerances may change. An institution with a $10 million endowment may undergo significant transformation should it have the good fortune to have a donor give it $250 million in permanently restricted funds. As this example illustrates, spending rates must be responsive and cannot be fixed into perpetuity. Yet the first sentence to Paragraph 7 implies just the opposite.
Taken in isolation, the quoted language could lead accountants to ignore changes in spending rates after the rate is initially set. In terms of the present example, that would mean treating the $30,000 of dividend income as unrestricted despite the board’s determination that it would be imprudent to spend the $30,000.
Unfortunately, the first sentence does not stand alone; there is also the third sentence which was quoted earlier. That sentence could result in the accountants reclassifying unrestricted assets from other endowment funds as permanently restricted. That would shift assets toward restricted classification, partially offsetting the $30,000 shift toward unrestricted. At the end of the day, the FASB should eliminate the extraneous and incorrect statements from Draft FAS 117-a.
Example 3, Accounting. Donor X gives $1 million to Crimson University, providing that principal must be maintained in perpetuity, but that Crimson can spend the income. Donor X specifically defines income as including net appreciation. He also provides that if the Donor X Fund’s value drops below $1 million, no portion of the income is to be spent until the fund is restored to $1 million. In Year 1, the Donor X Fund earns $30,000 in dividend income and the value of its marketable securities decreases to $800,000, so the fund’s net asset value is $830,000 at year-end. The trustees of Crimson University have adopted a 7% spending rate, set in accordance with Section 4(a) of UPMIFA. Assume the state with jurisdiction over the fund has enacted UPMIFA, but without adopting Section 4(d).
Although the trustees deem an overall spending rate of 7% to be prudent, they cannot legally spend any portion of the Donor X Fund. The $30,000 of dividend income may be income, but Donor X has specifically stated that the $30,000 must be used to restore the fund to $1 million. The donor’s expressed wishes always trump UPMIFA’s rules of construction.
At this point, Draft FAS 117-a would treat the entire fund, including the $30,000 of dividend income as restricted. What is unclear is whether the language in Paragraph 7 of Draft FAS 117-a would require that some portion of the unrestricted assets be recharacterized as permanently restricted. That result is not justified by law because the restricted fund has no legal claim on the organization’s other assets, but Paragraph 7 tells us that permanently restricted assets are not to be reduced by investment losses. Yet, if the accountants adhere to the “no reduction” admonition in Paragraph 7 of Draft FAS 117-a, they will inevitably look to the unrestricted accounts to keep the accounts in balance—you can’t have a credit without an equal debit.
Let’s assume that there is a second fund, the Donor Y Fund. It has $1 million in bonds, earning 9% per annum. The donor has specified that the bonds must be Triple A rated and insured. She has also specified that each bond must be held to maturity. The bonds earn 9%. In Year 1, Crimson legally can spend only $70,000 of the interest income.
Although Paragraph 7 contains no stacking rules, we suspect that the accountants would first reclassify the $70,000 in otherwise spendable income from Donor Y Fund as permanently restricted in an effort to preserve the Donor X Fund’s $1 million initial value. But this is clearly the wrong result from a legal standpoint. The Donor X Fund and the Donor Y Fund owe no obligations to each other. Under the law, Crimson University is free to spend only the $70,000 of interest income generated by Donor Y Fund.
Example 4—Accounting. Donor X gives $1 million to Crimson University, providing that principal must be maintained in perpetuity, but that Crimson can spend the income. Donor X does not address the treatment of appreciation or depreciation in the value of the fund.
In Year 1, the Donor X Fund earns $30,000 in dividend income and the value of its marketable securities increases to $1,100,000, so the fund’s net assets are $1,130,000 at year-end. The trustees of Crimson University have adopted a 5% spending rate, set in accordance with Section 4 of UPMIFA. The state with jurisdiction over the fund has adopted Section 4(d) of UPMIFA, providing in relevant part as follows:
The appropriation for expenditure in any year of an amount greater than seven percent of the fair market value of an endowment fund, calculated on the basis of market values determined at least quarterly and averaged over a period of not less than three years immediately preceding the year in which the appropriation for expenditure is made, creates a rebuttable presumption of imprudence. For an endowment fund in existence for fewer than three years, the fair market value of the endowment fund must be calculated for the period the endowment fund has been in existence.
This subsection does not:
(1) apply to an appropriation for expenditure permitted under law other than this [act] or by the gift instrument; or
(2) create a presumption of prudence for an appropriation for expenditure of an amount less than or equal to seven percent of the fair market value of the endowment fund.
In this case, Crimson can spend $56,500 (5% of $1,130,000) as a legal matter.
As we read Draft FAS 117-a, the financial statements will treat the $73,500 (all income above the 5% spending rate) as unrestricted assets. Once again, this comes about because Draft FAS 117-a continues to focus on historic value.
We fully acknowledge that our application of Draft FAS 117-a to these examples may be wrong. But that isn’t because we are stupid. Any error on our part stems from unfocused language, unnecessary verbiage, the slavish adherence to historic value, and most importantly, the refusal to address UPMIFA head-on.
V. THE QUESTION OF TEMPORARILY RESTRICTED. So far, we have focused on whether fund balances should be reported as restricted or unrestricted. In fact, restricted fund balances can be either temporarily or permanently restricted. Paragraph 8 of Draft FAS 117-a instructs that when determining whether a fund’s assets are temporarily or permanently restricted, we are to look to EITF Topic No. D-49. As a preliminary matter, this reference is troublesome for two reasons. First, as we noted at the outset, we shouldn’t have to look outside the four corners of what essentially is a re-codification of the accounting rules applicable to endowments. Second, and of far greater importance, EITF Topic No. D-49 specifically addresses how to apply the accounting rules to endowments governed by UMIFA. On the critical question of how to ascertain spendable income, UMIFA and UPMIFA offer two entirely different regimes. UPMIFA rejects the historic value construct set out in UMIFA, meaning that EITF Topic No. D-49 is obsolete.
Paragraph 8 of Draft FAS 117-a provides in full as follows:
In determining whether provisions in enacted legislation that are based on subsection 4(a) (“restricted assets” wording) or 4(d) (rebuttable presumption) of UPMIFA impose a temporary (time) restriction on the portion of a donor-restricted endowment fund that otherwise would be classified as unrestricted net assets, an organization shall apply the guidance in EITF Topic No. D-49, “Classifying Net Appreciation on Investments of a Donor-Restricted Endowment Fund” (see Appendix B).
We initially thought this paragraph was suggesting that endowment funds subject to total return principles should be classified as temporarily restricted assets because in theory spending portions of the fund is subject to the passage of time. That does not appear to be the point Section 8 when read in conjunction with EITF Topic D-49.
Before addressing Section 8 and EITF Topic D-49, we believe we should reject the notion that somehow endowments subject to UPMIFA represent temporarily restricted assets. That view focuses on the right to spend funds. We believe that such an outcome is wrong. It ignores the strong likelihood that the fund will also produce income, offsetting in some part the spending. In other words, experience demonstrates that endowments increase in value over the long-run despite the power to spend portions of them.
The reference to EITF Topic No. D-49 only confirms that our earlier interpretations of Draft FAS 117-a are probably correct. Relevant portions EITF Topic No. D-49 state:
The FASB staff believes that Section 2 of the Uniform Management of Institutional Funds Act and its reference to the standard of ordinary business care and prudence established by Section 6 does not extend a donor-imposed restriction as that term is defined in Statement 117…
Paragraph 168 of Statement 117 defines a donor-imposed restriction as "a donor stipulation that specifies a use for a contributed asset that is more specific than broad limits resulting from the nature of the organization, the environment in which it operates, and the purposes specified in its articles of incorporation or bylaws or comparable documents for an unincorporated association." The FASB staff believes that a requirement to exercise ordinary business care and prudence is not a limitation that is more specific than the broad limits of the environment in which charitable and other not-for-profit organizations operate. Furthermore, paragraph 127 of Statement 117 says, "Others, including Board members, believe that the responsibility to exercise ordinary business care and prudence in determining whether to spend net appreciation is similar to the fiduciary responsibilities that exist for all charitable resources under an organization's control." Thus, a legal limitation that requires that a governing board exercise ordinary business care and prudence when appropriating net appreciation is not the equivalent of a law that extends a donor-imposed restriction and, therefore, does not result in classification of net appreciation as donor-restricted, either permanently or temporarily.
As we read the incorporation of this language into Paragraph 8 of Draft FAS 117-a, this extends this interpretation to UPMIFA. This language confirms our understanding of the last two sentences in Paragraph 9: The board’s decision not to spend amounts above a certain rate converts all net appreciation above that rate into unrestricted assets. The FASB staff may want to perpetuate that fiction in nonprofit financial statements, but it does not reflect the law. In short, the staff’s position, as clearly revealed by Paragraph 8, is the imposition of historical value on nonprofit endowments. The staff is wrong.
VI. FOOTNOTE DISCLOSURE. Paragraph 12 of Draft FAS 117-a requires that the organization provide an extensive footnote disclosure regarding its endowment, including,
A description of the governing board’s interpretation of the law that underlies the organization’s net asset classification of donor-restricted endowment funds.
A description of the organization’s policy(ies) for the appropriation of endowment assets for expenditure (its endowment spending policy(ies)).
A description of the organization’s endowment investment policies.
The description must include the organization’s return objectives and risk parameters; how those objectives relate to the organization’s endowment spending policy(ies); and the strategies employed for achieving those objectives.The composition of the organization’s endowment by net asset class at the end of the period, in total and by type of endowment fund, showing donor restricted endowment funds separately from board-designated endowment funds. In addition, the organization must indicate the cumulative amount of investment return, if any, contained in the permanently restricted net asset class because of the organization’s interpretation of relevant law, beyond that required by explicit donor stipulations.
A reconciliation of the beginning and ending balance of the organization’s endowment, in total and by net asset class, including, at a minimum, the following line items (as applicable): investment return, separated into investment income (for example, interest, dividends, rents) and net appreciation or depreciation of investments; contributions; amounts appropriated for expenditure; reclassifications; and other changes. In addition, the organization must indicate how much, if any, of the additions of investment return to permanently restricted net assets are the result of the organization’s interpretation of relevant law, beyond that required by explicit donor stipulations.
We have absolutely no problem with disclosure. In fact, given the mess that the FASB staff has created with its proposal, we think some plain language disclosure will prove be helpful. Nevertheless, there is at least one significant problem with the required disclosure. That is found in the last sentence, which requires the organization to track investment returns. They are irrelevant because historical value is irrelevant. NOTE TO STAFF: Please, get that through your heads.
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