Two Decades after SFAS 117 and Five Years after Arizona’s UPMIFA – Endowment Restrictions Remain Problematic
I’m old enough that I was practicing in 1994 when the Financial Accounting Standards Board rocked the nonprofit accounting world by issuing Statements of Financial Accounting Standards 117, Financial Statements of Not-for-Profit Organizations. This seminal pronouncement moved us away from then predominant fund accounting concepts to a focus on net asset classifications. These net asset classifications are driven by donor-imposed restrictions and result in the aggregation of the net assets (the “equity” or net resources of the entity) into one of three categories: unrestricted, temporarily restricted, or permanently restricted. The important and sometimes overlooked point – only the donor imposes this restriction. Yes, assets may be subject to other types of restrictions such as banking agreements, investment liquidity and so on, but in terms of net asset classification, the intent of the donor (1) rules.
Our world was rocked again when, in 2006, the Uniform Law Commission, formally known as the National Conference of Commissioners on Uniform State Laws, approved the Uniform Prudent Management of Institutional Funds Act (UPMIFA). This model act was designed as a replacement for the decades old Uniform Management of Charitable Funds Act (UMIFA). Arizona adopted its version of UPMIFA in 2008 with passage of the Management of Charitable Funds Act (MCFA)(2), now found in the Arizona Revised Statues at 10-11801 through 10-11805. UPMIFA caused quite a stir in the nonprofit accounting world, and FASB reacted by issuing Staff Position 117-1, to provide additional guidance.
Law is meant to govern behavior; generally accepted accounting principles govern the recording of accounting transactions and presentation of financial statements. However, the model act led to concerns that many organizations would need to rethink how they were recording restrictions related to endowment gifts and then adjust their accounting practices to be in conformity with the law. While GAAP is currently—and I’ll add thankfully—not legislated, this idea that the law governs accounting still persists in practice.
A definition of endowment from the free law dictionary online:
A transfer, generally as a gift, of money or property to an institution for a particular purpose. The bestowal of money as a permanent fund, the income of which is to be used for the benefit of a charity, college, or other institution.
A brief, but decent, (undated) article (3) from a California law firm leads off with the question “What is an endowment?”
To paraphrase the article:
- To a donor, an endowment is a sum of money given to a charity for a charitable purpose, with only the “income” being spent and the principal being preserved.
- To the accountant, endowment equates to “permanently restricted”.
- To a lawyer, it is a fund not wholly expendable on a current basis under the terms of the gift instrument.
The article adds:
- A “true” endowment is one established or created by the donor. A board can create a “quasi- endowment” when it takes unrestricted funds and imposes a spending restriction.
As alluded to in the authors’ conclusion, accountants do understand the nature of restrictions and most understand that the net asset classification and the word endowment are not automatically aligned. In fact, endowments can be of any net asset classification. From the FASB master glossary:
Endowment Fund –
An established fund of cash, securities, or other assets to provide income for the maintenance of a not-for-profit entity (NFP). The use of the assets of the fund may be permanently restricted, temporarily restricted, or unrestricted (emphasis added). Endowment funds generally are established by donor-restricted gifts and bequests to provide either of the following:
- A permanent endowment, which is to provide a permanent source of income.
- A term endowment, which is to provide income for a specified period.
The glossary includes definitions for the board designated endowment and terms the quasi-endowment as a fund functioning as endowment.
While I’m not a lawyer, in legal terms we discuss maintenance of the “principal” of the fund as the historic dollar value at the time of gift; analogous to corpus in a trust setting. Some states imposed a stricter concept of preservation of purchasing power (think adjusting for inflation) in their version of the act, but Arizona chose not to do so. Instead, Arizona relies on the factors set out in the model act. From the Arizona Revised Statutes:
Except as otherwise provided by a gift instrument, the following apply:
- In managing and investing an institutional fund, the following factors, if relevant, shall be considered:
- General economic
- The possible effect of inflation or deflation
- The expected tax consequences, if any, of investment decisions or strategies.
- The role that each investment or course of action plays in the overall investment portfolio of the fund.
- The expected total return from income and the appreciation of investments.
- Other resources of the institution.
- The needs of the institution and the fund to make distributions and to preserve
- An asset’s special relationship or special value, if any, to the charitable purposes of the institution.
- Management and investment decisions about an individual asset shall not be made in isolation but shall be made in the context of the institutional fund’s portfolio of investments as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the fund and to the institution.
- Except as otherwise provided by law other than this chapter, an institution may invest in any kind of property or type of investment consistent with this section.
- An institution shall diversify the investments of an institutional fund unless the institution reasonably determines that, because of special circumstances, the purposes of the fund are better served without diversification.
- Within a reasonable time after receiving property, an institution shall make and carry out decisions concerning the retention or disposition of the property or to rebalance a portfolio in order to bring the institutional fund into compliance with the purposes, terms and distribution requirements of the institution as necessary to meet other circumstances of the institution and the requirements of this chapter.
- A person that has special skills or expertise, or that is selected in reliance on the person’s representation that the person has special skills or expertise, has a duty to use those skills or that expertise in managing and investing institutional funds.
Under most states previous law (UMIFA), organizations with underwater endowment funds were hamstrung. The law generally provided that a charity may only spend from current income—back then often considered dividends and interest, and not appreciation—and it was clear that organizations could not spend below the fund’s “historic dollar value”. The historic dollar value limitation proved administratively and economically burdensome for organizations, in particular in those cases where an endowment was created shortly before a market downturn. Still some interpreted the ability to spend “income” as permissible, even when the endowment was “under water.”
Under the model UPMIFA, historic dollar value was removed and replaced with a concept of prudence. Hence, a charity can spend the amount it deems prudent after considering the donor’s intent, the purpose of the fund, and the economic factors listed in the Act. So, if donor agreement was written to restrict spending to “income”, then exceeding that amount, however defined, would not be prudent. The concepts embodied in UPMIFA allow charities more flexibility in managing endowments. The idea is to promote prudent management and maintenance of donor provided endowment funds over a long-term horizon, involving a sensible system of governance and oversight, mixed with reasoned investment strategy and charitable spending goals.
Many states look to the Act to help deal with ambiguity, especially when an agreement was silent as to the spending policy. The model Act included optional language on spending limits; stating that an annual appropriation of seven percent or more may be deemed imprudent. Arizona chose not to include the seven percent guidance in its version of the law.
Even with all the above, the prevailing view is that a “true” endowment is permanent in nature and the principal at the time of gift should be preserved. The accounting response then, is to classify the original value of the gift as permanent, unless the donor gift instrument says otherwise.
When a fund is “under water”, the amount below the original gift is a deficit (or debit) in unrestricted net assets. When a fund is “above water”, the amount above the original value is considered temporarily restricted. The temporary restriction is removed when the funds are appropriated for the endowment’s purpose. The method of appropriation need not be overly formal, but organizations that previously swept endowment earnings to unrestricted net asset accounts without full consideration of the spending policy, needed to consider reclassifying those amounts when UPMIFA was enacted and FSP 117-1 was first implemented.
The following is a simple example of the tabular disclosure for endowments.
Net Asset Composition of Endowment Funds
| Temporarily | Permanently | |||
| Unrestricted | Restricted | Restricted | Total | |
| Endowment for education | $ (23,500) | $ – | $ 195,000 | $ 171,500 |
| Endowment for general support | 36,500 | 200,000 | 236,500 | |
| Board designated endowment | 75,000 | 75,000 | ||
| $ 51,500 | $ 36,500 | $ 395,000 | $ 483,000 | |
In the example above, the education fund is under water by $23,500. This condition is considered temporary, and a recovery in the following year would be used to offset the deficit amount. In the case of the endowment for general support, the fund is above the value of the original gift and the above water portion is held as temporarily restricted (4) until appropriated. However, the codification makes it clear in 958-205-45-18 that the classification of gains and losses is governed by the gift instrument. I believe the presumption for most funds is that a purpose restriction will be attached to the income from the fund as well as the gains, although for a general support fund, perhaps to a lesser extent. The example presumes appreciated assets for this fund.
Two decades after SFAS 117, we still see diversity in practice on net asset classification, in part driven by misunderstandings of the standard itself, in part driven by the ambiguity of grant instruments or mere facts and circumstances. We want our financial statements to be meaningful, and if an asset (or net resource) is unavailable based on a ‘real’ underlying restriction, donor imposed or not, we feel compelled to reflect the transaction in such a manner.
While FSP 117-1 and UPMIFA may have helped us think more clearly and more uniformly about endowments, it didn’t solve all our problems in this area. ‘Endowment’ to many still evokes ‘permanent’ and boards of organizations still struggle with having the necessary tools and policies to properly understand and discharge their duties over gifted funds.
Footnotes:
1 To me, the term ‘donor’ automatically connotes a contribution event, or a non-reciprocal transfer of resources, and not an exchange transaction. Thus, an exchange transaction would not ordinarily lead to a net asset restriction. However, when it comes to government grants, the distinction between contribution and exchange events can get a little murky. Perhaps in the future we will see the term ‘resource provider imposed restriction’.
2 See article at: http://www.fclaw.com/newsletter/materials/Nonprofit_Update_3-20-09.pdf
3 Link to the article here:
4 SFAS 124 paragraph 11, indicates that gains and losses on permanent funds are unrestricted events. Since SFAS 124 was issued in 1995 and FSP117-1 in 2008, it seems thinking changed on this over time.