SFAS 124: accounting for investments by not-for-profit entities.

A primary goal of the FASB’s continuing project on

not-for-profit (NFP) accounting is to reduce the inconsistencies in

accounting methods used in the various NFP sectors. To that end,

Statement of Financial Accounting Standards (SFAS) 116, Accounting for

Contributions Received and Contributions Made, standardized NFP

accounting procedures for contributions and SFAS 117, Financial

Statements of Not-for-Profit Organizations, established a minimum level

of financial reporting and disclosures for all NFPs. The latest chapter

of the FASB’s NFP project is SFAS 124, Accounting for Certain

Investments Held by Not-for-Profit Organizations. This standard provides

accounting and reporting requirements for all NFPs with certain types of

investments. Prior to SFAS 124, accounting guidance for investments of

NFPs was contained in four separate AICPA audit guides which resulted in

diverse practices among the different NFP sectors.

In general, SFAS 124 applies to investments in equity securities

(i.e., stock) with readily determinable market values and all

investments in debt securities. The standard became effective for fiscal

years beginning after December 15, 1995, with earlier application

encouraged. This article addresses the main points of SFAS 124,

including the special problems surrounding accounting for endowment

funds.

Accounting for Investment Gains, Losses and Income

SFAS 124 bears a striking resemblance to SFAS 115, Accounting for

Certain Investments in Debt and Equity Securities, which establishes

reporting requirements for business enterprises’. Investments. That

similarity is the use of fair value accounting. A primary difference

between the two investment standards is that there is no requirement

under SFAS 124 for investments to be categorized as either

held-to-maturity, available-for-sale or trading. Under SFAS 115,

investments must be classified in these groups, with different reporting

requirements for each group. SFAS 124 simplifies investment accounting

for NFPs by requiring all investment securities under its scope to be

accounted for at fair value.

As previously mentioned, SFAS 124 applies to an NFP’s

investments in equity securities that have readily determinable fair

values and to all investments in debt securities. Equity securities are

considered to have readily determinable fair values if any one of the

following conditions exist:

* For a security traded in the domestic market, a sales price or

bid-and-asked quotation is available on a securities exchange registered

with the SEC or in the over-the-counter market.

* For a security traded only in a foreign market, that foreign

market is of a breadth and scope comparable to one of the U.S. markets

referred to above.

* For an investment in a mutual fund, the fair value per share is

determined and published and is the basis for current transactions.

The quoted market price for equity securities meeting one of the

above criteria will be the measure of fair value used for accounting and

reporting purposes.

SFAS 124 also notes that quoted market prices represent the best

measure of fair value for debt securities. However, some debt securities

don't trade regularly and therefore, quoted market prices aren't

available. In these instances, other means of measuring fair value must

be used. These measures will be more subjective and should consider the

market price of similar securities and the results of valuation

techniques, such as the present value of expected cash flows discounted

at a rate commensurate with the risk involved. Regardless of the

particular method employed to determine fair value, the investments are

reported on the NFP’s statement of financial position at this

amount.

SFAS 124 requires all gains and losses, both realized and unrealised,

related to an NFP’s investments be reported in the current

period’s statement of activities. These gains and losses are

measured as the changes in the fair values of the investments. For

example, on January 1, 1995, Acme College has an investment portfolio

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with a fair value of $1,200,000. On December 31, 1995, the makeup of the

investment portfolio is unchanged. It's a fair value of

$1,300,000. For 1995, Acme College has a gain, albeit unrealised, of

$100,000 from their investments. The gain would be recognized in full in

the statement of activities.

In the absence of any donor-imposed or legal restrictions on how an

investment may be used, this gain would be reported as an increase in

unrestricted net assets. A loss, realized or unrealised, would decrease

unrestricted net assets. If restrictions do exist on the use of an

investment, the gain or loss is shown as an increase or decrease in

either temporarily or permanently restricted net assets, depending on

the type of restriction existing. Investment income (i.e., interest and

dividends) earned during the year is reported as an increase in

unrestricted net assets, unless the income’s use is restricted. In

that case, temporarily or permanently restricted net assets are

increased depending upon the restriction. The steps used in reporting

investments and their gains and losses are summarised in Table 1.

One issue concerning donor-imposed restrictions on the use of

investment income and gains is how to report these items when the

restriction is satisfied in the same period the income or gain is

earned. In this situation, the investment income and gains may be

reported as increases in unrestricted net assets as long as the

organization has a similar policy for reporting contributions received,

reports consistently from period to period and discloses its accounting

policy.

For example, assume an individual donates $1,000,000 to a private

college to establish an endowment to be used to bring nationally known

speakers to the college’s speakers forum. The $1,000,000 principal

is permanently restricted by the donor and the investment income can

only be used to pay speaker fees and related travel costs. During the

first year of the program, the endowment earned $95,000 of investment

income and the university spent $80,000 on speakers for the forum.

Therefore, during the year, the restrictions on $80,000 of the $95,000

of investment income were met and $80,000 would be shown as an increase

in unrestricted net assets in the statement of activities. The remaining

$15,000 would be reported as an increase in temporarily restricted net

assets. Of course, the $80,000 paid to the speakers would also be

recognized as a program expense (i.e., reduction of unrestricted net

assets).

This is a fairly straightforward example of a donor-restricted

endowment. However, these types of funds often create the greatest

complexities associated with applying SFAS 124. The next section

addresses the problems associated with endowment funds.

Accounting for Endowment Funds

A donor-restricted endowment fund results from a contribution

carrying a stipulation that the gift be invested in perpetuity or for a

specified time period. This donor stipulation sometimes relates not only

to the principal amount but also to a net appreciation value.

Reporting investment income and gains on endowment funds depends on

the existence of any donor restrictions concerning the use of the income

or investment appreciation. If no restrictions exist, investment income

and gains are shown as increases in unrestricted net assets. If part of

the net appreciation value is permanently restricted, any investment

income or gains would be reported as increases in permanently restricted

net assets until the required net appreciation value is reached. Once

this value is reached, any further investment income and gains are

increases in unrestricted net assets unless donor restrictions on their

use exist, in which case either temporarily or permanently restricted

net assets are increased, depending on the nature of the restrictions.

Classifying losses on endowment funds is slightly more complicated

than classifying gains, since most donor agreements are silent regarding

loss disposition. SFAS 124 requires, unless donor stipulations exist to

the contrary, that losses not affect permanently restricted net assets,

even if fair value falls below the principal amount. Instead, these

losses reduce temporarily restricted net assets to the extent that

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donor-imposed restrictions on net appreciation haven't been reached

before the loss occurs. Any remaining losses reduce unrestricted net

assets. Gains occuring in subsequent years that restore the endowment

fund to the permanently restricted amount are reported as increases in

unrestricted net assets. Table 2 summarizes the reporting requirements

for gains and losses on endowment funds.

As an example of accounting for a donor-restricted endowment fund,

assume on January 1, 1992, an individual donates $1,000,000 to a private

college. The donor stipulates that the principal plus the first $100,000

of net appreciation are to be permanently maintained. All remaining

income and gains earned by the fund are unrestricted. Further assume

that the fair values of the endowment fund are as follows:

December 31, 1992 $1,070,000

December 31, 1993 1,150,000

December 31, 1994 980,000

December 31, 1995 1,040,000

For the year ending December 31, 1992, the endowment fund has a total

gain of $70,000 ($1,070,000 fair value at the end of the year minus

$1,000,000 fair value at the beginning of the year). Since the fund has

not attained the required net appreciation value ($1,100,000) at this

point, the $70,000 gain is shown as an increase in permanently

restricted net assets.

The fund has an $80,000 gain in 1993 and met and surpassed the

required net appreciation value during the year. As a result, the first

$30,000 of the gain (the amount needed to reach the required net

appreciation value of $1,100,000) is shown as an increase in permanently

restricted net assets. The remaining $50,000 gain results in an increase

in unrestricted net assets.

The endowment suffers a loss of $170,000 in 1994. Since there are no

donor stipulations on loss disposition and the required level of net

appreciation value had been reached prior to the loss, the full $170,000

loss is shown as a reduction in unrestricted net assets.

Finally, the fund recovers somewhat in 1995 and shows a gain of

$60,000. The full amount of this gain is reported as an increase in

unrestricted net assets.

Required Disclosures

SFAS 124’s disclosure requirements are extensive and are

designed to allow the financial statement reader to understand the

investments owned, the changes in these investments and the risks

associated with the investments of the NFP. The standard requires the

following disclosures for each period for which a statement of

activities is presented:

* the composition of investment return, including investment

income, realized gains and losses on investments reported at other than

fair value. Net gains and losses on investments reported at fair

value. And

* a reconciliation of investment return to amounts reported in the

statement of activities if the investment return is separated into

operating and nonoperating amounts, together with a description of the

policy used to determine the amount that's included in the measure of

operations and a discussion of circumstances leading to a change, if

any, in that policy.

Additionally, the following must be disclosed for each period a

statement of financial position is presented:

* the aggregate carrying amount of investments by major types

(e.g., equity securities, mutual funds, corporate debt securities,

etc.);

* the basis for determining the carrying amount for investments not

covered by this standard;

* the method(s) and significant assumptions used to estimate the

fair values of investments other than financial instruments, if those

other investments are reported at fair value. And

* the aggregate amount of deficiencies for all donor-restricted

endowment funds for which the fair value of the investment at the

reporting date is less than the level required by donor stipulation or

law.

Finally. The most recent period for which a statement of

financial position is presented, the NFP shall disclose the nature of

each individual investment or group of investments that represents a

significant concentration of market risk.

Conclusion

SFAS 124 is the latest standard resulting from the FASB’s

ongoing NFP project. This standard eliminates inconsistencies in how

various NFP sectors account for investments and also enhances the

comparability of NFP financial statements with those of business

enterprises. For all investments under its scope, SFAS 124 requires fair

value measurement in the statement of financial position with the

effects of changes in fair value reported in the statement of

activities.

This standard is effective for fiscal years beginning after December

15, 1996, with earlier application encouraged. The adoption of SFAS 124

can be made either on a prospective basis with the related cumulative

effect reported in the current year’s financial statements or on a

retroactive basis with prior years’. Financial statements restated.

Table 1: Accounting for Investments

1. Determine which investments fall under SFAS 124’s scope.

A. investments in equity securities, not accounted for under the

equity method or in consolidation, with readily determinable fair

values.

B. all investments in debt securities

2. These investments are measured and reported at fair value in the

statement of financial position.

A. quoted market prices, if available, are best measures of fair

value

B. for debt security for which there is no quoted market price, use

selling price of similar securities or valuation techniques such as

discounted cash flows to determine fair value.

3. Report gains and losses, both realized and unrealised, related to

the change in the investment’s fair value on the statement of

activities.

A. if no donor restriction exists, the gain (loss) is an increase

(decrease) in unrestricted net assets

B. if donor restriction exists, the gain (loss) is an increase

(decrease) in either temporarily or permanently restricted net assets,

depending on the nature of the restriction.

Table 2: Accounting for Gains and Losses on Endowment Funds

1. Endowment funds are contributions required to be maintained in

perpetuity or for a specified period of time.

2. Reporting gains on endowment fund investments:

A. In general, until any net appreciation requirement is met, gains

are shown as increases in permanently restricted net assets.

B. Once the net appreciation requirement is met, gains are shown as

increases in unrestricted net assets unless donor restrictions exist. In

that case, either temporarily or permanently restricted net assets are

increased, depending upon the restrictions.

3. Reporting losses on endowment fund investments:

A. Assuming the net appreciation requirement has been met, losses are

shown as decreases in unrestricted net assets.

B. If the net appreciation requirement hasn't been met, losses are

shown as decreases in temporarily restricted net assets. Any remaining

losses are shown as decreases in unrestricted net assets.

C. All subsequent recoveries of previous losses result in increases

of unrestricted net assets.

Stanley J. Clark, PhD, CPA, is an assistant professor of accounting

at the University of Southern Mississippi. Charles E. Jordan, DBA, CPA,

is an associate professor of accounting at the University of Southern

Mississippi.