Dear Clients and Friends:

We are writing to inform you of several recent changes made by the Financial Accounting Standards Board (FASB) to generally accepted accounting standards expected to impact upcoming financial reporting: FASB Statement No. 157, Fair Value Measurements and FASB Statement No. 159, The Fair Value Option. Both statements will be in full effect for fiscal years beginning after November 15, 2007, with early adoption permitted (The effective date for certain nonrecurring nonfinancial assets/liabilities, like in-kind contributions, may be optionally deferred until fiscal years beginning after November 15, 2008). Measurement requirements will generally be applied prospectively in financial statements, except in limited circumstances that predominantly apply to industries like banking or insurance. 

In addition, FASB Staff Position 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 will be effective retroactively to the earliest year presented for fiscal years ending after December 15, 2008. Early application is permitted, assuming no annual financial statements for that fiscal year have been previously issued.

Please contact us should there be any concerns about identifying, evaluating and implementing these new accounting and reporting standards in preparation for the upcoming financial statement audit.   

Regards –

The Partners at Gelman, Rosenberg & Freedman, CPAs

A. Enhancement to Existing Fair Value Measurements

SFAS 157 does not introduce any new fair value measurement requirements for assets or liabilities that are not currently carried at fair value. Rather, it simply codifies the meaning of “fair value” used under other U.S. generally accepted accounting principles applying to a broad range of assets and liabilities, such as:

• Recurring financial assets/liabilities – those settled in cash or other financial instruments and measured at fair value annually (like trading securities, and an entity’s beneficial interest in a split-interest charitable remainder trust or perpetual trust)
• Nonrecurring financial assets/liabilities – those settled in cash or other financial instruments and measured at fair value only upon initial recognition (like pledges receivable, the obligation to lead beneficiaries in an irrevocable charitable remainder annuity trust where the reporting entity is also the trustee, and asset retirement obligations)
• Recurring nonfinancial assets/liabilities – those not settled in cash or other financial instruments and measured at fair value annually (like contributed real estate reported as “other investments”)
• Nonrecurring nonfinancial assets/liabilities – those not settled in cash or other financial instruments and measured at fair value only upon initial recognition (like in-kind contributions)

SFAS 157 is aimed at increasing the consistency, comparability, and transparency of fair value measurements used in financial reporting by:

• Establishing a single authoritative definition of “fair value”, which is the price using current market participant assumptions about future inflows/outflows in the “principal market” where the reporting entity would normally sell/dispose of an asset or transfer a liability. The marketplace is assumed to be the most advantageous market for the reporting entity, where asset prices would be maximized and liabilities would be minimized.   
• Establishing a framework for measuring fair value:
  • Level 1 – Quoted prices for identical assets or liabilities in an active market, like equity securities or bonds.
  • Level 2 – Quoted prices for similar assets or liabilities, like gifts of tangible physical assets (such as real estate) or accounts receivable. 
  • Level 3 – Due to limited market activity, market participation assumptions are based on the best internal and external information available under the circumstances, like long-term promises to give, split-interest agreements, long-term grants payable, and certain assets held for sale. 
  • Expanding fair value disclosure requirements to provide more useful information in making investment, credit or similar decisions. Disclosures focus heavily on the inputs and assumptions used to measure fair value under the new leveled framework. 

Preparing for the upcoming financial statement audit:
The following information should be documented and ready for audit in order to support fair value and appropriate disclosure requirements in accordance with SFAS 157:

• Analyze the types of investments within the investment portfolio and other assets/liabilities currently carried at fair value, and determine whether a current or comparable observable market exists (or whether hypothetical market assumptions will need to be determined).
• Document understanding of how applicable assets/liabilities are currently valued (including methodologies used by financial institutions or 3rd party pricing agents). The most common techniques of valuing assets or liabilities include the market approach, income approach (discounted cash flow method), or cost approach (replacement cost method).  
• Obtain SAS 70 reports, as necessary, and verify that valuation is included within the scope of those service auditor reports.

B. New Fair Value Options for Financial Assets and Liabilities

SFAS 159 permits, but does not require, entities to carry most financial assets and liabilities at fair value (Financial assets are only those that settle in cash or other financial instruments. It is anticipated that future revisions to U.S. GAAP will permit the fair value option for nonfinancial assets and liabilities, like fixed assets and goodwill). Reporting entities now have the irrevocable option on a case-by-case basis to measure financial assets and liabilities at recurring market, including those previously carried at different versions of cost or market. This may include certain legally binding purchase obligations (whose quantity, price and delivery date are fixed), and warranty rights and obligations.

In essence, most financial assets and liabilities can now be carried at recurring fair value – where they are initially recorded at the amount paid to acquire the asset or the amount received to assume the liability (e.g., the “entrance price”). Future value is then based on the current fair value (e.g., the “exit price”), with changes in fair value recognized in current-period earnings (including changes in fair value of available-for-sale and held-to-maturity securities). 

The fair value option mitigates the potential for mismatches that may occur in financial reporting when related items are measured differently. For example, an entity could avoid hedge accounting by electing to report both underlying debt and an interest rate swap at fair value. In addition, nonrecurring financial assets/liabilities can be converted to recurring financial assets/liabilities (e.g., pledges receivable or split interest obligations where the reporting entity is the trustee). This may result in simplified record keeping and a more faithful representation of actual balance sheet value. 

However, employing the fair value option may require reassessment of internal controls over reliable financial reporting, internal budgeting methods/assumptions, debt covenants and compensation arrangements. In addition, since this optional standard reduces comparability between entities, SFAS 159 requires extensive disclosures regarding the volatility risk caused by the use of fair value for some items and not for others. Therefore, the time and resources necessary for compiling financial statement disclosures may be increased. The fair value option for FAS 159 for existing financial assets and liabilities is only available at the time of the FAS effective date. Thereafter, it is only available for new financial assets and liabilities.

Preparing for the upcoming financial statement audit:
Identify any financial assets or liabilities where the SFAS 159 irrevocable fair value option may be desirable. Consultation with external accountants may be necessary to fully evaluate the cost-benefit of taking advantage of this election.

C. Net Asset Classification & Disclosures for Endowment Funds

The Uniform Prudent Management of Institutional Funds Act of 2006 (UPMIFA) intends to improve the quality and consistency of endowment financial reporting by serving as a “model” for modernizing state laws governing donor-restricted endowment funds (not board-designated funds). Approximately 2/3 of states and the District of Columbia have adopted or introduced UPMIFA into legislation. 

UPMIFA assumes that an entity will act “prudently” to preserve principal for the funds it manages, but does not require a specific amount to be set aside as principal. It does provide more explicit guidance on what constitutes “prudent” endowment spending, including express cost management obligations (e.g., suggested < 7% of the endowment annually), whole portfolio standards of performance (e.g., suggested 7% total return goal), express diversification requirements, portfolio balancing requirements, and special skills standards of performance (when endowment or investment management is delegated). 

The related FASB Staff Position (FSP) provides guidance on classifying the net assets (equity) associated with donor-restricted endowment funds. It also requires additional disclosures about endowments (both donor-restricted funds and board-designated funds) for all organizations, including those that are not yet subject to an enacted version of UPMIFA. 

Endowment earnings are now considered temporarily restricted until appropriated. UPMIFA holds that “unless stated otherwise in the gift instrument, the assets in an endowment fund are donor-restricted until appropriated for expenditure by the institution”. In addition, the FSP clarifies that a “time restriction” on endowment earnings exists until appropriated for spending. Therefore, earnings on endowment are expected to increase temporarily restricted net assets. Donor restricted gifts not for endowment will continue to be reported as unrestricted revenue in most situations. 

Preparing for the upcoming financial statement audit:
The following should be documented and ready for audit for implementation of FSP 117-1:

• Identify all donor-restricted endowment funds.
• Specify what was spent or “deemed spent” of endowment earnings.
• Analyze any bond covenants or other similar agreements.
• Calculate the amount for reclassification from unrestricted to temporarily restricted net assets (presented in a separate line item within the organization’s statement of activities for the period).
• Draft required disclosures for all endowment funds:

• Description of the Board’s interpretation of the law governing donor-restricted endowment funds
• The organization’s permanent endowment spending policy
• The organization’s endowment investment policies
• Detailed endowment information for all endowments (e.g., composition by net asset class and reconciliation of changes in endowment net assets for the reporting period)