The AICPA Financial Reporting Executive Committee (“FINREC”) and the Not-for-Profit Entities Fair Value Task Force recently released a whitepaper addressing fair value measurement pertaining to certain transactions frequently encountered by not-for-profit organizations (“NFP”).  While the whitepaper expresses the non-authoritative views of the FINREC, it does provide valuable guidance and instructions, effective for years beginning after December 15, 2011, on fair value measurements pertaining to the following:

• Unconditional promises (“pledges”) to give cash or other financial assets
• Beneficial interests in trusts, and
• Split-interest agreements

Unconditional Promises to Give

While other alternatives exist, FINREC believes that the present value technique will be most commonly used to measure fair value of pledges expected to be collected in one year or more.  The present value approach takes into consideration each of the following factors:

• Estimate of the future cash flows from the pledge
• Expectations about possible variations in the amount and timing of the cash flows
• Discount rate represented by the rate on risk-free monetary assets that have maturity date or durations similar to the expected cash flows from the pledge.  The appropriate risk-free rate would be the yield curve for U.S. Treasury securities
• A risk premium for the uncertainty inherent in the cash flows (will they pay as promised?)

While the risk-free rate is fairly easy to determine, the greater challenge is taking into consideration the appropriate risk premium. The risk premium varies depending upon whether contracted cash flows are used versus the expected cash flows. Expected cash flows take into account a lower risk premium since the cash flows have already been adjusted to reflect lowered expectations due to the risk of a donor’s default, possible poor credit history, etc.  For an individual donor, FINREC believes that when contracted cash flows are used the risk-adjusted discount rate might be determined using unsecured commercial lending rates available from a published source.

These discount rate considerations should be applied to each individual pledge or a group of similar pledges; however, bear in mind that each donor represents a different level of risk.  If the donor is a corporation or foundation, then the yield on publicly traded debt of that corporation or foundation should be used.  If the donor has not issued publicly traded debt then debt of a similar corporation or foundation could be used.

The main difference from the current practice is the selection and use of an appropriate risk adjusted discount rate. The challenge to NFPs is identifying and documenting the appropriateness of the chosen discount rate.

Beneficial Interests in Trusts

A beneficial interest is recognized by an NFP if a donor transfers assets to an independent trustee and specifies that the NFP will receive distributions from the trust assets.  While the assets are not controlled by the NFP, its financial statements should reflect an asset (the beneficial interest) that represents its irrevocable right to the stream of future cash flows.  There are two types of trusts in which the fair value reporting applies:

• Perpetual trusts - such a trust and the right to the income continue in perpetuity, the fair value of the beneficial interest can, in most cases, be measured by the fair value of the trust itself.  Exception to this might arise if the trustee has been directed not to distribute, or distribute a reduced amount, of income for a period of years.  Also, adjustment to the valuation is required if distributions are shared among multiple beneficiaries. In this case, the proportionate share of the trust assets are used to measure the beneficial interest.  Because the NFP will never have the ability to receive the assets in the trust, the fair value of the investment should be categorized as a Level 3 fair value measurement.
• Non-perpetual trusts - the distributions from such trusts have a prescribed life, the beneficial interest is measured at the present value of the future distributions projected to be received over the term of the agreement.  The discount rate considerations are similar to those discussed with respect to pledges.  However, cash flows from the trust are as risky as the assumed rate of return on its investments, the risk - discount rate should always equal or exceed the assumed rate of return on the trust assets.  If the inputs utilized in determining the fair value of a non-perpetual trust are observable, such interest could be categorized as a Level 2 fair value measurement.

Subsequent period adjustments to the value of the beneficial interest should follow the same computational approach as described above, but should be updated to reflect current market conditions, including appropriate changes to the discounted rated used.

Split-Interest Agreements

Split-interest agreements come in a variety of forms but in each instance the NFP is not the sole beneficiary under the agreement.  In some situations the NFP may be the current income beneficiary of the trust, and in others the NFP may be entitled to only the remainder interest in the trust.  Also, the NFP or the donor could be entitled to either a fixed stream of payments or one that is a fixed percentage of the assets contributed under the agreement.  Common names for such arrangements include charitable remainder trusts, charitable gift annuities, pooled income funds, lead interest trusts, etc.  Regardless of the type of agreement, accounting standards generally require the recognition of an asset, liability and charitable contribution, each initially measured at fair value.  The present value approach takes into consideration the amount and duration of the payment stream, the life expectancy of the donor and an appropriate discount rate.  Another approach to the fair value determination, depending on the type of arrangement, utilizes the value of a similar payment stream available from an insurance company under an annuity contract.

In practice, the fair value of the contribution and the liability to the donor is often derived from commercially available software whose purpose is to determine the amount of the donor’s tax deduction.  While this software may follow IRS guidelines, it does not necessarily yield a fair value under accounting standards.  For example, the IRS computation utilizes certain specified interest (discount) rates and mortality tables.  Such amounts may not be reflective of current rates or life expectancies.  If a transaction is large enough, consideration should be given to whether such differences might be significant to the financial statements.  Similar to the non-perpetual trust, if the inputs utilized in determining the fair value of a split-interest agreement are observable, such interest could be categorized as a Level 2 fair value measurement.

Next Steps

The whitepaper does not change the existing accounting for the types of transactions described above. However, it does highlight a number of factors to be considered in determining the fair value of the above instruments/agreements, particularly with respect to risk-adjusted discount rates.  Those seeking additional details are encouraged to review the whitepaper. Further guidance on accounting for the variety of split-interest agreements is also available in the AICPA’s Audit and Accounting Guide for Not-for-Profit Entities. If you have any questions related to the guidance on fair value measurements or the contents of this article, contact your local CBIZ MHM office.