Nonprofit Accounting Basics

Investments: Fair Value Disclosures

A common item on the financial statements of not-for-profit organizations (NPOs) is investments. These investments can often be the largest single line item on the financial statements. Additionally, they can range from plain vanilla CD’s to complex alternative investments. The two primary issues related to investments are valuation and disclosure.

Valuation

Under FASB 124, NPOs are required to report all investments at fair value. For most investments held by NPOs, this fair value is easily determined and is reported to the NPO by the investment custodian or manager. For example, the fair value of equity securities is based on publically traded market prices and the fair value of bonds can be calculated based on the interest rate, term, and riskiness of the bond issuer. The fair values of CDs and money market accounts are typically reported as equal to the cost basis given the relatively minor spread between the purchase price and ultimate proceeds from sale.

However, determining the fair value of the alternative investments can be much more complicated and subjective. Alternative investments include hedge funds, common collective trusts, and any other proprietary investment product offered by investment managers. These investments frequently are illiquid and therefore no public quoted market price exists to determine the fair value of the investment. The value of these investments is frequently determined by the investment manager based upon the value of the underlying assets.

As a result, any entity that invests in alternative investments must ensure it fully understands the methodology used by the fund manager to determine the fair value. In addition, the entity must implement procedures that allow it to determine the reasonableness of the value determined by the fund manager. This can be done either through the use of internal personnel or by engaging an investment consultant.

From an audit perspective, it is often difficult to obtain sufficient audit evidence to determine the reasonableness of the valuation. This makes it especially important that the auditor obtain an in-depth understanding of the procedures in place at the entity to assess the reasonableness of the fair value.

Disclosures

In recent years, the disclosures required on investments have increased significantly. The most significant additional disclosure was initially required under FAS157 and requires significant disclosures regarding the reliability of the reported fair value. These standards require entities include information on the inputs used to determine fair value of any assets or liabilities are reported at fair value. The information on the inputs used is to be segregated between levels 1, 2, and 3 based on the reliability and objectiveness of the input used.

Level 1 investments are those where the fair value is determined based upon a publically quoted market price - such as common stock of a company whose stock is traded on the NYSE or NASDAQ.

Level 2 investments are those where the fair value is determined using “other observable inputs.” The investments that fall into this category are often fixed income securities and the inputs include the interest rate, bond term, and credit rating of the issuer.

Level 3 investments include any investment that does not fall in levels 1 or 2. This category includes hedge funds, limited partnerships, and other alternative investments.

For level 2 and 3 investments, entities are also required to include a table showing a reconciliation of the balance in level, further broken down by investment type, from the beginning of the year to the end of the year. This reconciliation must include purchases, sales, gains/losses, and any transfers to/from the level.

Entities are also required to disclose the investment objective and restrictions on withdrawals for level 3 investments that calculate fair value based on a net asset value or equivalent – such as hedge funds and common collective trusts.

An example of the required fair value disclosure is:

The following is a summary of the inputs used as of May 31, 2011, in valuing investments carried at fair value:

 

A reconciliation of the beginning and ending balances for the year ended May 31, 2011, of the net assets whose fair value has been determined using significant unobservable inputs (Level 3) is as follows:

 

Net losses (realized and unrealized) reported above are included in net appreciation in fair value of investments on the statement of activities for the year ended May 31, 2011. The amount of the net losses related to investments held at May 31, 2011, was approximately $11,573,000.

Investments in common collective funds consist primarily of SSgA MSCI EAFE Index NL QP Common Trust Fund and the SSgA Russell 3000 ® Index NL Common Trust Fund. The fair values of these investments have been estimated using the net asset value per share of the investments. The investment objective of SSgA MSCI EAFE Index NL QP Common Trust Fund is to approximate as closely as practicable, before expenses, the performance of the MSCI EAFE Index over the long term. Redemption for this fund is available on a monthly basis without required notice. The SSgA Russell 3000® Index NL Common Trust Fund’s investment objective is to approximate as closely as practicable, before expenses, the performance of the Russell 3000® Index over the long term. Redemption is available on a daily basis without required notice.

The investment objective of the investment in a hedge fund is to seek above-average rates of return and long-term capital growth through an investment in Entrust Capital Diversified Fund Ltd. (the master fund), a fund of funds with a diversified portfolio of private investment entities and/or separately managed accounts managed by investment managers selected by the fund’s advisor. Redemption for this fund is available as of the close of the business on the last business day of any calendar quarter or any other date determined by the board of the fund in its sole discretion after the expiration of an initial 12-month lock-up period, provided, however, the board of the fund shall permit a shareholder to withdraw capital on a redemption date during the lock-up period subject to a withdrawal charge equal to 3% of the amount sought to be withdrawn.

Redemption notice of 90 days is required. If the shares being redeemed represent more than half of the shares held by the shareholder, one half of the shares to be redeemed by the shareholders shall be redeemed on the first redemption date following the expiration of the 90-day notice. The remaining shares for which the shareholder has made a redemption request shall be redeemed on the next quarterly redemption date.