Appendix A—Excerpt From AICPA Financial Reporting White Paper Measurement of Fair Value for Certain Transactions of Not-for-Profit Entities.²

A-1 Not-for-profit entities face various challenges in applying the provisions of Financial Accounting Standards Board Accounting Standards Codification 820, Fair Value Measurement, in part because markets do not exist for certain assets and liabilities. To assist practitioners, on October 14, 2011, the AICPA issued the white paper Measurement of Fair Value for Certain Transactions of Not-for-Profit Entities. The following excerpt provides assistance for measuring unconditional promises to give cash or other financial assets due in one year or more.

• Unconditional Promises to Give Cash
• 1. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 958-605,³ in discussing measurement principles for contributions, generally requires not-for-profit entities (NFPs) to measure at fair value recognized contributions of cash or other assets (for example, marketable securities, land, buildings, use of facilities or utilities, materials and supplies, other goods or services) and unconditional promises to give those items in the future.
• 2. The discussion of fair value measurements in FASB ASC 820-10-35 includes an exit price approach (that is, the price that would be received for a promise to give [asset] in an exchange involving hypothetical market participants, determined under current market conditions). Because no market exists for unconditional promises to give, assumptions about what a hypothetical acquirer would pay for these assets (the right to receive from the donor the cash flow inherent in the promise) are necessary in determining fair value. FASB ASC 820-10-35 and its interpretive guidance in FASB ASC 820-10-55 emphasize that because fair value is a market-based (not an entity-specific) measurement, the exit price is determined without regard to whether an entity intends to sell or hold an asset or a liability that is measured at fair value.
• 3. Paragraphs 4–32 address the application of FASB ASC 820-10-35 in determining the fair value of a promise to give cash at a date one year or more in the future. This white paper does not discuss the fair value of a promise to give nonfinancial assets. It also does not discuss how to determine the fair value of unconditional promises to give that are due in less than one year. As explained in FASB ASC 958-605-30-6, unconditional promises to give that are expected to be collected in less than one year may be measured at net realizable value because that amount results in a reasonable estimate of fair value.
• What Is the Unit of Account for an Unconditional Promise to Give That Is Expected to Be Collected in One Year or More?
• 4. For an unconditional promise to give that is expected to be collected in one year or more, the unit of account implied in FASB ASC 958-605 is the individual (stand-alone) promise to give.⁴ That means that the focus of the fair value measurement is on the individual (stand-alone) promise to give in which the exit price represents the amount that a hypothetical market participant would pay to acquire the right to receive from the donor the cash flows inherent in the promise to pay the NFP. The Financial Reporting Executive Committee (FinREC) believes that, consistent with the guidance in FASB ASC 820-10-35-17 on the measurement of the fair value of liabilities, it is appropriate to assume when measuring the fair value of a promise to give that the cash flows received by the hypothetical acquirer would be the same as the cash flows that would be received by the NFP and that no additional credit risk needs to be considered as a result of a hypothetical change in ownership.
• What Valuation Technique(s) Should an NFP Use to Measure the Fair Value of an Unconditional Promise to Give That Is Expected to Be Collected in One Year or More?
• 5. FASB ASC 820-10-35-24A provides that valuation techniques consistent with the market approach, income approach, cost approach, or all three should be used to measure fair value. Paragraphs 3A–3G of FASB ASC 820-10-55 explain those valuation techniques.
• 6. FASB ASC 820-10-35-24 clarifies that “[a] reporting entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.” For an unconditional promise to give that is expected to be collected in one year or more, FinREC believes that a present value (PV) technique (an application of the income approach) will be the most prevalent valuation technique used to measure fair value. In reaching that conclusion, FinREC observes that the market approach typically would not be operational for measuring the fair value of unconditional promises to give cash because no market exists, and the cost approach is not used for valuing financial assets, such as promises to give.
• PV Techniques
• 7. Paragraphs 4–20 of FASB ASC 820-10-55 discuss PV techniques. FASB ASC 820-10-55-5 states that

  [p]resent value (that is, an application of the income approach) is a tool used to link future amounts (for example, cash flows or values) to a present amount using a discount rate. A fair value measurement of an asset or a liability using a present value technique captures all of the following elements from the perspective of market participants at the measurement date:

  1. An estimate of future cash flows for the asset or liability being measured.
  2. Expectations about possible variations in the amount and timing of the cash flows representing the uncertainty inherent in the cash flows.
  3. The time value of money, represented by the rate on risk-free monetary assets that have maturity dates or durations that coincide with the period covered by the cash flows and pose neither uncertainty in timing nor risk of default to the holder (that is, a risk-free interest rate). For present value computations denominated in nominal U.S. dollars, the yield curve for U.S. Treasury securities determines the appropriate risk-free interest rate.
  4. The price for bearing the uncertainty inherent in the cash flows (that is, a risk premium).
  5. Other factors that market participants would take into account in the circumstances.
  6. For a liability, the nonperformance risk relating to that liability, including the reporting entity's (that is, the obligor's) own credit risk.

• 8. Risk and uncertainty associated with the amount, timing, or both, of cash flows of an asset (or a liability) are key considerations when measuring fair value because risk-averse market participants would demand compensation for bearing the uncertainty inherent in the cash flows (the risk premium).⁵ Paragraphs 7–8 of FASB ASC 820-10-55 explain that

  [a] fair value measurement using present value techniques is made under conditions of uncertainty because the cash flows used are estimates rather than known amounts. In many cases, both the amount and timing of the cash flows are uncertain. Even contractually fixed amounts, such as the payments on a loan, are uncertain if there is risk of default.

  Market participants generally seek compensation (that is, a risk premium) for bearing the uncertainty inherent in the cash flows of an asset or a liability. A fair value measurement should include a risk premium reflecting the amount that market participants would demand as compensation for the uncertainty inherent in the cash flows. Otherwise, the measurement would not faithfully represent fair value. In some cases, determining the appropriate risk premium might be difficult. However, the degree of difficulty alone is not a sufficient reason to exclude a risk premium.

• 9. FinREC observes that the requisite risk assessment requires judgments and that those judgments are significant in some cases. In making that assessment, consistent with FASB ASC 820-10-35-54A, FinREC believes that an NFP need not undertake exhaustive efforts to obtain information from or about the donor. Rather, the NFP would assess the risk associated with the promise to give using information that is reasonably available in the circumstances, considering factors specific to the donor and promise to give. FinREC believes that those factors may include, but are not limited to, the following:
  • The ability of the donor to pay (credit risk), which may be indicated by published credit ratings (for example, a credit rating might be available for an enterprise that is a donor or comparable to the donor); financial analysis (for example, cash flow and ratio analysis); or credit reports for an individual donor
  • Factors specific to the donor that might be relevant in assessing the donor's commitment to honor its promise, such as the extent to which the donor is committed to, or otherwise involved in, the activities of the NFP (for example, whether the donor is a member of the governing board); the donor's history of charitable giving and involvement with charitable organizations, including, but not limited to, the NFP; and the donor's financial circumstances and history (past bankruptcies or defaults); financial condition (including other debt); current employment (including its stability); earnings potential over the term of the promise; and personal circumstances (including family situation, age, and health)
  • Risk factors that affect certain groups of donors (for example, economic conditions in certain geographical areas or industry sectors)
  • The NFP's prior experience in collecting similar types of promises to give, including the extent to which the NFP has enforced the promises
  • Whether the underlying asset is held in an irrevocable trust or escrow, which may reduce default risk
• 10. FASB ASC 820-10-55 discusses two PV techniques: (a) the traditional or discount rate adjustment (DRA) technique and (b) the expected PV (EPV) technique, which may be applied using one of two methods. Those PV techniques differ in how they adjust for risk. Key differences are summarized in the following table:

  	DRA	EPV Method 1	EPV Method 2
  Cash Flows	Single set of cash flows (contractual or promised, most likely).6	Expected (probability-weighted) cash flows (or expected value), adjusted for general market (systematic) risk by subtracting the cash risk premium. The risk-adjusted expected cash flows represent a certainty-equivalent cash flow.	Expected (probability-weighted) cash flows (or expected value).
  	The single set of cash flows are conditional cash flows (in other words, contractual or promised cash flows are conditional on the event of no default by the debtor).	The risk-adjusted expected cash flows are not conditional upon the occurrence of specific events because they are probability weighted.	The expected cash flows are not conditional upon the occurrence of specific events because they are probability weighted.
  Discount Rate	Risk-adjusted discount rate derived from observed rates of return for comparable assets or liabilities that are traded in the market (that is, a market rate of return that corresponds to an observed market rate associated with such conditional cash flows and that, therefore, represents the amount that market participants would demand for bearing the uncertainty inherent in such cash flows).	Risk-free interest rate (for example, yield to maturity on U.S. Treasuries).	Risk-free interest rate (for example, yield to maturity on U.S. Treasuries), adjusted for general market (systematic) risk by adding risk premium. The risk-adjusted discount rate represents the expected rate of return that corresponds to an expected rate associated with such probability-weighted cash flows.

• What Are Some of the Key Issues That an NFP Should Consider in Determining Which PV Technique to Use to Measure the Fair Value of an Unconditional Promise to Give That Is Expected to Be Collected in One Year or More?
• 11. Conceptually, the three PV methods discussed in the chart in the previous paragraph should give the same results. FinREC observes that in practice, however, certain techniques may be easier, more practical, or more appropriate to apply to certain facts and circumstances. FASB ASC 820-10-55-4 states that the “present value technique used to measure fair value will depend on facts and circumstances specific to the asset or liability being measured (for example, whether prices for comparable assets or liabilities can be observed in the market) and the availability of sufficient data.”
• 12. A DRA technique using promised cash flows and observable market rates that reflect expectations about future defaults may be easier to apply at initial recognition than the EPV techniques, which require an NFP to probability weight the cash flows or estimate the systematic risk premium. However, to account for the unconditional promises to give in subsequent periods, the NFP must be able to identify when the level of defaults on its promises surpasses the level incorporated in the discount rate that it used for initial recognition, so that it can recognize an allowance for uncollectible promises on a timely basis if the actual uncollectible amounts exceed the amounts originally projected. This can be particularly challenging if the discount rate used is a market rate for which the level of default incorporated in the rate is not publicly available. The use of most likely cash flows, rather than promised cash flows, and a discount rate that is consistent with those cash flows will mitigate some of the challenges for subsequent measurement. That DRA technique is discussed in the next paragraph.
• 13. Although it might appear that the DRA technique may be easy to apply because it does not require an NFP to probability weight the cash flows or estimate the systematic risk premium, as required by the EPV technique, FinREC observes that the DRA technique using promised cash flows may be impractical to apply. FinREC observes that if an NFP uses the DRA technique with promised cash flows, it must use a discount rate that reflects expectations about future defaults, and the NFP must be able to identify when the level of defaults on its unconditional promises to give surpasses the level incorporated in the discount rate it used. This is particularly challenging if the discount rate used is a market rate, such as for unsecured borrowings in which the level of default incorporated in the rate is typically not available. If the NFP does not identify the level of defaults incorporated in the discount rate, it would be unable to timely report a credit impairment loss when the actual uncollectible amounts exceed the amounts originally projected. Thus, the benefit of avoiding the calculation of probability-weighted cash flows on initial measurement (if using the DRA technique with promised cash flows) would be substantially negated by the fact that the NFP would nevertheless have to estimate the cash flows initially expected when determining the allowance for doubtful accounts in subsequent measurements.⁷
• 14. A DRA technique that uses most likely cash flows (rather than promised cash flows) might be practical to apply because the cash flows initially projected are known, but that technique requires the NFP to use a discount rate that reflects market participant assumptions that are consistent with risks inherent in most likely cash flows to avoid double counting or omitting the effects of risk factors. As explained in paragraph 19, the discount rate would be higher than the risk-free rate used in EPV method 1 or the discount rate used in EPV method 2 because most likely cash flows are uncertain, but the discount rate would be lower than the discount rate used with promised cash flows because some of the uncertainty of promised cash flows is removed in the determination of most likely cash flows. Because the three PV techniques trade off the ease of determining a discount rate against the ease of determining the cash flows, FinREC observes that no one PV technique is inherently better than another for measuring unconditional promises to give.
• 15. FinREC observes that in estimating fair value, an entity is not precluded from using fair value estimates provided by third parties, such as valuation specialists, in circumstances in which a reporting entity has determined that the estimates provided by those parties are determined in accordance with FASB ASC 820-10-35. For example, in using a PV technique, valuation specialists may be helpful in determining a discount rate that is consistent with the cash flows used.
• What Are the Key Pricing Inputs When Using a PV Technique?
• 16. Key pricing inputs should reflect the factors that market participants would consider in setting a price for the promise to give. The FASB ASC 820-10-35 fair value hierarchy prioritizes market observable inputs but also allows for the use of unobservable (internally derived) inputs when relevant market observable inputs are unavailable. When using a PV technique, two key pricing inputs are the cash flows and discount rate. The factors considered in determining the cash flows and discount rate used should be documented.
• 17. As noted in FASB ASC 820-10-55-6(c), to avoid double counting or omitting the effects of risk factors, discount rates should reflect assumptions that are consistent with those inherent in the cash flows. For example, a discount rate that reflects the uncertainty in expectations about future defaults is appropriate if using contractual cash flows of a loan. That same rate should not be used if using expected (that is, probability-weighted) cash flows because the expected cash flows already reflect assumptions about the uncertainty of future defaults.
• 18. The cash flows used in a PV technique differ depending on the method used. Following is an illustration of cash flow estimates under the three methods (DRA, EPV method 1, and EPV method 2). Assume that an NFP holds a promise to give $100 in one year. The NFP believes that there is a 70 percent chance that it will collect the full amount, a 20 percent chance that it will collect $80, and a 10 percent chance that it will collect nothing. Under EPV method 2, expected cash flow would be calculated as follows:

  $100 x 70% =	$70
  $80 x 20% =	$16
  $0 x10% =	$0
  	$86

  Under EPV method 1, the expected cash flow would be less than $86 because it would be adjusted (reduced) for systematic risk. Because of the challenges in determining an adjustment for systematic risk, utilization of EPV method 1 may not be practical. Under the DRA technique, both the promised cash flow and most likely cash flow are $100.

• 19. FASB ASC 820-10-55-6 discusses general principles for determining the discount rate when applying PV techniques. FinREC believes that the discount rate used would fall on a continuum between the risk-free rate (minimum) and unsecured borrowing rate (maximum).

  Where the rate falls on the continuum would depend on the extent to which risk factors such as those discussed in paragraph 9 have been incorporated into the projected cash flows.

  (The lowest discount rate would be used for EPV method 1, and the highest discount rate would be used for the DRA technique using contractual cash flows,⁸ as discussed in paragraphs 21–32.)

  The relationship between cash flows and discount rates is depicted as follows:

  

  This diagram depicts the inverse relationship between risks being incorporated in projected cash flows and risks being incorporated in discount rates (that is, the discount rate increases as projected cash flows incorporate fewer risk factors and vice versa).

• EPV Method 1
• 20. When using EPV method 1, the risk-adjusted expected cash flows are discounted by the risk-free interest rate, which may be indicated by the yield to maturity on U.S. Treasuries. The risk-free interest rate is appropriate in this case because all risk is built into the expected cash flows, which therefore represent a certainty-equivalent cash flow. As discussed in FASB ASC 820-10-55-15, EPV method 1 adjusts the expected cash flows for the systematic (market) risk by subtracting a cash risk premium in arriving at risk-adjusted expected cash flows. However, as previously discussed, determining a certainty-equivalent cash flow typically would be impracticable for unconditional promises to give.
• EPV Method 2
• 21. When using EPV method 2, the expected cash flows are discounted by a risk-adjusted rate, which is determined based on the risk-free interest rate, adjusted for general market (systematic) risk by adding a risk premium.
• 22. In EPV method 2, some but not all risk is built into the expected cash flows. The expected cash flows are probability weighted and, therefore, adjusted for the likelihood of possible outcomes affecting the timing and amount of the cash flows. Probability weighting is not enough, however. It is also necessary to adjust for the risk premium that market participants would seek for accepting uncertainty. The following example illustrates this point:

  Asset B is a certain undiscounted cash flow of $10,000 due 10 years hence (a U.S. Treasury instrument is an example of asset B). Asset E has an expected undiscounted cash flow of $10,000 due 10 years hence; however, the actual cash flow from asset E may be as high as $12,000 or as low as $8,000 or some other amount within that range. A risk-averse individual would pay something less for asset E than asset B because of the uncertainty involved. Although the expected cash flow of $10,000 incorporates the uncertainty in cash flows from asset E, that amount does not incorporate the premium that market participants demand for bearing that uncertainty.

• 23. In EPV method 2, the compensation that market participants would seek for accepting uncertainty (the risk premium) is built into the discount rate. The risk-adjusted discount rate represents an expected rate of return that corresponds to an expected rate associated with such probability-weighted cash flows.
• DRA
• 24. When using the DRA technique, the projected cash flows are discounted by a risk-adjusted rate. As discussed in FASB ASC 820-10-55-10

  the [DRA] technique uses a single set of cash flows from the range of possible estimated amounts, whether contractual or promised (as is the case for a bond) or most likely cash flows. In all cases, those cash flows are conditional upon the occurrence of specified events (for example, contractual or promised cash flows for a bond are conditional on the event of no default by the debtor).

• 25. The risk-adjusted discount rate used in the DRA technique is derived from observed rates of return for comparable assets or liabilities that are traded in the market. Accordingly, the contractual, promised, or most likely cash flows are discounted at an observed or estimated market rate for such conditional cash flows (that is, a market rate of return). Therefore, it represents the amount that market participants would demand for bearing the uncertainty inherent in such cash flows. In circumstances in which the projected cash flows already reflect assumptions about future defaults, NFPs should apply a discount rate that is commensurate with the reduced risk inherent in the cash flows that anticipate defaults, in order to avoid double counting that credit risk, as discussed in FASB ASC 820-10-55-6.
• 26. Determining the observed rate of return for comparable assets that are traded in the market requires an analysis of market data for comparable assets. FASB ASC 820-10-55-11 explains that “[c]omparability is established by considering the nature of the cash flows (for example, whether the cash flows are contractual or noncontractual and are likely to respond similarly to changes in economic conditions), as well as other factors (for example, credit standing, collateral, duration, restrictive covenants, and liquidity).” As a basis for assessing comparability, FinREC believes that best practice is for the NFP to assess the likelihood that the donor will not honor its promise to give (default risk), as well as the risk premium reflecting the amount that market participants would demand because of the risk (uncertainty) in the cash flows.⁹
• 27. Market comparable data that might be relevant in determining the risk-adjusted discount rate used in the DRA technique will differ depending on the donor (for example, whether the donor is an individual, a corporation, or a foundation). Some examples follow.
• 28. If the donor is an individual, FinREC believes that the risk-adjusted discount rate might be determined using unsecured consumer lending rates that are generally available from published sources (major financial institutions). FinREC believes that best practice is to use those unsecured consumer lending rates in circumstances in which the credit characteristics of the donor are similar to the credit characteristics of those with unsecured debt.
• 29. FinREC believes that in applying the DRA technique using promised cash flows for promises from individuals, an unsecured consumer lending rate might be a starting point for determining an observable market interest rate. The NFP, however, may need to make adjustments to that rate, as discussed in paragraph 32, including, but not limited to, adjustments based on differences in the credit characteristics of the donor compared with the credit characteristics of borrowers of unsecured debt. (FinREC believes that such adjustments might be made based on the average credit characteristics of a homogeneous group of donors in circumstances in which the results would not be materially different from making such adjustments based on the specific credit characteristics of an individual donor.)
• 30. If the donor is a corporation, and the DRA technique using promised cash flows is used, FinREC believes that the risk-adjusted discount rate might be determined using the yield on publicly traded debt, whether issued by the corporation itself or a comparable corporation. FinREC believes that best practice is to use that yield on publicly traded debt in circumstances in which the promise to give is similar to the publicly traded debt. If the donor is a private foundation, FinREC believes that the risk-adjusted discount rate might be similarly determined using the yield on publicly traded debt, whether issued by the foundation itself, a comparable foundation, or a comparable corporation.¹⁰
• 31. In either case (whether the donor is a corporation or foundation), the NFP would consider factors specific to the promise, including its terms and risk, in assessing the extent to which the promise to give is similar to publicly traded debt. For example, FinREC believes that a promise to give a single fixed contribution at a future date likely would be more analogous to publicly traded zero coupon debt that pays a single amount at a future date than to a debt instrument that periodically pays interest or principal, or both.¹¹
• 32. In all cases, the NFP would evaluate comparability and adjust available market data for differences, so that the risk-adjusted discount rate used to measure fair value (such as unsecured lending rates or yield on publicly traded debt) is reasonable when considered in the context of the donor and cash flows used. For example, as discussed in paragraphs 12–14, if the NFP uses most likely cash flows, rather than promised cash flows, to mitigate some of the challenges for subsequent measurement, an observed market rate based on promised cash flows (such as an unsecured lending rate or a yield on publicly traded debt) would be adjusted downward to reflect the fact that most likely cash flows incorporate an assessment of default.