Facts

1. An organization purchases an equity security—fair value of $30,000 during 20X1.
2. At year-end, 12/31/20X1, the fair value of the investment is $40,000.
3. In 20X2, the investment is sold for $45,000.

Accounting

• At 12/31/20X1, the organization would record an unrealized gain of $10,000 ($40,000 fair value at 12/31/20X1 less $30,000 cost basis). In addition, the equity security's carrying value would be increased to $40,000.
• In 20X2, when the investment is sold, the organization would realize a gain of $5,000

  ($45,000 selling price less the carrying value on the date of sale of $40,000).

Fair Value Disclosures of Investments

Chapter 9 describes the disclosure requirements of GAAP for assets and liabilities that are reported at fair value, including the requirement to classify these assets and liabilities into three different levels, depending on the inputs to the valuation methods. To briefly summarize, the levels to be reported are:

• Level 1—Quoted market prices in active markets for identical assets and liabilities.
• Level 2—Quoted prices for similar assets in active markets, or other observable inputs, such as interest rates, credit risks, and default rates.
• Level 3—Unobservable inputs, which are the entity's own assumptions about what inputs and assumptions market participants would use in pricing an asset or liability.

One of the most common fair value disclosures found in the financial statements of not-for-profit organizations is the categorization of their investments into these three levels, along with the additional fair value disclosures required by GAAP. In practice, most of the investments reported by not-for-profit organizations are reported at fair value, so it is logical that fair value disclosures for investments are common.

Below are some examples of where different types of investments are generally categorized.

As discussed in Chapter 9, FASB ASU 2010-6 requires that categorization by level be disclosed for each class of asset or liability reported at fair value. This ASU provides examples (“methods”) of how this may be accomplished. The following is one method that FASB ASU 2010-6 provides to meet its disclosure requirements relative to investments (along with the footnote information that is also included in the method, but without the specific level classifications):

Cash
Equity securities:
US large-cap (a)
US mid-cap growth
International large-cap value
Emerging markets growth
Domestic real estate
Fixed income securities:
US Treasuries
Corporate bonds (b)
Mortgage-backed securities
Other types of investments:
Equity long/short hedge funds (c)
Event-driven hedge funds (d)
Global opportunities hedge funds (e)
Multistrategy hedge funds (f)
Private equity funds (g)
Real estate

a. This class comprises low-cost equity index funds not actively managed that track the S&P 500.

b. This class represents investment-grade bonds of US issuers from diverse industries.

c. This class includes hedge funds that invest both long and short in primarily US common stocks. Management of the hedge funds has the ability to shift investments from value to growth strategies, from small to large capitalization stocks, and from a net long position to a net short position.

d. This class includes investment in approximately 60% equities and 40% bonds to profit from economic, political, and government-driven events. A majority of the investments are targeted at economic policy decisions.

e. This class includes approximately 80% investments in non-US common stocks in the health care, energy information technology, utilities, and telecommunications sectors and approximately 20% investments in diversified currencies.

f. This class invests in multiple strategies to diversify risks and reduce volatility. It includes investments in approximately 50% US common stocks, 30% global real estate projects, and 20% arbitrage investments.

g. This class includes several private equity funds that invest primarily in US commercial real estate.

While this is presented only as an example, depending on the diversity of the investment portfolio and the significance of investments in each asset class, implementation of the disclosure requirements of FASB ASU 2010-6 will likely require most not-for-profit organizations to expand their level of disclosures about the fair value of investment to meet its requirements.

The FASB is continuing to fine-tune its accounting standards related to fair value measurements and disclosures by the issuance of Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in US GAAP and IFRS (ASU 2011-04). Although this ASU will affect all fair value measurements and disclosures, it is discussed in this chapter, as for a typical not-for-profit organization, the largest impact will be on investments carried at fair value.

ASU 2011-04 seeks to ensure that fair value has the same meaning in US GAAP and in International Financial Reporting Standards (IFRS). It changes the wording used to describe the requirements in US GAAP for measuring fair value and for disclosing information about fair value measurements. The amendments include the following:

1. Those that clarify the FASB's intent about the application of existing fair value measurement and disclosure requirements;
2. Those that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements.

In addition, to improve consistency in application across jurisdictions, some changes in wording are necessary to ensure that US GAAP and IFRS fair value measurement and disclosure requirements are described in the same way (for example, using the word shall rather than should to describe the requirements in US GAAP).

The amendments that clarify the board's intent about the application of existing fair value measurement and disclosure requirements include the following:

1. Application of the highest and best use and valuation premise concepts.
2. Measuring the fair value of an instrument classified in a reporting entity's shareholders’ equity (will not affect not-for-profit organizations).
3. Disclosures about fair value measurements. The amendments clarify that a reporting entity should disclose quantitative information about the unobservable inputs used in a fair value measurement that is categorized within Level 3 of the fair value hierarchy.

The amendments in ASU 2011-04 that change a particular principle or requirement for measuring fair value or disclosing information about fair value measurements include the following:

1. Measuring the fair value of financial instruments that are managed within a portfolio. A reporting entity that holds a group of financial assets and financial liabilities is exposed to market risks (that is, interest rate risk, currency risk, or other price risk) and to the credit risk of each of the counterparties. ASU 2011-04 permits an exception to the requirements for measuring fair value when a reporting entity manages its financial instruments on the basis of its net exposure, rather than its gross exposure to those risks. This provision is more likely to impact financial institutions.

Application of premiums and discounts in a fair value measurement. ASU 2011-04 clarifies when the application of premiums (“write-ups”) and discounts (“haircuts”) in a fair value measurement is appropriate and how these should be applied. ASU 2011-04 clarifies that the application of premiums and discounts in a fair value measurement is related to the unit of account for the asset or liability being measured at fair value. In the absence of a Level 1 input, a reporting entity should apply premiums or discounts when market participants would do so when pricing the asset or liability consistent with the unit of account that requires or permits the fair value measurement. ASU 2011-04 also clarifies that premiums or discounts related to size as a characteristic of the reporting entity's holding (specifically, a blockage factor) rather than as a characteristic of the asset or liability (for example, a control premium) are not permitted in a fair value measurement.

2. Additional disclosures about fair value measurements. The disclosures about fair value measurements are yet again expanded, including the following:
   1. For fair value measurements categorized within Level 3 of the fair value hierarchy:
      1. The valuation processes used by the reporting entity;
      2. The sensitivity of the fair value measurement to changes in unobservable inputs and the interrelationships between those unobservable inputs, if any (not required for nonpublic entities).
   2. A reporting entity's use of a nonfinancial asset in a way that differs from the asset's highest and best use when that asset is measured at fair value in the statement of financial position or when its fair value is disclosed on the basis of its highest and best use.
   3. The categorization by level of the fair value hierarchy for items that are not measured at fair value in the statement of financial position but for which the fair value is required to be disclosed (for example, a financial instrument that is measured at amortized cost in the statement of financial position but for which fair value is disclosed).

Investments in Certain Entities That Calculate Net Asset Value Per Share

Many not-for-profit organizations report all of their investments, including alternative investments, at fair value. Determining a fair value for many types of alternative investments (hedge funds, private equity funds, etc.) has often been a challenge for not-for-profit organizations. Matters of concern included whether the hedge fund or private equity fund was reporting its underlying investments at fair value, as well as limitations on withdrawals. The FASB issued Accounting Standards Update No. 2009-12 (Fair Value Measurements and Disclosures [Topic 820] Investment in Certain Entities That Calculate Net Asset Value Per Share [or Its Equivalent]) (FASB ASU 2009-12) to address at least some of these concerns by permitting a “practical expedient” to be used for reporting these investments, if certain conditions are met. If the investment does not have a readily determinable fair value and if the entity in which the not-for-profit organization has an investment reports in a manner consistent with an investment company, the provision of FASB ASU 2009-12 would apply. The not-for-profit organization would be able to use the reported net asset value per share as its fair value, provided that the net asset value per share is calculated in a manner consistent with investment company reporting principles, including that the measurement of all or substantially all of the underlying investments have been valued in accordance with the fair value requirements of FASB ASC 820. Upon implementation of ASU 2015-07, as discussed below, investments reported at net asset value as a practical expedient will no longer be required to be reported in one of the three fair value categories.

In other words, if the aforementioned conditions are met, the not-for-profit organization would report the net asset value per share as the fair value of the investment without adjustment for other attributes of the investment, such as restrictions on withdrawal. In return for this “practical expedient,” FASB ASU 2009-12 requires disclosures by major category of investment about the attributes of investments within its scope, such as the nature of any restrictions on the investor's ability to redeem its investments at the measurement date, any unfunded commitments (for example, a contractual commitment by the investor to invest a specified amount of additional capital at a future date to fund investments that will be made by the investee), and the investment strategies of the investees.

The FASB issued ASU 2015-07 Fair Value Measurement (Topic 820) Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent). ASU 2015-07 eliminated the requirement to categorize within the fair value hierarchy investments that are measured at net asset value per share (or its equivalent) using the practical expedient. Investments that calculate net asset value per share (or its equivalent) but for which the practical expedient is not applied will continue to be included in the fair value hierarchy.

ASU 2015-07 also removes the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. Instead, those disclosures are limited to investments for which the entity has elected to measure the fair value using that practical expedient. In other words, these disclosures are not required for investments reported at net asset value that are included in the fair value hierarchy because the practical expedient is not applicable.

Liquidity Restrictions and Other Investment Disclosure Considerations

In the recent past, the global financial markets experienced significant turmoil, resulting in substantial declines in investment market values, as well as limitations on withdrawals from certain investment funds. These events should have been considered by financial statement preparers in determining whether disclosure or other financial statement adjustments should be considered. The issue is addressed in a Technical Question and Answer issued by the AICPA, TIS 1100.15, “Liquidity Restrictions.”

Certain money market and other short-term investment funds have restricted the ability of investors to withdraw their balances in these funds. TIS 1100.15 points out that these restrictions should be considered in determining whether investments in these funds are properly classified as cash equivalents and whether they should be classified as current assets on classified balance sheets. If a classified balance is not presented, the withdrawal restrictions should be considered in determining the sequencing of assets on the balance sheet or disclosures in the notes to the financial statements providing information about the liquidity or maturity of assets. TIS 1100.15 also notes that reclassifications of amounts from current to noncurrent should be considered in determining whether any debt covenants have been violated.

TIS 1100.15 also addresses disclosures that may be required by these events beyond those normally required by generally accepted accounting principles. For example, such events may create or lead to risks and uncertainties pertaining to significant estimates such as measurement, liquidity and violation of debt covenants, and vulnerability from concentrations of investments in volatile markets. TIS 1100.15 provides that entities should consider whether they should make disclosures in their financial statements, beyond those required or generally made, about the risks and uncertainties resulting from such events and existing as of the date of the financial statements.

While many of the liquidity restrictions addressed by TIS 1100.15 have abated, its guidance remains important should these conditions be experienced in the future.

Loans Acquired in a Transfer

FASB ASC 310-30 addresses the accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences are attributable, at least in part, to credit quality. It addresses the initial recording of the loans acquired in a transfer as well as accounting for subsequent changes in expected cash flows.

Of important note to not-for-profit organizations is that excluded from the scope of these requirements are loans that are measured at fair value, if all changes in fair value are included in the statement of activities and included in the performance indicator if a performance indicator is presented. Accordingly, loans acquired in a transfer that are considered debt securities and reported at fair value as described earlier in this chapter are not within the scope of these requirements. Also of note is that the guidance applies only to loans acquired in a transfer—it does not apply to loans that are originated by the not-for-profit organization itself. Since these requirements address a type of transaction that is outside those typical of not-for-profit organizations, detailed analysis is not provided in this book. However, financial statement preparers should be aware of the requirements for the rare case where they may be applicable.

Donor-Restricted Endowment Funds

A donor-restricted endowment fund is created when a donor stipulates that the contributed assets be invested for a specific period of time or in perpetuity.

Donor stipulations, to the extent that they exist, determine the classifications of gains and losses from sales of restricted endowment funds. Securities held in perpetuity because of donor restrictions also may result in gains or losses increasing or decreasing permanently restricted net assets because of local law.

However, in the absence of donor restrictions or local law that restricts the use of gains, such gains will follow the treatment of investment income. Accordingly, gains are “unrestricted if the investment income is unrestricted or are temporarily restricted if the investment income is temporarily restricted by the donor.” (FASB ASC 958-205-45-17)

FASB ASC 958-205-47-22 and 24 state the following:

In the absence of donor stipulations or law to the contrary, losses on the investments of a donor-restricted endowment fund shall reduce temporarily restricted net assets to the extent that donor-imposed temporary restrictions on net appreciation of the fund have not been met before the loss occurs. Any remaining loss shall reduce unrestricted net assets.

If losses reduce the assets of a donor-restricted endowment fund below the level required by the donor stipulations or law, gains that restore the fair value of the assets of the endowment fund to the required level shall be classified as increases in unrestricted net assets.

Under existing GAAP, permanently restricted net assets are not reduced by losses on the investments of the fund (except to the extent required by the donor, including losses that the donor requires the organization to hold in perpetuity), nor are they reduced by an organization's appropriations from the fund. Losses on permanently restricted endowment funds reduce temporarily restricted net assets to the extent that donor-imposed temporary restrictions on net appreciation of the fund have not been met before the loss occurs. Any remaining loss shall reduce the unrestricted net assets. Upon implementation of ASU 2016-14, net assets without donor restrictions will not be reduced for losses on endowment funds. Rather, the endowment funds (which are part of net assets with donor restrictions) will be reported at their reduced amount and reflect any losses in excess of previous gains or unappropriated earnings. Most states have laws that govern certain aspects of managing donor-restricted endowment funds, and these laws should always be consulted when applicable. In many states the relevant law is referred to as UMIFA (Uniform Management of Institutional Funds Act). As of late 2011, an updated version of this law, referred to as UPMIFA (Uniform Prudent Management of Institutional Funds Act), has been adopted by all but two states (Pennsylvania and Mississippi). A more complete discussion of this matter is included in Chapter 8.

Investment Income

Investment income includes dividends, interest, rents, royalties, and similar payments and should be recognized as earned. The revenue should be reported as an increase in unrestricted, temporarily restricted, or permanently restricted net assets, depending on donor stipulations, or applicable law, on the use of the income. For example, if there are no donor-imposed restrictions on the use of the income, it should be reported as an increase in unrestricted net assets, unless the income comes from assets of a donor-restricted endowment fund, in which case the income is considered to be temporarily restricted until appropriated for expenditure by the organization. Such appropriation can occur by specific action of the governing board, through inclusion in a board-approved budget, or through a board-approved spending policy such as having a spending rate of, for example, 5% of the value of the endowment.

A donor may stipulate that a gift be invested in perpetuity, with the income to be used to support a specified program. The gift should be recorded as permanently restricted net assets. Investment income that is earned is reported as temporarily restricted. If the restrictions on the income are met, the statement of activities should report a reclassification from temporarily restricted net assets to unrestricted net assets. (AICPA Guide, paragraph 4.71)

Investment expenses. Investment expenses may be netted against related investment income, gains, or losses on the statement of activities, provided they are disclosed on the statement of activities or in the notes to the financial statements.

If the not-for-profit organization presents a statement of functional expenses, investment expenses netted against investment revenue should be reported by their functional classification. (FASB ASC 958-205-45-6)

ASU 2016-14 has a specific provision relating to investments, which is the requirement to report investment income net of external and direct internal investment expenses, and no longer requires disclosure of those netted expenses.

ASU 2016-14 has specific guidelines as to what can be considered direct investment expenses, which should be considered upon its implementation.

Direct investment expenses involve the direct conduct or direct supervision of the strategic and tactical activities involved in generating investment return. These include, but are not limited to, both of the following:

1. Salaries, benefits, travel, and other costs associated with the officer or staff responsible for the development and execution of investment strategy;
2. Allocable costs associated with internal investment management and supervising, selecting, and monitoring of external investment management firms.

In addition, a not-for-profit organization may present the amounts of net investment return from portfolios that are managed differently or derived from different sources as separate, appropriately labeled line items on the statement of activities.

Pooling of investments. Not-for-profit organizations sometimes pool a portion or all of their investments for portfolio management purposes. The number and nature may vary from organization to organization.

Ownership interests are initially assigned (typically through utilization) to the various pool categories (sometimes referred to as “participants”) based on the market value of the cash and securities placed in the pool by each participant. Current fair value is used to determine the number of units allocated to additional assets placed in the pool and to value withdrawals from the pool. Investment income and realized gains and losses (and any recognized unrealized gains and losses) are allocated equitably based on the number of units assigned to each participant. (AICPA Guide, paragraph 4.57)

FASB ASC 325-35 addresses the accounting for “other investments,” which are those not-for-profit organization investments that are not covered by GAAP. Other investments include, among others, investments in real estate, mortgage notes, venture capital funds, partnership interests, oil and gas interests, and equity securities that do not have a readily determinable fair value.

Specifically, GAAP provides the following guidance for other investments:

Colleges and Universities

Other investments of institutions of higher education, including colleges, universities, and community or junior colleges, that were acquired by purchase may be reported at cost, and contributed other investments may be reported at their fair market value or appraised value at the date of the gift, unless there has been an impairment of value that is not considered to be temporary. Other investments may also be reported at current market value or fair value, provided that the same attribute is used for all other investments. (Investments in wasting assets are usually reported net of an allowance for depreciation or depletion.) (FASB ASC 958-325-35-1)

Voluntary Health and Welfare Organizations

Voluntary health and welfare organizations should report other investments at cost if purchased and at fair market value at the date of the contribution if contributed. If the market value of the other investments portfolio is below the recorded amount, it may be necessary to reduce the carrying amount of the portfolio to market or to provide an allowance for decline in market value. If it can reasonably be expected that the organization will suffer a loss on the disposition of an investment, a provision for the loss should be made in the period in which the decline in value occurs. Carrying other investments at market value is also acceptable. The same measurement attribute should be used for all other investments and should be disclosed. (FASB ASC 958-325-35-3 to 5)

Other not-for-profit organizations

Not-for-profit organizations that are not colleges, universities, or voluntary health and welfare organizations should report other investments at either fair value or the lower of cost or fair value. The same measurement attribute should be used for all other investments. Declines in investments carried at the lower of cost or market value should be recognized when their aggregate market value is less than their carrying amount; recoveries of aggregate market value in subsequent periods should be recorded in those periods subject only to the limitation that the carrying amount should not exceed the original cost. (FASB ASC 958-325-35-6 and 7)

Alternative Investments

The AICPA has also issued a Practice Aid, Alternative Investments—Audit Considerations, to assist organizations and their auditors in dealing with this subject. While the Practice Aid is designed primarily for auditors of financial statements, its emphasis is on how auditors evaluate management's process to determine the valuation of alternative investments that are reported on the statement of financial position. The Practice Aid emphasizes that it is management's responsibility to value and maintain appropriate internal controls over its investments in alternative investments. The Practice Aid provides that auditors often obtain appropriate audit evidence with respect to the existence and valuation assertions associated with alternative investments in the form of (1) observable market prices (such as from recent purchase or sale transactions), (2) details of the underlying investments, or (3) audited financial statements of the alternative investments. Often, investors in alternative investments have difficulty in obtaining information about the fair value of the investment from the manager of the investment, which is a consideration that financial statement preparers should make sure that they have adequate processes in place to address.

Impairment of Equity Securities Reported at Cost

While the majority of the typical not-for-profit organization's investments are reported at fair value, there may well be investments that are carried at cost, as the guidance above demonstrates. FASB ASC 320-10-35 provides the GAAP requirements for evaluating these investments, which are reported at cost for impairment. The requirements identify a three-step process for identifying and accounting for impairment.

Step 1 is to determine whether an investment is impaired. The assessment should be made at the individual security level, which means the level and method of aggregation used to measure realized and unrealized gains and losses on debt and equity securities. For example, a common stock that is owned may have been purchased on several different dates. Each purchase would have its own cost basis; however, GAAP would permit the impairment assessment to be made on an average cost basis, as long as that is the basis that the not-for-profit organization uses to measure realized and unrealized gains and losses for the issuer.

An investment is impaired if its fair value is less than its cost. Accordingly, a not-for-profit organization should first determine if the carrying amount of the investment exceeds its fair value. Because the fair value of a cost method investment is normally not readily determinable, the organization should compare the carrying amount to an estimate of fair value determined for other purposes (such as for disclosure under FASB ASC 825-10-50, which is discussed in Chapter 29).

• If the carrying amount is more than the fair value of the investment, the not-for-profit organization should proceed to determine whether the impairment is other than temporary, as described later in this section in Step 2.
• If the not-for-profit organization has not developed an estimate of fair value for a cost method investment, the organization should evaluate whether an event or change in circumstances has occurred in the period that might have a significant adverse effect on the fair value of the investment (an impairment indicator). If an impairment indicator is present, the not-for-profit organization should estimate the fair value of the investment.

Impairment indicators include, but are not limited to:

• A significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the investee;
• A significant adverse change in the regulatory, economic, or technological environment of the investee;
• A significant adverse change in the general market condition of either the geographic area or the industry in which the investee operates;
• A bona fide offer to purchase (whether solicited or unsolicited), an offer by the investee to sell, or a completed auction process for the same or similar security for an amount less than the cost of the investment;
• Factors that raise significant concerns about the investee's ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.

If an impairment indicator is present, the not-for-profit organization should estimate the fair value of the investment. If the fair value of the investment is less than its cost, proceed to Step 2.

Step 2 is to determine whether an impairment is other than temporary. Other than temporary does not mean permanent.

For a debt security, if it is probable that the not-for-profit organization will be unable to collect all amounts due according to the contractual terms of a debt security, an other-than-temporary impairment is considered to have occurred. Recognition of an other-than-temporary impairment may also be required if the decline in a security's value is due to an increase in market interest rates or a change in foreign exchange rates since acquisition. Examples provided at FASB ASC 320-10-35-32 are when a security will be disposed of before it matures or the investment is not realizable.

FASB ASC 320-10-35-33 provides that if a not-for-profit organization does not intend to sell the debt security, it should consider available evidence to assess whether it more likely than not will be required to sell the security before the recovery of its amortized cost basis (for example, whether its cash or working capital requirements or contractual or regulatory obligations indicate that the security will be required to be sold before a forecasted recovery occurs). If the entity more likely than not will be required to sell the security before recovery of its amortized cost basis, an other-than-temporary impairment is considered to have occurred.

FASB ASC 320-10-35 provides the factors that should be considered when estimating whether a credit loss exists and the period over which the debt security is expected to recover:

• Length of time and the extent to which fair value has been less than the amortized cost basis.
• Adverse conditions specifically related to the security, an industry, or geographic area.
• The historical and implied volatility of the fair value of the security.
• The payment structure of the security and the likelihood of the issuer being able to make payments that increase in the future.
• Failure of the issuer of the security to make scheduled interest or principal payments.
• Any changes to the rating of the security by a rating agency.
• Recoveries or additional declines in fair value after the balance sheet date.

In making its other-than-temporary impairment assessment, GAAP provides that an entity should consider all available information relevant to the collectibility of the security, including information about past events, current conditions, and reasonable and supportable forecasts, when developing the estimate of cash flows expected to be collected. The information should include all of the following:

1. The remaining payment terms of the security;
2. Prepayment speeds;
3. The financial condition of the issuer(s);
4. Expected defaults;
5. The value of any underlying collateral.

GAAP provides that if the organization concludes that an impaired cost method investment is not other-than-temporarily impaired (a double negative meaning essentially that a loss will not be recognized immediately), it should continue to estimate the fair value of the investment in each subsequent reporting period until either (1) the investment experiences a recovery of fair value up to (or beyond) its cost, or (2) the investor recognizes an other-than-temporary impairment loss.

Step 3 is to recognize an impairment loss if the loss is considered other than temporary. If the organization concludes that the impairment is other than temporary, an impairment loss should be recognized equal to the difference between the investment's carrying amount and its fair value at the balance sheet date of the reporting period for which the assessment is made. The fair value of the investment would then become the new cost basis of the investment and should not be adjusted for subsequent recoveries in fair value.

Equity Method of Accounting

The equity method is used by a not-for-profit organization to account for an investment in a for-profit company when the not-for-profit organization has the ability to significantly influence that company's financial and operating policies.

The use of the equity method by a not-for-profit organization is essentially the same as would be used by an entity in the for-profit sector. As in the profit sector, when an organization uses the equity method of accounting, the original investment is recorded at cost. Thereafter, the amount of the investment is adjusted as follows:

• Increased for the organization's proportionate share of the entity's earnings;
• Decreased for the organization's proportionate share of the entity's losses;
• Decreased for dividends received by the not-for-profit organization from the entity.

The statement of financial position should include the investment that the not-for-profit organization has in the for-profit organization. Any earnings and losses are shown on the statement of activities.

The equity method, sometimes referred to as “one-line consolidation,” permits an entity (investor) to incorporate its pro rata share of the investee's operating results into its earnings. However, rather than include its share of each component (e.g., sales, cost of sales, operating expenses, etc.) in its financial statements, the investor shall only include its share of the investee's net income as a separate line item in its income. Note that there are exceptions to this one-line rule. The investor's shares of investee extraordinary items and prior period adjustments retain their identities in the investor's income and retained earnings statements and are separately reported if material in relation to the investor's income. It should be noted that the final bottom-line impact on the investor's financial statements is identical whether the equity method or full consolidation is employed; only the amount of detail presented within the statements will differ.

Accounting Rules

The GAAP requirements for the equity method of accounting are generally provided at FASB ASC 325-20. Absent evidence to the contrary, an organization is presumed to have the ability to significantly influence an entity if it owns (directly or indirectly) 20% or more of the entity's voting stock.

A not-for-profit organization should use the equity method to account for its interest in a for-profit entity if it has the ability to significantly influence the entity's operating and financial policies.

An organization may choose to report its ownership interest in a for-profit entity at market value if it reports its investment portfolio at market value.

The equity method should not normally be used to account for an organization's interest in another not-for-profit organization. Instead, the organization should consolidate the investment if it has the ability to control that other organization and it has an economic interest in the related organization. However, in rare cases, it may be the only possible method if the criteria for consolidation are not met, but there is significant influence combined with residual rights.

Ownership percentage determines the accounting method required by the not-for-profit investment in a for-profit entity. When a not-for-profit organization owns less than 20%, the accounting method used to account for the investment is at cost or market value. The equity method should be used when the ownership percentage is 20% to 50%. In circumstances where more than 50% of ownership is determined, the for-profit company should be consolidated.

The 20% rule provides some consistency in applying the equity method. An investor's ability to significantly influence an investee depends on a variety of factors and requires evaluation of all circumstances.

For example, if a not-for-profit organization owns less than 20% of the for-profit organization, but does exercise significant influence because of its presence on the board of directors and participation in making policy, the investment should be accounted for under the equity method.

GAAP provides that there is a presumption that the investor has the ability to exercise significant influence in the absence of evidence to the contrary if the investor owns 20% or more of the investee. It should be emphasized that the opinion does not require the investor to actively exert significant influence but only to have the ability to exercise such influence. Examples of evidence to the contrary might be that:

• The not-for-profit organization investor attempts and fails to obtain representation on the investee's board of directors.
• The investee files a lawsuit or complaint against the investor.
• Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the view of the investor.
• The not-for-profit organization investor seeks more financial information than is available to the investee's other shareholders and is unable to obtain that information.

Equity Method Application

Under the equity method, the investment is initially recorded at cost. Thereafter, the investment is reduced by dividends, and increased or decreased by the not-for-profit organization's proportionate share of the for-profit investee entity's earnings or loss.

The investment is shown in the organization's statement of financial position as a single amount, and the organization's share of the for-profit's earnings is reported in the organization's statement of activities as a single amount.

The following other considerations should be made in applying the equity method:

• Any difference at the acquisition date between the cost of the investment and the equity in net assets of the for-profit entity is required to be accounted for as if the entity were a consolidated subsidiary. The difference should be related to the entity's tangible and intangible assets based on their fair values, and any difference that cannot be related to specific assets should be considered to be goodwill.
• An organization's equity in the operating results of the for-profit entity should be based on the shares of common stock held, without consideration of common stock equivalents.
• Interorganization profits and losses should be eliminated until realized as if the for-profit entity were consolidated.
• An organization should report its share of a for-profit entity's extraordinary item (or prior period adjustment) as an extraordinary item (or prior period adjustment) unless immaterial.
• Capital transactions of the for-profit entity that affect the organization's share of the entity's stockholders’ equity should be accounted for as if the entity were a consolidated subsidiary.
• An organization should recognize a loss for declines in an investment's value that are other than temporary.
• An organization ordinarily should discontinue applying the equity method when its share of the entity's losses eliminates the amount recorded for the investment in the investee.
• Dividends on the entity's cumulative preferred stock should be deducted when computing the organization's share of earnings, regardless of whether they have been declared.

Differences in fiscal years. An organization may recognize its share of the for-profit entity's earnings or losses based on the most recent available financial statements of the entity so long as the time lag in reporting periods is consistent from year to year.

Income taxes. Accounting for an investment under the equity method may result in temporary differences between the amounts reported for financial and tax reporting. Not-for-profit organizations will need to carefully consider the tax implications of investments in for-profit entities accounted for by the equity method.

Changes in the equity method. When an organization no longer has the ability to significantly influence the for-profit entity's financial and operating policies, it should:

• Stop accruing its share of the for-profit entity's earnings or losses, and
• Begin accounting for the investment under the cost method or at market value. The investment's cost is its carrying amount on the date that it no longer qualified for equity method accounting.

Fiscal year discrepancies. In some cases the fiscal year-end dates of the for-profit entity and the not-for-profit entity may be different. A not-for-profit organization should utilize the most recent available financial statements of the for-profit entity when recognizing its share of the for-profit entity's earnings or losses. As long as the time lag is consistent from year to year, it is acceptable.

Investments

A not-for-profit organization should disclose the following information related to investments: (FASB ASC 958-320)

1. For the most recent statement of financial position presented:
   1. The nature and carrying value for each investment or group of investments that represents a significant concentration of market risk.
2. For each statement of financial position presented:
   1. The aggregate carrying value of each major investment type;
   2. The basis for determining the carrying amount for investments other than debt securities and equity securities with readily determinable fair values;
   3. The methods and significant assumptions used to estimate fair values of investments other than financial instruments if those other investments are reported at fair value;
   4. If the fair value of assets for all donor-restricted endowment funds is less than the amounts required by donors or by law, the aggregate amount of the deficiencies;
   5. Required fair value disclosures listed in the Disclosure Checklist.
3. For each statement of activities presented:
   1. Information about the components of investment return, including investment income, net gains and losses on investments reported at fair value, and net realized gains and losses on investments reported at other than fair value;
   2. If investment return is separated into operating and nonoperating amounts, a reconciliation of investment return to amounts reported in the statement of activities;
   3. A description of the policy used to determine the amount of investment return included in the operating amount and, if applicable, the reason for any changes to that policy.
4. The amount of investment expenses reported on the statement of activities as a reduction of investment income, gains, and losses.
5. The policy for reporting restricted gains and investment income whose restrictions are met in the same reporting period if the organization chooses to show them as unrestricted support.
6. For colleges and universities, the amount of investment income and realized and unrealized gains and losses from investments other than debt and equity securities disclosed in the financial statements or the notes.
7. For all investments in an unrealized loss position for which other-than-temporary impairments have not been recognized, the following should be disclosed:
   1. As of each date for which a statement of financial position is presented, quantitative information, aggregated by category of investment in tabular form:
      1. The aggregate amount of unrealized losses (that is, the amount by which cost or amortized cost exceeds fair value); and
      2. The aggregate related fair value of investments with unrealized losses.
   2. The disclosures in (1) and (2) above should be segregated by those investments that have been in a continuous unrealized loss position for less than twelve months and those that have been in a continuous unrealized loss position for twelve months or longer.
   3. As of the date of the most recent statement of financial position, additional information, in narrative form, that provides sufficient information to allow financial statement users to understand the quantitative disclosures and the information that the investor considered (both positive and negative) in reaching the conclusion that the impairments are not other than temporary. This disclosure could include:
      1. The nature of the investment(s);
      2. The cause(s) of the impairment(s);
      3. The number of investment positions that are in an unrealized loss position;
      4. The severity and duration of the impairment(s);
      5. Other evidence considered by the investor in reaching its conclusion that the investment is not other-than-temporarily impaired, including, for example, industry analyst reports, sector credit ratings, volatility of the security's fair value, and/or any other information that the investor considers relevant.
8. For cost method investments, the investor should disclose the following additional information, if applicable, as of each date for which a statement of financial position is presented in its annual financial statements:
   1. The aggregate carrying amount of all cost method investments;
   2. The aggregate carrying amount of cost method investments that the investor did not evaluate for impairment; and
   3. The fact that the fair value of a cost method investment is not estimated if there are no identified events or changes in circumstances that may have a significant adverse effect on the fair value of the investment; and
      1. The investor determined that it is not practicable to estimate the fair value of the investment; or
      2. The investor is exempt from estimating fair value of financial instruments under FASB ASC 825-10-50.

Equity Method

The following are the disclosures required for a not-for-profit organization for an investment in a for-profit entity accounted for under the equity method:

1. Identification of the for-profit entity and the percentage ownership held by the not-for-profit organization.
2. Where an investee is 20% or more owned, but not accounted for under the equity method, the reasons why the equity method is not used should be disclosed. Where an entity is less than 20% owned, but is accounted for under the equity method, the reasons the equity method is used should be disclosed.
3. The aggregate value of the investment based on the quoted price, when the quoted market price is available.
4. Summarized information about the for-profit entity's assets, liabilities, and results of operations should be disclosed if equity method investments are, in the aggregate, material to the organization's financial position or changes in net assets.