Revocable Split-Interest Agreements

A revocable split-interest agreement should be accounted for as an intention to give. Assets received by not-for-profit organizations acting as a trustee under revocable split-interest agreements should be recognized at fair value when received and as refundable advances. In other words, they are not recognized as contribution revenue, even for the not-for-profit organization's beneficial interest. The transferred assets are reported on the statement of financial position as assets, with a corresponding liability to return them to the donor.

Changes in the carrying value of assets received under revocable split-interest agreements and income from those assets that is not available for the organization's unconditional use should be recognized as adjustments to the recorded assets and related refundable advance liability. However, if income generated by assets is available for the organization's unconditional use, it should be recognized as either unrestricted, temporarily restricted, or permanently restricted contribution revenue, depending on the existence or absence of donor restrictions. In other words, the not-for-profit organization has no obligation to return the income to the donor in this example.

Assets received under a revocable split-interest agreement should be recognized as contribution revenue only when the agreement becomes irrevocable or the assets become available to the organization for its unconditional use, whichever occurs first.

Irrevocable Split-Interest Agreements

An irrevocable split-interest agreement is one that cannot be canceled by the donor. In the absence of donor-imposed conditions, not-for-profit organizations should recognize contribution revenue and related assets and liabilities when irrevocable split-interest agreements naming them trustee or fiscal agent are executed. In other words, the not-for-profit organization recognizes its share of its interest in the agreement, while at the same time recognizes that is has a liability to one or more other beneficiaries. (Chapter 11 provides additional information for recognizing assets transferred to a charitable trust.)

Initial recognition of unconditional irrevocable agreements. At the date of initial recognition of a split-interest agreement, contributions should be measured at fair value. Under a lead interest agreement, the fair value of the contribution can be estimated directly based on the present value of the estimated future distributions expected to be received by the not-for-profit organization as a beneficiary. Under a remainder interest agreement, future distributions will be received by the not-for-profit organization only after obligations to other beneficiaries are satisfied. In those cases, the fair value of the contribution may be estimated based on the fair value of the assets contributed by the donor less the present value of the payments expected to be made to other beneficiaries.

Any method for measuring the fair value of the contribution must consider:

1. The estimated return on the invested assets during the expected term of the agreement;
2. The contractual payment obligations under the agreement;
3. A discount rate commensurate with the risks involved.

In conformity with FASB ASC 835-30, the discount rate should be determined at the time the contribution is initially recognized and should not be revised subsequently.

Contribution revenues recognized under split-interest agreements should be classified as increases in temporarily restricted net assets unless:

1. The donor has permanently restricted the not-for-profit organization's use of its interest in the assets; or
2. The donor gives the organization the immediate right to use without restrictions the assets it receives.

Under many charitable gift annuity agreements, the assets received from the donor are held by the not-for-profit organization as part of its general assets and are available for its unrestricted use.

The contribution should increase permanently restricted assets if the donor has permanently restricted the organization's use of its interest.

If the organization has the immediate right to use its interest without restrictions by the donor, the contribution should be classified as an increase in unrestricted net assets.

When a not-for-profit organization serves as trustee or when the assets contributed by the donor are otherwise under the control of the not-for-profit organization, cash and other assets received under split-interest agreements should be recognized at fair value at the date of initial recognition.

If those assets, or a portion of those assets, are being held for the benefit of others, a liability, measured at the present value of the expected future payments to be made to other beneficiaries, should also be recognized at the date of initial recognition. The determination of the liability that is recorded may be based on the lives of one or more beneficiaries. Accordingly, the services of an actuary may be required to determine the amount of the liability to be recorded. In some cases, the future payments can be based on the terms of the agreement. In other cases, the future payments will be made by the not-for-profit organization only after the organization receives its benefits. In those situations, the present value of the future payments to be made to other beneficiaries may be estimated by the fair value of the assets contributed by the donor under the agreement less the present value of the estimated benefits to be received by the not-for-profit organization.

In arrangements in which cash or other assets contributed by donors under split-interest agreements are held by independent trustees or by other fiscal agents of the donors, or are otherwise not controlled by the not-for-profit organization, the not-for-profit organization should recognize its beneficial interest in those assets. Contribution revenue and a receivable should be measured at the present value of the estimated future distributions expected to be received by the organization over the expected term of the agreement.

Recognition during the agreement's term. In some cases, the organization obtains new information about the split-interest agreement that will have an impact on the accounting for the transaction. For example, the donor's life expectancy may change. When such a situation arises, the not-for-profit organization should add a caption to its statement of activities entitled “Changes in the Value of Split-Interest Agreements.”

The changes currently are classified as temporarily restricted, permanently restricted, or unrestricted net assets (net assets with donor restrictions and net assets without donor restrictions upon implementation of ASU 2016-14). This is dependent on the original classification used when the contribution was initially recorded.

When the organization is the trustee or fiscal agent for the agreement, income earned on the controlled assets, gains and losses, and distributions made to the other beneficiaries under the agreements should be reflected in the organization's statement of financial position, activities, and cash flows.

Amounts should be reclassified from temporarily restricted net assets to unrestricted net assets as distributions are received by not-for-profit organizations under the terms of split-interest agreements, unless those assets are otherwise temporarily restricted by the donor. In that case, they should be reclassified to unrestricted net assets when the restrictions expire.

Recognition upon termination of agreement. Upon termination of a split-interest agreement, asset and liability accounts related to the agreement should be closed. Any remaining amounts in the asset or liability accounts should be recognized as changes in the value of split-interest agreements and classified as changes in permanently restricted, temporarily restricted, or unrestricted net assets, as appropriate. If assets previously distributed to the not-for-profit organization become available for its unrestricted use upon termination of the agreement, appropriate amounts should be reclassified from temporarily restricted to unrestricted net assets.

Financial Statement Presentation

Assets and liabilities recognized under split-interest agreements should be disclosed separately from other assets and liabilities in a statement of financial position or in the related notes. Contribution revenue and changes in the value of split-interest agreements recognized under such agreements should also be disclosed as separate line items in a statement of activities or in the related notes. The notes to the financial statements should include the following disclosures related to split-interest agreements:

• A description of the general terms of existing split-interest agreements;
• The basis used (for example, cost, lower of cost or market, fair market value) for recognized assets;
• The discount rates and actuarial assumptions used in calculating present values.

Examples of Split-Interest Agreements

The following are the most common types of split-interest agreements:

• Charitable lead trusts;
• Perpetual trusts held by third parties;
• Charitable remainder trusts;
• Charitable gift annuities;
• Pooled (life) income funds.

Charitable lead trust. Under a charitable lead trust, a donor establishes a trust naming a not-for-profit organization as a beneficiary. The organization's use of the assets may be restricted by the donor. Charitable lead trusts may take the following form:

• Charitable lead annuity trust. Under this type of charitable lead trust, the not-for-profit organization periodically receives a specific dollar amount from the trust.
• Charitable lead unitrusts. Under this type of charitable lead trust, the not-for-profit organization periodically receives a distribution of a fixed percentage of the trust's fair market value determined each year.

The accounting requirements for recording a charitable lead trust agreement depend on whether the not-for-profit organization is the trustee or otherwise controls the assets.

Third party is trustee. An organization should initially record a contribution receivable and contribution revenue for the present value of the future benefits expected to be received from the trust. During the term of the agreement, the organization should record distributions as reductions of the contribution receivable account, rather than as contribution revenue.

The organization should also amortize the discount on the present value of expected benefits by increasing its contribution receivable balance and recognizing the change in value of split-interest agreements on its statement of activities (an increase or decrease in net assets).

If the estimated value of future benefits changes at some point during the term of the agreement, the organization should adjust its contribution receivable balance to reflect the change and record either a debit or credit to the change in value of split-interest agreements account as appropriate. When the trust terminates, the organization should adjust its remaining contribution receivable balance to zero and record a corresponding debit to the change in value of split-interest agreements accounts.

Split-Interest Agreements with Embedded Derivative Instruments

The FASB's Derivatives Implementation Group addressed the issue of embedded derivatives in split-interest agreements, which guidance is continued in FASB ASC 958-30-05. The first thing the reader should understand is that not every split-interest agreement will have what is defined as an embedded derivative. In fact, several of the exceptions to requirements of GAAP for derivatives that will be described below will likely result in only a relatively small portion of all split-interest agreements being considered to have embedded derivatives. However, because these types of agreements can take on any number of different terms and structures, it's important to understand when the requirements for derivatives would apply so that the concepts can be applied to various different types of split-interest agreements.

The reason that it is important to know whether there is an embedded derivative in a split-interest agreement that is subject to the GAAP requirements for derivatives is that the accounting for liabilities in such split-interest agreements as derivatives would differ from that described in the AICPA Audit Guide. A not-for-profit organization's obligation to make specified cash payments to a designated beneficiary or to convey the remaining assets to the donor or the donor's beneficiary under an irrevocable split-interest agreement is recognized as a liability by the not-for-profit organization. The AICPA Audit Guide requires that the discount rate used in estimating the present value of future expected payments to the beneficiary be determined at the time the contribution is initially recognized and this rate is not revised subsequently. For liabilities recognized under irrevocable split-interest agreements to which derivative accounting applies because there is an embedded derivative, the fair value of the liability would need to be calculated and recognized at the end of each reporting period.

Determining if a split-interest agreement contains a derivative instrument. The first step in determining whether the not-for-profit organization has a liability that must be accounted for as a derivative is to determine whether the agreement is period-specific or life-contingent. GAAP requirements for derivatives exclude from their scope contracts that are basically insurance-related where the payment of a benefit is a result of an identified insurable event, such as the death of an identified individual. For example, if the obligation is solely life-contingent (that is, contingent upon the survival of an identified individual, in which case the payments are only made if the individual is alive when the payments are due), that obligation would qualify for an exception, and not need to be accounted for under the requirements for derivatives.

The second step in determining whether the not-for-profit organization has a liability that must be accounted for as a derivative is to determine whether or not the obligation meets the definition of a derivative instrument in its entirety. Chapter 29 provides information for determining whether an arrangement meets the definition of a derivative financial instrument in its entirety. However, GAAP points to one of the criteria for identifying a derivative financial instrument that would not likely be met. This criterion requires the contract to have no initial investment or an initial investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. In a typical split-interest agreement, the initial net investment for the liability recognized is its fair value, meaning it would not meet the criterion for being a derivative financial instrument in its entirety.

The third step is to determine whether the split-interest agreement meets the definition of an embedded derivative financial instrument, using the criteria contained in FASB ASC 815-15-25. One of the criteria is that the economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract. Split-interest agreements with fixed payments would not meet this criterion and would not be subject to the accounting requirements for derivatives. Split interest agreements with variable payments would likely meet this criterion, providing they do not qualify for the life-contingent exception described above.

To summarize the GAAP requirements, the liability representing an obligation under a split-interest agreement contains an embedded derivative that warrants separate accounting if the payments are variable and the agreement is period-certain (rather than life-contingent). GAAP contains a number of examples for both charitable remainder trusts and charitable lead trusts that would be helpful in applying this guidance to various situations. The following example provided for a charitable remainder trust with period-certain, variable payments would be helpful in understanding some of the basic concepts described above.

In this example, shares of common stock are contributed to the control of a not-for-profit organization. The not-for-profit organization is required to make twenty annual cash payments to the donor or the donor's beneficiary that are equal to a specific percentage of the fair value of the assets at the beginning of each annual period. After the twenty payments have been made, the remaining shares will revert to the not-for-profit organization. During the term of the agreement, the not-for-profit organization has a liability that contains an embedded derivative which warrants separate accounting (i.e., it must be bifurcated). This example is that of a hybrid instrument composed of:

• A debt host contract.
• An embedded equity-based derivative that is not clearly and closely related to the debt host contract and that would meet the definition of a derivative if it were freestanding.

The embedded equity-based derivative would meet the definition of a derivative if it were freestanding because

• It has an underlying (which is the price of shares).
• It has a notional amount (number of shares in the trust at the beginning of each period).
• It satisfies the no-or-smaller initial net investment characteristics.
• It satisfies the net settlement characteristics because each annual payment is adjusted for the effect of the equity-based derivative.

The debt host agreement represents the liability for a series of twenty annual payments that would be required based on the assumption that the fair value of the common stock does not change over the twenty-year period. The embedded equity-based derivative relates to the increase or decrease in each of the twenty annual payments due to changes in the fair value of the common stock.

The above discussion cannot be all-inclusive for every situation since split-interest agreements can be structured in many different ways. However, these basic concepts should assist the reader in identifying the considerations that must be made in determining whether a particular split-interest agreement would have aspects of its liability that would be subject to the requirements of accounting for derivatives.