This article was written by Andrew J. Kelly, CPA, Manager
Most organizations that held investments in 2022 experienced declines in the value of their portfolio. This is no surprise if you look at some of the year-over-year trends in major stock market indices:
As a result, in most cases, tax-exempt organizations are recognizing significant investment losses. But those organizations with donor restricted endowments may also find that their endowments are “underwater” at the end of 2022. This situation comes with additional reporting requirements. Based on market performance the last few years, this is likely a concept that has received little attention in recent years, so it is important to brush up how to make sure you are meeting your fiduciary responsibilities.
For organizations in New York State, endowments are governed by the New York Prudent Management of Institutional Funds Act (NYPMIFA), which is New York State’s enacted version of the Uniform Prudent Management of Institutional Funds Act (UPMIFA). These acts were put in place to provide guidelines and structure for charitable entities’ investment management and spending of endowment funds. Although NYPMIFA and UPMIFA have a few key differences, one consistency in the two acts is an emphasis on preserving the purchasing power of the donor’s original endowment gift.
An endowment is underwater when the fair value of assets associated with an individual donor restricted endowment fund falls below the donor’s original gift. To illustrate:
Donor gift amount - $1,000,000
Fair value at 12/31/22 – $950,000
Underwater amount at 12/31/22 – ($50,000)
This is required to be tracked at the individual donor restricted fund level rather than the endowment fund as a whole. Therefore, it is highly likely that if you received and invested endowment gifts in early 2022, those specific endowed gifts were underwater at the end of 2022. If your internal tracking of endowments is not detailed enough to identify such instances, it is likely that you are not satisfying the standards of prudence set forth under NYPMIFA.
If you find your organization in a situation with endowments that are underwater, this does not automatically mean you are in violation of NYPMIFA. However, it is important to have policies in place for these types of situations. For example, you should have a policy in place relative to spending from underwater endowments. Some organizations have a policy that excludes any underwater endowments from its annual endowment spending draw, or a policy that applies a lower percentage to underwater endowments when calculating the annual endowment spending draw. These are policies that should be discussed at the governance level and should be formalized in writing as part of your overall endowment investment and spending policies.
Financial Statement Reporting and Disclosures:
Financial Accounting Standards Board ASU 2016-14 became effective for calendar year2018 non-profit financial statements. This was a significant overhaul for non-profit financial statement reporting. You may remember it as the one that converted “unrestricted net assets” to “net assets without donor restrictions” and combined “temporarily restricted” and “permanently restricted net assets” into “net asset with donor restrictions.” This is also the standard that created the “liquidity” footnote. These two changes were the most noteworthy aspects of ASU 2016-14, however, there were several more subtle changes. One those was a change to reporting and disclosures surrounding underwater endowments. Since ASU 2016-14 became effective, nonprofits are required to disclose in their financial statements the aggregate amount by which endowment funds are underwater. This disclosure includes the original gift amount and policies/decisions related to spending (or not spending) from those funds. Again, this is calculated at the individual endowment gift level, but disclosed in the aggregate, as illustrated in the example footnote disclosure below.
Additionally, the extent to which endowments are underwater is required to be reported as a reduction of net assets with donor restrictions. Prior to ASU 2016-14, such deficiencies would have been reported as unrestricted net assets.
The AICPA provides a sample footnote disclosure for underwater endowments (AICPA - CPEA ASU 2016-14) as follows:
“Note C – Underwater Endowments"
From time to time, the fair value of assets associated with individual donor restricted endowment funds may fall below the level that the donor or the Uniform Prudent Management of Institutional Funds Act (UPMIFA) requires Metropolis Hospital to retain as a fund of perpetual duration. Deficiencies of this nature exist in 3 donor-restricted endowment funds, which together have an original gift value of $3,500, a current fair value of $3,300, and a deficiency of $200 as of June 30, 2017. These deficiencies resulted from unfavorable market fluctuations that occurred shortly after the investment of new contributions for donor-restricted endowment funds and continued appropriation for certain programs that was deemed prudent by the Board of Trustees.
Metropolis Hospital has a policy that permits spending from underwater endowment funds depending on the degree to which the fund is underwater, unless otherwise precluded by donor intent or relevant laws and regulations. The governing board appropriated for expenditure $75 from underwater endowment funds during the year, which represents 3 percent of the 12-quarter moving average, not the 5 percent it generally draws from its endowment.”
Ensure your endowment recordkeeping is at a level of detail that is sufficient to track endowments at the individual endowment gift level. Ensure your endowment policies and procedures are robust, in writing and include verbiage relative to underwater endowments. If you find that you have underwater endowments, ensure your accounting and footnote disclosures are in accordance with ASU 2016-14.
If you need further guidance or have any questions on the impact of underwater endowments on your financial statements, we are here to help. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.