An endowment turns a few lines of a gift agreement into a multi-year accounting obligation. The auditor has to read the instruments, test the classification of every dollar of investment return, and make sure the footnote tells the same story as the spending policy the board actually follows.
This guide covers the endowment-specific work on a nonprofit audit. For the wider framework, see our posts on nonprofit financial statements under ASC 958 and contributions and grants.
Know which kind of fund you have
Start by sorting every fund into one of two groups, because the rules differ:
- Donor-restricted endowment funds. The donor required the gift to be invested in perpetuity, or for a stated term, with some or all of the return available for a purpose. These are the funds subject to the state's version of the Uniform Prudent Management of Institutional Funds Act (UPMIFA) in most states.
- Board-designated endowments. Also called quasi-endowments or funds functioning as endowment. The organization's own unrestricted money, set aside by the board and managed like an endowment. The board can undo the designation, so these remain net assets without donor restrictions.
UPMIFA is a model law adopted in most, but not all, states. Establish early which law governs each fund and whether the gift instrument selects one. The state statute, not the model act, is what the board interprets.
How the accounting works
Three rules drive the audit.
Classification of the corpus and the return. The original gift, later gifts to the fund, and investment returns on the fund stay in net assets with donor restrictions until the board appropriates them for expenditure. Return that has not been appropriated carries an implied time restriction.
Release. The time restriction lifts only when, and to the extent that, the board appropriates the return after weighing the prudence factors in the governing law. If the gift also carries a purpose restriction, the purpose still has to be met before the amount is released to net assets without donor restrictions.
Underwater funds. When the fair value of a donor-restricted endowment falls below the original gift amount or the amount the donor or law requires be maintained, the shortfall is reported within net assets with donor restrictions, not as an unrestricted loss. FASB made this change in ASU 2016-14. UPMIFA replaced the older bright-line historic dollar value test with a prudence standard, so an underwater fund is not automatically closed to spending, but the board must have a documented basis for any appropriation.
Risk areas
- Misread gift instruments. Wording such as "income only," "to be used for the library" or "so long as the school operates" decides the class. Auditors who rely on the development office's summary instead of the instrument miss restrictions.
- Return classified by the wrong rule. Appreciation recorded as unrestricted because it was spent, or because the investment accounting system lumped it with operating funds.
- Board-designated funds treated as donor-restricted, or the reverse. Either error misstates net asset classes and the endowment note.
- Underwater funds omitted or netted. Deficiencies offset against funds with surpluses in the footnote rather than aggregated as required.
- Appropriations without a record. Spending from the endowment that exceeds what the board approved, or that has no minutes behind it.
- Spending policy that differs from practice. The footnote describes one policy and the general ledger shows another.
Audit procedures
- Read every endowment instrument for new gifts and for any changed terms, and compare each to the fund listing the client maintains. Reperform the classification of a sample of funds from the instrument.
- Obtain the governing law and the board's interpretation. Obtain the board resolution or policy that states how it reads the statute, and compare it to the disclosure.
- Test the endowment rollforward by fund or fund group: beginning balance, contributions, investment return, appropriations, fees and ending balance. Agree the ending balance to the custodian statements, and confirm investments in line with AU-C 505 where the custodian can respond.
- Test appropriations. Vouch each appropriation to board or committee approval and compare to the written spending policy. Recompute the amount the policy produces for the year and explain any difference.
- Test release from restriction. For each appropriated amount, show that the purpose was met before it moved to net assets without donor restrictions.
- Compute underwater status fund by fund. Compare year-end fair value with the original gift amount plus additions, or the level the donor or law requires be maintained. Agree the aggregate to the note.
- Test fees and expenses charged to the fund and their presentation within investment return.
- Read the disclosures against the checklist below.
Required endowment disclosures
For a nonprofit with endowment funds, the endowment note must cover the following (ASC 958-205-50):
- Net asset classification and composition, and changes in composition.
- Spending and investment policies, including return objectives, risk parameters and strategies.
- The board's interpretation of the governing law.
- Endowment composition at period end, shown separately for donor-restricted and board-designated funds.
- A reconciliation of beginning and ending balances, including investment return, contributions, amounts appropriated and other changes.
For underwater funds, ASC 958-205-50 requires, in the aggregate, the fair value of the funds, the amount required to be maintained and the resulting deficiency, along with the policy on appropriating from underwater funds and any actions taken during the period.
Worked example
A foundation holds a donor-restricted fund created with an original gift of $1,000,000 (illustrative numbers). Over several years the fund earned returns that the board appropriated and spent, and at year end the investments are worth $940,000.
- The fund is underwater by $60,000 ($1,000,000 less $940,000).
- The $60,000 deficiency is presented within net assets with donor restrictions. It is not charged to net assets without donor restrictions.
- The note reports, in aggregate across all underwater funds, a fair value of $940,000, a required maintenance amount of $1,000,000 and a deficiency of $60,000. If the foundation has a second underwater fund, its amounts are added to these three lines.
- The board has appropriated $35,000 of spending from the fund for the following fiscal year. The audit file holds the board minutes showing that it weighed the prudence factors in the state statute, the policy rate applied, and a memo explaining why spending from an underwater fund is consistent with the board's interpretation of the law.
PBC items
- Fund listing with classification, original gift amount and governing instrument for each fund.
- Copies of gift agreements, letters and bequest documents.
- Board-adopted spending policy and investment policy, and the board's interpretation of the governing law.
- Board and committee minutes covering appropriations.
- Custodian and manager statements at year end, reconciled to the general ledger.
- Endowment rollforward by fund, with fee detail.
- Underwater fund schedule.
- Draft endowment note.
Red flags
- Spending from a fund that exceeds both the policy and the board's approval.
- Gift instruments that are not on file or are summarized only in emails.
Frequently asked questions
What is the difference between a donor-restricted and a board-designated endowment?
A donor-restricted endowment carries a requirement from the donor that the board cannot override. A board-designated endowment is the organization's own money that the board chose to treat as an endowment. Board-designated funds are net assets without donor restrictions.
Where do underwater losses go?
Within net assets with donor restrictions, together with the fund, under ASC 958-205 as amended by ASU 2016-14.
Can a nonprofit spend from an underwater fund?
UPMIFA moved from a fixed historic dollar value floor to a prudence standard, so the board can appropriate if it documents that spending is prudent under the statute and the gift terms. State versions differ, so the audit file should quote the enacted text that applies.
Sources
- FASB, ASU 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities, storage.fasb.org/ASU_2016-14.pdf
- FASB ASC 958-205, Not-for-Profit Entities, Presentation of Financial Statements (endowment classification and disclosure)
- AICPA, AU-C Section 505, External Confirmations
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