What is an endowment? Concise overview
Posted by: V.Weber
An endowment is an established fund of cash, securities, or other assets to provide income for the maintenance of a not-for-profit organization. The use of assets of the fund may be with or without donor-imposed restrictions. Endowment funds generally are established by donor-restricted gifts and bequests to provide a source of income in perpetuity or for a specified period. Alternatively, a nonprofit governing board may earmark a portion of its net assets as a board-designated endowment fund.
Type of Endowments
Endowments exist to help the preservation of a nonprofit organization; the funds are set aside to help the nonprofit to stay afloat over the years. There typically three types of endowments:
- Permanent endowments
- Quasi endowments
- Term endowment
In a permanent endowment (also known as “true” endowment) a gift’s original funding has to be kept intact and maintained in perpetuity. An example would be when a large sum of money was donated to a charity via will and the corpus of the funds are restricted to being maintained in perpetuity in investments with the income generated used for charity operations. Hence, this would be an income with donor restrictions.
Quasi endowment is something that is typically set up by the board or management. Hence these would be net assets without donor restrictions.
Term endowments are typically endowments with donor restrictions for a certain period of time. For example, a donor could provide a large sum of funds to a nonprofit organization specifying that the corpus of the donation is to be kept for a period of 10 years. This type of endowment would be a term endowment and would therefore be classified as with donor restrictions.
Key accounting factors when accounting for endowments
The key factor to understanding how to account for endowments is evaluating three parts that are typically involved in an endowment separately. Those three parts are:
- Original gift
- Gains and losses
- Interest and dividends
For an example the corpus of the original gift might need to be kept in perpetuity, but the interest and dividends might be able to be used for a specific purpose. As such, each of the three parts would need to be evaluated separately to determine a proper accounting method for each.
History of Endowments
In 1972 Uniform Management of Institutional Funds Act (UMIFA) was approved by the National Conference of Commissioners on Uniform State Laws (NCCUSL). The purpose of UMIFA was to remove uncertainties about nature and power of governing boards in area of investment management.
The act provides:
- Prudent use of appreciation
- Board’s investment authority including permission to invest in stocks
- Board’s right to delegate investment management
- Board can act similar to corporate board versus trustee
- Can sometimes release donor-imposed restrictions
UMIFA has created a concept of historic dollar value (HDV). HDV is the dollar amount of the original gift. For example, a donor provides a permanent endowment of a $1,000,000 to a charity – under UMIFA, the charity is not allowed to spend that $1,000,000. So, in this case $1,000,000 would be the amount of the historic dollar value. If there is any appreciation of that amount, then the charity has to evaluate based on donor restrictions (if any) whether they can spend the funds that are appreciated.
This law was in effect until 2006, when an updated version of the law was passed by NCCUSL – Uniform Prudent Management of Institutional Funds Act (UPMIFA). This updated law applies only to donor-restricted funds, and it does not apply to board designated funds. There is some variability state by state when it comes to interpretation of UPMIFA.
The main update of UPMIFA (p – stands for prudent) – is more of a long-term vision for the permanent endowments. It allows for appropriate prudent expenditure:
“May appropriate for expenditure or accumulate so much of an endowment funds as the institution determined to be prudent for the uses, benefits, purposes and duration for which the endowment fund is established.”
What is does essentially it allows not-for-profit organizations to set up some sort of spending policy. Typically, an analysis is done by performing a look back analysis, where the management and the board is looking back at about 3 years to see what amount of income has been generated from the corpus. For example, the average income produced over the past 3 years was 10%. The organization can set up a predetermined amount of 5% to spend those funds. This allows the organization to spend from these net assets that are permanently restricted (net assets with donor restricted). As such, the amount of appropriations from the endowment fund reduces net assets with donor restrictions.
If you would like to download the final act – please visit the official website of the Uniform Law Commission here.
What is underwater endowment?
This happens when a donor’s original gift that was invested for example in stock market and if the stock market was not performing as it was expected, the value of the investment can decrease below the original gift value, generating a loss in this way and become an underwater endowment. For example, a donor’s original endowment gift was $1,000,000 and due to a market downturn, its value decreased to $700,000. The difference of $300,000 would be a deficit to net assets with donor restrictions. Withing the notes to the financial statement an appropriate disclosure would need to be made showing the original endowment value, the decrease in value and the current value of $700,000. The spending policy would also have to be disclosed as well as the plans on the spending policy in the near future (whether the endowment will be held further until it is back in the positive balance etc.)
Conclusion
In this article we briefly reviewed some of the key factors related to endowments. This topic is very deep and has a lot of nuances to it, navigating the world of endowments can be a quite complex task. Is it of paramount importance to have proper accounting for endowments and endowment-related transactions for financial statements presentation. If you need additional guidance on this topic – be on the lookout for future articles related to this topic. If you need help with not-for-profit accounting from a not-for-profit CPA – do not hesitate to contact us directly. At WCC we specialize in not-for-profit accounting, and it is our mission to help mission-based organizations to achieve their mission.