AUDITING

DEALING WITH THREE DIFFERENT STANDARDS ON INVESTMENTS

By Bruce W. Chase and Nathan J. Kranowski

Many auditors have a varied list of clients that include not only diverse business organizations, but also not-for-profit and governmental organizations. When it comes to investments, both the FASB and GASB have relatively new accounting standards. There are now three separate standards governing how business, not-for-profit, and governmental organizations account for investments.

Business Organizations

Auditors have gone through the transition to SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, for business organizations. This standard requires the reporting of investments based largely on management intent that classifies investments into three categories, "held-to-maturity," "trading," and "available-for-sale."

Held-to-maturity securities are reported at amortized costs. Available-for-sale and trading securities are reported at fair value. However, the changes in value are reported differently for the two categories. Changes in value for trading securities are reported as part of earnings while changes in value for available-for-sale securities are reported as a separate component of stockholders' equity.

Not-for-Profit Organizations

SFAS No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, is effective for fiscal years beginning after December 15, 1995. This standard requires not-for-profit organizations to report debt and equity securities at fair value. Changes in value are reported as either increasing or decreasing net assets in the statement of activity. Institutions are given a great deal of flexibility in reporting items in the statement of activity. For example, part of investment earnings can be reported as operating and part as nonoperating. Institutions can also separate realized and unrealized gains and losses.

One of the more controversial aspects of SFAS No. 124 is the requirement that gains and losses be reported as unrestricted unless their use is temporarily or permanently restricted by explicit donor stipulation or by law. For many organizations, gains and losses on endowment funds are now considered unrestricted.

Governmental Organizations

The newest standard that auditors must work with was issued by GASB in March 1997 and is effective for fiscal years beginning after June 15, 1997. GASB Statement No. 31, Accounting and Financial Reporting for Certain Investments and for External Investment Pools, requires governmental entities to account for debt and equity securities at fair value with the exception of certain short-term debt instruments and nonparticipating interest-earning investment contracts (such as nonnegotiable certificates of deposit). Money market investments and participating interest-earning investment contracts that have remaining maturities of one year or less at time of purchase may be accounted for at amortized costs. Nonparticipating interest-earning investment contracts or debt instruments should be reported using a cost-based measure, unless the fair value of the contract is significantly affected by other factors. The standard also provides additional guidance for external investment pools that are not discussed in this article.

All investment income, including changes in fair value, should be reported as revenue in the operating statements of the funds. The standard allows for reporting changes in fair value separately from other investment income. However, realized gains and losses should not be reported separately from unrealized gains and losses. Unless there are legal or contractual provisions to the contrary, investment income, including changes in fair value, should be reported in the fund owning the investment. Public colleges and universities that elect to follow the AICPA Audit Guide, Audits of Colleges and Universities, and certain governmental entities that follow AICPA not-for-profit models are exempt from recording investment income in the fund owning the assets.

Major Differences

There are several major differences among the three standards on investments. One of the most significant differences concerns investments that may be reported at amortized costs (see Exhibit 1). Business organizations report debt securities classified as held-to-maturity at amortized costs. In contrast, not-for-profit and governmental organizations account for most investments at fair value. However, governmental organizations may use amortized costs to report certain short-term money market investments and participating interest-earning investment contracts. Not-for-profit organizations report all debt securities at fair value.

Governmental organizations should also use a cost method to report nonparticipating interest-earning investment contracts such as nonnegotiable certificates of deposits. Typically, nonparticipating interest-earning investment contracts do not meet the definition of securities and are also reported on a cost basis by business and not-for-profit organizations.

A second major difference is how investment earnings, including changes in fair value, are to be reported for the three types of organizations (see Exhibit 2). All three types of organizations include dividends and interest and realized gains and losses in reporting current year activity. Business organizations include only changes in fair value for trading securities in their earnings. Both not-for-profit and governmental organizations include changes in fair value for all investments reported at fair value in their statements of activities.

Governmental organizations are required to report interest, dividends, and realized and unrealized gains and losses as revenues. Change in fair value may be reported separately from other investment income, but realized and unrealized gains and losses cannot be reported separately. Not-for-profit organizations have a significant amount of flexibility in reporting activity and can separate items between operating and nonoperating. They may also report realized and unrealized gains and losses separately.

Not-for-profit and governmental organizations take different approaches regarding where investment earnings (dividends, interest, and gains and losses) are recorded. Not-for-profit organizations record investment earnings as unrestricted unless their use is temporarily or permanently restricted by explicit donor stipulations or by law. Governmental organizations take the other approach. Investment earnings are recorded by the fund owning the asset, unless other treatment is specified by legal or contractual provisions. For example, assuming there are no donor or legal provisions, dividends and interest, realized and unrealized gains and losses from an endowment fund are considered to be unrestricted for a not-for-profit organization. A governmental organization would add such investment income to the endowment fund.

There are some important differences among the three standards with respect to required financial statement disclosures (see Exhibit 3). The standard for business organizations is focused on disclosing distinctions between unrealized and realized gains and losses. It emphasizes separate disclosure of gross amounts of unrealized holding gains and losses for held-to-maturity and available-for-sale securities. It also requires disclosure of realized gains and losses and resulting effects on net unrealized holding gains and losses.

On the other hand, the not-for-profit and governmental standards stress disclosure of methods and assumptions used to estimate fair value of investments. The governmental standard also requires disclosing the policy used to reported investments at amortized cost. The not-for-profit standard is concerned with any deficiencies (asset fair value is less than the level required by law or donor) in donor restricted endowments, and requires the aggregate amounts of such deficiencies be disclosed. *

Bruce W. Chase, CPA, PhD, is associate professor of accounting at Radford University and is director of the university's Center for Governmental and Nonprofit Accounting. Nathan J. Kranowski, CPA, PhD, is associate professor of accounting at Radford University.

Editor:
Douglas R. Carmichael, PhD, CPA
Baruch College