January 2003

Accountants’ Responsibilities and the New York State Attorney General’s Charities Bureau

By William Josephson, Assistant Attorney General-in-Charge, Charities Bureau

New York State Attorney General Eliot Spitzer considers public education a most important part of his responsibilities. The Attorney General’s Charities Bureau has offices in Albany and New York City, and many of the Attorney General’s 13 regional offices employ lawyers with expertise in philanthropic law.

The Charities Bureau’s publications and forms can be found online at www.oag.state.ny.us/charities.They cover charities registration and reporting, professional fund-raising, and various transactions that affect charities.

The Charities Bureau has recently published a booklet, “The Regulatory Role of the Attorney General’s Charities Bureau,” that describes the scope of the bureau’s jurisdiction. It is available from the website or by request. At present, the Charities Bureau’s annual financial report review resources are limited, but the IRS, Guidestar, and the Urban Institute’s National Center for Charitable Statistics are working with state charities regulators in Pennsylvania, New York, and other key states to establish an information-sharing network for IRS Form 990 data. Pennsylvania has launched a pilot program, and New York hopes to follow by April 2003.

One way this effort will benefit charities and their accountants will be electronic filing of forms and, eventually, electronic payment of registration and annual filing fees. The Charities Bureau should benefit by being able to screen filings for key indicators and review more filings for accuracy than currently possible with 40,000 annual paper filings.

Endowment Fund Guidance

Recently updated guidance available at www.oag.state.ny.us addresses the historic dollar value of endowments and similarly restricted funds held by not-for-profit corporations. Donors may restrict the use of assets contributed to a not-for-profit corporation or charitable trust. In the rare case where the restriction is illegal or impracticable, the charity may obtain the consent of a living donor to release the restriction or, in other cases, may apply to the court, on notice to the Attorney General, for a release of the restriction.

A commonly imposed restriction prevents a charity from spending principal, thereby creating an endowment fund. Section 102(a)(13) of the not-for-profit corporation law provides that an endowment is “not wholly expendable by the corporation on a current basis.”

Properly invested, an endowment fund can generate significant appreciation, both realized and unrealized. Section 513(c) of the not-for-profit corporation law states that the value of endowment assets when given to a not-for-profit corporation, known as the historic dollar value, may not be expended by the corporation. Instead, the assets must be invested and the income—traditionally interest, dividends, rents, and royalties—is available for expenditure, even if the value of the principal drops below historic dollar value because of realized investment losses or unrealized declines in market values or both. If the endowment fund principal has depreciated below the historic dollar value, however, the board of directors of the corporation may prudently determine not to expend income or to reduce expenditures until the historic dollar value is restored, if such actions are consistent with the gift instrument. Similarly, in inflationary times, it may be prudent for the board to adjust the historic dollar value of an endowment fund upward to maintain its buying power.

In addition, if the value of the assets has appreciated over the historic dollar value, the net appreciation, realized (with respect to all assets) and unrealized (with respect only to readily marketable assets), may be appropriated for expenditure, unless prohibited by the donor in the applicable gift instrument. The law permits the corporation’s board of directors to appropriate these amounts if such a decision is prudent under the standard established by the law. Thus, officers, directors, and managers of New York State not-for-profit corporations should be aware that, even if the applicable gift instrument permits the expenditure of endowment fund appreciation, it cannot be expended unless the governing board appropriates the appreciation prudently.

To define prudence, section 717(a) of the not-for-profit corporation law requires a governing board to “consider among other relevant considerations the long and short term needs of the corporation in carrying out its purposes, its present and anticipated financial requirements, expected total return on its investments, price level trends, and general economic conditions.” In addition, section 513(b) requires the corporation’s treasurer to make an annual report to the board concerning the administration and use of the assets in each of the endowment funds held for specific purposes, and the income from such assets. The board should review all relevant information, including the treasurer’s annual reports under section 519(a)(2) and audited financial statements. The board should deliberate and vote on whether and to what extent to appropriate endowment appreciation for expenditure. Deliberations and decisions of the governing board should be thoroughly documented.

General purpose financial statements of not-for-profit corporations, prepared in accordance with GAAP, account for endowment appreciation as unrestricted net assets (or temporarily restricted net assets, if the fund is for a specific purpose). Officers, directors, other corporate managers, and accountants should be aware that even though such amounts are recorded as unrestricted (or temporarily restricted), these amounts are available for expenditure only in accordance with the provisions discussed above.

The not-for-profit corporation law does not appear to authorize the aggregation of endowment funds for purposes of appropriation for expenditure under section 513(c). Indeed, the law’s reference to an endowment fund in section 513(c) indicates that appreciation available for appropriation is determined on an endowment fund-by-endowment fund basis. This conclusion is also supported by the references in sections 513(b), (c), and (d) to “applicable gift instrument.” Generally, a gift instrument applies to only one endowment fund. This conclusion is also supported by the definitions of “endowment fund,” “gift instrument,” “historic dollar value,” and “institutional fund,” in sections 102(a)(13), (14), (16), and (17), respectively.

Thus, when there is a general decline in market values, the application of a total return spending policy, which provides for the annual expenditure of a percentage of the total net assets of a not-for-profit corporation’s endowment fund or funds, could well conflict with the obligation to preserve the historic dollar value of each endowment fund. In such circumstances, only prudently appropriated appreciation above the historic dollar value of a particular endowment fund and endowment fund income would be available for expenditure.

With regard to charitable trusts, in contrast to not-for-profit corporations, New York recently replaced the Principal and Income Act, EPTL sections 11-2.1, with Article 11-A, the New York Uniform Principal and Income Act. The bureau is preparing guidance on endowment issues for charitable trusts, which will appear on its website when completed.

Reporting Responsibilities

The February 21, 2002, Chronicle of Philanthropy published a letter titled “The Nonprofit World Is Ripe for an Enron-Like Debacle,” by Russy D. Sumariwalla, retired CEO of United Way International. Similarly, Henry Goldstein, in the February 7, 2002, Chronicle of Philanthropy, observed:

Boards rightly grumble because the financial information they need to make good decisions is not available sufficiently in advance of board meetings; and even sophisticated business people have trouble reconciling the general accounting principles they understand with arcane “fund accounting,” the bedrock of nonprofit bookkeeping.

Tardy financial reporting blindsides trustees and often results in nasty surprises. A good accountant will attach a letter to the audit effectively telling the nonprofit to clean up its act.

Nonetheless, many charities routinely seek extensions for filing with the federal and state governments, leaving their clients, regulators, and, most importantly, the public in the dark for too long. A July 2002 report of the State Commission of Investigations called upon the IRS and the Attorney General to cease routinely granting filing extensions.

One significant responsibility of the Charities Bureau is the review of major not-for-profit corporation transactions like mergers, consolidations, dissolutions, significant certificate of incorporation amendments, sales or other dispositions of assets, and mortgages of religious corporations. For example, while reviewing a proposed nursing home mortgage, it came to the bureau’s attention that the nursing home was not separately incorporated and was operated as a division of a not-for-profit corporation that had substantial unrelated philanthropic purposes. Yet, the corporation’s accountants had submitted audited financial statements for the nursing home operation, not for the not-for-profit as a whole, in apparent conflict with GAAP. The ensuing investigation revealed that the nursing home had a very substantial indebtedness to New York State that was not fully disclosed in the financial statements; that although the nursing home was operating at a deficit, the not-for-profit was using nursing home cash flow to finance other philanthropic activities; and that there were numerous financial transactions between the not-for-profit and some directors, officers, or other foundation managers that had not been appropriately documented or disclosed. As the bureau’s investigation ended, the not-for-profit decided to mortgage other real property and submitted the proposed new transaction to the Charities Bureau for review. This time the not-for-profit submitted financial statements audited by the same CPAs to a different proposed lender and the Charities Bureau that omitted the nursing home entirely, making no mention of the overall entity’s still substantial debt to the state, or the recent mortgage on the property devoted to the nursing home.

In another example, the Attorney General recently brought an action against the directors of a New York not-for-profit corporation, a private foundation for IRC purposes with net assets of approximately $10 million. The directors allegedly caused the foundation to pay themselves compensation and pension benefits that totaled $3.4 million over 10 years, an average of $56,000 per director per year. What responsibility do independent CPAs have to the public when auditing financial statements of such not-for-profits?

These examples are extreme, but the underlying behavior is not unusual. Many paid preparers of IRS Form 990PF for private foundations fail to check the self-dealing question “yes” and provide the required explanation for compensation and benefits paid to foundation managers. Instances of accountants’ filings that are not only late but years late, unsigned, undated, and unaccompanied by the required fees, are all too common. Accountants and other philanthropic professionals should be aware of the provisions of sections 520 and 521 of the not-for-profit corporation law:

Each domestic corporation, and each foreign corporation authorized to conduct activities in this state, shall from time to time file such reports on its activities as may be required by the laws of this state. All registration and reporting requirements pursuant to EPTL 8-1.4, or related successor provisions, are, without limitation on the foregoing expressly included as reports required by the laws of this state to be filed within the meaning of this section. Willful failure of a corporation to file a report as required by law shall constitute a breach of the directors’ duty to the corporation and shall subject the corporation, at the suit of the attorney-general, to an action or special proceeding for dissolution under article 11 (judicial dissolutions) in the case of a foreign corporation.

Section 521 on liability for failure to disclose required information reads as follows:
Failure of the corporation to comply in good faith with the notice or disclosure or reporting provisions of section 501 (stock and shares prohibited; membership certificates authorized), or paragraph (c) of section 503 (capital certificates), or paragraph (c) of section 505 (subvention certificates), or paragraph (b) of section 513 (administration of assets received for specific purposes), or section 518 (reports to comptroller) [section 518 has been repealed, but the cross-reference has not been corrected], or section 519 (annual report of directors), or section 520 (reports of corporation), shall make the corporation liable for any damage sustained by any person in consequence thereof.

Failure to prepare complete and accurate reports for charity clients could cause trouble with New York State, which cannot be good for the charities.

Some CPAs have suggested that the Attorney General formally complain to the accountants’ professional disciplinary bodies, such as the New York State Board for Public Accountancy, in cases where accountants have failed to comply with the law. The Attorney General does complain to the disciplinary committees of the bar, as lawyers are ethically obliged to do when they encounter significant unethical behavior on the part of fellow lawyers.

The NYSSCPA’s and AICPA’s codes of conduct require accountants to be professionally responsible for cooperating with each other to improve the art of accounting and maintain public confidence. They must be objective and independent. They must follow the requirements of governmental bodies and other regulatory agencies. They have a responsibility to ask themselves, “Have I retained my integrity?”

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