Valuation of Long-term Pledges in an Inflationary Environment

Not-for-profit accounting insights for long-term promises to give

The rising interest rate environment has ripple effects throughout the economy, including significant impacts to the not-for-profit sector. One such impact is in the valuation of promises to give.

When a not-for-profit organization receives a long-term unconditional promise to give cash, commonly referred to as a pledge, it should report the promise to give as a contribution and a receivable at fair value. There are various methods to estimate fair value; one of the most often used is the discounted cash flow method, in which an organization calculates the present value of a future steam of cash flows.

This methodology of calculating fair value requires the organization to determine a discount rate to use in the calculation. In a period of rising interest rates, discount rates used in such estimates will likely increase as well. The effect is that a promise to give is worth less today than it would have been a year or two ago.

While this may be straightforward for new pledges, many organizations are unsure of what to do with long-term pledges that originated in prior years, when interest and discount rates were at historically low levels. Treatment depends on whether the organization has elected the fair value option to measure its promises to give.

The fair value option

The fair value option allows an organization to measure certain eligible financial instruments at fair value, with changes in the fair value being recognized in the statement of activities. However, organizations can only elect the fair value option at certain dates. The decision to elect the fair value option is applicable on an instrument-by-instrument basis, applied to the entire instrument, and is irrevocable unless a new election date occurs.

Eligible items for the fair value option include recognized financial assets and financial liabilities, except:

• Investments in other entities that must be consolidated;
• Obligations for pension benefits, other postretirement benefits, postemployment benefits, and other forms of deferred compensation arrangements;
• Most financial assets and liabilities recognized under leases;
• Deposit liabilities that are withdrawable on demand from a depository institution; and
• Financial instruments that are classified by the issuer as a component of equity.

Contributions receivable are eligible for measurement using the fair value option. There are only certain times when an organization may elect to apply the fair value option:

1. The first recognition of the eligible item;
2. Entry into an eligible firm commitment;
3. Specialized accounting principles that required or permitted assets to be reported at fair value cease to apply;
4. The accounting treatment for an investment in another entity changes because it is now eligible for the equity method of accounting; or
5. Events that require fair value measurement for eligible items at the event date, such as business combinations or consolidation of an entity.

The fair value option cannot be simply applied when convenient for the organization; the organization should be consistent in how it applies the fair value option to its financial instruments.

When is the fair value option not applicable to your nonprofit organization?

If the organization has not elected to use the fair value option, it should not revise the discount rate used in its calculation of the present value of long-term promises to give and should not remeasure the present value of long-term promises to give. Any discount recognized at the time of the contribution should be amortized through the date of receipt using the interest method.

When should your nonprofit organization apply the fair value option?

If the organization has elected the fair value option for recording long-term promises to give cash, it should remeasure the value of the asset at every reporting period, including revision of the discount rate to match market conditions. Any unrealized gains or losses should be recognized in the current year statement of activities.

Conclusion

There were long periods of historically low interest rates; that time appears to have passed, at least for the moment. Not-for-profit organizations should be fully aware of the impact increased interest rates have on their financial statements, including the valuation of long-term promises to give cash. It may also impact the valuation of other items in a not-for-profit organization’s financial statements.

Interested in learning more about the accounting and reporting impact of rising interest rates on your not-for-profit organization? Contact your Keiter Opportunity Advisor today by email | call 804.747.0000.