Endowment Accounting for Nonprofits: Classification and Disclosures

Endowment accounting for nonprofits comes down to one question asked over and over: did a donor impose the restriction, or did the board? FASB Accounting Standards Codification Topic 958 requires every net asset to fall into one of two classes based on the answer, and every downstream entry, spending decision, and disclosure follows from that classification.¹ Get the classification right and the rest of the framework is mechanical. Get it wrong and the financial statements misrepresent what the organization is actually allowed to spend.

The Three Endowment Types That Drive Classification

A permanent endowment, sometimes called a true endowment, carries a donor stipulation that the original gift be held forever. The organization can spend income and, where its spending policy allows, a portion of investment appreciation, but the principal stays intact in perpetuity.

A term endowment also carries a donor restriction, but the restriction expires on a date or triggering event. A donor might specify that the principal be maintained for 20 years or until a building campaign concludes. Once the condition is met, the full principal is released for general use.

A quasi-endowment, also called a board-designated endowment or funds functioning as endowment, has no donor restriction at all. The board voluntarily sets aside unrestricted funds to function like an endowment, and because the restriction is internal, the board can reverse it at any time.

Donor restrictions create legal obligations. Board designations do not. Everything else follows from that line.

Net Asset Classification on the Statement of Financial Position

ASU 2016-14 collapsed the older three-class model (unrestricted, temporarily restricted, permanently restricted) into two classes: net assets with donor restrictions and net assets without donor restrictions.¹ Each endowment gift goes into one bucket based on the donor’s stipulations, not the organization’s preferences.

The principal of a permanent endowment is classified as net assets with donor restrictions. The historical dollar amount of the gift represents the floor that must be maintained, and it stays restricted for as long as the endowment exists. A term endowment is also classified entirely as net assets with donor restrictions until the time or event condition is satisfied, at which point a reclassification moves the full amount into net assets without donor restrictions.¹

Quasi-endowment principal sits in net assets without donor restrictions because no donor restriction exists. ASC 958 still requires the organization to show board-designated endowment funds separately from donor-restricted endowment funds in the disclosures so readers can tell them apart.¹ This is where mistakes cluster. A board designation can look like a restriction to someone unfamiliar with the accounting, but it carries no legal weight. An organization in financial distress can unwind a quasi-endowment by board vote. It cannot touch a permanent endowment regardless of circumstances.

How Investment Returns Are Classified

The default ASC 958 rule sounds simple: investment income, realized gains, and unrealized gains are increases in net assets without donor restrictions unless a donor restriction or applicable law limits their use. For endowments, that “applicable law” qualifier does most of the work. In every state except Pennsylvania, the Uniform Prudent Management of Institutional Funds Act creates an implied time restriction on endowment earnings, treating them as restricted until the organization formally appropriates them for spending.²

The practical result: endowment investment returns are initially recorded in net assets with donor restrictions and stay there until the board acts to release them. The returns are not permanently locked away. They are waiting for a formal appropriation. Without that documented appropriation step, though, the organization cannot spend them, no matter how good the year.

Spending Policy and the Appropriation Entry

The spending policy is what converts investment returns into dollars the organization can actually use. The board adopts a formula, typically a fixed percentage of the endowment’s average fair market value over a rolling period, and applies it each year. Most nonprofits use a rate between 3.5% and 5%, calculated against average market values over three to five years. The averaging smooths out volatility so a single bad quarter does not gut the annual distribution.

Modern spending policies almost universally follow a total return approach, treating both income (dividends and interest) and capital appreciation as available for spending rather than limiting distributions to income alone. That frees the investment committee to build a diversified portfolio without chasing high-yield assets just to generate distributable income. An endowment weighted toward growth equities might produce little dividend income but strong total returns; under an income-only model the organization would barely be able to spend, while under total return it draws a consistent percentage of the full portfolio value.

When the board appropriates a distribution, the entry decreases net assets with donor restrictions and increases net assets without donor restrictions by the same amount. Unappropriated returns stay classified as restricted, growing the endowment pool over time. On the statement of activities, organizations that distinguish operating from nonoperating activity often show the appropriated amount as operating investment return and the excess or shortfall of actual returns over the spending rate as a nonoperating line. The reclassification itself typically appears on a line labeled “net assets released from restriction,” which also captures releases of other time- or purpose-restricted gifts. Because that line collapses several types of releases into one number, the endowment note disclosures do the detailed work.

Whichever presentation format the organization uses, the notes must describe the policy for determining what is included in the measure of operations.

Underwater Endowments

An endowment is underwater when its current fair market value falls below the original gift amount or the level required by donor stipulations or law. Cumulative investment losses outpacing cumulative gains cause it, sometimes compounded by years of spending during a prolonged downturn.

Under current GAAP, the entire donor-restricted endowment fund, including any accumulated losses that push it underwater, stays classified within net assets with donor restrictions.¹ Before ASU 2016-14, the underwater amount had to be split out and reported in unrestricted net assets, which created the misleading impression that the organization was obligated to restore the shortfall from operating funds. It is not. Neither UPMIFA nor GAAP requires the organization to make up an endowment deficiency out of its operating budget.

For all underwater funds in the aggregate, the financial statements must disclose the fair value, the original gift amount or level required to be maintained, and the amount of the deficiency.¹

Spending from an underwater fund is not automatically frozen. Under UPMIFA the board can still appropriate if it determines the appropriation is prudent, though the analysis should be carefully documented because spending from an underwater fund invites closer scrutiny from auditors and the state attorney general. Individual gift instruments sometimes include language prohibiting distributions when the fund’s value falls below the original gift, and where a donor’s terms are more restrictive than UPMIFA, the donor’s terms control. This is why reviewing gift instruments becomes operationally critical when markets decline.

As an underwater fund recovers, investment gains first reduce the reported deficiency. Only after the value climbs back above the required level do returns become available for normal appropriation.

Required Note Disclosures

ASC 958-205-50 requires extensive note disclosures for both donor-restricted and board-designated endowments. At a minimum, for each period presented, the notes must include:¹

A description of how the board interprets the state law underlying its net asset classification of donor-restricted endowment funds, including its interpretation of the ability to spend from underwater funds.
A description of the spending policy, including any actions taken during the period concerning underwater funds.
Investment policies: return objectives, risk parameters, how return objectives relate to the spending policy, and the strategies used to achieve them.
The composition of the endowment by net asset class at the end of the period, in total and by type, with donor-restricted and board-designated shown separately.
A reconciliation of beginning and ending endowment balances, in total and by net asset class, showing at minimum investment return (split between investment income and net appreciation or depreciation), new contributions, amounts appropriated for expenditure, reclassifications, and other changes.
For underwater funds in the aggregate: fair value, the original gift amount or level required to be maintained, and the deficiency.

The reconciliation is where experienced readers spend most of their time. It shows how much the endowment earned, how much the organization spent, and whether new gifts are keeping pace with distributions. An organization whose appropriations consistently exceed investment returns and new contributions is drawing down its endowment over time, even if the nominal balance looks stable in a rising market.

A Note on Legal Boundaries

Two boundaries are worth flagging because they sit outside accounting but shape it. UPMIFA is state law and governs endowment spending everywhere except Pennsylvania, which operates under its own rules. And when a donor’s original purpose becomes impossible to fulfill, redirecting the gift requires a court proceeding under the cy pres doctrine, not a board vote or an accounting reclassification.

1
Financial Accounting Standards Board. Accounting Standards Update 2016-14 – Presentation of Financial Statements of Not-for-Profit Entities
2
Financial Accounting Standards Board. Accounting Standards Update 2018-08 – Not-for-Profit Entities Topic 958 Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made