From The AICPA Audit Committee Toolkit. Copyright © 2005 by the American Institute of Certified Public Accountants, Inc., New York, New York.

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Some transactions and financial arrangements put an organization at increased financial risk. The audit committee should be aware of these transactions, relationships, and circumstances that may require recognition in the organization's financial statements and should ensure that those transactions and events have been accounted for properly. Some of the more common of these transactions and relationships that the audit committee should be aware of are:

1. Tax-exempt financing

2. Investments in derivative financial instruments

3. Securities lending transactions

4. Relationships with legally separate entities

5. Joint ventures with other governments or organizations

The following information provides background about these types of transactions and relationships.

Tax-Exempt Financing

Many NPOs enjoy the benefit of tax-advantaged borrowing through the use of tax-exempt bonds. In the typical tax-exempt bond transaction, a conduit governmental agency issues bonds carrying interest rates below those of taxable bonds on behalf of the not-for-profit organization (NPO). Upon issuance, the bonds are purchased by an underwriter and sold to institutional investors, the general public, or both. The conduit agency simultaneously lends the proceeds to the NPO at repayment terms specified in the loan agreement and the bond indenture. Some tax-exempt bonds are issued with credit enhancement, giving the investors in such bonds assurance regarding their creditworthiness. NPOs use credit enhancement to lower the overall cost of borrowing. Such enhancement may be employed in the form of bond insurance or a letter of credit from a highly rated financial institution. In such cases the provider of credit enhancement usually requires certain fees, financial covenants, collateral, or any combination of such, from the NPO in return for providing the enhancement.

To assure success, the typical tax-exempt bond transaction involves the services of many experts. For example, the NPO should employ the services of competent borrower's counsel having an excellent track record in transactions similar to the proposed deal. The NPO will also need a highly experienced underwriter to help structure the deal, guide the process, and eventually sell the bonds. Often, an NPO borrower will engage a financial consultant to assist in developing financial proformas. In consultation with the conduit governmental issuer, the NPO will select the bond counsel, whose role is to protect the interests of bondholders and certify the bonds as tax exempt. If credit enhancement is part of the plan, the NPO will select an appropriate provider and negotiate the best possible credit deal. In addition, the conduit issuer and the credit enhancement provider will be represented by legal counsel. The fees for all these professionals are normally paid by the NPO borrower and become part of the bond issuance costs.

Bond issuance costs generally should not exceed 2 percent of the total face amount issued. Additionally, the repayment term for tax-exempt bonds usually cannot exceed the average estimated economic life of the project costs funded by such bonds and proceeds from the tax-exempt financing generally cannot be used to fund costs for which specific resources have been dedicated, such as restricted contributions received from institutional and individual donors.

Many regulatory issues are operative in issuing tax-exempt bonds. Audit committees of NPO tax-exempt bond borrowers should obtain assurance from management, competent advisers, or both that all applicable laws and regulations have been observed. Specific consideration should be given to:

1. State laws governing issuance and the use of tax-exempt bond proceedsAlthough tax-exempt borrowing is allowed by federal law (under certain circumstances), each state must enact enabling legislation to designate conduit issuers and regulate the use of tax-exempt bond proceeds. For example, some states may restrict the use of tax-exempt bond proceeds to housing programs.
    
2. IRS regulations concerning:
    
   1. Use of proceeds—IRS regulations include specific qualified uses for tax-exempt bond proceeds. Generally, proceeds must be used primarily for capital projects, with certain exceptions. No more than 2 percent of proceeds may be used to finance issuance costs.
       
   2. Qualifying borrowers and issuers—Issuance of tax-exempt bonds and use of the proceeds therefrom is restricted to certain types of entities. The IRS is the watchdog agency to ensure that the substantial benefits provided by tax-exempt borrowing accrue only to the intended beneficiaries.
       
   3. Report filing—At issuance, the NPO borrower must file IRS Form 8038, Information Return for Tax Exempt Private Activity Bond Issues. In addition, throughout the life of the bonds, the NPO borrower must periodically file additional forms with the IRS.
       
   4. Arbitrage rebate—These regulations are extremely complex, usually requiring the assistance of special experts to ensure compliance. IRS arbitrage rebate regulations ensure that NPO borrowers use bond proceeds in a timely manner in compliance with tax regulations. If an NPO borrower earns a profit from investment of tax-exempt bond proceeds in taxable securities and fails to timely use this profit (arbitrage) to pay project costs, IRS arbitrage rebate regulations require the NPO to return (or rebate) the excess investment earnings to the U.S. Treasury or face severe penalties.
   
    
3. SEC regulations concerning public debt offeringsSuch regulations include compliance requirements regarding initial offering statements, the types and quality of information provided to the public and the veracity of statements made concerning the bonds. Additionally, under SEC Rule 15c2-12, issuers of fixed-rate tax-exempt debt are required to make prescribed secondary market disclosures until the bonds are retired.

In short, due to the complexity of tax-exempt bond transactions, it is imperative that NPO audit committees monitor the organization's compliance with laws and regulations, both for the initial offering and on an ongoing basis after the debt has been issued. The audit committee should review the deal points of a proposed tax-exempt bond transaction well before the anticipated issuance date.

Derivatives

An organization's investment polices may allow investments in financial instruments that are not routine or actively traded in the market. Routine or actively traded financial instruments, such as repurchase agreements, government agency debt securities, and money market funds, have some degree of risk. However, derivatives, which are financial instruments or contracts that have unique characteristics underlying their ultimate investment yield, typically have much greater risk.

When an organization holds derivatives, these financial instruments are included in the amount of investments reported in the organization's financial statements, at the instrument's market value, referred to as its fair value. In many cases the derivative may not be actively traded in the market, or its fair value may be based on complicated, unknown events. For this reason, the notes to the financial statements should discuss the following: the organization's objectives for holding or issuing derivatives, the context needed to understand those objectives, and its strategies for achieving those objectives. In addition to many other details, the disclosure should provide information about the organization's policies related to the various types of derivative instruments and a description of the items or transactions for which risks are hedged.

Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities , is the source for technical guidance about accounting for derivatives and required reporting disclosures.

Securities Lending Transactions

Sometimes, organizations have large amounts of long-term investments in their portfolios. If an organization wants to earn additional income, it might lend some securities to brokers or financial institutions that need to borrow those securities to cover a short position (that is, they sold a security without owning it) or to avoid a failure to receive a security it purchased for delivery to a buyer. In these transactions, the organization transfers its securities for collateral, which may be cash or other securities, and agrees to return the collateral for its original securities at some time in the future.

When an organization lends its securities, it reports these securities as pledged assets in its financial statements. If the organization receives cash as collateral on the securities lending transactions, makes investments with that cash, or can sell the securities it received as collateral, these amounts are also reported as assets in the financial statements. Of course, because the collateral must be returned in the future, the organization also reports a liability for these transactions in the financial statements. In addition, the notes to the financial statements should disclose:

• The policy for requiring collateral or other security

• The carrying amount and classification of assets not reported separately in the statement of financial position

• The fair value of collateral and the amount sold or repledged as of the statement date in situations in which the transferor has received collateral that it is permitted to sell or repledge.

FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, provides specific guidance on accounting and reporting for securities lending transactions.

Relationship With Legally Separate Entities

Separate entities are created by not-for-profit organizations for a variety of reasons. Some of the more common reasons include greater efficiency in financing and administering debt backed by revenue-generating activities and providing additional services that may not have been envisioned when the organization's charter was written.

Financial reporting standards require an organization to determine when a separate entity should be included as part of the organization's financial reporting entity through consolidation. Although detailed and complex analyses ultimately determine which legally separate entities should be consolidated, entities are generally included if they are controlled by the organization.

AICPA Statement of Position 94-3, Reporting of Related Entities by Not-for-Profit Organizations , provides specific guidance on financial reporting under such circumstances.

Joint Ventures

A joint venture is a legal entity that results from a contractual arrangement to pool resources and share the costs, risks, and rewards of an activity with other organizations. In a joint venture, each of the participants retains an ongoing financial interest, an ongoing financial responsibility, or both.

Joint ventures typically are accounted for using the equity method of accounting. Under the equity method the organization recognizes its respective share of the joint venture's income or loss and any changes in the value of the joint venture.

Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock , provides specific guidance on financial reporting under such circumstances.

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