Got Compensation Program Risk?

Sharing actual experiences arising in our compensation consulting work provides some of the most valuable information for our readers. The questions we are asked and the types of work being requested by clients generally serve as a good source for timely topics. Without divulging any confidential information, I believe some of our recent experiences in the past few months offer a topic that warrants a closer look by many organizations.

We have encountered a number of instances this year where we have been asked to review several years of documentation supporting an organization’s governance of executive compensation. In some cases, our work involved a search for confirmation of detail to support a past pay action. In others there were specific requests to examine the quality of existing documents supporting the pay program. Both approaches allowed us a firsthand opportunity to see what clients had in their possession, or thought they had, regardless of the fact that the applicable questions on the Form 990 were checked with a “Yes.”

It is worth mentioning that the criteria we use to evaluate the materials follow the Internal Revenue Service (IRS) Intermediate Sanctions’ guidance for the Presumption of Reasonableness. We generally focus on determining:

  • The participants/role of independent directors in compensation decision making
  • The quality of competitive compensation data from “comparable” sources used in decision making
  • The quality of contemporaneous documentation (i.e., minutes) kept to record the discussions and decisions related to executive pay

These criteria can be met by satisfying some rather broad requirements outlined in the provisions of the Intermediate Sanctions. The precise manner of doing so is generally left up to the organization in question. Our reviews express our opinion as to how well organizations could substantiate their satisfaction of the requirements for the Presumption of Reasonableness.

In our reviews, we examined: board and compensation committee members; the schedule of their meetings; staff positions for which the board has direct compensation decision making authority; records of board meetings and resources used by board members engaged in compensation decision making. Additional materials such a formal compensation strategy/ policy statements, and board/compensation committee charters, for example, were also reviewed in those instances where organizations were using them.

In many cases, we discovered that despite the fact that the boxes were checked affirmatively on the Form 990s and the certainty of compliance expressed by individuals directly involved in the compensation process, there were opportunities to strengthen or initiate critical practices needed to secure the Presumption of Reasonableness. The balance of this article will highlight the types of issues we have encountered and provide steps that should be taken to avoid problems.


This requirement was the one most generally satisfied by the organizations reviewed. All independent members of the organization’s board or a committee of independent board members were usually involved in oversight of executive compensation matter. To the degree that opportunities for improvement were noted, they included:

  • Expanding the scope of board authority over staff pay to include all “Disqualified Individuals,” not just the Executive Director/CEO. In most cases, the organization’s CFO/principal financial officer should also be included in the scope of board- level authority. In fact, it might be highly desirable to have final authority for compensation of all positions reporting directly to the Executive Director/CEO rest with the board.
  • Board members should be especially cognizant of any role that the Executive Director/CEO might play in the determination of his/her own pay. While it may be perfectly appropriate for the executive to present a “self-appraisal” of performance or make recommendations for direct subordinates, the Executive Director/CEO should not solely be relied upon to provide competitive compensation information or a recommendation for his/ her own compensation. Furthermore, the CEO/Executive Director should be formally excused from the meeting as board members discuss and decide his/her compensation actions.
  • Formalize board/compensation responsibilities for compensation with a formal charter or statement of responsibilities and authority. All parties involved in the administration of the compensation must be fully aware of their respective roles.


Our reviews indicate that many organizations need to do a significantly better job to satisfy this requirement. In several instances, competitive data could not be produced despite earlier reports it was used nor could the actual data sources or specific Form 990s that were used be recalled. More often, we observed the following:

  • It was difficult or impossible to demonstrate that data from comparable organizations were being presented for board consideration.

– In some cases, pay data was reported from similar types of organizations, but no information about  the size / scope of the organizations included in the pay data sample was available. Accordingly, it was not possible to determine if pay levels represented much larger/ more complex organizations and / or locations with markedly different employment cost

– Form 990s were collected from organizations totally unrelated to the organization in question (different type(s) of entities and/or radically different size/scope of operation) with no rationale for their inclusion in the information shared with the board.

  • In some cases, even if organizations were generally comparable, it was not apparent that positions cited in the competitive analysis were comparable to the client organization.

– Jobs were “matched” strictly on the basis of generic office titles (e.g., Executive Vice President, Associate Director, etc.)

– No information was presented that ensured unique or unusual characteristics in the client’s position (or an external benchmark position) had been identified and addressed in the competitive analysis.

  • Competitive data of questionable quality was used in the compensation analyses.

– Surveys published or pay analyses performed three or more years ago were used as the basis for current decision making- Consultant reports failed to provide sufficient documentation to establish comparability in competitive analyses and/or relied upon poor quality data

– Consultant reports failed to provide sufficient documentation to establish comparability in competitive analyses and / or relied upon poor quality data.

– Only direct pay/cash compensation data was included in the competitive analysis without any consideration of benefits, perquisites and deferral/retirement income arrangements to assess total remuneration.


In most cases, we find this the area to be the one in need of the most improvement. Many organizations could not produce minutes of meetings that specifically address details of decisions surrounding compensation. Perhaps; out of concerns about confidentiality or confusion about the responsibility for taking the minutes, the minutes simply were never taker. other common areas we cited for improvement included:

  • Provide more detail in the meeting minutes to ensure that an accurate record of information, discussions and decisions about compensation were recorded.

– Noting members in attendance or participating by phone and mentioning staff or outside professionals participating in the discussion.

– Carefully noting that staff members or any conflicted parties were excused from meetings when compensation is being discussed or decided.

– Noting and including copies of any reports, surveys or other information used in the meeting.

– Recording the actual vote/affirmation made by the board or committee for the pay action in question.

  • Ensure that meeting minutes are drafted reviewed with participants and approved by the earlier of the next meeting or within 60 days. Initial drafts of meeting minutes can be circulated to meeting participants electronically with a request for comments, changes and / or approval. It is then quite easy to produce and circulate the final in order to obtain approval. It is important to verify and date the approval of the minutes by participants as part of the final document.
  • Organize and retain all documentation concerning the compensation program in a central location. Ensure it is a resource available for reference to board members in the future or outside authorities that may request to review it.
  • Finally, organizations might find it helpful to prepare a formal document which describes the overall compensation program as well as the  general principles which guide it. This type of document is helpful for a number of reasons.

It provides a means for discussing, arriving at a consensus and finally documenting the principles, policies and practices that will govern the organization’s approach to all forms of compensation by:

– Providing identification of pertinent “competitor” – similar service offering, employing/ competing for similar executive resources, etc., used to establish a marketplace for determination of competitive pay practices

– Defining the desired position of overall compensation in relation to the competitive marketplace (i.e, at, above, below the market) as well as the rationale for support of this desired position

– Identifying the components that will be used in the compensation program (i.e., salary, bonuses, retirement plan, benefits, perquisites) and the role that each will play to achieve he desired position described above

  • Encourages stability / consistency in pay policy and practices. Rotation of board member assignments, turnover in board members and / or the executive team sometimes produce changes in pay practices. Without a formal position on pay policy, pay practices can change based on personal points of view.
  • Finally, this document, along with the other forms of documentation discussed above, becomes an impressive component of an overall description of the compensation program that can be sued for new board member orientation / education or to explain it to any outside official that might have a need to review it.

Our experience suggests that many organizations have some, but not all, of the information needed to be reasonably certain of their entitlement to the Intermediate Sanction’ Presumption of Reasonableness. Incorrect, incomplete or non-existent records in any of the broad areas discussed here will seriously erode the likelihood of success. In all probability, the discovery of a few issues generally leads to additional requests for more information and more extensive examination.

No matter how carefully and well-intentioned the administration of the compensation program has been, the absence of appropriate documentation to support past practices and decisions will raise questions.

Outside board members and senior staff members would be well-advised to critically examine or arrange for an outside examination of the current state of their compensation program’s recordkeeping and documentation. Organizations should ask themselves the following question:

“Would an outsider reviewing these documents understand and accept this as evidence of good management of our pay?”

Waiting to discover problems until the organization is embroiled in a pay-related controversy or under review by government official invites needless worry and embarrassment.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Summer 2014). Copyright © 2014 BDO USA, LLP. All rights reserved.

Do you want $1 to go to charity?

Understanding Payments to Agents of Charitable Organizations

By Rebekuh Eley, CPA, MST

Many times local retail chains or restaurants ask customers to donate to a local charity with the payment of their restaurant bill or store purchase. Are these donations considered tax deductible contributions? The donation is not going directly to a charity. The donation is going to a business entity that will pay the donation to the charity on the customer’s behalf.

Payments to these businesses, or agents, in lieu of a direct contribution to a qualified Internal Revenue Code (IRC) 501(c)(3) organization, are considered tax deductible donations when paid to an agent of the organization. A valid agent of the charity may also provide the contemporaneous written acknowledgement to the donor as required to take a charitable contribution deduction. An entity that enters into this type of arrangement should comply with guidelines so a true agency relationship exists with the charity to avoid income treatment of the donations received on behalf of the charity and, to allow a charitable contribution tax deduction to the donor. These agency arrangements can also be mutually beneficial to both the charity and the business entity.

The Internal Revenue Service (IRS) has issued guidelines for entities to follow to assist with obtaining an agency relationship. According to Revenue Ruling 2002-67, the agency arrangement between a charitable organization and a person or entity acting on behalf of the charitable organization should first be established through a written agreement that is valid under the applicable state law. Not all contractual relationships will necessarily result in an agency relationship.

It is important to confirm that the state law recognizes the relationship established in the agreement as a valid agency relationship. The IRS further analyzed the terms and facts and circumstances of a written agreement to establish an agency relationship in PLR 200230005. The IRS noted the following characteristics that supported a valid agency relationship between a charity and a for-profit company receiving car donations on behalf of the charity.

  • The written agreement between the charity and the company clearly established an agency relationship pursuant to certain state agency laws.
  • The company was to act on the charity’s behalf and was subject to the charity’s control in the general performance of certain activities such as solicitation, acceptance, processing and the sale of donated property.
  • The company could exercise some discretion but this was not in conflict with state law.
  • The charity remained the equitable owners of the donated property until an authorized sale occurred.
  • The charity bore the risk of accidental loss, damage or destruction of the donated property until the donated property was sold.
  • The charity had the requisite degree of control and supervision.
  • The company agreed to provide monthly accounting reports and weekly advertising reports to the charity.
  • The charity reserved the right to inspect the company’s property donation program financial statements.

Under the written agreement, the company would pay certain costs and expenses, such as advertising and insurance. This fact did not preclude a determination that there is a valid agency relationship. Also, the fact that a related person to the company could purchase any vehicle at fair market value did not preclude the agency relationship provided the company acted in accordance with its fiduciary responsibility.

After an entity has established an agency relationship to receive contributions on behalf of a charity, the entity needs to evaluate if it is considered a charitable or professional fundraiser under state law. Many states impose additional registration and annual filing requirements on entities that are considered charitable or professional fundraisers.

After reviewing the requirements set forth by the Internal Revenue Service and various states, an entity may question the decision to establish an agency relationship. However, the agent will achieve a sense of community and purpose in helping the good cause of a charity while providing additional goodwill for its own business endeavors.

Please contact your Templeton advisor, John Templeton, with any questions you may have regarding nonprofits, or 561-798-9988.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Summer 2014). Copyright © 2014 BDO USA, LLP. All rights reserved.

What you need to know about the tax provisions in the 2012 American Taxpayer Relief Act

The 2012 American Taxpayer Relief Act, signed into law on Jan. 2, 2013 by President Obama, is a sweeping tax package that addresses the permanent extension of the Bush-era tax cuts for most taxpayers, revises the tax rates on ordinary and capital gain income for high-income individuals, modifies the estate tax, offers permanent relief from the Alternative Minimum Tax [AMT] for individual taxpayers, limits the deductions and exemptions of high-income individuals, and provides a host of retroactively resuscitated and extended tax breaks for individual and businesses. Here’s a rundown of the package:

  • Tax rates. For tax years beginning after 2012, the 10%, 15%, 25%, 28%, 33% and 35% tax brackets from the Bush tax cuts will remain in place and are made permanent. This means that, for most Americans, the tax rates will stay the same. However, there will be a new 39.6% rate, which will begin at the following thresholds: $400,000 (single), $425,000 (head of household), $450,000 (joint filers and qualifying widow(er)s), and $225,000 (married filing separately). These dollar amounts will be inflation-adjusted for tax years after 2013.
  • Estate tax. The new law prevents steep increases in estate, gift and generation-skipping transfer (GST) tax that were slated to occur for dying individuals and gifts made after 2012 by permanently keeping the exemption level at $5,000,000 (as indexed for inflation). The new law, however, permanently increases the top estate, gift, and GST rate from 35% to 40% It also continues the portability feature that allows the estate of the first spouse to die to transfer his or her unused exclusion to the surviving spouse. All changes are effective fore individuals dying and gifts made after 2012.
  • Capital gains and qualified dividends rates. The top rate for capital gains and dividends beginning in 2013 will be 23.8% if income falls in the 39.6% tax bracket. For lower income levels, the tax will be 0%, 15%, or 18.8%.
  • Personal exemption phase-out. Beginning in 2013, personal exemptions will be phased out (i.e., reduced) for adjusted gross income over $250,000 (single), $275,000 (head of household) and $300,000 (joint filers). Taxpayers claim exemptions for themselves, their spouses and their dependents. Last year, each exemption was worth $3,800.
  • Itemized deduction limitation. Beginning in 2013, itemized deductions will be limited for adjusted gross income over $250,000 (single), $275,000 (head of household) and $300,000 (joint filers).
  • AMT relief. The new law provides permanent AMT relief. Prior to the Act, the individual AMT exemption amounts for 2012 were to have been $33,750 for unmarried taxpayers, $45,000 for joint filers, and $22,500 for married persons filing separately. Retroactively effective for tax years beginning after 2011, the new law permanently increases these exemption amounts to $50,600 for unmarried taxpayers, $78,750 for joint filers and $39,375 for married persons filing separately. In addition, for tax years beginning after 2012, it indexes these exemption amounts for inflation.
  • Tax credits for low to middle wage earners. The new law extends for five years the following items that were originally enacted as part of the 2009 stimulus package and were slated to expire at the end of 2012: (1) the American Opportunity tax credit, which provides up to $2,500 in refundable tax credits for undergraduate college education; (2) eased rules for qualifying for the refundable child credit; and (3) various earned income tax credit (EITC) changes.
  • Cost recovery. The new law extends increased expensing limitations and treatment of certain real property as Code Section 179 property. It also extends and modifies the bonus depreciation provisions with respect to property placed in service after Dec. 31, 2012, in tax years ending after that date.
  • Tax break extenders. Many of the “traditional” tax extenders are extended for two years, retroactively to 2012 and through the end of 2013. Among many others, the extended provisions include the election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes, the $250 above-the-line deduction for certain expenses of elementary and secondary school teachers, and the research credit.
  • Pension provision. For transfers after Dec. 31, 2012, in tax years ending after that date, plan provision in an applicable retirement plan (which includes a qualified Roth contribution program) can allow participants to elect to transfer amounts to designated Roth accounts with the transfer being treated as a taxable qualified rollover contribution.
  • Payroll tax cut is no more. The 2% payroll tax cut was allowed to expire at the end of 2012.

Health care

Health care continues to be one of the more contemptuous issues our country faces. And no wonder, in 2011 alone, the U.S. spent $8,400 per person compared to the next highest-spending country, Norway at $5,352.

Since 2002, family premiums for employer-sponsored health care have increased by a whopping 97 percent placing the cost burdens on employers and workers.

The drivers of these cost increases include an aging Baby Boomer generation that is creating more patients and more treatments, a need for long term care for chronic illnesses, more sophisticated treatments and technology, and increasing inefficiencies, malpractice and administrative costs.

On March 23, 2010 President Obama signed the Patient Protection and Affordable Care Act (otherwise known as ObamaCare) into law. This law, while intending to offer more affordable health care to individuals and families, requires much employer compliance and action.

Overall the Act requires most U.S. citizens and legal residents to have health insurance by creating state-based American Health Benefit Exchanges through which individuals can purchase coverage, with premium and cost-sharing credits. These credits are available to individuals and families with income between 133-400 percent of the federal poverty level.

Separate Exchanges will also be created that will allow small businesses to purchase coverage. Employers will be required to pay for penalties for employees who receive tax credits for health insurance through an Exchange, with exceptions for small employers. New regulations on the health plans in these Exchanges will also be imposed in the individual and small group markets. Medicaid will also be expanded to 133 percent of the federal poverty level.

As this law moves into action and even if it is repealed, one thing is certain – change. It’s clear that quality, price and service are often sacrificed in the current health care model. So the change will have to come from employers, providers, physicians, payers and insurers. This is how:

• Employer driven change – 60 percent of the under 65 population have insurance through their employers and all are negatively impacted by escalating costs and inadequate quality. As a result, educating those employees is a must as well as focusing more on wellness and prevention.

• Provider/Physician change – Health care providers will go from a fee-based model to a newer value-based model and focus on being more accountable in their care. There will be consolidation and newer business models that require increased use of data analytics and clinical intelligence.

• Payer/Insurer change – By moving the focus away from claims processing to more collaboration in an effort to improve care and manage costs. There will also be a shift from administrator to supplier of data analytics/clinical intelligence.

So the question becomes for employers – are you going to pay or play ObamaCare?

Play means employers offer minimum essential coverage to all of your full-time employees.

Pay is an excise tax if you do not offer minimum essential coverage (or any coverage) and at least one of your full-time employees is certified as having enrolled in coverage through a state health exchange for which he or she received a premium tax credit or cost sharing reduction. This tax is applicable to employers with 50 or more full-time employees on average per business day. The monthly penalty (non deductible) is $166.67 (1/12 of $2,000) times the total number of full-time employees for the month minus 30.

What to do?

Look at your workforce Employers need to evaluate their workforce and look at their employees (both full-time and part-time) and see if any could be reclassified as employees for purposes of the mandate.

Business structure Employers also need to understand if their current business structure or model could cause the company to be subject to the employer mandate – and see if there are circumstances under which they could restructure to avoid the mandate.

Learn about Health Insurance Exchanges Examine the relationship between the employer mandate and the individual mandate and how the health insurance Exchanges that will be put in place in 2014 will provide opportunities for some employers and many individuals to acquire such coverage.

Florida recently returned $1 million planning grant to the federal government and has set up a non-ACA compliant health care initiative. However, if the state doesn’t set up an ACA compliant exchange, the federal government will.

Employers need to act now and consider an overall benefit redesign with an emphasis on better employee health. They should also set up and access information systems and reporting for compliance and start discussions with payers and providers that consider risk sharing.

Though overturning ObamaCare would mean relief from this compliance burden and potential penalties, it doesn’t necessarily change the need for an employer’s strategic evaluation of their workforce, business structure, overall plan design and employee communications.

This work upfront can save you a lot of heartache and expense down the road.

 For more information, please e-mail

Best Business Practices for Educational Institutions

A decrease in student enrollment due to the economic downturn has many private educational institutions modifying their budgets and preparing to get by on less.

Between the normal issues of balancing rising costs, schools and universities also have to juggle the need to consider raising tuition fees – since it is often their main source of income – without deterring potential students.

Here are a handful of best practices we’ve seen some of the more successful educational institutions implement over the past few years:

  1. Analyze your educational mission as a business enterprise.  Does your organization’s cash flow from “operations?” Does your budget provide cash flow to cover existing debt? While donations and contributions are no doubt important to any school’s livelihood, think of your institution as a business and treat your budgeting as such. Consistently and strategically measure against your budget on a monthly, quarterly and annual basis – it’s not just a one-time process. And yes, hold your department heads accountable to their budgets once they are approved.
  2. Anticipate the market and know how to react. The schools that have been successful during this downturn have been prepared enough to anticipate the worst, such as a drop in student count. With a little planning and flexibility, they then are able to modify their operating budgets based on a new normalized number of students than were originally anticipated.
  3. Take a zero-based budget approach. Are your expenses necessary? Are they adding something to your mission? Are those expenses helping revenue come through the door? Shed the mentality of spending funds in the same way every year, even if those line items have been allotted that way for as long as you can remember. Be open to change and accessing your school’s needs on a regular basis. Make sure your spending is tied into your mission and your revenue stream.
  4. Take a hard look at capital expenditures. Do you need that new fine arts facility or better yet, do you have the funds to build it? Heavily weigh cost benefits of whether to build or maintain. If building is the option, make sure a plan is in place that will bring in additional revenue to cover all the costs – whether that’s in the form of new students or programming.
  5. Be willing to pay for competent financial staff. What may seem like a hefty investment in the form of a highly experienced financial executive will often pay off handsomely in the end. The schools we see doing the best under this economic climate have very competent financial resources on their staff. They are often paid more than what some schools may feel comfortable paying but they make up for it in spades. An investment in quality can greatly impact an institution’s operational success.

With a little planning and business perspective, those at private schools, and universities and colleges can be better prepared and thrive under the pressures of the ever-changing academic environment.

To schedule a meeting to discuss your institutions’ needs, please feel free to contact us.  Our professionals have many years of experience working with educational institutions in varied ways to enhance operational efficiency.

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Audit and Accounting Standards Updates Nonprofits Need to Know


In this ever changing landscape of rules and regulations, nonprofit organizations need to be especially aware of the changes that will guide their audits. Being prepared for an upcoming audit is the best way to ensure a smooth and successful process. Please see our brief overview of Audit and Accounting Standards updates nonprofits need to know.

1. SAS No. 115 Communicating Internal Control Matters Identified in an Audit
Provides guidance to auditors with respect to what should be communicated to management and those charged with governance in an organization. It requires the auditor to make communications, in writing, to management and those charged with governance regarding significant deficiencies and material weaknesses in internal controls that you note in your audits.

2. SAS No. 116 Interim Financial Information
To revise AU section 722 of AICPA Professional Standards to establish standards and provide guidance on the independent accountant’s professional responsibilities when the accountant undertakes an engagement to review interim financial information of a nonissuer when certain conditions are met.

3. SAS No. 117 Compliance Auditing
Establishes standards and provides guidance on performing and reporting on an audit of an entity’s compliance with applicable compliance requirements of a governmental audit requirement.

4. SAS No. 118 Other Information in Documents Containing Audited Financial Statements
This is effective for audits of financial statements for periods beginning on or after December 15, 2010. It establishes a number of presumptively mandatory requirements for the auditor to perform when a client provides additional information in documents containing audited financial statements.

5. SAS No. 119 Supplementary Information in Relation to the Financial Statements as a Whole
Requires additional documentation from auditors and procedures around supplementary information, using the same materiality level used during the financial statement audit. Effective for audits of financial statements for periods beginning on or after December 15, 2010.

6. SAS No. 120 Required Supplementary Information
Effective for audits of financial statements for periods beginning on or after December 15, 2010.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under Internal Revenue Service Code. The technical information here is necessarily brief. No final conclusion on these topics should be drawn without further review and consultation. For additional information, please contact our firm at or 561-798-9988.


Templeton & Company hosts Grant Writing Workshops at 2nd Quarter Nonprofit Roundtables

Providing nonprofit leaders in Palm Beach and Broward counties with the opportunity to seek advice and to listen to how similar organizations were able to overcome the obstacles they are currently facing is the goal of Templeton & Company’s Quarterly Nonprofit Roundtable Luncheons. Templeton & Company’s May luncheon series will feature a presentation on Grant Writing by Rick Dunion from the Executive Service Corps of Broward. The Palm Beach event will be held on Wednesday, May 19,from Noon to 1:30 p.m.; the Broward event will be held on Wednesday, May 26, from Noon to 1:30 p.m.

“Our local nonprofit organizations do so much to help the community, we are happy to host events that can provide them with information that could make their jobs a little easier,” said Isabella Lunsford, Tax Partner, Templeton & Company.

For more information on these events, please e-mail


Perception and reality: shedding light on Level 3 assets

In the winter of 2007-2008, sweeping new financial reporting standards were launched – directly into the path of an unforeseen perfect storm.

Known as fair value accounting, these new rules had been years in development.  They were designed to unify global standards and provide greater transparency through market-based, rather than earlier cost-based, methods of valuation.

But no sooner had fair value gone into effect than markets worldwide all but evaporated in the worst economic crisis in over ninety years.  As asset values drifted erratically into what analysts called a “no man’s land,” accurate fair value reporting was put to the test.  And one obscure provision was taken head on by regulators.

We’re talking about Level 3 Inputs as defined by Accounting Standards Codification Topic 820: Fair Value Measurements and Disclosures (ASC 820), the least understood and thorniest area of fair value asset valuation, yet a category now critical to many organizations.

Do a quick internet search and you’ll get millions of hits on Level 3 Inputs, ranging from hard-to-follow bureaucratic explications to biased (often misinformed) broadsides in the blogosphere.  Our purpose here is to sift reality from perception and shed some light on this important area of financial reporting.

First, let’s briefly define terms.

As outlined by the ASC 820 (f/k/a Statement on Financial Accounting Standards No. 157: Fair Value Mearsument), fair value reporting provides for three distinct levels of inputs.

Level 1 Inputs, which in theory comprise the preponderance of most organizations’ portfolios, can be valued using independent observable market inputs: for example, stock prices as reported by the Wall Street Journal on a daily basis.  The idea is to peg an asset’s value to what it would fetch today – right now – in an “orderly transaction” between “willing market participants.”  Those two phrases are important.  Fair Value presumes the absence of compulsion or duress.

Level 2 Inputs don’t have readily-available market inputs, but can be accurately valued using comparable and observable data points.

Level 3 is unique.

This tier was created as a kind of “none of the above” category for perceptible yet hard-to-value assets with no observable inputs.  Generally speaking, Level 3 Inputs either are illiquid or traded so rarely there is no independent market price.  Examples might be private equity investments or certain long-term derivative contracts (typically managed by hedge funds).

To put all this in basic language:  Inputs in Levels 1 and 2 are “mark to market,” but assets in Level 3, where this is no market, are “mark to model.”

Constructing those models is what makes Level 3 asset valuation so exceedingly complex.  To meet fair value disclosure requirements, these valuations involve a combination of management forecasts, various macroeconomic and internal data, sophisticated mathematical models and other proprietary techniques – in other words, experience and specialized expertise from your accounting and audit firm.  Including a coordinated effort from both your accountant and your investment managed to insure that you have obtained full and adequate disclosure regarding those assets.

Sound accounting and audit procedure for Level 3 isn’t astrophysics, but in some respects it’s not far off either.

There’s an irony here.  While Level 3 assets are by definition hard to value, they are often precisely the types of investments one would expect in a widely (and wisely) diversified portfolio.  Many large organizations – foundations, for example – hold significant and sound assets in this fair value tier.  But in the current economic environment, Level 3 also is home to distressed assets such as complicated mortgage-backed securities for which markets seized up and have remained stagnant, making “orderly transactions” arguably impossible.

Thus Level 3 reporting is not only complex, it can be controversial.

What’s at stake for you?

Ultimately an organization’s board, investors, creditors and stakeholders comprise the real-world “jury” for any financial statement.  Credibility is the lynchpin of quality financial statements.  Our experience with a wide range of clients has shown, when done properly, Level 3 financial reporting can ensure a high degree of transparency and confidence going forward.

For more information on Level 3 assets or any other financial concerns, please contact

About the authors:

John TempletonJohn R. Templeton, CPA, CVA

John Templeton is a Partner with Templeton and leads the firm’s Audit and Accounting Services Division. He is an experienced provider of accounting, auditing, and advisory services for private enterprises in a variety of industries including nonprofit, agriculture, manufacturing, and distribution. He is a hands-on professional who approaches each audit with focus and efficiency. He is an advocate for many of the younger members of the firm, and develops and mentors these young associates.