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JOURN LOF

Accounting

EUJWER

ournal of Accounting and Economics 18 (1994) 233-243

&Economics

Choice of accounting method by

not-for-profit institutions

Accounting for investments by colleges and universities

Bruce W. Chase*,a, Edward N. Coffmanb

Department of Accounting, Radford University, Radford, VA 24142, USA

bVirginia Commonwealth University, Richmond, VA 23284-4000, USA

(Received July 1992; final version received March 1994)

Abstract

This study reports a preliminary empirical investigation into the relation between the

choice of investment accounting method used by colleges and universities and factors

such as type of institution, endowment sLe and returns, and debt. Because these

institutions use fund accounting, the effects of the choice of investment accounting

method can reasonably be isolated from other accounting decisions. The results indicate

that the selection of investment accounting method is influenced by type of institution,

endowment size and returns, but not by debt covenants.

Key words: Not-for-profit political process; Accounting choice

JEL classijcation:

M4

1 Introduction

The focus of recent accounting choice studies has been on the relation

between certain firm-specific variables and the choice of accounting method by

for-profit businesses. This study examines the choice of accounting method for

endowment investments by colleges and universities. While other studies have

*Corresponding author.

The authors gratefully acknowledge the comments and suggestions by Kenneth R. Ferris,

Glenn H.

Gilbreath, Ross L. Watts (the editor), and an anonymous referee.

0165-4101/94/%07.00 0 1994 Elsevier Science B.V. All rights reserved

SSDI 016541019400360 H

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234 B.W. Chase, E.N. Cqffm an J Journal q Account i ng and Econom i cs 18 1994) 233-243

investigated accounting choice for other not-for-profit institutions (i.e., Evan

and Patton, 1983; Baber, 1983; Ingram, 1984), this study is a first attempt to

identify factors that are related to accounting choice in colleges and universities.

The factors are selected based on political cost, and compensation and debt

agreements.

The investigation of the choice of methods of accounting for endowment

investments has an advantage. Endowment investment returns are reported as

a separate fund group by colleges and universities. Since the selection of the

accounting method for investments is the only accounting choice decision for

this fund group the effects of a single accounting method choice can be isolated

from other accounting decisions. While Zmijewski and Hagerman (1981) investi-

gated the joint effect of several accounting choices, most positive accounting

studies focus on a single accounting method choice, failing to control for other

accounting choice decisions.

The results indicate that a statistically significant association exists between

the accounting method for investments and the type of institution, size of

endowment, and return on endowment. Institutions that are private, have large

endowments, and have above average return on endowments are more likely to

use the fair market value method. The findings are consistent with the expected

effects of these variables. Debt ratio concerns did not have a significant influence.

2.

Accounting for endowment investments

For financial reporting purposes, endowment funds are reported as a separate

fund group. Colleges and universities may report endowment investments at

cost or at fair market value (FMV) in their balance sheets. A review of ac-

counting practices of colleges and universities by Peat Marwick (1985) finds that

78 percent use the cost method for valuing investments, indicating that the

majority of colleges and universities follow the traditional method of accounting

for investments.

Managers employing the cost method of accounting for endowment invest-

ments can influence the reported numbers through the timing of certain invest-

ment transactions. Under the FMV method, however, all changes in market value

would be reflected in the financial statements. For college and university endow-

ment investments, the fair market value method generally produces higher earn-

ings and asset values than does the cost method in a rising stock market.

The Peat Marwick (1985) study also reveals that many colleges and universities

do not disclose complete investment performance results. Because of the lack of

disclosure, readers of the financial statements in many cases are unable to accurately

compare performance results between institutions. The accounting method used

for endowment investments may therefore impact the way an external user of

the financial statements interprets an institutions investment performance.

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3 Factors related to accounting choice

Positive accounting theory assumes that managers act rationally and seek to

maximize their own personal wealth. College and university managers personal

wealth largely depends on their current salaries and the future value of their

human capital investment (Fama, 1980). The value of this human capital

investment is a function of the success or failure of the current as well as the past

organizations for which the manager has worked.

The value of the human capital investment plays an unusually significant

role for senior administrators in this environment. Senior administrators

are often less concerned with upward mobility within an organization and

are more concerned with outward mobility to a similar position with a

larger or more prestigious organization. For example, the president of

a college, as well as the senior financial officer, may increase his/her wealth

significantly only by moving to another institution. These managers work

to increase the success of their organizations in order to increase the value

of their human capital investment. The success (or failure) of a college or

university is often assessed by factors related to academic reputation and fiscal

soundness.

If managers act rationally in selecting accounting methods, they choose those

that report earnings that maximize their wealth. Although the majority of

managers uses the traditional cost method of accounting for investments,

understanding how certain factors can impact a managers wealth (discussed

below) provides insight into why some choose the FMV method.

3.1. Political cost

3.1.1. Type of institution

Watts and Zimmerman (1986) suggest that political processes impose costs on

organizations. Such costs are imposed on colleges and universities, especially

public institutions that receive a significant amount of financial support from

state appropriations. If a public organization receives a significant amount of

support from sources outside the states appropriation, such as from an endow-

ment, it seems reasonable to assume that state legislators consider this support

when making resource allocation decisions. The possibility that state funding

may be reduced because of endowment holdings could account for the fact that

many public colleges and universities use outside foundations to hold these

funds.

The Peat Marwick (1985) study finds that 32 percent of public colleges and universities

had annual fund/fund-raising foundations compared to only 6 percent for private colleges and

universities.

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The size of an institutions endowment is likely to influence potential donors.

A large endowment may signal to them that others have recognized the institu-

tions value: it also indicates to them that their largesse will not be wasted on

a financially failing institution. In contrast, donors may believe that well-funded

institutions do not need their contributions and may direct them to more needy

causes.

Institutions with the largest endowment funds3 would find the choice of

investment accounting methods to be especially significant. If endowment size

has a positive effect on donors, institutions with the largest endowment funds

have an incentive to depart from the traditional cost method of accounting and

use the FMV, which would report higher asset values.

3.2.

Compensation agreements

Watts and Zimmerman (1986) suggest that a managers choice of accounting

method is influenced by the existence of an earnings-based compensation bonus

plan. Managers who have such plans are more likely to select accounting

procedures that increase reported earnings.

Private colleges and universities do not use bonus plans based on earnings;

thus, a direct test of their influence on accounting method choice is not possible.

However, even in the absence of a formal incentive compensation plan, man-

agers salaries are affected by an organizations level of earnings. If above-

average earnings are achieved over time, managers are able to justify requests

for higher salaries. It also seems reasonable that managers want to avoid

reporting lower earnings. Trombley (1989) and Ayres (1986) find that managers

of firms that experienced a decline or a relatively small percentage increase

in earnings are more likely to elect early adoption of an income-increasing

accounting method.

Private college and university senior managers performance evaluations and

compensation are influenced by many variables other than reported revenues

and expenditures. Endowment holdings, however, can significantly impact the

institution and investing these funds is an important part of some managers

responsibilities. Investment returns published in the annual financial statements

can be used by donors and others outside the institution to evaluate the level of

stewardship demonstrated by management. It seems reasonable to assume that

3Large endowment funds are defined in absolute terms. As an alternative, a relative measure of size

was examined (fair market value of the endowment/full-time equivalent student) and found not to be

significant in the model. A relative measure of size may not have the same influence on potential

donors as absolute size. For example, a college with a small enrollment and a moderate endowment

may have a larger relative measure of size than a university with large enrollments and a large

endowment. Donors are likely to be more aware of the absolute size of the endowment.

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B. W . Chase, E.N. Coffman 1 Journa l of Account i ng and Economi cs 18 1994) 233-243

managers providing below average returns would want to avoid such indica-

tions in the financial statements. The cost method would provide more flexibility

in the reporting of earnings. Conversely, managers consistently producing above

average total return investment results4 would benefit from using the FMV

method. Financial statements under FMV would reflect this performance,

and the manager would not have to be concerned with the timing of trans-

actions.

3.3. Debt agreements

Watts and Zimmerman (1986) suggest that firms that are close to their debt

covenants are more likely to use accounting methods that increase reported

earnings. Dhaliwal (1980) suggests that a debt to equity ratio could be used as

a proxy for closeness to debt covenants, and firms with larger debt to equity

ratios prefer accounting methods that increase earnings.

Private colleges and universities often use their endowment asset holdings to

demonstrate financial health. A debt to endowment assets ratio is one measure

used by lending institutions to determine debt capacity. The debt to endowment

assets ratio may be similar to the debt to equity ratio used in other studies and

serve as a proxy for the constraints imposed by debt covenants. It appears that

colleges and universities with large debt to endowment assets ratios would

prefer the FMV accounting method, which reports higher asset values in the

endowment fund than would be reported under the cost method.

4.

Sample selection

The 1989 NACUBO Endowment Study NES), compiled from data obtained

directly from approximately 330 four-year colleges and universities with endow-

ment investments larger than 1 million, was the source for the initial sample

of institutions for this study. Information related to the amount of institu-

tional debt was obtained from the United States Department of Educations

4A common measure of investment performance is a total return calculation, computed by adding

income from the investments to any change in market value for the period and dividing the sum by

the portfolio beginning market value. This measure is computed independently of the accounting

method employed for endowment investments and thus can be used to compare performance among

organizations.

5The most current information available at the time of this study was for the 1987788 fiscal year. The

impact of using outstanding debt from 1987-88 should not have a major influence on this study

because debt structures of colleges and universities typically do not change significantly over

a one-year period. For example, institutions in the study reported an increase in long-term debt of

only 1.1 percent for fiscal year 1987-88.

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Table 2

Summary of data gathering process

Number of institutions in the 1989 NACUBO Endowment Study

Less:

Institutions eliminated due to:

Insufficient data

Report date other than June 30, 1989

Adjusted sample size

Number of completed questionnaires returned

Plus: Number of questionnaires completed by telephone

Total responses

330

102

35

193

136

34

170

Integrated Postsecondary Education Department Study (IPEDS) project.

Information on the accounting methods used for endowment investments was

collected by a questionnaire sent to the institutions. All other information was

collected from the NES.

A summary of the data-gathering process is presented in Table 2. To be

included in the study, an institution had to a) have the required information

available, b) use a reporting date of June 30th, c) and return the completed

questionnaire.

5 Analysis and results

For the variables related to the private institutions, the results of the t-

tests and Wilcoxon rank sum tests are reported in Table 3. The results

indicate a significant difference for the means and the medians of the two groups

for SIZE and TRET at the 0.10 level or better. DEBT/END did not differ

significantly between institutions that used the cost method and the FMV

method.

For private colleges and universities, the findings indicate that institutions

with larger endowment holdings are more likely to choose the FMV method in

accounting for endowment investments. The findings also indicate that institu-

tions that use the FMV method of accounting have higher mean investment

returns than do institutions that use the cost method.

The results do not indicate that private institutions with larger debt to

endowment assets ratios are more likely to use the FMV method. The findings

may indicate that the variable DEBT/END is not a comparable ratio to the debt

to equity ratio used by for-profit organizations. In addition, the reliance on

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Table 3

Descriptive and univariate statistics for quantitative characteristics for sample of 137 private

colleges and universities in 1989

Variables

cost

n = 101

Mean/

Std.dev.

Min./

Max.

Fair market value

n = 36

Mean/ Min./

Std.dev. Max.

p values

t-test

Wilcoxon

rank sum

test

SIZEb

158.27 3.39 422.50

12.06 0.0741 0.0063

323.00 2483.83 841.79

4478.98

TRET 15.07 0.40 16.48

4.10 0.0244 0.0049

3.21 20.90 3.11

20.50

DEBT/END 0.27 0.00 0.3 1

0.00 0.5661 0.1484

0.37 3.04 0.3 1

1.61

SIZE = fair market value of the endowment investments as of June 30, 1989; TRET = average

total return of the endowment investments for the five years ending June 30, 1989; DEBT/END =

ratio of total long-term debt (June 30, 1988) to the fair market value of the endowment investments

(June 30, 1989).

bExpressed in 10m6.

debt by colleges and universities appears less important than by for-profit

organizations.6

Eight institutions (all private) indicated on the questionnaire that they had

changed their method of accounting for endowment investments in the last five

years. All but two of these institutions changed from the cost method to the

FMV method. Table 4 reports the means of the variables for these institutions as

well as for the remaining sample of 129 private institutions. The differences

between the means of institutions that changed accounting methods for all

variables are consistent with the expected influence of these variables. In addi-

tion, for the variables DEBT/END and TRET the means for the nonchanged

institutions fell between the means of the two groups of institutions that changed

accounting method. The total return and debt ratio for the institutions that

changed to FMV were higher than the average (nonchanged institutions); the

total return and debt ratio for the institutions that changed to cost were lower

than the average. Because DEBT/END is not a significant variable (see Table 3),

6For example, the firms investigated by Dhaliwal(l980) had a mean debt to equity ratio of 0.68, and

for firms investigated by Zmijewski and Hagerman (1981), a mean debt to equity of 0.45 for large

firms and 0.47 for small firms. This indicates a substantially higher reliance on debt than the mean of

the significantly more conservative debt to endowment assets ratio (Table 4) for institutions included

in this study.

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Table 4

Comparison of means for sample private colleges and universities that changed investment ac-

counting methods during 198551989

Variables

SIZEb

TRET

DEBT/END

Cost to fair market value Fair market value to cost

All others

n=6 n=2

n = 129

92.61

42.00 238.31

16.80

15.15 15.40

0.29

0.18 0.28

SIZE =

fair market value of the endowment investments as of June 30, 1989;

TRET =

average

total return of the endowment investments for the five years ending June 30, 1989; DEBT/END

=

ratio of total long-term debt (June 30, 1988) to the fair market value of the endowment

investments (June 30, 1989).

bExpressed in S10m6.

the data suggest that total returns may be the factor influencing institutions to

change accounting method for investments. However, the number of observa-

tions is insufficient to determine statistical significance.

Ordinary least squares (OLS) regression was selected as the primary method

for the multivariate analysis for this study (Noreen, 1988; Stone and Rasp,

1991). The largest absolute correlation between variables (0.229) indicates that

the level of correlation among the variables is not important. The results of the

model presented in Table 5 indicate that the regression equation was statistically

significant at the 0.02 level (adjusted R2 of 0.0572). Two of the three independent

variables, TRET and SIZE, are statistically significant at the 0.05 level.

DEBT/END remained insignificant. Results are consistent with the univariate

tests.

6 Summary

Positive accounting theory was used in this study to examine the choice of

investment accounting methods by colleges and universities. An advantage of

using not-for-profit institutions is that the choice of accounting method for

investments can reasonably be isolated from other accounting decisions. The

results indicate that the choice of accounting method for investments by man-

agers of colleges and universities is influenced by certain variables associated

Exploratory use of probit and logit on the data in this study indicated that these methods did not

reveal any information beyond that produced using OLS regression.

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Table 5

OLS regression model of the relation between investment accounting method and the 137 sample

private colleges and universities characteristics; a positive coefficient value indicates a higher

probability of using the fair market method

Variables (expected sign) Coefficient value Standard error

T for Ho:

Coefficient value = 0

Intercept - 0.1425 0.1896 - 0.751

SIZE

? )

1.6E-07 7.6E-08 2.241 b

TRET +

) 0.0218 0.0118 1.848

DEBT/END + ) 1.0898 1.0356 1.052

The table reports the regression results for accounting method for investments (coded: 0 = cost and

1 = fair market value). Value of

F =

3.75, d.f. = 133; probability >

F =

0.0126;

R2 =

0.0780;

adjusted

RZ =

0.0572.

SIZE = fair market value of the endowment investments as ofJune 30,1989; TRET = average total

return of the endowment investments for the five years ending June 30, 1989; DEBT/END = ratio of

total long-term debt (June 30, 1988) to the fair market value of the endowment investments (June 30,

1989).

Significant at the 0.05 level for a two-tail test.

Significant at the 0.05 level for a one-tail test.

with positive accounting theory. Specifically, political cost and compensation

agreement variables were significant. This research provides further evidence

that positive accounting research can be applied to not-for-profit organizations

and further research in this area is warranted.

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