Valuation of Gifts in Kind: Pharmaceuticals - Part 2
If you have arrived at this article without reading part 1, I highly recommend going back and reading it.
Fair market valuation for most products is pretty straightforward. Where nonprofits tend to experience vertigo is with donated pharmaceuticals. Why are they more complicated? Let’s review the four components that define fair market value:
- Price: The fair value of an item is the price you would receive if you sold it. This is called the exit price.
- Orderly transaction: An orderly transaction assumes that the item would exchange between a willing buyer and a willing seller, each having reasonable knowledge of all relevant facts, neither under compulsion to buy or sell, and with equity to both.
- Market participants: Fair value assumes that the transaction to sell the item occurs in the principal market for that item or, in the absence of a principal market, the most advantageous market. This standard also assumes the highest and best use for the item.
- Transaction date: The fair value of an item is assessed when the transaction takes place. Any change in the market value of the item prior to or following the transaction has no bearing on the value of the item at the time of transaction.
The complication with donated pharmaceuticals is that two of the four components are difficult to apply for medicines.
E.M. (Mick) Kolassa describes the differences in the pharmaceutical market from typical markets that make the application of the “orderly transaction” fair market value component difficult to apply:
The market for prescription pharmaceutical products differs substantially from most other markets in a number of important ways. Typically, markets operate in response to consumer demand, which often can be affected to a great extent by marketing activities undertaken and prices charged by manufacturers and others… Pharmaceutical markets, on the other hand, exist in response to the initial medical need for the relief provided by the product; they are prescribed by an individual not involved in the financial transaction of the actual sale and they are consumed by another individual who, all things considered, would rather not need the product in the first place and may have no idea why it has been prescribed.
As Kolassa points out, the very nature of the pharmaceutical market cannot meet the accounting definition of an orderly transaction for the purpose of assessing fair market value. The buyer of medicines in this case is most likely unwilling, under a medical and health compulsion to buy, and most likely possessing deficient knowledge of all relevant facts. Before we get to the solution, let’s look at the next complication.
Accounting Standards Codification (ASC) Topic 820, Fair Value Measurement states that the fair market value of an item is its selling price. So, what does medicine sell for?
In Time Magazine’s March 4, 2013 cover story, “Bitter Pill: How outrageous and egregious profits are destroying our health care,” Steven Brill exposed and confirmed what the nonprofit community has expressed for years: There are no consistent or knowable costs of either health care or medicines in the United States. Brill writes, “… there seems to be no process, no rationale, behind the core document that is the basis for hundreds of billions of dollars in health care bills.” The story continues, “No hospital’s chargemaster prices are consistent with those of any other hospital, nor do they seem to be based on anything objective – like cost – that any hospital executive I spoke with was able to explain.”
Let’s complicate things further. Due to the high costs of medicines, consumers have access to government subsidy programs, discount group rates, insurance, and other financial aid programs providing potentially hundreds of different cost data points for the same item. Which one should a charity use in their appraisal of fair market value?
The selling price component of fair market value is difficult to apply for donated pharmaceuticals because the actual price is unknowable. In other words, there are no clear or consistent data points available for what a medicine would sell for to a consumer.
Despite these complications, we know that donated medicines have a value. And, there is a solution.
What Can Be Done?
The accounting industry is tackling this issue. The Financial Accounting Standards Board’s (FASB) Not-for-Profit Advisory Committee (NAC) continues to discuss several accounting and financial reporting issues, including the valuation of gifts in kind and the determination of an exit price under the provisions of ASC 820, particularly for pharmaceuticals and similar products donated for use in foreign countries.
The fair market value for donated pharmaceuticals is complicated. Lucky for us, some really smart people foresaw situations like this and provided the accounting industry with the Fair Value Hierarchy. This accounting tool prioritizes data inputs used to measure fair value into three broad levels (level 1, 2, and 3), moving from quoted prices in active markets (level 1) to unobservable inputs (level 3).
The fair value for donated medicines falls into the level 3 category where there are no directly observable “orderly transaction” selling prices for the items and where nonprofits must use all reasonably available information to appraise the medicine’s value. Using the Fair Value Hierarchy guidance, a nonprofit (and its CPA or other financial advisor) must carefully reason out a fair market value approach, using related market information that is observable, and then draw justifiable conclusions that can be defended through the demonstration of process and rationale.
It takes time, research, and careful consideration. It takes more than what can be explained through this article alone. For an example of how to document the development and rationale of a fair market value approach for donated goods and medicines, take a look at Principles Guiding Fair Value Research, from Program Services, Inc. And read this incredibly insightful and helpful article from the Journal of Accountancy,Gifts-in-Kind: What are they worth?
Nonprofits have been successfully assessing and reporting the fair market value of donated medicines for decades. However, with the growing number of nonprofits using aid distribution programs, the focus on valuing donated medicines has become a common topic of conversation; but it need not become a point of despair.
The AICPA states that, “Some items that NFPs receive as contributions are more difficult to measure than others, but difficulty in measuring fair value is not, in and of itself, a reason for not recognizing a contribution.” While there are many voices telling the nonprofit industry how not to do it, and voices who will have a problem no matter how it is done, I tell you this: It can be done, and it can be done well and with the highest level of transparency and integrity. Confidence can thrive for the charity once again!
Oh, and please make sure to listen to your CPA.
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