Functional ExpenseReporting for Nonprofits

The Accounting Profession^ Next ScanM?

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By Kennard Wing.Thomas Pollak,

Gordon, Mark Hager,Patrick Rooney

hrihe shock waves sent through the accounting profession

by Enron and other corporate scandals continue to be felL

CPAs have been working hard to overcome the damage

to their prestige and to the public tnist. The last thing

the profession needs is a new scandal.

Unfortunately, nonprofit financial reporting repre-

sents a potential ticking time bomb for the profession.

The authors' Nonprofit Overhead Cost Project (see the

Sidebar on page 17) found serious and widespread errors

in IRS Forms 990 and audited financial statements pre-

pared or attested to by CPAs. The dollar amounts

involved may be smaller than for large public compa-

nies, and the errors less likely the result of malfeasance,

but these errors can and should be corrected. This arti-

cle shows where the problems are, and presents one

approach to doing something about them.

The Importance of Functional Expense Reporting

The most widespread and serious problems in nonprofits concem expenses by functional classification (progratn,

management and general, and fundraising). Many nonprofits cannot provide good information about their relative

effectiveness in fulfilling their mission. As a result, donors, funders, and charity watchdog organizations have

placed undue reliance on financial indicators, many of which are based on reported functional expenses.

Two commonly used financial indicators are the program-spending ratio (total program expenses -̂ total expens-

es) and the fundraising-efficiency ratio (fundraising costs -̂ total contributions). Many articles aimed at donors use

these ratios as their primary basis for evaluating and ranking charities. However, such ratios are only as good as

the numbers used to calculate them, which generally come from an organization".s IRS Form 990.

IRS Form 990Publicly ti-ddcd companies' audited finan-

cial statements arc public documents, whilethe tax retum is a piivatc matter between thecorporation and the IRS. For nonprofits. theopposite is the case. A nonprofit's Foim 990is a public dcx'umenl. Nearly 2.4 million thathave been imaged by the IRS are availableonline at www.guidestar.org. In contrast,nonprofits' audited financial statements arerequired to be released by only a minorityof states" charity registration offices.

authors included two such organizations ina set of nine in-dcpth case studies they per-tbmied. The l'ii"st organization erroneouslyreported zeR) fundiTiising costs in its audit-ed financials. ;ind on its Fonii 990. The orga-nization had a part-time employee whoworked exclusively on fundraising. the exec-utive director was involved in fundraising.and the organization did some direct-maililindniising. In the second case, the tax pro-fessional at the audit tlnn prepared a Fonii990 with zero fundraising cost despite the

Form 990 reporting for nonprofits

composed of multiple, affiliated legal entities

makes overhead and fundraising cost

analysis problematic for users.

Because the data are readily available,most donors, funders, and charity watch-dog agencies calculate pmgram-spendinj:and fundraising-efficiency ratios usingFomi 990 data. The authors' study of thisdata fi)iind widespread reporting that defiesplausihilily in Ihc tuiictional expenses usedto make those calculations. Examplesinclude the following:

• 37% of nonprofits with at least $50,000in contributions report zero fundraisingcosts.• One-fourth of nonprofits reporting $ 1million to $5 million in contributions reportzero fundraising costs, as do nearly one-fifth of those reponing mure than $5 mil-lion in contributions.

• 13% of nonprofits report zero man-agement-and-general expenses.• 79(- charged all accounting fees toprograms, and another 20% split themaeross more than one eategory—despite thefact that Fomi 990 instructions use aecoiint-ing fees as an exampie of what is meantby management-and-general expenses.

Because of the large number of nonprof-its reporting zero fundraising costs, the

fact that the financials behind the opinion let-ter of the audit team showed more than$500.(XX) in fundraising expenses. When theauthors' researeh team asked about thisalmost a year later, no one inside the orga-nization had noticed, and all expressed bewil-derment as to how the error eould haveoccurred.

For a limited number of organizations.including the nine ease studies, the authorskx>ked closely at the Fonn 990 reporting.Aside from the functional expense problems,the authors found several other issues.

The case studies tumed up two differentways that nonprofits rcpoil restrieted con-tributions in Part I of Form 990. Usersrely on reported contribution amounts toealeulate fundraising-effieiency ratios.Those ratios may lead users to draw falseeonelusions if not all organizations reportcontributions the same way. Most organi-zations report the total of unrestrieted, tem-porarily restrieted. iind pemi;mentiy restrict-ed eontributions on Line Id. Yet the authorsalso found that some orgiuiizations reportonly unrestrieted eontributions on Line Id,and report the change in restricted net assets

on Line 20 as an "Other Change in NetAssets." A review of Form 990 and itsinstructions suggests that this problem aris-es because the fonn does not provide sep-arate blanks for unrestricted, temporarilyrestricted, and pemianently restricted rev-enue. The authors recommend that allcontributions be reported on Line Id.

The authors also found that oi^anizationsdo not always report donated space and ser-vices properly. Organizations that leveragesignificant amounts of such in-kind dona-tions ean appear to have unusually highoverhead beeause their value is excludedfrom revenue and expenses (unlike donat-ed goods). One organization in the easestudy had been told by a f under reviewingits Fomi 990 that its grant would not berenewed beeause overhead was more than30% of total expenses. Based on GAAPfinancials, the organization's overhead con-sumed only 12% of total expenses. EXjnatedspace and professional services accountedfor the difTerenee. Given the importanceof overhead reporting to publie users, it isimportant for preparers of Form 990 toinelude the value of these in-kind donationsin the appropriate places. It should appe;irin Part !V-A Line b(2) and Part IV-B Lineb(l). where the Form 990 values are rec-onciled to the audited financials. This value,plus iiny other donated services not valuedunder GAAP. should aiso be reported inPart VI Line 82(b).

Form 990 reporting for nonprofits com-posed of multiple, affiliated legal entitiesalso makes overhead and fundraising eostanalysis problematic for users. The major-ity of organizations in the ease study, andfive of the six with more than $1.5 mil-lion in annual revenue, consisted of suchconglomerates. Unless the entities are cov-ered hy a group exemption letter, theIRS requires separate reporting for eachentity. In three of the live largest eases,all or almost all management-and-gener-al and fundraising eosts were reported ina single entity's Form 990. leaving zeroor very low nonprogram costs in the otherentities. Given sueh praetices. the over-head and fundraising eosts of nonprofitswith eomplex legal structures eannot beaccurately assessed using Form 990data. The ease studies suggest this is notuncommon among large nonprofits. Thebest thing for users would be for the IRSto switch to consolidated reporting, such

16 AUGUST 2006 / THE CPA JOURNAL

as required by GAAP. Until then, tax pro-fessionals can make Fomi 990 informa-tion more accurate and useful by allocat-ing fair shares of management and gen-eral and fundraising co.sts to ai! reportingentities.

In addition to these problems with Form990. the case studies also tumed up a fewgross errors in audited finaTicial statements.The aforementioned organization whosestatement of activities erroneously report-ed zero fundraising costs is one sucherror. Another organization's audited finan-cials placed the statement of functionalexpenses in with the supplemental infor-mation, despite the fact that SFAS 117.Financial Stalements of Not-for-ProfiiOrganizations, clearly states that il is arequired pjirt of the core financial state-ments for this type of organization.

Problematic Accounting MethodsUpstream from the implausible func-

tional expense numbers reported on Fonns990 and financial statements lie account-ing methods that range from inadequateto incorrect. The authors' national surveyof a representative sample of more than1.500 nonprofit organizations, for exam-ple, found that only 25% of nonprofits thatreceive foundation grants properly classi-ty those projKJsal-writing costs as fundrais-ing expenses. Only 17% of nonprofitsthat receive government grants properlyreport those proposal-writing costs asfundraising expenses. This percentage ispaibably low, given that many govemmentgrants provide only incidental benefits tothe grantor. This type of grant is equiva-lent to a charitable contribution, and pro-posal-writing costs should be treated as afundraising expense. When the primarybeneficiary is the govemmental unit pro-viding the funding (i,e., an exchange tnins-action of money for services), proposal-writing costs are properly classified as man-agement-and general expenses.

Personnel costs fonn the largest expenseat miiny nonprofits. and how those costsare allocated across the program, manage-ment-and-general, and fundraising cate-gories can make a huge difference in theirprogram-spending and fundraising-eff1-ciency ratios. In the authors' survey, bare-ly one-third of nonprofits said they trackstaff time by functional expense categoryior each payroll period. Similarly, in the

case studies, three of the nine organizationshad a paper or automated time-trackingsystem that was capable of serving as thebasis for functional expense tracking.Unfortunately, only one of those three usedit for that purpose, and in that case thefundraising staffer charged proposal-writ-ing time to the grant-funded progrdin ratherthan properly accounting for it as fundrais-ing costs. (Interestingly, this organizationhad adopted its timesheet system only atthe urging of its auditor.)

At the other eight organizations, thevast majority of employees were classi-

fied as falling wholly within one of thethree functional expense categories. Therest of the staff made a retrospective judg-ment at year-end about how they hadspent their time, and this was used to allo-cate their personnel costs across the func-tional categories. The accuracy of suchjudgments is open to question, and giventhe emphasis that users place on low over-head and low fundraising costs, it is notsurprising that such judgments tended ton^sult in low percentages for management-and-general costs, and especially fundrais-ing costs.

The Nonprofit Overhead Cost Project

The goal of the authors' five-year Nonprofit Overhead Cost Project was to untJerstandhow nonprofits raise, spend, measure, and report funds for fundraising and administra-tion, and to work with practitioners, policymakers, and the accounting profession toimprove standards and practice in these areas. The overall study had three majorphases:

• Analysis of more than 250,000 IRS Form 990s

• In-depth case studies of nine organizations• 1,500 responses to a survey of U.S, nonprofits

An exploratory survey of nonprofit auditors was also conducted.

The project was supported by the Atlantic Philanthropies, the Ford Foundation, theCharles Stewart Mott Foundation, the David and Lucille Packard Foundation, and theRockefeller Brothers Fund.

A variety of publications from the Nonprofit Overhead Cost Project, resources for non-profit financial management, and useful links related to nonprofit accounting can befound at wvwv.coststudy.org.

Steps to Improve Nonprofit Reporting

• Many users of nonprofits' financial statements place primary emphasis on expens-es by functional classification, so nonprofits should treat the allocation of expenses asan important audit issue,

• CPAs should urge nonprofits to adopt staff timesheets and to use them for function-al-cost allocation.• CPAs should apply the same standards to Form 990— t̂he crucial public disclosuredocument for nonprofits—that they do to their audit and attest work.• NonprofitsshouldreportallcontjibutionsonLineldaf Form 990, regardless of whetherthey are unrestricted, temporarily restricted, or permanently restricted.• Nonprofits should report the value of donated space and services in Part IV-A andPart IV-B of Form 990 to avoid the appearance of excessive overhead,• Nonprofits that comprise multiple, affiliated legal entities not covered by a groupexemption letter should appropriately allocate management-and-general and fundrais-ing costs to all reporting entities on Forms 990.• CPAs should use the management letter to identify and raise concerns about thequality of functional expense accounting. If these concerns are not addressed, the CPAfirm should protect ttself by insisting on notes in the finaticial statements. Rnally, if improve-ments still do not take place, the CPA firm should consider a qualified opinion letter.

AUGUST 2006 / THE CPA JOURNAL 17

Root CausesUniformly, the nonprofit organizations

surveyed reporled that they used a CPAfirm with a regional practice and at leastone partner who specialized in nonprotlts.Typically, the same audit firm had beenused for some years and was familiarwith the organization's structure andfinances. Most Fomi 990s were preparedby a tax professional at the audit firm.Therefore, the authors' findings cannot bereadily explained away by lack of experi-ence at these public accounting firms.

This re.search suggests that a number offactors contribute to the current state ofnonprofit reporting:• Many nonprotlts, especially small onesand those with a majority of donor-restrict-ed funds, have inadequate accounting staffand systems.• The overemphasis on overhead expens-es by donors, lunders. and charity watch-dogs gives nonprofits a significant incen-tive to underreport overhead.• The accounting profession continues tothink of the audited financials as the publicdocument, and has not applied its auditand attest standards to the Fonn 990.• The accounting profession does notconsider the methtxJ by whieh expenses areallocated into functional classifications tobe an important audit issue.

Although the first two of these are pri-marily the responsibility of a nonprofit'sboard and management, clearly the publicaccounting profession is responsible for thelatter two, ajid has a role to play in address-ing the ftrst two as well. The underreport-ing of overhead that is so widespread inthe nonprofit sector could not exist with-out the tolerance of the auditors. And manynonprofits rely on their auditors to advisethem on accounting issues.

What to DoGiven the public nature of Fonn 990,

the profession must reorient its thinkingand begin to apply the same assurancestandards to that document as it appliesto audit and attest work. Next, the pro-fession must recognize the importance thatusers place on expenses by functionalclassification and make that an importantaudit issue.

At that point, auditors will have to faceboth the inadequate accounting systemsof most nonprofits. and their incentive to

underrepon overhead expenses. An audi-tor's desire to maintain a positive work-ing relationship with a client is going to bein conflict with the need to maintain puh-lic reputation and trust. As theEnron-Arthur Andersen case demonstrat-ed, public reputation and trust are the morevaluable assets at risk here. Nevertheless,a graduated response is possible.

In some cases, the auditor will be ahleto identify mi sal locations across function-al classifications and can require adjust-ing entries to correct the prohlem. Inother cases, the auditor will recognize weakaccounting metluKls that "happen to" resultin underreported overhead, but will beunable to detemiine the appropriate allo-cation of expenses after the fact.

The minimum response in these cases isto use the management letter to identifyand raise concerns about the quality ofaccounting lor functional expenses. If thesame problems persist the next year, theauditor's next response would be to pointout that notes to the financial statementsare required to explain significant account-ing policies, especially where altemativesexist, and that because functional expensereporting is so important to users, methodsof accounting for overhead require ftwt-note disclosure. This is less effective in thenonprofit worid than in the corporateworld, because the notes are not tied to thepublic Form 990. but nonetheless, it shouldsucceed in getting management to resolvethe problems.

If the problems remain the third year,the appropriate response for an auditor toconsider is rendering a qualified opinionletter that narrowly Ibcuses on problemat-ic alkx:ation of costs among functional cat-egories. This action would likely upsetthe nonprofit client tremendously, but isthe best way to protect the auditor's pub-lic reputation and trust,

Unfominately, there is currently no wayfor a CPA to ofter a similarly qualified opin-ion of the numbers on Form 990. IRSenrolled agent standards (Circular 230,particularly .sections 10.21. 10.22. and10.33). however, could provide support toa strong position taken by a CPA firmattempting to ensure that the Fonn 990retum fairly repiesents the fmiincial positionof a tax-exempt client. The AICPA'sStatements on Suindards for Tax Services(SSTS) could be amended to clarify that

preparation of returns based on auditedfinancial statements should properly n:flectaudited revenues and expenses with apprtvpriate reeoneiliation to equivalent figures onthe retum. Most important, state and nation-al accotinting orgLUiizations could serve asa strong positive force by educating theirmembers as to the importance of Form990 and the functional expense allocationsused by so many donors.

How the Profession Can RespondAll nonprofit organizations an; required

by SFAS 117 to report expenses by func-tional classification. The many users thatemphasize program-spending and fundniis-ing-efficiency ratios are relying on thesenumber;, and assuming that they fairly reflectthe activities of the organization. Takencollectively, the findings of the authors'Nonprofit Overhead Cost Project suggest thatthis information—often prepared by or attest-ed to by CPAs—is in many cases incom-plete, misleading, or inaccurate.

Members of the public accounting pro-fession can respond in three ways:• Recognize the emphasis that the pub-lic places on functional expense classifi-cation and make it an important audit issue.• Recognize that Form 990 is the majorpublic llnancial document in the nonprofitsector and apply the same standards to itthat are applied to atidit and attest work.• Confront the weak accounting andunderreporting at nonprofit clients throughthe graduated response suggested here. •

Kennard Wing, CMA, is principal ofKennani T. Wing & Co., Haveitown, Pa.,a cofisuhancy providing planning, research,and evuhuition seirices lo the nonprofit sec-tor. Teresa Gordon, PhD, CPA, is profes-sor of accounting at the University of Idaho,Moscow, Idaho. Mark Hager, PhD, isdirector of the Center for Coimmmity andBusiness Research at the Institute forEconomic Development. University ofTe.uislit San Antonio. Thomas Pollak, JD, isassistant director of the National Center forCharitable Statistics at the Urhan Institutein Washington, D.C. Patrick Rooney, PhD,is director of re.search at the Center onPhilanthropy at Indiana Universityand associate profes.wr of economicsand philanthropic studies at IndianaUniversity-Purdue University, Indianapolis.

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