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Misgivings

Recent studies raise an uncharitable question: Is nonprofit accounting off track?

4Jan

Relief International, a Los Angeles–based nonprofit that provides disaster-recovery services around the world, reported that it had collected more than $11 million in grants and contributions for 2005. Yet the organization claims in its audited financial statements that it didn't spend a dime on fund-raising that year. Likewise, RBC Ministries, a nondenominational religious nonprofit based in Grand Rapids, raised more than $29 million in 2004 without reporting any fund-raising costs.


On paper, at least, these organizations appear to be able to raise millions without incurring any costs. And they are not alone. A joint study by Indiana University's Center on Philanthropy and the Urban Institute found that one-fourth of nonprofits with at least $1 million to $5 million in contributions report zero fund-raising costs, while nearly a fifth of those that took in more than $5 million claim that it cost nothing to do so. Overall, 37 percent of nonprofits that raised at least $50,000 in contributions report no fund-raising costs.


To call these results suspect would be an understatement. "It's almost impossible to raise that kind of money without incurring at least some costs, whether it's printed materials, staff time, or something else," says Patrick Rooney, director of research at the Center on Philanthropy. Moreover, the study found that a number of organizations report no overhead costs or use incorrect methods to compute expenses. Some nonprofits may simply be getting their accounting wrong, but Rooney suggests that many are deliberately manipulating the numbers.


Why are nonprofits so concerned about minimizing costs? Charitable giving is at an all-time high, spurred by disaster relief for Hurricane Katrina and the Indian Ocean tsunami — and so is the number of nonprofits competing for that money. Giving USA estimates that Americans gave $260 billion to more than 1 million charities in 2005, the latest year for which data is available. And donors are becoming increasingly discerning about how charities spend their contributions, thanks to the growing availability of information about nonprofits on the Internet.


In particular, donors are looking at two metrics. One is the efficiency ratio, which compares how much a nonprofit spends on fulfilling its mission (known as its programs) with what it spends on overhead and fund-raising. The other is the fund-raising ratio, which compares fund-raising costs as a percentage of contributions. The higher a nonprofit's efficiency ratio and the lower its fund-raising percentage, the more comfortable donors will feel about giving money, knowing that most of it will be spent on programs.


The stepped-up scrutiny creates intense pressure on nonprofits to cut their overhead and fund-raising costs — or to improve their ratios by fudging their accounting, allocating more and more costs to programs. Indeed, a number of experts charge that nonprofit accounting is fraught with faulty bookkeeping and willful manipulations. "The numbers are highly unreliable," says Christine L. Manor, a CPA who conducts accounting for a number of small and midsize nonprofits. "Sometimes it's deliberate, sometimes it's not, but much of the accounting [in the nonprofit world] is appalling."


Says Rooney: "This is potentially the next big area of accounting fraud."



Money for Nothing


Rooney and his colleagues reached this conclusion after the Center on Philanthropy/Urban Institute study found "serious and widespread" errors on the Form 990s that nonreligious nonprofits with more than $25,000 in revenue are required to file annually with the Internal Revenue Service. (Many Form 990s are now widely available to the public; GuideStar.org, a leading nonprofit-research Website, posts more than 1.5 million 990s.) Fund-raising is by far the biggest area of reporting that, according to a 2006 report on the study, "defies plausibility."


True, some nonprofits may use an entirely voluntary staff to collect donations, or say that their money was given in a lump sum by one foundation. But those circumstances don't account for most of the missing overhead.


When questioned, nonprofits shrug off the fund-raising issue. Take RBC Ministries. Its claim to have incurred no fund-raising costs on $29 million in contributions is especially surprising, considering that the nonprofit promises on its Website to mail a compact disk to those who donate. What's more, RBC Ministries Foundation, a separate nonprofit entity that runs RBC's endowment and made a direct grant of $2 million to RBC that year, raised nearly $3.2 million and also reported no fund-raising costs. The foundation also cited just $170 in management and general costs in 2004, the most recent reporting period available.


Yet, RBC CFO Max Smith stands by the claim of no fund-raising costs. He says the organization doesn't do any telemarketing or direct-mail campaigns. About 513,000 people made donations in 2004, says Smith, putting the average gift at just $24. RBC doesn't consider the cost of opening all of those envelopes as fund-raising costs. It checked that assessment with the Evangelical Council for Financial Accountability, an agency set up to assure that members conduct financial affairs responsibly, "and they agreed," says Smith. Smith says he does spend some time helping donors with gifts — "I'm the closest thing we have to a development officer" — but he says he doesn't track the time or report it as a fund-raising cost.


Relief International CEO Farshad Restegar also admits that he spends time on fund-raising but doesn't track the cost of it. He says the organization did not break out fund-raising costs in 2004, because it did not have a development staff, which it is now assembling, and did not conduct any fund-raisers. "In most cases, individuals and companies send us money without us asking for it," says Restegar. In 2004, Relief International received more than $7 million in government grants. Restegar says the cost of writing grant proposals in 2004 was accounted for either as programs or administration costs, depending on the main function of the staffers who wrote them. (A partner at a national accounting firm says grant-writing activities typically should not be expensed to programs.) Both RBC and Relief International say they expect to report fund-raising costs in the future.



Hold the Phone


Besides reporting zero fund-raising costs, nonprofits commonly misreport what they spend on professional fund-raisers. Since the advent of the national do-not-call registry, which barred for-profit companies from calling those on the list but exempted nonprofits, professional telemarketers have aggressively marketed their services to nonprofits. While there are plenty of reputable fund-raisers, the firms are notorious for returning just a small portion of what they raise to the charities that hire them.


For example, a 2004 fund-raising campaign conducted by Reese Teleservices Inc. for the National Caregiving Foundation netted more than $2 million. But the telemarketer returned just $364,000, or 18 percent, to the foundation. A campaign conducted in the same year by the Civic Development Group LLC on behalf of the Cancer Fund of America raised $3.6 million, but returned just under $450,000 (12.5 percent) to the charity.


The rules clearly state that nonprofits should report the net proceeds as income and the portion that wasn't returned as an expense, on a line designated for professional fund-raising costs. The two organizations above reported the fund-raising expense correctly, but plenty of organizations don't, since the low returns can wreak havoc on efficiency and fund-raising ratios. Thanks to professional fund-raising, the Cancer Fund of America, for one, spent more than 55 percent of its $17 million budget in 2005 on fund-raising, earning it just one star of a possible four from Charity Navigator, an online watchdog group that evaluates nonprofit finances.


According to a 2006 study by researchers from Harvard University, Boston College, and George Mason University, 26 percent of nonprofits that use professional fund-raisers understate the cost of fund-raising by reporting net proceeds rather than the total cost of the campaign as required. Questionable filings are not always easy to find, said the researchers, since only some states require professional fund-raisers to report the results of each telemarketing campaign conducted in the state. But reports from states that do can be easily cross-checked with what individual charities report. For example, according to New York State's most recent report, Telecomp Inc., a professional fund-raising firm, collected $724,945 for New York and Presbyterian Hospital in 2004 and returned just $222,595 to the hospital. However, New York and Presbyterian didn't report the difference — $502,350 — as fund-raising, since it reported no fund-raising costs that year. The hospital says the amount was immaterial.


The study also found that an additional 14 percent of nonprofits improperly allocate some of the fund-raising costs to programs. The results likely understate the frequency of misreporting, since not all states provide the professional fund-raising data, says Elizabeth Keating, lead author of the study and senior research fellow at Harvard's Hauser Center for Nonprofit Organizations. "When in doubt, the impulse is always to allocate it to programs," says Keating.



Ends Justify Means


Meanwhile, it's not just fund-raising that's being fudged. The Center on Philanthropy/Urban Institute study also found that 13 percent of nonprofits report zero management and general expenses. Seven percent charged all accounting fees to programs and another 20 percent split them across more than one category, despite IRS guidelines that suggest that accounting fees should be considered management and general expenses.


The fund-raising expense numbers that charities do report are calculated using a variety of methods. For example, organizations use different approaches to determine how portions of a staff member's or executive's time — and therefore compensation — are attributed to different functions. That can be a difficult proposition, because the culture at most nonprofits is such that everyone pitches in on many different activities. The CFO, for example, might work in administration, but will often conduct some fund-raising and even help out on a program event.


"Some [nonprofits] use detailed time sheets and others just estimate, so the numbers are already squishy," says Elizabeth Boris, director of the Center on Nonprofits and Philanthropy at the Urban Institute. Boris says some nonprofits use just salaries to determine fund-raising costs, while others use salaries, benefits, and a portion of administrative costs. She says there needs to be more uniformity in reporting standards.


Keating says small nonprofits are much more likely than large ones to account for expenses incorrectly or devote insufficient resources to accounting. They include small-to-midsize health-and-human-services organizations, food banks, environmental groups, and community-building organizations. "They are always operating on the brink in a style that I call 'sustainably broke,'" says Keating. For them, the ends may justify the means: if underreporting of expenses is necessary to get the funding needed to stay open another year and do good work, so be it.


At larger nonprofits, one of the most common problem areas is joint cost allocations, according to Bennett Weiner, chief operating officer of the Better Business Bureau's Wise Giving Alliance, a watchdog group. When nonprofits perform activities that have both fund-raising and program aspects, they can allocate a portion of the activity costs to each function, provided certain conditions are met. For example, a direct-mail campaign might include a solicitation for a donation and an educational aspect, such as a letter advising recipients to beware of certain medical symptoms. Weiner says audits of the campaigns commonly turn up problems with the joint cost allocations, even though there are specific accounting rules that must be followed.


A few years ago, Walter Bristol, CFO of the American Heart Association, thought the AHA needed to be more consistent on how it tracked costs over the three functions of programming, administration, and fund-raising. So Bristol assembled and led a task force to analyze the nonprofit's cost accounting. The task force looked at every activity where costs intersect, such as an event where program activities and fund-raising are involved, and developed guidelines for separating the expenses into the appropriate buckets.


The guidelines are even more important today, says Bristol, now that the AHA is trying to add more program content to fund-raising activities. For example, a fund-raising walk now includes more print materials on quitting smoking, learning CPR, and so on. The additional materials not only help the AHA make a difference, they also help improve efficiency ratios, since a portion of costs can then be allocated to programs. From 2002 to 2005, the AHA cut fund-raising costs as a percentage of spending from 19.7 percent to 14.5 percent and increased efficiency from 73.2 percent to 78.1 percent.



The Wrong Measures?


Such efficiency and fund-raising ratios put the AHA comfortably above thresholds recommended by watchdog organizations. For example, The American Institute of Philanthropy says that an efficiency ratio of more than 60 percent and a fund-raising ratio under 35 are reasonable. The Better Business Bureau's Wise Giving Alliance states in its Standards for Charity Accountability that nonprofits should "spend at least 65 percent of its total expenses on program activities." (The alliance barely passes its own litmus test, with 67 percent of expenses going to programs in the 2005 fiscal year.) The alliance also recommends that nonprofits spend no more than 35 percent of related contributions on fund-raising in any given year.


But some observers in the nonprofit sector say these hard-and-fast thresholds encourage accounting shenanigans. "Many of these organizations are well intentioned, but we are making liars out of them by pressuring them to have low fund-raising costs," says the Center on Philanthropy's Rooney. Others single out nonprofit rankings, such as Charity Navigator's, for blame. (The AHA merits only two stars on Charity Navigator's four-star rating.) In general, critics say the emphasis on administrative and fund-raising costs is misplaced.


"It's a huge problem that nonprofits are discouraged from investing in support services," says Harvard's Keating. She adds that not only are many nonprofits getting the accounting wrong, they are measuring the wrong thing. "There is a sense that the right number is 100 percent on programs and nothing on administration and fund-raising."


Bristol says the AHA's donors get concerned when administrative and fund-raising costs climb above 25 percent. Still, while overhead spending is a key performance ratio that he pays close attention to, he doesn't want it to drive the organization. "It should be the other way around," argues Bristol. "I never want our mission and decision making to be too influenced by it. If we need to put money into fund-raising, then that's what we do. We make sure we report it correctly, and stay focused on our mission."


Still, the pressure to keep costs low leads other nonprofits to underspend on administrative needs, including accounting. In fact, a lack of finance resources and expertise continues to be a problem in the sector; experts say that most nonprofits are not purposely cooking the books, but simply making mistakes. "At lots of organizations, the person I train to do the accounting is the receptionist," says Christine Manor. "They're the only ones that have the time to do it."


Another problem is that the ratios are judged across the board, without much regard for the type of organization under review. A small start-up nonprofit working on an unpopular cause will have a much different spending profile than a national charity that already has name recognition. "I'm not sure it makes sense to lump all these organizations together and judge them the same way," says Gary Kowalczyk, CFO of the Carnegie Institution of Washington, a nonprofit science-research organization based in Washington, D.C. Those nonprofits with endowments, such as Carnegie, which has an endowment of approximately $750 million to draw from, have flexibilities that others do not.


Some foundations are pushing nonprofits to create more measures around the outcomes of their activities. For example, a homeless shelter would measure not just how many beds it provided, but also its impact on poverty in the neighborhood. Such measures emphasize not only efficiency, but effectiveness as well. The Bill and Melinda Gates Foundation and the William and Flora Hewlett Foundation have been at the forefront of pushing for these changes. Also, a movement among nonprofits to measure social return on investment as a better bottom line than efficiency is under way.


But one thing could stand in the way of getting better measures of effectiveness: it requires spending on administrative costs to conduct the research. Without a little understanding on the part of efficiency-minded donors, those research dollars could be hard to come by.



Joseph McCafferty is departments editor at CFO.



Who's Watching?


While nonprofits have plenty of incentive to show low overhead, there is little disincentive for doing so, because regulators are paying almost no attention. The federal agency that has responsibility for overseeing the Form 990s, the Internal Revenue Service's Tax-Exempt and Government Entities Division, is severely underfunded, says Elizabeth Keating, a senior research fellow at Harvard University's Hauser Center for Nonprofit Organizations. "Most of its resources go to deciding if organizations are eligible for tax-exempt status, not making sure that they are living within the [reporting] rules," she says.


For the most part, nonprofit reporting is policed at the state level, either by the attorney general or the secretary of state, and states vary greatly in their requirements. Some states, such as California, New York, and Massachusetts, demand independently audited financial statements for any nonprofit with revenues over a certain amount — $2 million in California, $500,000 in Massachusetts, and $250,000 in New York. Other states, such as Nevada, Kansas, and Kentucky, require almost no additional reporting beyond the Form 990, while some states don't even require a 990.


"There's almost no oversight. The sector is regulated as if it were a bunch of kids selling lemonade," comments Trent Stamp, president of Charity Navigator, an online watchdog group that evaluates nonprofit finances. "Is there the potential for an Enron-type situation in the nonprofit world? Absolutely."


To fill the void in oversight, private-sector watchdog groups have emerged. For instance, the Better Business Bureau's Wise Giving Alliance compiles reports on more than 500 charities; the reports include a review of the nonprofit's finances. Charity Navigator, for one, rates charities on the ratios they report, using an automated analysis of their 990 filings. Nonprofits that rate poorly on Charity Navigator's four-star scale usually spend a high proportion on administration and fund-raising. Other services, such as GuideStar, post 990s online without judgment.


However, these monitors can judge only by what gets reported in the 990, which may not be reliable. "Any nonprofit that can't manipulate the 990 to show better overhead and fund-raising just isn't trying very hard," says Paul Light, a professor at the Robert F. Wagner School of Public Service at New York University. — J.McC.



Is Supporting Distorting?


One potential source of nonprofit accounting abuse is the use of a separate entity to conduct fund-raising activities and carry the associated costs on its books. Such entities, known as supporting organizations, are common, especially for hospitals, and there is nothing illegal per se about them. But at a minimum, the setup does have the effect of making the parent organization look better in terms of efficiency and fund-raising costs.


Take Children's Memorial Hospital in Chicago, one of the top children's hospitals in the country. For the 2004 fiscal year, the latest one reported, the hospital reported direct public support of more than $37 million and government grants of more than $24 million. A glance at its accounting would show that it has a good efficiency ratio and a fantastic fund-raising ratio. Indeed, the hospital reported no fund-raising costs at all, because its fund-raising is conducted by a separate nonprofit called the Children's Memorial Foundation. The foundation raised $17 million in direct public support, but it spent almost $10 million to do it.


Trent Stamp, president of Charity Navigator, an online nonprofit monitor, says supporting organizations are sometimes used to hide fund-raising costs, enabling nonprofits to conduct lavish fund-raising events without fear of criticism. Supporting organizations also provide charities with a means of keeping huge CEO compensation out of sight, asserts Stamp, with each organization reporting only a reasonable-looking portion of the compensation.


Indeed, supporting organizations can sometimes resemble the special-purpose entities that were at the center of the financial fraud at Enron. Stamp, for one, believes that entities under the same organizational roof with the same mission and the same management should be required to report as a single entity. "If the massively complex and decentralized Red Cross can consolidate [its] operational entities into one entity with one financial-reporting mechanism," says Stamp, "can you honestly argue that the local performing-arts center needs to be six separate institutions?" — J.McC.



Red Flags


Common red flags and suspected violations among nonprofits



  • Reporting zero fund-raising costs while raising millions in funds

  • Reporting zero administrative costs or allocating accounting fees to programs

  • Reporting a percentage of administration and fund-raising costs as programs

  • Conflicting numbers on the Form 990 filed with the IRS and on audited financial statements

  • Misreporting what is spent on professional fund-raising

  • Incomplete and inaccurate 990s

  • Using unreliable methods to track staff time among expense components


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