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The Nonprofit Starvation Cycle

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Tim Sharpe

on 30 April 2014

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Transcript of The Nonprofit Starvation Cycle

The Nonprofit Starvation Cycle
Why Did I Choose This Topic?
General interest in fraud and nonprofits
To learn more about financial disclosure requirements for nonprofits
5 red flags of fraud (Professor Todd)
Because Dr. Daniels said "NO" to my first thesis proposal
Nonprofit Organizations
Two Types: Governmental and Nongovernmental
Nongovernmental: Religious or Nonreligious
IRS classification: 501(c)(3) - Public charities or private foundations

Underreporting of Overhead
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
"A knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment"
Donors look at two metrics:
1. Program ratio - compares how much a nonprofit spends on fulfilling its mission (known as program expenses) with what it spends on overhead/fund-raising
2. Overhead ratio - compares overhead/fund-raising costs as a percentage of contributions
25% of nonprofits with at least $1 million to $5 million in contributions report zero fund-raising costs
20% of those that took in more than $5 million claim that it cost nothing to do so
Susceptibility to Committing Fraud
Accounting for Nonprofits
Research Questions
Why do nonprofits underreport overhead expenses?
What can be done to prevent underreporting of overhead?
Misleading Reporting & Overhead Phobia
The majority of nonprofits under-report overhead on tax forms and in fund-raising materials.
Researchers examined the tax forms from 220,000 nonprofit organizations to determine the accuracy of financial reporting, they found “widespread reporting that defies plausibility.
"90 percent or even 100 percent of every dollar donated goes to fund programs."
Nowhere in its definition of program, management and general, and fundraising expenses does the IRS explicitly address how to account for marketing and communications activities.
Unrealistic Funders' Expectations
Donors tend to reward nonprofits with the “leanest” profiles.
They skew their funding towards programmatic activities.
Over 50% of adult Americans surveyed believe that all nonprofits should have overhead rates of 20% or less.
Funders do not want to hear about infrastructure or effective administration.
Pressure on Nonprofits to Conform
Nonprofit Starvation Cycle
In-Depth Look:
Accounting and Business Implications
Obvious transparency issues
Executive directors and their boards can find themselves under-investing in infrastructure necessary to improve or even maintain service-delivery standards
Staff members struggle to “do more with "less”
Could jeopardize an organization's very existence
Ultimately, it’s the beneficiaries who suffer
Suggested Solutions to the Problem
Starts with the accountant, who has a fiduciary duty to the public first and foremost
Funders need to be educated in the amount of overhead spending needed to make a nonprofit successful - “The Funders’ Expectations Gap”
Nonprofit grantees need to understand their organizational needs better
IRS needs to provide a better definition of overhead/indirect costs
Stricter punishment for nonprofits that do not accurately report their overhead expenses vs. program expenses
Make non-profits succumb to the standards set forth by the SEC
Nonprofits underreport their overhead expenses because they are trying to satisfy funders' expectations on what overhead spending should be
The nonprofit starvation cycle is what continues to fuel unrealistic expectations
Nonprofits that do not accurately report these expenses need to be penalized, which will level the playing field and eliminate the cycle
This could be the next big area of accounting fraud if changes are not made to the way organizations in the nonprofit sector account for their overhead expenses
References (cont.)
Vermeer, T. E., Raghunandan, K. K., & Forgione, D. A. (2013). GOING-CONCERN MODIFIED AUDIT OPINIONS FOR NON-PROFIT ORGANIZATIONS. Journal of Public Budgeting, Accounting & Financial Management, 25(1), 113-134.
Wing, K., Gordon, T., & Hager, M. (2006). Functional Expense Reporting for Nonprofits. CPA Journal, 76(8), 14-18.
Wing, K., M. A. Hager, P. Rooney, and T. Pollak (2004). Lessons for Boards from the Nonprofit Overhead Cost Project, Guide No. 2. The Center on Nonprofits and Philanthropy at the Urban Institute and the Center of Philanthropy at Indiana University. 76(8), 14-18.
Yetman, M. H., & Yetman, R. J. (2012). The Effects of Governance on the Accuracy of Charitable Expenses Reported by Nonprofit Organizations. Contemporary Accounting Research, 29(3), 738-767.
Yetman, M. H., & Yetman, R. J. (2013). Do Donors Discount Low-Quality Accounting Information? Accounting Review, 88(3), 1041-1067.
Bedsworth, W. “Nonprofit Overhead Costs: Breaking the Vicious Cycle of Misleading Reporting, Unrealistic Expectations, and Pressure to Conform,” Bridgespan White Paper 2008, http://www.bridgespan.org/nonprofit-overhead-costs-2008.aspx.
Calabrese, T., & Grizzle, C. (2012). DEBT, DONORS, AND THE DECISION TO GIVE. Journal Of Public Budgeting, Accounting & Financial Management, 24(2), 221-254.
Glassman, D. M., & Spahn, K. (2012). Performance Measurement for Nonprofits. Journal Of Applied Corporate Finance, 24(2), 72-77.
Gregory, A., & Howard, D. (2009). The Nonprofit Starvation Cycle. Stanford Social Innovation Review, 7(4), 48-53.
McCafferty, J. (2007). Misgivings: recent studies raise an uncharitable question: is nonprofit accounting off track?. CFO, The Magazine for Senior Financial Executives, (1). 38.
The Problem aka
"The Overhead Myth":
Public safety testing
Amateur sports
Animal/child cruelty prevention
Nonreligious 501(c)(3)'s with more than $25,000 in revenue are required to file form 990 annually with the Internal Revenue Service.
Nonprofit leaders feel pressure to conform to funders’ expectations by:
Spending as little as possible on overhead
Reporting lower-than-actual overhead rates
External watchdog organizations played a role in influencing donor behavior
Two of the major nonprofit watchdog groups, Charity Watch and Charity Navigator, include financials in their ratings and put great influence on the program and overhead ratios as part of their assessment.
Require nonprofits in all states to conduct an independent audit
Uniformity in accounting standards
Full transcript