Expense Reporting for Nonprofits
The Accounting Profession’s Next
Kennard Wing, Teresa Gordon, Mark Hager, Thomas Pollak,
and Patrick Rooney
2006 - The shock waves sent through the accounting profession
by Enron and other corporate scandals continue to be felt.
CPAs have been working hard to overcome the damage to their
prestige and to the public trust. The last thing the profession
needs is a new scandal.
nonprofit financial reporting represents a potential ticking
time bomb for the profession. The authors’ Nonprofit
Overhead Cost Project (see the Sidebar)
found serious and widespread errors in IRS Forms 990 and
audited financial statements prepared or attested to by
CPAs. The dollar amounts involved may be smaller than for
large public companies, and the errors less likely the result
of malfeasance, but these errors can and should be corrected.
This article shows where the problems are, and presents
one approach to doing something about them.
Importance of Functional Expense Reporting
most widespread and serious problems in nonprofits concern
expenses by functional classification (program, 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
commonly used financial indicators are the program-spending
ratio (total program expenses ÷ total expenses) 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.
traded companies’ audited financial statements are
public documents, while the tax return is a private matter
between the corporation and the IRS. For nonprofits, the
opposite is the case. A nonprofit’s Form 990 is a
public document. Nearly 2.4 million that have been imaged
by the IRS are available online at www.guidestar.org. In
contrast, nonprofits’ audited financial statements
are required to be released by only a minority of states’
charity registration offices.
the data are readily available, most donors, funders, and
charity watchdog agencies calculate program-spending and
fundraising-efficiency ratios using Form 990 data. The authors’
study of this data found widespread reporting that defies
plausibility in the functional expenses used to make those
calculations. Examples include the following:
37% of nonprofits with at least $50,000 in contributions
report zero fundraising costs.
One-fourth of nonprofits reporting $1 million to $5 million
in contributions report zero fundraising costs, as do
nearly one-fifth of those reporting more than $5 million
13% of nonprofits report zero management-and-general expenses.
7% charged all accounting fees to programs, and another
20% split them across more than one category—despite
the fact that Form 990 instructions use accounting fees
as an example of what is meant by management-and-general
of the large number of nonprofits reporting zero fundraising
costs, the authors included two such organizations in a
set of nine in-depth case studies they performed. The first
organization erroneously reported zero fundraising costs
in its audited financials, and on its Form 990. The organization
had a part-time employee who worked exclusively on fundraising,
the executive director was involved in fundraising, and
the organization did some direct-mail fundraising. In the
second case, the tax professional at the audit firm prepared
a Form 990 with zero fundraising cost despite the fact that
the financials behind the opinion letter of the audit team
showed more than $500,000 in fundraising expenses. When
the authors’ research team asked about this almost
a year later, no one inside the organization had noticed,
and all expressed bewilderment as to how the error could
a limited number of organizations, including the nine case
studies, the authors looked closely at the Form 990 reporting.
Aside from the functional expense problems, the authors
found several other issues.
case studies turned up two different ways that nonprofits
report restricted contributions in Part I of Form 990. Users
rely on reported contribution amounts to calculate fundraising-efficiency
ratios. Those ratios may lead users to draw false conclusions
if not all organizations report contributions the same way.
Most organizations report the total of unrestricted, temporarily
restricted, and permanently restricted contributions on
Line 1d. Yet the authors also found that some organizations
report only unrestricted contributions on Line 1d, and report
the change in restricted net assets on Line 20 as an “Other
Change in Net Assets.” A review of Form 990 and its
instructions suggests that this problem arises because the
form does not provide separate blanks for unrestricted,
temporarily restricted, and permanently restricted revenue.
The authors recommend that all contributions be reported
on Line 1d.
authors also found that organizations do not always report
donated space and services properly. Organizations that
leverage significant amounts of such in-kind donations can
appear to have unusually high overhead because their value
is excluded from revenue and expenses (unlike donated goods).
One organization in the case study had been told by a funder
reviewing its Form 990 that its grant would not be renewed
because overhead was more than 30% of total expenses. Based
on GAAP financials, the organization’s overhead consumed
only 12% of total expenses. Donated space and professional
services accounted for the difference. Given the importance
of overhead reporting to public users, it is important for
preparers of Form 990 to include the value of these in-kind
donations in the appropriate places. It should appear in
Part IV-A Line b(2) and Part IV-B Line b(1), where the Form
990 values are reconciled to the audited financials. This
value, plus any other donated services not valued under
GAAP, should also be reported in Part VI Line 82(b).
990 reporting for nonprofits composed of multiple, affiliated
legal entities also makes overhead and fundraising cost
analysis problematic for users. The majority of organizations
in the case study, and five of the six with more than $1.5
million in annual revenue, consisted of such conglomerates.
Unless the entities are covered by a group exemption letter,
the IRS requires separate reporting for each entity. In
three of the five largest cases, all or almost all management-and-general
and fundraising costs were reported in a single entity’s
Form 990, leaving zero or very low nonprogram costs in the
other entities. Given such practices, the overhead and fundraising
costs of nonprofits with complex legal structures cannot
be accurately assessed using Form 990 data. The case studies
suggest this is not uncommon among large nonprofits. The
best thing for users would be for the IRS to switch to consolidated
reporting, such as required by GAAP. Until then, tax professionals
can make Form 990 information more accurate and useful by
allocating fair shares of management and general and fundraising
costs to all reporting entities.
addition to these problems with Form 990, the case studies
also turned up a few gross errors in audited financial statements.
The aforementioned organization whose statement of activities
erroneously reported zero fundraising costs is one such
error. Another organization’s audited financials placed
the statement of functional expenses in with the supplemental
information, despite the fact that SFAS 117, Financial
Statements of Not-for-Profit Organizations, clearly
states that it is a required part of the core financial
statements for this type of organization.
from the implausible functional expense numbers reported
on Forms 990 and financial statements lie accounting methods
that range from inadequate to incorrect. The authors’
national survey of a representative sample of more than
1,500 nonprofit organizations, for example, found that only
25% of nonprofits that receive foundation grants properly
classify those proposal-writing costs as fundraising expenses.
Only 17% of nonprofits that receive government grants properly
report those proposal-writing costs as fundraising expenses.
percentage is probably low, given that many government grants
provide only incidental benefits to the grantor. This type
of grant is equivalent to a charitable contribution, and
proposal-writing costs should be treated as a fundraising
expense. When the primary beneficiary is the governmental
unit providing the funding (i.e., an exchange transaction
of money for services), proposal-writing costs are properly
classified as management-and-general expenses.
costs form the largest expense at many nonprofits, and how
those costs are allocated across the program, management-and-general,
and fundraising categories can make a huge difference in
their program-spending and fundraising-efficiency ratios.
In the authors’ survey, barely one-third of nonprofits
said they track staff time by functional expense category
for each payroll period. Similarly, in the case studies,
three of the nine organizations had a paper or automated
time-tracking system that was capable of serving as the
basis for functional expense tracking. Unfortunately, only
one of those three used it for that purpose, and in that
case the fundraising staffer charged proposal-writing time
to the grant-funded program rather than properly accounting
for it as fundraising costs. (Interestingly, this organization
had adopted its timesheet system only at the urging of its
the other eight organizations, the vast majority of employees
were classified as falling wholly within one of the three
functional expense categories. The rest of the staff made
a retrospective judgment at year-end about how they had
spent their time, and this was used to allocate their personnel
costs across the functional categories. The accuracy of
such judgments is open to question, and given the emphasis
that users place on low overhead and low fundraising costs,
it is not surprising that such judgments tended to result
in low percentages for management-and-general costs, and
especially fundraising costs.
the nonprofit organizations surveyed reported that they
used a CPA firm with a regional practice and at least one
partner who specialized in nonprofits. Typically, the same
audit firm had been used for some years and was familiar
with the organization’s structure and finances. Most
Form 990s were prepared by a tax professional at the audit
firm. Therefore, the authors’ findings cannot be readily
explained away by lack of experience at these public accounting
research suggests that a number of factors contribute to
the current state of nonprofit reporting:
Many nonprofits, especially small ones and those with
a majority of donor-restricted funds, have inadequate
accounting staff and systems.
The overemphasis on overhead expenses by donors, funders,
and charity watchdogs gives nonprofits a significant incentive
to underreport overhead.
The accounting profession continues to think of the audited
financials as the public document, and has not applied
its audit and attest standards to the Form 990.
The accounting profession does not consider the method
by which expenses are allocated into functional classifications
to be an important audit issue.
the first two of these are primarily the responsibility
of a nonprofit’s board and management, clearly the
public accounting profession is responsible for the latter
two, and has a role to play in addressing the first two
as well. The underreporting of overhead that is so widespread
in the nonprofit sector could not exist without the tolerance
of the auditors. And many nonprofits rely on their auditors
to advise them on accounting issues.
the public nature of Form 990, the profession must reorient
its thinking and begin to apply the same assurance standards
to that document as it applies to audit and attest work.
Next, the profession must recognize the importance that
users place on expenses by functional classification and
make that an important audit issue.
that point, auditors will have to face both the inadequate
accounting systems of most nonprofits, and their incentive
to underreport overhead expenses. An auditor’s desire
to maintain a positive working relationship with a client
is going to be in conflict with the need to maintain public
reputation and trust. As the Enron–Arthur Andersen
case demonstrated, public reputation and trust are the more
valuable assets at risk here. Nevertheless, a graduated
response is possible.
some cases, the auditor will be able to identify misallocations
across functional classifications and can require adjusting
entries to correct the problem. In other cases, the auditor
will recognize weak accounting methods that “happen
to” result in underreported overhead, but will be
unable to determine the appropriate allocation of expenses
after the fact.
minimum response in these cases is to use the management
letter to identify and raise concerns about the quality
of accounting for functional expenses. If the same problems
persist the next year, the auditor’s next response
would be to point out that notes to the financial statements
are required to explain significant accounting policies,
especially where alternatives exist, and that because functional
expense reporting is so important to users, methods of accounting
for overhead require footnote disclosure. This is less effective
in the nonprofit world than in the corporate world, because
the notes are not tied to the public Form 990, but nonetheless,
it should succeed in getting management to resolve the problems.
the problems remain the third year, the appropriate response
for an auditor to consider is rendering a qualified opinion
letter that narrowly focuses on problematic allocation of
costs among functional categories. This action would likely
upset the nonprofit client tremendously, but is the best
way to protect the auditor’s public reputation and
there is currently no way for a CPA to offer a similarly
qualified opinion of the numbers on Form 990. IRS enrolled
agent standards (Circular 230, particularly sections 10.21,
10.22, and 10.33), however, could provide support to a strong
position taken by a CPA firm attempting to ensure that the
Form 990 return fairly represents the financial position
of a tax-exempt client. The AICPA’s Statements on
Standards for Tax Services (SSTS) could be amended to clarify
that preparation of returns based on audited financial statements
should properly reflect audited revenues and expenses with
appropriate reconciliation to equivalent figures on the
return. Most important, state and national accounting organizations
could serve as a strong positive force by educating their
members as to the importance of Form 990 and the functional
expense allocations used by so many donors.
the Profession Can Respond
nonprofit organizations are required by SFAS 117 to report
expenses by functional classification. The many users that
emphasize program-spending and fundraising-efficiency ratios
are relying on these numbers, and assuming that they fairly
reflect the activities of the organization. Taken collectively,
the findings of the authors’ Nonprofit Overhead Cost
Project suggest that this information—often prepared
by or attested to by CPAs—is in many cases incomplete,
misleading, or inaccurate.
of the public accounting profession can respond in three
Recognize the emphasis that the public places on functional
expense classification and make it an important audit
Recognize that Form 990 is the major public financial
document in the nonprofit sector and apply the same standards
to it that are applied to audit and attest work.
Confront the weak accounting and underreporting at nonprofit
clients through the graduated response suggested here.
Wing, CMA, is principal of Kennard T. Wing &
Co., Havertown, Pa., a consultancy providing planning, research,
and evaluation services to the nonprofit sector.
Teresa Gordon, PhD, CPA, is professor of
accounting at the University of Idaho, Moscow, Idaho.
Mark Hager, PhD, is director of the Center
for Community and Business Research at the Institute for Economic
Development, University of Texas at San Antonio.
Thomas Pollak, JD, is assistant director
of the National Center for Charitable Statistics at the Urban
Institute in Washington, D.C.
Patrick Rooney, PhD, is director of research
at the Center on Philanthropy at Indiana University and associate
professor of economics and philanthropic studies at Indiana
University–Purdue University, Indianapolis.
more of this month's Special Focus on Nonprofit Management,