Because nonprofit financial reporting fraud often looks quite different than it does in the for-profit world so should the methods for finding it.
Have you ever tried to measure the air’s temperature using a calculator? It cannot be done so why even try?
To a lesser extent, the same can be said about the operations of a nonprofit entity: Measuring the “temperature” of a nonprofit using a calculator (and a financial statement) will not garner the facts you need.
By comparison, things are fairly simple in the for-profit world. The goal of a business is to make money for its owners. The measure of a business’ success in achieving that goal primarily is found by looking at the bottom line – the net profit on the income statement. Sure, other things come into play in evaluating a business, but it all starts with the bottom line on the P&L.
In the nonprofit world, the goal of an organization is to carry out programs designed to accomplish a mission. And that mission is inherently non-financial.
The closest thing a nonprofit organization has to a true financial measure of performance is its ratio of program expenses to total expenses (or to total income). This ratio is used (and often over-emphasized) by many funding sources, charity watchdog groups, and others to evaluate nonprofits and to compare one to another.
All expenses of nonprofit organizations can be categorized as either “programs” or “supporting services.” Program expenses are those associated with the delivery of goods or services in fulfillment of an organization's mission. Supporting service expenses are all other expenses that are necessary to run an organization. Most charities report two categories of supporting service expenses:
- Fundraising (the cost of soliciting contributions), often referred to as the “cost of generating funds” outside the U.S., such as in the United Kingdom and Australia; and
- Management and general (all costs that do not accomplish programs or solicit funds).
Here is where the risk of financial reporting fraud enters the picture. Over the years, the pressure on nonprofit organizations to issue financial statements that maximize the proportion of expenses classified as program expenditures has reached extreme levels. Some organizations have resorted to a variety of tactics designed to inflate their program expense ratios.
There are many incentives, from both personal and organizational perspectives, to commit such financial reporting fraud: