Nonprofit Fraud: When the Bottom Line is Not the Bottom Line

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:

1. Funding sources establish minimum program expense ratios as one of the criteria for making grants to an organization.
2. The media ranks and compares nonprofits based on program expense ratios. (For example, in each of the last couple of years, Worth magazine has profiled its “best” and “worst” charities based, in part, on program expense ratios.)
3. Charity “watchdog” groups in the U.S., such as the BBB Wise Giving Alliance, an affiliate of the Council of Better Business Bureaus, established minimum program expense ratios as one of the standards by which they evaluate charities. (BBB Wise Giving Alliance expects at least 65 percent of an organization’s expenses to be classified as program expenses.)

Of course, people, not organizations, are behind financial reporting fraud. In the case of nonprofit financial reporting frauds, a direct or indirect benefit to the perpetrator may or may not be part of the motive. In some cases, the fraudster may gain a promotion, increase in salary, or bonus if an entity’s reported program expense ratio achieves an established threshold. In other cases, a motive can be simply a pat on the back for a job well done or the assurance of job safety.

There are at least five different methods fraudsters can use to artificially inflate a program expense ratio:

1. netting the results of special fundraising events and activities;
2. exaggerating the values of non-cash gifts received and made;
3. improperly reporting contributions raised on behalf of other nonprofits;
4. misapplying the accounting rules applicable to “joint” activities that purport to serve both programmatic and fundraising objectives; and
5. outright misclassification of fundraising or management expenses as program expenses.

Each method results in a program expenses/total expenses ratio that is inflated, without affecting the bottom line. (The effect of correcting the financial statements of a charity that has committed all five types of fraud is illustrated in the exhibit below.)

Netting 

Netting occurs when a nonprofit reports as contribution income the net amount left after conducting a fundraising event. U.S. accounting rules were clarified several years ago to drastically limit the instances in which this practice is acceptable. Nonetheless, some organizations continue to do it rather than report the total amount received as income and the costs of the event as fundraising and management and general costs. Only in rare instances are any of the costs of these events considered program costs (a topic that will be discussed below under joint activities). Netting results in lower than actual fundraising and management and general costs, which artificially inflates the program expense ratio.

Exaggerating Values of Non-cash Gifts 

Some charities receive non-cash contributions in the form of food, clothing, equipment, supplies, cars, and other assets. Additional non-cash contributions may include rent-free use of land or buildings and volunteer time. U.S. accounting rules require that most of these contributions be recorded at fair market value. (Certain types of contributed services are not to be recorded at all.) In most cases, this means recording income and expense (or inventory and later, an expense) in equal amounts. Most of the expenses are classified as program expenses since the donated items or services are used in carrying out program activities. As a result, the use of inflated market values distorts the program expense ratio.

Improperly Reporting Other Contributions 

Another area of accounting in which the U.S. rules have changed in recent years involves a charity that raises funds on behalf of other charities. When a donor makes a $200 payment to Charity A, but earmarks $100 of that gift for Charity B and $50 for Charity C, how much income should Charity A recognize? Current accounting rules limit income recognition to the $50 left for Charity A to keep. The $150 that Charity A does not control should be reflected as a liability until transferred to Charities B and C. Some nonprofits will inappropriately recognize all $200 as contribution income, with the $150 of earmarked gifts classified as program expenses, as though they were grants made by Charity A to the other charities. Again, the result is inflation in the program expense ratio.

Misapplying Joint Activities Rules 

A joint activity is one which purports to accomplish multiple purposes simultaneously, most commonly a fundraising and a program purpose. Direct mail activities often are claimed to have dual purposes. They solicit a contribution (a fundraising purpose). But they also provide useful information related to a charity’s mission (a program purpose). However, over the years many nonprofits have abused this area. Often, a nonprofit included some limited information about the entity’s cause with a solicitation. The only reason for including the information was to help establish a need for the requested financial support. Yet, the majority (and sometimes all) the costs of the activity would be classified as a program cost.

The American Institute of CPAs (AICPA) issued stricter rules on joint activities in 1998 (Statement of Position 98-2), which established tougher criteria for classifying costs as anything other than fundraising. But many feel the rules are confusing and misapplied.

Outright Misclassification 

I have saved the most obvious method for last because even in the most flagrant of situations, the question of intent comes into play with many nonprofit financial reporting frauds. If a nonprofit manager pays a professional fundraiser to raise funds for the organization and intentionally classifies that fee as a program cost, there is no question that financial reporting fraud has occurred. Or is there? What if the mission of the organization is to raise funds for other charities? Does that change the classification of a fundraising cost to a program cost? The answer, according to the accounting standards, is a resounding NO – costs incurred to solicit contributions, whether those contributions are for the soliciting entity or other charities, are always to be classified as fundraising costs. If an entity simply does not understand these rules and mistakenly thinks these costs are program costs, the intent to defraud is not present. But the entity may still appear guilty to outsiders, and that is one of the factors that makes this issue especially tricky.

And to complicate the situation, too many auditors and fraud examiners – despite the charity frauds in the headlines – still audit and examine nonprofits no differently than for-profits. They focus on whether net profit or loss (change in net assets) and the balance sheet (statement of financial position) are fairly stated. In each of the financial reporting frauds described here, neither of these elements of the financial statements will be affected, as illustrated in the exhibit on page 46. Frauds may go undetected if fraud examiners or auditors are unaware of the risks. Most government-level enforcement efforts in the area of financial reporting of nonprofits have come from the state or province level. Several states and provinces have aggressively gone after charities that have filed fraudulent financial statements or other reports with state or provincial agencies.

The closest thing that U.S. nonprofits have to a Securities and Exchange Commission or other federal-level oversight body is the Internal Revenue Service (IRS), which has been under increased pressure to do more in this area. In response, the IRS has for the first time announced that it will begin assessing penalties in connection with inaccurate filings of nonprofit information returns (known as Form 990). Up to now, these penalties have been reserved for missed filings and intentional omissions of required data on the returns. Additionally, U.S. Congressional support for increased penalties associated with misleading Form 990 information has gained momentum.

The laws and penalties for nonprofit financial reporting fraud are still in flux but one thing is certain. The awareness of the risks has increased dramatically. As a result, nonprofits and their external auditors and advisors, are entering a new era of skepticism and oversight that is looking more like the for-profit world every day.

Gerard M. Zack, CFE, CPA, is the author of the book, “Fraud and Abuse in Nonprofit Organizations: A Guide to Prevention and Detection” (published June 2003 by John Wiley & Sons and offered through the ACFE). He is a partner in the consulting and accounting firm of Williams Young, LLC, as well as the founder of the Nonprofit Resource Center. Zack is based in Rockville, Md. He may be contacted at (301) 987-0287 or through NRC’s Web site. 

GAAP vs. Tax Dilemma 

Complicating the comparison of U.S. charities are the differing pictures painted of an organization’s financial results depending on which document is being used. Unlike the comparison of for-profit businesses, which is usually based on an evaluation of audited financial statements prepared in accordance with generally accepted accounting principles (GAAP), there are two different sources of data used to evaluate nonprofits. While many users evaluate charities based on audited financial statements prepared in accordance with GAAP, many evaluations are also based on the annual Form 990 information return charities file with the IRS. And the basis of reporting used on the Form 990 can have several important differences from the financial results reflected on GAAP-basis financial statements. The most notable and potentially material of these differences involves non-cash contributions received by charities. Form 990 limits the reporting of non-cash gifts on the main statement of activities to transfers of assets to a charity (i.e. food, supplies, clothing, equipment, stocks, etc.). But GAAP-basis financial statements may reflect two additional types of non-cash contributions that must be excluded from the Form 990:

1. The value of volunteer labor (much, but not all, of which is reported for GAAP purposes), and
2. Donated use of facilities (i.e. rent-free space).

For GAAP purposes, these two categories of support are frequently reported as contribution income and program expenses in equal amounts. But since they are left off the Form 990’s statement of activities, very different (and lower) program expense ratios will be calculated when the IRS-submitted form is utilized.

This exclusion of the value of contributed services and use of facilities is not unique to U.S.-based reporting to governmental agencies by charities. In Canada, for instance, the Registered Charity Information Return filed with the Canada Customs and Revenue Agency specifically excludes such contributions from the definition of “gifts” to be reported.

Similar Issues Emerging Outside the U.S. 

In comparing GAAP in the U.S. with standards established in several other countries, it appears that the U.S. standard-setting bodies – the Financial Accounting Standards Board (FASB) and the American Institute of CPAs (AICPA) are unique in having established several separate accounting standards (from FASB) or statements of position (from AICPA) that apply solely to not-for-profit organizations. But that does not mean that some of the same issues have not been considered by non-U.S.-based standard-setting bodies or that increased focus on reporting by nonprofits is not under consideration.

In May 2003 the United Kingdom’s Accounting Standards Board issued a “Discussion Paper” designed to begin the process of developing ideas for improving the quality and consistency of reporting for “public benefit entities” (a term that includes not-for-profit organizations). In 2000, a revised Statement of Recommended Practice (SORP) on Accounting and Reporting by Charities was published for U.K. charities. In this SORP, many of the same issues addressed in this article are addressed, such as non-recognition of contributions received as an agent for other charities and recognition of donated assets and contributed services (referred to as “intangible income”) at fair market value. But in the area of classifying expenses as fundraising or program-related, guidance is limited to using a “reasonable, justifiable and consistent basis.” Guidance on addressing “joint activities” is very limited in comparison with the rules described in the AICPA’s SOP 98-2.

In Australia, there are no separate accounting standards for not-for-profit organizations. However, the Institute of Chartered Accountants of Australia issued a report in May 2003 that evaluates the quality and consistency of financial reporting by nonprofits. In the report, the ICAA recommends reporting of donated goods and services at fair market value, with only limited differences from the methods required in the U.S. However, there is no specific guidance on allocating expenses and little on distinguishing program-related activities from fundraising activities. But clearly, this report, along with a separate checklist, indicates a heightened sense of importance of reporting by nonprofits.

Similarly, Canada’s accounting standards also do not include separate rules addressing these issues unique to nonprofits and there is no guidance similar to that found in SOP 98-2. However, it has been indicated that Canada's Accounting Standards Board may be looking into expense allocations and disclosures in the near future, though a separate standard is unlikely.

Exhibit
An Illustration of Nonprofit Reporting Fraud