Knowledge and Insights

Nonprofit organizations tend to make almost two times more accounting errors on their public financial statements than similarly-sized for-profit companies; that is according to a study by an associate professor of accountancy at the University of Notre Dame, on which a few recent articles I’ve read were based.

For most nonprofits, and particularly in today’s competitive fundraising environment, financial statements play a critical role in communicating key information to important constituents, including current and potential donors, financial institutions, regulatory agencies, and the general public.  Incorrect or omitted information not only impacts the overall quality of the financial statements, but also may mislead those relying on them about the organization’s true performance, obligations, resources and efficiency.  Clearly, either occurrence can jeopardize an organization’s future.

Indeed, the study supports our long-term experience at Mercadien about what happens when nonprofits with limited resources rely on staff that may not have extensive nonprofit financial reporting and accounting backgrounds or utilize auditors inexperienced in nonprofit accounting, to help ensure their financial statements are free from material misstatements.  They are, more often than not, unsuccessful in the endeavor and end up paying for it, literally and figuratively.  Since management and the board of directors are ultimately responsible for the organization’s financial statements and filings, and any misrepresentations of same, it’s vital for them to be actively involved in executing and/or reviewing their financial reports and, even more importantly, to understand the financial statements and required presentation of financial information and disclosures.

In fact, and not surprisingly, the study noted that nonprofit financial statement errors have a strong positive correlation to internal control deficiencies and were most commonly related to the accounting treatment of expenses, such as rent, insurance, depreciation, payroll taxes, vacation and sick wages payable, and costs of donated goods or services.   The reporting errors, approximately 18% of those identified, can be categorized into five main areas.

1. Recognition Errors

The most common of these include failing to recognize or misreporting contributions of services, volunteer hours, gifts-in-kind, and lease payments. Incorrectly classifying expenses or applying standards established by the Financial Accounting Standards Board (FASB) can result in material misstatements in the financial statement. This is an area where many nonprofits benchmark themselves against one other.  If one organization reports in-kind income and expense and another does not, but should have, there is an immediate failure in the comparison.  Similarly, if one organization reports fundraising expenses as expenses and another reports them net of the event income, it is impossible to compare the two.

2. Allocation Errors

The majority of allocation errors consist of failures to appropriately apply an allocation method, or to maintain a documented policy on cost allocation methodology or enough detailed records to determine appropriate allocations, or just over-allocation.  Many errors in this category specifically relate to allocation and documentation of nonprofit executives’ and employees’ time attributed to various programs, as well as indirect overhead costs.

3. Presentation Errors

Presentation errors are the most complicated and common. They generally fall into two categories: failing to report expenses (by functional class, i.e., program services, fundraising, and management and general) and misreporting.  Examples of these errors include incorrectly labeling restricted assets; or improperly classifying fundraising or advertising and branding expenses as program costs; mixing expenses; or excluding expenses from a category or total, or incorrect disclosures for all of above.

4. Disclosure Errors

These are also among the most common errors and fall into two general types. First is failure to disclose adequate details, usually for program expenses, methods for allocating functional expenses, lease arrangements, and contributed expenses.  The second type involves failure to disclose activities, such as total fundraising expenses, interest paid and capitalized, rent on operating leases, advertising costs and related-party transactions.

5. Statement of Functional Expense Errors

Nonprofit managers often fail to include certain applicable expenses on this statement, or mistakenly omit it entirely from their financial statements.

Although nonprofit expense accounting and financial statement reporting are complex, errors and risks can be minimized through diligent oversight by management and the board, as well as involvement or training by knowledgeable and highly-credentialed auditors, such as those in Mercadien’s Nonprofit Services Group.  We are here to help clients and the nonprofit community with these issues.  For a formal assessment or informal second opinion on the state of your internal control systems, accounting processes and financial statements, please contact me at [email protected] or 609-689-9700.