Not-for-profit organizations tend to make almost twice as many accounting errors on their balance sheets as similarly sized, for-profit companies; this is what emerges from a study by an associate professor of accounting at the University of Notre Dame.
For most non-profits, especially in today's competitive fundraising environment, financial statements play a vital role in communicating important information to key constituents, including donors, current and potential institutions, financial institutions, tax agencies, regulators, and the general public. Incorrect or omitted information affects the overall quality of financial statements and can also mislead those who trust them about the organization's actual performance, obligations, resources, and effectiveness. Both events can jeopardize the future of an organization.
Indeed, the study confirms our long-term experience on what happens when non-profits with limited resources have staff who may not have extensive experience in financial reporting and accounting for non-profit organizations or use auditors that are inexperienced in non-profit accounting to ensure their financial statements are free from material misstatement. In most cases, they fail in the effort and end up paying for it, both literally and figuratively. Since the board of directors and management are ultimately responsible for the financial statements and records of the organization and any inaccuracies therein, it is imperative that they actively participate in the execution and/or maintenance of the organization's review of their financial statements and, most importantly, that they understand the financial statements and the necessary presentation of financial information and communications.
Indeed, and surprisingly, the study found that errors in the financial statements of non-profit organizations have a strong positive correlation with deficiencies in internal control and are most often related to the accounting treatment of expenses, such as insurance, rent, payroll taxes, depreciation, vacations and sickness wages payable and costs of donated goods or services. The reporting errors, about 18% of those identified, can be categorized into five main areas.
1. Recognition Errors
The most common include non-recognition or misreporting of service contributions, volunteer hours, in-kind donations, and rent payments. Incorrect classification of expenses or applying standards set by the Financial Accounting Standards Committee (FASB) can cause material misstatement in the financial statements. This is an area that many non-profits grapple with. If one organization reports in-kind income and expenses and another does not, but should, there will be an immediate failure of the comparison. Likewise, if one organization reports fundraising expenses as expenses and other reports net event income, it is impossible to compare the two.
2. Allocation Errors
Most allocation errors consist of the inability to properly apply an allocation method or maintain a documented policy on the cost allocation methodology or records in sufficient detail to determine the appropriate allocations or simply in an over-allocation. Many errors in this category relate specifically to the allocation and documentation of executive and non-profit staff time allocated to various programs, as well as indirect costs.
3. Presentation Errors
Presentation errors are the most complicated and the most common. Typically, they fall into two categories: failure to report expenditures (by functional categories, i.e., program services, fundraising and administration, and general) and incorrect reporting. Some examples of these errors include incorrect labeling of restricted assets, incorrect classification of fundraising or advertising, and labeling costs as program costs, mixing costs, excluding expenses from a category or total, or disclosure for all of the above.
4. Disclosure Errors
These are also among the most common mistakes and fall into two general types. First, the correct details are withheld, typically for program expenses, allocating functional expense methods, leases, and contribution expenses. The second type refers to the non-disclosure of assets, such as total fundraising expenses, interest paid and capitalized, operating leases, advertising costs, and related party transactions.
5. Statement of functional expenses errors
Managers of not-for-profit organizations generally do not include certain applicable expenses in this statement or omit them entirely from their financial statements.
Although expense accounting and financial reporting for non-profit organizations are complex, errors and risks can be minimized through diligent management and oversight of the board of directors and participation or oversight training of auditors experienced and highly accredited for not-for-profit organizations.
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