Before making a contribution to a charity or nonprofit organization, some potential donors check the organization’s financial records to see how much of the donated funds are actually going toward the work the donor supports. But what if those financial figures are wrong?
Jeffrey Burks (FIN ’97), associate professor of accountancy at the Mendoza College, recently tackled this question in his research titled, “Accounting Errors in Nonprofit Organizations,” published in the June 2015 edition of Accounting Horizons.
Burks found that about 6 percent of public charities report accounting errors each year, a rate that is 60 percent higher than public corporations, and twice as high as similarly sized corporations. “Donors assume that the resources of a nonprofit are being used properly,” Burks says. “When an error arises, it could be a sign of larger problems. It could also be a sign of poor internal controls.”
Most of Burks’ research focuses on accounting errors that corporations make, but he was interested to know more about errors in the not-for-profit sector. “I really didn’t know what I would find,” Burks says. “We know that many nonprofits produce audited financial statements. What does a typical error look like for a nonprofit? How often are errors made? Accounting issues that they face tend to be simpler than those of a corporation, so maybe nonprofits don’t make as many errors? I wasn’t sure what the answer was going to be.”
To find out, Burks and his team took a sample of 5,511 audited financial statements — mostly from 2006 to 2010 — from GuideStar, a data provider for nonprofits. After analyzing the data, Burks found that most of the errors nonprofits make are what he describes as “errors of omission.”
“It’s things like, ‘We didn’t book an expense,’ or ‘We didn’t book something we should have’ rather than errors of commission like, ‘We booked something that we shouldn’t have.’ Often the errors appear to be simple cases of, ‘We forgot to book it,’” Burks says.
Why so many errors in the nonprofit books? Burks suggests there are a few things driving it. “There is a lot of pressure on nonprofits from donors to devote most of the revenue to mission-related activities,” he says, “so outside of the largest nonprofits, you don’t see many organizations spending a lot of money on accountants. They may have a CFO who handles many different functions within the organization, including accounting, but a lot of nonprofits do not have a full-time or highly trained accountant. That’s the likely explanation for why more errors happen.”
Additionally, very few charities invest in audits by top accounting firms. Instead they tend to rely on smaller, regional companies to take care of reviewing the books. “Nonprofits that have Big 4 auditors, or the second tier (those ranked five to eight), have very low rates of error,” Burks says. “A lot of it is probably self-selection. Nonprofits that already have sound accounting practices and internal controls tend to opt for these bigger firms, and the bigger firms are willing to take them on as clients. But in most cases, nonprofits are constrained for resources, so they can’t make the investments that would make them an attractive client for a large audit firm.”
So what can a cash-strapped nonprofit do to make sure it isn’t making accounting errors? Burks has a few suggestions. “A nonprofit can set up regular reviews to try to identify things that it may have forgotten to book,” he says. “Also, an organization can figure out what its common triggering events are and set up processes so that those events are reported to the accounting function.” And what about from the vantage point of the donor? Should such errors keep them from making contributions to some nonprofits? Burks generally doesn’t think so, but he advises donors to be cautious. “I think there should be some concern on the margin,” he says. “You want to invest your money in an organization that is run well and pursues causes that you care about. Say you identify a set of nonprofits that are doing good work. Where should you put your money? You want to go with the one that has its act together. Sound accounting practices tend to go along with being a well-managed organization, both financially and operationally.”