Nonprofit organizations often cite the high percentage of their incoming donations that go directly to the cause they support, not to administrative costs. However, a new study by Jeffrey Burks, associate professor of accountancy at the University of Notre Dame’s Mendoza College of Business, found that nonprofits make accounting errors at a relatively high rate, most likely because they don’t devote many resources to administrative costs.
Burks noted that the rate is almost twice that of similar-sized for-profit corporations.
“Nonprofits of all sizes tend to have high error rates,” Burks said. “The rate of errors does vary with the size of the nonprofit’s audit firm. The clients of the largest eight audit firms in the country have a significantly lower rate of errors. The clients of these large audit firms tend to be large nonprofits, but the effect does not translate into a lower error rate for large nonprofits overall because so few nonprofits are audited by the top eight audit firms — only about 7 percent of my sample.”
Burks had a team of undergraduate research assistants download the audited financial statements of nonprofits and look through them to identify cases when the nonprofit disclosed that it was correcting an error.
“The financial statements were downloaded from the Guidestar website, through which many nonprofits make their financial statements available to the donor community,” he said. “I then reviewed each error, recording details such as the amount of the misstatement, the accounts involved and the circumstances surrounding the error. I also used statistical analysis to identify factors that are associated with errors, such as the type of auditor and the presence of internal control weaknesses.”
Burks believes that the low administrative costs that nonprofits cite may, in fact, be contributing to their high rate of accounting errors.
“From talking with nonprofit CFOs and auditors, nonprofits have limited resources and understandably seek to expend the vast majority of those resources on mission-related activities rather than on administrative functions like accounting,” he said. “Although investments in high-quality information systems can pay off by improving a nonprofit’s efficiency and effectiveness, there are difficult tradeoffs to make because dollars spent to upgrade systems or to hire an accountant could mean fewer dollars going to mission-related activities.”
If resource constraints and competing priorities make it difficult for many nonprofits to make large investments in reporting systems and internal controls, what, then, are some realistic and low-cost steps nonprofits can take to reduce errors?
“I found that most errors are errors of omission rather than commission,” Burks said. “For example, most of the time the mistake is not that we booked an expense that we shouldn’t have, or booked an expense for the wrong amount. Instead, the mistake is that we forgot to book the expense in the first place. Forgetting or failing to book items — revenues, expenses, assets, liabilities — is by far the most common type of mistake that nonprofits make.
“Nonprofits could attempt to cut down on these types of mistakes by improving their accounting systems’ ability to collect information from their operating environments and signal when items should be booked. This could involve training staff throughout the organization to identify common triggering events that would require items to be booked, developing procedures through which those events are communicated to the accounting function, and conducting regular management reviews to detect triggering events.
“For example, when a donor makes a written promise to give, this should trigger the booking of revenue, but sometimes this step is forgotten because the organization has received nothing actionable like a check that someone must deposit in the bank. There should be established procedures for ensuring that promises to give are captured by the accounting system. Furthermore, management should schedule periodic reviews of these recorded promises so that they remember to reduce the recorded amounts if events occur that make collection doubtful.”
Burks’ study appears in the journal Accounting Horizons. It can be viewed online here.
Contact: Jeffrey Burks, 574-631-7628, firstname.lastname@example.org