Posted by Christina Bell, CPA
A study performed by Jeffrey J. Burks and reported in “Accounting Errors in Nonprofit Organizations” Accounting Horizons 2015, analyzed 5,511 audited financial statements from 2006 to 2010, obtained from Guidestar.org, the world’s largest source of information on nonprofit organizations, and discovered an error rate 60% higher than that of publicly traded companies. Burks discovered that the error rate was negatively correlated with the size of the nonprofit’s audit firm. Specifically, nonprofit organizations audited by the Big Four and second-tier firms had a lower error rate compared to organizations audited by smaller firms. Burks also discovered that the errors were commonly errors of omission and had a strong positive association with internal control deficiencies. This signals that accounting departments of nonprofit organizations should emphasize the importance of correctly identifying, recognizing, and recording transactions.
From my experience certain financial statement items are at a greater risk of being omitted due to their complexity. These items include contributions, contributed services, restrictions on net assets, and fundraising expenses. Information to aid in correctly identifying, recognizing, and recording these items is as follows.
- Contributions –
- Contributions are recognized as revenues or gains upon the occurrence of the underlying event.
- A contribution is an unconditional transfer of assets, which means that all events preceding the contribution are complete and the donor has no right to the return of any transferred assets (or if the assets were promised rather than transferred, the donor has no way to avoid the obligation to transfer the assets in the future). Assets include gifts in kind that can be used or sold by the organization.
- A conditional transfer of assets depends upon the happening (or failure to happen) of a future and uncertain event before the recipient has the right to retain any assets that have been transferred to it. Similarly, a conditional promise to give depends on the happening (or failure to happen) of a future and uncertain event before the recipient of the promise has a right to expect the payment of any promised assets. A condition is effectively a barrier that must be overcome before a promised gift becomes a contribution and can be recognized.
- Contributions are measured at the fair value of the assets received. Difficulty in measuring the transferred assets is not a reason for not recognizing them.
- Contributions received by a nonprofit organization may be subject to restrictions placed on the contributions by the donors, but those restrictions do not change the timing of the recognition of the contribution.
- Contributions are reported gross. Contribution revenue should not be reduced by fundraising expenses incurred in soliciting the resources. In circumstances in which an organization hires a professional fundraiser to solicit contributions on its behalf, the organization should report the contributions raised and the fees charged gross, rather than net.
- Contributed Services – The fair value of donated services should be recognized in the financial statements if the services either create or enhance a nonfinancial asset, or require specialized skills, are provided by entities or persons possessing those skills, and would be purchased if they were not donated. Difficulty in measuring contributed services is not an acceptable reason for not recognizing them. Services that meet the recognition criteria should be recognized using best estimates of value. Services that do not meet either of the preceding criteria should not be recognized.
- Restrictions on Net Assets – Net assets should be classified into one of the following three categories depending on the absence or presence and nature of donor-imposed restrictions.
- Unrestricted Net Assets, which are not restricted either by donors or by law.
- Temporarily Restricted Net Assets, whose use has been limited by donor-imposed time restrictions or purpose restrictions. If two or more temporary restrictions are placed on a contribution, the reclassification from temporarily restricted net assets to unrestricted net assets is made when the last restriction expires.
- Permanently Restricted Net Assets, which have been restricted by donor or by law to be maintained by the organization in perpetuity.
The failure to identify restrictions placed on contribution revenue can cause the omission of temporarily and/or permanently restricted net assets and incorrectly report those assets as unrestricted.
- Fundraising Expenses – Nonprofit organizations are subject to a unique accounting and reporting requirement that requires the reporting of expenses according to the purpose for which they are incurred. Expenses for nonprofit organizations are grouped in functional categories as either program or supporting service expenses. Supporting service expenses are further broken down into the categories of management and general and fundraising. Expenses are directly applied to one of these functional categories, or indirectly applied through an allocation. Fundraising expenses are those that are undertaken to induce potential donors to contribute money, securities, materials, facilities, or other assets. Fundraising expenses also include soliciting contributions of services from individuals, regardless of whether those services meet the recognition criteria for contributed services. A common error is to record fundraising expenses as 100% program expenses. While a portion of the costs may be attributable, and should be classified as program expense, it would be difficult to argue that a portion is also not attributable to fundraising. As such, it would be expected that any nonprofit reporting contribution revenue also be reporting fundraising expenses.
Questions regarding identifying, recognizing, and recording financial items should always be addressed with your organization’s accounting and/or auditing firm but hopefully the above information will help you avoid some of most common omission errors.