Are Joint Costs Valid?

Charity Navigator last year issued a change to the financial metric reporting.  The tone of the statement by Charity Navigator brings up an interesting debate about what is or isn’t accurate reporting.   The statement by Charity Navigator is this:

“Joint Cost Allocation Adjustment

Generally Accepted Accounting Principles (GAAP) allow for organizations that follow SOP 98-2 or ASC 958-720-45 to report their specific joint costs from combined educational campaigns and fundraising solicitations and the IRS requires organizations to disclose this on the Form 990. In most cases, charities utilizing this technique allocate a small percentage of their solicitation costs to program expenses from fundraising expenses. However, we believe that donors are not generally aware of this accounting technique and that they would not embrace it if they knew a charity was employing it, nor does Charity Navigator. Therefore, as an advisor and advocate for donors, with rare exception, when we see charities using this technique we factor out the joint costs allocated to program expenses and add them to fundraising.”

Let’s break down this statement and address it in light of GAAP and IRS requirements:

“Generally Accepted Accounting Principles allow…utilizing this technique…”

This is an interesting choice of words by Charity Navigator.  They say that GAAP allow organizations to follow principles rather than require.  Charity Navigator is taking a stance here on where they see the importance of GAAP.  What they seem to be saying is that GAAP are a set of principles that are allowed, and organizations simply pick and choose which of the principles they would like to follow.  They also do not refer to them as accounting principles but rather, techniques, not a term I’ve heard used before.

I’d like to suggest that this is bad guidance to follow.  Don’t fall into the trap of thinking that you simply pick the principles that you like, follow those, and ignore the ones you don’t like.  If your organization has an activity that meets the criteria of joint costs/activities, you should report it as such.  Accounting records should not be massaged to influence watchdog rating criteria.

The guidance for Joint Activities is found in ASC 958-720-45, starting at paragraph 45-28.  Looking at paragraph 45-29, the guidance states, “If the criteria of purpose, audience, and content are met, the costs of a joint activity shall be classified as follows…”  The guidance here and in the following paragraphs does not seem to make any provision for organizations to elect or choose to follow this guidance.

For more information on accounting for joint costs, see our previous post Joint Costs and Joint Activities

For more information on functional expense reporting, see our previous post Functional Expense Reporting

The Form 990 line that Charity Navigator is referring to is Part IX, Line 26.  The instructions for this line refer only to specifics kinds of joint activities.  Per the Form 990 instructions, “An organization conducts a combined educational campaign and fundraising solicitation when it solicits contributions and includes, with the solicitation, educational material or other information that furthers a bona-fide non-fundraising exempt purpose of the organization.”  Given this specific criteria, it is possible that an organization would have joint costs allocations in their audited financial statements that would not be included on Line 26 of Part IX of the 990.  As always, check with your tax professional for advice.

“…charities…allocate…solicitation costs to program expenses…”

The wording that Charity Navigator uses to describe the process here, instantly influences the reader to a certain opinion as to what organizations are doing.  It’s subtle, but I think it’s important.  What CN is saying is that organizations are taking expenses from fundraising, and moving them to programs.  It makes it seem like organizations are doing some creative accounting.  But, this is not what is happening in most cases.

An organization following GAAP, is not moving expenses, but is rather reporting expenses in the correct bucket to begin with.  The expenses recorded under joint costs are program expenses because they are the expenses for running programs.  They are not fundraising expenses and therefore cannot have been moved from fundraising to programs.  By framing these expenses as having been moved, it places doubt in the mind of the reader as to the validity of the joint costs.  However, most organizations reporting joint costs are simply accurately reporting their expenses, and not moving anything.

Joint costs, along with the functional expense allocations in general, can and will be manipulated by some charities.  I’m not so naive as to think this doesn’t happen.  However, CN is singling out one line on the Form 990 as being “bad” (the only line they single out on the 990) and worthy of arbitrary reallocation with no input by charities as to the nature of the expenses.

“…add them to fundraising.”

Charity Navigator, once identifying all joint costs as invalid, takes the additional step of deciding for charities where the program costs should then be moved to.  They have decided on fundraising.  Given that joint costs can be programs, fundraising, or management & general, I find it curious that they have been able to determine that all program costs should be moved to fundraising, and not some or all to M&G.  Since the amount of costs spent on fundraising is a key metric for CN, representing about a third of the financial rating of an organization, this change could be critical for some organizations.

The risk that CN is trying to address is stopping organizations from misstating their functional expenses.  However, if an organization is already misstating their functional expenses, they will likely just stop reporting anything on Line 26 and easily avoid the new CN criteria.  The risk CN is trying to address will likely not be addressed with this change, it only hurts the organizations that are being truthful in their reporting and are following GAAP.

“…donors are not generally aware…”

Charity Navigator’s justification for this change is not a justification I would follow for the purposes of financial reporting.  The reason they give for altering charities’ financial statements is that (1) donors are not aware of it, (2) donors would not embrace the practice, and (3) CN does not embrace the practice.  In other words, CN does not approve of GAAP, therefore they are making the assumption that donors do not either, not that the donors are aware of it anyway.

Donor opinions are important and valid in determining practices in many areas of fundraising.  However, this is probably not sound practice for determining whether or not to follow GAAP.  The vast majority of donors do not understand most if not all accounting principles.  For instance, members of the general public likely don’t understand the Black-Scholes method for valuing stock options, but that doesn’t mean that the SEC should restate the financial statements of all companies that follow it.  Donors likely do not understand joint cost allocations or any of the functional expense allocations; therefore, it makes a very poor reason to restate organizations’ financials.

Why then is Charity Navigator making this change?

The answer can be found on Ken Berger’s blog, “Ken’s Commentary”.  Ken Berger, the president of Charity Navigator, was interviewed by Anderson Cooper.  During that interview, Cooper pointed out that CN had given a favorable 3 star rating to the National Veteran’s Foundation, an organization under investigation for shady fundraising practices, and asked if CN would review their rating.  Looking at NVF’s Form 990, you’ll find that 76% of their expenses are reported as joint costs.  It appears that CN’s reaction to being called out by Anderson Cooper was to address the low-hanging fruit: joint costs.  Ken Berger makes the statement in the comments of his blog that “We made a substantial upgrade of our metrics to minimize the chance we would run into a situation like this again.”  The addition of the joint cost adjustment was the only change to the CN metrics in 2012; therefore it is assumed this is what he is referring to.  By reallocating NVF’s joint costs, their rating was dropped to zero, and the problem resolved.  Unfortunately, the treatment given to this one bad apple seems to have been applied to all charities.

(Update 2.25.13 – In this article by the Chronicle of Philanthropy, Ken Berger states that about 50 charities lost ‘stars’ as a result of the rating change.  CN has gone back and reevaluated those charities by examining their websites to check for significant focus on education, and if so, reversed the rating change.  Of those 50, 11 charities have had the joint cost reallocation reversed and ‘stars’ restored.)

The number of watchdog groups is growing, and their influence and popularity is growing.  The work that they do to inform and educate donors is important, however, I urge you, do not let watchdog criteria decide your accounting practices and especially not your programmatic goals.  Follow GAAP, follow IRS guidelines, and report your finances truthfully.