Posts Tagged ‘Non-profit reporting


Overhead rate is a poor measure of efficiency

There is no financial metric more scrutinized in the not-for-profit world than overhead percentage. As a result I am always hesitant to write on the topic because any article on overhead tends to be perceived as one of two messages: “Overhead rates are too high, and not-for-profits are not to be trusted” or “Overheads don’t really mean anything, so stop trying to compare organizations and just give us money anyway”. The truth is that organizations should welcome comparisons to peers. Such comparisons allow donors to make wise decisions, which results in funds flowing to the best managed not-for-profits. But, is overhead the best measure of quality management?

I like to point out that the effectiveness (not efficiency) is usually a donor’s primary concern when giving. At least this is true for me. Of course I would like the organizations to which I give money to be both effective and efficient. However, if you made me choose, I’d rather an organization make an inefficient but real change, than operate efficiently but fail to make a substantive change with their programs. The problem is that effectiveness is difficult to measure and much harder to compare across organizations. How do you compare teaching a child to read, saving a forest, and preventing a disease through immunization? In which case does a dollar achieve the most good? And even more challenging; how do you compare program quality across these categories? Absent comparable effectiveness measurements, donors and not-for-profits turn to overhead as a measurement of quality management. Overhead doesn’t measure effectiveness, but at least it measures efficiency . . . or does it?

I am participating in a project to measure the efficiency of the finance function across many of our organization’s ministry national offices. To do so, we’ve defined some efficiency metrics which allow us to compare our offices. These metrics include items such as cost per paycheck generated, cost per invoice paid, cost per employee expense report, etc. The common theme in these efficiency ratios is that the cost is divided by the outcome achieved. This allows for meaningful comparisons across offices, and useful evaluations of potential process improvements.

In doing this work I was struck by how different an overhead rate is from the efficiency metrics we are using. Overhead is not the measurement of cost against an outcome (cost per life transformed, cost per tree saved, cost per beneficiary trained), rather it is a ratio between types of costs (percentage of costs which are general and administrative, as compared to costs which are directly related to programs). This ratio among costs fails to capture actual efficiency and can lead to some surprising results. Consider a food shelter that is able to replace hired food servers with volunteers. The food servers are directly related to program activities, thus when they were paid the costs were programmatic. Removing these program costs increases the shelter’s overhead ratio. This works in reverse as well. Imagine a charity finds three vendor bids for a product needed for distribution in its programs. The organization could reduce overhead by intentionally purchasing from the more expensive vendor.

Now, these examples may be a bit of a stretch. However, I think you see my point. The overhead ratio rewards inefficiency in program costs, which are the majority of most not-for-profits’ costs. I certainly do not believe organizations are intentionally choosing inefficient program costs to manipulate overhead. But, I think it is possible that the focus on overhead rates can blind management to potential efficiency gains in program costs. Ironically, if donors and managers have been focused for years on managing to a low overhead rate, many organizations may have already realized the big efficiency wins in management and general expenses. For these organizations improvements in overall efficiency may yield higher overhead rates.

The strongest advantage of overhead as a metric is that it can be used to compare different types of nonprofits. Hospitals, schools, conservation groups, and homeless shelters all can be compared on overhead rate. Unfortunately this strength breaks down on more detailed inspection. One of the more interesting things I have learned since I started working for a nonprofit is that overhead closely corresponds with the type of nonprofit organization (or at least their funding source). Organizations with a large GIK component to their ministry often have very low overhead rates due to the value of the goods they distribute. Child Sponsorship organizations tend to have higher overhead rates due to the additional administrative effort required to connect each sponsor and child. (There are arguably programmatic and stability advantages to this higher cost). Grant funded organizations tend to have overhead rates which fall in the middle. In other words, the type of donations received can have a bigger impact on overhead rate, than the quality of an organization’s management.

So, what should we be measuring? There is clearly need for comparisons among not-for-profits. There are also benefits from these comparisons both for donors and management. But there are clear flaws in overhead as the comparison tool of choice. I think it would be wise to evaluate similar types of not-for-profits based on a grouping by mission (for example Relief & Development, Conservation, Medical Research, etc.). For each grouping an efficiency measure could be determined by dividing total costs by a common outcome metric. For example, animal shelters could report costs per animal served. Then efficiency could be better gauged for similar organizations.

I also think that breadth of analysis can be a solution as well. Part of the problem with overhead is that it is often viewed as the defining, authoritative metric. If other metrics are considered as well (unrestricted undesignated net assets, growth rate adjusted for organizational size, liquidity, etc.) a more complete and useful comparison emerges.


A Good Audit Experience, Part II

Yesterday, I discussed some tips for NFP accounting departments for having a good audit experiences.  Today I wanted to give some tips to the external auditors, for working through their audits with clients.

Tips for the external auditors

  1. Clearly communicate issues and errors immediately.  Few things are more frustrating for a client then to have a problem, issue, or error reported late in the audit process.  If these issues are raised early, the client can manage expectations, and often can provide additional information/context which would mitigate the error.
  2. Be courteous of your client’s time.  Accounting departments at NFPs are generally short staffed.  Additionally, the latter half of the calendar year (when many audits take place) is the busiest time for many NFPs.  Understand that your clients are busy and have limited time available.  Clearly communicate your time needs to your clients.  Schedule interviews and walkthroughs ahead of time.
  3. Be proactive.  Schedule audit dates well in advance.  Send out request lists in advance.  Offer things to the client that they can get done early.  Keep the client informed of new accounting issues that you know will affect them.
  4. Be open and responsive.  The financial statements are those of the organization, and the organization knows how they run best, better than anyone.  Be willing to take the time and listen to the client’s explanations and expectations.  Give clients a chance to respond to errors, adjustment, and suggested changes.
  5. Know the business.  Each organization is unique.  Not for profits span a variety of industries, from hospitals, to universities, to relief and development organizations.  Get to know not just your client’s industry, but how they run their business.  This will greatly increase your ability to have a successful relationship with your client, identify audit and business risks, and add the most value to them.  This will enable you to exercise good judgment when evaluating the client, rather than simply applying stock audit procedures.
  6. Be creative.  You may not be able to get exactly what you want, or perform an audit procedure exactly the way the canned procedures states, especially if it is a new request.  Each client is unique.  New systems to track and report take time to put into place.  But if you think creatively, you can often identify information which provides good indicators to answer your questions and complete your procedures.
  7. Add value.  Audits can often seem to clients to be a hassle and a waste of time.  Change this attitude by adding value to the audit.  Partner with the organization, encourage them to discuss issues with you, provide access to CPE.  Concentrate on the important things.  Clients are generally not going to what to deal with small, trivial issues or “reviewer’s preference.”  When presenting issues to the client, ensure its importance; clearly explain the effect on the financial statements and the audit.
  8. Reversing entries ≠ fraud.  On most accounting systems, if an error is made to an entry, the only way to correct it is to post a reversing entry, then the correct entry.  Accounting systems are unforgiving.  Because of this, reversing journal entries are normal occurrences and generally not an indication of fraud.  Additionally, month end accrual entries are typically automatically reversed the next day.
  9. Communicate regularly.  Hold regular status meetings with your client when the audit is taking place.  During the off-season, keep in touch with your client about the audit, and new accounting issues that need to be addressed.
  10. Own the project management and timelines. (You will notice that this is also in the client’s tips). It is in both parties’ interest to create and stick to an efficient audit schedule. With both sides managing the timeline, due dates are easier to keep.  Schedule the audit well before you are to arrive at the client site (> six months).  Plan dates that you will be onsite and in the office.  Help the client determine the date that you will issue.  Plan for and schedule time for manager, partner and concurring reviews.

An audit can be a good experience for both sides.  We hope these tips help your next audit be a good experience for all.


A Good Audit Experience, Part I

Within our group here, we have many years of experience being external financial statement auditors and many years working in non-profit accounting, preparing financial statements, being audited, and conducting internal audits.  Seeing things from both sides of the table, we thought we’d offer some insights into working with auditors and not for profits, in order for both sides to have a good audit experience.  I’ve broken this up into two posts, to make it a bit more digestible.

Tips for the NFP accounting department (the client)

  1. Don’t fear audits.  When working as an auditor, I would often get the reaction from clients that we were someone to be feared and cautious around.  Auditors are there to do a job that you have hired them for.  Most of them are friendly, outgoing, fun-loving 20-somethings (and looking younger by the day).  There are no tricks and auditors will generally give you ample opportunity to explain yourself.  Be friendly and build good relationships with your auditors.
  2. See the auditors as partners.  Auditors have access to accounting resources, often well beyond what is available at a typical not-for-profit.  For instance, auditors visit several organizations throughout the year and therefore see the way that many orgs approach the same thing.  Additionally, they are backed by the other employees and partners of the audit firm who often have combined decades of experiences.  Many audit firms have members that are on FASB committees or other working groups, are presenting at conferences and teaching CPE.  The combined knowledge of the auditors is great.  Use this available resource to shore up your accounting practices, and interpret and apply new accounting standards.
  3. Be pro-active in communicating with your auditors. Stop by; see if they have any questions.  Schedule regular status meetings.  Bring issues to them. This may seem counter intuitive, but it builds trust and ensures any issues which arise are resolved quickly and don’t spin out of control.
  4. Be sure of your documentation and understanding.  The financial statements are yours, the organization’s.  Make sure that you understand the financial statements and therefore any changes that the auditors propose.  Also, much audit work is based on the documentation provided to the auditors.  When designing or evaluating your internal processes, make sure that each process and each transaction is well documented so that there will be an audit trail to follow.  An easy to follow audit trail will likely result in fewer questions from the auditors and answering questions will be easier.
  5. Provide what they need.  Auditors generally want the audit to be done as quickly as you do.  Since the audit is dependent upon information that you provide, the timeliness of the audit often depends on how quickly and fully the client provides information requested.  To make this easier, obtain the PBC or Audit Request List from the auditor at least a couple months ahead of the audit.  Review the list and assign tasks to applicable people in your departments.  Finally, have the documentation ready for the auditors when they arrive on site.  Additionally, if there are known samples that the auditors will be choosing, provide the listings that they will choose from in advance, so that you can have the sample documentation ready when they arrive.  Ask the auditors if there is anything else you can provide in advance.
  6. Own the project management and timelines. (You will notice that this is also in the auditor’s tips). It is in both parties’ interest to create and stick to an efficient audit schedule. With both sides managing the timeline, due dates are easier to keep.  Schedule the audit well before the auditors are to arrive (> six months).  Plan dates that they will be onsite and determine the date that you will issue.
  7. Feel free to push back.  Sometimes, the auditors will request something that was not planned, that would require a large amount of work to prepare, or seems out of line with the audit.  If you have a legitimate concern with an audit request, feel free to push back in a cooperative manner.  Explain your position, why you think the request is unnecessary, and ask the auditors what they are trying to achieve.  When you know what they are trying to achieve, you can often find an alternative that would be more useful.  Additionally, during a time when the audit is not occurring, schedule time to meet with the auditors to go over the Request List and suggest changes as necessary.  The audit will still have to occur, and the auditors will need to do their necessary procedures, but take the opportunity to make sure the audit goes well for both parties.
  8. Don’t take it personally. The auditors are not auditing you personally.  While you may be involved in key transactions, or in audit findings, it is not a mark against you.  The auditors are doing their job, working through procedures, and are not attempting to comment on anyone personally.
  9. Keep up to date.  Accounting rules are constantly changing so keeping up to date on changes and standards can seem daunting.  However, there are many resources available.  Most major CPA firms provide webcasts and CPE trainings that are often free to attend.  The AICPA publishes yearly audit and accounting guides and industry updates that can be purchased from their website.  Keeping up to date on issues will allow you to respond effectively and efficiently.

(Tomorrow, tips for the external auditors)


Functional expense reporting

Unlike public companies, non-profits expenses are reported by their functional classification.  Functional reporting involves grouping expenses by major classes of programs and supporting services.  Additionally, when an organization is a voluntary health and welfare organization, it is required to report in a separate financial statement the statement of functional expenses – a matrix of expenses by both its functional classification and natural classification (salaries, rent, utilities, supplies, etc).  One of the benefits to functional reporting is donors have more meaningful information about the types of programs and activities carried out to fulfill an organization’s mission

A word of caution:  We you analyze functional expenses, there is no “right” answer for how much an organization should spend on program expenses vs. supporting services.  Too much program expense may mean an organization is under investing in technology, personnel support and development, or financial planning and audit services.  Too little program expense may mean an organization is not being as efficient as it should be with donor contributions.  When assessing an organization’s program expenses vs. supporting service expenses, I recommend you compare it with the ratios of similar organizations instead of expecting there is a “right” % which would be expected for all non-profits.

GAAP requirements:  Functional reporting is required for all non-profits, but only voluntary health and welfare organizations are required to report information by both natural classification and functional classification.

Functional classifications include Program services and Supporting services:

Program services – “The activities that result in goods and services being distributed to beneficiaries, customers, or members that fulfill the purposes or mission for which the NFP exists.  Those services are the major purpose for and the major output of the NFP and often relate to several major programs.  For example, a large university may have programs for student instruction, research, and patient care, among others.  Similarly, a health and welfare entity may have programs for health or family services, research, disaster relief, and public education, among others.” (FASB ASC 958-720-45-3)

For some organizations, reporting one category of program services may be sufficient to reflect the activities of the organization.  For others, multiple program service categories may be necessary to meaningfully present the services provided by an organization. 

Supporting services – All activities of a NFP other than program services.  Generally, supporting services include the following activities:

  1. Management and General:
    1. Oversight
    2. Business management
    3. General record keeping
    4. Budgeting
    5. Financing, including unallocated interest costs pursuant to paragraph 958-720-45-24
    6. Soliciting funds other than contributions, including exchange transactions (whether program-related or not), such as government contracts, and related administrative activities
    7. Disseminating information to inform the public of the NFP’s stewardship of contributed funds
    8. Announcements concerning appointments
    9. The annual report
    10. Related administrative activities
    11. All management and administration except for direct conduct of program services or fundraising activities (FASB ASC 958-720-45-6 and 45-7)
  2. Fund-raising
    1. Publicizing and conducting fund-raising campaigns
    2. Maintaining donor mailing lists
    3. Conducting special fund-raising events
    4. Preparing and distributing fund-raising manuals, instructions, and other materials
    5. Conducting other activities involving soliciting contributions from individuals, foundations, government agencies, and others (FASB ASC 958-720-45-9)
  3. Membership development activities–
    1. Soliciting for prospective members
    2. Membership relations
    3. Similar activities (FASB ASC 958-720-45-11)

Expenses related to more than one function:   Expenses may relate to one program or supporting service, or they may relate to multiple activities or functions.  Those expenses which relate to multiple activities should be allocated among the applicable functions.  There is no specific GAAP which defines acceptable methodologies for allocating indirect costs, but costs should be allocated consistently and objectively.

Example:  This excel report provides an example of how to functionally allocate various types of expenses, as well as an example of a statement of functional expenses.  Next time, lets talk about joint costs, and the specific GAAP rules which need to be applied when programs or other supporting activities are in part fund-raising activities.


Outcome reporting and Failure Reports

Is the future of non-profit reporting changing?

Historically, non-profit reporting made available to the public includes among other requirements: a mix of financial results; significant accounting assumptions and disclosures; governance and accountability; and program outputs. Non-profit watchdogs and accountability organizations like the BBB and the IRS typically have their own reporting requirements. However, these requirements tend to focus on financial results rather than outcome reporting.

Outcomes differ from outputs in that outputs represent products or services produced. Outcomes are the achievements or effects and changes resulting from the outputs. For example, a child’s attendance at school is the output of an education program. Children learning reading skills are the outcome which results from school attendance.

More and more, I hear discussions about how non-profits should be assessing and reporting outcomes. Charity Navigator is implementing several phases to revise its charity rating system (CN 2.0). The last phase expects charities to disclose information about their results. Not their financial results, but their programmatic results. In this video Ken Berger talks about the continuum charities are on, the evolutionary process that makes for high impact organizations. The sense that I get is that it’s not about being perfect; rather it’s about moving past yesterday’s errors and learning from past shortcomings.

Taken a step further, I’ve recently seen several non-profit organizations preparing “failure” reports. These reports openly describe a few instances when an organization has not done well on a project, or even failed at it, as well as lessons learned from these experiences. These reports go as far as identifying several changes to be made in the future.

Both Engineers without Borders Canada and the Robert Wood Johnson Foundation publish “failure” reports. Even though it exposes some of their failures, I come away believing their next dollar raised will be used even better because they have learned from their mistakes. They are moving down a continuum to not only gather data and assess outcomes, but also incorporate their outcome assessments into their next strategy.

Are failure reports the latest trend in non-profit reporting or a useful tool for meaningful learning and innovation? If failure reports are not done with the right motivation, in the right way, they could have negative effects. Here are several opportunities, advantages pitfalls and disadvantages to consider about whether or not to prepare a failure report:

• The biggest opportunity is to learn, then invest, then develop new programs which are more successful long-term. Improvements and innovation can become part of routine assessments instead of incidental happenstance.
• Reflection, a process so often overlooked in the tyranny of the urgent, is instead prioritized. Resources are invested to intentionally assess and evaluate outcomes and failures.
• Organizations have an opportunity to learn from each other’s mistakes through increased visibility of past failures and lessons learned.
• Organizations have a better opportunity to avoid recurring failures.
• Donors have an opportunity to see which organizations are making improvements and moving down a positive continuum.
• Publishing failures and planned changes creates a public accountability partner to push an organization to prioritize the necessary follow-through.

• If the report is created out of the wrong motivation, it may be easy to fall in the trap of surface level, cleansed, or “PR friendly” assessments. (kind of like in a job interview when you say your biggest weakness is working too much…)
• Donors who can not maturely accept failure or who do not see enough improvement may not give to the charity again.
• Current donor perception is often driven solely by financial results. In order for failure reports to be successful, the public perception of charities and their values must be changed to value innovation and effectiveness.
• Many non-profit industries are typically expected to spend all of their donated funds immediately. This expectation must be bucked to allow time for innovation and investment in newer, more successful project models.

It’s always been important for donors to get assurance about financial results, but the interest in reports on organizational programmatic effectiveness, or its lack thereof, is increasing. If we can’t honestly measure, report and analyze program effectiveness, we won’t gain the important lessons that provide for the greatest success.


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