Economic Consequences of Expense Misreportingin Nonprofit Organizations: Are Donors Fooled?*Michelle H. Yetman**Associate Professor of AccountingThe University of California at DavisJuly 31, 2009Preliminary. Do not quote without permission.* I thank Chris Jones, Michael Maher, Carl Olson, Dan Tinkelman, Robert Yetman, workshopparticipants at the University of California at Davis, the 2009 Midyear Meeting of the AmericanAccounting Association Government and Nonprofit Section, and the 2009 Western Meeting ofthe American Accounting Association for their valuable comments and advice.** AOB IV, One Shields Avenue; Davis, CA 95616; phone (530) 754-7808; [email protected] copy available at: 1268582

Economic Consequences of Expense Misreportingin Nonprofit Organizations: Are Donors Misled?Abstract: Prior research finds that donors reward nonprofits that allocate larger proportions oftheir expenses to charitable purposes with more donations. Research also finds that managersoverstate the amount of expenses reported as charitable, ostensibly to attract more donations.This paper examines the extent to which donors adjust their reliance on nonprofit financialreports that overstate charitable expenses when making donations. Results show that donorsplace significantly less weight on financial information for those organizations that overstatetheir charitable expenses. Results also show that as the ease of obtaining financial informationhas improved over time, so has donors’ disentanglement of low quality financial reporting.The findings suggest that donors are at least partially able to see through low quality financialreporting.JEL Classification: G1 G18 G3 G38 L3 L30 L31 M4 M41 M43 M48Keywords: nonprofit organizations, program service ratios, financial reporting quality,regulation, cost shifting, agency problems1Electronic copy available at: 1268582

1. IntroductionPrior research finds that donors consider nonprofits’ reported financial results when makingdonations allocation decisions.1 Nonprofit organizations incur and report three broad categoriesof expenses on their primary publicly available IRS Form 990 report (IRS 990): programservices, fundraising, and administrative. The program service ratio (PSR), which is the ratio ofprogram service expenses to total expenses, measures the proportion of expenses that aredirected towards the charitable mission. Prior research provides evidence that nonprofits thatreport higher PSRs are rewarded with more donations (Weisbrod and Dominguez 1986; Posnettand Sandler 1989; Tinkelman 1999; Okten and Weisbrod 2000; Tinkelman 2004; Parsons 2007).Donor reliance on reported nonprofit financial information provides nonprofit managers with anincentive to overstate charitable (and understate administrative and/or fundraising) expenses.Indeed, a growing body of research finds that nonprofits appear to manipulate their financialreports by increasing the proportion of expenses classified as charitable (Jones and Roberts 2006;Krishnan et al. 2006; Keating et al. 2008).This paper moves beyond documenting the existence of nonprofit financial statementmanagement by investigating its economic consequences. More specifically, I examine whetherdonors disentangle nonprofit financial reporting management when making donations decisions.In addition, I explore whether donors’ disentanglement of financial reporting management hasimproved over time with the increased accessibility of financial information and/or is influencedby donor characteristics, such as the motivation for giving.The central research hypothesis I test is whether donors reduce their reliance on reportedPSRs when they are of low quality when making donations decisions. To examine the question, I1Nonprofits receive three types of donations. Private donations are received from individuals and corporations.Indirect donations are received from collections agencies such as the United Way or from related organizations.Government grants are received from state or federal agencies.2Electronic copy available at: 1268582

rely on models used by prior research that show donors are sensitive to expense classification,rewarding firms that report spending proportionately more on charitable outputs (i.e., higherPSRs) with larger amounts of donations. I introduce into this model a reporting quality metric,and interact this quality metric with the ratio of charitable to total expenses. The basic premiseunderlying the model choice is that if donors can identify overstated charitable expenses asreflected in the reported quality metric, then they will reduce their reliance on the reported PSRwhen an organization has overstated their charitable expenses.My reporting quality metric is whether the nonprofit reports zero fundraising expensesdespite earning substantial donations. Prior research finds that when a nonprofit receivessubstantial private donations (over 100,000 in my study) yet reports zero fundraising expenses,it is highly likely that the organization has understated its fundraising expenses and thusoverstated its charitable expenses (Krishnan et al. 2006). The number of nonprofits that fall intothis category is surprisingly large, approximately 35 percent.Results suggest that donors are able to see through low quality nonprofit financialinformation. In particular, when making donations decisions, donors place less weight on thereported ratio of charitable to total expenses for organizations that report zero fundraisingexpenses as compared to organizations that do report fundraising expenses. This result suggestsdonors do not naively respond to reported financial information, but are willing and able to atleast partially disentangle some forms of nonprofit financial statement manipulation. I also findthat as the ease of obtaining financial information has improved over time, so has donors’disentanglement of low quality financial reporting.This study has important implications. From a public policy perspective, this study isimportant as donors’ inability to see through low quality financial reports can lead to improper or3

unintended resource allocations. The amount of donation dollars at stake is large. In 2006nonprofits received about 260 billion in donations, of which over 75 percent were fromindividual donors (Giving USA Foundation 2007). In addition, this study provides potentiallyuseful information to government regulators. As in the for-profit setting, perceived deficienciesin nonprofit financial reporting have increased regulatory attention (Strom 2004). Concerns thatdonors are being misled by low quality financial information has led some state governments toimpose some provisions of the Sarbanes-Oxley Act on nonprofits.2 The U.S. Senate has heldseveral hearings on how to enhance nonprofit reporting quality and also may impose someprovisions of the Sarbanes-Oxley Act on nonprofit organizations (United States SenateCommittee on Finance 2004, United States Senate Committee on Finance 2005). This studyaddresses this policy issue by investigating the extent to which donors are aware of poorfinancial reporting quality and consequently reduce their reliance on those reports in makingdonations decisions.The paper proceeds as follows. The next section presents background and theory, followedby the development of the research hypotheses. The following section describes my empiricalmodel and its variables. Subsequent sections discuss the data and the empirical results, and thefinal section concludes.2. Background and Hypothesis Development2.1 The Role of, and Donor Response to, Nonprofit Financial InformationMany organizations, regardless of their ownership structure, face agency problems becausecontracts are costly to be written and enforced (Jensen and Meckling 1976, Fama and Jensen2For example, California passed the Nonprofit Integrity Act of 2004, which imposes several of the provisions of theSarbanes-Oxley laws on nonprofits.4

1983). Agency theory recognizes that a manager’s own objectives may not necessarily coincidewith the owner’s objective and typically presumes that managers will tend to maximize their ownwelfare, including benefits that are financial (wages) and non-financial (shirking or investing inpet projects) (Coase 1937). Although nonprofits are not owned in the traditional sense (i.e., theydo not have residual claimants), they are accountable to several stakeholders including donors,lenders, customers, and regulators. Nonprofit stakeholders such as donors can reduce agencylosses through monitoring (Hansmann 1996). Financial reports play an important role inmonitoring managerial actions as they provide a means for donors and other stakeholders toevaluate whether the nonprofit is using donations towards the charitable mission in an efficientmanner. Indeed, several studies show that donors reward nonprofits that report higherproportions of their total expenses as charitable (and correspondingly lower proportions as eitheradministrative or fundraising) with more donations (Weisbrod and Dominguez 1986; Posnett andSandler 1989; Tinkelman 1999; Okten and Weisbrod 2000; Tinkelman 2004; Parsons 2007).32.2 Managerial Manipulation of Nonprofit Financial InformationGiven that donors rely on nonprofit financial reports for their donations allocation purposes,nonprofit managers have an incentive to manipulate those financial reports. Several studies findthat nonprofit managers respond to this incentive by understating their administrative and/orfundraising expenses, which results in increased charitable expenses and improved reportedefficiency. Jones and Roberts (2006) examine situations in which nonprofits engage in jointeducational and fundraising campaigns (i.e., combining a plea for donations with informationabout their charitable purpose). Under these situations, the nonprofit is required to partition thecosts of such campaigns into charitable (the education portion) and fundraising expenses. Jones3The exact empirical specification of the measure of charitable relative to total expenses varies across the studies,but all capture a similar underlying relationship.5

and Roberts find that nonprofits use joint costs to mitigate changes in the program ratio.Krishnan et al. (2006) find that many nonprofits report zero fundraising expenses when they infact are engaging in fundraising activities. By understating their fundraising expenses (all theway to zero), these nonprofits are increasing the proportion of expenses classified as charitable.More recent research by Keating et al. (2008) finds that nonprofits that engage in telemarketingcampaigns systematically understate their fundraising costs, which has the effect of overstatingtheir charitable costs.2.3 Donors’ Use of Low Quality Financial InformationTo summarize the existing body of research, it is relatively well established that donorsrespond to reported nonprofit financial information, rewarding nonprofits with higher ratios ofcharitable to total expenses with more donations. A growing body of research shows thatmanagers are apparently aware of donor sensitivity to this ratio and respond by manipulating theamounts of expenses reported as charitable. The question that prior research leaves largelyunanswered is the extent to which donors disentangle managerial manipulation when makingtheir donations allocation decisions. My primary research hypothesis (in null form) is that donorsdo not disentangle nonprofit financial statement management but rather naively use theinformation as reported regardless of its quality.Tinkelman (1996, 1999) examines whether the relation between donations received by anonprofit and the PSR is affected by the reliability of the PSR (as measured by whether thenonprofit reported any fundraising expenses) using a small dataset of New York regulatoryfilings. There are several key differences between Tinkelman’s work and this study. First,Tinkelman uses a limited sample of New York nonprofit organizations across a limited timeperiod, whereas this study uses a broad sample of nonprofit organizations across a long time6

period. His sample of New York nonprofits may not be generalizable. In addition, the availableof nonprofit information has changed substantially since the early 1990s (his sample time frame)and it is possible that the results from that time period do not hold in more current time periods.Second, Tinkelman does not screen on reasons that a firm could plausibly report zero fundraisingexpenses (Krishnan et al. 2006), which introduces bias into his reliability measure. Third,Tinkelman uses New York regulatory filings to measure whether a firm reports fundraisingexpenses, whereas this study uses the publicly available IRS 990. It is key to use the publiclyavailable IRS 990 to address the question of whether donors are fooled by expense misreportingbecause nonprofits have both a stronger ability and incentive to manage their IRS 990 relative totheir regulatory reports and because empirical evidence has documented differences in thereporting of amounts in their expense categories across their publically available and regulatoryreports (Krishnan and Yetman 2009). Fourth, Tinkelman uses reported fundraising to control forthe effect of fundraising effort on donations. This is a biased proxy as many firms that reportzero fundraising are actually underreporting it (Krishnan et al. 2006). This bias has the effect ofpotentially inducing his results. I improve upon the proxy for fundraising effort by estimatingfundraising effort for organizations reporting zero fundraising.2.3.1 Time-Series VariationI also examine whether the disentanglement of low quality financial reporting has improvedas the ease of obtaining nonprofit financial information has increased. Both new IRS regulationsand the development of Guidstar have made it easier and more cost effective to obtain IRS 990sover the past ten years. Before 1999, IRS regulations required nonprofits to allow the public toinspect the IRS 990 in person. Without having access to an IRS 990, donors would have to relyon published reports of nonprofit efficiency ratios, such as Wise Giving Alliance or donations7

solicitation information received from the nonprofit. Thus, donors may have used the PSR whenmaking donations decisions before 1999, but it was much more difficult and costly to obtain thedetails regarding expense reporting and therefore was more difficult to identify low qualityreporting.In June 1999, the regulations changed and required organizations to respond to a writtenrequest for their IRS 990, making it much easier for the public to obtain IRS 990 (although aformal request was still necessary and the nonprofit was permitted to charge fees for coping andmailing). Guidestar was created in 1994, and by 1996 they collected information (e.g., data onrevenues and expenses) on over 40,000 charities and launched their website( In 1998 they expanded their database to include all 501(c)(3) publiccharities in the IRS Business Master File and added a digitized IRS 990 to charities' reports. By1999, they report IRS 990s for more than 200,000 public charities. This leads to my secondresearch hypothesis (in alternative form), which is that donors’ ability to disentangle nonprofitfinancial reporting management improved in the time periods in which the ease of obtainingfinancial reports increased (i.e., 1996, 1998, 1999).3. Empirical Model and Variable DefinitionsTo test my hypotheses, I build on prior empirical economic models on the determinants ofdonations (Weisbrod and Dominguez 1986, Okten and Weisbrod 2000). The model is as follows:Private Donationsi,t β0 β1 PSRi,t-1 β2 Zero Fundraising Indicatori,t-1 β3 PSRi,t * Zero Fundraising Indicatori,t-1 β4 Fundraising Efforti,t-1 β5 Agei,t β6 Agei,t * Fundraising Efforti,t-1 β7 Government Grantsi,t-1 β8 Feeder Donationsi,t-1 β9 Sales Revenuesi,t-1 β10 Assetsi,t ε.8(1)

Consistent with prior research, the model is estimated using natural logs and expressesprivate donations as a function of lagged information (with the exception of age and assets),consistent with the idea that donors are expected to respond to information from the prior year.Private Donations (line 1a of the IRS 990) is the dollar amount of donations from individualsand corporations, as well as grants from foundations. PSR is the proportion of charitableexpenses (line 13 on the IRS 990) as a fraction of total expenses (line 17 on the IRS 990); thus β1captures donor sensitivity to an organization’s relative efficiency of operations. I expect thecoefficient on the ratio to be positive, in line with prior research, suggesting that donors rewardnonprofits that are more efficient. The primary variable of interest is the interaction of this ratiowith the reporting quality variable, Zero Fundraising Indicator, which is equal to one if thenonprofit reported zero fundraising expenses (line 15 on the IRS 990), and zero otherwise. Ifdonors at least partially see through low quality financial reports and adjust their sensitivity to theratio, the interaction term will be negative and significantly different from zero. Alternatively, ifdonors are unable to see through (or see through but don’t care about) low quality nonprofitfinancial reports, the interaction will not be statistically different from zero.There are several possible candidates for the reporting quality metric, including misreportedtelemarketing expenses (Keating et al. 2008), misreported joint costs (Jones and Roberts 2006),and misreported fundraising expenses (Krishnan et al. 2006). The reporting quality metric I useis from Krishnan et al., who find that when a nonprofit receives substantial private donations(over 10,000 in my study), yet reports zero fundraising expenses, it is highly likely that theorganization has understated its fundraising expenses and, thus, overstated its charitableexpenses.4 I favor this reporting quality metric over other possible candidates for two reasons.4The central notion of this prior analysis is that earning donations is a production function and fundraising effort is aprimary input. Although some donations can plausibly be raised with zero fundraising effort, in order to consistently9

First, it is the only metric that applies to the majority of nonprofits. Information on telemarketingexpenses as examined by Keating et al. is available for approximately one percent of allnonprofits, and the joint cost metric examined by Jones and Roberts applies to less than onepercent of all nonprofits.Second, the Krishnan et al. (2006) quality metric is arguably the easiest for a donor toobserve prior to making their donation allocation decisions. To observe misreportedtelemarketing expenses as examined by Keating et al. (2008), a donor would need to access stateregulatory filings and compare them to the organization’s IRS 990. To observe misreported jointcosts as examined by Jones and Roberts (2006), a donor would need to employ a statisticalexpectations model to determine expected joint costs and compare that figure to actual jointcosts. By contrast, the metric examined by Krishnan et al. is simply whether or not the nonprofitreports any fundraising expenses. To observe zero reported fundraising expenses, a donor needsto examine only a single line on the front page of the IRS 990 (i.e., line 15).5 If it is zero and thenonprofit reports earning substantial donations and has no other plausible reason to be reportingzero fundraising expenses (e.g., it received donations through a feeder organization), thenonprofit is likely understating its fundraising expenses and correspondingly overstating itscharitable expenses. Thus, a large benefit of using this metric is that it is relatively easy todisentangle. To the extent donors do not disentangle zero reported fundraising, it is unlikely thatthey would disentangle any of the other, arguably more complex, types of financial statementmanipulation documented in the literature. In other words, the results in this study set a lowerbound on donors’ ability to disentangle nonprofit financial statement management.earn larger amounts of donations, a nonprofit must undertake some fundraising effort, and this effort should revealitself as an expense on the IRS 990.5There are many ways to obtain an organization’s IRS 990. First, every organization must supply a copy if asked.Second, the IRS will supply a copy for a small fee if asked. Third, all IRS 990s of all organizations can be found, a free Internet-based service.10

Fundraising Effort is the reported dollar amount of fundraising expenses (line 15 of the IRS990) for those that report non-zero fundraising, or estimated values of fundraising for those thatreport zero fundraising. This variable serves to control for the direct effects of fundraising effort,which is that of informing potential donors of the charitable need, much as advertising informspotential buyers of a product or service (Weisbrod and Dominguez 1986, Okten and Weisbrod2000). For firms that report non-zero fundraising on their IRS 900, in my primary analyses Iestimate their fundraising effort by using the statistical method of calibration (i.e., reverseregression). I begin by using the firms that report non-zero fundraising to observe therelationship between donations and fundraising by estimating industry specific regressions offundraising on donations. Then, using the industry specific regression estimates, I estimatefundraising effort for the sample of firms that report zero fundraising. In robustness tests, Iutilize alternative methods to estimate fundraising effort, as well as estimate the model withoutcontrolling for fundraising effort to ensure the results are not sensitive to my primary method forestimating fundraising effort.Age is the age of the nonprofit in years and is intended to be a proxy for reputation capital(Weisbrod and Dominguez 1986, Okten and Weisbrod 2000). The next three variables controlfor other sources of revenues that could crowd out (or crowd in) private donations (Posnett andSandler 1989). Government Grants is the dollar amount of grants received from federal or stateagencies (line 1b on the IRS 990), and Feeder Donations is the dollar amount of donations fromfederated fundraising organizations such as the United Way (line 1b on the IRS 990), SalesRevenues is the dollar amount of revenues received from the sales of products and services (line2 of the IRS 990), which could also crowd out (or crowd in) private donations (need cite).Donors could view sales revenues favorably as a form of self-help or, unfavorably, as a11

distraction from the primary exempt mission. Assets is year-end total assets and is included tocontrol for size. All models include single digit industry and year indicator variables.6Because the analysis uses a pooled cross section, the possibility of non-independence ofobservations arises. In particular, it is very likely that an organization’s financial reportingbehavior and the amount of donations received is correlated across time, in which case ordinaryleast squares will produce downwardly biased standard errors (although the coefficient estimateswill remain unbiased). A direct way to address this issue is to use the full panel of data, but toadjust the standard errors using the method of White (1980), with an additional adjustment forrepeated firm observations (i.e., “clustered" standard errors).7 In addition, in all analyses, I screenfor influential observations using Cooks D and Welsch Distance (Belsley et al. 1980).4. Data4.1 SampleThe IRS 990 is the primary source of publicly available nonprofit financial information. Allnonprofits with revenues over 25,000 must file the IRS 990 annually. Congressional reportssuggest that the IRS 990 serves as the primary source of publicly available nonprofit financialinformation (Joint Committee on Taxation 2000). To ensure the wide dissemination of IRS 990information, the IRS Statistics of Income division sponsors the Urban Institute to collect andmake freely available IRS 990 data for virtually all nonprofits. This data can be found on the6The National Taxonomy of Exempt Entities was established by the Internal Revenue Service as a means ofcategorizing nonprofits into 26 broad categories. Information related to the nomenclature can be found eterson (2009) provides an extensive review and analysis of the various methods used to address correlationsacross time and/or firms and provides the unambiguous recommendation that if a firm effect is suspected to bepresent (i.e., there is correlation across time within firms), the standard errors should be clustered by firm. Froot(1989), Rogers (1993), and Peterson (2009) show that clustered standard errors are unbiased and produce correctlysized confidence intervals in the presence of either temporary or permanent firm effects. Furthermore, clusteredstandard errors are robust to heteroskedasticity. The fixed effects estimator is not tractable as the zero fundraisingindicator variable has little within-firm variation.12

Internet at or can be obtained in computer readable form from the NationalCenter for Charitable Statistics for a fee at The IRS 990 contains typicalfinancial statements, including a statement of revenues and expenses and a balance sheet, as wellas a substantial amount of other information related to the nonprofit’s charitable purpose andactivities.8The data I use for the analysis is from the Internal Revenue Statistics of Income files. Thesample includes only public charities (and excludes private foundations) exempt under InternalRevenue Code 501(c)(3). Although there are well over 10 types of tax-exempt organizations,501(c)(3) organizations comprise the economic bulk and are differentiated from other types ofnonprofits both because they are tax exempt and because their donors receive tax deductions fortheir donations. The IRS data is available from 1982 to 2005, with the exception of 1984. SinceI need lagged values in my analysis, I begin with 1985.The original full sample from 1985 to 2005 is reduced by requiring a minimum of 10,000in private donations as nonprofits that receive donations in excess of 10,000 are likely to haveundertaken at least some fundraising effort, thus reducing possible measurement error in the zerofundraising indicator variable.9 In addition, I remove observations that have alternativeexplanations for reporting zero fundraising as described Krishnan et al. (2006). Alternativeexplanations for reporting zero fundraising involve organizations with transactions betweenrelated parties (where one organization could reimburse the other for its administrative orfundraising expenses) or organizations with fundraising as their primary purpose (as theseorganizations could classify those expenses as charitable rather than fundraising). Thus, I remove8Keating and Frumkin (2003) provide an in-depth discussion of the IRS 990.Consistent with Krishnan et al. (2006), I exclude the other two types of donations (i.e., government grants andfeeder donations such as those from the United Way) as those can frequently be raised with little consistentfundraising effort. In addition, results are not sensitive to decreasing this minimum private donations threshold downto 1 or increasing it up to 1 million.913

organizations that are members of affiliated groups as reported on lines H and J of the IRS 990,auxiliary and fundraising organizations, whose primary purpose is fundraising (denoted by twodigit NTEE codes ending in a 11, 12 and 19), and philanthropic organizations for reasons similarto fundraising organizations (denoted by NTEE code “T”). Finally, I require nonmissing valuesfor all of the regression variables. The final sample includes 96,217 usable observations.4.2 Descriptive StatisticsTable 1 provides the descriptive statistics of the analysis variables partitioned acrossFundraising. All variables, except for Age and PSR, are scaled by 1,000. Of this final sample of96,217, approximately 39 percent report zero fundraising. Of those with zero fundraising,average private donations are approximately 1.2 million. For these zero-reporters, the averagePSR is 83 percent. On average, observations that report fundraising expenses report moredonations ( 6.6 million) and a lower PSR (79 percent). This difference in PSRs is at leastpartially due to under-reported fundraising expenses for those that report zero.Table 2 presents the Pearson correlation statistics for some of the analysis variables. Asexpected, the amount of private donations received has a large economic and statisticallysignificant positive correlation with the amount of fundraising expenses reported. Because ofthis, coupled with the fact that the PSR is negatively affected by the amount of fundraising effort,it is difficult to interpret the relationship between PSR and donations in a univariate sense.However, although the correlation between private donations and the PSR is negative, it issmaller for firms with lower quality reporting as measured by the zero fundraising indicator (0.4561), consistent with my hypothesis of donors being less sensitive to the program ratio whenthe nonprofit reports zero fundraising. This is consistent with donors at least partiallydisentangling nonprofit financial statement management. However, as evidenced by the negative14

sign on the correlation between PSR and private donations, a multivariate analysis is required tocontrol for variables correlated with both PSR and private donations.5. ResultsThe multivariate empirical results are contained in tables 3 through 6. Table 3 provides thefull sample pooled analysis, whereas tables 4, 5, and 6 partition

in nonprofit financial reporting have increased regulatory attention (Strom 2004). Concerns that donors are being misled by low quality financial information has led some state governments to . rewarding nonprofits with higher ratios of charitable to total expenses w