October 1, 2009 | Read Time: 5 minutes
Each year, millions of dollars are spent attempting to promote ethical behavior in the nonprofit world, improve the accuracy of financial reporting, reduce misunderstanding and misuse of nonprofit financial information, improve the ability of nonprofit organizations to carry out their missions, and help nonprofit groups find ways to measure their contribution to society.
Yet we could have all those things instantly with just one simple change in financial-reporting rules. And it’s a change that would save charities money, not increase the time and money they put into bureaucracy.
The simple solution is to stop requiring nonprofit groups to report to the Internal Revenue Service or anyone else how much of their spending went to the “functional” expense categories: programs, fund raising, management and general costs. Many charities now make big blunders when they report their spending by functional category.
As the Urban Institute’s Nonprofit Overhead Cost Project showed, after examining the data provided by more than 200,000 organizations, many nonprofit groups regularly and routinely underreport their overhead expenses both on their audited financial statements and to the Internal Revenue Service.
For example, only 25 percent of nonprofit groups that receive grants from foundations, and only 17 percent of those that receive grants from government, properly classify proposal writing as a fund-raising expense. Thirteen percent of nonprofit organizations say on their informational tax returns that they spent nothing on management and general expenses, while 37 percent of organizations that receive at least $50,000 in private contributions report that they spent nothing to raise money or to hold special events. Those figures suggest serious flaws in reporting.
Nonprofit groups generally report their overall spending and revenue accurately; it’s just when they have to classify spending as program or overhead that they systematically get things wrong. As a result, it often looks on paper as though they are spending a lot less on overhead than the reality.
Eliminating the requirement to report expenses by functional category would overnight result in a sharp reduction in unethical underreporting in the nonprofit world and immediately eliminate gross inaccuracies in the financial information about nonprofit groups available to the public.
Given that some organizations honestly report their overhead costs, and others vastly underreport them, the efficiency ratings that magazines, newspapers, and charity-watchdog groups produce based on the numbers reported publicly are often extremely misleading. While the ratings purport to make valid comparisons, they can be no better than the reported numbers on which they are based.
Whether grant makers or individuals are trying to assess the charities they want to support or when nonprofit groups are trying to benchmark themselves against their peers, the misreporting of overhead spending results in serious misunderstandings of how nonprofit groups are using their resources. Eliminating the requirement to categorize spending by functional category would erase this misunderstanding instantly.
The Nonprofit Overhead Cost Project also discovered another very important thing: Many nonprofit groups do not spend money on the things they need to be effective because they are so worried that those things would make it look like they were spending too much on “overhead.”
An advocacy organization that saw cellphones as a frivolous overhead expense, for example, learned that the hard way when it missed an opportunity to get publicity in a major news outlet simply because a reporter couldn’t reach anybody after normal business hours. A crisis hotline didn’t upgrade its phone system because a key grant maker refused to allow the group to spend much on overhead; as a result a person considering suicide could end up getting a busy signal even though counselors were available.
Such situations are common in the nonprofit world, and as a result, the goal of doing an outstanding job of carrying out a charitable mission is frequently sacrificed on the altar of low overhead. Too often people both in and out of the nonprofit world foolishly believe that a cost labeled “program” has a halo over it and one labeled “overhead” has horns and a trident. Get rid of the distinction and right away organizations will have to ask only one question about an expense: Is this something we need to be effective? That will put the focus on results and nothing else.
Today national magazines and watchdog groups encourage donors to make decisions based on simplistic measures that can never substitute for real assessments of whether a nonprofit group makes a difference.
The number of dollars an organization spends on program activities is nothing more than a measure of the amount of resources consumed by programs. Eliminate the requirement to report functional costs, and this misuse of nonprofit financial information will disappear overnight.
More important, once we throw out the broken gas gauge we use now, donors and others will demand a speedometer that works. These demands will be just the encouragement the nonprofit world needs to develop new methods to help the public judge how well a charity performs its mission.
The distinction between a nonprofit group’s program and other activities has outlived whatever usefulness it once had. Eliminating the requirement to classify spending by functional category will promote ethical behavior, improve financial reporting accuracy, reduce misuse of financial information, improve nonprofit groups’ ability to carry out their missions, foster creation of new measures of nonprofit contribution to society — and save time and money.
What are we waiting for?
Kennard T. Wing is a senior consultant to the Center on Nonprofits and Philanthropy at the Urban Institute. The views expressed in this article are his own.
