Getting to the bottom of financial disclosure issues in the not-for-profit sector

Professor Qiu Chen has just published research examining a key transparency issue in the nonprofit sector: to increase opportunities for donations, some managers misreport fundraising and/or administrative expenses as program expenses.

Chen set out to determine what happens to director monitoring in such scenarios. She found that when nonprofits underperform financially, directors “understand that their fiduciary duty is to both monitor managers and work with them to raise funds. Under these circumstances, directors are found to compromise their monitoring to help managers impress donors,” said Chen, an assistant professor in accounting and CPA Ontario Fellow.

Concerns had been voiced about transparency in the sector but the research was still developing when Chen started her Ph.D, at Queen’s University in 2009. In response to well-publicized accounting scandals the academic focus on nonprofits had matured by the time Chen completed her doctorate in 2011. The following year the American Accounting Association launched a journal dedicated to governmental andnonprofit accounting. The industry had arrived at a critical juncture on a whole range of accounting-related issues: social responsibility, accounting standards, political activities and auditing – all areas that Chen is researching.

The upturn in interest in nonprofits is welcome because there is a longstanding myth that nonprofits are small, or somehow less worthy of study, than private sector firms, says Chen. “There is little basis for saying so, as a large number of charities, many of them headquartered here in Ottawa, are of considerable scale,” says Chen. The accounting quality issues in these organizations do not appear to be “more or less prevalent as in the private sector.” However, the issues “do come up in very different contexts, where charitable goals and donor expectations are strong drivers of people’s motivations and behaviours, not always in optimal ways.”

Chen carried out an experiment with 189 nonprofit directors. She noted that two factors, the evaluation approach of donors and the transparency level of organizations’ expense disclosures, can impact director monitoring. When directors perceived that donors were adopting a more balanced approach to organizational evaluation, one focused on both financial and nonfinancial performance, they monitored less. “But enhanced transparency of expense disclosures increased director monitoring,” Chen explained; “it appeared to reduce the tendency to accept management expense misreporting.”

Balanced donor evaluations are generally preferable to financially focused ones. On the other hand, they do not encourage directors to reduce expense misreporting in nonprofits, the findings of this study show. Moreover, transparent expense disclosures in nonprofits’ financial statements improve director monitoring of management, contrary to what some observers have claimed. The implication for regulators is clear: “Probably transparent expense disclosures should be mandatory, rather than voluntary.”