Note: This post was written in 2014. We’ve written more content with new research since then, including How to Get Nonprofit Software Discounts.
Regardless of type, size or administrative budget, timely and accurate financial reporting plays a vital role in determining whether a nonprofit can fulfill its mission. Financial statements that contain accounting errors can undermine both the long-term and short-term viability of an organization.
According to a study conducted by Dr. Jeffrey Burks, Deloitte Faculty Fellow and associate professor of accountancy at the University of Notre Dame, nonprofits have a 6.1 percent accounting error rate—roughly 60 percent higher than the error rate for publicly traded corporations.
Moreover, Burke’s study found that 71 percent of nonprofit accounting errors are caused by basic mistakes, such as bookkeeping and recording errors. By comparison, basic mistakes account for only 54 percent of errors in corporations.
We interviewed Burks and two professional accountants with nonprofit experience to learn more about why these accounting errors tend to occur, the impact they can have on financial reporting and steps organizations can take to prevent them from happening in the first place.
Don’t Rely on Volunteers or Untrained Personnel
Dawn Brolin is a certified public accountant (CPA) and managing member of Professional Accounting Solutions, LLC, a full service accounting and QuickBooks consulting firm. She says one of the reasons financial mismanagement is such a common problem for nonprofits is that organizations frequently expect untrained volunteers to manage and perform recordkeeping and accounting activities.
“This expectation can lead to inaccurate recording of transactions, which results in poor financial reports,” Brolin explains. Because financial reports help nonprofits secure funding from both existing and potential donors, not to mention grants and other funding sources, errors that lead to poor reports can pose a significant threat to the fiscal solvency of an organization.
CPA Dan Soukup is an attest partner at Soukup, Bush & Associates, P.C., where he oversees financial statement and 401(k) audits, internal control and financial statement reviews and compilations.
Most of Soukup’s nonprofit clients are smaller organizations, and like Brolin, his experience has been that nonprofit accounting errors can generally be traced back to the use of untrained personnel. According to Soukup, however, assuming untrained volunteers and staff are the actual source of the problem obscures a more fundamental issue.
“In many situations, the true mistake in nonprofit accounting is made on the executive level,” he explains. “Nonprofit boards and executive directors place unrealistic expectations upon inexperienced and undereducated bookkeepers.”
Employ a Professional Bookkeeper or Accountant
The main reason most nonprofits delegate recordkeeping to untrained personnel has to do with funding. Many nonprofits operate on shoestring budgets, and as Burks explains, “It’s a very difficult allocation decision for these nonprofits because they like to keep their program ratios [the percentage of expenditures allocated to programs and services] high. So to spend money on somebody who has a CPA is a big tradeoff.”
Although nonprofits tend to assume that foregoing professional assistance will improve their bottom line, Brolin says that allowing others to do the work can have the opposite effect. “When an organization fails to budget for a professional, it has the potential to close an organization,” she says. “Having a knowledgeable person on staff is crucial.”
Soukup also cautions that when nonprofits try to cut corners with “cost-saving” measures, such as purchasing accounting-specific software for untrained bookkeepers to use, it can end up costing an organization far more in the long run.
“Many accounting software programs have done a wonderful job allowing a person to input cash receipt activity quite easily, but what these software programs cannot replace is an experienced and educated person’s skill,” Soukup explains.
“The software helps you organize the information once it’s been input, but the issue is that it’s not being input in the first place,” adds Burks.
According to Brolin, bringing accounting expertise on board is often a real game changer for nonprofits. She recalls an instance in which one of her nonprofit clients—responsible for providing hundreds of scholarships to students at a major university—relied on part-time bookkeeping by an individual who had no nonprofit accounting experience.
When the client finally decided to hire a full-time professional with a master’s degree in accounting, their financial reporting improved and resulted in substantial growth. The university’s fund grew from under 10,000 donors to over 25,000 donors in less than four years, annual donations grew from $3 million to $25 million within five years and endowments grew from $500,000 to $5 million within the same period.
At the end of the day, the amount nonprofits will need to spend on professional accounting help depends on their size and revenue. “For small, local nonprofits, just to do an annual audit and tax returns runs about $12,000,” Soukup says. “To get a good, salaried bookkeeper is another $45,000-$50,000 per year, which is just out of reach for most smaller organizations.”
For organizations that can’t afford to hire a seasoned bookkeeper full time, the best solution is to have an employee do the basic data input and then hire a firm or an advanced bookkeeper with a CPA to oversee financials on a monthly basis. For most nonprofits, Soukup says, “That’s really the best bang for your buck.”
Test Bookkeepers Before Hiring
If your organization can afford to hire professional help, it’s a good idea to put an individual’s skills to the test before entrusting them with your financials. Soukup’s CPA firm screens bookkeepers by giving them a basic accounting test that’s similar to what one would expect to find in college-level principles of accounting courses.
“We test their ability to book accounting journal entries based on the kinds of transactions they’re going to have at their nonprofit,” Soukup says. “For example, we might say, ‘You just received a $50,000 grant, which is to be received over the next three years. How would you record this transaction?’ Or, ‘You just entered into a capital lease; how should that be reflected on the financial statement? How would you record the journal entry?’”
Soukup’s CPA firm also gives applicants a test on QuickBooks. “We basically ask the applicant the same questions, but instead of journalizing their answers on a piece of paper, we’ll ask them to record their answers into QuickBooks,” he explains.
Because financial statements play an essential role in determining whether a nonprofit can fulfill its mission, Soukup says the best test for gauging expertise is to ask a candidate to do a cash-flow statement.
“A balance sheet and an income statement can be spit out using QuickBooks,” he says, “but if a bookkeeper can actually generate a cash-flow statement, which is required under GAAP, it’s a good indicator of the level of expertise we look for.” (GAAP, or generally accepted accounting principles, are widely-used conventions for recording, summarizing and preparing financial statements.)
Know How to Make Accrual Accounting Adjustments
According to Soukup, most nonprofits accounting errors occur as a result of bookkeepers failing to make accrual accounting adjustments. “Effective bookkeepers must have the expertise and experience to understand the nuances of full accrual accounting under GAAP, where revenues and expenses are recognized when earned and incurred respectively,” he says.
A bookkeeper may believe that simply recording cash receipt activity is sufficient, but as Soukup explains, “The cash basis of accounting is not GAAP, and based upon the audit requirements that many nonprofits face, only recording cash transactions isn’t sufficient.”
When a nonprofit earns income, for example, this must be recorded as a receivable. “But often, when a nonprofit receives cash from either grants or program services, they’ll record it as revenue,” Soukup says.
“The journal entry then reflects a debit to cash and credit to revenue, but that’s not proper under GAAP. When you receive money from program services or a grant, you’re supposed to debit accounts receivable and credit revenue, and that makes a big difference on cutoffs for revenue recognition.”
These errors can have serious consequences. Soukup recalls working with a nonprofit had initially had “some of the worst bookkeeping I had seen in my professional career.” To their credit, he says there were many complex transactions involved, but because so many adjustments and correction entries were required to complete the year-end audit, it wound up costing nearly double what it should have.
“The cost was a result of accrual accounting mistakes, as well as a result of a previous bookkeeper making egregious mistakes and the new bookkeeper not being able to fix them,” he explains.
“At the end of the day, the cost of the audit plus the bookkeeper’s full-time salary was absolutely exorbitant, and the anguish and anxiety this problem caused to all decision makers of the organization throughout the year was significant.”
To remedy the situation, the nonprofit hired a CPA firm to perform quarterly compilations (bookkeeping) for the organization in addition to a year-end audit. As a result, the quality of the organization’s financial report improved drastically and the year-end audit fee was cut in half.
For nonprofits with trained professionals already on staff, Brolin says nonprofit accounting software, such as Intuit’s 2014 QuickBooks Premier nonprofit, “allows organizations to properly and accurately track their budget against the actual budget expenditures and use certain classes to track funds.”
Soukup agrees that, in the hands of trained professionals, certain software can help, but he cautions that software won’t necessarily prevent accrual accounting mistakes from happening.
In the case of accrued payroll, for example, Soukup says that, since December 31st can occur in the middle of a pay period, if a nonprofit pays out every two weeks, come the end of the year you might have two weeks of accrued payroll that should be recorded as a liability. Basically, the problem here is that the organization is crediting a liability and debiting an expense, so they’re understating their expenses.
“I’ve seen a lot of mistakes like that, where even a CPA firm is missing the recording of those,” Soukup says. “The last audit we did, one nonprofit didn’t properly accrue wages, and that was a $100,000 mistake. If a CPA firm can miss that, what do you think somebody putting it through QuickBooks is going to do?”
Implement a Review Process
Burks explains that many accounting errors occur because “the accounting department wasn’t aware certain transactions occurred, or if they were aware, somebody dropped the ball and there weren’t enough reviews in place to catch the mistake.”
To prevent this from happening, Soukup says accounting transactions require a segregation of duties and a review process, meaning all accounting processes should be reviewed by at least two sets of eyes. “Every accounting journal entry should have a preparer and a reviewer at the very least,” he says.
Referencing his earlier example of the nonprofit with numerous accounting mistakes, Soukup says the organization’s executive director and board members believed the bookkeeper was recording everything correctly and up to date, but nobody was actually reviewing what she was doing.
“At the end of the day, two sets of eyes allow you to prevent going down a path where things turn out so wrong that it requires a massive effort to fix it,” he says.
Brolin agrees. In the case of the university fund client, she says, “Helping the board of directors realize the importance of additional staffing and segregation of duties assisted in the cleanup of the audit process.” As a result, “board reporting was improved and sharpening the pencil on the budget was accomplished.”