The CPA Journal

AUDITING

Planning Materiality in Audits of Nonprofit Organizations

By William D. Stout

The assessment of materiality in planning and completing an audit of a nonprofit organization is inherently difficult. The for-profit world's rules of thumb for materiality thresholds, such as calculating a percentage of net income, do not easily apply to charitable organizations. Instead, auditors apply various percentages to total assets, total revenues, or some other measure of an organization's size.

The AICPA's 1994 Audit and Accounting Guide, "Audits of Certain Nonprofit Organizations," noted that assessments of materiality involve both quantitative and qualitative judgments. Nevertheless, that guide went no further in specifying the types of qualitative matters that may be important in materiality judgments. In both the 1996 and 1999 editions, the AICPA modified its guidance and went a step further. The 1999 Guide suggested that auditors consider "other measures" for assessing planning materiality, such as unrestricted contributions, total program expenses, the ratio of program expenses to total expenses, and the ratio of fund-raising expenses to contributions.

Although the SEC does not regulate nonprofit organizations, in 1999 it commented on materiality issues in Staff Accounting Bulletin (SAB) 99, Materiality. The SEC noted that the magnitude of a misstatement in quantitative terms is but the first step in evaluating materiality and cannot replace a "full analysis of all relevant considerations." Citing Statement of Financial Accounting Concepts No. 2, the SEC highlights FASB's reference to materiality as when there is "substantial likelihood that a reasonable person would consider it important." That conception of materiality parallels the U.S. Supreme Court's view in TSC Industries v. Northway, Inc. [426 U.S. 438, 449 (1976)]. According to the Court, materiality must be judged within the "total mix" of information. Auditors can also refer to the allocation of joint costs under the AICPA's Statement of Position 98-2, Accounting for Costs of Activities of Not-for-Profit Organizations and State and Local Governmental Entities that Include Fund-Raising.

With these options, an auditor of a charitable organization trying to assess materiality might misclassify program spending as administrative/fundraising spending.

Using the ratio of program spending to total spending method is commonly used to avoid these problems. This ratio has recently been a topic of discussion because of SOP 98-2. In "Accounting for Joint Activities Under SOP 98-2" (The CPA Journal, August 1998), author Patrick Yogus notes that regulators and others were concerned that nonprofit organizations were not allocating costs properly between program and fundraising activities. According to Yogus, the increased specificity of SOP 98-2 would facilitate higher and more consistent scrutiny of cost allocation. SOP 98-2 deals only with certain activities, however, and not-for-profit organizations still struggle with the allocation of overhead costs.

Donor Reaction

A study of United Way volunteers' responses to changes in the ratio of program expenses to total expenses (PE/TE) indicates its importance. First, watchdog organizations use this ratio as a benchmark when recommending organizations to donors. For example, the Better Business Bureau's current standards require the PE/TE ratio to be at least 50%.

The United Way organization participating in this study did not provide specific written guidance to the allocation committees. Evaluation of an appropriate level of PE/TE was left to the discretion of the committees and committee members. Participants were reflecting their personal views on changes in PE/TE, not the guidelines set forth by United Way. (Admittedly, participants' views are shaped by other committee members and personal experience.)

The inverse of the PE/TE ratio reveals the amount that the organization must receive to spend $1 on programs. For example, if an organization's PE/TE ratio is 80%, this means a donor must give $1.25 (the inverse of the PE/TE ratio) in order to increase the output of spending for programs by $1.00. As informed consumers, many donors seek out organizations with the highest PE/TE ratios when making their charitable giving decisions. The author conducted a study to determine whether changes in the ratio would trigger statistically significant changes in the amount of funds given to an organization.

Description of the Study

Participants in the study were members of allocation committees of a United Way located in a southeastern U.S. city. These committees comprise volunteers from a variety of backgrounds whose primary objective is to effectively allocate the significant sum of funds raised by the United Way. The 15 separate allocation committees awarded amounts ranging from $25,000 to $300,000. The participating United Way organization typically raises more than $12 million annually.

Like many donors making large grants to nonprofit organizations, allocation committee members review summarized financial statement information (from the balance sheet and statement of activities), the ratio of program to total spending, and other information deemed relevant by agencies that prepare the information for the committees. Certain information, such as the ratio of program to total spending, is generally required.

The study was conducted during allocation committee meetings (with a few exceptions), and required the participants to review financial information for 13 nonprofit organizations in random order. Seventy-six individuals from diverse backgrounds participated in the study, all of them members of the participating United Way's allocation committees. Most participants indicated that they were employed as business managers, in healthcare, or as professionals. Ninety percent of the participants reported that their understanding of financial data was at least average, and more than three-quarters use financial information in their employment.

The survey organizations were typical of the organizations funded by the participating United Way organization. Of the 13 cases presented, five are germane to this study (the others relate to a different study). Participants reviewed information summarized from the organizations' statement of activities and balance sheet. The cases presented five levels of PE/TE: 85%, 80%, 75%, 70%, and 60%, chosen based on the advice of experts in resource allocation decisions. Based on that information and a request for funding, participants were asked to indicate the amount they would recommend be allocated to the organization (the resource allocation decision).

Results

The Exhibit shows the average resource allocations for each level of PE/TE. Average resource allocations for the five levels of PE/TE ranged from a high of $258,511 to a low of $177,877. The mean resource allocations for a PE/TE of 85%, 80%, and 75% all fall under the same grouping (A) indicating that they are not statistically different from each other. From the standpoint of materiality, then, one can conclude that a misclassification of expenses that would change a PE/TE from 85% to 75% would not be a material misstatement with regard to the classification of expenses.

The Exhibit also shows that the average resource allocation at a PE/TE of 70% is not in the same statistical group as a PE/TE of 85% or 80%. Therefore, a misclassification of expenses that would change the PE/TE from 80% to 70% might signify that the financial statements are materially misstated with respect to the classification of expenses. Likewise, a misclassification resulting in a PE/TE of 70% rather than 60% might represent a material misstatement.

These results reveal that a misclassification on the statement of activities (and related information) could significantly affect the decision of a user of a nonprofit organization's financial statements. This study also provides a practical means of implementing the guidance provided in the AICPA's Audit and Accounting Guide, "Not-for-Profit Organizations." In planning an audit of a nonprofit organization, an examination of the forecasted or budgeted spending allocations could enhance the estimated level of PE/TE, which then could be the basis for projecting a material misstatement of the statement of activities from the standpoint of expense classification.

For example, assume an audit engagement of a nonprofit organization whose total spending amounts to $200,000. Of that spending, $160,000 is budgeted for programs and the remaining $40,000 for administrative and fundraising activities, making the budgeted PE/TE 80%. Based on the results of this study, the materiality would be the amount of tolerable misstatement (misclassification) of spending. Because a change of 10% of PE/TE would represent a material misstatement, materiality for expense classification should be $20,000 (10% of $200,000 total spending). In addition, the same approach would apply at the conclusion of the audit when deciding whether the financial statements are presented in accordance with generally accepted accounting principles.