Predicting Financial Vulnerability in Charitable Organizations

Article excerpt

One result of the trend toward privatization of government social services has been a tremendous increase in the number of tax-exempt organizations. According to the Independent Sector, an organization that reports on the state of the tax-exempt sector, the number of such organizations has increased by more than 500 in the past decade. There are now more than one million nonprofit organizations that generate in excess of $600 billion in total revenues and employ close to 7% of the total workforce. As this sector continues to grow, the demand for accounting services by these organizations will increase. One potential service area for CPAs is the evaluation of the financial condition of organizations in this sector.

Auditors are presented with three chat lenges when trying to evaluate the financial condition of a tax-exempt organization. First, financial measures that have been developed in the business sector are often inappropriate for organizations whose purpose is to maximize service rather than profit. Second, few financial benchmarks allow for comparison with similar organizations. Finally, no method has been developed that can assess the financial vulnerability of tax-exempt organizations to a financial shock, such as a lawsuit, loss of a major funding source, or a sudden downturn in the economy. The forprofit sector, on the other hand, has many methods that use accounting information to determine such vulnerability.

Sources of funding for charitable organizations are constantly evolving. Despite the widespread belief that charitable organizations depend primarily on government grants or contracts, this is generally not the case for the sector as a whole. During the past 10 years, reliance on governmental funding has decreased substantially. Currently, more than 700% of charitable revenue is generated from nongovernmental sources (i.e., fees and private giving).

Indeed, charitable organizations operate in an atmosphere of increasing governmental regulation and public scrutiny. Since 1994, 14 states have either instituted or increased nonprofit regulation and reporting requirements, and the 1996 Taxpayers Bill of Rights required significantly increased nonprofit disclosure. Nonprofit organizations are now required not only to supply a copy of their informational tax returns (Form 990) to any requesting party, but also to make these returns "widely available." Further, the National Center for Charitable Statistics (www.nccs.urban.org), an arm of the nonprofit think tank the Urban Institute, has placed Form 990 information from more than one million tax-exempt organizations on the Internet.

With these attributes in mind, we extracted certain financial measures from the framework originally set forth by nonprofit research economists Howard Tuckman and Cyril Chang. These measures focus on the ability of a charity to continue to carry out the mission of the organization if faced with one or more financial shocks:

* Debt ratio (DEBT). A charity with a higher proportion of debt in its capital structure will be more limited in its ability to replace these lost revenues, when faced with a financial shock, than one with a lower proportion of debt. Conversely, a charity with less debt in its capital structure is more likely to be able to leverage its borrowing power, under similar circumstances. Thus, the higher the debt ratio, the more likely the orgy nization is to be financially vulnerable.

* Revenue concentration index (CONCEN). Charities derive revenue from gifts, grants, program services, membership dues, sales of inventories, and investments. Charities with fewer revenue sources are more vulnerable to financial shock than those with multiple revenue sources, because a charity with multiple sources may be able to rely on alternative sources of funding and thus avoid reducing services. A charity that receives all of its revenue from one source has a "revenue concentration index" of one. …