Using Financial Ratios and Benchmarks
Charitable organizations represent a significant part of the U.S. economy. Independent Sector reports that in 2009, more than 5% of the gross domestic product and approximately 10% of all employment was provided by this sector. The number of charitable organizations registered with the IRS has more than doubled in the past 30 years, and, in spite of the recession, the sector has continued to grow: More than 30,000 charitable organizations registered with the IRS for the first time in 2010. As the number of charitable organizations in the United States increases, the demand for nonprofit audits does as well. And as the amount of economic resources these organizations control rises, their boards will face greater accountability for the organizations' overall quality of financial reporting.
This article provides information that can assist auditors and audit committees that serve charitable organizations. It extends work first published by Janet S. Greenlee and David Bukovinsky ("Financial Ratios for Use in the Analytical Review of Charitable Organizations," Ohio CPA Journal, January-March 1998, vol. 57, issue 1, pp. 57-62) by addressing two concerns that arise when attempting to apply the analytical procedures required by Statement on Auditing Standards (SAS) 56, Analytical Procedures, to charitable organizations. These are 1) a lack of meaningful ratios developed for assessing the financial condition and results of operations in this sector, and 2) suitable benchmarks for determining when a ratio appears out of line. This article uses 2007 (the latest year available) Form 990 tax information submitted to the IRS by 501(c)(3) charitable organizations to develop key industry ratios for certain types of charitable organizations and to provide benchmarks for several ratio values. The analysis was conducted using a database of Form 990 data from more than 300,000 501(c)(3) charitable organizations. These ratios, representing several commonly used financial indicators, can assist auditors and audit committees in their analytical reviews of charitable organizations.
Ratio Analysis in the Charitable Sector
Quality of financial reporting has received much attention since the SarbanesOxley Act of 2002 (SOX). Provisions enacted by SOX enhance and establish new financial reporting and auditing standards for public company boards, management, and auditors. The provisions of SOX generally do not extend to charitable organizations, but they nonetheless can benefit from embracing many of its provisions. For example, the AICPA has published an Audit Committee Toolkit for nonprofit organizations that, among other things, encourages nonprofit audit committees to take steps to ensure that the committee understands 1) which financial ratios and indicators are appropriate for the organization 2) how the organization's performance compares with its budgetary targets and its peers, and 3) how management plans to address any unfavorable variances.
Understanding which financial ratios are critical to the charitable organization and its "industry" is challenging because traditional financial statement ratios are designed for the for-profit sector and generally are not applied to nonprofit organizations. This may be due to the fact that charities lack the profit motive common to for-profit organizations and rely primarily on voluntary contributions from individuals and corporations rather than revenue from the sale of products or services. In contrast to for-profit organizations, a charitable organization's purpose is not to maximize operating profit; its purpose is to carry out the mission of the organization, which usually focuses on the provision of services. Any ratio developed for use by charitable organization audit committees - or by auditors who must apply SAS 56 analytical procedures to such organizations - must therefore focus on 1) the availability of sufficient financial resources to support the charity's mission, and 2) the way in which these resources are used to carry out the mission. …