Magazine article The CPA Journal

Planning Materiality in Audits of Nonprofit Organizations

Magazine article The CPA Journal

Planning Materiality in Audits of Nonprofit Organizations

Article excerpt

THE INVERSE OF THE PETE RATIO REVEALS THE AMOUNT that the organization must receive to spend $1 on programs.

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 Notfor-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 982. 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 982 deals only with certain activities, however, and not-forprofit 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 (PET 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 PETE 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 PETE was left to the discretion of the committees and committee members. Participants were reflecting their personal views on changes in PE/IE, not the guidelines set forth by United Way. (Admittedly, participants' views are shaped by other committee members and personal experience.)

The inverse of the PEAT ratio reveals the amount that the organization must receive to spend $1 on programs. …

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