Why Do Nonprofits Misreport Their Financial Performance? It’s About Manager Pay

When you donate, your money often doesn’t support the nonprofit’s mission as much as it says it does.

Based on the Research of Eric Chan

Faced with the coronavirus pandemic and economic downturn, many Americans are turning to nonprofits for assistance. And those of us seeking to help them are lending support through our donations.

Nonprofits are big business. They employ 10% of the U.S. workforce and contribute 5% of gross domestic product, according to the 2019 Nonprofit Employment Report. Giving USA 2020 reports that nonprofits received private donor contributions of almost $450 billion in 2019.

But these donations may not be contributing as much to nonprofits’ primary missions as we think. That’s because many nonprofits inflate the program ratio — the proportion of an organization’s mission-related expenses to its total expenses — used by charity rating agencies to evaluate a nonprofit’s performance.

“When we donate, we want to make sure the money is going to the right places, not just for administrative purposes and marketing, but to the beneficiaries. The program ratio captures that idea,” says Eric Chan, an assistant professor of accounting at Texas McCombs and co-author of a new study on nonprofit misreporting.

Prior research has documented evidence of pervasive inflation of financial performance by nonprofits to the IRS. Chan wanted to know what motivates managers to misreport and how regulators can deter it.

The answer lies in how much money they make, according to Chan and study co-author Xinyu Zhang of Cornell University. Their study finds that pay level is a key factor in not only why managers inflate the numbers, but how often.

Paying and Attracting Managers

Pay at nonprofits is on the rise, drawing a wider mix of managers driven by different motivators. To examine these motivators, Chan and Zhang ran an experiment on an online labor market platform.

Participants chose one of two hypothetical manager jobs: a nonprofit job where participants designated a real-life charity that other participants, playing the role of donors, could give to, or an alternative job where participants did not raise money for charity.

The researchers designed the experiment such that for a random group of participants, the nonprofit pays less than the alternative job, and for other participants, the nonprofit pays more.

Post-experiment questions revealed that how much each manager cared about the mission of the real-life charity depends on how much money the manager was paid to do the nonprofit job.

“Lower-paid nonprofit managers on average valued and cared about their nonprofit’s mission more than the higher-paid group.” — Eric Chan

“Higher-paid nonprofit managers are in one of two camps. A minority also cared about the nonprofit’s mission. But a larger group are not as mission-driven and took the nonprofit job only because it paid more than the alternative job.”

Discouraging Misreporting

The researchers next studied misreporting.

Study participants continued in their assigned roles as either donors or nonprofit managers. Managers were privately assigned a program ratio, which determines the proportion of donor money their real-life charity will actually receive. Managers could choose to either honestly report or inflate and misreport the program ratio to donors. Donors, meanwhile, could either select a nonprofit based on the reported program ratio, or audit these numbers so that the nonprofit with the higher actual program ratio received their donations.

“We wanted to create a setting where participants acting as nonprofit managers have to make real decisions around financial reporting that have real outcomes for their chosen charity,” Chan says.

The study finds that sacrificing personal wealth appears to be a key driver in misreporting by lower-paid managers.

Lower-paid managers are more likely to inflate the program ratio than equally mission-driven managers in the higher-paid group. About a third of the study’s higher-paid group were mission-focused, but they inflated the program ratio significantly less often — 14% versus 33%. They were also less likely to justify misreporting than lower-paid managers, suggesting the number on one’s paycheck is a bigger factor in misreporting than belief in the mission.

“It gives you the moral license to do something unethical later on,” Chan says.

“These lower-paid, mission-focused managers believe they have made a sacrifice and can justify inflating the program ratio to potentially benefit the organization.” — Eric Chan

With the goal of discovering ways to deter misreporting, the researchers compared the effectiveness of imposing a penalty on the nonprofit overall versus the misreporting manager.

“We found that penalizing the organization is a more effective deterrent to misreporting in lower-paying nonprofits, while penalizing the manager is more effective in higher-paying ones.” Chan says. “Ultimately, how much nonprofit managers are paid not only influences why they misreport, but also how to effectively discourage their misreporting.”

“Understanding and Deterring Misreporting in Nonprofits: The Joint Effects of Pay Level and Penalty Type” is forthcoming, online in advance in The Accounting Review.

Story by Sally Parker