Donors often reach out to CharityWatch for ratings of small, local charities operating in their geographic areas. While it is sometimes possible to obtain the data we need in order to subject these smaller organizations to the rigorous analysis necessary to be able to provide meaningful information to donors, often it is not. It's important to understand how smaller charities differ from larger ones so that their financial efficiency and governance can be judged in the appropriate context.
Cash Basis Accounting
Smaller charities tend to report their financial activities using the cash basis rather than accrual basis method of accounting. Though the IRS allows charities to use cash basis accounting to prepare their annual IRS Form 990 tax filings, the cash basis accounting method is not acceptable under Generally Accepted Accounting Principles (GAAP) in the United States. Accrual basis accounting reports revenue as it is earned and expenses as they are incurred, providing a more complete picture of an organization's assets and liabilities (resources owed to outside parties), and a better measure of how efficiently it is operating. Cash basis accounting is a less reliable method for assessing a charity's financial health or measuring its financial efficiency because it reports revenue and expenses based on the timing of when cash deposits or payments are made, which can be arbitrary and open to manipulation. Charities often opt to use the cash basis method of accounting when they are newly formed or small in size because it is more simple than using accrual basis and requires less accounting expertise to maintain.
Donors can check out a charity's IRS Form 990, Part XII, line 1 to see what accounting method it reports using for that fiscal year's Form 990 reporting. A number of online databases exist that post charity tax forms obtained from IRS records. Read more information here to understand the limitations of these forms and from where they can be obtained.
Economies of Scale
Economies of scale occur when the size of an organization's operations allow it to operate more efficiently. As an organization grows it costs it less (per unit) to produce its goods or services due to its overhead and other fixed costs being spread over a larger volume of output. For example, a small charity that serves 500 poor people per year may need to pay $8,000 for its annual financial audit. A larger charity that serves 3,000 poor people per year may need to pay $10,000 for its annual financial audit. The first charity spent $16 per person served for the overhead cost of its audit, while the second spent far less at only $3.33 per person served. Charity rating methods suitable for larger organizations often cannot be fairly applied to much smaller charities given that the latter lack the economies of scale necessary to operate at the same level of efficiency. Small charities that assist underserved populations, that are fulfilling an unmet need, or that are new or in the process of scaling up to a larger size may still be worthy of donors' support despite CharityWatch's inability to rate them due to this comparability issue.
Lack of Independent Audited Financial Statements
Most charities forego hiring external auditors to produce annual audited financial statements until they reach a size that subjects them to regulations requiring them to do so, such as to satisfy state fundraising regulations, to obtain credit, or for insurance purposes. Audits conducted by Certified Public Accountants (CPAs) can cost thousands of dollars, which is relatively expensive for small charities. The lack of an audit, however, means that a qualified outside party has not subjected the charity's financial reporting to auditing standards that would test the effectiveness of its internal controls and assess whether or not the charity's financial information is fairly presented and free of material misstatements.
In the IRS Form 990, Part XII, lines 2a & 2b, charities are asked to respond "Yes" or "No" to the following questions:
- "Were the organization's financial statements compiled or reviewed by an independent accountant?"
- "Were the organization's financial statements audited by an independent accountant?"
If a large charity (annual revenue of $1 million or more) responds "No" to both of the above-referenced financial statement questions on the Form 990, this is a potential red flag since it is unusual for larger charities to not have their books compiled, reviewed, or audited by an outside accountant. A lack of independent audited financial statements has prompted CharityWatch to investigate certain large charities in the past, such as HeroBox and Central Asia Institute, where we uncovered and reported on additional problems.
If a smaller charity (annual revenue of $1 million or less) responds "No" to both of the above-referenced financial statement questions on the Form 990, the charity's governance over its internal processes and procedures becomes all the more important for ensuring that it is adequately safeguarding its assets against fraud or financial mismanagement. Before donating, consider asking the charity for a copy of its policy outlining its procedures for receiving and distributing funds, conflict of interest policy, and whistleblower policy. Review the charity's IRS Form 990 to see if its board of directors is adequately large and independent (Parts VI & VII), if any close family relationships exist (Part VI, line 2 & Schedule O), and if there are any related party transactions between the charity and the people operating it (Schedule L). Also check to see if the charity has reported a diversion of assets (Part VI, line 5) or any excess benefit transactions (Part IV, lines 25a & 25b).
If a charity responds "Yes" to having an independent compilation, review, or audit, it's important to understand some of the differences among and limitations associated with these three types of services:
- Compilation: A compilation is simply a service that assists the managers of a charity in presenting the organization's financial statements. It does not incorporate audit procedures to provide any assurances regarding the information presented.
- Review: A review is slightly better than a compilation. It entails conducting limited analytical procedures that can identify possible problems with a charity's financial records, such as comparing end balances in certain accounts over several years to look for trends, or performing reasonableness tests to examine the validity of certain accounting information.
- Audit: An audit is far superior to either a compilation or review. An audit includes inspecting a charity's assets and examining its accounting records, including source documents (e.g., invoices, purchase orders, expense reports, credit memos, cancelled checks), journal entries, and ledgers (the aggregate set of records containing all of a charity's accounts). Before expressing an opinion on a charity's financial health and conformity (or nonconformity) with Generally Accepted Accounting Principles (GAAP), an independent CPA conducts analytical procedures to identify possible problems with its financial records and investigates them. Analytical procedures may include comparing different sets of operational and financial information, reviewing the consistency of historical relationships, and examining trends in financial ratios to identify any unexplained variances.
A number of state regulatory bodies post copies of charity audits on their websites. A charity soliciting donors within a state's borders may be required to be registered there even if its physical office is located in a different state. For example, if a large charity based in Ohio is soliciting donors nationally, a copy of its audit might be found in one of the following state databases:
California Attorney General
Florida Department of Agriculture and Consumer Services
Illinois Attorney General
Massachusetts Attorney General
North Carolina Secretary of State
New Mexico Attorney General
New York Attorney General
Oklahoma Secretary of State
It may be more difficult to find independent data on charities that solicit only locally or within one state. Check with your state's charity regulatory body to find out what information it has on charities operating locally, such as Bylaws, Articles of Incorporation, or annual financial filings.
Some charities are composed of hundreds of separately controlled, local affiliates. These affiliates are often governed by local volunteers that primarily raise and spend donations within their own communities. Such local affiliates are often relatively small and not uniformly required to file full tax forms with the IRS and other government offices. In cases where a charity files consolidated audited financial statements that include its local affiliates, CharityWatch may be able to provide a rating reflecting how efficiently the organization is operating on the whole. In cases where the financial activities of the local affiliates are not reported in consolidated form, CharityWatch may report only on the national office. In some cases, the national office of a charity that has many local affiliates may provide certain administrative or fundraising support to those affiliates and then bill the affiliates for the services provided. In such cases, a local affiliate's reported expenses may include significant reimbursements to its national office.
For some examples, you may view CharityWatch's data on the following organizations:
Boy Scouts of America (National Office)
Boys & Girls Clubs of America (National Office)
Covenant House & Affiliates
Girl Scouts of the USA (National Office)
Goodwill Industries International (National Office)
Habitat for Humanity International (National Office)
Jewish Federations of North America
Meals on Wheels America (National Office)
The Y (National Office)
United Way Worldwide
Volunteers of America
Some additional tips for researching local charities can be found here.