Crunchy or Smooth?

Crunchy or Smooth?

Like peanut butter, deferred funding accounting is a matter of preference. Charity Intelligence prefers crunchy.

Canadian charities can choose different accounting methods to report donations. Some pick the deferred funding method. The accounting method a charity chooses can produce widely different financial ratios. Neither accounting method is right or wrong, good or bad. Charity Intelligence sees accounting methods like peanut butter; crunchy or smooth is simply a matter of preference. We prefer crunchy.

Like many, you may find accounting dry and boring. Imbibe with us as we use the Ice Bucket Challenge and ALS Canada as a fascinating case study that shows why accounting matters – and how the fine print can dramatically affect a charity’s financial ratios.

ALS Canada is a charity that raises money to fund research into the deadly disease ALS and to support people and families affected by ALS. Over the summer of 2014, there was a social phenome with people across North America dumping ice water on themselves and donating to ALS charities. The Ice Bucket Challenge resulted in ALS Canada receiving a $13.7 million windfall in donations.

Following the ALS Ice Bucket Challenge, ALS Canada chose to change its accounting policy, switching from the restricted fund method to the deferred funding method. This change, along with the Ice Bucket Challenge windfall, dramatically affects ALS Canada’s financial ratios.

The deferred fund method of accounting shows donations received only when the money is spent. This deferred method neatly matches income with expenses. While the deferred fund accounting method is neat and tidy, it also “smooths earnings”. Deferred accounting can mask what actually happens in a year.

For example, the $13.7 million Canadians donated to the Ice Bucket Challenge doesn’t show up in ALS Canada’s 2014 income. Since ALS Canada didn’t spend any Ice Bucket money, it doesn’t show up in revenues on the income statement. Donors got their tax receipts, but ALS Canada didn’t “recognize” the money, in accounting parlance.

 

See! The $13.7 million in Ice Bucket Challenge donations doesn’t show up in the income statement in 2014 because it is “deferred”. Instead, ALS Canada is showing part of this money, $7.3 million in Ice Bucket donations, being recognized in 2015. The rest will show up in future years when ALS Canada spends the money.

If ALS Canada hadn’t changed accounting methods in 2014, and instead stuck with the restricted fund method, the Ice Bucket Challenge money would have shown a very different picture.

This is how Charity Intelligence reports ALS Canada’s financials:

Charity Intelligence prefers using an “as it happened” basis for reporting. We feel this method best reflects events and best shows the ratios for each year. Unwinding deferred donations can show the ups and downs of annual events that affect charities. Compared with the deferred fund “smooth” method, the “as it happened” basis is “crunchy.”

Please remember, neither accounting method is right or wrong, good or bad – they are just simply two different acceptable accounting methods. Like peanut butter, crunchy or smooth is simply a matter of preference.

What’s more, Charity Intelligence consistently unwinds deferred fund accounting (where material)[1] across all charities analysed. Consistently using the “crunchy” method gives donors the ability to make comparisons between charities using different accounting methods.  

 

Why does deferred fund accounting matter? It doesn’t normally … unless there is a big one-time event.

 

Most often unwinding deferred donations has no material effect. Yet sometimes there is a big event that causes a massive inflow of donations. Charity Intelligence typically sees extraordinary events affecting disaster response charities, like Canadian Red Cross and Doctors Without Borders. In the wake of disasters, like the 2010 Haiti earthquake or the 2016 Fort McMurray fire, donors will respond and donate millions of dollars.

When these one-time events occur, showing what happened during the year by adjusting the deferred donations can present dramatically different numbers. The financial ratios for fundraising costs and administrative costs are calculated using donations and revenues. The fundraising costs and administrative costs remain constant – it’s the denominator that changes.

ALS Canada and the Ice Bucket Challenge is a great case study that shows the effect of deferred accounting relative to cash-based accounting on financial ratios.

 

This table shows the effect of the different accounting methods on financial ratios.  

  • 2013’s numbers are the same. Fundraising costs are 26% of donations, administrative costs are 12% of total revenues. Charity Intelligence reports the overhead costs at 38%. For every dollar a donor donated, 38 cents covers overhead costs or ($1.00 – $0.38) = $0.62 cents “goes to the cause”.
  • 2014’s ratios show the difference between the accounting methods: the Ice Bucket Challenge windfall, all coming in during 2014, depressed overhead ratios. In 2014, using the crunchy cash method, fundraising costs are 13% of total donations and administrative costs are 3% of total revenues, for a combined overhead cost of 15%. In 2014, using the deferred fund method, ALS Canada reports fundraising costs of 32% with administrative costs 9% of total revenues. Total overhead costs are 41%. 2014’s fundraising costs include $924,100 in credit card processing fees from on-line donations compared with a more typical $34,100 in 2015.
  • In 2015, the deferred fund method understates cost-efficiency ratios: the cash method shows fundraising costs at 29% of donations versus 8%, and administrative costs of 15% of total revenues compared with 4%.

The costs are the exact same: it’s the accounting method that produces the different ratios.

 

One of the strengths of the as it happened reporting method is highlighted by fundraising costs. It’s obvious that 2015’s fundraising efforts had no effect on the Ice Bucket Challenge donations received in 2014. Deferred fund accounting must be adjusted to reflect the reality of 2015. In the words of Babe Ruth, “yesterday’s home runs don’t win today’s game.”

To its credit, ALS Canada does just this, stating in its 2015 Annual report its fundraising costs are 28%.[2]

 

 

Why does Charity Intelligence unwind deferred revenues?

 

Charities ask us why we unwind deferred revenues and report “different numbers” from what a charity is reporting. We don’t do it to intentionally confuse donors. We do it because:

  • “crunchy” reporting we feel is the most accurate picture of financial accounts. In our experience, it gives the clearest picture of a charity’s annual results. Our job is to give donors what we feel is the most accurate information.

 

  • The crunchy approach also eliminates carryover effects that can distort the ratios. The deferred accounting of the Ice Bucket Challenge doesn’t just affect ALS Canada’s 2014 and 2015 numbers. It will affect the financial ratios over all the years the Ice Bucket Challenge money is spent, likely out to 2018.

 

  • We too questioned whether it was worth going to the bother of going through the accounting steps to unwind deferred donations. In 2011, when we became aware of how accounting can dramatically affect reported ratios, we asked some donors. These donors specifically asked that we present the numbers on an “as it happened basis” to best track when donations are received.

 

We highlight the donors we surveyed were a small number of sophisticated grantors, which is not representative of Canadian donors. Yet what we report to this elite should be the same as we report to all. We hope our notes are clear and simple so everyone can see the adjustments we’ve made and why. Our mission is to help donors be informed, donors both large and small, and we are committed to providing all donors with the best information we can. We feel that the crunchy approach is best.

 

We’ve heard from charities that our decision may be confusing to the ‘average’ donor. To which we ask “should Charity Intelligence therefore ‘dumb it down’”? We feel it would be unethical to give one select group of donors better information than all. And practically it would be too much work for us to keep two sets of books. We feel the best way to raise one’s level of understanding is to get educated.

 

Given that charities can have up and down years, Charity Intelligence reports always show financial information for the most recent three years. Three years can show trends. Donors should always look at the three-year trend rather than just one year in isolation.

While donors are interested in financial ratios, Charity Intelligence urges donors to consider other aspects of a charity’s operations in making giving decisions. Cost-efficiency matters, but not as much as good results reporting and impact.

 

Donors should cheer “Bring on the Deficit”

 

ALS Canada management has expressed concerns that Charity Intelligence’s reporting on a cash basis will show annual deficits; as ALS Canada spends down the ice bucket money, it will be spending more money than it raises. As such, the as it happens method will report substantial deficits in 2016 and 2017.

Rather than being concerned, donors should celebrate these deficits. This is the charitable sector, rather than the for-profit sector. While investors may desire companies with huge cash reserves on balance sheets, social investors should see this as a sign of idle capital. Investors will desire companies that generate huge net profits – social investors should be suspect of charities with large annual surpluses. In the upside-down world of charity analysis, charity deficits can also be a good signal.

Charity Intelligence reports a deficit of $774,000 for ALS Canada in 2015. This shows that, of the $13.7 million in donations given in 2014, this money is now being used to fund research and client programs. This was why donors gave the money in the first place. Donors want to see it spent.

We hope ALS Canada’s deficits will be huge in 2016-2019. This will show it is spending down the remaining $13 million of Ice Bucket money. With ALS, time matters. We will continue to emphasize the moral imperative of deficits in our reporting on ALS Canada.

 

As always, while the accounting methods highlight the financial ratios, donors must not be distracted – the greatest issue with ALS Canada is not the financial ratios, it’s how the Ice Bucket money is spent, when it is spent, and the results it achieves. Charity Intelligence will be updating ALS Canada in June 2017 with its 2016 results.

 

End notes: 

1. Charity Intelligence uses a 10% materiality test; where deferred funds represent 10% or more of annual donations, Charity Intelligence takes the extra step in unwinding deferred funds to present donations on a cash basis. Where deferred fund accounting does not materially affect donations, Charity Intelligence presents the donations and revenues as reported.

2. ALS Canada’s 2015 annual report confirms this reporting “On regular fundraising, outside of the ALS Ice Bucket Challenge revenue, ALS Canada had a fundraising ratio of 28%, which is within the acceptable level for the charity sector and Canada Revenue Agency standards.” ALS Canada 2015 Annual Report, Management Discussion and Analysis, p.17

One interesting point to consider: according to Canada’s charity accountant guru, Phil Cowperwaite, unrestricted contributions must be recognized as revenue in the period received.

“Donation revenue usually comprises donations actually received in the year. Donors do not enter into a contract with the organization when making a donation. The revenue is, therefore, generally only recognized in the reporting period in which the donations are actually received.”

In addition to changing its accounting method in 2014, ALS Canada apparently elected to “restrict” the Ice Bucket Challenge donations. Donors were likely largely unaware that their donations were “restricted” donations.

The restriction of donations from fundraising events is a growing practice among Canadian charities that Charity Intelligence is tracking.

http://187gerrard.com/2010/07/understanding-annual-financial-statements/

 

 

 

 

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Legal disclaimer: The information in this report was prepared by Charity Intelligence Canada and its independent analysts from publicly available information. Charity Intelligence and its analysts have made endeavours to ensure that the data in this report is accurate and complete but accept no liability.

The views and opinions expressed are to inform donors on matters of public interest. Views and opinions are not intended to malign any religion, ethnic group, organization, individual, or anyone or anything. Any dispute arising from your use of this website or viewing this material shall be governed by the laws of the Province of Ontario, without regard to any conflict or law provision.

 

 


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