On June 15, 2004, Peter Swords presented the following paper at the CityBar Center for Continuing Legal Education seminar of the Association of the Bar of the City of New York. This paper is drawn, in part, from Swords’ publication How To Read the Form 990 & Find Out What It Means which can be accessed (for free) at www.npccny.org/Form_990/990.htm. For an indepth look at the 990, Swords has written Form 990: A Detailed Examination. This can be accessed online at www.npccny.org/More_990/990.htm.
Working a Form 990
The Form 990 was first put out in 1943. It consisted of two pages and asked primitive questions aimed at detecting violations of the nondistribution constraint, that is, finding out whether funds of an exempt organization that should have been used to advance an exempt purpose had been improperly siphoned off into private hands. It has greatly expanded over the years and today for 501(c)(3) organizations who have to file Schedule A, it runs to 12 pages to which there are required to be attached enumerable explanations and schedules. Its big expansion took place in the late 1970s, prompted by the Filer Commission’s observation that the financial activities of nonprofit organizations should be conducted in the full light of public scrutiny. The Filer Commission, known officially as the Commission on Private Philanthropy and Public Needs, after noting that the Form 990 “is not financial-statement oriented but is directed to regulatory needs” recommended that the Form 990 be amended to better reflect financial information. About the same time, the IRS and state charity officials began to work together to add material to the Form 990 that would make it a suitable disclosure instrument for state as well as IRS purposes.
As you all know, the Form 990 is an information return that must be filed each year by exempt organizations with the IRS. It contains much financial and program information. In addition the Form 990 now makes up the heart of the annual reports that charities must file with over 36 state charity offices. It is our sector’s big disclosure document and in a way is similar to the myriad of filings that registered companies have to make with the SEC.
In recognition of the Forms 990’s value to the public, not long after its return was mandated, Congress enacted a law requiring the Secretary of the Treasury to make any Form 990 available to the public. This was a somewhat daunting process for the public, and beginning in the mid-1980s the disclosure laws expanded so that today organizations are required to provide copies of their last three Forms 990 for a nominal fee to whoever asks for them. Moreover, for several years now a private firm, GuideStar, has been posting Forms 990 on the Internet and last February the IRS began to accept electronic filing of the Form 990. Taking a long view we are only a short bit away from the day when it shall be mandatory to file Forms 990 electronically with the IRS and state charity offices. (The SEC stopped receiving hard-copy filing of its documents in 1997.) This is highly significant since when this happens an IRS automated error–check systems could be developed which would instantly review every Form 990 that is filed and return it if it is incorrectly filed. For the first time ever, all Forms 990 will be reviewed by the IRS and in many cases by error-check systems developed by state charity offices. Folks, for example, will no longer be able to get away with leaving Part II, the expense statement, blank and attaching a schedule of expenses that tracks the expenses as set out in an organization’s audited financial statements. Parenthetically, I predict that so far as expense statements go, audited financials will begin to follow the Form 990’s Part II rather than the other way around. Finally, GuideStar information tends to be fairly old. Mandatory filing will produce immediate postings.
How important is the Form 990 in the greater scheme of things? There obviously are not hordes of stock analysts and the like poring over Forms 990 to determine whether making contributions to filing groups would be a good investment. It is hardly ever the case that anyone’s private welfare is damaged if they contribute to a group that doesn’t use their funds as they would have liked. And yet there are many of us who believe that a functional and effective nonprofit sector adds immeasurably to the polity and public welfare of our country. How does the Form 990 help bring this about? Before answering this, let me notice what the Form 990 is not. In a sense the Form 990 provides little information on what many people really want to know about nonprofits. Many are interested in such things as what nonprofits do and whether what they do is important, and, if it is important, whether the particular nonprofit in question will do it effectively and efficiently. Part III provides some information about what a filer does, but very little, and the form has been drafted in such a way as to limit what can be said about a filer’s program. Little in the 990 sheds much light on a filer’s effectiveness or efficiency. (Beware of ratios.) This does not disturb me. I strongly believe that answers to these kinds of questions are not likely to be reliably and informatively developed in a data instrument that is based on textual answers. I believe that answers to these kinds of questions can only be gained by actually visiting nonprofit organizations, talking to people associated with them and the like.
So I return to my question. Despite what I have just said, does our highly public Form 990 help promote the functionality and effectiveness of the nonprofit sector? Can the public find out things from reviewing a Form 990 that might result in a better sector?
I, of course, believe that the answer is “Yes.” I find three categories of information in the Form 990 that are useful. First, there is information that those who run one particular nonprofit can find out about other similar nonprofits that can help them make decisions and better understand their own operations. Second, there may be information about filers abusing their nonprofit status the revelation of which will help deal with bad apples that so damage the sector’s reputation. Or at least it may be that the awkwardness of having to file a Form 990 that misrepresents what occurred during the year being reported on in order to mask improper transactions may deter such behavior. Finally, there is information that will prove helpful to people in deciding whether to contribute to or work for a group or not: both financial and program information. I will now give some examples of these three kinds of information.
(1)
I begin with information that one group may seek about other groups in the same field.
1. Salary information found at Part V is important in setting salary levels for an organization’s Executive Director. It is useful in developing comparable information to establish the rebuttable presumption under the intermediate sanctions provsions of § 4958 that effectively shifts the burden to the IRS in proving that the award of a compensation package is unreasonable or excessive.
2. It may also be of interest to know what other high officials of sister organizations are being paid, for instance, CFOs or Development Officers. This information may be found at Part V or Part I of Schedule A. By examining comparative salary information found at Part V and Part I of Schedule A, one can also find data about the level of benefits sister groups are giving their top staff. Furthermore, it may also be of interest to know whether sister groups are engaging independent contractors for professional services, like fundraisers, and how much they are paying. This can be found at Part II of Schedule A.
3. It may well be of interest of find out how many people serve on the boards of sister groups and who they are. It may also be of interest to know whether they are paid. This can be found at Part V.
4. The size of sister groups’ staff, which can be found at line 90b of Part VI is of obvious interest.
5. It may be instructive to find out whether sister groups rely primarily on contributions or also receive program service revenue. This can be important for performing arts groups who charge admission to their events. How much is the New York Collegium collecting in ticket revenues and how does that compare to the Early Music Foundation’s take? This information can be found by looking at Lines 1 and 2 of Part I.
6. Human service groups may be interested in knowing how much government funding sister groups are receiving. This information can be found at Line 1c of Part I.
7. It may be of interest to know whether sister groups engage in lobbying activities and how much. This could be important to board members who would like to see their nonprofit do more or less lobbying. This information can be found at Line 1 of Part III of Schedule A and at Part VI of Schedule A. In this connection it might also be interesting to know whether sister groups have made the h election. This can be found out at Part VI of Schedule A.
8. Here are several other things, perhaps of less interest;
a. Do sister groups run special events? – see Line 9,
b. Do sister groups generate any unrelated business income? – see Line 78n of Part VI.
c. Do sister groups solicit contributions in other states? – Line 90a may be suggestive.
(2)
We now come to the Form 990 as an accountability tool: an instrument for the detection and deterrence of abuses. This is stuff of regulators and goes back to the origins of the 990. As we all know the big “no no” in the nonprofit world is the violation of the nondistribution constraint: the improper transfer of funds into private hands that should have been used to advance the organization’s exempt purposes. This usually includes excessive compensation, self-dealing and sometimes just plain looting. As I hope to demonstrate in a minute, I believe the 990 has been carefully drawn so that it is virtually impossible if an abuse has occurred to accurately fill out the 990 and not disclose the abuse. Of course, one would have to be totally inept and dead from the ankles up to do this and the rogues who are smart and street-wise enough to commit these abuses are usually smart enough to grasp the inadvisability of self-confessing their malfeasance by having their 990s accurately completed. So where there is abuse, there is very likely to be an intentionally misrepresented 990. So what’s the point? Is the 990 a paper tiger as an accountability tool? I’ll answer this in a minute, but let me now show you where abuses would show up if the form was correctly done.
A filer must show the full compensation package of its key employees at Part V and the next five highest paid employees (assuming they make over $50,000) at Part I of Schedule A. Thus the salaries of at least six of a filer’s top staff will be reported. An organization’s executive director is a key employee. The Instructions to the 990 define the term “key employee” in part as including “the chief management and administration officials of an organization” including the “chief financial officer and any officers in charge of administration or program operations if they have authority to control the organization’s activities, its finances or both.” In many cases there will be more than one key employee reported at Part V or there should be. For our purposes, the point is that it is almost certainly the case that anyone who might cause the nondistribution constraint to be violated by having him or herself paid an excessive salary would be included in Part V or Part I. Would, however, the too high salary be reported? That is the paper tiger question.
The other major area of abuse is self-dealing. Here we look at the Great Self-Dealing Question found at Line 2 of Part III of Schedule A. This question covers literally every possibility of self-dealing and well as sheer looting. So in addition to asking whether the filer engaged in the sale or exchange of property and the like with directors and key employees and a long list of other insiders, Line 2 asks whether the filer transferred any part of its income or assets to such folks. This last transaction covers what I think of as sheer looting. If there has been a case of improper self-dealing during the year, how likely is it that the preparer of 990 will have checked the appropriate “Yes” box, particularly since if the box checked the “Yes” box the filer are required to attached a detailed statement explaining the transaction? Again, the paper tiger question. But before addressing that question generally, let me quickly point out that there are many examples of what I call benign self-dealing transactions, cases, for example, where a board member sells a building to the nonprofit on whose board she sits for well below fair market value. When this happens, the “Yes” box must be checked but the benign and non-malignant nature of the transaction can be explained in the attached statement.
Finally, as you know, excess benefit transactions under §4858 may be considered as abuses or quasi-abuses. Line 89b of Part VI asks whether the filer engaged in any excess business transactions during the year or became aware of any such transactions occurring in prior years. The paper tiger looms.
Now, how real is the Form 990 as an accountability tool? Can it help stop abuses? It seems to me that this can happen if two conditions are satisfied. First, that there are those who know or suspect that an abusive transaction may have occurred, and second, that such people have easy access to the 990. Who would those be who might suspect bad doings? To begin with, there may be conscientious, independent board members who suspect that funny stuff might have gone on during the year. Or there might be employees who, while not being insiders to the abusive transaction, came during the year to smell a stinking fish of abuse. If such board members or employees are disgruntled, they may be all the more likely to be suspicious. So our first condition is likely to be satisfied if there are good and watchful people around. We have already established that the second condition, easy access to filed 990s, is satisfied. They are all up on the Internet and relatively soon they will be all up there right after they are filed.
What will board members or employees do if they believe that the Form 990 they have looked at misrepresents what happened during the year being reported on? They can confront the folks who they believe are behind the malfeasance. They can share their suspicion with state and federal regulators and, perhaps most likely of all, they can go to the media. As someone who is regularly being called by the media from all over the country for help in understanding the 990, I can attest that hard news reporters are more and more using the 990 as one good place, among others, to investigate for nonprofit abuses.
Even if those who are suspicious lack the nerve or feel squeamish about blowing the whistle on their friends, potential rogues now know that the 990s they are causing to be filed in a false way will be accessible by anyone without their knowing they are being looked at. And this possibility, which will be made all the more possible by mandatory 990 filing, may well deter rogues from going forward with their abuses.
What this suggests for nonprofit governance is obvious. Boards ought to have many independent members who keep their eyes peeled for the possibility of malfeasance and who read and know how to read the Form 990.
Before leaving the realm of paranoia and the stern superego of the regulator’s gaze, let me mention a few other things. Some attention might be paid to Part II, the expenses section. If the filer reports a large amount for legal fees at Line 32, that might signal trouble. Also, if a large amount is reported under Other at Line 43, the motivation may have been to obscure some expenses that the filer does not want exposed to the full light of day by relegating them to an artfully done attached statement. Finally, some people, including state regulators, think that a kind of abuse occurs when much of the money that nonprofits raise in contributions is spent on fundraising to raise such funds. If this bothers you, you can quickly develop a fundraising ratio by dividing total fundraising expenses reported at Line15 by total expenses reported at Line 17 and then look at Part II to see what those expenses were spent on. I, for one, don’t put much stock in such ratios.
(3)
As we all know, there is a large amount of financial information in the Form 990. It contains an income statement – Parts I and II, and a balance sheet - Part IV. When comparing the financials of one organization with another, Forms 990 are arguably more useful than audited financials, since they are all filled out the same way according to detailed directions while audited financials vary from statement to statement. When producing audited financials, groups and their auditors have considerable leeway in choosing the format and to a considerable extent the content of the statements. Forms 990, on the other hand, are all the same. Furthermore, Part II, the expense section of the Form 990 income statement, is much more detailed than the usual audited financial statement with some 22 separate natural cost categories. Of course, audited financials have informative footnotes that explain things that aren’t explained by the Form 990. Optimally, in doing a financial analysis of a nonprofit organization, one ought to look at both the Form 990 and audited financials of an organization.
What is it that you want to find out from a nonprofit’s financials? Certainly not whether it has been profitable and shows continuing promise of being profitable so that a decision to invest your funds in such an organization would be prudent. Not this. But many will be interested in knowing whether as a purely financial matter a nonprofit organization seems to be in good shape and promises to continue to be financially healthy in the future. This will be particularly important for those who are deciding whether or not to go to work for an organization or for those who are deciding whether to serve on an organization’s board. But this information will also be important for those who are contemplating contributing to a nonprofit group.
I believe that there are two key financial questions about the finances of a nonprofit organization that it is useful to get the answers to. First, will the organization be able to continue as a financial matter and second, and related to the first, if the organization falls on hard times, how long will it be able to continue, based on its current reserves?
Plainly, knowing whether a filer ended the year being reported on with a surplus or deficit is central to answering the first question. At this point we need to deploy the past-is-prologue-to-the-future assumption. If the filer ended the year with a surplus, in normal circumstances, it is prudent to assume that it will do so again in the following year. Of course, there is hardly any guarantee that it will. But despite this lack of rock solid certainty, if you think about it for a moment, a huge amount of financial analysis is based on the past-is-prologue-to-the-future assumption. If the company made profits this year, we might expect it will next year. If sales were strong this year, we might expect that they will be next year. And so, if a nonprofit filer ended the year with a surplus, we might expect it will next year. In doing this kind of analysis, it is obviously important to have more than one Form 990 to look at. If you learn a filer has run surpluses for two years, the past-is-prologue-to-the-future assumption is firmer than if it is based on one year. And now remember that organizations are required to make available their Forms 990 for the past three years. And, again taking the long view, before too much longer when the inevitable mandatory filing is in place, it will be very easy to access a filer’s last three 990s. Obviously, everything I have said about surpluses applies to deficits.
So where do we look to find out whether a filer ended the year with a surplus or a deficit. You might think that Line 18 on page 1 of the Form 990 is the place to look. Line 18, after all, shows the excess or deficit of income over or under expense for the year. You might think this, but, as I will show, you would be wrong. No -- you look at Line 67 in Part IV’s balance sheet – unrestricted net assets. If Line 67(B), unrestricted net assets at the end of the year, is greater than Line 67(A), unrestricted net assets at the beginning of the year, then you have a surplus that in normal circumstances you can rely upon. Let me try through the use of an example to explain the problem with relying on Line 18. If the filer received a multi-year grant for the year being reported on, say $300,000 to be spent at the rate of $100,000 a year, all $300,000 would be included in income and thus would be included in the amounts reported on Lines 1 and 12, although only $100,000 was available for the spending that year. Thus, other things being equal, Line 18 would show a surplus $200,000 larger (or a deficit $200,000 smaller) than what was actually the case for than year. By like token, if $100,000 was released from temporarily restricted assets for the year being reported on, other things being equal, the filer would show a surplus $100,000 smaller or a deficit $100,000 larger than was actually the case, since normally expenses would reflect the $100,000 released, but there would be no offsetting income included on Lines 1 or 12 to match those expenses although they were in fact defrayed by the funds released from temporarily restricted assets. An analogous problem would come up if the filer received a contribution to permanently restricted assets for the year being reported on. None of these distortions are embedded, however, in Line 67 so that is where you first look to get a reliable cut on whether the filer ended the year with surplus or deficit.
But there is more you should ponder. If the filer received an usually large amount of pledges for the year, given the fact that all these pledges are booked in income in the year of the pledge and that payments on some pledges may not be made for several years, you might want to discount somewhat the size of the surplus or increase somewhat the size of the deficit. Pledges are found at Line 48 of Part IV. Likewise if the filer reports a large amount of realized gains (Line 8 on page 1) or unrealized gains (Line 20 on page 1) from the sale of securities, if you wonder whether the income from such transactions is not usual, again you might want to discount somewhat the size of the surplus or increase somewhat the size of the deficit. Of course, if you have available more than one year’s worth of Forms 990, you will be better able to make judgments regarding pledges and gains.
As a cautionary matter, it is prudent to check to see if the filer reported an unusually large amount of accounts receivable (Line 47 of Part IV) or accounts payable (Line 60 of Part IV). A large increase in accounts receivable might mean that the filer is beginning to have trouble collecting what it is owed and a large increase in accounts payable might mean that the filer is beginning to have trouble paying what it owes. Neither bodes well for the future. Needless to say, there may be reasons for the increases that do not reflect negatively on the filer’s financial future. But these points seem to me worth checking. Again more than one year’s worth of Forms 990 helps. Even with only one Form 990, however, you can spot a large increase in receivables by comparing what is reported at column (A) for the beginning of the year and what is reported at column (B) for the end of the year.
Now to finish your assessment of the financial viability of a filer’s future, you might want to leave Part IV and return to Part I to look briefly at sources of income. If Line 1c, government income, when compared to total income at Line 12, suggests that the filer relies to a considerable extent on government income, you might reflect that the filer’s financial future could be hostage to the vagaries of government funding. Similarly, if Line 9, special events income, reports a large amount, there may be a suggestion that the year being examined for the filer was a good year because of an especially successful benefit. On the other hand, more than one 990 might suggest that successful special events are an annual occurrence. Finally, if the filer reports relatively large amounts of interest income at Line 4 and dividend income at Line 5 and Line 69, permanently restricted net assets, on Part IV suggests a sizable endowment, you may conclude that the filer is blessed with a particularly reliable source of income for the future.
Now to finish my efforts, we will briefly examine what I believe is the second key financial question to be asked and answered by looking at a filer’s Form 990, namely, if the filer fell on hard times and received no funding for an extended period, how long could it survive? This can get quite complicated, but for this afternoon I will try to keep it simple.
What it is that we are very roughly setting out to determine is the amount of spendable assets that might be available to meet expenses in the event of an income drought. Note assets such as the filer’s building reported on Line 57(B) would not be spendable assets available to meet expenses, at least not without radically changing the nature of its operation.
We begin at Line 59(B), total assets at the end of the year. From this we subtract amounts listed at Lines 54-57, which includes such things as security investments, other kinds of investments and real property owned by the filer. As suggested, these assets may not be easily liquidated and thus would not be available as spendable assets to meet expenses. And, our friend pledges come in again. If an unusually large amount is reported at Line 48(B), we may decide it is prudent not to count the full amount as spendable assets available for next year’s expenses and this amount should also be subtracted from total assets. Next you would subtract total liabilities reported at Line 66. As I have said, what I am suggesting is a very rough and ready calculation. A more sophisticated work-up might decide that there were liabilities that would not have to be paid for several years, a long-term loan for example, and reduce this amount from the total of liabilities. Finally, from this figure — total assets less non-liquid assets and some pledges minus total liabilities — we subtract any amount reported at Line 68(B). In doing this we are assuming the total amount reported at Line 68(B) is required to be spent in the next year. Of course, this might not be the case. But in making these calculations on the back of an envelope, it is prudent to make the assumption that all the temporarily restricted assets reported on Line 68(B) will be spent the following year. What is left after all this is the amount of what I have called spendable assets that can be used to meet expenses in the following period assuming a worst-case scenario, that is, that the filer will receive no more income for sometime.
If we then take the filer’s expenses for the year being reported on, which can be found at Line 17, and, on the assumption that the filer’s expenses are incurred fairly evenly throughout the year, divide the Line 17 amount by 12, we will have determined roughly what the filer will spend each month. If we take this figure and divide it into what we have determined is available spendable assets, we can estimate how many months the filer can continue operation without anymore funding.
Wow! That is it. Who says you can’t find out stuff from the Form 990? Thanks.
Peter Swords is the former executive director of the Nonprofit Coordinating Committee of New York and a lecturer at Columbia Law School & Teacher’s College.