Watchdog Cracks Down on Misleading Statements on Fundraising Costs

When Ken Berger, head of a prominent charity-ratings group, appeared on CNN one night last spring, the anchorman Anderson Cooper asked him a pointed question.

The network had just aired an investigation into two veterans charities that spent most of the money they raised on commercial fundraising firms instead of on services to veterans. But Mr. Berger’s group, Charity Navigator, had awarded one of them, the National Veterans Foundation, three out of four stars.

“Based on what you now know, would you want to continue to look at that?” Mr. Cooper asked Mr. Berger.

“Oh, yes, we’re definitely going to check it out,” Mr. Berger replied.

That exchange led Charity Navigator to revamp the way it evaluates charity finances. It demoted the National Veterans Foundation to a zero-star charity and stripped stars from about 50 other charities that used similar accounting methods.

It did that by challenging a long-established practice that allows charities to count some money they spend on activities that involve fundraising, like direct mail or telemarketing campaigns, as program costs on their financial statements or Form 990 tax filings.

Misleading Donors

Some critics, including state regulators, say the practice, known as “joint-cost allocations,” can be used to mislead donors by disguising high fundraising costs.

But Charity Navigator’s new approach has drawn fire from charities and fundraising experts who say it has no right to override financial reports that independent auditors have approved.

“Our members adhere to fundraising standards and best practices to ensure donor trust, and having a third party toss out one of the standards via a Web-site declaration seems arbitrary,” says Senny Boone, a senior vice president at the Direct Marketing Association’s Nonprofit Federation, referring to Charity Navigator’s online description of its new methodology.

In fact, some charities, including the American Heart Association, have persuaded Charity Navigator to reverse its decision to downgrade them, arguing that their spending breakdowns were done by the book.

Educational Messages

But a look at the National Veterans Foundation, which operates a toll-free helpline for veterans and their families, highlights some of the issues that can arise when a nonprofit group allocates big chunks of its spending to joint costs.

The organization won three stars from Charity Navigator partly because it reported to the Internal Revenue Service in 2010 that 67 percent of its spending was allocated to programs, suggesting that most of a donor’s contribution would go directly to helping veterans.

However, most of that money—$6.8-million out of $7.7-million—actually paid for direct-mail fundraising appeals that the group said included educational messages. Exclude those costs, and the charity’s program spending plummets to 8 percent.

Rewarding Efficiency

Under the standard that governs the practice, blessed by the Financial Accounting Standards Board, charities are supposed to allocate joint costs only in certain circumstances: They must design the activity to get people to take a specific action to support their mission—for example, contact a public official, recycle waste, or reduce health risks. And they must select recipients because they are able to take that action or would benefit from it—not because they are likely donors.

Defenders say joint costs, if used appropriately, reward efficiency, since a charity can combine multiple goals in a single campaign and reflect that in its breakdown of expenses.

Christopher Corrigan, chief financial officer at the Arthritis Foundation, says advocacy and public awareness are central to his group’s mission and are often conducted separately from fundraising efforts.

However, sometimes, he says, “it’s more efficient to say, We want to tell you about arthritis, and, oh, by the way, we’d like you to donate to us.” He plans to protest Charity Navigator’s decision to downgrade the group from two stars to one.

‘Doesn’t Pass the Test’

But critics say many donors don’t think of “programs” in that way.

CharityWatch, another prominent ratings group, has never counted joint costs as program expenses when calculating a charity’s A-to-F grade—and has long criticized Charity Navigator for not going beyond the numbers reported by the organizations themselves.

Mr. Berger says the accounting method might be justified when a group has a strong public-education mission.

“But a lot of these other cases are, ‘I put a pamphlet in with the mailing, so it’s partly educational,’” he says. “It doesn’t pass that test for what donors would perceive as a logical programmatic expenditure.”

Charity Navigator at first took a hard-line approach, saying that except in rare cases it would start counting as fundraising costs all program money that came from joint costs.

IRS Approval

Mr. Berger says the group expected the new system to affect just a small percentage of charities. Only about 6 percent of the 6,000 nonprofits it reviews allocate joint costs—and most do it sparingly, he says. The 50 charities that lost stars came from a pool of about 3,000 groups that the organization has re-evaluated so far.

But after some internal discussions, Charity Navigator decided to temper its original approach.

Now if a nonprofit is in danger of being demoted, Mr. Berger says, Charity Navigator examines its Web site to see if it reflects a “significant focus” on education, thus signaling to donors that joint costs may be appropriate.

Mr. Berger says his group has restored stars for 11 nonprofit organizations that were originally downgraded.

The American Heart Association, which fell to two stars because of joint costs, is now back to three.

According to its 2012 tax form, the charity allocated $227.5-million out of total spending of almost $596-million to joint costs and spent 78 percent on programs. Program spending falls to 51 percent if joint costs are discounted.

The group argued that it had strictly followed principles that are accepted by the IRS “and gave specific examples of activities that justifiably had both fundraising and program expenses,” says Amit Chitre, a charity spokesman.

‘Big Fudge’

That back-and-forth demonstrates the challenge involved in policing joint costs. While many charities that use the method have received an auditor’s OK, such evaluations can be more of an art than a science.

Michael Sack Elmaleh, an accountant and teacher who writes about nonprofit issues, calls joint-costs allocation a “big fudge” and says the rules should be tightened.

Just as with for-profit companies, a nonprofit chief financial officer will try to make the group’s finances look as positive as possible, but, he says, “I believe in most cases these so-called joint activities should be classified as fundraising.”

But it’s hard to draw up “overarching general rules” that apply to so many different types of nonprofits, says Chris Cole, a manager at the American Institute of CPAs, who works with that group’s nonprofit expert panel.

“That’s why it’s really important [that] when you have a situation like joint costs, you have the ability to apply professional judgment.”

The BBB Wise Giving Alliance, another charity-monitoring service, accepts the use of joint costs but sometimes questions spending breakdowns—even if approved by an independent auditor—to ensure they meet its standard for “accurate expense reporting,” says Bennett Weiner, the chief operating officer.

Program Costs

For example, after reviewing direct-mail appeals sent by Defenders of Wildlife, an animal and plant conservation charity, the BBB concluded that the group was overreporting fundraising costs as program expenses.

Out of $9.7-million in joint costs reported on an audited financial statement for fiscal year 2010, the charity assigned more than $6.6-million to programs, $2.2-million to administration, and $870,470 to fundraising, it says in its online report on the group.

Yet “a significant portion of the content of the appeals could be considered fundraising, as it explains why one should donate to Defenders rather than fulfilling a programmatic or administrative function.”

Charity Navigator also demoted Defenders from three to two stars because of its joint-cost allocation.

When asked about those reviews, Jamie Rappaport Clark, the group’s president, said in an e-mail: “We take all external ratings of Defenders of Wildlife’s performance seriously. We are presently doing a thorough evaluation of these assessments to reassure our members that our effectiveness and efficiency are reflected in these ratings.”

Direct Mail

But charity-ratings groups may not be the worst threat to groups that are accused of misreporting their expenses.

Last fall, the National Veterans Foundation filed amended tax returns for 2009, 2010, and 2011 because the California attorney general’s office concluded that it had not applied joint costs properly.

The amended figures, the charity reports on the tax forms, “properly reflect all such expenses as professional fundraising expense.”

The veterans organization’s fundraising costs started skyrocketing after it signed a six-year contract in 2008 with Quadriga Art, a direct-marketing company that has come under scrutiny by the news media and regulators for its connection to charities that spend little of the money they raise on programs.

Quadriga recently agreed to end the contract with the veterans group at its request, and Rich Rudnick, the charity’s director of operations, says he hopes his organization can eventually return to Charity Navigator’s good graces.

“The National Veterans Foundation has a 27-year history,” says Mr. Rudnick. “Of those years, only three, maybe four, have been less than 78-percent program costs,” he says. “We expect to return to those levels in the very near future. At that time, we’ll ask Charity Navigator to evaluate us.”