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Government and Nonprofit ResearchPhD Project ADSA

August 6, 2011

Bill BaberMcDonough School of Business

Georgetown University

With a little help from …

Sudipta Basu (Temple)Angela Gore (George Washington)

Christine Petrovits (George Washington)Bob Yetman (UC–Davis)

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Organization1. Overview: Reasons to be Excited about GNP

Research

2. Distinguishing features of GNP enterprise

3. Representative studiesSubtitle: “Lots of low-hanging fruit”

(if time)

4. What am I doing now?(if time)

5. Related literature; Resources(make time)

6. Avenues for future research/advice

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Overview

Reasons to be excited about

GNP accounting research

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Three reasons to be excited about GNP research

reason #1

Sector is a significant (and growing) part of the economy

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Two kinds of GNP organizations …

Nonprofits charities, foundations, associations

Governmental municipal, state, federal (national)

governments

Not a clean distinction (e.g., hospitals, universities, nursing facilities, etc.)

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“Independent Sector”

More than 1.9 million tax exempt organizations in the United States alone

The majority of these –- about 1.6 million –- make up the “independent sector.”

501(c)(3)s (public charities, private foundations, and religious congregations) and 501(c)(4)s (social welfare/advocacy organizations)

5.5% of U.S. GDP; employs 10% of the workforce

http://www.independentsector.org/

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Government sector

Federal and state government accounts for …20% of U. S. GDP (2010, U.S. Bureau of Economic Analysis)

15% of paid employment (2008,U.S. Bureau of Labor Statistics)

In contrast, publicly-traded firms account for

20% of U. S. GDP

25% of paid employment

Source: Bob Yetman

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reason #2

#1Sector is a significant (and growing) part of the economy

#2 High profile public policy issues

Opportunity to make a difference

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Opportunity to make a difference

New York Sues Breast Cancer Charity Over DonationsReuters 6/28/11

China Red Cross Society Scandal http://www.youtube.com/watch?v=MNjegNbAXF0 7/8/11

Greek Debt Crisis May Be First Domino for EuropeCBS News 6/17/11

America’s AAA Rating Is at RiskDavid Walker, Financial Times 5/12/09

Meredith Whitney: State finances are worse than estimatedFortune, 6/6/11

Anyone from Arizona, Massachusetts, or Ohio?

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Worst state finances http://charlestonteaparty.org/financial-crisis-2011-the-ten-worst-states/

 Rank Worst deficits

Deficit % of reserves

Worst debtsDebt % of GDP

Worst unfunded benefits %GDP

1 Arizona 65% Massachusetts 9.0% Ohio 57.6%

2 California 53% Connecticut 8.8% Wisconsin 47.1%

3 Nevada 47% New Jersey 8.1% Alaska 43.6%

4 Illinois 44% New York 5.9% Illinois 43.1%

5 New Jersey 40% Illinois 4.7% Alabama 41.5%

6 New York 39% California 4.3% New Jersey 37.7%

7 Rhode Island 35% Wisconsin 4.1% S. Carolina 37.3%

8 Kansas 34% Maryland 3.8% Colorado 36.6%

9 Oregon 32% Louisiana 3.5% Connecticut 34.5%

10 Alaska 29% Florida 3.4% Minnesota 34.5%

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reason #3

#1 Sector is a significant (and growing) part of the economy

#2 High profile public policy issues

Opportunity to make a difference

#3 Perceptions about GNP research are changing

Increasing number of papers in TAR, JAR, JAE

New journal

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Journal of Governmental & Nonprofit AccountingEditorial Board

2011

William R. BaberEditor

Georgetown University

David Burgstahler Leslie G. Eldenburg University of Washington University of Arizona

Randal J. Elder Angela K. Gore Syracuse University The George Washington University

Michael Granof Steven J. Kachelmeier University of Texas at Austin University of Texas at Austin

Marlys Gascho Lipe Christine M. Petrovits University of Oklahoma The George Washington University

Gregory B. Waymire Joseph P. Weber Emory University Massachusetts Institute of Technology

Jerold L. Zimmerman University of Rochester

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Cons

Investment required to obtain the institutional knowledge

Finding data isn’t always easy, but data availability and quality are improving

Critical mass problem

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Distinguishing features of

GNP organizations

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Useful to think about…

• Differences between private and public (GNP) enterprise

• Differences between governmental and nonprofit entities

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Differences between the GNP and corporate settings …

Financial reporting objectives

GNP objective is typically to break even, not to show a profit

In some cases, the incentive is to appear needy rather than financially robust

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Differences between the GNP and corporate settings (continued) …

Role of relevant market participants

Competitive capital markets and product markets align incentives and discipline managers in the private sector

Role of markets is less straightforward in the GNP context

Voters and donors typically characterized as passive monitors

(More about this later )

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Differences between the GNP and corporate settings (continued) …

Regulatory environment

States play a significant role; federal laws often don’t apply

Governments: U.S. Constitution (and the Tower amendment 1975) proscribes federal regulation of state and

local governments; on the other hand, municipalities are creations of the state

Nonprofits: state attorney general typically provides oversight; incentives and resources are at issue

IRS matters for charities, although enforcement can be an issue (e.g., form 990 filings)

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Differences between the GNP and corporate settings (continued) …

… the consolidation issue

Reporting entities tend to be defined legally, rather than based on economic control

Examples of problems created by this difference:

GovernmentalHow do we think about debt burden? Overlapping debt

Charities 501c3/501c4 issue

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… with important differences between Governments and private NFP organizations

As examples,

Differences in contracting with managers:Government officials ultimately face elections; NFP managers typically do not

Differences in how the organization obtains resources: Taxes versus contributions

Governments can and frequently do issue public debt; NFPs typically do not (with notable exceptions)

Differences in who decides GAAP

GASB for governments; FASB for Nonprofits

Differences in how the agency model applies:

Governments have something like a residual claimant (taxpayers)

Not obvious that this is true for all NFP organizations (e.g., Charities)

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Examples of differences (continued) Market discipline and external monitoring

Governments

Elected officials operate in political markets where (non-competitive) coalitions may be a better characterization

Most would argue that a well-developed system (the media) exists for monitoring government officials

Political competition and Tiebout competition applies to governments

Nonprofits

Many nonprofits (charities, in particular) rely on the market for contributed capital

Charities compete in the market for contributed resources where the disconnect between donors and beneficiaries raises questions about incentives to monitor agents. Who is the principal?

Case for regulation is stronger in the case of charities than in other forms of enterprise

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Representative studies

Disclaimer regarding method

Agency costs

Earnings management

Compensation

Regulation

Other studies

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Need to know …

NFP spending is typically separated into three mutually exclusive categories

– Administration – Fundraising– Program activities

Charitable contributions frequently depend on ratings administered by private oversight agencies (e.g., Better Business Bureau)

Private oversight agencies use financial information as part of the ratings process

Oversight agencies like spending on programs; dislike spending on administration; are occasionally more tolerant, but still dislike, spending on fundraising

The ratio of program spending to total expenditures (or to total revenue) is an important input into the ratings process; therefore, charities are particularly concerned about program spending ratios.

Many academic studies validate the importance of both ratings and program spending ratios as determinants of charitable contributions

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NFP Agency

Core, Guay & Verdi (2006) JAE, Agency problems of excess endowment holdings in not-for-profit firms

–Examine excess cash holdings (or “endowments”) by foundations–Considers excess endowment related to (1) growth opportunities (2) monitoring, (3) agency problems–Estimates excess endowment using the Fisman and Hubbard (working paper) approach–Find excess endowment holdings are associated, not with growth opportunities or monitoring, but with agency problems, such as higher director/officer pay, and lower efficiency (i.e., more spent on administrative overhead, and less spent on charitable program services)

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Why is CGV (2006) important?

Provides a way to think about and investigate agency problems in the NFP

context, and thus, inspired additional recent work

I.e., CGV (2006) provides us with something to do

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Governmental agencyEvidence of the influence of

Core et al (2006)

Gore (2009) Why do cities hoard cash? Determinants and implications of municipal cash holdings TAR

Applies Core et al (2006) agency characterization to municipalities

Finds that the evidence is stronger in the governmental than in the NFP context

Relates excess cash to taxes

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NFP “earnings management”

Krishnan, Yetman & Yetman (2006) Expense Misreporting in Nonprofit Organizations TAR

Find that charities manage spending classifications (particularly fundraising expense) to be in line with standards applied by oversight groups.

Includes a link to Core (2006) regarding incentives

Jones and Roberts (2006) Management of Financial Information in Charitable Organizations: The Case of Joint Cost Allocations TAR

Charities allocate “joint costs” opportunistically

In particular, away from fundraising and administration and toward program spending

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NFP “earnings management”(continued)

Grein and Tate (2011) TAR, Monitoring by auditors: the cases of public housing authorities

Examine pre- and post-audit adjusted financial data, finding that auditors make significant material audit adjustments

Interesting twist in that they examine whether financial statement ratios are manipulated to meet housing authority ratio thresholds

Also interesting because it highlights that sometimes data are available in the GNP setting that aren’t in the corporate sector

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Governmental “earnings management”

Chen, Kido and Weber (2011) working paper, The influence of elections on the accounting choices of governmental entities

– Examine discretionary use of a single account (compensated absences liability) surrounding state gubernatorial elections

– Find that discretionary compensated absence accrual is significantly lower in election years

– Links c. a. liability to election outcomes– Illustrates an “election cycle effect” which is peculiar

to the governmental sector

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Compensation - NFP

Baber, Daniel & Roberts (2002)

We presume that charities exist to broker resources from donors toward the philanthropic objective. Thus,

Compensation to charity CEOs = f (program spending)

How do charity CEOs increase program spending?

Two general ways. By increasing resources (fundraising) and by managing resources efficiently toward the charitable objective. Thus,

%ΔCOMP = β0 + β1 (%ΔRevenue) + β2 (%ΔYield)

where YIELD is the fraction of revenue allocated toward program spending.

We find that program spending increases matter, regardless of whether they result from increases in resources or in yield.

We interpret this as good news, given the focus on altruism as a motivator in charities and the emphasis by oversight agencies on program spending

ratios rather than fundraising success

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Compensation - Governmental

Gore, Kulp & Li (working paper), Golden handshakes for bureaucrats? Ex ante severance contracts in the municipal sector

Explore determinants of city manager severance pay packages

Find evidence that political markets matter. In particular, political risk (risk of being fired for political or election-related reasons)

increases severance pay.

Relates executive compensation to the probability of dismissal – political risk

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Regulation -- Governments

Baber and Gore (2008) TAR, Consequences of GAAP disclosure regulation: Evidence from municipal debt issues

– Compare aspects of municipal debt issues in states that mandate GAAP accounting for all cities with those that have no regulations

– Study is not about the use of GAAP; rather, it’s about state requirements to use GAAP

– Finds municipal debt issued in states mandating GAAP for all governments experience significantly lower debt costs, both cross-sectionally and when GAAP requirements are implemented

– Also finds that the use of public debt (versus private debt) is greater in states mandating GAAP

– Illustrates how municipal context permits comparisons of alternative disclosure regimes

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Regulation -- NFPs

Desai and Yetman (working paper), Constraining Managers without Owners: Governance of the Not-for-Profit Enterprise

Considers both charities and foundations

Focuses on state oversight as a remedy for agency problems in NFP organizations

Finds that indices that measure state oversight of charities and foundations vary directly with foundation payout, fundraising performance, program spending ratios, and inversely with NFP executive compensation

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Other recent NFP studies that parallel work in the private sector

Aggarwal, Evans & Nanda (working paper) Nonprofit boards: Size, performance and managerial incentives

Relates board size with manager pay-performance incentives, program spending, and fundraising performance

Concludes that, in contrast with evidence from publicly-traded firms, larger boards have positive effects.

Petrovits, Shakespeare & Shih (2011) The causes and consequences of internal control problems in nonprofit organizations TAR

Find that internal control weaknesses are more substantial for small, growing, complex, financially distressed NFP organizations

Find that contributions (both private and public) subsequently decline for charities that report internal control weaknesses

Notice that investment in internal control would increase administrative spending

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What am I doing now?

Baber, Gore, Rich & Zhang (working paper), title: TBA

Accounting restatements in the municipal context

About a quarter of the municipalities restate their CAFRs (comprehensive annual financial reports)

Research objectives are to (1) document the adverse consequences of restatements;

(2) ascertain the role of governance as a determinant of adverse consequences …

… in municipal debt markets

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Baber, Gore, Rich and Zhang (continued)

Oversight (governance) considered along two dimensions

– Audit oversight

– Political (voter) oversight

Construct indices designed to capture these dimensions

Audit oversight = f (auditor type; audit committee; auditor switch)

Voter oversight = f (council turnover; staggered council; initiative; referendum; recall)

Indices vary directly with oversight

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Baber, Gore, Rich, and Zhang (continued)

Specification

TIC (true interest cost) = β0 + β1 Post-restatement +

β2 (Audit oversight) + β3 (Post-restatement*Audit oversight) +

β4 (Voter oversight) + β5 (Post-restatement*Voter oversight) +

controls (including Bond Buyer Index)

We are interested in β1, β3, and β5

Sample is 373 new municipal debt issues 2001-2004

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Results BGRZ

All debt issues

(n=381)

Audit oversight only

(n=373)

Voter oversight only

(n=373)

Both audit and voter oversight

(n=373)

Post-restatement

0.34 (4.92)***

0.63 (5.28)***

0.49 (6.33)***

0.93 (6.79)***

Audit oversight

0.19 (3.90)***

0.22 (3.88)***

Audit oversight * post-restate

-0.20 (-2.72)***

-0.27 (-3.84)***

Voter oversight

0.06 (1.20)

0.11 (2.58)*

Voter oversight * post-restate

-0.15 (-1.94)**

-0.20 (-3.67)***

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Other items/Related literature/Resources

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Case studies

Soybel (JAPP 1992)Municipal financial reporting and the general obligation bond market

New York City, 1961-1975

Bond market saw through NYC accounting shenanigans

Baber, Roberts & Visvanathan (Horizons 2001)Charitable Organizations' Strategies and Program Spending Ratios

Illustrates the consolidation problem in the NFP context

Tinkelman (JAPP 2009) Unintended consequences of expense ratio guidelines

The Avon breast cancer walks

Demonstrates practices intended to circumvent CBBB financial ratio standards

Federal government accounting seems a particularly appropriate context for case studies

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Other Methods

Behavioral studiesE.g., seeing laboratory studies of how financial performance, and how the framing of financial performance, influences decisions to donate

TheoryE.g., seeing analysis of incentives

in the context of defense contracting

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Background – Nonprofit organizations

Book

Steinberg 2004. Economics of Nonprofit Enterprise

Journal articles

Hansmann, 1980 The Yale Law Journal. The Role of Nonprofit Enterprise

Fama and Jensen, 1983 JLE. Separation of ownership and control

Weisbrod and Dominguez 1986 J of Public Economics. Demand for collective goods in private nonprofit markets: Can fundraising expenditures help overcome free-rider behavior?

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Background – Governments (political markets)

Books

Anthony Downs 1956. An Economic Theory of Democracy

Michael Laver 1981. The Politics of Private Desires

Journal articles

Stigler, 1972 Public Choice. Economic competition and political competition

Zimmerman, 1977 JAE, The municipal accounting maze: an analysis of political incentives.

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Other Resources

Check Hauser Center studies(Kennedy School at Harvard)http://www.hks.harvard.edu/hauser/

Ratings Studies by Gordon, Keating, Fischer, Neely, etc.

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Summary: some researchable topics in the nonprofit area

The consolidation issue – how to define control

Trade-offs in the market for contributed capital (Weisbrod and Dominguez 1986 versus Petrovits, Shakespeare & Shih 2011)

Perquisite consumption; non-pecuniary compensation (Core et al 2006)

NFP organizations that behave like clubs (Buchanan 1965)

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Summary: some researchable topics in the government area

Why do states differ in terms of the extent that they regulate municipalities? (from Baber and Gore 2008)

Election cycle effects and other accounting decisions (from Chen, Kido and Weber 2011)

Why doesn’t political competition reduce agency problems in municipalities? (from Gore 2009)

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Final advice regarding GNP work

– Coursework in political economy, political science

– Expect and impose the same standards and rigor that are required of mainstream accounting research

– Look for insights and results than can be generalized

– Correspond with young people who are working in the area

– Look for co-authors who have had success in the mainstream literature and who are strong methodologically

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wrb7@georgetown.edu