Financial misreporting in UK charities

Mahmood, Farooq (2020) Financial misreporting in UK charities. (PhD thesis), Kingston University, .


The thesis consists of three separate studies related to financial misreporting in UK charities. The first study investigates whether large UK charities misreport numbers in their financial statements, and if so what motivates them in doing so. Using semistructured interviews of eleven finance directors of charities, two auditors and a banker, I find that it is predominantly funding pressure that generates incentives for the misreporting of financial accounts in large UK charities. In addition to traditional agency theory, I look at this topic through the prisms of resource dependency and legitimacy theories. I focus on three important areas of charity accounting reporting: reserves, fundraising costs and bottom-line net incoming resources. In the second study, I provide empirical evidence about the extent to which charities engage in accrual and real-based manipulation. The sample consists of charities that report to the Charity Commission for England and Wales over the period 2007 to 2016. I find evidence that charities manipulate their bottom-line income figure to achieve a target benchmark of a small surplus. By categorising the sector according to the predominant funding type and funders’ sophistication, I also find that the sophistication of funders is positively associated with financial reporting quality. The donorbeneficiary separation in charities increases the likelihood of real earnings management; whereas for the service-oriented charities where the funders are also the users of a charity’s services, there appears to be an increased appetite for manipulation through accruals-based earnings management. Overall, I provide empirical evidence on earnings management in a little-researched sector that is widely regarded as beyond reproach. In the third and final study, using the same sample as in the second study, I present evidence of expense misclassification in UK charities between 'good' the programme costs and 'bad' the fundraising expenses. Employing three prediction models, I consistently find a strong negative relationship between unexpected levels of fundraising and unexpected programme costs. I further study the impact of the charity and donor types on the nonprofit managers’ willingness to misclassify expenses. The relationship becomes less negative for the nonprofits supported by more-sophisticated funders and those with lower donor-beneficiary separation. This suggests that donor sophistication and lower donor-beneficiary separation reduce the appetite for misclassification as funders have access to sources other than just the financial reporting one to gauge a charity's efficiency. Among various expense ratios, the nonprofit managers appear more willing to misclassify expenses when a charity has a low ‘programme ratio’ within its peer group. I do not find evidence that a high support cost is a compelling prerequisite for misclassification.

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