6 Red Flags in a Nonprofit Annual Report

A nonprofit annual report is a marketing document, and the six red flags below are the places where marketing most often crowds out disclosure. None of them proves an organization is badly run. Each one means you should open the Form 990 before you write a check. The 990 is the annual return most charities file with the IRS, it is public, and it does not have a design budget. When the glossy report and the 990 disagree, believe the 990.

1. Output numbers with no denominator

“We served 40,000 people last year” is the most common sentence in the genre, and on its own it tells you almost nothing. Served how? At what cost per person? Compared to what? A food bank that distributed 40,000 meals and a job-training program that graduated 40,000 people are doing different things at different costs, and the report should say which.

Look for the number next to the number: cost per outcome, the size of the population the organization is trying to reach, or the prior year’s figure so you can see direction. A report that gives you a big count and nothing to divide it by is asking you not to do the division.

2. Financial totals that do not match the Form 990

Annual reports usually include a one-page financial summary. Pull the organization’s most recent Form 990 from the IRS Tax Exempt Organization Search and compare total revenue and total expenses. Small differences are normal, because fiscal years and accounting bases vary. Large differences are not. If the report shows $5 million in revenue and the 990 shows $3 million, one of them is describing a different organization, a different year, or a different definition of revenue, and the report should explain which.

Also check the year. Some reports quietly present the strongest year from the last three rather than the most recent one.

3. No functional expense breakdown

The 990 requires charities to split expenses into program services, management and general, and fundraising. A good annual report shows the same split. A report that gives total expenses and a pie chart of “impact areas” but never says what share went to fundraising or administration has omitted the one breakdown donors most want.

Be careful with the opposite failure too. An organization that claims 98 percent of every dollar goes to programs is either very unusual or classifying costs aggressively. Overhead is not waste. Rent, accounting, and staff who keep the lights on are how programs happen. What you want is honesty about the ratio, not a suspiciously perfect one.

4. Compensation and related-party dealings buried or missing

The 990 lists the compensation of officers, directors, and the highest-paid employees, and it asks whether the organization did business with insiders or their family members. Annual reports rarely repeat this, which is fine, but the information should be easy to find somewhere. If the executive director’s pay is nowhere in the report and the 990 shows it at a level that would surprise the donors reading the report, that gap is the red flag, not the salary itself.

Related-party transactions, such as leasing office space from a board member’s company or paying a consulting firm owned by a relative, are legal when disclosed and approved. Undisclosed ones are how small charities get into large trouble. Schedule L of the 990 is where they appear.

5. Net assets with no explanation

Two versions of this one. First, a large and growing pile of unrestricted reserves with no stated purpose. Reserves are prudent; most advisers suggest several months of operating expenses. Several years’ worth, accumulating while the report describes unmet need, deserves a sentence explaining the plan. Second, and more serious, negative unrestricted net assets, which means the organization has spent money that donors restricted to specific purposes. That appears on the 990 balance sheet and almost never appears in the annual report.

6. Outcomes with no method

“Our program reduced food insecurity by 30 percent” is a claim about the world, and it needs a baseline, a comparison group or at least a before-and-after measure, and a source. Reports that borrow national statistics to describe the problem, then attribute changes in those statistics to their own work, are the most common offenders. The Census Bureau’s poverty data, for example, describes the country, not any one organization’s results, and a report that implies otherwise is confusing context with outcome.

The honest version says: here is what we measured, here is how, here is what we cannot claim. Organizations that work on hard, slow problems such as poverty, wages, or housing often cannot show short-run outcomes at all, and the credible ones say so rather than invent a percentage.

Applying the list

You do not need all six to walk away. One or two, in an otherwise transparent organization, usually mean a small communications team wrote a report without the finance staff in the room. Three or more, or any instance of flags two or five, mean the 990 is now required reading and a call to the organization is reasonable before giving.

The IRS search tool linked above lets you confirm exempt status, check the automatic revocation list, and open filed 990s in one place. Charity rating sites summarize some of the same data, but they are only as current as the last 990 they scraped, and they cannot read a report’s tone.

If you want to see the tests run on real organizations, one published review of charities working on poverty walks through how to compare program spending, transparency, and stated outcomes across several groups in the same field. Whatever review you use, treat it the way you treat the annual report: as a starting point, and then open the 990.

Why this matters more for small charities

Large national organizations get audited, rated, and reported on. Small and mid-sized charities, which do most of the direct work in most communities, mostly do not. Their annual report and their 990 may be the only two public documents that exist. Reading both takes half an hour. For a gift of any size you would notice on your own budget, that is time well spent, and it is the same half hour whether the organization is a nonpartisan advocacy group, a shelter, or a scholarship fund.