The abrupt bankruptcy in early 2015 of the sizeable New York City-based nonprofit Federation Employment Guidance Services – FEGS – stunned many in the charitable world at the time. Its collapse has raised a host of questions regarding a substantial number of these entities, not the least of which is their economic viability.
Nonprofit human services organizations throughout the U.S. provide services which include employment and workforce development, health and disabilities counseling, home care, and early childhood and after-school programs. FEGS extended these services as well as housing for the developmentally disabled, with a budget of $250 million. It is estimated that it provided these services to approximately 120,000 individuals per year from 350 locations throughout Metropolitan New York City, with as many as 1,900 employees. Additionally, it had been providing other services and resources through separate related for-profit entities, including information technology, human resources, health-care management, residential and home care services.
After being in existence for nearly 80 years, FEGS hastily filed a voluntary petition in the U.S. Bankruptcy Court for the Eastern District of New York seeking relief under the provisions of Chapter 11 of the U.S. Bankruptcy Code. The action was initiated about three months after FEGS revealed, in an all-staff e-mail, a $19 million loss on its audited June 30, 2014, financial statements. Court papers listed several reasons for its demise. The on-the-record reasons that FEGS gave to justify its bankruptcy request were:
- Inadequate financial systems and revenue cycle management (as well as general and administrative inefficiencies);
- A failure to adequately reserve and plan for the repayment of significant regulatory and governmental advances and contract termination costs;
- Unallocated and vacant space;
- An overly prohibitive administrative cost structure … significantly more than industry standards; and,
- Numerous unprofitable agreements.
Looking back, what, if anything, could’ve prevented the demise of this behemoth? Should anyone have known, could anyone have predicted the debacle, and, if so, what could have been done?
WHEN, EXACTLY, DID FEGS CEASE TO BE A GOING CONCERN?
By some perspectives, FEGS’s financials might have warranted a going concern opinion. Earlier financials revealed working capital deficiencies, a need to seek new sources or methods to dispose of substantial assets and operating lease commitments, unprofitable for-profit subsidiaries, and high-service demand with low reimbursement, causing approximately 75 percent of its programs to be losing money.
Bewilderingly, in the January 2016, issue of The CPA Journal, John H. Eickemeyer and Vincent J. Love, in their article “The Concerns with Going Concern,” state that, “GAAS is clear in its affirmation that an auditor is not an oracle who can accurately predict future business and economic events. The standards also recognize that an entity’s failure within the forward-looking period, even though the auditor did not address a substantial doubt about the entity’s ability to continue to exist in its report, ‘does not, in itself, indicate inadequate performance by the auditor.’” In all likelihood, however, common judgment biases on the part of FEGS’s auditor in its audit design of this long-standing client appear to have failed to foresee the collapse.
FINANCIAL STATEMENTS COULD HAVE TOLD A BETTER STORY
Consolidating the nonprofit operations with its multiple for-profit entities, for which a footnote simply summarizes each operation without relevant financial information, including intercompany transactions, while allowed, is not transparent enough, especially if there is no alternate source for the information. Yet the dictates of GAAP and GAAS are allowing the luxury of such opaque presentations. A published classified balance sheet would have been helpful. To the extent possible, receivables not expected to be collected in the next operating cycle (one year) should be excluded from current assets.
In an interesting recent development, on March 21 of this year, FEGS's creditors filed a complaint with the U.S. Bankruptcy Court of the Eastern District of New York in which they alleged that the management letters for years ending June 30, 2011, to June 30, 2013, of the audit firm did not address or raise any concerns about FEGS’s overstated accrual of accounts receivable and that these doubtful receivables had never been properly reflected on its respective annual financial statements.
The same is true for investments. Unless they are expected to churn within the year and be available for operations, investments should be considered non-current. Six pages of a fair-value measurement footnote regarding investments does not make immediately clear those that were to be used for operations (liquid) versus investments intended for other uses (as was the case with FEGS using investments for deferred compensation and to secure a line of credit). On April 22, 2015, the Financial Accounting Standards Board issued an exposure draft entitled Not-for-Profit Entities (Topic 958) and Health Care Entities (Topic 954). Among its major provisions is 6c.-Management of liquidity, (which would likewise define the time horizon used to manage liquidity) and quantitative information, as of the reporting date, about financial assets available to meet near-term demands for cash, including demands resulting from near-term financial liability. Application of this provision might have helped.
Given the tragedy of FEGS, I expect stakeholders (donors, creditors, regulators and other users) in not-for-profits will want significant improvements to financial statements, including footnotes. On Sept. 8-9 in 2001, FASB‘s Not-For-Profit Advisory Committee considered, and had a strong consensus in favor of, requiring or encouraging management’s discussion and analysis. Interestingly, the committee noted that board members of nonprofits are generally not involved in directly running the nonprofits and, therefore, should be considered users of financial statements.
Financial statements should provide adequate information, including a description of the entity’s notion of operating inflows and outflows and a discussion and analysis of the entity’s operating results for the period. Information about operating results, particularly for entities with several discrete programs, segments, or lines of business, generally can be enhanced by reporting the interrelationships of the entity’s expenses and revenues by those programs, segments, or lines of business.
Segment-like disclosure would be useful to nonprofit entities in “telling their story.” Improved transparency about both revenues and expenses of segments, lines of business, or major programs and activities would provide additional information that could be utilized and complement the MD&A discussion with respect to operations.
In an Invitation To Comment on July 12, 2012, FASB likewise addressed other metrics relevant to users of financial statements. Consideration could be given to information that management uses to run its business and allocate resources internally. Might information used by management or reported to the CEO or CFO as risks to the business be another way of assessing relevance? Along with an understanding of the entity’s liquidity, there should be an assessment of its sufficiency to carry out and sustain its operations.
After having read the June 30, 2014/2013, comparative financials of FEGS, it’s difficult to determine specifics about assets and liabilities and income and expenses of its core company, let alone the 16 for-profit and nonprofit subsidiaries, affiliates, social enterprises and ventures within the FEGS network. Absent a classified balance sheet, it was somewhat of a challenge to determine working capital so liquidity could be evaluated much more readily. Likewise, the services, expenses and profitability being provided by FEGS’s cornucopia of entities within its network were not at all distinguishable.
To facilitate analysis, in the absence of the classified financials, I created a “best-guess” equivalent. Since no industry classification is readily available on any form 990, NAICS (North American Industry Classification System) Number 624190 – Other Individual and Family Services seemed a reasonably appropriate benchmark. I went on to use an industry analysis product by Sageworks, called ProfitCents, which produced the following results for the comparative years ending June 30, 2014 and 2013:
1. Current ratio, receivable days and operating margin for FEGS were well below the industry sector range … working capital deteriorated to a negative $7.5 million at June 30, 2014, while it had been a positive working capital balance of $6.9 million at June 30, 2013.
2. Program efficiency and operating reliance each fell within the industry sector range.
3. Gross program and operating margins were each below the industry sector range, or weak as compared to that of similar organizations. Expenses had increased at a rate greater than revenue growth.
4. Debt, likewise, grew at a rate faster than revenue.
5. Management and general expenses, however, at 12.6 percent of total expenses for the year ended June 30, 2013, were essentially similar to management and general expenses at the Jewish Board of Family and Children’s Services (JBFCS, took over $75 million of FEGS’s programs, and became as large as FEGS had been).
6. The Z-score, a rate which measures the overall health of a business and an early predictor of an organization's probability of bankruptcy, indicated a high risk of bankruptcy at June 30, 2014, yet only an average risk at June 30, 2013.
7. Likewise, in applying the Beneish M Score (a probabilistic model that will not unequivocally detect scheming with 100 percent accuracy) the result indicated less than a 1 percent probability of financial statement manipulation.
WHY CREATE FOR-PROFIT SUBSIDIARIES?
With a limited pool of charitable dollars on which to rely, nonprofit organizations have increasingly created subsidiaries, expecting to provide services outside their core mission, whose profitability could likewise subsidize core operating deficiencies. FEGS created what one observer called a dizzying network of for-profit subsidiaries, including the following:
- AllSector Technology Group, founded in 1998, to provide information technology consulting to other nonprofits, for-profits, and the public sector, of which FEGS had been a 95 percent owner. FEGS transferred more than $30 million to this entity, which would not be evident in a consolidated set of statements. From conversations with a former employee, I’ve surmised that AllSector was not responsive to issues that FEGS had with AllSector’s product(s);
- HR Dynamics Inc., operating for over 20 years, to provide human resources (temp agency) consulting, which FEGS fully owned;
- Staff Resources Inc. -- also 100 percent owned -- provided staff resource consulting to nonprofits, for-profits and public organizations;
- FEGS Home Services Inc., incorporated in 1983, to provide residential home care services to Medicaid/NYC HRA residents and members of managed care plans; and,
- Single Point Care Network LLC, founded in 2012, owned 50 percent by FEGS (ostensibly in collaboration with Selfhelp, another UJA Federation network agency), to provide specialty delegated health care management. It was characterized as a mission-related venture and reported a $215,000 loss in fiscal 2013.
In an affidavit for FEGS’s bankruptcy hearing, its CEO pointed to the for-profit ventures as some of the organization’s biggest mistakes.
WAS GOVERNMENT COMPLICIT?
In a statement, FEGS (partly) blamed its deficit on the aforementioned variety of causes, including government contracts that did not cover related costs, and performance-based government contracts in which the agency did not meet its targets. In its nonprofit report for FEGS, Guidestar, an information service specializing in reporting on U.S. nonprofit companies, indicated that over $48 million of FEGS’s revenue – presumably We Care - was funded by the New York City Human Resources Administration.
It’s relevant to acknowledge that organizations are likely hampered by a variety of ancillary government-reporting formats, let alone the onerous requirements of the New York State Consolidated Fiscal Report and to have its compartmentalized details reconcile to annual financial statements. Such forestalling, adverse to timeliness, seriously undermines the average stakeholder’s ability to scrutinize the worthiness of information in a timely manner. The result is that regulatory reporting may end up exerting an unfitting sway on financial reporting.
BUT WHAT ABOUT THE 990?
In its March 10-11, 2014, meeting, a Not-For Profit Advisory Committee member of FASB stated that Form 990 (considered the “go-to” source document for finding financial information on nonprofits because it is more accessible than audited financial statements, even if oftentimes done incorrectly) is of little use for multiple-legal-entity structures for which the 990 will not show information on a consolidated basis.
Total revenue on FEGS’s June 30, 2013, Form 990 is $227 million, with the loss being just over $1 million. Yet, on the financials, revenue is $25 million greater with “profit” being $1.5 million (excluding extraneous items). Accordingly, it would appear that all the other non-consolidated entities had a combined profit of approximately $2.5 million. Additionally, accounts payable excluded accrued salaries and vacations payable of almost $11 million, which was instead included as an “other liability.”
Perhaps details should be required for “other current liabilities” for which an organization could more appropriately exhibit its imminent obligations. They are now bundled on a line called “other liabilities.” Likewise, should advances of almost $12 million not have been considered deferred revenue without an added explanation on a supporting schedule? Finally, short-term obligations on long-term debt (tax-exempt bond liabilities and secured mortgages and notes payable) need to be listed separately.
For some time, organizations have been encouraged, if not mandated, to institute whistleblower policies. (In its 2014 Report to the Nations on Occupational Fraud and Abuse, the Association of Certified Fraud Examiners noted that tips were involved in the detection of more that 40 percent of all fraud cases.) In its instructions to the Form 990, the Internal Revenue Service views such policies as helpful because “a whistleblower policy encourages staff and volunteers to come forward with credible information on illegal practices or violations of adopted policies of the organization, specifies that the organization will protect the individual from retaliation, and identifies those staff or board members or outside parties to whom such information can be reported.” In addition, the New York Non-Profit Revitalization Act of 2013 specifically requires organizations with over $1 million in annual revenue and 20 or more employees to adopt a whistleblower policy.
Given FEGS’s abrupt demise, a more robust execution of its whistleblower strategy might have alerted not only its board and management, but also its external auditors. Additionally, I believe that whistleblowing should extend to staff of external auditing firms as well. While the field auditor is becoming acquainted (or reacquainted) with, documenting, and testing internal control, they are certainly positioned to become aware of questionable practices, inappropriate or incomplete regulatory reporting and deficient presentation of operating results as presented in the auditee’s annual report.
Given the information publically available regarding FEGS, it seemed clear that the organization was at risk of being financially unsustainable. While there is no indication that FEGS’s operating procedures and protocols were lacking, a strong case can be made that more robust whistleblower policies at both the nonprofit and its audit firm could have highlighted issues not apparent in rote activities.
My conclusion is that external auditors need to appreciate more fully “their” whistleblower obligations. Could the FEGS fiasco have been halted by a more forthcoming audit team? Accordingly, I recommend the profession consider a whistleblower clearinghouse for staff auditors at a professional level, to address, discuss and dispel concerns they might have about organizations they feel are being given extended latitude by audit management.