Operational Efficiency

In general, the operational efficiency of an organisation refers to the extent to which it has used its available resources to achieve its objectives (Anthony 1983; Drtina 1984; Cherny et al. 1992; Daft 2000; Ricardo and Wade 2001). In the NFP context, performance of the operational efficiency of a NFP is associated with the extent to which the organisation allocates its available resources to activities which support its social mission (Parsons 2003).

Most stakeholders are interested in disclosures which are related to the operational efficiency of an organisation, in general (Meyer and Rowan 1977; Gandia 2009; Ryan and Irvine 2012; Carey et al. 2013; Flack et al. 2014; Parsons et al. 2014; Eckerd 2015) as well as in the NFP sector (Hyndman 1991; Callen and Falk 1993; Khumawala and Gordon 1997; Gordon and Khumawala 1999; Parsons 2007; Trussel

and Parsons 2007; Bonga and Jegers 2009; Gandia 2009; Ryan and Irvine 2012; Carey et al. 2013; Flack et al. 2014; Parsons et al. 2014; Eckerd 2015).

NFPs are dependent on the support of different stakeholder groups, for their resource inflows, as discussed in Chapter Three. To promote the legitimacy of their operations vis-à-vis different stakeholder groups (Hines and Jones 1992; Burger and Owen 2010); and to influence these stakeholders' economic decisions (Holthausen 1990; Jones and Roberts 2006; Krishnan et al. 2006; Borgloh et al. 2013), NFPs use accounting disclosures (Michel and Rieunier 2012).

Accounting disclosures, which are related to the operational efficiency of an organisation, are those published financial information which reflect "how well" the organisation uses resource inflows to achieve its mission (Drtina 1984; Parsons 2003, page 113; Parsons 2014). In the NFP sector, stakeholders use different ratios to assess the operational efficiency of an organisation; and these ratios include administration expense ratio (measured as the proportion of total administration expenses to total expenses), program ratio (calculated as the program expenses to total expenses) (Khumawala and Gordon 1997; Barrett 1999; Jones and Roberts 2006; Faulk 2011), fundraising ratio (being the ratio of fundraising expenses to total expenses) (Greenlee et al. 2007); and the cost of fundraising ratio (calculated as the proportion of fundraising expenses to total revenue) (Ryan and Irvine 2012). Among these different ratios, the most commonly used measures of NFP operational efficiency are program and fundraising ratios (Weisbrod and Dominguez 1986; Posnett and Sandler 1989; Callen 1994; Tinkelman 1999; Okten and Weisbrod 2000; Baber et al. 2002; Krishnan et al. 2002; Yetman and Yetman 2002).

To consider the influence of the performance of a NFP on its extent of accounting disclosures, this sub-section discusses the two above-mentioned most common NFP operational efficiency measures, namely, program and fundraising ratios, next.

5.2.1.1 Program Ratio

Program ratio represents the proportion of total expenses which are incurred to directly support the social mission of a NFP (Baber et al. 2001; Krishnan et al. 2002; Tinkelman 2006; Trussel and Parsons 2007; Hoffman and McSwain 2013; Burks 2015). The main purpose of a NFP is to maximise social welfare-related outputs (Rose-Ackarman 1996; Brown and Moore 2002) and the performance of a NFP is measured in terms of its provision of social welfare goods and services rather than in terms of its financial surpluses, as in the commercial sector (Ebrahim 2003b; Saxton et al. 2014). Thus, in the NFP context, program ratio represents a direct measure of the performance of an organisation (Hyndman 1991; Khumawala and Gordon 1997; Baber et al. 2001; Krishnan et al. 2002; Roberts et al. 2003; Trussel and Parsons 2007).

Program ratio is an important financial statement disclosure metric which is used by stakeholders, mainly resource providers, in their economic decision-making process (Weisbrod and Dominguez 1986; Harvey and McCrohan 1988; Posnett and Sandler 1989; Callen 1994; Tinkelman 1998; Trussel and Parsons 2007; Chen 2011; Yetman and Yetman 2013). Accounting disclosures which are related to the program ratio of a NFP, allow stakeholders to compare the operational efficiency of the organisation, with the performance of other similar NFPs (Herman and Renz 2008; Cnaan et al. 2011; Ashley et al. 2012) and to eventually make economic decisions, that is, to decide whether to extend or withdraw their support from a NFP (Weisbrod and Dominguez 1986; Hyndman 1991; Khumawala and Gordon 1997; Parsons 2003; Trussel 2003; Chen 2015).

In general, stakeholders perceive NFPs as organisations which engage in social welfare activities (Austin 2000; Frumkin and Andre-Clark 2000; Parker and Bradley 2000; Lyons 2001; Taylor and Warburton 2003; Kilby 2006; Cheverton 2007) and these stakeholders expect NFPs to allocate most of their resource inflows to social welfare activities (Chen 2015). Stakeholders associate high program ratios with operationally efficient NFPs and low program ratios with NFPs which allocate most of their resources to activities which are unrelated to their social mission (Krishnan et al. 2006). This implies that NFPs which have large program ratios attract higher

levels of resource inflows, than organisations which have low program ratios (Weisbrod and Dominguez 1986; Posnett and Sandler 1989; Callen 1994; Tinkelman 1999; Greenlee and Brown 1999; Okten and Weisbrod 2000; Parsons 2003; Marudas 2004; Tinkelman 2004; Buccheit and Parsons 2006; Tinkelman and Mankaney 2007; Parsons 2007; Gandia 2009; Gordon et al. 2009; Jacobs and Marudas 2009; Kitching 2009; Thornton and Belski 2010; Verbruggen et al. 2011; Kitching et al. 2012; Hoffman and McSwain 2013).

To influence stakeholders' perception of its performance, an organisation uses disclosures, including accounting disclosures (Merkl-Davies and Brennan 2011; Osma and Guillamon-Saorin 2011; Nagy et al. 2012; Brennan and Merkl-Davies 2013). NFPs rely on the stakeholders' resource inflows to carry out their operational activities. To retain current or attract additional stakeholders' support, NFPs have incentives to make themselves appealing to different stakeholder groups (Krishnan et al. 2006). Given the positive relationship between the program ratio of a NFP and its resource inflows NFPs have incentives to manipulate their financial disclosures, to eventually inflate their program ratio (Smallwood and Levis 1977; Tinkelman 1998; Krishnan et al. 2002; Hager 2003; Torres and Pina 2003; Hager and Greenlee 2004; Roberts 2005; Khumawala et al. 2005; Jones and Roberts 2006; Krishnan et al. 2006; Greenlee et al. 2007; Keating et al. 2008; Ayer et al. 2009; Krishnan and Yetman 2011; Kitching et al. 2012; Parsons et al. 2012; Lecy and Searing 2014; McGregor- Lowndes et al. 2014; Parsons 2014; Chen 2015).

However, the manipulation of financial statement disclosures is outside the scope of this study, as previously outlined in Chapter One. For this reason, this study does not consider the manipulation of accounting disclosure items to inflate program ratios; and only focuses on the influence of the program ratio on the extent of accounting disclosures made by a NFP.

Further, NFPs use disclosures related to their program expenditure items, to demonstrate the legitimacy of their operations (Kreander et al. 2009; Hyndman and McMahon 2010; Samkin and Schneider 2010; Chen 2011; Hyndman and McMahon 2011); as well as to demarcate themselves from organisations which are less operationally efficient (Healy and Palepu 2001; Whittaker 2013; Peng et al. 2015).

The literature on the relationship between the program ratio of a NFP and the disclosure practices adopted by the organisation is still at its preliminary stages. Studies which have examined this relationship (namely, Parsons (2003) which relates to the US NFP sector and Ryan and Irvine (2012) which examined Australian NFPs) observed a positive relationship between the program ratio of a NFP and the extent of disclosures made by the organisation. Taking into account the observations made by the two extant studies which have explored program ratio and NFP disclosures, this study develops its first hypothesis as follows:

H1: The higher the program ratio of a NFP, the higher its extent of accounting disclosures.

5.2.1.2 Fundraising Ratio

The fundraising ratio of a NFP represents the proportion of total expenses which are allocated to fundraising activities (Greenlee et al. 2007), as previously described in this chapter. In other words, this study assesses fundraising ratio in terms of the cost of fundraising. In Australia, fundraising is not a precisely defined concept (McGregor-Lowndes et al. 2014).

Fundraising expenditure items, in broad terms, refer to those expenditure items which a NFP engages in, to promote its mission vis-à-vis stakeholders and to eventually attract resource inflows (Flack 2004; McGregor-Lowndes et al. 2014).

Fundraising expenses, being the costs that are not directly related to the social mission of a NFP, are generally perceived as overhead costs which indicate the operational inefficiency of the organisation (Eldenburg and Krishnan 2003; Krishnan et al. 2006; Bagwell et al. 2013). In most instances, stakeholders withdraw their support from organisations which disclose high fundraising ratios35 (Greenlee and Brown 1999; Tinkelman and Mankaney 2007; Jacobs and Marudas 2009; Tinkelman and Mankaney 2007; Chen 2009; Tinkelman 2009; Szper and Prakash 2011; Yetman and Yetman 2012; Chikoto and Neely 2014); and conversely, they support NFPs which have low fundraising ratios36 (Weisbrod and Dominguez 1986; Posnett and

35 _{The proportion of fundraising costs to total expenses.}

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Sandler 1989; Callen 1994; Schervish and Havens 1997; Schlegelmilch et al. 1997; Tinkelman 1999; Bennett and Gabriel 2003; Parsons 2003; Bowman 2006; Sargeant et al. 2006).

In line with the arguments of RDT, NFPs signal their operational efficiency by disclosing information which highlight their operational efficiency (Froelich et al. 2000; Brooks 2005; Eckerd and Moulton 2011; Krishnan and Yetman 2011; Verbruggen et al. 2011), by understating their fundraising costs, to eventually maintain stakeholders' support and hence their resource inflows (Jacobs and Marudas 2012; Morales and Caraballo 2014).

Recall from Chapter One and prior discussions made in the current chapter, this study does not consider financial statement frauds and distortions; but instead focuses on the influence of different factors, such as fundraising ratio, on the extent of accounting disclosures made by a NFP.

Similar to the relationship between program ratio and NFP disclosures, few studies (namely Ryan and Irvine (2012), Saxton et al. (2014) and McGregor-Lowndes et al. (2014)) have examined the impact of fundraising ratio on NFP disclosures. These existing studies have drawn mixed conclusions about the relationship between the fundraising ratio of a NFP and its extent of disclosures. Saxton et al. (2014) examined NFPs operating in the USA and argues a positive relationship between the fundraising ratio of a NFP and the extent of web disclosures made by the NFP. Ryan and Irvine (2012, p.359) examined Australian NFPs and observed a positive relationship between the fundraising ratio of NFPs and the disclosures made in the “narrative sections” of annual reports published by these NFPs (Ryan and Irvine 2012, p.359). On the other hand, the study by McGregor-Lowndes et al. (2014) identified an inverse relationship between the fundraising ratio of Australian NFPs and the extent of financial statement disclosures made by the organisation.

Taking into account the limited number of studies which have examined the relationship between the fundraising ratio of NFPs and the disclosures made by the organisation, this study develops a hypothesis which measures the influence of

36 _{NFPs which disclose a low proportion of fundraising costs to total expenses.}

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fundraising ratio and NFP financial statement disclosures following McGregor- Lowndes et al. (2014). The latter has considered financial statement disclosures made by Australian NFPs; and hence is more closely related to the purpose of this study than the works done by Ryan and Irvine (2012) and Saxton et al. (201437).

Taking into account McGregor-Lowndes et al. (2014), it is hypothesised:

H2: The higher the fundraising ratio of a NFP, the lower its extent of accounting disclosures.

This study acknowledges that ratios, such as program and fundraising ratios, run the risks of being misinterpreted (Wesibrod and Dominguez 1986, Posnett and Sandler 1989) and misrepresented (Hager 2003, Jones and Roberts 2006, Yetman 2009) in the annual report disclosures made by NFPs. Ryan and Irvine (2012) examplify the risks associated with the use of ratios by highlighting that some NFPs tend to report zero fundraising-related expenses and yet disclose high levels of fundraising income; indicating that NFP financial statement disclosures, on their own, might not depict have enough transparency about the activities of a NFP. The Charity Commission however advocates that NFP annual report users are interested in disclosures which are associated with program-related expenses (Charity Commission 2004) and there has been a call for greater transparency about the fundraising expenses of NFPs (Charity Commission 2012). Taking into account the claims made by the Charity Commission, this study pursues its exploration H1 and H2 in the Australian NFP context.

Figure 5.1, from section 5.1, depicts that three types of internal factors, namely, performance, resource dependence and governance, influence extent of accounting disclosures. The current sub-section has developed hypotheses which measure the impact of the performance of a NFP on its extent of accounting disclosures. To

37 _{Narrative (explored by Ryan and Irvine 2012) and web disclosures (examined by Saxton et al.} 2014) may include financial disclosures; but unlike financial statement disclosures, narrative and web disclosures are not formulated by the AAS (AASB101 2015) AASB101 (2015) prescribes the presentation of financial statements. This AAS, however, only mentions that narratives, in the form of notes, can be used to support financial statement disclosures (without any further elaboration). Further, AASB101 (2015) does not include any description nor prescription about web disclosures.

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further develop hypotheses which address the research question of the study, the next sub-section considers the resource dependence of a NFP.