Moderate regulations are optimal for NFP program expense allocations: Findings from the combination of mechanism design and k-means clustering

Introduction

As a case in the educational collection of the University of Texas at Austin, not-for-profit organizations (NFPs) often confront ethical dilemmas in terms of fundraising (Drumwright, 2022). Program expense allocations by executives of NFPs tend to be inflated and are prone to manipulation. Of course, mutual trust between executives and contributors is an element of governance for NFPs (Pilon and Brouard, 2025). Program expense allocations may violate this trust, similar to financial misconduct in profit-oriented entities (Honigsberg, 2020). However, there may be another reason NFP executives are considering even though expense allocation may harm mutual trust. For example, some NFPs aim to secure greater contributions by overstating their programme expense ratios. Accounting standards allow for some discrepancies between executives, and under certain circumstances, they are able to legally report inaccurate expense allocations. The context of this study is the ethical dilemmas faced by NFP executives.

This study examines the ways in which regulators determine the extent to which expense allocations should be limited or prohibited, whereas there is a lack of consensus in the literature. Prior literature mainly focuses on how regulators can prevent inflated expense allocation outright. Actual data can provide clues on how to resolve disagreements. The paper also aims to illustrate how to combine mechanism design and classical computer science problems, ex. K-means clustering can be useful for research accounting for NFPs. Its focus is to interpret the public sector’s decisions, such as that of California’s governor and attorney, through game theory.

Rating organizations such as CharityWatch have criticized the expense allocations of NFPs, and the public sector has periodically tried to regulate them. Notably, California Assembly Bill 1181 aimed to regulate allocation broadly. In a detailed explanation, CharityWatch expressed regret that this bill was vetoed by the governor (CharityWatch, 2023). The governor indicated that the bill could “pose burdensome implementation challenges for the charities impacted by its provisions” (Senate Judiciary Committee, 26:2021). Similarly, the attorney generally halted sanctions on NFPs in California (Bonta, 2019). Subsequently, he became a federal health secretary. The Department of Health and Human Services had the tightest relationship with NFPs in all federal agencies (WSJ, Jan. 13, 2021). It can be assumed that he rescued NFPs from burdensome implementation challenges, which is consistent with the governor’s actions. It is doubtful that complete prevention of inflated expense allocations is the best economic policy. For example, all three NFPs with expense allocations listed in the first paragraph of Bonta (2019) are humanitarian organizations. These organizations may have beneficiaries whose lives are in danger or have special fundraising needs.

This study adopts game theory as a framework. The contributors are principals and executives are agents. Game theory provides a convenient framework for the analysis of this problem, as it is necessary for executives to gauge how contributors react to their actions.

The presumption is that states and countries have similar regulations as in California. According to the ABA (American Bar Association), California is the leading state for the MNCA (Model Nonprofit Corporation Act) (Nonprofit Organizations Committee, 2022). All U.S. states have Financial Accounting Standards Board (FASB) accounting standards for NFPs. Contemporary Japan has similar regulations for NFPs to California, although it has different regulations elsewhere. Notably, Japan has Specified Non-Profit Judicial Person (NPO) accounting standards, which are based on FASB’s accounting standards.

The remainder of this paper is organized as follows: Section 2 presents the prior literature. Section 3 builds on this theory. Section 4 explains the methodology of this study. Section 5 presents the results of the study. Section 6 extends the discussion. Finally, Section 7 concludes the study.

Prior literature

Prosocial activities are a common topic in finance. For example, Walker et al. (2023) wrote about finance for these types of activity. There is also an extensive literature on expense allocation. Dang and Owens (2020) indicated that approximately 25% of British NFPs are financially misreported. Cyr et al. (2022) indicate that regulations influence how executives of Canadian NFPs recognize expense allocations. Ling and Roberts (2023 and 2025) and Allen et al. (2024) explain expense allocations in the U.S. and ways to prevent inflated expense allocations. There is prior literature on the limitations of the contributors. Caviola et al. (2020) revealed that contributors have limited ability to understand the effectiveness of NFPs. According to Yang and Northcott (2021), one method for regulators to build public trust is to investigate public concerns about “wrongdoing” at NFPs. Chan and Zhang (2021) focused on sanctions for misreporting NFPs.

Some prior studies cast doubt on the current accounting norms of NFPs. Burkart et al. (2018) argue that financial transparency does not always increase the utility of stakeholders surrounding NFPs, indicating that rating organizations sometimes lead the push for transparency. Mitchell (2017) insists that some financial norms paradoxically hamper NFPs, although his focus is slightly different from that of this study. A reduction in the flexibility of NFPs reduces their efficiency. Burkart et al. (2018) and Mitchell (2017) are consistent with Muller (2018) in criticizing not only program expense ratios, but also various metrics. Goncharenko and Khadaroo (2020) warned that accounting regulations may restrict NFP activities based on Russian law.

The financing of humanitarian organizations is a significant factor when examining NFPs. Tariq et al. (2023) assert that the funding of humanitarian organizations is not only insufficient but also volatile.

Bénassy-Quéré et al. (2019) explain the shapes of economic policy and describe it as a succession of trade-offs. Regulators were also included in the public sector. Fowler (2023) depicted the ambiguity of the public sector as a double-edged sword and showed practical trade-offs. The concept of trade-offs is discussed in Section 6 of this paper.

Rasmusen (2007) uses textbook game theory, which includes explanations of agency theory. The players’ utility is frequently considered. Financial reporting is also within the scope of this study. In addition, the labor market is discussed by dividing the supply side into “serious” and other applicants. K-means clustering is a classic statistical method. For example, Kopec (2019) explained k-means clustering in a recent study. Hsu et al. (2021) adopted k-means to analyze the finances of NFPs but did not combine k-means with game theory.

There is ambiguity as to whether inflated expense allocations are deliberate falsification, and these distorted expenses are often lawful and may even be justifiable in some circumstances. Sandel (2010) separated lies from other kinds of misinformation and suggested that certain falsehoods are more justifiable than lies. Finlayson (2005) describes psychologist Kohlberg’s theory as influenced by philosopher Habermas, which posits that even though laws must usually be complied with, sometimes they ought to be disobeyed.

Theory

Decisions by executives at NFPs rely on expected decisions by contributors to NFPs; therefore, game theory is a suitable framework for analysis. NFPs’ expense allocations can be regarded as an issue in the mechanism design for messages. Regulators can influence financial reporting as messages from NFPs through mechanism design. NFP executives want to be trusted by contributors through their messages (financial reporting), even though their financial reporting has sometimes been manipulated.

The NFPs mentioned here have program expense ratios, both in actual terms and in terms of fundraising needs. Program expense allocations are unnecessary for NFPs with good program expense ratios and NFPs without fundraising requirements. Notably, if an NFP is a humanitarian organization and the utility of its executives reflects the utility of its beneficiaries whose lives are at risk, fundraising success strongly influences the utility of executives. The von Neumann–Morgenstern utility is often adopted in game theory. Thus, this study adopted this utility.

Methods

It is well known that the total amount of contribution in the U.S. and the U.K. is large. While ample statistical data exist concerning the financial statements of NFPs in both countries, raw data for contributors are rare. However, there are raw data for contributors with large sample sizes in Japan, which have been paying attention to the legal system for NFPs in California since the last part of the 20th century.

The Japan Fundraising Association provides a dataset of Japanese contributors for each fee. The dataset was used as the data source for this study. The association collected statistical data through the Nationwide Survey on the Reality of Donations (Zenkoku Kifu Jittai Chosa). Because only anonymized datasets are provided by the association, IRB review is unnecessary for this study.

How processed by summing up various categories of contributions, consistency with Giving USA was brought to each sample of this dataset (IUPUI Lilly Family School of Philanthropy, 2023). This is the sum of NQ2_1_8 and NQ2_1_19 for the numbering of the dataset. Because the annual income of each respondent is recorded only as a range and not as a precise figure, the annual income of each respondent is substituted by the midpoint of each respondent’s annual income category. Samples that did not make any contribution can be assumed to be not or only slightly influenced by the culture of the U.S. donation market. Then, the setting up of k-clustering was completed by removing samples that did not make any contributions. Next, Equation (5) was calculated. Finally, if (5) is not a positive value, (6) is calculated.

Results

The descriptive statistics of the processed dataset are shown in Table 1 (n = 1,003).

The results of the k-means clustering were calculated. There were 966 cases in the first cluster and 37 in the second cluster. The cluster center of the first cluster was 9,343, and the cluster center of the second cluster was 160,581. The number of repeats required was 12.

The above result was negative. Thus, manipulation is a dominant strategy for an NFP when there are no sanctions.

Decremental donation revenue was calculated using the formula below, as shown in Figure 1. The x-axis represents r_s and the y-axis represents the decreasing amount.

Figure 1. Relationship between expense allocations and sanctions.

When r_s = 1,027,947/3,008,446, (7) is achieved.

Discussion

The scarcity of serious contributors is consistent with the findings of Caviola et al. (2020). In addition, consistent with Cyr et al. (2022), there is space for mechanism design by regulators.

Regulators could hypothetically use sanctions to prevent all inflated expense allocations, an amount that is less than approximately 34% of all expense allocations, which appears to be an achievable goal (7). In the real world, there are frequent expense allocations by NFPs across the U.S., including California. Thus, regulators who recognize the goals of NFPs intentionally adopt moderate regulations. This is not because of potential costs for regulators, but because of the burdensome implementation challenges for NFPs. This result is consistent with the decisions made by California’s governor and the attorney general, as described in the Introduction. Regulatory decisions can be interpreted from the perspective of mechanism design.

Some sanctions are necessary to maintain mutual trust within the donation market, and maintaining the market is the point of decision. However, regulators do not want to impose sanctions on all inflated expense allocation. To achieve the objectives of NFPs, fundraising through inflated expense allocation is sometimes required. As Burkart et al. (2018) and Mitchell (2017) warned about some normative goals, complete prevention would harm the beneficiaries of some NFPs. Bénassy-Quéré et al. (2019) also explained that regulators are confronted with trade-offs.

Allowing inflated expense allocations is a possible option. Through imperfect sanctions, regulators make NFPs navigate through a series of obstacles. In terms of obstacles for NFPs, humanitarian organizations are particularly volatile and have imminent fundraising needs, as Tariq et al. (2023) state. According to Sandel (2010) and Finlayson (2005), it can be assumed that there is a space where these types of imperfect sanctions are permitted.

The California governor’s and attorney general’s decisions seem less than optimal for preventing all inflated expense allocations, but optimal in terms of maximizing the utility of NFPs stakeholders, including beneficiaries.

Conclusions

By theorizing mechanism design and k-means clustering, it is indicated that regulators choose moderate regulations on the expense allocations of NFPs. Such regulations appear to force NFPs to navigate obstacles and optimize the utility of NFP stakeholders, including beneficiaries. For example, California’s governor and attorney general appear to have done so. The findings here contradict some rating organizations but are consistent with prior academic literature. Because there is debate among regulators on how to tailor the obstacles for NFPs in the prior literature, this finding for actual data can contribute to the literature.

Other studies adopting classic computer science problems may provide further insights into accounting for NFPs. The limitation of this study is the extent to which the findings fit. It is somewhat unclear whether the findings apply sufficiently to cases other than California, or in states or countries influenced by California.

Ethical approval

This paper did not involve in any human subject experiments and did not need ethical approval of the institutional review board (IRB).