Audit of Not-For-Profit Organisation (NPO)

This paper considers the practices applied in the auditing of NPOs and the improvements introduced in the standards and regulations. It also considers the implications of the audit and vulnerability of NPO to fraudulent activities.

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Table of Contents

INTRODUCTION……………………………………………………………………………….3

Audit of Not-for-profit Organisation (NPO)..............................................................................3

Statistical Study - Increase in NPOs and Reasons behind Increase.........................................4

Statistical Study - Increase in fraudulent practices in NPOs....................................................5

Objectives of NPO Audit.............................................................................................................6

DEVELOPMENT..........................................................................................................................7

Increase Scope and Diversity on Accounting & Auditing.........................................................7

Revised Audit & Accounting Framework..................................................................................7

SOX Act 2002 – Whistle Blower Protection & Protection of documents.................................8

Change in FASB Codification (ASC Section 958)....................................................................9

Revised OMB Circular 122 & 133.............................................................................................9

COSO Framework – Enterprise Risk Management ...............................................................10

Internal Code of Ethics..............................................................................................................9

Training Arms – ACAUS & ICAEW.......................................................................................10

CASE STUDIES...........................................................................................................................11

Case Study 1 - Red Cross Scandal............................................................................................11

Case Study 2 - The Salvation Army of Australia...................................................................134

CONCLUSION............................................................................................................................16

Future direction........................................................................................................................16

REFERENCES............................................................................................................................17

APPENDICES…………………………………………………………………………………..21

2

INTRODUCTION

Audit of Not-for-profit Organisation (NPO)

Not-for-Profit Organisations (NPOs) are charities or service organisations which do not

run their operations on share capital, as they operate on funds and donations. Any surplus is not

distributed to the organisation as dividend or any other incentives to its members. The purposes

of settling up NPO is to support government in helping society by provision of education for

poor children, support for senior citizens, sports facilities for athletes, or health services.

Unlike for profit organisations, audit of NPO is not required by law, but considering the

recent circumstances, most organisations have established a firm requirement for the audit of

NPO. Moreover, with the revolution of NPOs changing into business-like entity, stronger

emphasis is essential to comply with voluntary corporate governance policy. It is enforced by the

Internal Revenue Service, if an NPO earns profit more than $25,000 it has to file an annual Form

990. Likewise, NPO need to have all the managerial activities such as having a budget to control

costs, monitoring utilization of resources on activities, a risk management plan to counter any

unforeseeable events besides conducting fundraising activities to generate and acquire funds to

fuel their activities and services.

3

Statistical Study - Increase in NPOs and Reasons behind Increase

The significant growth of NPOs can be inferred from the fact that, 1.5 million NPOs were

registered with the Internal Revenue Service in 2007. There is a 60% increase in size of Public

charities (Wing, 2009) under S501(C)(3) within time span of a mere 10 years, from 1997 to

2007. Alarmingly, the cumulative assets owned by NPOs increased by 70% in this decade.

(Source: Urban Institute, National Centre for Charities statistic, the IRS Business Master File)

The growth in NPOs is a result of government granted benefits in the forms of tax

exemption, limited liability, grants and donations, and the power to organise (IPC). Tax

exemptions are provided to NPOs from local, state and federal taxes; which include property tax,

income tax, and sales tax amongst others. Another benefit of an NPO is that no individual will be

personally liable for debts and obligations. Government also assists registered non profit

organisations. NPOs are being established on a too fast pace without need for them in various

area. According to Broekhoven, donations run into billions which makes NPOs vulnerable to

fraud.

4

Statistical Study - Increase in fraudulent practices in NPOs

(Source: Association of Certified Fraud Examiners)

From the above data, it can be seen that the trend of fraud peaked in the year 2008. The

increase in the cases of fraud are due to; economic downturn in the past years, ineffective

internal controls and ineffective measures for transparency of operations in NPOs. That is the

reason why rigorous requirements have been developed to conduct audit of NPO.

A sharp drop in the cases of fraud was observed after 2008 and this can be attributed by;

reestablishment of economic circumstances, stability in employment, and restrictions imposed by

donors for accountability and transparency. According to Mueller, et al 2006 it is morally right

for NPOs to be accountable as they receive money from government as well as volunteer donors;

this step is important because it enhances accountability. Udochi, 2007 held that management

failed because they followed traditional interpretation of accountability.

5

Objectives of NPO Audit

The failure in compliance with the regulations and statutory requirements has led NPOs

to engage themselves in unethical acts like corruption, fraudulent financial statements, and asset

misappropriation. The American Red Cross is used to illustrate how it engaged in acts of

corruption such as bribery, establishment of illegal gratuities to earn illegal profit and economic

extortion. Fraudulent financial statements are also prepared that show excessive expenses or

overcompensation and the amount covered under those false heads is utilized illegally.

To address the increasing frauds and misappropriation of funds in NPOs, the objectives to

inculcate development in auditing standards and regulations are: to enhance the accountability,

transparency and integrity for NPOs; to improve regulations and standards that provide

framework for the operations of NPOs; to provide a criteria which defines the credibility of

NPOs; and to make the functions of NPOs even more effective.

6

DEVELOPMENT

To achieve the objectives, steps taken by governments to ensure that NPOs act ethically

are the establishment of the following:

Increase Scope and Diversity of Regulators

Initially there were no legal requirements for the checks on non profit organisations and

audit of NPOs was not necessary. But keeping in view the statistics of cases of fraud as presented

above, the scope of procedures in order to enhance the accountability of NPOs has been

widened. The NPOs should be controlled by the government regulatory that have been created

by the Non-Profit Organizations Act. To state a few, The Charity Commission is the regulator

for charities in England and Wales (Charity Commission for UK and Wales, 2010); they ensure

NPOs maintain the standards of governance, transparency and public accountability. While in the

US, The American Institute of Philanthropy acts as a charity watchdog to ensure NPOs serve the

public in an ethical manner.

Revised Audit & Accounting Framework

Not-for-profit organisations are required to comply with several standards as set by the

American Institute of Public Accountants (AICPA) and contained in the General Accepted

Accounting Principles (GAAP). SOP 98-2 accounting for cost of activities of Not-for-Profit

Organisations and State Local Government Entities that include Fundraising provides guidelines

on how an NPO should account for fundraising related activities, (Clark &Jordan, 2001). U.S.

Federal Office of Management and Budget offers guidelines and circulars in costing and auditing

for NPOs (Garfinkel, 2002).

7

SOX Act 2002 – Whistle Blower Protection & Protection of documents

The SOX Act 2002 provisions are mainly addressed to public companies. There are only

two provisions that suitably apply to all organisations, the rest of SOX requirements regarding

best practices on governance are not binding for NGOs. However, NPO is free to establish an

internal audit function that will benefit the NPOs by improving financial reporting, minimising

fraud cases, improved internal controls and increase credibility of the NPOs (AICPA, 2010).

o Whistle blower protection ( SOX Section 806)

SOX Act requires an organization to develop, adopt and disclose a formal process to deal

with the complaints from the employees of the organization. In order to protect retaliation

against the complaints made by any employee, an organization is advised to develop procedures

to protect the employee. An organization is required to execute a proper investigation on the

basis of complaints made by the employees and to rectify the flaws in the system.

o Protection of documents (Board Source, 2006)

In order to ensure accountability, regulations require all NPOs to have a proper written

record of its activities, along with electronic files and voicemails. The retention of documents is

specifically important for any official investigation conducted on the basis of written documents

therefore a complete record of documents needs to be maintained and all the documents need to

be provided in order to avoid criminal obstruction.

8

Change in FASB Codification (ASC Section 958)

In US and UK, the NPOs should prepare the financial statements according to the

International Financial Reporting Standards while auditing is guided by the International

Auditing Standards. FASB No.116 deals with contribution made and received. This Statement

requires NPOs to differ between contributions received that increase permanently restricted,

temporarily restricted, and unrestricted net assets. It also requires NPOs to recognize the

expiration of restrictions imposed by donor. FASB No. 117 provides guidelines for Financial

Statements of Not-for-Profit Organisations (FASB, 2010). The recent changes made in the

standards are: accounting for contributions and presentation of financial statements, investments,

statement of cash flows, accounting of contributions received, gains or losses incurred on

investment made by the organisation from contributions.

Revised OMB Circular 122 &133

OMB Circular 122, Cost Principles for Non-Profit Organizations and OMB Circular 133,

Audits of States, Local Governments and Non-Profit Organizations were enacted in May 2004

(revised) and June 2003 respectively. OMB Circular 122 establishes principles for determining

costs of grants, contracts and other agreements with non-profit organizations. OMB 133 makes it

a statutory requirement to conduct audits of non-profit organizations (WhiteHouse.gov).

9

Committee of Sponsoring Organizations Internal Control – Integrated Framework

COSO framework is a model which is used to evaluate risk within the internal controls of

an entity. The internal control of an entity is a process that is affected by its board of directors,

management and key personnel who possess an effective control over the operations of an

organization. For an NPO, COSO model possesses high importance to establish and evaluate an

effective internal control in NPOs, especially where risk of fraud is significant. COSO model

also includes risk management principles which can be used to identify and mitigate risks.

Internal Code of Ethics

Internal code of ethics includes principles of honesty, truthfulness and commitment to

task. This is an extremely important aspect because by application of code of ethics, a culture of

honesty can be developed in a non profit organization. An example is represented by the

Evangelical Council for Financial Accountability. This organisation is responsible for ensuring

the accountability in protestant evangelical churches organisations in USA. They reviewed the

standards to include adherence to the Biblical teachings in the management of NPOs.

Theological beliefs have been used even with organisations that are not affiliated to any religion.

Training Arms – ACAUS & ICAEW

There are some authorities that ensure the continuous development and effectiveness of

auditors. Training arms in UK and US are the audit firms and professional educational

institutions such as ICAEW. These entities ensure that the auditors acquire proper knowledge

regarding their practice. Audit firms; such as PWC, Deloitte, Ernst & Young and KPMG,

conduct training of their employees through seminars and professional development sessions.

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In order to avoid or mitigate fraudulent practices, the developments discussed above can

be strictly legalized. Thus the NPOs would be able to mitigate the frauds.

CASE STUDIES

Case Study 1 - Red Cross Scandal (September 11 & The Hurricane Katrina)

Red Cross has been continuously reported in different cases of fraud in the past decade.

Major frauds include; lack of proper documentation and misappropriation of donations executed

at the time of the September 11 attacks and Hurricane Katrina disaster. The American Red Cross

was accused of a failure to meet its own guidelines with the funds that had been received from

well wishers. Donations of untold millions were never accounted for therefore the exact amount

of donation misappropriated by Red Cross cannot be investigated. It has been estimated that the

total donations amounted to US$561 million, but only US$154 million was given to the victims

of the attacks, and it was said by Red Cross officials that the rest of the amount would be utilized

on the war against terror.

It was observed and brought up that there were loopholes in the manner in which the

National Disaster Fund was being managed. This was true even when the Red Cross had its own

auditors auditing its regulations and its accounts. The external firm KPMG was appointed by

Red Cross to conduct its audit. One of the reasons that caused the situation was the lack of

transparency. The American Red Cross had faced scandalous allegations and yet their books had

been audited by one of the most internationally recognised audit firm (Holguin, 2002). The Red

Cross pledges total transparency and yet the details of what each chapter had received from the

National Disaster Fund were not available to the press (Holguin, 2002). The auditors of Red

Cross admitted that money given to the Boston chapter was not traceable. This was the reason

11

why the auditors failed to detect the fraud, and clearly management is responsible for letting such

loopholes exist.

The question that arises at this point is who should take the responsibility for the fraud.

From the above scenario, it can be rejoin from ISA 250, Consideration of Laws and Regulations

in an Audit of Financial Statements; it is management’s responsibility to ensure the effectiveness

of the internal controls and due to management failure, some individuals find loopholes for the

fraud. Besides, ISA 240, The Auditor's Responsibilities Relating to Fraud in an Audit of

Financial Statements state as well that an auditor’s duty is to provide reasonable assurance

regarding the effectiveness of internal control, detecting material fraud and expressing opinion of

the fairness of the financial statements. Therefore an auditor cannot be held responsible for the

non compliance of the management, especially when corruption by creating bogus or destroying

documents can cause detecting fraud impossible.

The weakness in the system of the Red Cross is the failure of the organization to meet the

requirements made by the regulations. The improvement in the system can be made if the

organization establishes COSO Framework. If any complaint is made regarding any internal

matters, the directors should execute a proper investigation and should ensure that the problem is

resolved.

Some improvements to eliminate American Red Cross existing weaknesses include

having a proper whistle blower system in order to find out the specific individuals who meddle

with the operations of the organization. Also, The American Red Cross should also put in place a

supervisory department to protect documents of transactions and empower employees to act in

order to ensure all documents are properly prepared and accounted for.

12

Furthermore, to ensure Auditors serve due diligence to The American Red Cross during

an audit, they are encouraged to constantly improve their skills and knowledge through attending

seminars and trainings conducted by the Training Arms – ACAUS & ICAEW.

Lastly, Corporate Governance practices should be strengthened by avoiding

concentration of power in the hands of one person. Concentration of power can be hazardous for

the organization if the person utilizes his power for unfair or unethical means. Red Cross should

also provide complete authority to the auditors and have an Audit committee that are

knowledgeable, independent, and empowered to act effectively.

13

Case Study 2 - The Salvation Army of Australia

The Salvation Army is one of the most well known and successful NPOs. It is an

exemplary organisation and its example is given as arguably the best Not-For-Profit

Organisation. The Salvation Army has managed to successfully apply corporate governance in

all its matters. The trustees are active and they attend all or most of the meetings (Australia

Salvation Army, 2010). There are separate councils and advisory boards which monitor each

other to ensure accountability and transparency. These boards self police the controls to ensure

compliance with the regulations set by the regional authorities for NPOs.

In order to promote the culture of honesty among the staff members, there is a code of

conduct which all employees are obliged to follow to enhance the principles of ethics in the

organisation. The donations are utilized in a transparent manner, and the prominent results are

enough to retain the trust from the public. The auditing of the Salvation Army is conducted by

KPMG.

The organization’s collaboration with agencies such as Transparency International, GRI,

FTSE Group and FEE are a clear indication that the organisation's core values include

sustainability, transparency and the full accountability of the organisation. In order to ensure that

the developments in regulations and statutory requirements are consistently applied by Salvation

Army, it has established an internal control system with guidelines that assist the entire

organisation in following the regulations. The best practice by the Salvation Army include

providing holistic care that focuses on personal rights, choices and wishes, supporting and

assisting victims to lead their lives to the fullest potential and enhancing end user active

participation.

14

There is no doubt in the fact that the record of Salvation Army has been clear when

compared to other NPOs, but it cannot be denied that it became a victim of some fraud as well.

Assets worth $1 million were misappropriated in 2005 and an accountant misappropriated funds

of nearly US$166,000 in during the period Jul’04-Sep’05 in Manhattan New York City. The

organization faced difficulty after the disclosure of these fraud but these fraud was recovered by

the organization later by conducting formal investigations. The status obtained by Salvation

Army is due to the continuous compliance of the organization with the regulations.

The challenges encountered by Salvation Army when implementing new regulations

were maintaining the effectiveness in the internal controls of the organization, maintaining the

ethical practices by the employees and to establish new records and their retention under the new

regulations. The Salvation Army has a Quality Assurance System developed by Booth House

and SAHA, which is internally audited on a regular basis. It is the responsibility of any NPOs

under CSR to fulfil their corporate social responsibilities.

15

CONCLUSION

From the above report, it can be inferred that the audit standards, regulations and the

developments made in those regulations are helpful in maintaining a better environment for

NPOs and they are helpful in reducing the misappropriation of funds and fraudulent practices.

Despite being helpful, these developments are not enough. Therefore, in order to ensure the

optimum level of accountability and transparency, strict regulations are required for NPOs.

Future direction for Not-For-Profit Organisation

After the analysis, there are various issues that must be made known and corrected;

1. Strict regulations should be imposed on all NPOs to review the roles and

responsibilities of management of NPOs on a regular basis.

2. NPOs need to come up with very clear core values and adhere to them.

3. To emulate and modify best practices from other NPOs such as Salvation Army.

4. The authorities should conduct surprise audits without any formal pre-

arrangements.

5. In order to eradicate employee fraud and collusion of management, NPOs should

conduct employee and executive training.

6. NPOs should periodically evaluate their internal audit procedures.

7. NPO to ensure a proper code of conduct is implemented in the organisations.

16

8. NPOs should introduce rewards for staff who report fraudulent practices.

17

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APPENDIX

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http://www.urban.org/uploadedpdf/412085-nonprofit-sector-brief.pdf (Accessed: 20 October

2010)

22

ACFE. (2010) 2008 Report to the nation on occupational fraud & abuse. Available at:

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23

http://www.sox-online.com/coso_cobit_coso_framework.html (Accessed: 15 October 2010)

http://narcosphere.narconews.com/notebook/bill-conroy/2009/01/whistleblower-rights-

legislation-signals-changing-guard (Accessed: 10 October 2010)

24