Implications of the New Corporate Accountability for Nonprofits

Executive Leadership Institute Implications of the New Corporate Accountability for Nonprofits Larry Ladd larry.ladd@gt.com 617-848-4801 November 15, 2003 A New Era of Accountability and Scrutiny Scandals at major corporations and accounting firms 2 A New Era of Accountability and Scrutiny The Not-for-Profit World Is Not Immune CEO of United Way convicted of misuse of funds (1992) Foundation for New Era Philanthropy Nonprofits defrauded of more than $135 million on phony investment scheme (1997) 18 of 19 trustees removed for handling of various conflicts of interest and for overcompensating president (1997) Arizona Baptist Foundation Declares bankruptcy after 13,000 investors defrauded (1999). Andersen settles for $217 million. 3 Recent Events (Part One) • Administrators charged with embezzlement at Riverside Community College (CA) (June 16, 2003) • President of Lewis & Clark College resigns amid controversy over loan to now bankrupt energy company (June 18, 2003) • Ford Foundation keeps board chair who reached fraud settlement with SEC for $8M over role as Xerox CEO (July 8, 2003) • D.C. United Way Board's actions at issue over $1.6M in improper payments to CEO (September 4, 2003) • CFO of University of Florida Foundation arrested and charged with embezzling $700K (September 19, 2003) 4 Recent Events (Part Two) • Boston Globe reports trustees of some private foundations are diverting assets, intended for charitable causes, to pay themselves." (October 9, 2003) • Police investigating theft of $192K from Cal. State U. Fresno Foundation over 2 year period (October 22, 2003) • Texas Southern U. settles lawsuit for $350K with whistleblower who alleged employee theft (October 24, 2003). • Boston University paid $30M in 2001-02 to companies and non-profit groups in which BU trustees were involved as executives or board members (October 31, 2003) 5 Media Coverage • Media coverage has increased, raising awareness among all of your stakeholders 6 IRS • IRS is considering increasing the required disclosures by tax-exempt organizations related to governance matters in their filings with the IRS • Last year, the IRS sought comments on the advisability of additional questions on the Form 990 regarding whether the organization has an Audit Committee and a conflict of interest policy 7 Examples of Issues • Management overstated earnings • Board overpaid executives • Board did not ask hard questions or take stands when necessary • Auditor did not "stand up" to Management • Auditor provided consulting services to management – Consulting service fees exceeded audit fees – Consulting "product" was then audited 8 Topics for Today • Sarbanes-Oxley Act of 2002 • (required of SEC-registered entities but does not apply to not-for-profit entities) • GAO Audit Independence Standard (2002) • (required of not-for-profit entities who receive federal funds) • Implications for Financial Governance of Not-for-Profit Organizations 9 Sarbanes-Oxley Act of 2002 • The Sarbanes-Oxley Act of 2002 (the “Act”) signed into law on July 30th 2002 • Applies only to SEC-regulated corporations, not to not-for-profits, however………….. 10 Sarbanes-Oxley Act of 2002 • Public accounting firms are likely to change how they relate to all clients, whether required to do so or not • Sarbanes-Oxley creates a new public awareness of issues of accountability and independence that will "spill over" into the notfor-profit sector • NFP board members will begin to model themselves on corporate governance "best practices" initiated by Sarbanes-Oxley 11 Sarbanes-Oxley Act of 2002 Audit Committee Membership • The Audit Committee must be comprised of "independent" Board members • One member should be a "financial expert" - a person who through education or experience has expertise in (1) general accepted accounting principles and (2) preparation of financial statements, application of accounting principles, internal controls, and audit committee functions 12 Sarbanes-Oxley Act of 2002 Audit Committee Role • Directly responsible for the appointment, compensation and oversight of the Auditor including resolution of disagreements • Auditor reports directly to the Audit Committee • Directly responsible for pre-approving all audit and permitted non-audit services (unless the non-audit service is de minimis) • Must have procedures for handling complaints about auditing or internal control 13 Sarbanes-Oxley Act of 2002 Relations with Auditor • Prohibits officers and board members from influencing, coercing, manipulating or misleading the Auditor "for the purpose of rendering such financial statements materially misleading" • Auditor can't perform any audit service if the CEO, CFO, Chief Accounting Officer, Controller or any person in an equivalent position has been employed by the Auditor and participated in the audit during the 1-year period preceding the audit 14 Sarbanes-Oxley Act of 2002 Auditor Responsibilities • Audit partner (and concurring partner) must rotate every five years • Auditor must attest to and report on management's assessment of the company's internal control structure and procedures 15 Sarbanes-Oxley Act of 2002 Management Responsibilities • CEO and CFO must certify quarterly and annual financial reports • CEO and CFO must establish and maintain appropriate internal controls • CEO and CFO must disclose to the Auditor and the Audit Committee – fraud – all deficiencies in internal control 16 Sarbanes-Oxley Act of 2002 Financial Statements and Disclosures • Each financial report is to be prepared in accordance with GAAP • Each periodic report must disclose all material off-balance sheet transactions and other relationships with unconsolidated entities • Issuer must disclose information on material changes in its financial condition or operations on a rapid and current basis 17 Sarbanes-Oxley Act of 2002 Other disclosures • Whether there is a Code of Ethics • Whether at least 1 audit committee member is a "financial expert" 18 Public accounting firms (Including foreign firms) must: • Register and agree to cooperate with the Public Accounting Oversight Board (PAOB) • Retain workpapers and reports for 7 years • Require a concurring partner review • Rotate the engagement and concurring reviewer every five years • Adopt quality control standards • Provide to audit committee copies of written correspondence with management 19 Public accounting firms (Including foreign firms) must: • Evaluate the internal control structure and procedures and describe in the audit report (or separate report) whether: – records accurately and fairly reflect transactions – transactions recorded in a timely manner to permit preparation of GAAP financial statements – material weaknesses exist – material noncompliance was found in testing 20 Public accounting firms Scope of services: Prohibited activities 1. Bookkeeping or other services related to the issuer's accounting records or financial statements 2. Financial information system design and implementation 3. Appraisal or valuation services, fairness opinions, or contribution-in-kind reports 4. Actuarial services 21 Public accounting firms Scope of services: Prohibited activities 5. Internal audit outsourcing services 6. Management functions or human resources 7. Broker-dealer, investment adviser, or investment banking services 8. Legal services and expert services unrelated to the audit 9. Any other services that the Board determines is impermissible 22 Public accounting firms Other non-audit services • The auditor would be in violation of the law is it performs a service not pre-approved by the audit committee (or within the de minimus exception) • Employment “cooling-off” period 23 GAO Auditor Independence Standard • U.S. General Accounting Office issued its Auditor Independence Standard on January 25, 2002 "establishing significant changes to the auditor independence requirements under Government Accounting Standards (the "Yellow Book.") 24 GAO Auditor Independence Standard Applicability • Applies to federal, state and local government • Applies to not-for-profit and for-profit recipients of federal grant and loan assistance (for example colleges, universities, trade schools, hospitals, charitable organizations, and many state-administered programs and contracts 25 GAO Auditor Independence Standard "Two Overarching Principles" • Auditors "should not provide nonaudit services that involve performing management functions or making management decisions" • Auditors "should not audit their own work or provide non-audit services in situations where the non-audit services are significant/material to the subject matter of the audits." 26 GAO Auditor Independence Standard "Routine" Activities Permitted • Auditors may participate in committees or task forces "in a purely advisory capacity to advise on issues related to the knowledge and skills of the auditors" • Auditors may provide "routine advice…to assist in activities such as establishing internal controls or implementing audit recommendations, can answer technical questions, and/or provide training." 27 GAO Auditor Independence Standard "Routine" Activities Permitted • Auditors may "provide tools and methodologies, such as best practice guides, benchmarking studies, and internal control assessment methodologies that can be used by management." 28 GAO Auditor Independence Standard Prohibited Activities • Accounting, bookkeeping and record-keeping • Recommending a single individual for a specific position or conducting an executive search or recruiting program • Operating or supervising IT system • Preparation of indirect cost proposal when prior year recovered costs exceeded $1M 29 GAO Auditor Independence Standard Personal Impairment • Auditor (& audit staff) should have no "personal impairments" such as • Relationships that might cause an auditor to limit inquiry or disclosure to weaken or slant audit findings • Preconceived ideas towards individuals, groups, organizations, or objectives of a particular program that could bias the audit • Financial interest that is direct, or is substantial though indirect, in the audited entity 30 Additional Potential Regulatory Attention to Not-for-Profits: The States New York State Attorney General Elliot Spitzer has proposed new "corporate accountability" laws that include not-for-profit organizatons "While some beneficial changes were instituted by the Sarbanes-Oxley Act, those protections….do not apply…to not-for-profit entities that have custody of billions of dollars of charitable funds." (March 12, 2003) 31 Additional Potential Regulatory Attention to Not-for-Profits: The States • Spitzer's proposals include • CEO/CFOs to sign the corporation's annual report • Requires Audit Committees • Requires Conflict of Interest Policies • Protects "whistleblowers" 32 Additional Potential Regulatory Attention to Not-for-Profits: The States • New York State Legislature is considering several bills, including one that requires an executive committee with three or more board members for entities with boards of more than 25 directors • While New York is in the forefront of considering new regulations for not-for-profit organizations, we can expect other states to follow 33 Additional Potential Regulatory Attention to Not-for-Profits: Agencies • Ratings agencies may adopt requirements for institutions with publicly traded debt • Accrediting and regulatory agencies may adopt requirements as part of their standards 34 BoardSource & Independent Sector • BoardSource (formerly the National Center for Nonprofit Boards) and Independent Sector have just issued a report with specific recommendations for action for not-for-profit organizations • "The passage of this bill should serve as a wake-up call to the entire nonprofit community. If nonprofit leaders do not ensure effective governance…, the government may step forward and regulate…" 35 BoardSource & Independent Sector Sample Recommendations Regarding Boards • Have an Audit Committee separate from the Finance Committee • Full board should review the annual audit and the Audit Committee's report and recommendations • At least one member of the Audit Committee should meet the criteria of financial expert • Orientation of board members should include financial literacy training 36 BoardSource & Independent Sector Sample Recommendations Regarding Auditors • Follow Sarbanes-Oxley on approval by Audit Committee of non-audit services by Auditor • Rotate the audit firm or "at least" the audit partner every five years Get a copy at www.independentsector.org 37 Alliance for Children & Families (with support from the Surdna Foundation) • Surveyed entire membership and conducted focus groups with 12 member agencies • Issued The Financial Reporting Practices of Nonprofits by Patricia Heinz 38 Alliance for Children & Families (with support from the Surdna Foundation) Selected Findings on Awareness: • "Alliance members are likely to have some knowledge of Sarbanes-Oxley, though much of it is limited in nature and often linked only to corporate scandals" • "Alliance member executives were more likely to have received their knowledge from the media or from their own board than from their accountants or auditors" 39 Alliance for Children & Families (with support from the Surdna Foundation) Selected Findings on Accountability: • "Executives and CFOs believe nonprofits are already held to a high standard of accountability and scrutiny by state regulators and IRS" • "Executives believe their auditors are already doing an excellent job of assessing internal controls and improving financial reporting" 40 Alliance for Children & Families (with support from the Surdna Foundation) Selected Findings on Governance: • "No consistent pattern of what board committee has responsibility for audit work oversight" • "Whatever committee is charged with audit oversight, it usually includes multiple individuals with expertise in finance, accounting or business • "The majority of agencies separate audit work from other services" 41 Implications for Not-for-Profit Governance The Opportunity for Improved Accountability • Recent events represent an opportunity for not-for-profit organizations to model best practices to improve transparency, trust, and accountability • In addition, your organization needs to have a good answer for your stakeholders when asked about your governance code and practices 42 Implications for Not-for-Profit Governance Best Practices: Board Responsibilities • The Board is accountable for financial reporting, controls, and assessment of business risk • The Board should have an Audit Committee with the exclusive function of monitoring those responsibilities • The Board, and especially the Audit Committee, should include one or more financial experts. 43 Implications for Not-for-Profit Governance Best Practices: Board Responsibilities • The Board should keep management compensation from becoming excessive • The Auditor works for the Board, not Management • The Board should ask tough questions of Management and the Auditor about the quality of financial information and assessment of business risks for the organization 44 Implications for Not-for-Profit Governance Best Practices: Board Responsibilities • The Board should take responsibility and assess the effectiveness of internal controls over financial reporting • Internal controls should provide reasonable assurance that – Transactions are properly authorized – Assets are safeguarded – Transactions are properly recorded and reported 45 Implications for Not-for-Profit Governance Best Practices: Board Responsibilities • The Board should adopt conflict of interest policies and a code of ethics that: – Preserves its own independence – Preserves the independence of its Auditor, including limiting and approving nonaudit services – Models good behavior for everyone • The Board should monitor compliance with regulations regarding advocacy and support of political activity 46 Implications for Not-for-Profit Governance Best Practices: Management Responsibilities • The CEO and CFO should review carefully, on a consistent basis, the organization's financial statements and inform the Board that the statements are complete and accurate • The CEO and CFO should establish and monitor effective systems of internal control • Any known deficiencies in financial reporting and internal control should be reported to the Board 47 Implications for Not-for-Profit Governance Best Practices: Auditor Responsibilities • Auditor should report to the Board its assessment of the organization's internal control structure and procedures • Auditor should report to the Board discussions with management of alternative accounting treatments 48 Implications for Not-for-Profit Governance Best Practices: Financial Reporting • Financial reporting should be based on "full disclosure," including significant interfund borrowing and off-balance sheet items 49 Implications for Not-for-Profit Governance Best Practices: Disclosure • The annual report, your website, and similar communication vehicles should be utilized to disclose financial and governance information • You should have a policy that identifies what information you will disclose and when, and the scope of information should be very broad 50 Executive Leadership Institute Questions, Answers, Discussion Larry Ladd larry.ladd@gt.com 617-848-4801