Want to Avoid Fraud? Look to Your Board

While we would like to think that fraud doesn't happen as often in the nonprofit community as in the business community, it simply is not true.  I still remember the story of the national religious organization whose Treasurer walked off (for a period of time) with $2 million dollars.  While speaking to someone who knew the story I asked "How could that have happened?"  The response was that the Treasurer had buried the Board in paperwork, creating confusion and a subterfuge to mask her thievery.

In my own experience, I caught an attempt at fraud by an employee who had given her resignation.  She had lifted at least one check and might have cashed it had I not discovered the check was missing.  Could she have done major damage?  Not really, but it was a lesson for me to do better at checking potential employees' backgrounds.  Seems she had done the same thing on more than one occasion at her previous job.  The following article by Dr. Eugene Fram and Dr. Bruce Oliver provides excellent advice on what you need to do in order to protect your nonprofit against fraud.  Enjoy!  Bunnie

Want to Avoid Fraud? Look to Your Board:

Dr. Eugene Fram


Here’s a guide board members can use to keep fraud away from your door.
By Eugene H. Fram & Bruce L. Oliver

The board of the Association for Underprivileged Children is meeting in the aftermath of a dreadful situation. The police report summarizes what happened:

Over $50,000 designated for camping scholarships for the Association for Underprivileged Children has been stolen. The perpetrators are John Roe, the Association’s chief financial officer and his wife, Nancy, the camp director. The couple pilfered assets over a three year period. Nancy requested camp expenses, such as athletic equipment, for nonexistent campers. John then approved payment to a shell company operated by Nancy. Both are currently thought to be in South America. The organization doesn’t have fraud insurance. Funding for the current camping program is in jeopardy.



Dr. Bruce Oliver

 While the above scenario is fictional, it approximates an alarmingly common occurrence. One estimate, by Harvard University’s Houser Center for Nonprofit Organizations, suggests that fraud losses among U.S. nonprofits are approximately $40 billion a year.

How can nonprofits avoid such traumatic situations? The first step is to make certain that board members have the knowledge necessary to keep fraud at bay. Here are some suggestions for doing just that:

Be sure your board has the following committees:

(1) A finance committee charged with these tasks:

• Review the overall results of a yearly independent audit, conducted by an outside auditor.

• Oversee executive compensation, pension benefits, and other finance activities.

(2) A separate dedicated audit committee containing only independent board members. (Since nonprofit board members aren’t compensated by the organization, all directors are, by definition, independent. However, some directors may have strong social, family, or political links to management personnel. It’s prudent to exclude such people from serving on the audit committee.) The board members on this committee should be reasonably financially competent, with at least one having a strong finance background who is able to overview audit issues in detail. In particular, the committee should do the following:

• Conduct a yearly review of conflict-of-interest policies.
• Make certain that all employees and board members sign a conflict-of- interest statement.
• Assure that new hires are vetted for honesty.
• Meet every four to six months. (In times of organizational emergency or stress, meetings may be required more frequently.)
• Be sure that a certified audit is completed at least every two years – once a year if at all possible.

Hire an external auditing firm

In the past, it was common for managers to select the external auditing firm with “rubber stamp” approval by the board. In today’s more vigilant environment, the board must be more involved. Hiring an auditing firm should be a partnership effort between management and board. The task is as serious as hiring a CEO and should be given the same amount of time and care.

The board audit committee should review the following information when hiring the auditing firm:

• the nonprofit audit experience of those who will be performing the audit
• the history and client list of the auditing firm
• the proportion of the firm’s clients that are nonprofits
• the size of the firm and whether it has the ability to serve a new client well
• the estimated costs for each audit 
• the firm’s suggestion for a financial consulting firm if your organization needs such counseling. (It’s a conflict of interest for an auditing firm to do both auditing and financial consulting.)

Meet with external auditors

When your board’s audit committee meets with the external auditors, the organization’s CFO and other key financial personnel will be present. At some point in each meeting, however, board members need to meet with the auditors in executive session without the CFO, CEO, and other managers. At these private sessions, board members need to ask the auditors, “Do you have anything to tell the board without management present?” This gives auditors a chance to report any concerns that need board consideration, such as unusual travel, entertainment, or other expenses or any transactions that raise red flags. Audit committee members also have an opportunity to raise questions about the professional competence of the organization's internal financial personnel.

Some larger organizations may employ one or more internal auditors. The audit committee should meet with these people several times a year.

Unless specified in the audit agreement, fraud detection is a secondary purpose of the external audit. The main purpose is to assure that information in financial statements is a fair representation of financial activities. However, auditors can -- and often do -- uncover indications of fraud during a routine audit, and it’s their duty to report it.

Develop a conversation with external auditors

In the typical nonprofit, only one or two audit committee members will be able to formulate detailed technical questions for the external auditors. However, to help uncover fraud, every board member should be familiar with six audit- related topics and be able to pose questions about these six topics:

(1) Are internal controls adequate? The organization’s control system needs to be divided into operating functions. Then, each operating function must be performed by someone different so that each person checks the others’ work. For example, a sales associate completes a retail sale, but a sales audit person deposits the cash to the bank account. In addition, all financial people need to take scheduled vacations so that another employee is responsible for the vacationer’s work for at least two consecutive weeks a year. (In the fraud case that begins this article, the transactions between husband and wife shouldn’t have been allowed. At the very least, the transactions should have been reviewed in detail by a qualified independent third party. Proper internal controls would have brought the fraudulent situation to light.)

(2) Are financial records accurate? External auditors must certify that the following records are in proper form: financial statements, management contracts, sales of major assets, bonus payments, and long term lease agreements.

(3) Are activities and expenditures properly authorized? For example, have any extensive changes in plans been approved by the board? Have major expenses been properly budgeted? Have travel costs over a prescribed level been approved by a senior officer? Depending on the size of the organization, do all expenditures over a certain amount require two signatures from senior officers?

(4) Do all reported assets actually exist? This question is especially important to answer if the organization holds any physical assets at a distance from its main offices.

(5) Is the organization performing any activities that might endanger its tax-exempt status? Smaller nonprofits sometimes let licenses or even tax-exempt certificates lapse. It’s vital to certify that such documents are up to date and that taxable income and charitable donations are reported separately.

(6) Is the organization paying its payroll taxes, sales taxes, and license fees on time? Does the organization file its financial reports, like the IRS 990 report, on time? Many fraudulent cases involve failure to report and pay employee withholding taxes.

Trust but verify

Since fraud is such a pervasive cancer in the nonprofit environment, it needs intense board attention. Cases of nonprofit fraud undermine the good work of the organization and the nonprofit sector.

Every board member should know enough about finance to spot suspicious activity when it occurs. Everyone involved in the organization should be alerted to the fact that board members are giving serious attention to the fraud issue. That knowledge, in itself, may deter someone from trying to steal.

Prime Reading for Your Board

Be sure all board members have read the following Nonprofit World articles (available at www.snpo.org/members):

How to Have an Audit without Breaking the Bank (Vol. 20, No. 4)

New Internal Control Guidance (Vol. 28, No. 1)

Nonprofits without Audit Committees Risk Disaster (Vol. 22, No. 2)

Fraud: How to Prevent It in Your Organization (Vol. 26, No. 3)

Make Good Use of the Treasurer and Finance Committee (Vol. 27, No. 2)

Protecting Your Organization against Financial Misuse (Vol. 17, No. 4)

The Audit Committee: Why You Need one, How to Form One (Vol. 6, No. 6)

Setting Up a Control System for Your Organization (Vol. 16, No. 3)

New IRS Employment Tax Initiative: What Does It Mean for Nonprofits? (Vol. 28, No. 2)

Conflict of Interest in the Board Room (Vol. 17, No. 2)

How to Find the Perfect Auditor (Vol. 22, No. 3)


Dr. Eugene Fram (eugenefram@yahoo.com) is professor emeritus, E. Philip Saunders College of Business, Rochester Institute of Technology (RIT). He is the author of Policy vs. Paper Clips, which describes a nonprofit governance model that has been adopted by thousands of nonprofit organizations. Dr. Bruce Oliver (blobbu@rit.edu) is professor of accounting and director of the Saunders Institute for Business Ethics and Corporate Social Responsibility at RIT.

It's Never Good to Play With the Tax-Man

Nonprofits throughout the United States are in audit season, getting ready for their 990 filings in May. This time of year always reminds me of a nonprofit I interviewed with a few years ago.

Being the kind of due diligence gal that I am, before the interview I asked for three years of audited financial statements. Financial statements give you a good snapshot of the organization such as: where the revenue comes from; what programs cost; how much is spent on administration vs. program; are there problem areas or could there be belt tightening; etc. I hope there are no potential executive directors out there that would take a job without looking at the financials. Even if the organization is in financial difficulty, you need to know that so you can intelligently decide whether or not to take the position.

I didn’t get audited statements, instead I got Quickbooks Profit and Loss statements. A part of me thought maybe the board members didn’t understand what I was asking for and I could make it clear during the course of the interview.

The interview itself went swimmingly until we turned to the subject of finance. I again, politely requested three years of audited financials. At that point I was told by the board chair that the organization, that had been in existence for over fifteen years, had never had an audit conducted. I was a bit surprised and I think I said something like “You might want to consider having an audit done.” I mentioned that it didn’t necessarily have to be every year but perhaps at least every two or three years.

I brought up Sarbanes-Oxley, the law that had been passed after the Enron scandal that was supposed to bring transparency to a corporation’s financial operations. A result of that law is that nonprofits now have stricter standards that they have to meet, such as setting up audit committees and getting audits. I was summarily told that they didn’t believe Sarbanes-Oxley required audits, it just suggested audits.

Still curious as to why there was such resistance to having an audit, I said something like “Well what about your funders or potential grantmakers?” I was told that they had never had a problem since their large donors were businesses they dealt with regularly.

Realizing I was getting nowhere, I moved on to a line item that I had questions about. That item was a type of commission they had set up with equipment suppliers, in other words, when those suppliers sold equipment as a direct result of being present at their conference or through advertising in their newsletter, the organization would receive a modest commission on the sale.
The Treasurer then informed me that they preferred not to call them commissions, but rather donations as they didn’t want to have to pay Unrelated Business Income Taxes or UBIT.

I have no clue what expression must have swept across my face, I’m sure it was odd, since I immediately visualized my having to sign a 990 that had false information in it. I stopped asking questions about the financial statement and began wrapping up the interview with “Thank you so much for your time, it was great to meet you,” or something like that.

The next day I called and removed myself from the running. It wasn’t so much that their shady practices made me nervous as it was I sensed a complete unwillingness to clean up their behavior and a resistance to my advice.

Whatever you do nonprofits, don’t play fast and loose with the Internal Revenue Service, it ain’t a good idea. There are consequences that include loss of your exemption, heavy penalties and even jail for the person who signs the 990. In simple parlance, falsifying a tax return is fraud.

While audits can make some nervous, there's nothing like getting a clean management letter. You can proudly take that to funders and members as your report card that you are managing the organization with care and responsibility. I know that smaller organizations often don’t feel they have the money to be audited every year, but certainly should make sure they have the money to be audited every couple of years. It is also highly recommended that you set up an audit committee, even if it’s only three people, just to make sure that money is being accounted for correctly and that the organization’s finances are transparent.

Managing a nonprofit, whether as the chief officer or board member, requires ethical practices and stewardship. After all, people give their money charitably in the belief that their money will be well spent.

Bunnie

contact Bunnie at info@riedelcommunications.com