Nonprofits, Government Entities Wearing Their Own SOX

Four years after its enactment, the Sarbanes-Oxley (SOX) accounting reform law, designed primarily for public company reporting, is having major impact on the nonprofit sector and on state and local governments.

“Sarbanes-Oxley’s impact has been far broader than its supporters intended or envisioned,” James K. Gentry, a professor and former dean of the School of Journalism and Mass Communications at the University of Kansas, writes in a posting on the Web site. The impact has been especially pronounced on nonprofits.

His report notes that it is not unusual for nonprofits, particularly one with very large budgets, to be using “a number of practices that mirror those used by public companies,” including:

  • Establishing internal audit committees comprised of non-compensated members who are not part of the nonprofits’ management teams.
  • Having chief executive (CEO) and chief financial officers (CFOs) attest to the accuracy, completeness and fairness of financial statements, including Form 990 annual reports
  • Having the top officers attest to the organization’s internal controls.
  • Adopting and publishing codes of ethics and rules regarding transactions with insiders.

The impetus behind the voluntary adoption of SOX-like rules includes 2004 Senate hearing testimony by Internal Revenue Service (IRS) Commissioner Mark Everson, who warned of “abuses of charity" by corporations making donations that provide tax advantages. “If these abuses are left unchecked, there is the risk that Americans not only lose faith in and reduce support for charitable organizations, but that the integrity of our tax system will also be compromised,” Everson warned.

The hearings by the Senate Finance Committee resulted in recommendations that included: the IRS review of organizations’ tax-exempt status every five years; a move toward improving the scope and quality of Form 990 reports and toward greater transparency in nonprofits’ overall reporting.

It actually became apparent that SOX would impact nonprofits and government entities in early 2003 when the General Accountability Office (GAO), the investigative arm of Congress, set new SOX-like reporting rules for the "yellow book" audits of government entities and some federally funded non-government clients, which include a good number of nonprofits. Those rules, among other things, prohibit auditors working with those clients, from also performing management functions or making management decisions, and from providing non-audit services in which the amounts involved are "significant" or the work is "material to the audit."

More recently, states have stepped forward as “another driving force” in applying SOX-like rules to the nonprofit sector, according to Gentry. She notes that California has enacted a "Nonprofit Integrity Act" that requires nonprofits with budgets of more than $2 million to be audited by an independent auditor and to make the results available to the public.

Another recent issue has been government entities’ increasing presence on the SOX radar screen. Gentry says that some accounting firms have been warning government entities “that special interest groups and oversight agencies can be expected to take a closer look at their practices in the current environment,” and that some academic research indicates that “failure to adopt SOX-like oversight can be costly to taxpayers.” He cites a study by Justin Marlowe and David Matkin at the University of Kansas that found that the cost of issuing debt is higher for governmental units with internal control problems.

In an apparent advisory to all CPAs with government entity clients, Gentry says, “As research findings like these become widely known, how long will it be before taxpayer groups and other activists demand tighter review of local and state government?”

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