Nonprofits Without Audit Committees Risk Financial Disaster

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By, John R. Owen, III, Esq., Polito & Smock, P.C.

In the wake of Enron and other business scandals, the audit committee of a company's board of directors has resurfaced as a key tool for preventing fraud and ensuring sound financial management. But in the nonprofit world, the boards of many organizations operate without audit committees in the mistaken belief that charities do not need them.

Financial improprieties are not limited to for-profit enterprises. Nonprofit organizations have also had to weather recent headline-grabbing scandals, such as:

  • American Red Cross – The agency faced scalding publicity and a management crisis when it was accused of diverting funds that had been donated for victims of the 9/11 attacks.
  • United Way of the National Capital Area – The entire board of directors was replaced after allegations that the organization inflated fundraising figures and understated overhead costs, that it double-dipped on administrative fees and that its executives abused expense accounts.
  • Hale House –The Harlem charity acclaimed for its work with children of drug-addicted or imprisoned mothers suffered the misappropriation of more than $1,000,000, thanks in part to the creation of a phony board of directors.
  • Allegheny Health Education & Research Foundation (AHERF) – The organization's former CEO pleaded guilty to the misuse of charitable funds and AHERF itself declared bankruptcy.
  • San Diego Red Cross – Allegations of excessive compensation prompted the dismissal of the CEO and the entire board of directors.

A nonprofit organization, no less than a profit-making business, needs a strong and independent board of directors to prevent or detect financial mismanagement within the organization and, in extreme cases, stave off disaster. And the board of directors must have an audit committee to do its job properly.

Several factors make nonprofit organizations especially vulnerable to fraud:

  • An atmosphere of trust within the organization
  • A steady stream of cash donations
  • Reliance on volunteers to perform important tasks
  • Limited supervisory or investigative resources
  • Unpaid boards of directors with little or no financial expertise.

Some nonprofit boards mistakenly believe that an audit committee is unnecessary because the outside auditor will conduct the required financial supervision. But it is not the job of the outside auditor to detect mismanagement or fraud. Rather, the board of directors is responsible for supervising management, its financial reporting process and internal controls. The board must exercise its legal duties of care and loyalty, and must protect the organization's tax-exempt status. The audit committee is the board's main tool for carrying out these responsibilities of financial oversight, thereby protecting the nonprofit and avoiding liability for breach of fiduciary duty.

The role of the audit committee is to serve as the direct line of communication between the board and the outside auditor. The audit committee is also charged with oversight of management's performance with respect to its financial responsibilities and disclosure obligations. A board of directors with a diligent audit committee is much more likely than an unspecialized board to discover any financial irregularities before they can threaten the organization.

The most important function of the audit committee is to select the outside auditor. A mistake commonly made by nonprofits is to have management choose the auditor. The audit committee, acting without management interference, should select the auditor and ensure that the auditor can act without any conflict of interest. The audit committee must work closely with the auditor to monitor the nonprofit's financial condition. Audit committee members should freely consult with the auditor and should schedule formal updates with the auditor before the end of the nonprofit's fiscal year.

The audit committee also must ensure that the organization has an "open door" policy whereby employees are free to report suspected fraud to either upper-level management or the board of directors.

An audit committee should consist of independent directors with financial management expertise. Committee members should have some understanding of the audit process, but they may require additional training. It is especially important that audit committee members understand their role in carrying out the board's oversight responsibilities and the potential for director liability if they fail to do their job.

Until nonprofits become serious about devoting resources to preventing financial irregularities, we can expect to see continued misappropriation of charitable funds and resulting mistrust of nonprofits by the public. Nonprofits must regulate themselves effectively or the federal government may step in with legislation like the Sarbanes-Oxley Act, which imposed strict new requirements on the audit committees of public companies, or even with a new regulatory agency – an "SEC" for nonprofits.

There is little that a single nonprofit organization can do to stem the tide of regulation, but it can at least plan for its own survival. The best way for a nonprofit to ensure its long-term financial stability is for the board of directors to carry out its responsibility to keep the organization's financial house in order through a well-trained, knowledgeable audit committee.

John R. Owen, III, is a Shareholder of Polito & Smock, P.C., a law firm headquartered in Pittsburgh, who specializes in business, tax and tax-exempt organization law. He is Secretary and a Director of the Pennsylvania Association of Nonprofit Organizations. He can be reached at 412-394-3343 or [email protected]. Amy J. Herne, Esq., of Polito & Smock assisted in the preparation of this article.

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